Small distant problems before big immediate ones

At least that is the elite political consensus on dealing with the fiscal balance sheet of the United States government. We saw in 2005 a party run itself off a political and electoral cliff campaigning against Social Security as a social insurance program. And this attempt to privatize and destroy it near the top of a bubble (amazing how that is always the case) was supported by a massive amount of elite media support. The Pain Caucus was alive and well; convinced that we could not afford as a society to guarantee our retirees roughly 32% (under current law and intermediate projections) to 40% (current law, low cost projections)replacement rate incomes. We had to destroy the system to resolve an anticipated problem in either fifteen years as the elite was seeking to renege on their promises from 1983 or thirty five years. Social Security was in trouble and non-sustainable in its current form for any length of time.

But never mind any of the other fiscal proposals that had/have larger ongoing projected costs than OASDI --- those are either critical penis enhancement projects where we must stay for 100 years to show resolve, or critical changes in the tax code that encourage dead people to be more productive.

Yet when we look at the evidence today, Social Security is not that big of a problem. Over the 75 year projection range, the Social Security Administration projects the entire program deficit to be 0.6% of GDP. In the grand scheme of things that will produce a large number but it is fundamentally a rounding error. Let us take a look at a couple of other major policy initiatives --

a) John McCain's tax proposals would result in a permanent loss of roughly net $400 billion dollars a year in revenue. That is slightly more than 3.0% GDP, or roughly five times the size of the projected long run Social Security deficit. Yet he is a 'credible' individual on economic policies.

b) The supplemental appropriation for Iraq this year was roughly $200 billion dollars this year. That is roughly 1.5% GDP

c) The economic stimulas package/bi-partisan ass covering rebate check plans this year is roughly $130 billion dollars or about 1% of GDP.

A and B are long run changes in revenue/expenditure slopes for the United States while C is a one-off policy change, but in the past year 'serious' new proposals for expenditures and revenue losses make up roughly 5.5% of GDP, or about 9 times the size of the long run deficit for OASDI. Just keep that in mind when told that Social Security is in trouble.

Lowered Expectations

Great News --- the housing bust has bottomed

Psyche!

CNN.Com is reporting some good news in housing, or at least that is how it is being perceived --- housing starts came in above expecations.

Privately owned housing starts fell to a seasonally adjusted 1,065,000 annual rate in Feburary, according to the Census Bureau. The rate was down 0.6% from January and off 36% year-over-year.

Economists surveyed by Briefing.com expected 995,000 new starts.

Permits for new building declined 7.8% to 971,000, well below the 1.02 million Briefing.com consensus forecast.

So being down 36% Year over Year, and running at a level we have not seen in 16 years, and this is good news... wow it is amazing what lowering one's expectation is. Next week's paycheck will be grand as I am expecting that I will only be earning minimum wage, so I'll enjoy the shock to the upside...[/snark]

Who gets crammed

Daniel Gross has long advanced the argument that this decade will be the cram-down decade in which explicit and implicit promises to most people will be routinely broken as more has been promised than is available to fulfill those promises. Furthermore, the incentive structure is set up to discourage the fulfillment of those promises in the quest for short term returns.

Healthcare, defined benefit pensions, and pay raises in line with productivty increases, are some of the explicit promises being broken. The substitution of defined contribution plans (think 401(K) or 403(b)) has the implicit promise that people can still decently retire on their savings but due to a combination of systemic risk, low/no real income growth, inflation ex inflation and behavioral reasons as to why individuals are poor investors on their own, this promise is weak.

Paul Krugman in today's New York Times notes that the Federal Reserve will be attempting to engineer a series of bail-outs for the credit/insolvency crisis. Hopefully this bail out is a systemic bail-out and not a get out of jail free card for people who have made dumb decisions. It should be targetted at people who made good decisions using good processes but got kicked in the nuts anyways. I don't think we'll see that type of bailout this year; I don't think we'll see a formal bail-out at all this year.

Dave at the Glittering Eye is making a very smart prediction on some of the policy and political dilemnas facing any potential bail-out.

BTW, a lot of the shareholders and bondholders he’s saying should take a bath are institutional investors, particularly pension funds. As I’ve been saying for nearly 30 years the scandal of the 2010’s will be the default of pension funds.

I agree with Dave that a lot of the large institutional pension funds are in trouble due to systemic risk --- the value of their assets falling sharply just as cash outflow increases as my parents' generation retires. However I am also placing a high degree of trust in retiree's political self-interest in guaranteeing that the promises that had been made to them either implicitly or explicitly will be honored, or at least dishonored the least. Gray power is real, and with Boomers entering into the highest propensity to vote years as a massive cohort, they will continue to get protection at the expense of everyone else. And that means a tougher job market as fewer Boomers drop out to retire, higher taxes to insure Social Security is more generous and in the intermediate term solvent, and large general revenue transfers to both the Pension Benefit Guarantee Corporation and some type of super special add-on to the 401(K) that has yet to be created.

The Boomers won't take getting crammed down if they can avoid it, and they are numerous enough to avoid the worst of the pain.

