Here’s a not-so-quick note on covered bonds.  What is a covered bond?  It is a form of secured lending, where a bank borrows money and offers a security as collateral.  That security remains on the bank’s books, but in a default the covered bondholder could claim the security in lieu of payment from the bank’s receiver.

It is not a passthrough, it is a bond.  The covered bond buyers do not receive the principal and interest from the security held by the bank, the bank receives it.  The covered bondholder (in absence of default) receives timely payment of interest at the stated rate, and principal at maturity.  Only in default does the value of the security for collateral matter.  If the collateral is insufficient to pay off principal and interest, the covered bondholders are general creditors for the difference.

Okay, so we’re talking about a type of secured lending, or secondary guarantee.  That exists in many places in different forms:

• Credit Tenant Leases, which are secured first by the lease payments, and secondarily by the building.
• Commercial and Residential Real estate loans are secured by property, and the ability of the debtor to service the loan.  Same for auto loans.
• Utilities do a certain amount of first mortgage bonds where they pledge valuable plant and equipment, and receive attractive financing terms.
• Enhanced Equipment Trust Certificates are how airlines and railroads do secured borrowing, pledging airplanes and rolling stock as collateral if they don’t pay.
• Insurance companies in certain large states can set up guaranteed separate accounts.  If the insurance company’s General Account is insolvent, the separate account policyholders are secured by the assets of the separate account.  The separate account is tested quarterly for sufficiency of assets over liabilities.  If there isn’t enough of a positive margin, more securities must be added.  If those assets prove insufficient in an insolvency, they stand in line for the difference with the general account claimants.

That last example, obscure as it is, is the closest to the way a covered bond functions under the current Treasury Department’s statement on best practices for covered bonds.

Here is what collateral is eligible for the as the pool of assets securing the bonds (stuff from the Treasury document in italics):

Under the current SPV Structure, the issuer’s primary assets must be a mortgage bond purchased from a depository institution. The mortgage bond must be secured at the depository institution by a dynamic pool of residential mortgages.

Under the Direct Issuance Structure, the issuing institution must designate a Cover Pool of residential mortgages as the collateral for the Covered Bond, which remains on the balance sheet of the depository institution.

In both structures, the Cover Pool must be owned by the depository institution. Issuers of Covered Bonds must provide a first priority claim on the assets in the Cover Pool to bond holders, and the assets in the Cover Pool must not be encumbered by any other lien. The issuer must clearly identify the Cover Pool’s assets, liabilities, and security pledge on its books and records.

Further collateral requirements:

• Performing mortgages on one-to-four family residential properties
• Mortgages shall be underwritten at the fully-indexed rate
• Mortgages shall be underwritten with documented income
• Mortgages must comply with existing supervisory guidance governing the underwriting of residential mortgages, including the Interagency Guidance on Non-Traditional Mortgage Products, October 5, 2006, and the Interagency Statement on Subprime Mortgage Lending, July 10, 2007, and such additional guidance applicable at the time of loan origination
• Substitution collateral may include cash and Treasury and agency securities as necessary to prudently manage the Cover Pool
• Mortgages must be current when they are added to the pool and any mortgages that become more than 60-days past due must be replaced
• Mortgages must be first lien only
• Mortgages must have a maximum loan-to-value (“LTV”) of 80% at the time of inclusion in the Cover Pool
• A single Metro Statistical Area cannot make up more than 20% of the Cover Pool
• Negative amortization mortgages are not eligible for the Cover Pool
• Bondholders must have a perfected security interest in these mortgage loans.

Other major requirements (not exhaustive — stuff copied from the report in italics):

• Overcollateralization of 5% must be maintained.  It must be measured each month.  If the test fails, there is one month to get the overcollateralization over 5%, else the trustee can terminate the covered bond program and return proincipal and accrued interest to bondholders.
• For the purposes of calculating the minimum required overcollateralization in the Covered Bond, only the 80% portion of the updated LTV will be credited. If a mortgage in the Cover Pool has a LTV of 80% or less, the full outstanding principal value of the mortgage will be credited.  If a mortgage has a LTV over 80%, only the 80% LTV portion of each loan will be credited.
• Currency mismatches between the collateral and the currency that the bond pays must be hedged.  Interest rate mismatches may be hedged.
• Monthly reporting with a 30 day delay
• If more than 10% of the Cover Pool is substituted within any month or if 20% of the Cover Pool is substituted within any one quarter, the issuer must provide updated Cover Pool
  information to investors.
• The depository institution and the SPV (if applicable) must disclose information regarding its financial profile and other relevant information that an investor would find material.
• The results of this Asset Coverage Test and the results of any reviews by the Asset Monitor must be made available to investors.  The issuer must designate an independent Asset Monitor to periodically determine compliance with the Asset Coverage Test of the issuer.
• The issuer must designate an independent Trustee for the Covered Bonds. Among other responsibilities, this Trustee must represent the interest of investors and must enforce the investors’ rights in the collateral in the event of an issuer’s insolvency.
• Issuers must receive consent to issue Covered Bonds from their primary federal regulator. Upon an issuer’s request, their primary federal regulator will make a determination based on that agencies policies and procedures whether to give consent to the issuer to establish a Covered Bond program. Only well-capitalized institutions should issue Covered Bonds.  As part of their ongoing supervisory efforts, primary federal regulators monitor an issuer’s controls and risk management processes.
• Covered Bonds may account for no more than four percent of an issuers’ liabilities after issuance.
• Issuers must enter into a deposit agreement, e.g., guaranteed investment contract, or other arrangement whereby the proceeds of Cover Pool assets are invested (any such arrangement, a “Specified Investment”) at the time of issuance with or by one or more financially sound counterparties. Following a payment default by the issuer or repudiation by the FDIC as conservator or receiver, the Specified Investment should pay ongoing scheduled interest and principal payments so long as the Specified Investment provider receives proceeds of the Cover Pool assets at least equal to the par value of the Covered Bonds.  The purpose of the Specified Investment is to prevent an
  acceleration of the Covered Bond due to the insolvency of the issuer.
• Not more than 10% of the collateral may be composed of AAA-rated mortgage bonds.

