All aboard the monoline Titanic
What disturbs me most about the current mess in debt markets is the apparent inability of banks and investors to act in a rational and co-ordinated way to prevent a relatively small, local financial difficulty turning into a global meltdown.
I鈥檓 talking about the buffeting of the monoline insurers, whose shares 鈥 notably those of and 鈥 have been taking a beating.
The importance of these companies is that they provide guarantees to bonds with a value of $2400bn.
It鈥檚 their sole business, which is why they are called 鈥渕onoline鈥.
They exist to provide insurance that turns good-quality bonds into bonds that are supposedly of impeccable quality, almost as good as US Treasuries, because there are certain risk-averse investors that can only buy the best triple A securities.
They have typically provided this service for bonds issued by US municipalities 鈥 which is stuff that is intrinsically okay 鈥 and bonds linked to US subprime mortgages, which is stuff that is intrinsically stinky.
So as fears have increased about how much sub-prime lending will eventually be written off, estimates have risen about future payouts that the monolines will have to make.
Which is why the ratings agencies are reviewing the credit ratings of Ambac and MBIA for possible downgrade.
If the monolines lose their own triple A ratings, then the bonds they insure will 鈥 automatically 鈥 lose their premium ratings.
Those bonds will 鈥 also as a matter of automaticity 鈥 fall in value.
estimates those losses would be $200bn.
But it鈥檚 impossible to be precise about this 鈥 because if risk-averse investors were to dump several lorry-lorry loads of this stuff on the market, who knows how far the prices could fall.
There is a simple solution.
The banks and investors most at risk from a bond meltdown could pump fresh capital into the monolines, to prop them up. The few billions needed by the monolines are trivial in comparison with the potential losses that would be generated throughout the global financial system were they not to be mended.
But the current spirit on Wall Street is anarchic sauve qui peut.
All the big banks are so pre-occupied mending leaks in their own respective hulls that they appear to be blind to the looming iceberg.
Let鈥檚 hope they are capable of taking collective evasive action at the last, because otherwise we could enter a horrific new phase of the credit crunch.
Oh, and you may remember that the great hope of the government is that it will persuade one of these insurers to guarantee billions of bonds that would be created out of its loans to Northern Rock.
That鈥檚 the sine qua non of a so-called commercial rescue of the Rock.
But it is literally the worst time in recorded history to buy such insurance.
The one or two reinsurers still in business can charge what they like for this service.
Would it be in taxpayers interest for the chancellor and prime minister to pay out eye-watering amounts of our money for this bond-wrap or guarantee?
Mr Brown and Mr Darling be make a tasty dish for the Public Accounts Committee if they even thought about doing so.
Update 09:29: Oh to have been a fly on the wall in the offices of , the fund manager, when its share opened more than 40% lower this morning, knocking more than 拢130m off the value of the company. The reaction from - New Star鈥檚 strong-willed founder who is probably best known for having made some colourful remarks about the Germans a few years ago - would probably have been great theatre. But then the news out of New Star was horrendous: poor investment performance; an outflow of funds; a savage dividend cut; a shocking profits warning. It doesn鈥檛 come much worse than that.
I'm 
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Robert - isn't the missing link in this proposal of yours the fact that it's largely the banks who benefit from the insurance, so supporting the insurers means, in effect, self-insuring.
I fear your argument is logically similar to;
"Insurers won't insure homeowners in Gloucestershire against flooding because it's likely to happen and would cost them too much to pay out, but if Gloucestershire Council just charged extra council tax and underwrote the insurers, they could afford the payouts".
What you're suggesting Robert is plainly wrong.
If a bank provides capital, so the bonds it is holding do not get downgraded, then effectively it is insuring itself - which means there is no insurance whatsoever!
And how long would that capital last? The basic problem is the size of looming default which is scheduled to continue at least for the remainder of this year.
Using both French (sauve qui peut) and Latin (sine qua non), Robert. A strong effort.
Perhaps the sovereign funds could be inclined to pump some capital into the monolines. After all a medium term recovery in the Financials will see them make good on their recent investments in UBS et al.
