Wall Street Blues!

Three articles published in the past few days observe the investing and money lending landscape with a keen eye on the economic realities of people. From Microsoft Money, Bloomberg Financial Services, and The Guardian respectively: 

The next banking crisis on the way

Write-downs for high-risk, high-yield corporate debt, known as ‘junk,’ could dwarf losses in the mortgage mess. And

that’s when this financial crisis will finally hit bottom.

Is this the quarter when banks finally admit all of their problems?

On Jan. 15, Citigroup announced it would take an $18.1 billion write-down on its portfolio of subprime mortgages

and other risky debt, and the bank cut its dividend 41%.

With other banks following suit — Merrill Lynch  reported $16 billion in write-downs and other

charges two days later, and Wells Fargo  delivered similarly huge losses — will they throw everything, including

the kitchen sink, into their losses? That kind of quarter always marks the bottom in a crisis like this.

Nah. The banks and other financials have more losses from the subprime-mortgage mess on their books that they

haven’t yet confessed. Worse, the mortgage debacle has spread to other types of debt, with banks and other

financial companies reporting mounting losses in their credit card and auto loan portfolios. And worst of all, the

next big leg of the crisis — the one I think will mark the true bottom — has just started.

As the economy slows, the default rate is rising for corporate debt, especially for the high-risk, high-yield

corporate debt called “junk” by many of us. That’s opening a Pandora’s box of potential write-downs that could

dwarf the losses in the mortgage market.

If that’s true, it would push off the kitchen-sink bottom until the second or third quarter of 2008, depending on

how bad the economy gets and how long it stays in the dumps. 
It’s not surprising that it will take so long to work through this mess, if you remember how it all began. The

current crisis is yet another in a string of financial bubbles — the tech bubble that burst in 2000, the housing

bubble that burst in 2007 and the debt-market bubble that’s bursting now. Behind each bubble stands a global flood

of cheap money created by:

Central banks running their printing presses to fend off economic slowdowns or financial-market crashes.

A weak yen that let traders and speculators borrow for almost nothing in Japan in order to buy stocks and bonds in

other markets.

A huge surge of exports from countries such as China determined to hold down domestic consumption.

Soaring oil prices that gave oil producers billions of dollars to invest somewhere.
All of those dollars chased a limited supply of real assets and traditional stocks and bonds, bringing down returns

just as a falling dollar and signs of inflation lowered real returns more. Everyone wanted something as safe as

U.S. Treasurys that paid more than Treasurys.

Wall Street obliged by packaging and then slicing debt backed by mortgages, so that even the riskiest mortgages

could earn a safe AA or AAA rating from Standard & Poor’s, Moody’s  or Fitch. It performed the same magic with

credit card debt, with auto loans and finally with corporate debt — even the riskiest kind, called high-yield

because it pays out a higher dividend to compensate for its higher risk. It’s known as junk because in hard

economic times it can become worthless.

Everyone wanted to believe that Wall Street’s magic worked. Investors from Citigroup to the Hillsborough County

Public Schools in Florida (exposure: $573 million) bought in. The more investors who bought in, the more of these

new products Wall Street could sell and the more money it was willing to lend to home builders, home mortgage

lenders and credit card companies; to the savings and loans and banks that created the raw materials (mortgages,

credit card debt, auto loans) that Wall Street needed to manufacture its products; and to the hedge funds and

structured investment vehicles that bought what Wall Street produced.

It worked out just fine until reality stuck a pin in the bubble. It turns out that you can’t lend more and more

money to less- and less-qualified home buyers without driving up the number of borrowers who pay late or can’t pay

at all.

JPMorgan Chase reserved $2.3 billion against rising loan losses in the fourth quarter. That looks good compared

with an $18 billion write-down at Citigroup. Now, MSN Money’s Jim Jubak says, the buzz is that JPMorgan could buy

Washington Mutual. But is that a good idea?