My Stab at Analysis

The four percent limitation takes a lot of wind out of the sails of this for now.  The regulators are taking this slow.  They want to see how this works before they let it become a large part of the financing structure of the banks.

So long as this remains small, there shouldn’t be any large effects on the yields for unsecured bank bonds, both of which are structurally subordinated by the new covered bonds.  In other words, if some more assets are off limits in an insolvency, particularly more of the better-quality assets, that means that much less is there to recover.  Now, discount window borrowing and FHLB advances are secured already, so this just makes the issue of what is left in an insolvency to the unsecured lenders tougher.  That doesn’t affect depositors under the FDIC limits, but if you have deposits or CDs exceeding the limits, you might want to watch this issue.

Acceptable collateral is generally high quality, which means the bank has to pledge some of its better mortgages, and accept a 5% minimum haircut on the amount received back.  This should provide some support to the jumbo loan market; I didn’t see any size limits.  It looks like it would be impossible to issue subprime loans because of the 80% LTV, income verification, no neg am, first lien, underwriting must be done at the fully indexed rate.  Maybe some Alt-A could be done, but I’m not sure.  With the requirement that you have to replace collateral if a loan goes 60-days delinquent, I’m not sure a bank would want to put in collateral with a high probability of replacement.

For underwriting, an LTV of 80% or better is acceptable.  Other underwriting guidelines are left implicit to guidance given in the past on lending practices.  It’s possible that appraised values could be stretched to meet the 80% hurdle.  It’s happened before.

AAA-rated mortgage bonds are an interesting twist here as well.  I assume that it has to be AAA at every agency rating the bonds, first lien collateral, Prime or Jumbo collateral in order to be consistent with the intent of the document, but that is not explicitly defined.  Could a bank contribute a AAA home equity loan to the pool?  I doubt it, but…

Securitization is still getting done through Fannie and Freddie, but so long as the private mortgage securitization market is closed, this could be an attractive option for some banks to finance their mortgage loans.  When the securitization market comes back, covered bonds should reduce considerably as a financing source.  Overcollaterization for a securitization is less than the 5%+ that is necessary here, and it gets the loans off of your books, reducing capital requirements.  If I were a bank entering into a covered bond program, I would only borrow for the amount of time that I would expect the securitization market to be closed.  That could be years, but at some point, it will likely be cheaper to securitize, and the bank won’t want the mortgages trapped in the covered bond program then.

Beyond that, the bank would analyze whether it has better terms in securitized borrowing from the FHLB, or the newly non-stigmatized discount window of the Fed.  Even funding the loans through an ordinary deposit/MMMF/CD base would be most attractive under normal conditions, if the bank has the capital to support the loans.

Other collateral was proposed for use in covered bonds, but the regulators are taking it slow there as well.  They are starting with higher quality collateral; it might get expanded later.  The banks would probably like that.

Two final notes, and a tentative conclusion: this is a relatively complex solution for giving a new financing method to banks.  Only medium-to-large banks could be able to use it.  I’m not sure who a logical buyer of small transactions might be…. Hmm… maybe it could be a substitute for CD investors.

Second, the inclusion of of a Specified Investment is interesting.  It further constrains what can be done with the proceeds of the bonds, which could be a big negative.  Are banks going to buy GICs from insurers?  BICs from other banks?  I don’t know.  Maybe I am misundstanding that part.

My conclusion, after all that, is that I don’t think this is going to be that big of a help to banks in the short run.  Why?

• Small size of the program.
• High overcollateralization.
• Mostly (90%+) high quality mortgages can be pledged.
• Capital requirements don’t change because the loans stay on the books.
• Need for the Specified Investment.
• Marginally increases the yields on unsecured debt.

But the benefit they get is a cheap-ish borrowing rate.  Would this get a AAA yield and rating?  Probably.  Is that enough to overcome the negatives?  Well, let’s watch and see, but I would expect it to have less impact than many expect.