A stake in a thriving investment bank is worth a lot more than a stake in an ailing one.
Oh the joy of foreign phrases!
Why not chuck in caveat emptor or my personal favourite and something that sems to be sadly lacking in the financial markets at the moment uberrima fides.
Forget women and children first the financial markets seem to be acting like headless chickens.
It's surely time for someone to stand up and be counted.
I have seen this argument from Robert before, and it doesn't work. By putting equity into the monoline insurance pot, you are shoring up the credit rating of your bond holdings by taking on the same risk in your equity holdings, and getting paid the risk premium. In effect you are insuring yourself. What's the value added by the monoline? It is the equivalent of Norwich Union saying that they have run low on house insurance reserves, they can therefore not guarantee to pay you out in full if your house burns down, so could everyone please remortgage and put some money into the pot.
An excellent piece Robert, another of the gems in your reporting that one can find amid all the guff about NR. Can we please concentrate on this, the main event now, rather than the Geordie side-show?
On the topic of Buffett's venture into bond insurance, I find it instructive that he set up his own rather than bail out an existing monoline. Share prices have fallen further since his decision, but I wouldn't like to try pricing in the sub-prime factor if it was my $1bn...
Perhaps if everyone involved had acted in uberimma fides we wouldn't be in this problem.
Having said that caveat emptor should guide everything you do when dealing with financial whizzkids that think they know everything.
"The few billions needed by the monolines are trivial in comparison with the potential losses that would be generated throughout the global financial system were they not to be mended."
Sorry Robert, isn't the problem that the potential losses run into the hundreds of billions, hence the end of the world scenario looking ever more likely.
If it was a few billion the markets would have faith in these companies raising more (as they have already) to shore up their balance sheets. Sadly the scale of this disaster will only really be seen when it is agreed the monolines cannot insure these bonds because they are broke. It is a total scandal already that they have been allowed to keep AAA ratings!
Post 2 has made a valid point. Robert, your solution is naive, a few billions are drops in the ocean. If it works, you could have solved Northern Rock problem in the same way.
It should have been seen much earlier that the use of very low interest rate to revive the economy will lead to the present situation. Part of the western world is drowning in debts, the other part is immensely rich and don't expect the rich to be charitable.
The only solution left is going back to that devil of very low interest rates to force the rich to put their money back into the market.
"They have typically provided this service for bonds issued by US municipalities 鈥 which is stuff that is intrinsically okay 鈥 and bonds linked to US subprime mortgages, which is stuff that is intrinsically stinky"
Actually they haven't 'typically' provided subprime insurance - that's what's caused this mess for them because they have had limited experience in this area. In their defence, traditional US subprime mortgages have been reasonable investments - the current problem lies in an underpricing of the risk and hence the premiums charged. Warren Buffett has always said about insurance that oneday, someday there's a big hit coming - the question is whether that rsik has been properly recognised and charged for.
Actually they haven't 'typically' provided subprime insurance - that's what's caused this mess for them because they have had limited experience in this area. In their defence, traditional US subprime mortgages have been reasonable investments - the current problem lies in an underpricing of the risk and hence the premiums charged. Warren Buffett has always said about insurance that oneday, someday there's a big hit coming - the question is whether that risk has been properly recognised and charged for.
Robert - unfortunately Guarantee brings protectionism and that doesn鈥檛 fit well with capitalism - its a trade off mate - either we choose path of becoming too rich or insolvent in no time or we all share the big pie -- regardless to say "human" has rejected the 2nd theory already.(cause 鈥 it makes them to look uncharacteristically ordinary)
I suppose this is not intended to be read by ordinary people like myself, I dont understand the french or latin
phrases!
I find some of the comments so far disturbing.
Before passing comment some of the posters should do research on bond insurers.
If something isn't done quickly to raise capital to shore up their balance sheets loans everywhere will become more expensive.
Why do you think Berkshire Hathaway have formed a bond insurer to help the markets?
Using both French (sauve qui peut) and Latin (sine qua non), Robert. A strong effort.
