Buying pigs in a poke.

[Jim Nickerson]

poke: something offered in such a way as to obscure its real nature or worth *unwilling to buy a pig in a poke*

http://www.bloomberg.com/apps/news?pid=20601039&sid=a6iHo4wg_Kak&refer=home

Sovereign Funds Invest Where Buffett Won't: Michael R. Sesit

Commentary by Michael R. Sesit

Jan. 4 (Bloomberg) -- Sovereign wealth funds have been buying up stakes in troubled U.S. and European money-center banks, brokers and other financial institutions at such a rapid pace that you have to wonder: Do they know something other investors don't or are they just spending too much, too fast?



``We don't know why anyone would want some of these financial institutions, as their franchises aren't worth much; and they have big, complicated messes that won't be fun to try to unravel,'' Ray Dalio, Westport, Connecticut-based president of Bridgewater Associates Inc. with $150 billion under management, said in a late November report.

Many banks make money playing the gap in prices, or spreads, between different securities, currencies and interest rates. These strategies, however, can be replicated without banks' large, expensive overheads.

``We are all competing to create the most efficient portfolios to make our spreads over our cost of funds,'' Dalio said. ``Why would you want a bank as your platform, especially when the quality of portfolio managers working there are those who built the portfolios that yielded these results?''



The managements of these banks and brokers are nothing to cheer about. Just look at their losses. And by taking minority stakes, opting not to sit on boards and surrendering voting rights -- as they have in several instances -- the funds are betting on the same folks responsible for the red ink.

Bottom line: ``Owning a big American bank is a bit like owning a big American automobile company, or a big American newspaper, or, for that matter, the U.S. dollar,'' Dalio said. ``For all of them, the memory of what it was carries a certain cache that tends to make it trade for more than its real value in the modern world.''


Perhaps the most telling evidence that sovereign funds may be buying pigs in a poke is billionaire Warren Buffett's rebuff to U.S. financial institutions seeking cash infusions. ``So far, we have not seen a deal that causes me to start salivating,'' the chairman of Omaha, Nebraska-based Berkshire Hathaway Inc. said in a Dec. 26 interview on CNBC. Of course, Buffett isn't averse to all banks. Berkshire Hathaway is the biggest shareholder in Wells Fargo & Co. and the second-largest in M&T Bank Corp.


Unlike most private-sector fund managers, sovereign funds can also afford to be long-term investors. And being government entities, they aren't required to constantly mark their investments to market.
Even so, the stocks aren't cheap relative to the financial sector's long-term valuation multiples, Dalio said. What's more, Bridgewater says the full extent of bank losses isn't known. ``We also believe that the credit problems that lie beneath the surface are much larger and more threatening than the ones that have surfaced,'' the firm said in a Nov. 21 report.

When a crisis hits, it's almost reflexive for financial institutions to understate losses and postpone acknowledging them.

Nonetheless, ``2008 will likely present the best buying opportunity for high-quality financials in the last decade,'' Lehman Brothers Holdings Inc. said in a Dec. 7 report.

Three problems: One, figuring out which ones are high quality. Two, in July, Lehman was wrong when it said the worst of the global credit-market rout was over. Three, Dec. 7 isn't a very lucky date in American history.

[jk]

either the swf's are being foolish, dazzled by the brand names, or they are after something else- such as the political connections all these institutions have.

[WDCRob]

either the swf's are being foolish, dazzled by the brand names, or they are after something else- such as the political connections all these institutions have.

Perhaps they're looking for connections because they're foolishly dazzled by the brand name.

[Jim Nickerson]

That below is from John Mauldin's weekly letter free by email to subscribers. http://www.safehaven.com/article-9158.htm

To subscribe to John Mauldin's E-Letter please click here:
http://www.frontlinethoughts.com/subscribe.asp (http://www.frontlinethoughts.com/subscribe.asp)



Who's Got My Credit Default Swap Back?

My middle son is an online gamer, typically playing combat games with teams formed by players from around the world. To advance in the rankings, you have to work together. "I've got your back" is a frequently heard term in my house. If no one has your back in the gaming world, you can be pretty sure that the enemy will soon be there and you will be a statistic.