On Jan. 9, Countrywide Financial reported that the foreclosure rate on its 9 million mortgages had climbed to 1.44%

in December, double the 0.7% rate of December 2006. The delinquency rate had climbed to 7.2% of unpaid balances, up

from 4.6% in December 2006. The rates were the highest ever for Countrywide, which entered the mortgage business in


Within a week, as bankruptcy rumors swirled around Countrywide, Bank of America agreed to acquire the company for

$4 billion.

Damage goes beyond mortgages

But the cause of this mess stretched far beyond any problems specific to the mortgage sector, so the damage wasn’t

limited to that part of the debt markets. On Jan. 10, for example, American Express (AXP, news, msgs) announced

that credit card debt at least 30 days past due had climbed to 3.2% of its portfolio from 2.9% in the third

quarter, and write-offs of bad debt had climbed to 4.3% from 3.7% in the same period. In 2008, American Express

expects write-offs to average 5.1% to 5.3%.

How about auto loans? On Jan. 15, Sovereign Banc said it would take $1.6 billion in charges for the fourth quarter

of 2007, including a $600 million write-down on consumer and auto loans. The company had aggressively expanded its

auto loan business in Arizona, California, Florida, Georgia and Nevada in 2006 and 2007 — just in time to get hit

by the cooling of the hot real-estate market in those states. The company has pulled out of the auto loan market in

Arizona, Florida, Georgia, Nevada, North Carolina, South Carolina and Utah because of rising default levels.

But it’s the emerging problems in the corporate-junk-bond market that really worry me. The sector and the problems

are big enough to produce another big setback for financial companies and the economy as a whole.

The real concern: Credit-default swaps

Actually, I’m worried not so much about the junk-bond market itself as the huge market for a derivative called a

credit-default swap, or CDS, built on top of that junk-bond market. Credit-default swaps are a kind of insurance

against default, arranged between two parties. One party, the seller, agrees to pay the face value of the policy in

case of a default by a specific company. The buyer pays a premium, a fee, to the seller for that protection.

This has grown to be a huge market: The total value of all CDS contracts is something like $450 trillion. Because

buyers and sellers of insurance usually create multiple “policies” as they attempt to control risk, that number

includes a lot of duplication. Real exposure, says the Bank for International Settlements, may be only 20% of that,

or $90 trillion. Some studies have put the real credit risk at just 6% of the total, or about $27 trillion. That

puts the CDS market at somewhere between two and six times the size of the U.S. economy.

The CDS market has been a good place to make money in the past few years because default rates in the junk-bond

market have been historically low. The default rate for all junk bonds declined to 1.7% in 2006. That’s the lowest

rate since 1996. With defaults that low, sellers were paid insurance premiums but didn’t have to cough up much in


But that default rate started to rise in 2007, climbing to 2.6%. And Standard & Poor’s projects the rate will climb

to 3.4% by October. At that rate, 56 bonds would go into default in 2008, compared with 14 in 2007.

That level of default isn’t likely to inflict too much damage on the CDS market. The historical rate for defaults

by corporate junk bonds has averaged 5% a year since 1980. But the default rate has run as high as 12.7% in

previous recessions.

Will investors walk or run for the exits?

The junk-bond market isn’t in a panic yet, but the fear is climbing. The spread between the yield on the safe U.S.

Treasury bonds and comparably risky high-yield bonds climbed by 0.81 percentage point in the few trading days up to

Jan. 9. That’s the biggest increase in the spread in the first days of January ever measured.

I’d say that junk-bond investors, taking a clue from the 30%-to-50% losses suffered in the subprime-mortgage market

by investors who held on too long, are moving toward the exits with all due speed. They also know that in the CDS

market it’s very hard to tell who is ultimately holding the long or short end of any deal. And it’s even harder to

judge the financial strength of the ultimate holder of any individual insurance contract. If the mortgage crisis is

a guide, some of that insurance may turn out to be worthless because it’s held by an investor without the ability

to pay.