Debt, Austerity and Iraq

The United States is in the middle of a major debt crisis that has both illiquidity and insolvency components. Illiquidity means some loans/bonds are unable to be paid off on time due to merely cash flow issues and thus can be worked out so that the NPV of the loan can be fully paid off at some point in the future. The collataral and cash flows will eventually be there, just not right now. Insolvency involves loans whose NPV will never be paid off. The borrower lacks any reasonable projection of being able to pay off their debts. The solution here is some type of shared pain agreement where the borrower pays what they can while taking a hit on their credit rating and the lender seizes the underlying collateral, and takes a loss on the difference between the loan amount and the collateral value.

Right now almost all of the carnage is occurring in the private markets, and the pain is going to be sharp and prolonged. However the pain and the costs of cleaning up are slowly moving away from the private markets and toward a public bail-out of the dumb decisions that have been made. The Term Securities Lending Facility where the Federal Reserve gives out very liquid and valuable US Treasuries in exchange for AAA rated (yeah right) mortgage backed securities for 28 days and the re-rolls them over is the first step of the public bail-out (the use of the Federal Home Loan Banks was a covert step of a bail-out). The Federal Reserve takes lipsticked pigs wallowing in MBS slop and calls it the equivilant of the full faith and credit of the US government.

I am assuming that this bail-out will continue and grow in size and scope for the near future. No one wants to account for the highly probable losses that should be massively marked-down. Instead being able to transfer assets to the Fed and allowing the Fed to by the crypt of zombie debt allows companies to ignore reality for a while longer. And that is attractive when your bonus structure is based on a pleasant reality at the end of the quarter.

So we could have a situation where a really nasty private sector debt crisis transforms itself into a really nasty public-private debt crisis. And here is where things could get really interesting, as the recent model for resolving national public debt crisi is for categorization (what's okay, what's illiquid, and what is insolvent), international bridge loans to carry over the okay and illiquid debt to better days, harsh liquididation of the insolvent debt, export led policies to generate more foreign currency, and severe austerity on the public budget which means cutting back almost everything except debt service.

There are a couple of big differences between this low probability, high cost scenario I am spinning right now and most traditional debt crisis resolved by the Washington Consensus prescription. The most important is that the US debt is denominated in US dollars; massive inflation is a viable option of avoiding some forms of policy pain. The other is that the groups with money to bail the US out are the mercantilist/Bretton Woods II countries (OPEC, China etc) and their strings being attached to any package are most likely different than the strings the US would attach.

Paul Krugman notes the interconnected relaionships of issue and policy space, and how the creeping bail-out will significant crimp option space of the next President:

I used to think that the major issues facing the next president would be how to get out of Iraq and what to do about health care. At this point, however, I suspect that the biggest problem for the next administration will be figuring out which parts of the financial system to bail out, how to pay the cleanup bills and how to explain what it’s doing to an angry public.

If the US government embarks upon a significant bail-out of significant elements of the US financial sector, it will need massive injections of foreign capital. Most foreign capital that is willing to come into the US is not profit maximizing capital at this time; instead it is either risk averse capital or politically controlled capital. If the US is able to attract a massive lump of capital then few choices will need to be made. However if there are problems, austerity will be imposed to free up additional cash.

The Pain Caucus is much weaker today than it was five years ago or twenty years ago, so Baby Boomer retirement programs are relatively safe. The other big pool of cash floating around in the government is the defense budget and the biggest discretionary portion of that budget is Iraq. $200 billion per year is some serious money. There are already large pre-exisiting political groups (most of the Democratic Party) that thinks this is a damn dumb idea for one reason or another already, and as we move forward more people will be screaming for relief. The ability to propose non-trade-off solutions will decrease.

A debt crisis could provide very convienent political cover to withdraw from Iraq and save $150 billion per year in expenditures (some money will be spent to maintain 'containment forces', and other funds will be used to pork out the supplier's districts). And pulling out of Iraq could be one of the strings attached to any implicit or explicit foreign bail-out.

Another one bites the dust

With all the talk of monoline rescue plans, bail-outs for AMBAC and MBIA, business splits into a safe muni and toxic waste CDO branches, reality is harsh for the monoline insurers, as a previously infused monoline that thought it could have maintained its AAA rating saw it cut today (via Reuters)

Moody's cut CIFG's insurance financial strength rating four notches from "AAA" to "A1" -- the fifth highest investment-grade rating....

Banque Populaire and Caisse d'Epargne, which together own French bank Natixis took over control of CIFG from Natixis last year as part of a $1.5 billion capital injection aimed at stabilizing CIFG's top ratings.

Time to flush that $1.5 billion down the drain....

Jackpots and optionally ending games

Mish at Global Economic Analysis is taking a look at a hedge fund that is closing down. It opened a while back with $1 billion from investors, and it now is worth $200 million dollars. However it had a good year before it went bust. The managers of the hedge fun are bailing and closing it down now. However, take a look at the pay package:

Focus Capital had $1 billion under management and made 33% in 2007.
Let's do the math.

