Saving AMBAC, the Homeowners, or the Banks?

AMBAC had a long term business as insurers for state and municipal government bonds, which is apparently a lucrative and stable business even today. Indeed this is the part of the business Warren Buffett would like to take over. Its also the part of the business that Elliott Spitzer, governor of NY State, characterized as unnecessary extortion.

What IS a problem is that AMBAC and other monolines insured groups of bonds that were NOT local government bonds, but rather were these Collateralized Debt Obligations (CDOs) that were bundles of mortgages that were apparently misrated at high levels like AAA that did not adequately reflect their risk. That risk factor is now coming home to roost with a vengance, as large numbers of mortgagees start to default (estimate is now in the ten percent range). Its a mixed problem of poor credit lending criteria AND falling home values. Why pay a loan on an asset that is now worth much less than what is owed?

In order to get those AAA ratings, the banks contracted with AMBAC to insure them in the event of default, which is happening now. On a default, AMBAC is obliged to pay the principal and interest to the bondholders. What do you think would be happening if the bondholders were you all, the general public?

The government folks do not wish AMBAC to lose their own high credit ratings, because if this happens it will impact the municipal and state bond market negatively. Since most agree that so far defaults in this part of the business are no problem, and the business itself is healthy enough for hard-nosed capitalists like Warren Buffett to covet it and indeed offer to take it as it is, we probably can remove that concern from the table for the time being.

By the way, why don't the States and their associated municipalities just self-insure? Why isn't this covered by something similar to FDIC, but for states? The flaw in the current scheme is obvious. In the event of a black swan failure no small private corporation can possibly cover something as large as a state government in default. Some of the US states are like not-so-small countries. Its insurance that is only good when it isn't needed. Hence the 'extortion' definition by Spitzer.

It seems that the real heart of the problem is that AMBAC was being used as a "cover" by the banks which originated these bundles of mortgages to get their mispriced ratings. Now that the mortgages are failing and the banks are stuck with them, AMBAC cannot possibly pay, they cannot cover the debt. And the banks don't wish to mark these CDOs to market because they are probably at best worth 60 cents on the dollar, but are being held by the banks on balance at roughly par. That's a 40 percent haircut on enough debt to sink every bank involved in this situation (see list below). Indeed for all intents and purposes if marked to market these banks are now insolvent.

So, the banks will provide capital to AMBAC, which they will use to pay the principal and interest on the CDOs which is presumably much less than 40 percent and can be paid out over time BACK TO THE BANKS. Or, the banks can just rip up the insurance and let AMBAC off the hook for a piece of the company.

Does anyone else see the problem with this? What about the failing CDOs that are the core of the problem? Forget the insurance, because unless an uninvolved entity picks up the tab (Joe Q Public and the foreign government Sovereign Wealth Funds, etc.) its just a game of passing money around.

This bad debt will be covered by printing money, period. Its merely a question of who takes the hit for it in wealth erosion, and to what degree.

So why are the banks engaging in this charade? This looks like an attempt to extend the payouts on a vast Ponzi scheme gone bad that is starting to collapse, with no fresh capital being put in by the sucker. The banks have been caught with their pants down, and a UK style bailout such as we saw in Northern Rock is not palatable to the American Public, particularly in an election year. It would also catch the shareholders and management of the banks in a bad way.

And that's the real heart of this. Its to help the owners and shareholders of the banks. Pure and simple. It does not fix the problem. It gives them time to lay off their exposure to 'someone else.' The Treasury and the Fed (they are owned by these same banks as you may recall) support this because it gives them time to try and work out the real fix, by essentially printing money, but at a more gradual rate so as to not break the buck or the bond.

At the end of the day this is a Ponzi scheme that has failed. Our objection to the solutions as proposed is that while it does create a good by not triggering a destructive systemic failure in our financial system, it is being done in very opaque fashion which is permitting the same people who caused the problem to extricate themselves from the negative fallout, and not only shift it to the public, but to further enrich themselves by using their knowledge of the situation to make further profits through speculation in the equity, currency and bonds markets.