The "back" for the mortgage investment business seems to be particularly absent. As in the online gaming world, it could get ugly really quick. And a lot uglier than I thought just a few weeks ago.

In a brilliant article in the Wall Street Journal, Carrick Mollenkamp and Serena Ng detailed the rise and fall of a collateral debt obligation (CDO) called Norma, ushered into existence by Merrill Lynch. This is a $1.5 billion CDO created in March of 2007 with over 90% of its paper rating "A" or better, and $1.125 billion rated AAA. In November 2007, the entire CDO was downgraded to junk.

That is not particularly news, as there are a lot of subprime CDOs that are being downgraded. What caught my eye was how this CDO was created.
Quoting (and emphasis mine)[Mauldin's]:

"For Norma, [the manager] assembled $1.5 billion in investments. Most were not actual securities, but derivatives linked to triple-B-rated mortgage securities. Called credit default swaps, these derivatives worked like insurance policies on subprime residential mortgage-backed securities or on the CDOs that held them. Norma, acting as the insurer, would receive a regular premium payment, which it would pass on to its investors. The buyer protection, which was initially Merrill Lynch, would receive payouts from Norma if the insured securities were hurt by losses. It is unclear whether Merrill retained the insurance, or resold it to other investors who were hedging their subprime exposure or betting on a meltdown.

"Many investment banks favored CDOs that contain these credit default swaps, because they didn't require the purchase of securities, a process that typically took months. With credit default swaps, a billion-dollar CDO could be assembled in weeks.

"UBS Investment Research estimates that CEOs sold credit protection on around three times the actual face value off triple-B-rated subprime bonds. 'The use of derivatives "multiplied the risk," says Greg Medcraft, chairman of the American Securitization Forum, an industry association. 'The subprime mortgage crisis is far greater in terms of potential losses than anyone expected, because it's not just physical loans that are defaulting.'"

The article goes on to detail how the entire CDO world is one large daisy chain of credit default swaps. Who's got your back? And who's got the back of the guy who has your back? And .... you better hope it is not ACA.

Never heard of the company? You will. ACA has dropped 95%, from $16.55 to $0.86 today. Why? Because the company sold credit insurance on CDOs. "If now junk rated ACA can't come up with an additional $1.7 billion in capital by January 18, it will be insolvent and the $69 billion in credit default swaps on CDOs it underwrote will be worthless." (Shilling) $69 billion? That is huge. Think that won't hurt balance sheets all over the world?

Counterparty Risk is the Real Sleeper Issue

There is never just one cockroach. Write this down. Counterparty risk in the credit default swap market will be a huge story in 2008. Losses are going to mount far higher than estimates from just a few months ago. I believe that many financial institutions will be taking large losses every quarter for the next few quarters. At the end of each quarter, investors will hope that this is finally the end. "Surely this time they have gotten it all out in the open." It won't be, because banks can't write down loans until the counterparty risk problem is solved. Who's got your back?

Between more massive subprime-related losses, being forced to bring SIVs back onto their balance sheets, and deteriorating credit quality in other bank lines (like credit cards and auto loans, as well as commercial real estate), banks are going to be forced to raise capital and tighten lending standards. This is not something that is going to happen in one quarter. It may take the better part of the year for all of this to flush out of the system.

This tightening stance will also contribute to a slower than usual recovery. Even if the Fed cuts rates again and again, the banks still have to raise capital and become more prudent lenders. And that means the cost of borrowing is going up. [Underlined emphasis:JN]

What I continue to gather from all this is that nobody really knows how all this mess is going to end up.