PS — One other note: I read this elsewhere today, but Yves Smith points out that covered bond markets can have panics too.  Good to know; nothing is a panacea.

Now, I’ve never been a great fan of the financial guarantee insurers, or the rating agencies.  Consider my post dealing with then over at RealMoney, Snarls in Insurance Investigation, Part 2.  In it, three-plus years ago, I suggested that Eliot Spitzer should investigate the relations between the rating agencies and the financial guarantors.

Now the City of Los Angeles is bringing a suit against the financial guarantors for forcing them to buy unnecessary municipal bond insurance.  Oh, please.  Did the armies of MBIA and Ambac surround LA City Hall, threatening violence if you didn’t give in to their protection racket?  This suit almost makes the failed efforts of regulators to split the guarantors into separate municipal and non-municipal insurers seem intelligent.

First, the real value of the municipal bond insurance was not for credit enhancement.  Municipal bonds rarely default, and when they do, they often become current again.  It was liquidity insurance.  Now, for a city like Los Angeles, maybe that’s not needed, but most municipalities are small issuers, and there is not enough manpower at bond managers to analyze them all.  The rating agencies fill part of the gap with their ratings.  For most municpalities, they are the only analytical coverage at all.

Now, the municipalities had the choice of issuing insured or uninsured bonds.  Insured bonds could be sold at AAA rates, and bond managers would buy them more easily because they were more liquid.  The question to an issuer boiled down to which is cheaper?  Pay AAA rates plus the guarantee fees and have an easy sale, or, pay at the rates that managers demand for lower-rated municipal bond?  For many munipalities they chose an insured sale because it was cheaper, or not much more expensive.

Any yield premium paid could possibly be attributed to their investment bankers, who did not want the extra work of having to actually sell the bonds.  With the AAA, they would fly out the door with no questions.  A lower-rated bond would cause some bond managers to sit on their hands; even though they could look at the rating from the agencies, they would not trust the rating without further analysis, and that takes time and effort.  (I know from my time as a bond manager, you can’t push your credit staff too hard, or they start making mistakes, because they can’t do quality work.)

The municipalities had another choice as well.  They could have borrowed less money, and raised more taxes, bringning their credit profiles up to AAA.  I know, the rating agencies should have rated municipalities higher, but that’s not who they are suing.  (That said, credit ratings are only moderately related to the yield spreads paid.)

A suit like this would have a better chance if it alleged implicit collusion between the rating agencies and the financial guarantors, and sued them both.  I still don’t think the City of Los Angeles would win such a suit, but the real flaw was not the insurers, but the ratings, including the ratings the financial guarantors themselves, which in my opinion, were always somewhat liberal.  (Hint: with financials, don’t just look at the rating, but look at the implied rating from the spreads on their debt.  The rating agencies holding company debt always traded at wider yields than their stated ratings would imply.)

Now, with the added fun in the space since Moody’s moved Assured Guaranty and FSA to negative watch, something I did not expect, this leaves Berky as the last man standing in the space.  But one seller does not a market make.  What this means, if Moody’s follows through, and S&P follows suit, is that muni bond insurance is likely dead for some time.  Who loses?  Small municipalities primarily.  They will face higher debt issuance costs.  Even large issuers have found the new issue market less than inviting recently.

In closing, could this come at a worse time for municipalities?  Revenue bases are eroding even as demands for services rise.  (Housing price will be a drag here for a few more years.)  They can’t print money or issue debt at whim to solve the problem, so they have to make painful cuts.  I will add this, even more painful cuts will come over the next 10-20 years as the pensions/ retiree healthcare crisis descends on the municipalities.  Not a fun time for anyone… and I’m sure there will be more lawsuits over the whole shebang, most of them bogus.

I am overweight financials, but I don’t own any banks, or entities where the primary business is credit risk.  I own a bunch of insurers, because they are cheap.  The first one to report came Monday after the close, Reinsurance Group of America.  They beat handily on both earnings and revenues.  They are the only pure play life reinsurer remaining.  Competition is reduced because Scottish Re is for all practical purposes dead.  They make their money primarily off of mortality, charging more to reinsure lives than they expect to pay in death claims.

This is a nice niche business, and a quality competitor in the space — well-respected by all.  And, you can buy it for less than book value.  Well, at least you could prior to the close on Monday.

Here are the financial stocks in my portfolio at present:

• Safety Insurance  (Massachusetts personal lines)
• Lincoln National (Life, Annuities, Investments)
• Assurant (Niche lines — best run insurer in the US)
• Hartford (Life, Annuities, Investments, Personal lines, Commercial Lines, Specialty Lines)
• RGA (Life reinsurance)
• Universal American Holdings (Senior Health Insurance — HMO, Medicare, etc.)
• MetLife (Life, Annuities, Investments, Personal lines)
• National Atlantic (waiting for the deal to close)

Now, I do have my worries here:

• Even though asset portfolios are relatively high quality, they still take a decent amount of investment-grade credit risk, and even squeaky-clean portfolios like the one Safety has are exposed to Fannie and Freddie, unlikely as they are to default on senior obligations.
• Those that are in the variable annuity and variable life businesses might have to take some writedowns if the market falls another 10% or so.  For those in investment businesses, fees from assets under management will decline.
• Pricing is weak in most P&C lines.