And to make matters MUCH worse, there is little doubt that having done this now several times, unless the situation changes the banks will invent a new scheme, and take us back to the same place again. From LTCM, to Enron, to the IPO bubble, to the Housing Bubble. Settlements and wristslaps do not work.

The only way to resolve this is that any government intervention to save 'homeowners' from foreclosure must:

1. Glass-Steagall restrictions on ALL banks doing business in the US including multinationals.


2. A significant set of Congressional hearings and the appointment of a special prosecutor assigned to investigate, with FBI support, the pervasive frauds in the US financial industry from Enron to Subprime.


3. A return to the concept of regional and local banks through a reinstatement of laws limiting bank ownership across state lines


4. A national usury ceiling for all interest rates and fees on all debt, both revolving and non-revolving, to prevent banks from perpetuating predatory interest rate schemes based individual state laws.

And a modest proposal from Bank of America from Tanta at CalculatedRisk: The Bank of America Bailout

"A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government — now that it is in trouble.

The proposal warns that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes.

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates."

And the news item from Marketwatch referenced above:

Banks may recapitalize Ambac to save AAA rating
Capital boost from counterparties may be simpler than splitting bond insurer
By Alistair Barr, MarketWatch
Last update: 6:43 p.m. EST Feb. 22, 2008

SAN FRANCISCO (MarketWatch) -- A group of eight banks that are major counterparties to Ambac Financial Group may recapitalize the struggling bond insurer in a bid to save its crucial AAA rating, two people familiar with the situation said Friday. The negotiations have progressed in recent days, the people said, on condition of anonymity.

The plan could be unveiled Monday or Tuesday, according to one of the people. But the other person said no firm timetable has been set. Both also noted the plan isn't a done deal.

Barclays PLC, BNP Paribas, Citigroup Inc., Royal Bank of Scotland Group, Societe Generale, UBS AG, Wachovia Corp., and Dresdner Bank, are the banks involved in the talks, the two people said. The group recently hired boutique bank Greenhill & Co. to help with the negotiations.

"We have a lot of alternatives. A capital raise has always been an option to stabilize the rating," said Vandana Sharma, a spokeswoman for Ambac in an interview. "We're trying to do the best by all constituents, including policy-holders, shareholders and counterparties." Sharma declined to comment on specific plans.

Bond insurers agree to pay interest and principal on debt in a timely manner in the event of default. The $2.4 trillion business relies on AAA ratings to win new business. But those top ratings are in jeopardy now because of concerns insurers like Ambac and MBIA will have to pay big claims from guarantees they sold on complex mortgage-related securities known as collateralized debt obligations (CDOs).

If the situation gets bad enough, regulators including New York State Insurance Superintendent Eric Dinallo are considering splitting bond insurers in two. That would separate their steady muni bond businesses from the more troubled structured finance units, which are being pummeled by CDO exposures.

Indeed, FGIC, a big rival of Ambac and MBIA, submitted a plan with some of those attributes last week. However, splitting up bond insurers would be difficult, pitting policyholders against shareholders of the bond insurer holding companies. "The lawyers have already begun gearing up on that one," said Josh Rosner, a managing director at research firm Graham Fisher & Co.

Injecting capital

So Dinallo and others have also been working on other solutions that focus on attracting more capital into the industry. As part of that strategy, the New York regulator has been trying to persuade big banks that are counterparties to the industry to help boost bond insurers' capital.

Many banks have tried to hedge CDO exposures by buying guarantees from bond insurers in the form of credit default swaps (CDS), a type of derivative. If lots of bond insurers are downgraded or if some collapse, these banks may suffer more write-downs because these CDS contracts will be worth less. See full story.

One proposal involves banks injecting roughly $5 billion of capital into specific bond insurers and also providing a $10 billion line of credit.

Another idea involves commuting, or effectively tearing up, CDS contracts between banks and bond insurers. In return for dropping their claims, the banks would get a preferred equity stake in the bond insurer.

"Putting capital into an insurer is more of a contract issue between the companies involved, rather than a regulatory issue," said James Gkonos, vice chairman of the Insurance Practice Group at law firm Saul Ewing. "That would be the simplest and most efficient way to do this."

