After seeing the amazing “refinancings” done by entities like MBIA, Thornburg, WaMu, and Rescap, I felt it was right to comment on last-ditch financing methods, so that you can recognize desperation (if it’s not obvious already).  Here are some methods:

• Borrow money using a healthy subsidiary while limiting capital flows up to the less than healthy holding company (e.g., MBIA) .
• Do a rights offering at a significant discount, diluting existing shareholders if they don’t participate.
• Offer common stock at a significant discount to a private buyer (perhaps with warrants), diluting existing shareholders, but perhaps allowing the company a chance to play again another day. (e.g. WaMu, Thornburg).
• Offer a convertible bond/preferred to monetize the volatility of the stock price, contingently diluting existing shareholders. (e.g. Lehman, Citigroup, Merrill)

With the exception of the first one, all of these dilute existing shareholders, usually driving the stock price down in the short run, unless the removal of fear of bankruptcy is the dominant factor.  With the first one, it is an example of structurally subordinating lenders to the holding company, who now lose “first dibs” on the value of the healthy subsidiary.

I try to avoid companies that do financings like these, or are likely to do them.  They have a high default rate.  And what goes for the stock here, goes triple for the corporate bonds, where you have all of the downside of the stock, and little of the upside, if the company should manage to survive.

Well, it’s that time again. Time to make a few portfolio swaps. At present I have two placeholder securities, the industrial Spider, and the technology Spider. Those will go, and I may sell one more security, but that’s it. I will use the proceeds to buy 2-4 positions, so that I will end with 34-35 positions.

When I run across an idea between quarters, I write it down on a sheet and wait for the next reshaping. Well, here is the list of tickers I came across over the last 3 months:

AAUK ACE ADI ADPT ADSK ALB ALL ALV AMAT AMGN AMH AN ANDS APD ARG ASH AW AZN BA BDK BGC BNI BRCD BTU CAG CB CC CCI CHRS CIU CLNE CNQ CONN CPB CRC CRI CSCO CSE CSX CTHR CVG CVI DEO DITC DKS DNR DRI EMC EQ ETFC ETP FMX FRX FSII FTD GDI GIII GT GTI GTS HAR HBOOY HCC HD HOC HTCH HTH HUM IBM INFS ISLN ITRN JBL JCI JCP JRT JTX KFS KMP KMX KOP KR KSS LAMR LDIS LM LOW LXK MAS MCHP MMP MNKD MSN MTA MTW MYE NII NSC NTGR NTT NUHC OMX ORCL OVTI OXY PARL PAYX PBR PCZ PERY PHH PMRY POM PTEN PVX PX QTM RAI RDC RDS RELL RES RHD RJF ROST RSC S SCSS SCX SHW SIRF SNDK SNY SPIL STX STZ SU SUN SUR SVU T TBAC TDW TGT TM TOT TRV TSN TSO TXN TXT TZOO UNP UPRT URBN VMW VOXX VZ WAG WC WDC WHR WIN WLP WNR WPC WTM XRX YUM ZURNY

One of the fun parts of this exercise is that I invite readers to submit their own ideas as well. Feel free to leave them in the comments below.

From here, I will update my industry model, run some screens, and post additional tickers. After that, I will compare the replacement candidates against my existing portfolio, using my multifactor appoach. I will keep you apprised of my thoughts as I move toward making the portfolio changes.

Full disclosure: long XLI XLK

I received this in the mail on Saturday:

ABC logo

March 31, 2008

Dear Investor,

I am writing to tell you that my firm is in very good financial condition. Normal market conditions would not require this correspondence. But I understand that many people are deeply concerned about the stability of their brokers at this time.

I have always tried to earn my clients’ trust by running the firm conservatively, with clients’ interests in mind. Today, 75% of the Company’s assets are in cash or cash equivalents and we have no debt. In addition, we have no investments in collateralized debt obligations or similar instruments. As a matter of policy, we do not carry positions or make markets.