Away from that, though, the companies are cheap, and I have a reasonable expectation of significant book value growth at all of them.  Also, a number of the names benefit from the drop in the dollar — Assurant, MetLife, Hartford, and RGA.

One final note before I close: diversification is important.  I have Charlotte Russe in the portfolio, and it got whacked 20%+ yesterday.  Yet, my portfolio was ahead of the S&P 500 in spite of it.  If Charlotte Russe falls another 5% or so, i will buy some more.  There is no debt, earnings are unlikely to drop much (young women will likely continue to buy trendy clothes), and there are significant assets here.  I don’t expect a quick snapback, but as with all of my assets, I expect to have something better 3 years from now, at least relative to the market.

Full disclosure: long SAFT LNC AIZ HIG RGA UAM MET NAHC CHIC

Dividends can be controversial.  Are they tax-efficient?  Not as good as compounding capital gains over a long period, and it will be worse when the Bush tax cuts expire.  There is no tax on buying back shares, but individuals get taxed on dividend payments.

Are they the best way to tilt value portfolios?  My guess is no.  There are many factors that drive the calculation of value, and dividends are one of them.  A multifactor model including dividends will probably beat a dividend yield only model.  It will definitely allow for a more diverse portfolio, rather than being just utilities, financials, LPs, etc.

Do dividend-yield tilted portfolios always do better than the indexes?  No, they don’t always do better.  Take the current period as an example.  These two notes from Bespoke are dated, but still instructive.  The total returns off of stocks with above average dividend yields has been poor recently.  Part of that is the current trouble in financials.  Part of it is the financial stress that is leading to cuts in dividends (again, mainly at financials).

Dividend paying stocks tend to lag when bond yields rise, also.  I remember an absolute yield manager who floundered in the early-to-mid ’90s when rates rose dramatically and bonds proved to be greater competition for the previously relatively high-yielding stocks.  They had a great time in the ’80s as yields fell but 1994 proved to be their undoing.

That said, dividends are an important part of total returns, probably one-third of all the money a diversified portfolio earns.  Also, on average, companies that pay dividends also tend to do better in the long run than companies that don’t pay dividends.  Why?

DIvidends have a signaling effect.  They teach management teams a number of salutary things:

• Equity capital has a cash cost.
• Be prudent risk takers, because we want to raise the dividend if possible, and avoid lowering it, except as a last resort.
• Focus on free cash flow generation.  Be wary of projects that promise amazing returns, but will require continual investment.
• Be efficient at using capital generated from free cash flow.  The dividend forces management teams to do only the most productive capital projects.  Increasing the dividend is alternative use of capital that must be considered.
• Dividends keep management team honest in ways that buybacks don’t.  Buybacks can quietly be suspended, but in the American context, a dividend is a commitment.

Now, if you are going to use dividend yields as a part of your strategy, you need to pay attention to two things:

• Payout ratios, and
• Growth of the dividend is more important than its size

Is the company earning the dividend?  Do they have enough left over to pay for capital expenditures for maintenance and growth?   Be careful with companies that have high dividends.  My belief is that companies with middling dividends tend to offer value, but the really high dividends portend trouble.  High dividends tend to be cut during periods of financial stress, as we are seeing today.  This article on newspaper stock yields does not convince me.  I have been a bear on the industry for the last ten years.  You can’t maintain high dividends in a industry with significant competition from new entrants (Internet destroying ad revenue, classified ad revenue, and sales revenue).

REITs have decent dividend yields, but the companies with the best total returns had low dividend yields, but they grew them more rapidly.  In general, growing dividend yields where payout ratios are not deteriorating are usually good stocks to own.  Think of it this way, the dividend yield plus its growth rate will approximate the total return of the stock in the long run (for dividend paying stocks).

Two more notes before I end.  FIrst, special dividends usually not a good idea; they signal reduced prospects for the company to deploy capital productively; better to do a dutch tender and buy back shares.  When Microsoft did their special dividend four years ago, I made the following comment at RealMoney:

		David Merkel
		Note From Fed Chairman: Don’t Worry, Be Happy
		7/21/04 12:46 PM ET
Alan Greenspan completed his testimony slightly after noon today. The Q&A went quicker than usual. No real news from the affair; Dr. Greenspan tells us that inflation is not a problem, growth is not a problem, there is no systemic risk, the carry trade is reduced, a measured pace of tightening won’t hurt anyone, etc.Very optimistic; I just don’t go for the Panglossian thesis that everything can be fine after holding the fed funds target so low for so long. Bubbles develop when credit is too easy.And as an aside, I’d like to toss out a dissenting question on Microsoft (MSFT:Nasdaq). I know that the software business is not capital intensive, but if Microsoft disgorges a large amount of its cash, doesn’t it imply that they don’t see a lot of profitable opportunities to invest in it? Buying back $30 billion of Microsoft stock is a statement that they see no better opportunities (that the government will allow them to do), than to concentrate on current organic opportunities. It implies that additional organic growth opportunities are limited, no? No positions in stocks mentioned

TSCM quoted me in two articles at the time of the special dividend.  I was ambivalent about the buyback, and Microsoft stock has done nothing since then.