$1 billion in assets
33% return in 2007
20% of the gains go to fund management.
6.6% net goes to managers
2.0% management fee is on top of that
8.6% total
$1,000,000,000 * .086 = $86,000,000

$86 Million is not a bad sum of money to make for turning $1 billion into $200 million. Clearly this is the advantage of leverage (at least for those running the fund). All you need is one big year. Who cares after that? I think I could almost retire on $86 million.

In this incentive structure, with minimal personal skin in the game, one good year is all one needs to cash out and be able to do whatever one wishes to do for the rest of one's life. And people wonder why there is so much short-sightedness, and herd behavior. If you only have to be lucky once and being subsequently bad has next to no material impacts, the incentive is strong to gamble with other people's money to enrich oneself legally if potentially unwisely.

Failure Bonuses

I'm not on the board of any multi-billion corporations, hell I'm not on the board of any single dollar corporations or non-profits, but if I was, I would be scratching my head at a proposal to award massive pay raises, and large scale retention bonuses to the leadership team that took what was once one of the most profitable and predictable business models in the world, and turned it around to sustain massive losses and destruction of the basic value proposition. I would be very curious as to why I would want to retain this team in the first place.

And if I was on a board and was asked to approve the hiring of a C-level individual who took part in this fiasco, I might suggest that this individual be hired as the desk guard as that position could not seriously damage my company's net worth. But that is just me, and not Wall Street, as MBIA's leadership is getting shown more money than competent second string NFL cornerbacks are receiving from the New Orleans Saints. [Via CNN]

MBIA Inc. granted raises to some of its executives and offered bonuses to managers who stay another year as part of a plan to retain key people during a troubled period for the company.

In a regulatory filing Monday, the Armonk, N.Y.-based bond insurer said its compensation committee last month approved salary increases of as much as 60% for some executives. The committee also approved a "retention award" of as much as $2.3 million for executives who stay with the company a year.

MBIA (MBI) said it approved raises for 2008 after the company's stock plummeted 75% in 2007, because the company needs to retain people during a "critical period."....

Screwing up massively and losing credibility, respect and billions of dollars and people in charge are still getting rewarded. It is amazing how the risks and penalties of these screw-ups are transferred down the responsibility chain and the rewards never follow. Only the shit flows down hill, not the sunshine and rainbows.

Short sightedness is being rewarded, and we are systemically shocked when short sightedness dominates decision making. Amazing!

FGIC wants to split the baby

The problem with the monoline insurers is that they had a boring, highly profitable sure thing business model insuring municipal bonds backed by the taxing power of municipalities. Their model was to remove information costs and a bit of the default/credit risk so that big money investors would not worry about buying $5,000,000 from the Steel Valley School District. The insurers would credibly assure the big investors that Steel Valley was good for the money, and get a bit of a fee from the school district for allowing them access to cheaper credit. The bond insurers took on the risk of being wrong, but overall, a nice simple, boring and very profitable business model. And this is why Warren Buffet wants to buy this segment of the market.

And then they went beyond their area of expertise into the CDO and CDS markets insuring things they did not understand and set themselves to be hammered. Ratings have dropped, capital requirements have increased and there is no chance of cheap bail-out money being available as no one has a good idea of what the monoline insurers' exposures to the debt market meltdown actually tallies up to.

FGIC, a major insurer has been hammered with its credit rating dramatically falling and thus incapable of attracting new and profitable business as its comparative advantage has disappeared. They are now trying to split the baby in half -- safe, boring municipal bond insurance which has a good chance of being profitable in the long run to one side, and then the toxic waste on the other.

FGIC Corp., the bond insurer stripped of its Aaa guaranty rating by Moody's Investors Service, asked to be split in two to protect the municipal bonds it covers, according to the New York Insurance Department.

FGIC applied for a new license so it can separate its municipal insurance unit from its guarantees on subprime- mortgages, David Neustadt, a department spokesman, said in a telephone interview.

The toxic waste pile will be massively undercapitalized and therefore the value of the FGIC guarantee will be extraordinarily questionable. This is self-strip mining of the highest order in the hopes that there is something valuable that the current management team and company can hold onto. Everyone else will be left twisting in the wind as losses will be marked to a much harsher model or market.

Banks, which bought protection for the CDOs, stand to lose $70 billion if bond insurers are stripped of their ratings, Oppenheimer & Co. analyst Meredith Whitney in New York said last month.

Concern that MBIA and Ambac may lose their top rankings has spread to the $300 billion market for auction rate securities. Investors, wary that the municipal debt they are buying may soon be downgraded, have fled the market, causing more than $20 billion of auctions to fail this week.

Splitting the baby will not restore confidence in the current monoline insurance practices.

Captain, the containment field, it's failing

Ahh, a year ago the concept of a credit crunch was a farcical fantasty of fevered bloggers and professional doomsdayers. There were a few minor credit problems in the subprime mortgage market, but these problems were contained to just the small subprime market and there would be absolutely no spillover effects. Well, the containment field expanded over the summer to include mortgage backed securities, some Alt-A loans and some A/prime loans. Now it has expanded to include the monoline insurers, credit default swaps, auction rate securities and who knows what else, but it is contained.