[Jim Nickerson]

http://hussmanfunds.com/wmc/wmc080107.htm 1/8/07


On the mortgage front, it is important to reiterate that the swell in mortgage refinancings only began in October, and will continue well into 2009. Though Treasury yields have plunged, market lending rates such as LIBOR, commercial paper, BAA rates and so forth have been much stickier, so it is not at all clear that the rush to the safety of Treasuries (and the inevitable willingness of the Fed to align the Fed Funds rate lower in response) will result in meaningfully lower refinancing burdens. In the typical foreclosure event, there is first a burdensome reset, followed by several months of attempted payments, followed by several months of delinquency, and only then by foreclosure action. Given that the heavy resets only started in October, we are still about two or three quarters away from the really serious credit losses, foreclosures and writedowns.

To imagine that financial companies can simply “come clean” and “just put their cards on the table” assumes that lenders actually know which loans are facing default, and how many. But lenders are still months away from even finding that out. Meanwhile, publicly traded financials face a double-edged sword if they boost loan loss reserves too much in advance, because the SEC discourages it as a potential method of “managing” and misrepresenting ongoing earnings. Finally, with funding sources becoming more risk averse, my impression is that major banks will inevitably be forced to sharply cut their dividends in an attempt to maintain capital. This possibility is increasingly being discussed, but is not fully discounted as a fait accompli.
.
.
In short, if the potential negatives such as profit margin contraction and credit problems turn out to be only passing, minor events, then it might be true that the market has fully discounted them. We can certainly allow for that possibility, because we are not net short in any event. However, my impression is that the scope of these problems is likely to be much broader than anticipated at present, and that the combination of worsening outcomes and a growing consensus could result in substantially more weakness than we've observed thus far.

Emphasis JN

[c1ue]

Jim,

I'm still seeing if the old bank rule holds true: any declared losses in a debacle are 1/3 of the actual losses.

So whatever was declared in Q4 2007 should be 1/3 of the actual losses.

[Jim Nickerson]

Jim,

I'm still seeing if the old bank rule holds true: any declared losses in a debacle are 1/3 of the actual losses.

So whatever was declared in Q4 2007 should be 1/3 of the actual losses.

C1ue,

What I am gathering from all this is that whatever is the outcome, it is not right around the corner.

[c1ue]

Jim,

Actually, you may be surprised in that assumption.

The only thing holding the cat in the bag thus far is the hope that interest rate cuts will revive the go go era; in a month or two it may become clear that this is not going to happen.

Should this occur, I foresee the first of the bank auctions (not REO auctions, auctions of a bank itself) as those most in the hole desperately try to recapitalize.

From what I can see, the real estate implosion is actually happening even faster than us perma-bears thought - and this bodes ill for the holders of the real estate derivatives.

I don't know if this is what prompted the iTulip sell order though...

[Jim Nickerson]

Marc Faber on Bloomberg

http://www.bloomberg.com/avp/avp.htm?clipSRC=mms://media2.bloomberg.com/cache/vw1GsscBsGL0.asf

Besides continuing to browbeat Greasespam, Faber thinks a good place to be for 3-6 months will be the Bonar. He opines there will be no decoupling of US and world markets, especially financial markets. Thinks commodities and PM will correct soon.

[Jim Nickerson]

http://www.safehaven.com/article-9175.htm

Words from the Wise for the Week That Was (Dec 31, 2007 - Jan 6, 2008)
by Prieur du Plessis

I am not done reading this article, but it seems to be a good review of what has happened and what may happen.

Marc Faber is quoted:

I have never experienced a bull market in equities without the participation of financial stocks. In addition, when financial stocks across the board collapse it is a very negative sign for the overall health of the stock market.
The fact that a stock has declined from the peak by 50% or even 90% does not make it necessarily inexpensive. In 1985, I recommended the purchase of a basket of Texas banks, which at the time had declined by 95% from the peak, as a contrarian play. Subsequently, they all went bankrupt.
As I have explained before, the financial sector has become disproportionally large over the last 15 years or so. Therefore, I would also expect the reversion to the mean of the financial sector to take several years and not to be completed in just six months! In short, I would avoid purchasing financial stocks for now and would also defer new commitments to equities.Emphasis JN

I keep putting stuff in this thread that supports the notion that the credit debacle is not going to be something that quickly dissapates. And though C1ue suggested I might be surprised that things happen more quickly, I don't think I shall be surprised at anything that happens either soon or much later.