I also wrote this article to talk about the value of excess cash flow to management teams.  My view continues to be that excellent management teams should be given free rein to add value, while poor management teams should pay out excess cash to shareholders.

Also, there is a rule in the reinsurance business: buy back shares when the price-to-book ratio is under 1.3; issue special dividends when the price-to-book is higher, and you have slack capital.  But be careful.  Slack capital can be valuable.  I remember Montpelier’s special dividend before the 2005 hurricanes.  Ill-advised in hindsight.  The stock was a disaster, and is the only time in my career that I have flipped from long to short on a stock, post-Katrina.

Finally, I don’t look for dividends.  It is a factor in my models, but not a big one.  That said, 20 of 36 of the stocks in my portfolio pay dividends, and I receive a 2% yield or so on the portfolio as a whole.  I would rather focus on free cash flow, but dividends follow along behind free cash flow.

Bringing this back to the present, be wary.  High dividend yields, particularly on financial stocks, may be cut.  Analyze the payout ratios on stocks you own.  In general, dividends are good, but analyze the situation to determine the sustainability of the dividend.

1) Going back to one of my themes, be wary of companies that sell their best assets to bail out their worst assets.  Tonight’s poster child is GM.  How to get cash?  Borrow against the remainder of GMAC, foreign subsidiaries (most promising part of the corporation), etc.  Not a promising strategy.  As I have said many times before GM common is an eventual zero.  Same for Ford.  All the errors in labor relations over the years, compounded with interest, are coming back to bite, hard.

2) So where does GM cut expense?  White collar retiree medical care.  This is rarely guaranteed, except to unions, so it is legal to cancel it.  A word to those whose corporations or state/municipal employers presently have retiree medical care.  It is worth your while to find out whether there are guarantees of coverage or not.  If there aren’t, I can assure you that it will be terminated in the next ten years.  If there are guarantees, then you need to see whether there are standards of care guaranteed, and whether the plan sponsor has the wherewithal to make good on his promises.

One more prediction: many states and municipalities will devise clever ways to escape guarantees over the next 20 years.  That will include Chapter 9 of the bankruptcy code.

3) Note to the SEC, not that the powers-that-be read me: if you’re going to require a contract to borrow shares in order to short for a bunch of financial companies, then require it for every company, now.  Shorts are not the problem.  Failure to properly locate and borrow shares is a problem.  Let there be a level playing field in shorting, and let the investment banks that are lending out more than they have suffer.  (Ironic, huh, ‘cuz they are the ones complaining…)

4) Note to the new management of AIG: please do the following: a) locate lines of business with low ROAs and significant borrowing for funding in order to achieve high ROEs.  b) Close down those lines.  Possible areas include GIC-MTN programs, and life insurance generally.  c) Take a page out of Greenberg’s early playbook, and exit lines, or sell off divisions where it is impossible to achieve superior ROEs.  (I can see American General re-emerging, with SunAmerica in tow!)

5) File this under Sick Sigma, or Six Stigma — GE is finally getting closer to breaking up the enterprise.  It has always been my opinion that conglomerates don’t work because of diseconomies of scale.  As I wrote at RealMoney:

		David Merkel
		GE — Geriatric Elephant
		4/27/2007 1:16 PM EDT

First, my personal bias. Almost every firm with a market cap greater than $100 billion should be broken up. I don’t care how clever the management team is, the diseconomies of scale become crushing in the megacaps.

Regarding GE in specific, it is likely a better buy here than it was in early 1999, when the stock first breached this price level. That said, it doesn’t own Genworth, the insurance company that it had to jettison in order to keep its undeserved AAA rating. Which company did better since the IPO of Genworth? Genworth did so much better that it is not funny. 87% total return (w/divs reinvested) for GNW vs. 28% for GE. A pity that GE IPO’ed it rather than spinning it off to shareholders…

But here’s a problem with breaking GE up. GE Capital, which still provides a lot of the profits could not be AAA as a standalone entity and have an acceptable ROE. It would be single-A rated, which would push up funding costs enough to cut into profit margins. (Note: GE capital could not be A-/A3 rated, or their commercial paper would no longer be A1/P1 which is a necessary condition for investment grade finance companies to be profitable.)

Would GE do as well without a captive finance arm (GE Capital)? It would take some adjustment, but I would think so. So, would I break up GE by selling off GE Capital? Yes, and I would give GE Capital enough excess capital to allow it to stay AAA, even if it means losing the AAA at the industrial company, and then let the new GE Capital management figure out what to do with all of the excess capital, and at what rating to operate.

Splitting up that way would force the industrial arm to become more efficient with its proportionately larger debt load, and would highlight the next round of breakups, which would have the industrial divisions go their own separate ways.

