A new disclosure "Magically" appears

In August – which in this market seems like years ago – I did two posts on MGIC  – the largest mortgage insurer and a company colloquially known as Magic. 

These posts are here and here…

I concluded that I did not believe in Magic – but I outlined the bull case (which was that the companies had something close to positive cash flow) and had a readers who tried to convince me that the bull case was right.  (I was and remain short.) 

In the second post I made an observation about statutory capital and possible shortages thereof. 

My further objection is that statutory capital deficiency happens way earlier than this - and stat capital deficiency will close the business as per TGIC.

It is an innocuous line – but two readers (both of whom I respect) followed me up on it – and one was sure that statutory capital was going to be adequate (he was long).  The other modelled it with brackets for his own uncertainty – and we thought that statutory capital might run short.

Anyway MGIC’s results contained a new disclosure on this issue:

Some states that regulate us have provisions that limit the risk-to-capital ratio of a mortgage guaranty insurance company to 25:1. If an insurance company’s risk-to-capital ratio exceeds the limit applicable in a state, it may be prohibited from writing new business in that state until its risk-to-capital ratio falls below the limit.

We believe that our 2006 and 2007 books of business will continue to generate material incurred and paid losses for a number of years. The ultimate amount of these losses will depend in part on the direction of home prices in California, Florida and other distressed markets, which in turn will be influenced by general economic conditions and other factors. Because we cannot predict future home prices or general economic conditions with confidence, we cannot predict with confidence what our ultimate losses will be on our 2006 and 2007 books. Depending on the extent of future losses, MGIC’s policy holders position could decline and its risk-to-capital could increase beyond the levels necessary to meet these regulatory requirements and this could occur before the end of 2009. As a result, we are considering options to obtain additional capital, which could occur through the sale of equity or debt securities and/or reinsurance.

That is slightly worse than the worst end of the models my readers created for me in August.

In other words it is bad out there.  And if you look its bad not in Magic’s subprime book (where the number of delinquent loans are up only a little in year – because the bad loans have been mostly foreclosed).  It is bad in the prime book (which is really a near-prime book).  Delinquent so called “prime loans” are the problem as they were when I wrote the original posts.  In that category the delinquency (by which they mean edge-of-default delinquency) has nearlydoubled and the loss per claim has also nearly doubled in the last 5 quarters…  [For those interested in actual loans – a year ago they had 11,700 subprime near default loans.  Now they have 12,700.  For “prime loans” the near default pool has risen from 36,700 to 71,100 loans.]

Anyway the disclosure about needing more capital is super-bad.  If the company is forced to stop writing business it will end nastily because the holding company is levered.  And I doubt very much it can raise capital now. 

The stock is down less than 50% in the past two months – so I can’t crow about the short.  (Plenty that is that levered is down more.)  But if the long investors can explain to me why they shouldn’t run for the exits right now I would appreciate it. 

There is also some disclosure that appeared far more prominently.  I looked for it before and it was in footnotes.  I know I should read the footnotes but…

Anyway it says more about Fannie and Freddie than it does about Magic.  It is a definition of “full documentation” that could only exist in the twenty first century mortgage industry:

In accordance with industry practice, loans approved by Government Sponsored Enterprise and other automated underwriting systems under “doc waiver” programs that do not require verification of borrower income are classified by us as “full documentation.”

 

It's about the real economy now

Wal Mart was always a down market retailer.  I feel at home in Target - wide, brightly lit isles, a good collection of kids clothes.  I don't at Wal Mart.

The average household income of people who shop at WalMart and not Target is above what I lived on as a student, but below the income of my (mostly part-time-employed) student household.  

Three years ago Jeff Matthews commented on the difference by saying WalMart had "Target Envy".   This reflected income demographics in the US - where the squeeze was already on lower income households (oil etc) and the middle income demographics were doing middling to OK.  

Target envy might be a thing of the past - but it is clearly getting worse in Wal Mart's demographic.  Paul Kederosky talks about things that WalMart is now seeing.  