It is my opinion that Americans, and everyone else who plays in the US stock market, have become very accustomed to the markets always bouncing back after these less than 10% corrections, and at some point that mild market behavior will end.

[Jim Nickerson]

Alan Abelson's opinion in Barron's 1/14/08 http://online.barrons.com/article/SB120009605682085107.html?mod=9_0031_b_this_weeks_ magazine_columns Susbscription.


The betting among Street savants is that before Ben's good right arm gets sore from swinging that old machete he'll have sliced rates from 4.25%, where they now rest, to less than 3%. Just the kind of stuff the market loves to hear.

So no doubt Mr. Bernanke went home happy Thursday night, only to have the rug pulled out from under him on Friday, when those fickle investors took it all back and stocks tanked across the board. So what happened to turn sentiment from roused to roiled?

Possibly, a little reflection (which is about all most Street denizens indulge in) revealed that the Fed's whacks out of rates last year provided a quick lift to stock prices, followed by renewed queasiness. It may have been enough, in this instance, to raise doubts anew as to just how much wallop the Fed still packs in the rate-making arena (put us down as believing "not very much").

And it hardly helped sustain the uptick in investor mood when the New York Times reported that Merrill Lynch (http://online.barrons.com/public/quotes/main.html?type=djn&symbol=mer) stands to take a tidy $15 billion write-down, nearly twice the original official reckoning, and a heap more than even the Street's upwardly revised estimates have anticipated. If nothing else, it's a painful reminder that the great credit squeeze, easily the most malign and encompassing one since the Depression, is still very much with us.

The hard truth is, as the Merrill disclosure and the shotgun wedding of Bank of America (http://online.barrons.com/public/quotes/main.html?type=djn&symbol=bac) and the putatively bankrupt Countrywide Financial (http://online.barrons.com/public/quotes/main.html?type=djn&symbol=cfc) furnish lugubrious evidence, the hemorrhaging among lenders of virtually every description and everywhere is far from stanched. Something on the order of $100 billion in write-downs have been grudgingly owned up to by the red-faced banks, and it'll likely be years and another $200-$300 billon before the dreary process sighs to an end.

It's a running, virulent wound, and the fragile financial system and the economy are destined to continue to suffer from it for a long, long while. And despite seizures of vertigo -- Friday's plunge is only the most recent -- the stock market, we fear, has yet to face up to the full measure of the damage being wrought and to be wrought.

The big washout we alluded to a few weeks back has still to come and remains a necessary prelude to any semblance of stability in the equity market.


What is intriguing to me, as I am sure it is to everyone who is not in the throes of death, is how big this debt-monster will end up being? How big was Godzilla?

[Jim Nickerson]

Here's another assessment, thanks to WDCRob on another thread. http://www.washingtonpost.com/wp-dyn/content/article/2008/01/11/AR2008011103959.html

"I almost feel like we're in the first innings of a bear market," said Jim Herrick, director of equity trading at Robert W. Baird. "It's really hard to see the light at the end of the tunnel."

and


Joe Brusuelas, chief economist at the research firm IdeaGlobal, said the magnitude of these losses may be staggering.

"We haven't even scratched the surface of what the losses will be," Brusuelas said. "I don't think we're anywhere near the end. Rather, we're still at the beginning of this."



Of course, I don't know if these guys know their elbows from their noses.

[Jim Nickerson]

http://www.safehaven.com/article-9261.htm 1/18/08



Credit Default Swaps: The Continuing Crisis
As noted above, I said three weeks ago that the big story for 2008 would be the counter-party risk for credit default swaps. That story is coming faster and larger than I thought. Bill Gross of Pimco suggests that the ultimate cost could be another $250 billion dollars on top of the $250-plus billion in subprime losses. That means we have only seen the tip of the iceberg in write-offs in the financial sector.