Yesterday I noted that the some of the same structural problems that permeated the mortgage market have spread to other consumer credit markets; namely car loans were being stretched to seven years. This step will marginally bring down monthly payments. Throw in the heavily advertised negative equity loan offers being offered by local dealers, and the same toxic mixture of loose credit with no standards is being is in the auto market as it was in the housing market. I was beginning to wonder when there would be significant problems in the servicing of those debts.

Thankfully USA Today read my mind and printed this story concerning rising repossessions:

Car and truck repossessions this year are headed for the highest level in at least a decade, thanks to easy credit and a faltering economy, says an economist for one of the largest wholesale auto auction services.
So many vehicles are being snatched from owners who stop making payments that some repo operators and auto auctioneers say lots are overflowing.

This year's predicted 10% rise in vehicle repos to 1.6 million would be a third higher than 10 years ago, says Thomas Webb, chief economist for a unit of Atlanta-based Manheim, which sells cars to dealers worldwide. The increase comes atop a 10% rise in repos last year....

An executive at another big auto auctioneer says that easy subprime car loans in recent years are a big reason for the flood of repossessed cars...

"Our business has skyrocketed," says Patrick Altes, president of Falcon International in Daytona Beach, Fla. In recent times, his service saw a first wave of defaults that involved picking up boats and recreational vehicles.

Now, it's cars and trucks, often in affluent neighborhoods.

"A lot of the vehicles we're getting are high-dollar pickups" whose owners got caught in the construction downturn, Altes says.

Speculative purchases based on ever increasing values of cash being accessible through either HELOCS or annual refinancing is where the cash came for these cars and trucks. Now that the home ATM is shut off and HELOCS are being squeezed by higher credit standards, there is no cash to pay the monthly payment.

I don't know how much more containment we can take.

Quirky non-inflation

The BLS Consumer Price Index does not measure the cost of housing/shelter directly by looking at the prices of mortgages, taxes, insurance etc. The cost of shelter is derived by a proxy measurement of looking at Owner Rent Equivilant. Basically the idea is that rents are less sticky and more frequently reported than home sales and we are interested in the cost of housing today and not ten years ago when a home and mortgage was locked in. There is an additional assumption that ownership costs closely correlate with the net present value of rental income streams. Reality bites and this correlation holds true over the long term, but not in the intermediate and short terms.

Rents have been slowly increasing over the past decade while home prices have skyrocketed in absolute, proportional and real terms. Since rents have been increasing at near trend levels, there has not been any significant reported increases of inflation due to shelter while anyone who has bought a home in the past five years would severely disagree with the statement that housing inflation has not occurred. On the flipside, as home prices have fallen in the past eighteen months or so, OER has been relatively stable.

Calculated Risk is passing along what will be an interesting statistical quirk on how housing price inflation will be reported as increasing despite the reality of dropping values:

California Apartment Assn., the state's largest organization of rental property owners, estimates that as much as a quarter of all foreclosed single-family residences are occupied by renters. The number of renters ensnared in the foreclosure fiasco is even larger when duplexes and other multi-unit buildings are factored in.

And the evictions show no sign of abating. Total foreclosures of single-family homes statewide rose more than 400% to a record 31,676 in the fourth quarter from a year earlier, according to DataQuick Information Systems.

Foreclosed homes and rental units are removed from the market for some length of time as banks and MBS trusts don't want to be landlords. That is a skillset past their area of minimal competence and profitability. Units are left empty. Combine renters being evicted due to failure of their landlords to pay the mortgage, individuals who are walking away from their homes, and individuals who are renting today who three years ago would have qualified and taken a NINJA loan to buy a house, the demand for rental units has greatly increased while supply is constrained. Rental prices will increase, and due to how BLS measures housing inflation, OER will increase.

This is not a conspiracy, it is not a cover-up, it is a deliberately chosen statistical quirk that will smooth itself out over the next three or four years, as it is correcting for the underreporting of housing inflation during the bubble years as the rental demand was artificially low, leading to lower prices than a correctly clearing market would have dictated.

Tightening Credit

The Federal Reserve is seeing systemically tighter credit, and I am seeing two anectodotes illustrating this tighter credit. Let's start with the actual evidence from the Fed Reserve's survey of bank officers:

In the January survey, one-third of domestic institutions—a larger net fraction than in the October survey—reported having tightened their lending standards on C&I loans to small as well as to large and middle-market firms over the past three months.....

About two-fifths of domestic banks—a higher net fraction than in the October survey—reported having increased spreads of loan rates over their cost of funds over the previous three months.