Throughout the years, in making decisions about my business, I have always put the safety of my clients’ assets first. This is one of the primary reasons my firm clears on a fully disclosed basis through DEF LLC (DEF), a GHI company. DEF clears our clients’ trades and is in custody of their accounts. Their name appears with ours on monthly statements and confirmations. As of December 31, 2007, DEF had net capital in excess of $2.1 billion which exceeded its minimum net capital requirement by more than $1.9 billion.

In addition, when you do business at ABC, your account receives coverage from the Securities Investment Protection Corp. (SIPC) as primary protection for up to $500,000, including a limitation of $100,000 for cash. SIPC coverage is required of all registered broker-dealers. Since most “cash equivalent” money market mutual funds are considered securities under SIPC, investments in money market mutual funds held in a brokerage account are protected by SIPC along with your other securities to a maximum of $500,000. Of course, there is no protection that will cover you for a decline in the market value of your securities. You may visit www.sipc.org to learn more about SIPC protection.

Furthermore, DEF has arranged for additional protection for cash and covered securities to supplement its SIPC coverage. This additional protection is provided under a surety bond issued by the Customer Asset Protection Company (CAPCO), a licensed Vermont insurer with an A+ financial strength rating from Standard and Poor’s. DEF’s excess-SIPC protection covers total account net equity for cash and securities in excess of the amounts covered by SIPC, for accounts of broker-dealers which clear through DEF. There is no specific dollar limit to the protection that CAPCO provides on customer accounts held at DEF. This provides ABC clients the highest level of account protection available in the brokerage industry to the total net equity with no limit for the amount of cash or securities. And, unlike many other brokers, there is no “cap” on the aggregate amount of coverage for all of our customers’ assets. You may access a CAPCO brochure about “Total Net’ Equity Protection” at ABC.com [deleted]….

If you are concerned about the status of your assets at another brokerage firm, you might consider moving them to ABC. It is easy to transfer assets. If you have friends who are concerned about their brokers, you might consider referring them to us. We continue to offer free trades for asset transfer and referrals. If you have questions about anything in this letter, please feel free to call us at 800-xxx-xxxx from 7:30 a.m. –7:30 p.m. ET, Monday-Friday. Once again, thank you for your trust and your loyalty.

Sincerely,

President and Chief Executive Officer of ABC

I used to do business with ABC, and I presently do business with GHI. Both of them are good firms, doing business on a fair basis for their clients. To me, it is interesting to use financial strength as a marketing tool.

On another level, how many people actually check the solvency of their brokers before doing business with them? On a retail level very few, if any. On an institutional level, that’s a normal check for sophisticated investors.

That said, I would be surprised to see any major retail brokers go insolvent aside from those with significant investment banking exposure. Even there, accounts are segregated, and client cash typically has the option of being in a money market fund.

This is not something that I worry about in investing, but if I were worried about my broker, I would make sure that my liquid assets over $100,000 were in a non-commingled vehicle, most likely a money market fund.

What of Excess Insurance?

Now, I will add just one more note in closing. CAPCO is a nice idea, but I am always skeptical of small-ish insurers backing large liabilities with a remote possibility of incidence. There aren’t that many AAA reinsurers out there, and I am guessing that Berky is not one of them. Buffett does not like to reinsure financial risks, aside from municipal debt. That leaves the AAA financial guarantors — Ambac, MBIA, Assured Guaranty, and FSA (though I am open to a surprise here). I’m guessing it’s the first two, and not the last two. CAPCO is owned by many of the major brokers, but in a crisis, CAPCO has no recourse to its owners, but only to its reinsurers, should that coverage be triggered. The recent financial troubles have led S&P to place CAPCO on negative outlook, mainly because:

Standard & Poor’s assigns a negative outlook when we believe the probability of a downgrade within the next two years is at least 30%. The revised outlook reflects the challenging environment for broker/dealers and their parents. Deterioration in their credit quality and risk-management capabilities could affect CAPCO’s financial strength. In the past couple of months, Standard & Poor’s has revised the outlook on several of CAPCO’s members’ parents to negative. Also, the ratings on a couple of members are on CreditWatch with negative implications, which means there’s the potential for a more imminent downgrade. The capital of CAPCO’s members and–in some cases–their parents is an important resource for mitigating CAPCO’s potential payments for its excess SIPC (Securities Investors Protection Corp.) coverage.