Perhaps the sovereign funds could be inclined to pump some capital into the monolines. After all a medium term recovery in the Financials will see them make good on their recent investments in UBS et al.
A stake in a thriving investment bank is worth a lot more than a stake in an ailing one.
Perhaps there should have been some more uberimma fides shown by the various parties in all this.
The monolines and the rating agencies that have allowed them to keep AAA rating have been a disaster waiting to happen for a long time.
The financial markets have gone along happily getting more and more exposed for yars now with no apparent chance of failure.
To be honest I think the Titanic analogy is an excellent one. The market has been incredibly over exposed and has pushed things far too far. There are a number of massive icebergs out there in 2008.
Why on earth would anyone want to pump money into the monolines?
They are fundamentally alchemists - they are the magic behind the AAA rating of the bonds, and their business is basically turning muck into gold.
However, it appears that they may have been undercharging for this, or insufficiently providing for their risk, and so are now looking very unhealthy.
The only reason the banks might have an interest in supporting these monolines is if the insurance is not worth the paper it is printed on becuase the monolines are incapable of paying out. But then again, that rather looks like self insurance.
It all looks to me like another symptom of the underlying problem that has plagued this crisis - the mis-pricing of risk, whether negligently, hopefully or deliberately in the knowledge that the shit wouldn't hit the fan until long after the salesmen had pocketed their bonuses.
My own take on the crisis is that without the factors leading to it, we'd have had a consumer fuelled bust for the last 10 years, and would be looking at a very different economy. Unfortunately, whereas at some point the taps get turned off to prevent the banks running out of money, various governments around the world have rather enjoyed the fruits of the boom, and the taps have been left running, only to find that actually they've bled the supply dry. Shame.
Robert - unfortunately Guarantee brings protectionism and that doesn鈥檛 fit well with capitalism - its a trade off mate - either we choose path of becoming too rich or insolvent in no time or we all share the big pie -- regardless to say "human" has rejected the 2nd theory already.(cause 鈥 it makes us to look uncharacteristically too ordinary)
This s a classic game therory problem - what is rational for the group is not rational for the individual. Wishful thinking and appeals to the collective won't change that - it will simply punish those who listen to them.
The way to avoid this is not to get into this positionin the first place, by regulating financial institutions effectively and appropriately so that that bubbles like the sub-prime don't happen.
I'm re-reading Galbraith on the Great Crash. Why does every generation have to learn this lesson again?
"Perhaps if everyone involved had acted in uberimma fides we wouldn't be in this problem.
Having said that caveat emptor should guide everything you do when dealing with financial whizzkids that think they know everything."
I doubt the "whizzkids" ever studied Latin. I have visions of John Cleese as the centurion in the Life of Brian: "'Ello, what's this then?" "It says we can turn junk bonds based on subprime mortgages into AAA bonds if htey are insured" "no, it doesn't - it says garbage in, garbage out". Write out 100 times: "You cannot turn base metal into gold".
What is it with these people? First we have Leeson crashing Barings because he tried to beat the futures market, then the dot.bombs because none of the "whizzkids" actually seemed to know that a share is the present value of all the future profits due, while the profits must be a % of turnover and so, those valuations required enormous turnovers? Now we have people, whose risk assessment seems to be nothing more than "it won't happen or if it does, we can borrow from somewhere else to fill the hole we first thought of". Thus the risk probability is almost nil and the value at risk very small!
Oh, wait a minute - in all three cases, the "experienced" supervising managers are getting big bonuses if the values are high and the perceived risks very low.
Have a look at Jim Cramer's rant on about this,"doomed financials", far more entertaining, and hilights the problem with the ratings agencies in all of this. The solution? market forces, let bad business go under, but the businesses have to be transparent, and it appears there has been a lack of that.
"Mr Brown and Mr Darling be make a tasty dish"? "Automaticity"?? Has Robert had a funny turn?
No, it's not naive, you're naive to think it is. What is needed now is time. Both to come up with a better plan, and to prepare for what may come.
This really is as scary as it gets, when they need is emergency capital, but it needs to be given in such a way that if it still fails, the person who tries to re-inflate the life raft isn't harmed by the blow back.