About 80 percent of domestic banks reported tightening their lending standards on commercial real estate loans over the past three months, a notable increase from the October survey

About 55 percent of domestic respondents indicated that they had tightened their lending standards on prime mortgages, up from about 40 percent in the October survey.2 Of the thirty-nine banks that originated nontraditional residential mortgage loans, about 85 percent reported a tightening of their lending standards on such loans over the past three months, compared with about 60 percent in the October survey.3 Finally, five of the seven banks that originated subprime mortgage loans noted that they had tightened their lending standards on such loans, a proportion similar to that in the October survey

About 60 percent of domestic respondents indicated that they had tightened their lending standards for approving applications for revolving home equity lines of credit over the past three months. Regarding demand, about 35 percent of domestic banks, on net, reported that demand for revolving home equity lines of credit had weakened over the past three months.

large majorities of domestic and foreign banks expect a deterioration in loan quality in 2008. Regarding loans to businesses, between about 75 percent and 85 percent of domestic and foreign banks expect a deterioration in the quality of their C&I and commercial real estate loan portfolios. About 15 percent of domestic and 20 percent of foreign respondents expect a substantial deterioration in the quality of their commercial real estate portfolios. Concerning residential real estate loans, between about 70 percent and 80 percent of domestic respondents expect the quality of their prime, nontraditional, and subprime residential mortgage loans, as well as of their revolving home equity loans, to deteriorate in 2008. Finally, about 70 percent of domestic respondents expect a deterioration in the quality of both credit card and other consumer loans.

So the banks are tightening up their controls and increasing the spreads that they charge in order to cover their costs and risks. This means each basis point of Fed rate cuts is slightly less effective than they otherwise would have been. Furthermore even at lower rates, there are fewer borrowers seeking loans and fewer loans being approved so the question as to whether or not the American consumer is tapped out should get raised, again.

Anectodally I am seeing the same tighter standards and fewer offers of credit. First, I have been receiving a lot less junk mail credit offers and the ones that I am receiving either have higher initial teaser rates, significantly lower credit limits, or much narrower reply now deadlines. And on the mortgage front, the grocery store near my house has a major bank's branch office in it. They are advertising a 30 year fixed rate mortgage for 5.625% which is a pretty damn good rate. However the fine print is for 20% down, and a FICO over 720. Three years ago, that rate would have been for 7.5% down and a FICO over 650.

Watching the falling knife go by

The bond insurance business model is split into two parts. The first is the simple and traditional activity that Berkshire Hathaway is stepping into; insuring and upgrading the credit of municipal bonds for a fee with the promise of making bond holders whole if the issuing agency defaults. The second is a world of magic, voodoo and potential half trillion dollar losses. This is the part of the business model that everyone with money and brains is now trying to avoid, including major private equity firms that don't think the risk is worth a bail-out.

Leading private equity firms are unlikely to participate in any recapitalisation of Ambac and MBIA, increasing the pressure on banks to come up with a rescue package for the troubled US bond insurers....These investors have all concluded that the risks are too great, according to people familiar with their thinking....

The reluctance of big private equity firms to become involved comes after they looked closely at the two large monolines. They also studied the experience of Warburg Pincus, which committed $1bn to MBIA in early December at what seemed an attractive price, only to see MBIA's share go into freefall. Additionally, they noted that Blackstone, which has a minority stake in FGIC, had so far declined to put more money into that troubled bond insurer.

"If we worry that we can get shot from the shadows by something we can't see coming, it is not for us," says the managing director in charge of financial service investments for one of the leading private equity funds.

"The financial guarantors pass neither the shadow test nor the ability-to-understand test."[emphasis mine]

Risk is real, and it can be costly, but it can be calculated and hedged against by either a very cheap purchase price, or writing a complex set of options. Uncertainty is unmeasurable and that is what is killing the potential of a smart deal here. However uncertainty is pervasive right now because no one knows what else is coming out of the fiasco and no one can trust the word of the monoline insurers.

If private equity steps into the bond insurance market it will be to salvage the institutional expertise of a failed insurer and focus exclusively on the highly profitable but boring business of municipal bond insurance.

Trend Employment Figures

I'm grumpy and looking for a fight right now after spending most of the day playing plumber, and I am a really bad plumber, and moderating our comment section for the evening. However when I popped over to the Corner via Memeorandum for a commentary on the recent January jobs report, I have to agree with Ponnoru:

Seems to me that everyone is making too big a deal out of the January jobs report. My local paper's top story was the estimate that the total number of jobs fell by 17,000. If that estimate is revised later, to look better, I'm guessing it won't be the top story. And such a revision is very possible.....

He then makes an implied media negativity bias claim, but he is right on the face of it, any one datapoint is merely interesting but analytically of low value. However looking at the bigger picture and the trends, even if the drop in jobs is later revised to show a gain of 20,000, 40,000 or 80,000 jobs, the story remains the same. Employment growth is slower than population growth, and the labor market is slack right now. Barry Ritzholtz has a good graph of the revisions and benchmark changes in employment for the past year. Any month with more than 170,000 new jobs is a great month, anything below 140,000 is less than population growth, and below 100,000 is mediocre at best



We have not had a good month since last May, and within the past seven months, there has been one mediocre month (July), five slow growth months, and an initial negative month (January) dependent on revisions. The trend here is not our friend.