Wal Mart has always had a pay-check related shopping spike - with a substantial number of customers living (as I did when a student) from pay stubb to pay stubb.  

But for the first time they are having pay-check driven spikes in the sales of baby formula suggesting the economic pressure is more widespread.  

It is about the real economy now.  

John Hempton

Why Lehman mattered

Read my post on the 1934 Act first… this will not mean much to you unless you have done so… and after that get ready for some seriously wonky stuff…

I was chit-chatting with a very prominent NYC financial journalist the other day and gave him the accepted view – which is that the decision to let Lehman fail was a big mistake. 

He asked quickly and fairly why it was a big mistake. 

I had to confess that I did not know.  Just the facts on the ground since that decision have confirmed that it was a mistake.  That hardly seemed satisfactory to me or to him.

At the time of the decision I thought that whilst the decision was risky Paulson had made the correct call.  Lehman was – he thought and I thought – just not important enough.  I blogged about constructive uncertainty and unfortunately I was wrong.

Krugman (who I admire almost to the point of idol worship even though I think he wrong often) had an editorial in the New York Times which said that Paulson was playing with a loaded gun – but Krugman was not then prepared to call it a mistake (though he has since).   (Score Krugman 1, me 0).

But I now I think I know why letting Lehman fail was a mistake.  It was the absence of suitable broker-dealer regulation in the UK. 

The 1934 Securities Act was written with recent memory of what it means for a major broker-dealer to fail.  Indeed legislators were so scared of this they enacted two pieces of legislation – the first ring fenced the broker deal from all the other business of the broker (the 1934 Act) and the second (Glass Steagall) prohibited combining any of it with a conventional bank. 

It turns out I think that the Great Depression double-separation was overkill – and you could do without the Glass Steagall legislation.  But you could not do without the 1934 Act. 

Anyway Lehman had lots of assets pledged to its European broker dealer which they could in turn repledge to finance client business (as would be possible in the US) and to finance their own business (which would not be possible in the US).  As Lehman’s own business became stretched the UK broker dealer repledged more and more client assets to keep Lehman alive.  This eventually made the UK hedge funds (and the European operations of many US hedge funds) unsecured creditors of Lehman.

Now it turns out that many of the most levered books were resident in the UK.  Why?  Because the UK had eschewed many capital controls of the type favoured in Great Depression legislation.  Lehman’s own UK book was similarly levered.

Lehman UK behaved appallingly pledging pretty well the entire UK client asset base and sending big cheques back to NYC. 

Several hedge funds (notably led by Harbinger) are trying to investigate these transactions and have made requests to the US bankruptcy judge to force Lehman to hand over the details.  I guess the issue is fraudulent conveyance.  Lehman has asked the bankruptcy judge to deny the request for administrative reasons.  The bankruptcy judge should force Lehman to hand over the documents, but being Southern District of NY (the most creditor friendly bankruptcy jurisdiction in the world) Lehman will probably get its way.  A prosecutor looking for indictments should probably look here too…

But let’s see it as it now is.  The assets and liabilities of these highly levered hedge funds became assets and liabilities of Lehman in bankruptcy.  [The entire books effectively were hocked to Lehman creditors…]  The leverage had to come off – and fast.

And so what the Lehman bankruptcy did was trigger waves of delivering – and it did it through the mechanism of UK broker-dealer.

The European trade de-jour – run at high leverage through the UK Broker Dealer was long Porsche, short Volkswagen.  Porsche (a very fine company indeed) owns a very large amount of Volkswagen (read General Motors for Europe).  Indeed Porsche owns several times its market cap in VW stock.   It was a trade everyone had on.  And the more leveraged a player the more they had on – and they had it on in London because it was (a) European, and (b) favoured by people with leverage.

