If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?

One of the quandaries of running a subscription service is that
when you have some really juicy stuff, you inherently limit the
audience that you are able to reach. Normally, this isn't that big a
deal. When you believe that there is a mass cover up aiming to prop up
the largest cadre of zombie, insolvent companies in modern history it
becomes a much bigger deal. This leads me to distribute a significant
amount of research for free. On that note, I have been following the
breadcrumb trail of hidden (or more aptly put, concealed) corporate
liabilities, and it has led me to (of all places) off the balance sheet
of the big banks. I have spent a lot of time concentrating on exactly
where the losses, if any, will come from in these banks. We have
already established that the smaller banks had, have and will totally
drain the FDIC's insurance fund over a year and a half ago (see As I see it, 32 commercial banks and thrifts may see the feces hit the fan blades Friday, 23 May 2008, notice how many of the banks have went under since then) in the post "I'm going to try not to say I told you so...

I would also like to add that I have raised the flag on this regional
bank/commercial real estate issue many months before the sell side and
the main stream media said a peep. This is not to brag or boast, for I
am a fundamental investor and the market has definitively ignored the
fundamentals for 7 months running. The point that I am trying to convey
is that analysts in the big sell side banks work for their trading
desks, underwriting and sales departments, and not for the investor (be
it retail or institutional). Thus, proclamations of "Buy! Buy! Buy!" do
not necessarily mean we have entered into a fundamentally firm area in
which to buy stocks, bonds or any other risky assets covered by these
guys. For a sterling example, see "The sell side is pushing with all of their might to inflate the market...".

As a matter of fact, I have also focused on those very same brokerages,
banks, insurers and REITs that went bust, starting as far back as 2007,
again before it was fashionable to do so (see Is this the Breaking of the Bear? January 2008, GGP and the type of investigative analysis you will not get from your brokerage house November 2007 to December 2008, A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton circa November 2007, etc.)

Now, that everyone feels the coast is clear and we will be entering a
new bull market amid a broad economic recovery sprouting green shoots
all over the place, I am intent on quantifying what remaining risks
there are - if there are any remaining risks I am also in the process
of fine tuning the market neutral strategy that can produce profits up
until and through the period that these banks bring the market and
economy back down (see Option Strategy Analysis Update for the strategy analysis and their performance thus far).

This started from a re-examination of the monoline insurers (primarily
Assured Guaranty) that simply looked a bit to rosy for my eyes.

I have covered AGO, MBIA, and Ambac well before they started going bust, saying, well,,, they will go bust: ·         A quick over view of what I see thus far in Assured Guaranty ·         My Analyst's Comments on MBIA/Ambac/Moody's Post ·         I told you so, AGO ·         Reggie Middleton on Assured Guaranty Are the Mortgage Insurers in Serious Trouble? 9/3/2007 A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton -11/13/2007 ·         Tie-in to the Halloween Story11/21/2007 Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion in Equity 11/29/2007 Follow up to the Ambac Analysis    Subscription content:  Ambac Portfolio Analysis - Etrade mark to market - Public Version 2008-01-01 16:03:45 275.50 Kb  Ambac_AutoReceivables Locked 2008-01-01 15:31:26 39.50 Kb  Ambac_PortfolioAnalysis_Etrade_mini_app 2008-01-02 14:12:52 383.50 Kb  Assured Guaranty_Consolidated 2008-11-22 06:29:28 796.13 Kb

I dug in deeper, and I saw a lot of skeletons in the closet, hence I
went bone hunting. I digress... Let me start from the beginning. A user
posted this interesting link from IRA, which I will excerpt: Institutional Risk Analytics and then lead into the next part of my thesis:

By eschewing securitization and buying banks after they have been
restructured, JPM gained a huge advantage for its equity and bond
holders. BAC and WFC, on the other hand, still face the daunting task
of cleaning up the mess left by the troubled acquisitions of
Countrywide, Merrill Lynch and Wachovia. In the case of BAC, we hear
that this includes buying defaulted mortgage paper at par from the
various securitization vehicles sponsored by BAC directly or acquired
from Countrywide and/or Merrill Lynch. The latter, in case you've
forgotten, was the biggest CDO sponsor on Wall Street. This one reason
we told our friends at Fast Money that we believe BAC is next in line
behind Citigroup (NYSE:C) in terms of financial problems and could be
back in the arms of the US government by the middle of 2010.

The thing that many people still don't understand about securitizations
is that it was not just overtly profitable for the sponsors. There also
was a hidden profit in many deals that were not disclosed, a profit
that is now become a liability. Consider a hypothetical example based
on actual deals. Say Countrywide created a new DE trust and contributed
$100 million face amount of loans to the entity, call it "QSPE1″ for
"qualifying special purpose entity" under the FASB rules, which
incidentally are scheduled to be rescinded at the end of the year. The
folks at Moody's (NYSE:MCO), S&P or Fitch would then be paid a fee
to provide a rating for the new entity prior to the issuance of
securities. We'll come back to this point in a future comment.

In return, QSPE1 gave Countrywide an IOU for $100 million and then sold
bonds to investors for at least that amount, allowing QSPE1 to repay
the IOU to Countrywide. But the dirty little secret that Wall Street
still conceals from the Congress, the public and the shareholders of
all banks is that the collateral contributed by Countrywide to QSPE1
was not worth nearly $100 million, but in some cases closer to $95
million or even less. This is why during the interview earlier this
year ("Back to Basis for Securitization and Structured Credit: Interview With Ann Rutledge'),
Ann talked about the fact that the mezzanine tranches of many
late-vintage securitizations never converge on "AAA," unlike an auto or
credit card securitization. In plain English, this means that there is
never enough collateral inside QSPE1 to pay the investors interest and
principal - without an under-the-table subsidy from the sponsor.