Carnage in the bond insurance markets

Reading Bloomberg after work is becoming an interesting hobby and schradenfreude generator as the monoline insurance companies are swirling ever faster around the drain:

Fitch today downgraded Financial Guaranty Insurance Co., the world's fourth-largest bond insurer, two levels to AA from AAA, after the company failed to raise capital. Earlier this month, Fitch also cut Ambac Assurance Corp. to AA from AAA, and Hamilton, Bermuda-based Security Capital Assurance Ltd.'s XL Capital Assurance and XL Financial Assurance five steps to A.

There are rumors floating that MBIA and Ambac, the two largest insurers will soon be downgraded. A hedge fund principal, who is short on monolines, is arguing that Ambac and MBIA are hiding four or five times their stated losses at the moment and could be exposed to even more risk than they are stating:

MBIA Inc. and Ambac Financial Group Inc., the two largest bond insurers, may each lose $11.6 billion on guarantees of mortgage-linked debt and other securities, according to hedge fund manager William Ackman.

The losses were calculated using a model supplied by an unnamed investment bank, and the findings were sent in a letter to the Securities and Exchange Commission and New York Insurance Superintendent.....Ambac said Jan. 22 it expects to pay claims on CDOs of $1.1 billion. MBIA said Jan. 9 it will likely report a $737 million expense for the fourth quarter to cover losses related to deteriorating subprime-mortgage securities it guarantees. MBIA is scheduled today to report its fourth-quarter results after the close of regular U.S. equity trading

Another analyst in the same article hits the information uncertainty nail on the head as one of the big problems companies have been having is that no one knows what things are worth due to a combination of illiquid markets, financial chicanary and piss poor underwriting.

``If we had the same level of data on every deal, we wouldn't have a problem,'' said Christopher Whalen, managing director of Institutional Risk Analytics, which makes software for banks. ``The data would be ground up, the losses would be known and we'd have a functioning market again.''

2nd Order Impacts of Housing

Pittsburgh has escaped the worst of the first order effects of the bursting of the housing bubble as the city and region never really experienced the bubble. Good homes in decent school districts were and still are available for less than twice the area median household income. Pittsburgh is not alone in escaping the burst, as other Rust Belt cities never saw the boom:

Median sales prices for single-family homes in Pittsburgh increased 6.1 percent from a year ago, while some cities in Florida and California posted double-digit declines in sale prices during the same period, suggesting that home prices have fallen most dramatically in areas where the speculative frenzy was hottest.

"Pittsburgh doesn't have a hangover because it wasn't at the party," said Dr. Marc Louargand, president of the American Real Estate Society and a principal with Saltash Partners LLC in Hartford, Conn.

However the second order effects of the bubble burst are being felt in Pittsburgh even if this region never got too frothy. The Post-Gazette reports today of the real estate industry job losses:

The U.S. mortgage meltdown is roiling Pittsburgh's western suburbs in unexpected ways. Jobs, not homes, are being lost.

Pittsburgh-area companies eliminated 1,590 mortgage-lending and consumer finance positions between the end of 2005 and the end of 2007 -- the 10th highest drop among any metro area in the country, according to Moody's Economy.com.

Many of those layoffs occurred along the Parkway West, in towns such as Moon and Robinson, Coraopolis and Green Tree, where companies have aggregated to provide appraisals, title insurance, closing and deed preparation services for mortgage lenders nationwide.

These are decent to well paying jobs; I interviewed for a couple of them in 2003 and 2004 and they were paying above median wages for people straight out of college. Pittsburgh is doing better than other Rust Belt cities but job growth has been slowing down in the region faster than the national slow down.

Ahh, the joys of integrated national economies so even when a region did not go crazy, the second order effects impact the region anyways.

When $15,000,000,000 is mere piffle

I've been writing about the bond insurance market for a while now and how it could impact the city of Pittsburgh as recent refinancings and debt issues will begin to see balloon payments in the next couple of years. The basic story is that Pittsburgh has a mediocre credit rating and to get a better rate, it has taken out insurance with one of the major bond insurers (Ambac, MBIA, FGIC etc). These insurers agree to cover the payment of principal and interest to bond buyers if the city defaults on its obligations. They charge a fee that is less than the net present value of the differential between the enhanced credit rating that they supply to the bonds and the inherent credit rating/risk of the city of Pittsburgh.

The problem is that these insurers got greedy and went away from their core competency of very profitably insuring municipal bonds to insuring anything that they did not understand or want to understand including mortgage and other asset based securities. And they are getting burned right now as losses are much, much higher than expected from the CDO and ABS policies they issued. Some insurers have already lost their AAA ratings, and others are being treated as if they are nearly junk bond companies despite having a AAA rating.

The recent talk of bailing out the insurers through a collective Wall Street bail-out organized by the State of New York has released some of the pressure on the big insurers with the scariest risk profiles, but there is a simple problem of the size of the proposed bail-out may not match with the size of the exposure, first from Bloomburg:

Talks in New York with the unnamed banks are part of Insurance Superintendent Eric Dinallo's effort to stabilize the bond guarantors and bolster the market's finances, said agency spokesman Andrew Mais....