And so – after the Lehman bankruptcy – this trade exploded.  VW went up every day – Porsche went down and the ratios became totally absurd.  Go look – either Porsche is absurdly cheap or VW is absurdly expensive or both.  Anyone that believes in the rational market hypothesis (and there are plenty of them out there) would have a real problem with this data as there is no way the movement is explained by rational valuation… 

Anyway Porsche Volkswagen example of massive deleveraging – but it was perhaps the most spectacular.  It happened across the board – and anyone who was levered to anything that looked like an obvious position had their backsides thrashed following Lehman.  It did not matter if they were housed at Goldman Sachs because enough people would have had the position on at Lehman London to get market prices to administer the thrashing. 

There was a day when high short interest stocks started rising in a falling market for no reason.  Almost all high short interest stocks.  Why?  My guess is because someone at Lehman London was short them and Lehman started covering the positions in bankruptcy.  The move was big enough to destroy some levered players.  But it also happened to stocks into which people were levered long. 

Soon delivering took on its own dynamic because people who were housed way-away from Lehman but were still over-levered got themselves in the vortex. 

Finally the redemptions are coming – and if you were not over-levered before the redemptions you can be over-levered after them.  Redemptions have their own dynamic.

The leverage of course was not only in equity markets – leverage is much more pronounced in debt markets because debt markets typically only have a couple of points of spread and you need to lever that seven to twenty times to get a reasonable ROE.  Moreover Lehman was always primarily a debt house, not an equity house – and the debt-arb funds were far-more-likely to be housed at Lehman than the equity guys…

The deleveraging of debt markets following the Lehman failure left everyone (maybe except Uncle Warren) hoarding cash.  [It also ran the Federal Reserve out of balance sheet in a single day – something that I will come back to in a later post…]

Lehman’s failure cracked this market – and it did so because the UK lacked the basic depression era legislation (the 1934 Act) and had encouraged reckless leverage by reducing capital requirements to low levels. 

It was the failures of London that made Paulson’s decision wrong.  I didn’t see it at the time – and nor did he.  However I have never been CEO of a broker-dealer – and Paulson has.  So one bad mark for me and three for him.  I keep score…

 

 

John

PS.  I should tell you what the German take is on Volkswagen and Porsche… a surprising number think it is reasonable that Porsche trades so cheap because the arb is between a voting stock and a non-voting stock – and being Germans they have seen non-voters ripped off shamelessly in the past – so it is reasonable to discount Porsche massively.  They do think that Volkswagen is over-priced but as there are already so many people on the trade it is an expensive stock to borrow and hence hard to short.  The problem with this argument is that it was just as true when the spreads were a third as attractive as now.  The market remains irrational – but it might be irrational for rational reasons.  

PPS.  This is a good summary of the legal issues as they are now...   http://www.iht.com/articles/ap/2008/10/16/business/NA-US-Lehman-Brothers-Bankruptcy.php

The 1934 Securities Exchange Act and all that

When you sign up to a margin account in almost all cases you pledge your securities to the broker with the ability for them to repledge. 

The reason to broker-dealer must be able to repledge is that it needs to finance the loans to you – and to reduce the cost of that financing it needs to offer collateral. 

So, when I take my million dollars worth of securities to the broker and borrow 100K on my margin account it looks like I have pledged a million dollars to a broker who might be questionable in order to get 100 thousand worth of financing.

There is one word for this.  Dumb.  They can – on face of it – take your assets and pledge them to finance their risky business.

If you do not believe it is dumb have a look at my post on Opes Prime, a small broker-dealer that went down in Australia taking something near a billion in client assets with it.  It involved organised crime, guys that killed hitmen and all sorts of other colourful characters.  There ain’t no way I would want to lend my securities to these guys and wind up an unsecured creditor.

The US had huge problems with broker-dealers in the 1930s.  They folded and lots of people lost their entire fortune by not understanding their credit arrangements. 

Enter the US Securities Exchange Act of 1934.  This is one piece of depression era legislation that survives and thank the Good Lord for that.

