8 November 2007 – The Aleph Blog

Contemplating Life Without the Guarantors

Posted on 8 November 2007 by David Merkel

Here’s another recent post from RealMoney:

		David Merkel
		Contemplating Life Without the Guarantors
		11/1/2007 1:30 PM EDT

Hopefully this post marks a turning point for the Mortgage Insurers and the Financial Guarantee Insurers, but when I see Ambac trading within spitting distance of 50% of book, I cringe. I’ve never been a bull on these companies, but I had heard the bear case for so long that my opinion had become, “If it hasn’t happened already, why should it happen now?” Too many lost too much waiting for the event to come, and now, perhaps it has come. But, what are all of the fallout effects if we have a failure of a mortgage insurer? Fannie, Freddie, and a number of mortgage REITs would find their credit exposure to be considerably higher. The Feds would likely stand behind the agencies, because Fannie and Freddie aren’t that highly capitalized either. That said, I would be uncomfortable owning Fannie or Freddie here; just because the government might stand behind senior obligations doesn’t mean they would take care of the common and preferred stockholders, or even the subordinated debt.

Fortunately, the mortgage insurers don’t reinsure each other; there won’t be a cascade from one failure, though the same common factor, falling housing prices will affect all of them.

Other affected parties will include the homebuilders and the mortgage lenders, because buyers without significant down payments will be shut out of the market. Piggyback loans aren’t totally dead, but pricing and higher underwriting standards restrict availability. Third-order effects move onto suppliers, investment banks and the rating agencies. More on them in a moment… this will have to be a two-parter, if not three.

Position: none

And since then, the mortgage insurers have fallen a bit further.? On to part two, the financial guarantors:

Unfortunately, the financial guarantors have had a tendency to reinsure each other.? MBIA reinsures Ambac, and vice-versa. ? RAM Holdings reinsures all of them.? The guarantors provide a type of “branding” to obscure borrowers in the bond market.? Rather than put forth a costly effort to be known, it is cheaper to get the bonds wrapped by a well-known guarantor; not only does it increase perceived creditworthiness, it increases liquidity, because portfolio managers can skip a step in thinking.

Now, in simpler times, when munis were all that they insured, the risk profiles were low for the guarantors, because munis rarely defaulted, particularly those with economic necessity behind them.? In an era where they insure the AAA portions of CDOs and other asset-backed securities, the risk is higher.

Now, guarantors only have to pay principal and interest on a timely basis.? Mark to market losses don’t affect them, they can just pay along with cash flow.? The only trouble comes if they get downgraded, and new deals become more scarce.? Remember CAPMAC?? MBIA bought them out when their AAA rating was under threat.? Who will step up to buy MBIA or Ambac?? (Mr. Buffett! Here’s your chance to be a modern J. P. Morgan.? Buy out the guarantors! — Never mind, he’s much smarter than that.)

Well, at present the rating agencies are re-thinking the ratings of the guarantors.? This isn’t easy for them, because they make so much money off of the guarantors, and without the AAA, business suffers.? If the guarantors get downgraded, so do the business prospects of the ratings agencies (Moody’s and S&P).

Away from that, municipalities would suffer from lesser ability to issue debt inexpensively.? Also, stable value funds are big AAA paper buyers.? They would suffer from any guarantor getting downgraded, and particularly if Fannie or Freddie were under threat as well.?? All in all, this is not a fun time for AAA bond investors.? A lot of uncertainties are surfacing in areas that were previously regarded as safe.? (I haven’t even touched AAA RMBS whole loans…)

This is a time of significant uncertainty for areas that were previously regarded as certain.? Keep your eyes open, and evaluate guaranteed investments both ways.? I.e., ABC corp guaranteed by GUAR corp, or GUAR debt secured by an interest in ABC corp. This is a situation where simplicity is rewarded.

Holding My Nose, Still

Posted on 8 November 20078 November 2007 by David Merkel

Three companies of mine reported after the bell, Flagstone, Deerfield, and National Atlantic. I’ll take them in that order.

Flagstone beat handily, as I would have expected a property-centric reinsurer to do in this environment. Let’s see what optimism tomorrow brings. At 96-97% of book value, it seems cheap, but I can’t imagine property reinsurance rates will be that robust next year.

Deerfield is a little more tricky. They took a loss due to mark-to-market events in their portfolio. REIT taxable income is reasonable at 50 cents/share, and much of the writedown is a GAAP anomaly that shaves $1.20 off of the current book value. Economic book value is $11.84, which provides some support to the stock. The dividend of 42 cents is still intact. There is reasonable excess liquidity, even after the increase in repo margins during the third quarter. Let’s see what the market thinks.

Now for the problem child, National Atlantic, which takes an 83 cent loss. Here’s the main offending paragraph from the press release:

“For the three months and nine months ended September 30, 2007, reserves have increased by $17.6 million and $9.4 million, respectively, principally as a result of the strengthening of the reserves for bodily injury claims. During the third quarter it was determined that the Company’s policy related to claims handling procedures and reserving practices were not applied consistently, primarily within the bodily injury claims unit. As part of the resolution of this matter, the Company retained an independent claims consulting firm.”

For a company the size of National Atlantic, these are huge reserve changes, particularly for a short-tail line like auto. What I am about to write here is only a guess, but this likely was building up since sometime in 2006. One of the reasons I am willing to be a little more bullish on short-tail insurers is that it is a lot harder to get the reserve wrong. Looks like I am getting one of the rare events that teaches greater caution. (That said, my average cost is $8.85, so I’m not that badly hurt.) Given the large reserve change this period, ordinarily, the decks are cleared for future periods, but who can tell for sure? Also, this places the combined ratio since 2002 at 103.7%. It makes me think that the company will do well to eke out any underwriting profit.

I’ll be listening to the call tomorrow. What’s the endgame here? Given the marginal ability to earn underwriting profits, perhaps the company would best be reconciled by merging with another firm. That wasn’t my opinion over the past three years, but it is my opinion now. There are many firms that could have an interest at the right price, which probably approximates the book value of $13.28. That said, many of them may have kicked the tires already and passed, some probably thinking that a bid at book value would not be honored. All I can say is, give it a shot. Rumor is that Commerce wasn’t offering more than book, so if you want a greater presence in NJ personal lines, it may be available at a reasonable price.

Full disclosure: long FSR DFR NAHC

Circuit Breakers, but no Curbs

Posted on 8 November 2007 by David Merkel

Posted today at RealMoney:

		David Merkel
		Bye-bye to Trading Curbs
		11/7/2007 2:37 PM EST

When the NY Composite fell 2% today, no trading curbs kicked in. Program trading went on unfettered by a need for upticks. Around 1:20, when the curbs would have kicked in, the market fell a little, stabilized, and began to rally. So much for the curbs. Now all that remains are the circuit breakers, which kick in when the DJIA is down 10% and 20%. The circuit breakers only came into existence in 1987, and to the best of my knowledge, have never been triggered. (Anyone else know for sure? I don’t have intraday data.)

Using closing data since 1900 (again, I don’t have intraday), the circuit breakers would have been triggered 5 and 2 times each. That’s once every 21 and 54 years, respectively. To me, that’s not frequent enough to have a rule in place, even if intraday data would double the frequency.

Position: none

As it was, the market finished down nearly 3% today.? I suspect that curbs wouldn’t have helped much, but who can tell.? The market is a lot more game-friendly than it used to be; far fewer rules to observe (or flout).

On an unrelated note, here are my two REIT charts from yesterday, in thumbnail form, for those who had a hard time with them yesterday.

Mortgage REITs

Equity REITs