They cannot be allowed to fail, and if they do, we'll all regret it.
Although off topic I was highly amused to hear that Gordon Brown is busy in China promoting the UK financial services sector..
What on earth have the Chinese ever done to us that makes them deserve such a punishment?
Robert,
I am an employee of Northern Rock and on our intranet site this morning is the quote of the day as follows:
Any fool can criticize, condemn, and complain -- and most fools do by
Dale Carnegie
SOUNDS ALOT LIKE YOU REALLY!!
Re Post 16. I also would heartedly endorse people to read J K Galbraith's excellent book on the Great Crash as well as people having a study of Games Theory .
The Great Crash book is currently not available on Amazon so no doubt many people have rushed out to buy it.
Its not only the monolines that may loose their triple A rating but also the US government
One must ask what mechanism is at work that has created the mess in the first place. One must conclude that it has to have something to do with economic stability.
It a bit like building houses on a flood plane. The lack of flooding or in financial terms, the lack of risk, makes one vulnerable.
It difficult to see how banks can lend to each other with risk models that they know are unreliable. Each bank will adapt their models to what they see fit and tread carefully.
Our easy access globally, to memes is another factor:
They act as non linear agents, chaos theory, in a world governed by linear mathematics. People have walked over the edge of the cliff a bit like a looney tune character, its all very bizzare.
There is a ninety per cent drop in the share price of some of the monoline insurers.
Bloomberg is saying an eighty per cent chance of a bankrupt insurer soon. Sounds ominous.
regards
Buffet has only gone to business to play in the muni bond market. He is much to shrewd to go into subprime.
The real problem is greed all round that has seen instuments like the said bonds used 'creatively' to fuel the sustained 'growth' of past decade & more.
I fear there is no easy answer except as Tony Lee says, for starters, get the people who have gotten rich to put some of that money back.
Geoff #16, there is a selfish argument for pooling together individual risks and thereby smoothing out the expected outcomes, the existence of insurance companies is evidence of this. However, what Robert is suggesting doesn't achieve this. When the bond insurer runs low on reserves, it means the bonds they insure are no longer safe from the "disaster" scenario of the insurer not being able to pay up in a crisis with lots of defaults, and the credit rating drops. By putting equity into the insurer, you may have averted the disaster in terms of your bonds, but the same disaster will now befall your equity. Fairly pointless exercise, I would have thought.
It's a difficult dilema that is being faced - the importance of this and other sectors (banking) to the general economy mean that propping up or trying to find a solution seems to be a top priority, however it is gaulling that others need to bale them out.
These industries almost feel like they have a one way ticket to take risks to make money and award themselves huge compensation - all very well if the downside is that they lose out if the risk comes home to roost. Unfortunately it looks like when the risk gets too big there is an expectation that they will be propped up and a limit placed on their downside - if we accept this then in future there should be a compensating cap on the upside (albeit almost impossible to put in place!)
Robert, you are the man.
I am bi-lingual (English & Danish) but not French and Latin.
I pay my licence fee in UK pounds. Please write in English.
As for the article, I believe you are correct, this will get worse.
The other shoe to drop this morning was investors being unable to cash in their chips in the Scottish Equitable property fund. All around Edinburgh's St Andrews Square are the offices of defunct/migrated life offices which have lain expensively empty for years. And yet will have some fancy price tag on the balance sheet even though the buildings are of no forseeable economic use. Until that is, the fund managers are forced to get real, organise a fire sale, and return the land sites to residential development. Today is another step towards them having to bite that particular bullet.
Robert spot on with your analysis,
Thought an update on Ambac may prove useful.
I believe Ambac unveiled its capital raising plans on Wednesday 16/01/08, but the company also warned that it may suffer more than $1 billion of losses from guarantees on complex mortgage-related securities that are deteriorating. In the wake of that warning, Moody's Investors Service said on Thursday that it may downgrade Ambac's AAA rating within 60 days.
Ambac shares slumped 52% to $6.24 on Thursday, adding to declines of more than 20% from Wednesday.