New capital may help preserve the top credit ratings for the bond guarantors such as MBIA, the industry's largest, and halt any erosion of investor confidence in the $2.4 trillion of assets they guarantee. Ambac, MBIA's biggest rival, lost its AAA grade from Fitch Ratings this month on concerns that losses tied to subprime mortgages may increase....

The infusion may be as much as $15 billion, the Financial Times reported

$15 billion in cash could still be considered mere piffle, even if one factors in a 10:1 leverage ratio as the problem. Calculated Risk is passing along this estimate via the London Times concerning the size of the potential exposure:

America's biggest mortgage bond insurers collectively need a $200 billion (£101 billion) capital injection if they are to maintain their key AAA credit ratings, a figure that dwarfs a plan by New York regulators to put together a capital infusion of up to $15 billion

Even leveraging up the $15 billion to hedge fund levels, there is not enough cash to cover probable contigencies. If I was in charge of $15 billion dollars, I would have bought myself Super Bowl tickets, and then used the rest of it to carcass pick the insurers of the good risks that are thoroughly vetted agaisnt a proven track record of analysis. The $15 billion dollars may be the vulture's payment for municipal bond insurance as that is a predictable market with known risk profiles, but it is a joke in the face of the asset backed bond tsunami and the earthquake from the CDOs insured by the bond insurers.

Ambac and Pittsburgh

Fitch Ratings downgraded municipal bond insurance company Ambac from AAA to AA. The downgrade is most likely the first of many downgrades as the value of the Ambac guarantee is becoming extraordinarily questionable.

Credit rating agency Fitch Ratings downgraded bond insurer Ambac Financial Group Inc. to "AA" from "AAA" on Friday, which could force the company to stop writing new insurance....

The rating also remains on negative credit watch for a further downgrade.

The City of Pittsburgh has used AMBAC as a bond insurer for at least the 2002 general obligation debt offering but went to other insurers for the 2005 and 2006 restructurings. If the 2002 offering was structured similiarly to the 2005 and 2006 offerings, this insurance downgrade will not have any immediate impact as those two bond offerings did not have any clawback mechanisms.

The bonds were sold as AAA with insurance and anything that happens after that which impacts the ratings is borne by the new bond holders. That means there is no short term fall-out.

The intermediate term fallout and increased expenses for the city will come when the bonds start to balloon mature in 2009 to 2011 from these two tranches. The city will not have enough cash to pay those maturing bonds off, so they'll have to rollover the debt or at least a significant portion of it

The 2002 Ambac insured bond issue is similiar to the 2005 and 2006 structures. The most significant difference is that the city's fiscal health was slightly better in 2002 than in later years, so it was able/willing to borrow money over long terms. The balloon payments for this tranche of bonds do not start until 2012 instead of the 2010/2011 for the 2005 issue and 2008 and 2009 for Series A of the 2006 issue. The big chunk of 2006 is in Series B where the worrying times are after 2013.

With the municipal bond insurance market significantly weaker and a previous relationship now valueless, Pittsburgh has some breathing room in 2008 and 2009, but will need to issue a large refinancing/rollover bond by late 2010.

Really, AAA is good

Paying for groceries and gas on your credit card and not being able to zero balance at the end of the month because you are broke is tolerable if you know that the month is a particulary bad month and your income and cash flow will quickly improve. Paying for groceries with your credit card and incurring 17% effective interest because you have no other viable options available to you is very bad news. It is very easy to get into a debt service death spiral as your minimum monthly payments are overwhelmed by new expenditures and you quickly hit your credit limit.

This is the basic scenario that a AAA rated bond insurance company is facing now. MBIA is in trouble and recently they issued a special debt offering that under specific accounting rules they can treat as if it is an equity offering. Since they are on the hook for significant CDO and ABS obligations, and have taken some losses there, they needed to recapitalize, and do so quickly. However the interest on the bonds is now very similiar to credit card interest rates [h/t Calculated Risk]:

The notes, issued by the embattled bond insurer to shore up capital and preserve its crucial triple-A credit rating, fell 5 cents on the dollar to about 89.5 cents on Wednesday and are now yielding 17 percent, said Wayne Schmidt, senior portfolio manager at AXA Investment Management.

MBIA's notes yielded 14 percent when they were first sold on Jan. 11. A higher yield suggests that sellers of MBIA's notes in the secondary market are having to sweeten the deal to entice potential buyers.

Right now, I have access to cheaper debt via junk mail credit card offerings than MBIA with its AAA credit rating and yet MBIA still maintains its AAA rating.

Do these ratings really mean anything other than the fact that Fitch, S&P, and Moodys' are scared shitless of a systemic financial crisis if any of the bond insurers' are significantly downgraded to reflect their actual ability to access the credit markets? Do the ratings have predictive value, or are they mere ornamentation that tells investors and lendors little useful information?