Whether that exit continues at a purposeful walk or turns into panicked flight largely depends on the speed with

which the economy slows and on the duration of any slowdown. Wall Street continues to talk as if all we’re facing

is a two-quarter downturn, although perhaps of some severity, but the early money is starting to behave as though

things are likely to be worse than that.

JPMorgan Chase reserved $2.3 billion against rising loan losses in the fourth quarter. That looks good compared

with an $18 billion write-down at Citigroup. Now, MSN Money’s Jim Jubak says, the buzz is that JPMorgan could buy

Washington Mutual. But is that a good idea?

On Wall Street, fears have a nasty tendency of becoming self-fulfilling prophecies.

All it takes is enough investors behaving as if the short-term, asset-backed commercial-paper market is risky for

that market to freeze into immobility, which leaves companies with less-than-sterling credit ratings without a

source of short-term working capital.

All it will take in the CDS market is enough buyers and sellers deciding they can’t rely on this insurance anymore

for junk-bond prices to tumble and for companies to find it very expensive or impossible to raise money in this


And that would be enough to make any economic downturn both longer and deeper than stock prices yet reflect.

Source: MSN Money (By Jim Jubak)

MBIA, Ambac Bond Default Risk Exceeds 70%, Swaps Show

MBIA Inc. and Ambac Financial Group Inc., the two biggest bond insurers, have a more than 70 percent chance of

going bankrupt, credit-default swaps show.

Prices for contracts that pay investors if Armonk, New York- based MBIA can’t meet its debt obligations imply a 71

percent chance the company will default in the next five years, according to a JPMorgan Chase & Co. valuation

model. Contracts on New York- based Ambac imply 72 percent odds.

Ambac shares have plunged 71 percent the past three days as the company scrapped plans to raise equity capital and

Moody’s Investors Service and Standard & Poor’s put the insurer on review for a downgrade. Fitch Ratings cut

Ambac’s AAA guaranty rating today. MBIA has dropped 47 percent since Jan. 15. Credit-default swaps on the

companies, which rise as confidence erodes, are trading at record highs.

“In this market, a downgrade could mean the beginning of that company’s eventual collapse,” said Matt Fabian, an

analyst with Municipal Market Advisors in Westport, Connecticut. While Fabian said he still expects the companies

to keep their rankings, he said he has grown “much more anxious.”

MBIA and Ambac are the largest of seven bond insurers that place their AAA stamp on $2.4 trillion of debt,

including municipal bonds and securities linked to mortgages. Losing those rankings may cost borrowers and

investors as much as $200 billion, according to data compiled by Bloomberg.

Dividend Cuts

Both companies slashed their dividends this month and announced plans to raise as much as $2 billion each. MBIA has

lost 88 percent of its market value since the start of 2007 while Ambac’s has fallen 93 percent after the insurers

expanded into subprime-mortgage securities and collateralized debt obligations that are now slumping in value.

Ambac today said it’s opting not to raise equity capital because of “market conditions and other factors” and

“is continuing to evaluate alternatives,” according to a statement.

Ratings companies, which affirmed their assessments a month ago, are scrutinizing bond insurers to ensure they have

enough capital to protect against losses. Standard & Poor’s yesterday said industry losses on subprime securities

will be 20 percent more than it initially forecast. S&P said that isn’t enough to start downgrading the companies.

MBIA spokeswoman Elizabeth James and Ambac spokesman Peter Poillon didn’t immediately return telephone calls for


Investor Protection

MBIA and Ambac credit-default swap prices are soaring as investors rush to protect against the risk the companies

won’t make good on guarantees the bond insurers sold them on securities linked to mortgage bonds, corporate loans

and other assets.

“Investors are concerned about counterparty exposure,” Gregory Peters, head credit strategist at Morgan Stanley

in New York, said in an interview on Bloomberg Television today. “That’s the overhang that the market has to

contend with.”