For many years in the securitization sector, the fact of a secular
increase in the value of collateral masked these unsafe and unsound
practices in the banking industry. Sponsors such as Countrywide were
assumed to be willing to "cure" such defects - that is, substitute
collateral in the event of a default or advance cash to the
securitization trust - in order to make sure that the trustee in charge
of QSPE1 was able to make timely payments to bond holders. The legal
fiction was that QSPE1 and Countrywide were separate entities, but the
economic reality is that QSPE1 and Countrywide are one and the same.

Click here to
see Ann's presentation from the June 10, 2009 PRMIA event, "Regulation
of Credit Default Swaps & Collateralized Debt Obligations." Look at
slides 12-16, showing various securitizations by Ford (NYSE:F) and the
last by Countrywide. Notice that while all of the F deals converge on
"AAA" early, the Countrywide deal never accumulates sufficient
collateral and cash to ensure repayment of bond investors. Only because
Countrywide and other issuers were willing to "cure" these deals with
undocumented payments to the securitization trust could investors ever
be repaid.
http://www.prmia.org/Chapter_Pages/Data/Files/3227_3508_PRMIA%20CDS_pres....

 After reading this I thought to myself, hmmmm. If these products
really do not converge on AAA, and Assured Guaranty has made a business
on insuring what they consider AAA, super senior tranches that they
consider bullet proof, somebody in this situation is sadly mistaken. Of
course, before I go on with my findings on Assured Guaranty, it would
be prudent to reveal what I have found in the banks that they insure
and stand as counter party to, particularly in light of what Ms.
Rutlege has alleged over at IRA.

I will be detailing findings
on several big banks over the next few banks, and hopefully wind it up
with a synopsis that some explains how AGO can characterize their risks
as AAA - or not.

Comments

[Econophile]

Good article.

1. Wouldn't this be fraud?

2. Were they not backed by CDS?

3. Some of these deals required Countrywide to swap out bad debt for good?

[Anonymous]

there's no fraud....it all good baby....everything
is backed by the good faith and credit of the
united states....benhole will swoop in to buy it all
up....

[SWRichmond]

IMO securitization was always about, first and foremost, lying about credit quality and getting away with it via obscurity.  The lies about quality enabled massive extractions of upfront "profits" to be booked and the risk to be outsourced.

My early reads about this crisis (Fall '07) were about FGIC, Ambac, MBIA, and the poster-child, ACA Capital and its step-daddy, Bear.  Their names scream "leverage", and will always invoke the once widely-accepted notion that these miniature firms could ensure hundreds of billions in deals on a few billion in capital.  My conviction of the ultimate fate of the U.S. economy was sealed when I read about the process used to create CDOsquared, where mezzanine tranches were sliced and diced to reveal another 75% AAA-rated sausage.  At that point, printing by the Fed was virtually assured.

[Anonymous]

Dear Lloyd:

How's the weather in lower Manhattan, Amigo? Futures sure were impressive this morning. I'm sorry, but I have to ask....was this to suck the rest of the retail longs in so that you could dump? I'm curious because we have had four gaps in the last 7 sessions. This looks like your work.

Here's the problem, Lloyd, and I'm sure you see this. There's no follow through. The retail long isn't coming back no matter what you do. Sure, it's painful to watch your little daily ramp job, but frankly we have better things to do with what's left of our money than give it to you for, err, safekeeping.

So we watch with amusement, knowing full well what you probably know too, that is, that somebody is going to lose this bet and then that somebody is going to go to the Treasury and ask to be backstopped yet again.

Last fall we were frustrated, Lloyd. We wrote to our Congresspimps and Senatewhores by the millions and they ignored us. So we turned up the volume. This fall we're mad. This fall we're screaming. They can't ignore us any more because when it comes right down to it, they're nothing more than gutless cowards whose job it is to give us what we want so that we don't go nuts and ruin the game. The problem (for you anyway) is, what the public seems to want now more than anything else is some Wall Street lynchings.

A word of advice? Sure, I thought you'd never ask. Better unwind pronto, Cochise. Bank the profits, hell, make a big charitable contribution. Don't push it. You're painting yourself into a corner, and your usual bagholder is nowhere to be seen. He isn't coming back, Lloyd. You killed him.

[McGriffen]

quickly a question on AGO:  I'd thought the prime reasons that Ambac, MBIA, FGIC, etc had struggled/sucked wind greatly was monoline insurance guaranty of super-senior CDO (above other risks which are notable).  It's been months since I've seen any league tables, but Assured used to be way low on that ranking for any CDO-related biz.

In other words...AGO maybe not 'best of' but better than others when it came to structured finance monoline guaranty biz.

[Anonymous]

If no one hears a buble burst,they will!

WSJ
Major U.S. banks and securities firms are on pace to pay their employees about $140 billion this year -- a record high that shows compensation is rebounding despite regulatory scrutiny of Wall Street's pay culture.

[koaj]

thanks for coming on board over here reggie...was turned onto your blog about 18 months ago and its one of my must reads everyday

[Reggie Middleton]

Your very welcome.

[lynnybee]

I read every word & am grateful to the creator of the website for my education.    It was difficult for me, being a novice person to this financial world stuff, but, I am learning.   Thank you for your article.     Sincerely ...........