It would be interesting to know for certain the underwriters and terms of CAPCO’s reinsurance. I’m not losing any sleep over it, though… there are bigger things to worry about, my personal broker is well-capitalized, and I have less than $100K at risk in cash, and that is in a money market fund. So long as accounts remain segregated, risks are small.

There have been many writing about the impact of the lack of an uptick rule in the present market.  In the past, before a player could sell short, the stock had to trade up from the last trade — an uptick.  This made it hard to short a stock too heavily, forcing the price down.

Well, maybe.  I still think shorting is a pretty tough business.  First, the long community is much larger than the short community.  Second, the longs can always move their positions to the cash account if they don’t like other players borrowing their shares.  (Move to the cash account, squeeze the shorts.  Wait.  You don’t want to lose the securities lending income?  Shame on you; you should put client interests first.)

The thing is the uptick rule is not the real problem.  The real problem is that shorts don’t have to get a positive locate at the time of the shorting; a mere indication from the broker enables the short for a few weeks, while search for loanable shares goes on. This is a computerized era.  There is no reason why there can’t be real-time data on loanable shares.

There is a second problem, and less so with stocks, than with other financial instruments that are borrowed.  There needs to be stricter rules/penalties on what happens when a party fails to deliver a security.  As it is, when the cost of failing to deliver is miniscule, it can really bollix up the markets.

The longs have adequate tools to fight the uptick rule; they don’t have adequate tools to help against naked shorting and failures to deliver.

1) A lament for Bill Miller.  Owning Bear Stearns on top of it all is adding insult to injury.  Now, living in Baltimore, I get little bits of gossip, but I won’t go there this evening.  I think Bill Miller’s problems boil down to lack of focus on a margin of safety, which is the main key to being a good value manager.  During the boom periods, he could ignore that and get away with it, but when we are in a bust phase, particularly one that hurts financials.  When financials get hit, all forms of accounting laxity tend to get hit, making the margin of safety more precious.

2) Now perhaps one bright spot here is rising short interest. Short interest is a negative while it is going up, but a positive once it has risen to unsustainable levels.  What is unsustainable is difficult to define, but remember Ben Graham’s dictum, that the market is a voting machine in the short run, and a weighing machine in the long run.  The value of stocks in the long run will reflect the net present value of their free cash flows, not short interest or leverage.

3)  Now, if you want the opposite of Bill Miller in the value space, consider Bob Rodriguez of FPA Capital.  Along with a cadre of other misfit value managers that are willing to invest in unusual long-only portfolios aiming for absolute returns while not falling victim to the long/short hedge fund illusion, he happily soldiers on with a boatload of cash, waiting for attractive opportunities to deploy cash.

4) Retirement.  What a concept amid falling housing and equity prices.  Though we have difficulties at present from the housing overhang, and the unwind of financial leverage, there will be continuing difficulties over the next two decades as assets must be liquidated and taxes raised to support the promises of Medicare, and to a lesser extent, Social Security.  My guess: Medicare gets massively scaled back.

5) I get criticism from both bulls and bears.  I try to be unbiased in my observations, because amid the difficulties, which I have have been writing about for years, there is the possibility that it gets worked out.  When there are problems, major economic actors are not passive; they look for solutions.  That doesn’t mean that they always succeed, but they often do, so it rarely pays to be too bearish.  It also rarely pays to be too bullish, but given the Triumph of the Optimists, that is a harder case to make.

6) Bill Rempel took me to task about a post of mine, and I have a small defense there, and perhaps a larger point.  Almost none of my close friends invest in the market. It doesn’t matter whether we are in boom or bust periods, they just don’t.  These people are by nature highly conservative, and/or, they are not well enough off to be considering investments in equities.  They are not relevant to a post on investing contrarianism, because they are outside the scope of most equity investing.  They are relevant to a discussion of the real economy, and where your wage income might be impacted.