Position: none, and I have never understood the attraction to GE as a stock

6) One to think about: if US Bancorp is having a bad time of it, shouldn’t most large banks be having a worse time of it?  I spent a little time this evening reviewing the prices of junior debt securities of marginally investment grade banks (and a few mutual insurers, also).  The pressure on marginal financial institutions bearing credit risk is huge.

7) Speaking of junior debt securities, Moody’s gave the GSEs, and the US Government a shot across the bow when it downgraded the preferred stock ratings of Fannie and Freddie.  With the fall in the common and preferred stock prices, any possiblity of private capital raising fades.  The Administration and Congress should realize that whatever flexibility/help they grant the GSEs will be taken, and quickly.  Budget for the worst case scenario.

Then again, Ackman’s plan to restructure the GSEs, which is similar to mine (given in the last week), is reasonable.  Leverage is reduced and a market panic is avoided.

9) But even if neither plan is implemented, the dividends may be cut for the GSEs common stocks.  Shades of GM.  What is more significant, is if the GSEs feel they can’t issue preferred stock at acceptable yields, maybe they will omit those dividends as well.

10) Now, in the midst of expensive bailout talk, is there a cost imposed on the US?  Yes.  The dollar is weak, and default swaps on US government debt are rising in yield.  (Thought: how do swaps on US government debt pay off?  Hopefully not in dollars…  Also, what qualifies as an event of default?  Inflation doesn’t count, most likely, and yet that is one of the main ways for a government to try to escape debt.

11) Socialism!  Is the bailout socialism? Even for a libertarian like me, I can justify a bailout like Ackman’s, because it hurts those that tried to profit from the public/private oligopoly.  But no, I can’t justify what Paulson is trying to do, and maybe, just maybe, the market is sending him a message that half-measures won’t work.

12) More on preferred stocks.  They have been crushed.  This reinfirces why I rarely recommend preferred stocks, or junior debt securities: the payoff is low in success, and losses are high when things go wrong.

13) Let me get this straight.  You trusted Wall Street on an implicit guarantee?  You didn’t get a formal guarantee in writing?  Oh, my, it happens every decade… implied promises fail, and the cold, hard, printed text governs.  “Yes, that could technically be called, but don’t worry, they never do that.” “AAA insurance obligations never fail.”  “Portfolio insurance will protect you; you don’t have to buy puts.”  Never trust implicit promises of Wall Street, because in a real crisis, they go away.

14) Looking over some of my indicators, it looks like we are close to a bounce.  It feels a lot like January of 2008.  So, is it time to buy?   I’m not sure, but I am adding little by little to my stockholdings.  I’m probably going to up the equity percentage in some of my accounts where I have few options (old job Rabbi Trusts).

15) Not that I am likely to liquidate 401(k) assets, or anything like it.  That some are doing so is a sign of the stress that we are under.  Don’t do it, if you can avoid it.  Better, perhaps, to take in a boarder.  It increases cash flow on an underused asset, and optimally, increases community relations.

Four notes for the evening: first, on Lehman Brothers: Deal Journal wrote a piece earlier this week on Lehman potentially selling their subsidiary Neuberger & Berman.  I generally agreed with the piece, and wrote the following response:

Be wary when managements sell their best/safest assets to stay alive. It means that the remaining firm is more risky, and that should the downturn persist, the firm will be in greater jeopardy.

Firms that sell their troubled assets (really sell them, not park the assets in affiliated companies) can survive the harder times. Trouble is, that requires taking losses, and sometimes the balance sheet is so impaired that that cannot be done.

So, selling the good assets may be a necessity, but it does not imply a good future for Lehman.

The same applies to Merrill regarding their stakes in Blackrock and Bloomberg.  Also, I am skeptical that Lehman was truly able to reduce its risk assets as rapidly as they claimed in the midst of a bad market.  I believe that if the tough credit markets persist into 2009, Lehman will face a forced merger of some sort.  Merrill Lynch has more running room, but even they could face the same fate.

Second, Alt-A lending worked when it was truly using alternative means to screen borrowers to find “A” credits.  It failed when loan underwriting ceased to be done in any prudent way.  Alt-A lending will return, but it is less likely that Indymac will see the light of day again.  Whether in insurance or lending, underwriting is the key to long-term profits.  Foolish lenders/insurers economize on expenses at the cost of losses.

Third, we have a possible deal that the US government may buy a convertible preferred equity stake in Fannie and Freddie.  This comes on the heels of news that no access would be granted to the discount window, but this deal would include discount window access.  (Ugh.  Is it going to take a Dollar crisis to make the Fed realize that only the highest quality assets should be on the balance sheet of the Fed?)

Now, this is not my favored way of doing a bailout, but it probably ruffles fewer political feathers, and many get to keep their cushy jobs for a while longer.  My question is whether $15 billion is enough.  It will certainly dilute the equity of Fannie and Freddie, but is it large enough to handle the losses that will come?

Now, reasonable followers of the US debt markets have shown some worry here, but in the short run, this will calm things down.