A forced splitting up of a bond insurer by a regulator such as the New York State Insurance Department would be an "extreme scenario" that would involve public hearings and litigation and take a long time to complete, he explained.

Still, any re-capitalization of Ambac by bank counterparties would present its own problems too, because it could dilute existing investors in the company.

Such a plan would also use up capital that banks may need to help them through other problems thrown up by the global credit crunch.

"Sometimes there are problems that just can't be solved," Rosner said. "At some point, the market is going to realize that there is not always a best solution. There is often just a least worse solution."

Alistair Barr is a reporter for MarketWatch in San Francisco.

Are Commodities in a Bubble?

Are the commodity markets in a pricing bubble? Many people's judgement tells them that they are, as they look at the short term price movements of certain commodities like gold, wheat, copper.

Granted, they might think that the weak dollar is just making the problem a little worse with a monetary inflation if they are multidisciplinary thinkers. But as you probably know by now, we think that judgement is good, as long as it is informed by solid data. Let's take a look at a few of the commodity charts. As always, you may click on any of the pictures or charts to see a larger version.

Sure looks like an impressive growth in price, and a potential bubble. How much of that might be attributed to the fact that the CRB is priced in dollars?














Here is the CRB Index deflated by Euros. That casts a little bit different light on things. It looks as though commodities are rebounding from a low period and going back to retest some prior highs. Historically, just how high WERE those highs?

Here is a long term chart of the CRB Index deflated by Euros. With this perspective it seems clear that the prior high was just a test of the upper bound of a longer term trendline that shows a gradual rise in the price of commodities that clearly is NOT a bubble. Just looking at this chart, we must conclude that the trend will continue, which implies higher priced commodities in terms of the dollar, until it is broken.

Trading for the Short Term

One of the best brief descriptions of how to trade for the short term is in this video describing the trading action from Friday at one of our favorite sites, Alphatrends. You can view it here: Alphatrends Blogspot for Friday February 22.

Of course we don't always agree with Brian Shannon's interpretations of the short term chart patterns, but we usually do and always find them useful, and listen with great attention and respect. We find his overall approach, and his coaching remarks in passing, to be very appropriate in particular, and his style is our style for short term trades. No matter how good you think you are, traders are fighting a constant battle in adapting to changing markets and new experience, and the creeping bad habits that can develop into major trading slumps.

Enjoy listening to Brian, and always remember that, once you get past the basics, trading is 90% self discipline and a willingness to subject your ego to learn from the discipline of the markets. Please keep in mind that short term trading, intermediate trading, and investing are very different disciplines, despite their similarities, and each demands its own approach and techniques.

The Great Crash of 1929 - A Walk Down Memory Lane

It is difficult to obtain a copy of the best documentary which we have ever seen about the stock market crash of 1929. It was written by the award winning screenwriter Ronald Blumer, and produced by Middlemarch Films for WGBH Boston, and shown on the excellent PBS history series American Experience Its title is The Great Crash of 1929.

The last time we checked you could not buy a copy from PBS, and it's rarely shown on television, perhaps due to a lack of corporate sponsorship (lol). This might have changed but we doubt it. If it is ever shown again on PBS try to DVR or Tivo it, since it is exceptionally well made, informative, entertaining, and contains many insights into the people and the period that you rarely get to see anywhere else, especially in dry economic analysis. It captures the spirit of the time, the zeitgeist.

The documentary contains a significant amount of original photos, film footage, and personal commentary, arranged in the style that Ken Burns has perfected to bring to life so many other historic documentaries. There is a web site for it from PBS which you can visit by clicking here: The Great Crash of 1929. There is a transcript for portions of the film, and they make interesting reading if you cannot see the actual film.

We first saw this video when we were doing work in Silicon valley. An acquaintance at a high tech IPO gave us a VHS copy to watch, just prior to the Nasdaq Bubble bust of 2000. It inspired us to investigate many of the written sources cited in the film, including Sobel, Galbraith and Klingaman, and greatly enriched our understanding of this little understood period of American history. It also persuaded us to sell all of our stocks that represented much of our life's savings, a few months before their prices plummeted about 90%. It made a deep impression on us after that. It might make a similar impression on you now as well.