The real problem is the "monoline insurers" like ACA, Ambac, and MBIA. Here's a quick primer on how they work. Let's say you are a small municipality and want to borrow $10,000,000 for a bond offering to build a road or a water treatment plant. If you went to the market with your credit rating, it would be a low rating and the cost of the money would be high. But if you get one of the seven monoline insurers to guarantee your bond, then you get whatever their credit rating is. The fees for such insurance are lower than the savings you get on the bond, so everyone wins.

But over the years, most of the monocline insurers went from boring municipal bonds and jumped into the mortgage-backed security markets, selling credit default swaps that significantly juiced up their earnings. But it also added a lot of risk that they clearly, in hindsight, did not understand.

ACA has already seen its rating go from A to CCC, which is basically junk. This puts it out of business, as no one will pay to be rated as junk. ACA now has only $425 million in capital to cover the $69 billion in mortgage and corporate bonds they insure. Interestingly, they added $20 billion of that between April and September of last year. Talk about doubling down on a losing trade. Merrill wrote down almost $2 billion in bonds that were insured by ACA. They will not be alone.

Today, Fitch downgraded Ambac Financial Group two notches from AAA to AA. That doesn't seem like a lot, until you realize that 74% of their revenue comes from that AAA rating that covers $556 billion in municipal and structured finance debt. Fitch did so because Ambac decided not to do an equity offering for $1 billion to stem the bleeding. Six months ago Ambac was at $96 or thereabouts. Today it is as $6.20. Its market cap is only $629 million, so a $1 billion offering would dilute current shareholders by around 70%. Ouch. And you can bet any offering they do now will be on terms that shareholders will not like, most likely a convertible offering that dilutes current shareholders even more.

Oh, and that means that 137,990 municipalities that were insured by Ambac will see their credit ratings drop and their costs rise. Think their customers will hang around?

Moody's says it is going to review MBIA. MBIA, which is rated AAA, raised $1 billion last week from Warburg Pincus and did another offering for surplus notes for $1 billion at 14%. As Michael Lewitt noted, that means 14% is the new price for AAA bonds. Except that today it is 23%. If you bought that note, you are not looking good right now. They are trading at 70 cents on the dollar. Of course, that is better than Ambac's 30-year bonds, which are trading at 35 cents on the dollar.

When Warren Buffett bought Gen Re, the large re-insurer, five years ago, he presciently made the decision to reduce their exposure to credit default swaps. It took them four years to reduce the number of contracts from 23,218 to just 197 at the end of 2006.

"We lost over $400 million on contracts that were supposedly 'safe and properly priced' and we did it in a leisurely way in a benign market," says Mr. Buffett. "If we had to unwind it today in one month, who knows what would have happened?" (The Wall Street Journal)

If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss. Quoting from a recent note from Michael Lewitt:

"MBIA's total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (CDOs that own other CDOs, or mortgages piled on top of mortgages, or, to quote Jeff Goldblum's character in Jurassic Park again, 'a big pile of s&*^'). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA's stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share.

"The bond insurers' business model is irreparably broken. In HCM's view, it will be all but impossible for these companies to raise capital at economic levels for the foreseeable future and certainly in enough time to work out of their current difficulties. The performance of MBIA's 14 percent bond issue will prove to have been the death knell for this business. The market needs to come to the realization that the so-called insurance that these companies were offering is not going to be there if it is needed. The fact that these companies were rated AAA in the first place will remain one of the great puzzles of modern finance for years to come."

You can bet that the $8 billion in CDO-squareds is gone. It is a matter of time. MBIA's market cap is about $1 billion. Current shareholders will be lucky if they only get diluted 75%.

Watch Warren Buffett swoop in and take that boring old municipal bond insurance business. Watch a few large hedge funds buy the remains of the monoline carriers to get their staff and experience (especially the municipal sales teams), and launch new companies with pristine credit.

If you have Ambac or MBIA insurance, as a bank you have not yet written down any debt they insured. They are still rated AAA. But that re-rating is coming. And what about the monster CDS business in the hedge fund world? Who wins and loses? There will be huge winners, and there will be total wipe-outs. There are going to be more losses in the biggest banks, and even bigger investments by Sovereign Wealth Funds. Count on it. This is a story we will return to time and time again.
Emphasis JN