What the broker dealer act does is (a) ring fence the US broker dealer and (b) limit the amount that the broker dealer can borrow against your securities and the amount of collateral it may take. 

I am hardly a lawyer – so take the bush lawyer caveat – but the way it works is that the broker dealer may not borrow against your securities to finance their own business, only client business.  So Lehman Brothers US broker dealer could take collateral of securities and if they had 100 million out on client margin loans the most that they could raise using client securities is 100 million and not a brass razoo more.   This is really important because it meant that client assets were not used to finance Lehman’s disastrous commercial real estate and other businesses. 

Moreover when you deposit a million dollars at the broker dealer and give them the right to repledge those securities they can only rehypothecate 140 percent of your outstanding balances.

If you have 1 million deposited and you have 100 thousand borrowed then only 140 thousand can be rehypothecated and the rest must sit in a segregated client account.  [If your broker wants to steal from the segregated client account there are precious few defences – but…]  You can not contract out of this requirement. 

So (provided the broker is not acting criminally) you should get the bulk of your money back if the broker dealer fails.  And provided the capital requirements are adequate (and they mostly are) the broker dealer won’t fail.  Even the Drexel Burnham Broker Dealer did not fail.

Goldman Sachs claims that they can determine the capital requirements of their broker dealer intra-day.  I have no proof of this claim – but in this age of computers that is plausible.

The result.  Whilst Lehman brothers went bust Lehman US broker dealer did not.  This pretty well saved the US hedge fund industry. 

Europe however was a different story.  Lehman Europe failed – and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman.  Many funds have folded.  Far more have been nicked.  Whilst the US hedge fund business is currently looking dazed, confused and a little problematic the UK business is on life support. 

In some sense this is the end of the City of London.

I am on record as saying the UK took Maggie Thatcher to heart and deregulated financial activity to such an extent that the whole UK market worked without capital.  That was of course inordinately attractive in a boom where having capital was just a cost.  That attractiveness was one of the reasons why the London market grew and grew – and why UK banks wound up being amongst the biggest in the world.

But now with the biggest bank in the world by balance sheet (Royal Bank of Scotland) effectively nationalised and the and a large part of the UK hedge fund community lying with open veins it looks a little stupid.

This puts in a different light the 8 billion dollars that Lehman London transferred to the US when it was failing.  I stand open to correction – but I would guess that the money was obtained from client accounts from the European/London broker dealer.  It is certainly being investigated by Lehman clients.   This is a scandal of the first order allowed by an insane lassis faire approach to financial regulation. 

So here is a plea for US Depression style financial regulation.  Some of it (such as the Broker Dealer regulation) was well thought out and should be duplicated.   (Some of it was less sensible…)  

If I have a plea to my home country (Australia) after the Opes Prime debacle – a copy of the US 1934 Act would be a good start. 

As for London – I am sorry, but it is a wreck.  Maggie Thatcher you stand condemned.

 

John Hempton

Fred Goodwin hangs tough

Come on Sir Fred

You worked for an inconsequential arm of National Australia Bank.

You walked to an historic but small bank in Scotland.

You went on a binge of overpriced and insane acquisitions and turned your tiny bank into the world's largest by balance sheet.

The bank failed at huge risk to the global economy and required government to bail it out.

And you did not resign and instead hung tough for a golden parachute.

I have said that you are the worst CEO of any major bank anywhere. Vindication I claim.

Resign and waive the right to any package. It is simply indecent to charge a parachute to the taxpayers.


John

Bakkavor Group, an Icelandic follow up...

I got no comments on the Bakkavör Group accounts, see here...

For those that want to know, the balance sheet is written in pounds. It is serious money. Almost 2 billion dollars in debt for a token Icelandic food processing company.

It is the corporates, not the banks that are going to send this around the world. I noted the list of principal bankers contain more usual suspects – they are Barclays, RBOS, Rabobank, Mizuho, Fortis, ABN Amro, Bank of America Securities and HSBC.