7) To close for the night, then, a note on contrarianism.  When I read journalists, they are typically (but not always) lagging indicators, because they aren’t focused on the topics at hand. They get to the problems late.  But when I think of contrarianism, I don’t look for opinions as much as financial reliance on an idea.  Many opinions are irrelevant, because they don’t reflect positions that have been taken in the markets, the success of which is now being relied upon.  Once there is money on the line, euphoria and regret can do their work in shaping the attitudes of investors, allowing for contrary opinions to be successful against fully invested conventional wisdom.  But without fully invested conventional wisdom, contrarianism has little to fight.

For those that read my book reviews, let me simply say that unless I say that I skimmed a book, I read every book that I review, and I don’t use the publishers notes to aid me, as many other reviewers do. I just give you my opinion straight, even if I didn’t like it, realizing that there will be no commissions at my Amazon Store from that review. And that is fine with me. I review new and old books — I just want to point my readers to what I think is good, and away from the bad stuff.

I would also add that my Amazon Store is my equivalent of the tip jar. If you value my writing, when you need to buy a book from Amazon, simply start by clicking on a book on my leftbar, and buy the books that you would buy anyway. It doesn’t increase your costs at all, and I get a small commission.

Anyway, onto tonight’s book review. I am genuinely not sure what to conclude on “7 Commandments of Stock Investing.”  There was much that I liked, and much I did not.  I know that Mr. Marcial wrote a column for Business Week for many years, but that was not something I followed closely.  This is my first real introduction to his thought.

Let me take his seven principles, and go in order:

Buy Panic –  Hey, I can go for that.  The difficulty for average investors, and even many seasoned investors is that they buy too soon in a panic.  One also has to focus on companies that are high credit quality in order to avoid big losses.  That got some attention in the book, but not enough for me.

Concentrate, Diversify Not — Ugh, I like having 35 companies in my portfolio, because I concentrate industries.  To the extent that you concentrate, you must have superior knowledge of the companies that you own.  Without that knowledge, the average investor should diversify more, and investors with no special knowledge should buy index funds.

Buy the Losers –  Again, I can go for this, but it takes a special person to separate out the companies that will crater from the companies that have a sustainable business model and will bounce.  Buying quality companies is a must here, or else you can lose a lot.

Forget Timing — I agree.  I keep roughly the same equity exposure all the time, and my rebalancing discipline helps protect me as well.

Follow the Insider –  That’s a good principle, but I’m not sure that it should rank so highly in a set of stock picking rules. Insiders do do better than the market as a whole, but using insider purchase and sale data takes discretion to interpret.

Don’t Fear the Unknown –  By this he means have some foreign equity exposure and biotechnology investments.  One of my rules is, “If you can’t understand it, you won’t know how to buy and sell it.”  Getting comfortable with any area of the market that is volatile takes study and effort.  This is not trivial.  As for biotech in particular, that takes a lot of incremental skill that I don’t have.  After reading what Mr. Marcial wrote, I would not feel confident investing there.

Always Invest for the Long Term: Seven Stocks for the Next Seven Years — He employs a multi-year holding period, like I do, and then points out seven stocks that he thinks will do well.  I’m not going to spoil that part of the book by mentioning any of the seven, but none of them interest me.  (Well, maybe one or two at the right level.)  All of them are large caps, and are quality companies.

Quibbles

Under his first principle, he recommends buying the stock of the company that you work for when it gets hammered down (page 8).  Unless you are an industry expert here, be careful… you are compounding your risks, because your wage income derives from the health of the firm.  Don’t put your savings there too, unless you are dead certain.  (Full confession: I put one-third of my net worth on the line on my employer, The St. Paul, in March of 2000, selling in August of 2000.  Great trade, but no one else knew in the firm did it.)

On page 62, calling Primerica the predecessor firm to Citigroup is a bit of a stretch.  Yes, I know how the case could be made, but there were links in the chain where the smaller company was acquired by a larger one, and the smaller company came to dominate the management of the combined firm.