Will the current shareholders ride to the rescue?
An Ambac Financial shareholder told the bond insurer on Thursday to give up its efforts to raise extra capital because the future returns on that new money won't be big enough.
Evercore Asset Management, which holds 700,000 Ambac shares, said the bond insurer would be better off giving up its AAA rating and pursuing new business that doesn't require that top rating.
Ambac could also go into "runoff," slowly shutting itself down and allowing policies to expire, Evercore added.
"From the standpoint of Ambac's current shareholders, there is nothing to be gained from continuing to attempt to maintain a triple-A credit rating," the investor said in a statement.
Evercore said on Thursday that it's now too late for Ambac to raise new capital by selling new equity and equity-linked securities.
How did the company react? This is the latest news release on Ambac鈥檚 website 18/01/08.
NEW YORK, January 18, 2008-- Ambac Financial Group, Inc. (NYSE: ABK) (Ambac) stated today that it has determined that as a result of market conditions and other factors, including the recent actions of certain ratings agencies, raising equity capital is not an attractive option at this time. The Company is continuing to evaluate its alternatives.
As for MBIA, I believe it had a capital base of $2.6 billion on policies insured of $680 billion around 20/12/07.
This level of leverage make Northern Rock look positively conservative.
No wonder Berkshire Hathaway started afresh, they could become the only game in town.
Everyone in the industry knew that the monoline insurers were operating on razor thin capital to insure the notional value of the bonds they wrapped. It wasn't a problem when they were just insuring muni bonds but the hunt for revenue made them big players in the CDO market. I believe that the business model offered by AMBAC, MBIA and Radion is flawed. The municipal bonds they insure are risky because the various municipalities have invested in credit enhanced securities guaranteed by the insurers. I met a few of these guys in the embryonic days of the CDO market and it is quite clear they had little or no idea of the risks they were opening themselves up to. To avoid complete financial melt-down we have to assume that Uncle Sam will step in and provide an explicit guarantee of all municipal securities and all quasi-soverign securities such as Fannie May and Freddie Mac in the event of the collapse of a bond insurer. The increased liability to the US tax payer will be enormous but the alternative, which is the default of a security considered as good as US treasuries, is too scary to consider. Without the AAA status of the US government the global financial system will be in a turmoil that will be at least as bad as the great depression.
The whole sitution is a classic problem in the sense that many people are driven by Greed...
With the ridiculous and obscene bonuses on offer people who work for these institutions are taking greater and greater risks in the name of profit.
Without tigher and stricter financial controls from states these situations will continue to happen and new Scams (repackaging, reinsurance, AAA+) and tricks will emerge to keep the party rolling for a bit longer until there is a bigger disaster.
The whole situation is driven by the chase for excess profit and greed.
These institutions are reaping what they have sown. Its pension funds and the hard working i feel for who just want to be comfortable in retirement.
MWAHAHAHAHAHAHAHAHAAAAAA!
There are 3 people on one island and 3 on an other.
Island A works hard and grows food and goods.
Island B buys the food and goods and writes IOU's to the other island and does plenty of business importing these goods and selling them to the other people on their Island. It is great on this Island since everything is cheap and easy to get.
One day Island A realises that it is unlikely that B can actually pay it back the IOU's so try's to sell them to another Island but that island doesn't want them much either.
So Island B has an idea - we can write more IOU's and pay them with that, but nobody wants these IOU's anymore so Island B cant buy any food and goods from A. Suddenly Island B realise they will have to grow their own food and make their own goods or go Hungry.
So now that there are no goods on Island B suddenly people leave and the value of the 3 houses on Island B are not worth much however the price of the houses on Island A start to go up.
I agree with the comments made by others that Robert has totally underestimated the size of the problem: it won't be solved by "a few billion dollars" when the exposure of the monolines is estimated at $2.4trn.
The scandalous dilatoriness of the rating agencies in downgrading the monolines---CDS prices suggest a "C" rating at the very best---is wrecking what little is left of their credibility.