The Icelandic confessional has included Erste Bank in Austria (a crash large enough to close the Austrian exchange) and various UK banks and will include others.

But more, still more, will come to the confessional...

J

Iceland denies the airbase link

It did not take long. Iceland has denied the airbase link.

http://www.timesonline.co.uk/tol/comment/columnists/bronwen_maddox/article4916541.ece

But it is clear the Russians have an agenda. What it is is unclear.

Iceland however needs the foreign currency desperately and should take it.

Welcome to the 21st century...

British deposits in Icelandic banks

I simply said in a previous post that Iceland intended to default on its deposit insurance obligations.

They now say they intend to honour them.

http://www.bloomberg.com/apps/news?pid=20601102&sid=aXXW.vOmh8Ao&refer=uk

Intention is fine. They do not have the cash.

J

Funny reaction as to the prostitution comment

Two people I trust suggested that this post is a little hot headed and that I should revise or tone down.

The email however is suddenly running very supportive.

The purpose of the post is and was to make sure everyone knows just how important and nasty financial crises are.

If I have offended people doing that I am sorry, but the crisis is the central fact in what will be modern Icelandic history...

The central policy question raised by the Asian crisis was 'why did the market deal such harsh punishment for so minor economic crimes?'

This will be the question asked by Icelandic people too. And it is a question that should be asked of all those who subscribe to the dumb doctrine that is Austrian economics...

In Asia they ran large current account deficits caused mostly by good excess investment... it still crashed (and recovered).

The stakes here are very high. Iceland is a nasty case but there is no 'Icelandic exceptionalism' and there will be no 'Australian exceptionalism' if we stuff up either. Australia is warmer than Iceland and that is a darn good thing. But it is a small thing.

So, please take my hot headedness as it is intended, which is to outline the stakes...

********************


There is a long history of financial crises, there is a long history of the aftermath. I made a semi-flippant comment about part of the aftermath. It has sent my email and the comments wild. I have gone from 1 regular Icelandic visitor who knew my views in detail because he asked to hundreds of Icelandic visitors. The comment was about financial crisis and prostitution.

I know of no crisis where pretty women have not prostituted themselves out of desperation or for advantage. There are people who have emailed me who can confirm this first hand for Argentina, both as clients and as good Catholic girls turned to distasteful work. Do not think for a moment that I am pleased by these stories...

The journalist whose story of the Russian crisis was one of pretty women aspiring to be dollar whores said it as a matter of fact...

This is not new.

I have now had so many emails and comments that tell me that Icelandic women would rather shoot me and eat me than prostitute themselves that I am sick of it. It may be true but it is not an option open to most Icelandic people.

Financial crises are pernicious affairs. And if there is something about Icelandic exceptionalism I do not see it in the market place. Take your Icelandic exceptionalism and stick it with what is left of your Krona.

I do not mean to be tough. I think that the US should bail out Iceland. Its a democracy full of fundamentally decent people and they deserve much better than what is about to befall them. If the goal of US policy is to make the world safe for democracy fixing Iceland is a cheap shot.

But the US is not going to bail out Iceland. And life is going to be very tough indeed. Tough enough to undo all Iceland's excessively high opinion of itself.

For that I am sorry.

Australia also has a high opinion of itself, and an unsustainable current account deficit. Not as unsustainable as Iceland but bad. I would not like it at all if what is about to befall Iceland befell my home town.

John

PS. My view is not fundamentally different from this view in the British press...

http://www.independent.co.uk/news/business/news/fear-on-streets-of-reykjavik-as-country-can-only-go-to-imf-for-financial-bailout-957876.html

Iceland the absurd

I mentioned Iceland a few times only on this blog – because it was sort of well known in the hedge fund community – a crowded trade even.  Paul Krugman did an (incorrect) anti-hedge fund piece where he happily swallowed the dogma about hedge funds of conspiring against Iceland.  You didn’t need to conspire against Iceland – it was obvious once you read the balance sheet of any of the banks or any of the major corporates.