Lehman Brothers Holdings Inc., the biggest U.S. underwriter of mortgage bonds, told investors last month that it

was buying credit-default swaps to hedge against the risk that bond insurer guarantees on securities become


Merrill Lynch & Co., the biggest underwriter of collateralized debt obligations, said it will write off $2.6

billion in default protection from bond insurers, mostly from ACA Capital Holdings Inc., whose ratings were cut 12

levels to CCC in December.

`Material Jeopardy’

Credit-default swaps tied to MBIA bonds have risen 10 percentage points the past two days to 26 percent upfront and

5 percent a year, according to CMA Datavision in New York. That means it would cost $2.6 million initially and

$500,000 a year to protect $10 million in MBIA bonds from default for five years.

Credit-default swaps on Ambac, the second-biggest insurer, have risen 11.5 percentage points to 26.5 percent

upfront and 5 percent a year, prices from CMA Datavision show.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s

ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash

equivalent should a borrower fail to adhere to its debt agreements. A rise indicates deterioration in the

perception of credit quality; a decline, the opposite.

Fitch today lowered its rating on Ambac’s insurance unit two levels to AA and said it may cut further. Without its

AAA rating, Ambac may be unable to write the top-ranked bond insurance that makes up 74 percent of its revenue.

`Two Options’

“They have two options,” said John Giordano, a credit analyst at New York-based BlueMountain Capital Management,

which manages $4.8 billion. “One is you get the white knight who comes in and buys you and is a natural AAA and

solves a lot of problems. And the other is maybe private equity. I don’t think they can even touch the public

markets, whether that be debt or equity. I can’t imagine anybody’s going to touch them.”

Ambac shares fell 4 cents to $6.20 today in New York Stock Exchange trading. MBIA fell 67 cents to $8.55.

“The ability of Ambac to survive as a going concern is now in material jeopardy,” Rob Haines, an analyst at bond

research firm CreditSights Inc. in New York, wrote in a report yesterday.

The default probability derived from the pricing model, which traders use to value the contracts, assumes a 40

percent recovery rate on the companies’ bonds in the event of a default.

MBIA and Ambac are trading near levels reached by Countrywide Financial Corp., the mortgage lender battered by

speculation it would file for bankruptcy before agreeing last week to be bought by Bank of America Corp.

Bonds Plunge

Ambac’s $400 million of 6.15 percent bonds due in 2037 have plunged by 25 cents on the dollar this week to 35.4

cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory

Authority. The yield has soared to 17.6 percent from 10.5 percent and the extra yield investors demand over

government securities with similar maturities has widened 7.2 percentage points to 13.4 percentage points.

Ambac would survive without its AAA rating if it stopped trying to insure debt and let the existing policies wind

down, shareholder Evercore Asset Management LLC wrote in a letter to directors that it released yesterday. Evercore

had opposed Ambac’s plan to raise capital.

Ambac’s chief executive officer departed Jan. 16 after the company reported greater-than-expected writedowns on the

bonds it insures. Moody’s said the losses were “significantly” more than Ambac indicated.

Ambac said yesterday that the Moody’s review was “surprising.”


S&P assumes losses on mortgages made in 2006 to people with poor credit will reach 19 percent, up from its prior

forecast of 14 percent, as housing prices decline more than it anticipated.

Under the new assumptions, losses for bond insurers may be $13.6 billion, 20 percent higher on average than those

projected a month ago, S&P said yesterday. Ambac’s projected losses are now $2.25 billion, 22 percent more than in

December. MBIA’s are $3.5 billion, an increase of 11 percent, S&P said.

The revised S&P assumptions probably won’t require MBIA to raise more capital than it already plans, according to a

statement on MBIA’s Web site.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to

specific events like changes in the weather or interest rates.