Well, another AAA rated investment is in trouble. Orion Finance, a SIV, defaulted on its debt, which forced S&P to face reality:

Standard & Poor's on Wednesday cut its credit ratings on Orion Finance, a structured investment vehicle, after the fund defaulted on its obligations to pay off maturing commercial paper.

S&P lowered the fund's issuer credit rating to "D," for default, from "AAA," the top investment-grade rating. Orion's commercial paper and medium-term note ratings were also cut to "default."

Wow, Orion went from AAA, a great risk, only slightly more risky than holding US government debt to complete default and near total losses for the bond holders. The ratings agencies did a great job there [/snark].

So what is AAA worth --- right now not a whole lot. Some companies deserve to be rated very highly as their cash position is good, they have sufficient reserves, their debt to income rations are low, and their business model makes sense. Other companies are screwed and receiving market credit at credit card rates. Yet right now they are both AAA --- so why trust AAA if you don't know what that phrase actually means.

Recessions, Exports and Employment

Paul Krugman earlier this week has posited that exports may lead the US into avoiding a full blown recession:

I pointed out that up through the third quarter of 2007 rising exports had roughly offset the impact of the housing bust.....
So did the U.S. economy dodge a bullet?

Yes, it did — which is why I haven’t been as sure about a looming recession as, say, Larry Summers or Marty Feldstein, let alone Nouriel Roubini. (No, I’m not always a doom and gloom guy — only when the situation warrants, which has been pretty often lately.)

While we dodged a bullet, however, there are between one and three more bullets headed our way.....

I am wondering if he is positing a point of hope that has little practical reality as I am musing that an export led recession buster would still feel like a significant recession on the employment and wage front even if GDP growth never goes negative for a quarter or the official recession line of two quarters. Exports are still overwhelmingly goods as the US service economy is a local economy. The goods that are produced are either manufactured goods, raw materials or agricultural products, and here we have a real divergence in productivity. And this is why I think a 'mild' recession won't feel like one to anyone who works for a living.

The Bureau of Economic Analysis has the composition of US exports here, and as you can see over the past twenty years, there is a mild downslope of goods to total US exports, however this is a matter of two points; real, especially when viewed within the context of a larger export share of the US economy, but mild.



Over the last couple of years once we got back to trend performance instead of the job-loss and jobless recovery, a significant chunk of the employment gains came through the housing and construction booms; either directly by increased employment in the building trades, assessors, appraisers, mortgage processors etc, or indirectly through the multiplier effect jobs and localized services fueled by people buying new appliances, new rugs, and new cars through the wealth effect of seeing their home values increase. A good chunk of these people will need to find new jobs as this sector of the economy has and will continue to be punched in the groin for a while longer.

Some of the economic activity transfer has occurred already as Dr. Krugman noted, US exports are up and have taken a good chunk of the GDP slack. However on a short to intermediate employment term, this is bad news for most workers as the primary export sector (good production) is way more productive than the general US economy; via the Bureau of Labor Statistics is the index of output per hour, with 1992=100 for manufacturing and business in general:



Since manufacturing productivity has grown faster than business productivty over the past twenty years, the shift of a dollar of GDP from business expenditures to manufacturing expenditures means we are getting far less employment for the buck than we would have gotten twenty years ago. The productivity gap is fairly significant between the sectors, and the growth rates are still divergent in favor of manufacturing.

So even if we are able to dodge a technical recession on the basis of increased exports, and assuming that goods still constitute roughly 70% of US goods and services exports, then we can still see a fairly significant jobs, wages and waiting time for employment recession type environment.

Pittsburgh Bond Risk Assessment

I've been worried about the turmoil in the bond insurance market as Pittsburgh has massive amounts of debt that it will need to roll over in the reasonably near future. I have spent some time over the Christmas break reading through the 2005 and 2006 bond reports and a little more digging, so when I saw this story at Calculated Risk this morning, I was able to breathe a little easier:

Fitch Ratings on Wednesday said it may cut its ratings on certain residential mortgage-backed securities insured by MBIA Inc, Ambac Assurance Corp, FGIC Corporation and Security Capital Assurance.

Fitch said it may cut 87 MBIA-insured mortgage bonds, 64 Ambac-insured bonds, 35 FGIC-insured bonds and 19 SCA-insured bonds.

Fitch is basically saying that they don't trust the value of the insurance on these bonds, which given what has gone on in the credit markets makes a whole lot of sense. However, when I went through the two most recent general obligation bond reports, the city does not have any clawback mechanisms on the interest rates as confidence building measures for bond holders. The bonds were sold as AAA with insurance and anything that happens after that which impacts the ratings is borne by the new bond holders. That means there is no short term fall-out.

The intermediate term fallout and increased expenses for the city will come when the bonds start to balloon mature in 2009 to 2011 from these two tranches. The city will not have enough cash to pay those maturing bonds off, so they'll have to rollover the debt or at least a significant portion of it. At that point the city's recent slightly improved credit rating of BBB comes into play if the guarantee value of bond insurance is near nil. At that point the city will be paying significantly higher debt service costs.