As a final note, I would simply like to say to all value investors out there that the key discipline of value investing is not cheapness, but margin of safety.  I write this not to sneer at those who have messed this up, because I have done it as well.  Pity Bill Miller if you will, but neglecting margin of safety and industry selection issues have been his downfall, in my opinion.  (And don’t get me wrong, I want to see Legg Mason prosper — I have too many friends in money management in Baltimore.)

I’m coming up on my next reshaping, and one thing I have focused on is balance sheet quality, and earnings stability.  Many value managers have been hurt from an overallocation to credit-sensitive financials.  They own them because the value indexes have a lot credit-sensitive financials in the indexes, and who wants to make a large bet against them?

Well, I have made that bet.  Maybe I should not have owned as many insurers, but they should be fine in the long run.  There is still more leverage to come out of the system, and owning companies that have made too many risky loans, or companies that need a lot of lending in order to survive are not good bets here.  Look at companies that can survive moderate-to-severe downturns.  If the markets turn, you won’t make as much, but if the markets continue their slump, you won’t get badly hurt.

Ugh.  I’m still not home yet, but after my recent 48-hour news blackout, the news on Fannie and Freddie is pretty amazing.  Now, I would not be so certain that an interpretation of SFAS 140 would force Fannie or Freddie to raise capital — GAAP accounting often has little to do with regulatory capital rules.  Only if OFHEO decides to mimic the treatment in GAAP would it force capital-raising, absent any net worth covenants on their debt that might be poorly written.

All that said, the problems with Fannie and Freddie are not primarily accounting-driven, but are being driven by diminishing housing prices, which erodes their margin of safety on their lending and loan guarantees, and diminishes the value of the mortgage insurance that they rely on for some of their business.  Writedowns from these items are what hurt.  It is likely that Fannie and Freddie need to raise capital, but the great questions are how much is needed, and how much can the market stomach?

At times like this, I run through my pecking order of the “financing methods of last resort.”

• Have you maxed out trust preferred obligations? Other subordinated debt?
• Have you maxed out preferred stock?
• Have you issued convertible debt to monetize volatility?
• Have you diluted your equity through secondary IPOs, rights offerings, PIPEs, and/or deals with strategic investors?
• Have you sounded out investors in your corporate bonds about debt-for equity swaps?
• And, unique to Fannie and Freddie, have you asked the US government for a capital infusion or a debt guarantee?

All of these financing methods carry a cost.  (And, as with most situations like this — if it were done, best it should be done quickly.  Delay usually means that cost of financing rises.)  Most of the cost is dilution to existing shareholders, whether common or preferred.  The debt guarantee, or investment by the government has costs for the US taxpayer, which I would rather not see.

Clearly, Fannie and Freddie have room to raise more capital, but the room is not unlimited.  As the Financial Guarantors found, when your stock price gets too low, the jig is up.  You can only raise so much capital relative to the size of your current market capitalization before the market chokes.  After all, most capital raising requires a discount to current price levels, and somehow the diluted value of the equity needs to represent a premium price where new capital gets put in.

In short: it’s tough to get new investors to pay for past losses.  Capitalize a new company?  Could be done, and has already happened with the Financial Guarantors, which has largely sealed the fate of the tarnished incumbents.  That said, why would the US government want a competitor to Fannie or Freddie, aside from GNMA?

As for the US Government, perhaps this all waits for a new President and Congress to act.  Personally, I think that any help extended to Fannie or Freddie should have strings attached.  Investments, or debt guarantees should allow the US government to profit if things turn around.  Other things to explore: only guaranteeing new liabilities, or, expanding the role of GNMA, which is a full-faith-and-credit of the US Government lender.

The one thing I don’t want to see is a bailout that benefits the shareholders of Fannie or Freddie.  They have long had private profits with many public subsidies for years.  Now it is time for the shareholders to bear the losses; let public money only step in to keep senior obligations whole, if it steps in at all.

(Note: these are my private opinions, and not those of my employer.)

Readers have suggested some additional tickers for me.  Here they are:

GE, MSFT, BMY, BA, ANAT, KCLI, and DE

Beyond that, there was my country screen — cheap names in Taiwan and Korea that trade in the US?

WF SHG LPL KEP KB IMOS AUO

Then for the industry screen.  Here’s the most recent list of cheap industries; I used the ones labeled “Dig Through”:

Remember, this can be used in momentum mode (red) or value mode (green).  I’m using it in value mode, and it gave me a flood of tickers — remember, in this screen, Price-to-book times Price-to-next year’s earnings must be less than 10.  That’s usually a pretty strict criterion, but this time it turned out 121 tickers:

ABD ABG ACE ACGL AEG AEL AFG AGII AIG AMCP ASI AWH AWI AXA AZ BBI BBW BC BKI BWINA BWINB BWS BZ CAB CHB CINF CMRG CNA CNO CONN CPHL CRH DSITY EBF EIHI FFG FMR FNF GBE GIII GLRE GNW GT HALL HMN HSTX IHC INDM ING INT IP IPCR KGFHY KPPC LFG LGGNY LIZ LNY M MERC MGAM MHLD MIG MIGP MRH MRT MSSR MTE MW MYSZY NP NSANY NSIT NYM OB OSK OXM PAG PCCC PEUGY PL PMACA PNX PSS PTP PTRY RCL RE RNR ROCK RSC RT RUSHA RUSHB RUTH SAH SEAB SEOAY SIGI SMLC SSCC SSI SUR SWCEY SWM THG TI TRH TUES TWGP UFCS UFS UNM UPMKY USMO UTR VOXX VR WHR XL ZFSVY

Well, the quantitative ranking method will have its work cut out when I build the main spreadsheet — it will take some effort to scrub the accounting data, and come to some buy decisions, but that’s my next task.