As George Santayana said, "Those who cannot learn from history are doomed to repeat it."

NARRATOR: Everything was not fine in 1929 with the American economy. It was showing ominous signs of trouble. Steel production was declining. The construction industry was sluggish. Car sales dropped. Customers were getting harder to find. And because of easy credit, many people were deeply in debt. Large sections of the population were poor and getting poorer.

Just as Wall Street had reflected a steady growth in the economy throughout most of the 20s, it would seem that now the market should reflect the economic slowdown. Instead, it soared to record heights. Stock prices no longer had anything to do with company profits, the economy or anything else. The speculative boom had acquired a momentum of its own.

NARRATOR: Wealthy investors would pool their money in a secret agreement to buy a stock, inflate its price and then sell it to an unsuspecting public...

Mr. ROBERT SOBEL (Historian): I would say that practically all the
financial journals were on the take. This includes reporters for The Wall Street Journal, The New York Times, The Herald-Tribune, you name it. So if you were a pool operator, you'd call your friend at The Times and say, "Look, Charlie, there's an envelope waiting for you here and we think that perhaps you should write something nice about RCA." And Charlie would write something nice about RCA.
A publicity man called A. Newton Plummer had cancelled checks from practically every major journalist in New York City.

Mr. NESBITT: Then, they would begin to -- what was called "painting the tape" and they would make the stock look exciting. They would trade among themselves and you'd see these big prints on RCA and people will say, "Oh, it looks as though that stock is being accumulated."

Mr. SOBEL: Now, if they are behind it, you want to join them, so you go out and you buy stock also. Now, what's happening is the stock goes from 10 to 15 to 20 and now, it's at 20 and you start buying, other people start buying at 30, 40. The original group, the pool, they've stopped buying. They're selling you the stock. It's now 50 and they're out of it. And what happens, of course, is the stock collapses." [and on a large enough scale, the stock market, and the regional or national economy].

We came to the conclusion back in 1999 that stock market crashes are by and large the end result of reckless credit expansion, lax regulation, and widespread corruption of the society by a like-minded group of individuals who turn society on its head for their own selfish and personal benefit. They don't need to have a plan, they don't even need to communicate. Its simply what they do, like musicians play music, and bakers bake, and painters paint. They are financial predators.

Of course there are willing fools and greedy individuals up and down the food chain. One only has to look at the current mortgage crisis to see how that happens. They do not intend it to end in ruin, but it seems that the leaders, the primary movers, always take it just one step too far, and lose control, and then step aside.

Its not because they need the money. Its a pathology, a will to power, a need to be in control. They have great holes in their being, and they try to fill them with the most money, the most power, the most of everything. They feel the overwhelming need to be .... different, better, than everyone else. They join exclusive clubs, send their children to exclusive schools, drive exclusive cars, and do exclusive things to... exclude "the lesser men" whom they might view as potential servants, or useless eaters. And if they cannot excel by writing a great book, or performing great music, well, they can try to stand out by destroying and humbling everyone else by subverting the public good and the law.

We don't know why it is, but they always seem to cheat: in school, in business, in marriage. They think the laws are not for them, and relish breaking them, while using them to subvert the little people. And they always seem to have a father or mother they despise because they made them feel unworthy. In a way, for them its all just game, because being sociopaths they cannot feel the misery that they cause. They can feel very little actually, and are generally incapable of normal human love and friendship. So they try to feel something through excess and indulgence in drugs, dress, drink, cars, fads, marriages, houses. Incapable of a mature loving relationship, they oscillate between immature romance and impersonal sex. They are driven, and once you get past the public face, they are pathetic, rarely at peace, and often downright scary.

In 2005 we forecast that 2000-2 was a preview, and that they would do it all over again, and this time the country would not be getting up from it intact for many, many years. We think we're well on our way. May God have mercy on us.