The Financial Guarantors are receiving a lot of attention these days, and for good reason.  I want to offer a few observations to give my own take on the problem:

1) With structured finance, the initial choice is “Do we ask a financial guarantor to bring the credit up to AAA, or do we do it through a senior-subordinate structure?”  A senior-subordinate structure has classes of lenders with differing rights to payment.  The AAA, or, senior lenders only take losses after the subordinate lenders (who are receiving higher yields) have lost all of their money.  In the present environment, S&P and Moody’s have been downgrading subordinates, and even some senior bonds in senior-sub structures.

This should lead to downgrades of MBIA and Ambac, eventually.  The rating agencies can’t keep downgrading bonds that are similar to those guaranteed by MBIA and Ambac, without downgrading them as well.  Remember, MBIA and Ambac were late to the party; their bonds are disproportionately weak because later lending standards were weaker.

2) The main difficulty with a bailout of the guarantors is that most interested parties have different interests.  That said, the beauty of a bailout is that the guarantor can sit back and pay timely principal and interest, while waiting for better times to come.

3) Did the rating agencies force the guarantors into the CDO business?  I’ve heard rumors to this effect, but it would be pretty easy to prove or disprove.  Look at when MBIA and Ambac entered the business, and look at the commentary from the rating agencies around it; if they are trumpeting diversification, then it is likely that they pitched it to the guarantors.  If not, then the guarantors did it on their own.

4) Even in a bailout of financial guarantors, current shareholders may find themselves diluted beyond measure.  Given current political pressures, those risks are elevated; remember that management teams want to keep their jobs, and that regulators have some say in that.

5) As I noted today at RealMoney:

		David Merkel
		Considering the “Margin of Safety”
		2/5/2008 11:07 AM EST

Tim, I like your stuff, since I am a value investor. Be careful with XL Capital. The challenge is estimating what sort of guarantees they face from Security Capital Assurance. When I looked at them last, the potential payments could be huge — potentially larger than XL’s net worth, but hey, that’s the financial guarantee business. I looked at XL during my last portfolio reshaping — Finish Line also, and could not get past the potential risks. I had easier plays to go for, with less uncertainty, if also lower upside. I don’t try to hit home runs, so it makes it easier for me to not buy the stocks that are optically stupid cheap, but might have balance sheet issues. Cheap means that a company will have the capability to carry their positions through a downturn; it’s part of the “margin of safety” that we require.

Anyway, keep it up, and let’s see if we can’t make some money on our value investing.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance and Finish Line to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

 XL was downgraded recently as a result of those guarantees.  I would be cautious here.

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Summary: there is still downside risk here.  Avoid the financial guarantors, and economic areas affected by the overleveraging of our credit markets.   Stick with companies that have strong balance sheets.

I started my business career as an actuary.  For an actuary, though, I had an unusual background — I wasn’t a math or a statistics major, I was an economics major, though admittedly, one with a lot of math.  You can’t get through the Ph.D. courses in econometrics without a lot of math.  In my business career, I’ve put my economics background to use, and added to it through studying finance.  Now, I studied much of the finance and economics of risk literature back in grad school, and developed a healthy dislike for MPT, the CAPM, and suchlike.

I grew up in a home where my self-taught mother used her head and picked stocks.  She did it quite well, too, and continues to do so today.  I figured that I could do it too, and over the past fifteen years, have done so.  Perhaps my major theme would be “hunt for value, and don’t be afraid to have a portfolio that looks weird.”  My studies of finance in my post-academic days were practical in nature, analyzing ways of beating the market, or reducing risk, realizing that any strategy can become overused, and useless.

After leaving my former employer, I’ve done a bunch of things — writing, consulting, etc.  Now it is time to focus.  I have taken a job as Chief Economist and Director of Research for Finacorp Securities, based in Irvine, California.  Their main focus is serving the investment needs of municipalities.  I have three main tasks:

• Publish research that encourages clients to trade with us.
• Provide research for internal staff and clients, enabling staff to serve clients better.
• Build an asset management franchise for our clients around my value investing, and bond investing.

Beyond that, aid in the management of the firm where possible.  Now, I’m not changing locations; I am still based near Baltimore.  What I do can be done from anywhere, so long as I can connect to the Internet.
I have already produced a draft version of a newsletter for our institutional clients.  I am making preparations to offer equity asset management services to clients.  What form that will take is still open.

That said, it is interesting at this point in my life to finally have the word “Economist” in my job title, as well as “Chief.”  In one sense, this dovetails well into my interests, as those who read my blog will know.  I write about the intersection of macroeconomics and investing.  That’s what I do.  It allows me to keep my interests broad, while solving a wide array of practical problems.  I have sometimes said that I am an investment omnivore.  That’s not quite true, but I like to wander across the investment wilderness, and gather disparate data, gaining good conclusions about the total investment landscape.

Anyway, that is what I am up to now.  To the extent that our newsletter or investment services might be open to individuals, I will let you all know.  I thank you all deeply for your support of me.

PS — I may be on FOX Business Wednesday between 12 and 2PM Eastern.  This is uncertain at present.  We will see.