Under his third principle, he favored GM and Ford.  I can’t support buying such credit quality impaired investments under the rubric of “Buy the Losers.”  These are two companies that will have a hard time surviving in their present forms.  Motorola would be another example… a pity there is such a lag between writing and publication.

Summary

The book is intelligently written, and is short enough for an average person to read in 4 hours (188  pages).  He gives plenty of examples to illustrate his points.  I wasn’t usually enthused by the companies that he chose — I prefer to go further off the beaten path, and buy them cheaper.

His basic principles are good principals to follow, but they need to be tempered by a focus on risk control.  It’s one thing to serve up investment ideas as a writer — you can throw out a lot of promising ideas, and do it well.  What is tough is owning the companies, and trading through their troubles.  That’s a dirtier business; one where average investors will be more prone to fear and greed, and may not do so well, just because they can’t stomach the risks.

He also does not make clear how the seven principles work together. Need you follow all seven on every investment?  I think that’s what he is saying.

Away from that, you can’t use his principles on low quality stocks; that would be a recipe for regular large losses.  Buying panic, buying weakness, and concentrating requires a high quality approach to investing.

With that, I recommend the book to those that have enough maturity to know that they will have to bring their own risk control models to the game.  His methods presuppose a degree of ability in interpreting the fundamentals of companies, so I do not recommend this book to beginners; it would be a dangerous way to start out in investing.  Better to start with Ben Graham.

Full disclosure: If you buy this book, or any other book through the links on this page, then I get a small commission.

Late in the day, I looked at a table of valuations of the remaining major investment banks, and thought, “Huh, they’re priced like Bermuda Reinsurers.  Price-to-book near 1 or lower, and expected P/Es in the middle single digits.”  Well, that got me thinking… how are those two groups of companies alike?

•  When losses come they can be severe.
• Both have strong underwriting cycles where a lot of money is made in the boom phase, and a lot gets lost in the bear phase.
• Earnings quality can be poor, unless management teams have a bias against meeting Street expectations, and allowing earnings to be ragged.
• The opacity of the investment banks’ swap books is matched by that of the reinsurers’ reserving.
• Both businesses are highly competitive, and global in scope.

Now, what’s different?

• The reinsurers typically don’t have asset problems, only reserving problems.
• The Bermuda reinsurers know that one day a change in their tax status may come (somehow forced to pay US tax rates — ask Bill Berkley), and that would lower earnings.
• The financial leverage of the reinsurers is a lot lower.
• The financing of reinsurers is a lot more secure.

The risk-reward seems balanced to me across the two groups.  The reinsurers are lower-risk/lower-reward, and the investment banks are higher on both scores.  Choose in accordance with your risk tolerance — as for me, I’ll look at the reinsurers.

Given the furor of the day, I thought I might have to abandon the National Atlantic Teleconference call.  I didn’t miss the call.  The transcript is here (thanks, Seeking Alpha).  Let me quote my portion of the call.

=-=-=-==-=-=-=-=-=-=-=-=-==-=-=-=-=-=-=-=-=-

Operator

Thank you, sir. Today’s question-and-answer session will be conducted electronically. (Operator Instructions). We’ll go first to David Merkel of Finacorp Securities.

David Merkel - Finacorp Securities

Hi, Hello.

James V. Gorman

Good morning, David.

David Merkel - Finacorp Securities

Very good. I wanted to ask a little bit about the, you had a number of parties go over your reserves, three and all I believe and how, I would assume at this point you are rather certain that you have been able to clean up most of reserving problems particularly given what was happening in your claim department prior to, I guess September 2007? Can you walk us through that one more time?

James V. Gorman

Yes, we have taken a very hard look at the claim review process, within the claim department. We have modified the procedures, we have updated our diaries. And when you go through a change like this, your historical information and your typical loss development patterns are no longer appropriate to use.

David Merkel - Finacorp Securities

Right.

James V. Gorman

In estimating alternates. So, we had to rely heavily on projecting the open, ultimate number of claims that will be paid and the severity associated with those clients. And I think our review that was done as well as that done by our external auditors have focused on looking at average claim cost as opposed to looking at normal loss development methods.