The first time I mentioned Iceland on this blog was in my list of current account deficit countries with potential banking problems.

Later I mentioned – but only in the comments – the raid on the UK savings market done by IceSavings and Kaupthing.  These were high interest rate deposits that seemed to be insured by a combination of the Icelandic and UK government if you read the documentation.

I wrote a post about high rate deposits (Wachovia will walk over you) and I confess that I had an ulterior motive – I was looking for someone to tell me how much the Icelandic banks were raiding the deposit market of Norway.  I got a few nice helpers amongst my readers (thank you). 

But this post is an ex-post analysis of just how absurd Iceland became – and some speculations from there.

Firstly the Russian loan (5.4 billion) is really big.  The population of Iceland is about 320 thousand people.   This translates to almost 17 thousand per person.  That is a real bailout – none of this small stuff that America is doing. 

It is pretty hard to see how an economy that has functionally destroyed itself is going to pay that back.  Whatever it looks like a darn big loan to a very dodgy credit – and I presume that there is a non-financial motive for granting it.

In my quick post on Iceland (done at JFK airport with a beer whilst waiting for a plane and not adequately fact checked) I linked to Andrew Neil who thought that the ulterior motive was Russian access to Iceland as a military base – or at least as a military refuelling depot – an unsinkable aircraft carrier if you will.

That is plausible because there is no obvious financial motive for this loan.  But there is an alternative theory doing the rounds – which is that one of the Icelandic banks was closely tied to the Russian Mafia – and the loan by the Russian Government is just make-good.  [The implication being that the Russian Government is just another arm of the Russian Mafia.]  Again I have no proof for that hypothesis – however as you need a non-commercial explanation of the loan its as good as most.  [Access to military bases however looks more likely…]

But you got to realise just how big the Icelandic problem is relative to the Icelandic economy.  Kaupthing Edge and IceSavings raided the UK deposit market as noted above and raised 3 billion pounds in deposits.  That is another 20 thousand dollars per person in Iceland.  Iceland as I need not remind readers cannot print pounds or dollars.  It is small wonder the Icelandic government is not going to meet its deposit insurance liabilities.  We have the Sovereign Default of a democracy at hand.  That is rare… I always thought it was populist dictators that defaulted.   Now I guess it is just populist democracies.

So Iceland is going to default at the national level and the level of every bank.  Lets have a look at its corporates.  I did this – there are about 20 companies listed on the Icelandic stock exchange.  I went and read the annual reports of about 5 and they were mostly similar – over-levered global acquisition conglomerates with Kaupthing as the major investment bank. 

Bakkavör Group sticks in mind – just because it was so levered in such an ordinary business – processed fresh food.  The five year summary is as follows:

(Click for detail...)

Yes – it does have quick ratios of less than one, current ratios of less than one and ebit of only about a ninth of outstanding debt. 

It might be possible to survive that – but it will be tough.

And whilst the investment bank is Kaupthing with whom it shares multiple board members – the list of “principal bankers” contains more usual suspects – they are Barclays, RBOS, Rabobank, Mizuho,  Fortis, ABN Amro, Bank of America Securities and HSBC.

Oh Iceland the international.  What happens in Iceland does not entirely stay in Iceland.

==========

It is also worth considering what happens to Iceland in the absence of new funding...  It has no banking system left.  There is nobody much willing to take Icelandic Kroner.  The country has no reserves of hard cash that matter.  Its winter coming.

They can sell fish and energy intensive manufactures (their main exports) for hard currency.  But this is not like Australia - when the going got really tough in Australia in the depression you gave up and went and hunted (feral) rabbits for food.  

Iceland is a little colder.

My guess - and it said only half in cynicism - the women are beautiful in Iceland - the place just pushes out Miss World winners.  Its almost as close to NYC as Vegas.  Sex Tourism for hard cash will be their next export industry.

If they adopt the Vegas slogan will it work for financial crisis as well?  What happens in Iceland/Vegas ...

J