Panic selling shuts £2bn fund

Scottish Equitable acts after slump
Fears that other funds are at risk

The fund, invested in London office blocks and shopping centres across Britain, apparently no longer has sufficient

cash reserves to meet demands from investors. Photograph: Martin Argles

One of Britain’s biggest property funds was forced to shut its doors to withdrawals yesterday after the slump in

commercial prices triggered panic selling by small investors.

The move prompted fears of a Northern Rock-style run on billions of pounds invested in once high-flying funds which

many savers have seen as a safe haven for their pensions.

Scottish Equitable said yesterday that 129,000 small investors in its £2bn property fund will not be able to access

their money for up to a year, although payments relating to regular income already being paid, retirements and

death claims will not be affected.

It said the fund, invested in London office blocks and shopping centres across Britain, no longer had sufficient

cash reserves to meet demands from investors wanting to withdraw their money. Its “buffer fund” was down to 1% of

its total assets, instead of the usual 10-15%.

Commercial property values, especially in the City of London office market, have dived amid fears of a recession

brought on by the global credit crunch.

In late December another insurer, Friends Provident, halted access to its £1.2bn property fund and last night

speculation was growing that Scottish Widows may be on the verge of restricting customer withdrawals on some of its

funds. The insurer said last night: “We are looking at all the options, but no decisions have been taken.”

Scottish Equitable’s parent group, Aegon UK, is due to announce the closure of its fund today. It said last night:

“Aegon UK has decided to take this step to protect investors following a significant level of customer withdrawals

from the UK property fund market.” It blamed “worldwide phenomena relating to concerns over the US sub-prime

mortgage market fallout, rising interest rates and talk of recession”.

The Financial Services Authority said it was closely monitoring the situation and had been informed by Aegon of the

decision to halt withdrawals.

The crisis in Britain’s commercial property market is now worse than at any time since the early 1990s, when

Olympia & York, the company that began the Canary Wharf office development in London, went into administration.

The credit crunch has raised borrowing costs, making many property deals no longer attractive. Financial

institutions hit by the fallout are already beginning to cut staff, reducing demand in the City office market in

which most of the UK’s property funds are invested. A downturn in consumer spending growth is also making retail

shopping developments less attractive to investors.

Small investors have put about £15bn into property unit trusts – £5bn pouring in during 2006 and early 2007 alone.

Billions more are invested through pension funds held by millions of company employees. Investors bought into

promises of rich returns after a decade in which returns far outstripped gains on shares or bonds.

But the downturn in values since the middle of 2007 has been savage. Shares in British Land, the UK’s leading

property company, have fallen by nearly half, and most funds are showing falls of between 20% and 40%. But

investors stampeding for the exit are now finding that they cannot access their cash.

The crux of the problem is that the funds are invested in buildings which can take months to sell, and therefore

cannot produce the cash to pay out money to small investors if they all want it back at the same time.

Usually the funds hold a cash “buffer” of 10-15% of total assets to meet withdrawals. But Scottish Equitable said

yesterday that the cash buffer in the £2bn fund had fallen to just £80m following a wave of redemptions, giving it

little choice but to suspend the fund. The only alternative was a “fire sale” of its holdings which could leave

investors even worse off.

It emerged yesterday that staff at some of the property managers have been informing key clients in advance that a

fund is heading for suspension. The FSA said that such trading may fall foul of its rules regarding treating

customers fairly.

Financial advisers continue to recommend that investors take their cash out of the funds that remain open. Jason

Hemmings of Albannach Financial Management in Edinburgh said: “There are lots of rumours going about that other

providers may be considering following Friends Provident and Aegon.”

The Aegon/Scottish Equitable property funds are managed by Morley Fund Management, which also runs the £4bn Norwich

Union Property unit trust, the UK’s biggest property fund. This week Norwich Union said the fund had fallen in

value by a fifth over the year, but its cash buffer was at 6.4% after selling office blocks in London and

Manchester worth £165m.

Aegon UK added that it believes the “underlying fundamentals of the asset class remain healthy”.

Source:The Guardian

— Amr


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