We continue to look very closely, as part of our quality control process to make sure that the adjusters are in fact keeping claims up to date that we are managing them affectively and that we are in fact putting in place an aggressive settlement policy to move these claims off of our balance sheet. So, we are cautiously optimistic that we have our arms around, our ultimate liabilities. But, obviously there is no guarantee but we have scrubbed this thing it from many different angles.

David Merkel - Finacorp Securities

Great, well that’s good. The re-insurance recoverable change, it was $3.1 million or something like that? What was that about?

James V. Gorman

While we project our direct loses, we also project how much is going to commend in ceded loses and you know based upon our current retention as a company we’ve retained the first 500,000 of loss the emergence of ceded losses is very slow to develop.

David Merkel - Finacorp Securities

Right.

James V. Gorman

And we have looked more carefully at our projected reinsurance recoverables and determined that we are not going to be in a position to collect as much as we had previously thought. This is not connected at all to any reinsurance recoverable on paid clients.

David Merkel - Finacorp Securities

Yes got it.

James V. Gorman

This is based on projected losses.

David Merkel - Finacorp Securities

Okay. Last question, do you have side of your balance sheet, you know, there is a decent amount of turmoil out there now, with respect to various types of AAA structured product and I know you didn’t do that much with subprime or anything like that. But, what are you experiencing if anything on the asset side of your portfolio at present, I assume that it’s just ordinary payments of cash flows from your mortgage bonds and other assets, because you have a fairly high quality portfolio we use the way the rating agencies rate them. Are you experiencing any difficulties there at all?

James V. Gorman

Well, I’ll start that answering your question David and then I’ll turn it to Frank, but from the investments, I would like to just further assure our investors that we have absolutely no subprime exposure. In addition, any bond that we have is A or better on its own merits without the effective any MBIA or AM backed insurance less to the rating, further we have no equities in our portfolio. So, on the investment side, I think that we are pretty planned and pretty solid and we had a great yield in ’07 given all of the decrease in interest, average interest rates. Frank can you add anything to that on the balance sheet.

Frank Prudente

I think you well covered it I may I think we felt for a long time, we have a conservative portfolio and with a disruption we’ve seen in the market it’s evident it’s conservatism by us not having any issues.

David Merkel - Finacorp Securities

Well, thank you gentlemen. I appreciate it and I will be looking forward to any releases that describe the logic for the $6.25 purchase price. So, I thank you both.

James V. Gorman

Thank you, David.

David Merkel - Finacorp Securities

Take care.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

Okay, why did I ask those questions?  Why not bluster about the huge discount to book that they are selling the company at?

Rather than do it that way, I asked about the two least certain items on their balance sheet — their loss reserves, and the value of their assets.  If they express confidence in those two numbers, then it will be hard to back away from an adjusted book value north of $10.  Why does this have value?  Well, there are many other investors bigger than me in the company, and this gives them a reason to vote down the deal.  NAHC has no debt; there is no solvency crisis here, so a large discount to book is not warranted.  With a short-tail P&C company you could hire a specialist to inexpensively run the book off, and after a year or so, sell of the tail of the company.  We would definitely realize a price north of $6.25.

But what if the deal goes through?  In that case, I might not tender my shares, but file for appraisal rights.  I would show the judge the management’s answers to my questions, demonstrating the confidence that they had in the asset values and reserving, immediately after the deal announcement.  It is rare that the judges allow deals to go out at less than tangible book value, particularly on short-tailed P&C companies with little insolvency risk.

So, that’s why I asked those questions.  Now to see what happens.

Full disclosure: long NAHC

I will have a fuller post after I talk with Jim Gorman, CEO of National Atlantic.  If he thinks his company, which he owns around 13% of is only worth $6.25/share, that is a real surprise to me, and inconsistent with all of the other discussions that I have had with him over the last four years.  A few of you have asked me about appraisal rights.  Really, we should talk about this later if the deal gets approved; it’s too early to speculate there.  For those that remember my early posts at RealMoney on the Mony Group acquisition, remember that book value is sometimes illusory.  I don’t think that is the case here, but let me talk with Jim Gorman, and listen to the earnings call on Monday.  If they deliver another bomb, like last quarter, maybe $6.25 is generous.