It was always seemed a hostage to fortune to give these clearly inadequate agents such a big role in determining the adequacy of bank capital, as provided now under Basel 2.
Monoline default, when, not if, it happens, will provide a shock to the financial system many times worse than that of subprime mortgages.
Robert,is this by any chance the same New Star who couldn't wait to get hold of the weekly Bank of Englands figures in order to report how much money NR borrowings had increased over the past week?.If so perhaps they would have done better spending their time looking after their clients investments!
And the Best Blog Post award for 2008 goes to ........ sorry struggling with the envelope a bit here ......... Goes to ... Number 39.
Raptuous applause rings out.
In most businesses the financial advisors give their views and then... if you have any sense.... you usually ignore them.
The people responsible for building businesses do invariably understand their businesses better than financial advisors鈥urprising as it often seems to those people.
The problem in the financial and banking markets is the financial advisors end up advising each other... without any apparent moderator.
So business models keep getting pushed to the limit until they inevitably fail.
The idea in the article, that not only might the financial industry be prone to systemic errors; but the pricing of risk; and also the reward for failure, is mismatched.鈥攎ay be because the lunatics are really running the asylum.
So in this madhouse everybody can receive massive cash bonuses for dismal failure--- while in the real world people start getting turfed out of their houses, jobs and lives as a result of that failure.
There seems a complete mismatch of reward, punishment, fairness and balance so I am going to suggest solution may be a reverse application of the same --- simply take any Bank or financial institution that "fails to perform" and sack 1/10th of the executives and take 1/10th of the previous year鈥檚 total remuneration from the remaining executives and allocate it to deserving causes.
The executives to be sacked can be selected by any random process that pops into the selectors mind...the percentages can be varied on a whim.
The people responsible for making these decisions to be formed from any bus queue nearby at the time, and the definition of "fails to perform" will be decided anew each time -- no reference to past criteria will be necessary.
As a way of introducing 鈥榗hecks and balances鈥 into the system; this is obviously an unfair , illogical, dreadfully unbalanced, nastily punitive, and totally random, non-system open to enormous abuses and manipulation--and as such I feel is entirely suited to purpose
-----As it entirely mirrors the present non-system in place for rewarding these people.
I've just heard that Chairman Brown and HMG have decided to go for the v.expensive monoline bondwrap.(10pm 18/01/08 -5live news).
If all in the above blog is true, then it is safe to assume that saving the Rock is now regarded by this government as a necessity inorder to save the face of this Government... money no object!
I hope I can safely assume that you, Mr Preton, can put an accurate ball park figure to what this monoline reassurance is going to cost us -the GBtaxpayer and will be bloging it, broadcasting it and being that first line of 'hold to account' that you and the 大象传媒 tend to be.
Well it's happened, hasn't it. Ambac has lost its AAA rating, MBIA to follow soon. Just as the twin towers collapsed after being fatally damaged on Sept 11th, the whole banking industry is about to collapse.
The fact the monolines NEED to be AAA rated to remain in business shows why they should never have been AAA rated in the first place.
It is high time we looked hard at the role the Rating Agencies have played in this "Credit Crunch". In the first place, it is they who provided the highest ratings on pools of "sub prime" mortgages - which have ultimately proved to be overly optimistic.
Urgently we need to focus on how the Rating Agencies are monitored and controlled on a Global basis. I would be interested in any suggestions on how this could be undertaken effectively.
Why don't the repective governments lay down the law and instruct the heads of the investment banks to resumme normal lending protocol (carry on regardless) and pretend the credit crunch is just a figment of their imagination. If that means they have to share the burden quid pro quo then so be it.
Because it is now apparent that this is what the guru's who were supposed to be managing these institutions have been doing, for many years.
"If it works, you could have solved Northern Rock problem in the same way"
isn't this the way the government have 'solved' the NR crisis? using their Visa to pay their Mastercard debt?
Simple logic.
Disaster happens, somebody pays. Prop the monolines for now and we avert the disaster for later. The market has to stop its flamboyant nonsensical attitude towards packaging risk again and again till you have no clue what the original risk was, or we will end up again and again in such a recessive situation.