We’re not quite to the endgame yet, but the jig is up for MBIA and Ambac, after the downgrades from Moody’s at the holding companies to Baa2 and A3 respectively.  Wait, why I am I mentioning the holding companies?  Isn’t it the operating subsidiaries that matter?

Well, yes, for sales and regulatory purposes, but the ratings at the holding companies matter for a different reason — notching.  But let me tell a story first.

Failure improves markets by introducing risk-based pricing.  In the late 80s and very early 90s, virtually all of the life insurance industry was rated AAA/Aaa, or A+ from A.M. Best.  Taking advantage of the good opinion that the raters had of the industry, many life insurance companies issued Guaranteed Investment Contracts [GICs] to institutions for their Defined Benefit and Defined Contribution pension plans.  The insurance companies levered up issued AAA liabilities, and invested the proceeds in lower rated bonds, commercial mortgages, limited partnerships, and other things yet more risky.  (These were the days prior to risk-based capital.)

After a few failures hit — Pacific Standard (who?), Executive Life, Mutual Benefit, Fidelity Mutual, Confederation, and the near miss on the Equitable (what a story — I was on AIG’s failed takeover attempt team), the rating agencies went into full scale defense mode, downgrading every company in sight.  It was everything a company could do to retain its ratings — and there were almost no ratings upgrades until 1996 or so.

The rating agencies are ratchets. (or, do I mean rackets? )  Downgrades come easily, upgrades come hard, and almost no corporate credit ever gets upgraded to AAA.  But, in this case, the downgrades have come for this industry in the way that I predicted earlier this year:

		David Merkel
		Moody’s Downgrades XL Capital Assurance
		2/7/2008 3:34 PM EST

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade).

Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. 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

Once your insurance operating subsidiary is downgraded below AAA/Aaa, there are many classes of business that cannot be written anymore.  Revenue dries up.  What’s worse, is that the rating agencies no longer have any practical reason to not downgrade further; the revenue model is broken for the rating agencies, and if there are highly rated new entrants, there is no reason to care about the company; the industry will survive, and the rating agencies will get fees.

Now, supposedly, New York doesn’t want to take the operating subsidiaries into conservation because it would trigger acceleration clauses in the CDS.  If those contracts were written at the operating companies, the insurance commissioner has the power to nullify any seniority those contracts possess — you can’t favor one insurance claimant over another.

But Dinallo wants to favor municipal claimants, which is probably illegal.  They could force the capital into the operating company, but they would rather see the municipal business reinsured.

Oh, notching — once a holding company is rated lower than Aa3/AA-, there is no way to get a subsidiary to have a Aaa/AAA rating.  The rating agencies will not allow it to happen.

So, I don’t see good things ahead for the guarantors.  Two final notes: Ambac tells Fitch to take a hike.  Fitch won’t do it.  Expect a downgrade soon.  Triad goes into runoff; my old colleague John must be smiling… he always thought they wrote the worst business.

The last several days have been interesting to me regarding National Atlantic. It started with a discussion with another person who worked for my former employer (no, not the same one as last time). It went something like this:

Friend: Did you see the filing by our old boss?

DM: Yes, but unless he files suit alleging fraud, it is unlikely to amount to much.

F: Good point. What do you think the odds are of the deal going through?

DM: The deal is more likely to go through than not, but if the deal does fail, the stock will fall to $4, and if the deal succeeds it will go to $6.25. The payoff is asymmetric. I think the odds are 65% that the deal goes through.

F: So why are you holding on if the odds are that poor relative to the rewards?

DM: Uh…

So, on Thursday of last week and yesterday, I sold away 70% of my position after voting “no” on the deal. My thoughts: it is quite possible that the deal will get voted down. Sure, it isn’t in the short term interest of stock holders to see the deal fail, but National Atlantic has so annoyed shareholders that many will vote against their short term interests because of the egregiousness of the deal.

As an aside, NAHC is the sort of stock that if you are not careful, a large order can disrupt the market; I ended up using discretionary reserve orders routing through Arca [NYSE Archipelago], which allowed me to show 100 shares with much more behind that, and have discretion to lift bids within a penny of the stated offer. I was able to sell a lot without disturbing the market.

If the deal does get voted down, I will buy back in, at much lower prices. If it succeeds, I will take the small gain and move on.

Full disclosure: long NAHC