Full disclosure: long NAHC

1) I typically don’t comment on whether we are in a recession or not, because I don’t think that it is relevant. I would rather look at industry performance separate from the performance of the US economy, because the world is more integrated than it used to be. Energy, Basic Materials, and Industrials are hot. Financials are in trouble, excluding life and P&C insurers. Retail and Consumer Discretionary are soft. What is levered to US demand is not doing so well, but what is demanded globally is doing well. Much of the developed world has over-leverage problems. Isn’t that a richer view than trying to analyze whether the US will have two consecutive quarters of negative real GDP growth?

2) So Moody’s is moving Munis to the same scale as corporates? Well, good, but don’t expect yields to change much. The muni market is dominated by buyers that knew that the muni ratings were overly tough, and they priced for it accordingly. The same is true of the structured product markets, where the ratings were too liberal… sophisticated investors knew about the liberality, which is why spreads were wider there than for corporates.

3) Back to the voting machine versus the weighing machine a la Ben Graham. It is much easier to short credit via CDS, than to borrow bonds and sell them. There is a cost, though. The CDS often trade at considerably wider spreads than the cash bonds. It’s not as if the cash bond owners are dumb; they are probably a better reflection of the true expectation of default losses, because they cannot be traded as easily. Once the notional amount of CDS trading versus cash bonds gets up to a certain multiple, the technicals of the CDS trading decouple from the underlying economics of the bond, whether the bond stays current or defaults. In a default, often the need to buy a bond to deliver pushes the price of a defaulted bond above its intrinsic value. Since so many purchased insurance versus the true need for insurance, this is no surprise.. it’s not much different than overcapacity in the insurance industry.

4) If you want a quick summary of the troubles in the residential mortgage market, look no further than the The Lehman Brothers Short Swaption Volatility Index. The panic level for short term options on swaps is above where it was for LTCM, and the credit troubles of 2002. What a take-off in seven months, huh?

5) Found a bunch of neat charts on the mortgage mess over at the WSJ website.

6) I have always disliked the concept of core inflation. Now that food and fuel are the main drivers of inflation, can we quietly bury the concept? As I have pointed out before, it doesn’t do well at predicting the unadjusted CPI. Oh, and here’s a fresh post from Naked Capitalism on the topic of understating inflation. Makes my article at RealMoney on understating inflation look positively tame.

7) The rating agencies play games, but so do the companies that are rated. MBIA doesn’t want to be downgraded by Fitch, so they ask that their rating be withdrawn. Well, tough. Fitch won’t give up that easily. Personally, I like it when the rating agencies fight back.

8 ) Jim Cramer asks if Bank of America will abandon Countrywide, and concludes that they will abandon the bid. Personally, I think it would be wise to abandon the bid, but large companies like Bank of America sometimes don’t move rapidly enough. At this point, it would be cheaper to buy another smaller mortgage company, and then grow it rapidly when the housing market bounces back in 2010.

9) Writing for RealMoney 2004-2006, I wasted a certain amount of space talking about home equity loans, and how they would be another big problem for the banking system. Well, we are there now. No surprise; shouldn’t we have expected second liens to have come under stress, when first liens are so stressed?

10) In crises, hedge funds and mortgage REITs financed by short-term repo financing are unstable. No surprise that we are seeing an uptick in failures.

11) As I have stated before, I am not surprised that there is more talk of abandoning currency pegs to the US dollar. That said, it is a getting dragged kicking and screaming type of phenomenon. Countries get used to pegs, because it makes life easy for policymakers. But when inflation or deflation gets to be odious, eventually they make the move. Much of the world pegged to the US dollar is importing our inflationary monetary policy.

12) Finally, something that leaves me a little sad, people using their 401(k)s to stay current on their mortgages. You can see that they love their homes, as they are giving up an asset that is protected in bankruptcy, to fund an asset that is not protected (in most states). Personally, I would give up the home, and go rent, and save my pension money, but to each his own here.