A not so encouraging dead link

I was doing a little research on Washington Mutual. In particular I was trying to work out whether the entire Long Beach Mortgage portfolio is as toxic as Mish's benchmark deal.

So I go through WAMU investor relations site - and looking for IR for fixed income. I get to this site. I click on the link to WaMu Asset Acceptance Corp (where all the Long Beach stuff resides).

The link is dead.

When major banks can't keep their IR page in order to give you credit data I can't blame people for being skittish.

Memo to WaMu: please fix.

Somthing to say for getting old - or just ignoring survival bias

Getting old is better than the alternative.

But Floyd Norris suggests that it seems to be better for your investing.

As I am getting older at the rate of one year per year Floyd's article should cheer me up. But it doesn't.

An article that suggests that older investors are less likely to be caught up in a bubble has a causality problem at its heart.

If you are likely to get caught up in a bubble you are unlikely to STILL be a professional investor by the time you are 50.

The article seems to suggest that age makes you wise.

But the alternative hypothesis is also possible: wisdom that allows you to grow old (and stay in business).

And if that is the case getting older at the rate of one year per year has fewer benefits than I hoped.

Things I once wrote

In my previous career (that is in May last year) I wrote a brief history of US finance since the 1970s. It explained our positions winning and losing. You can find it on the web here.

Before you read it though – read yesterday’s post on things that I stuffed up. The credit risk/interest rate risk. The conclusions to my article from last year seem wrong in several important ways.

Things I stuffed up – edition one - Interest rate risk versus credit risk

Anybody that trades stocks makes mistakes. I have made plenty. I would prefer sweep those under the carpet but a little bit of healthy self-flagellation is good for the spirit. Besides I hope it will make me a better investor. Besides I just posted that I purchased Ambac - something that could (easily) wind up as the next mistake. So you should know just how much I stuff up.

So this is the first of (almost certainly) many posts detailing things I stuffed up.

The list for the first choice is long. How about these?

(a) Believing that regional banks of Credit Agricole (which are very good) would offset the losses at the investment bank (which is very bad). Stock is down from 36 to 12.

(b) Believing that the mortgage insurers would blow up this cycle but the bond insurers would probably be OK. Ambac is down 90 to 1ish and is no longer writing much business. MTG (which was my favourite short) is down from 60 to 6 but is writing plenty of business. Got the wrong shorts… and didn’t short the bond insurers…

(c) Believing that the (seemingly extreme) valuation difference between News Corp and other media stocks would solve itself by New Corp’s stock price rising. It didn’t as a stock price comparison of Viacom, Time Warner and News Corp will attest. (It was a wash – all the stocks lost a little.)

(d) Buying Origin Energy at under $2 and selling it at about $4 on the basis that the utility parts of the business were fully recognised. I sold it despite loving the management. It is currently under hostile takeover at $15.60 – and the Aussie dollar in which it is priced has almost doubled. I didn’t recognise just how good the gas assets were. This was non-trivial as the fund I worked for owned almost 5% of the company – and left more half a billion dollars on the table and it was my fault.

Against this it should be pretty hard to tell what the worst intellectual error I made in the past five years is. But I have a candidate. I thought that the interest rate risk in US banks would blow up before the credit risk.

Background

The US has a very unusual mortgage market. Most mortgages have the peculiar term of being fixed rate when rates are rising – but being refinanceable if rates fall. This means that customers pay more for their mortgages than most jurisdictions – but that all the interest rate risks fall on the financial sector.

For instance in most markets the difference between central bank fund rate and the average mortgage rate is less (often much less) than 200bps. In the US it is unusual to get a conventional mortgage at under 6 percent – and the feds fund rate is 200bps. Mortgage margins in the US are more than double most countries.

For this however the system as a whole takes an awful lot of interest rate risk. If short rates were to go to say 8 percent there would be 5-7 trillion in mortgages that yield less than that. Individual institutions might say they were hedged – but the system as a whole cannot be hedged.

I spent an awful lot of time looking for banks and other institutions that were particularly levered to interest rate risk. WestAmerica Bancorp (an otherwise pristine bank) stood out. If you look at the balance sheet I linked in my previous post you will see that it contains $1.5 billion in fixed rate securities financed floating. That number is very significant compared to pre-tax income of 120 million or tangible book value of about 270 million. And WABC is by no means the largest offender.

My back of the envelope calculation was that the system had about 400 billion of pre-tax profits. That included all brokers, all banks, all insurance companies, fund managers – the works.

The US system had 7 trillion of interest rate miss-match. Almost half the profits of the entire US financial system could disappear in a 200bps rise in rates across the yield curve. And they would have disappeared without a penny of credit losses. A lot of institutions would lose their profits entirely. They would in my view all try to hedge simultaneously guaranteeing the dynamic hedging strategies that were in place did not work.

And I thought with Alan Greenspan setting the tone of the Fed the stuff up on inflation and hence interest rates was inevitable. Greenspan never saw a problem he could not fix by pumping more liquidity into the system. I thought Helicopter Ben was even more likely to use a little inflation to get the US out of its mess. Indeed that is where the “helicopter” moniker comes from – a speech to that effect. So essentially whilst I thought that credit problems were sort of inevitable – the US would inflate their way out – and hence the real manifestation would be an interest-rate-risk debacle.

So I spent a couple of years getting completely obsessed about interest rate risk. It led to some OK shorts (eg Fannie and Freddie) but meant I underestimated the credit story.

The credit risk I thought had been passed pretty heavily to the non-bank sector. It existed in the Europeans (I sort of knew about UBS). It existed in the investment banks (including Citigroup). It existed in some regional banks (I knew about Bank United). But I was stunned it wound up quite so bad at Fifth Third. Just stunned.

I thus covered a Fifth Third short many years ago. (Ooops.) I was short a bunch of interest rate risk sensitive banks (such as North Fork which was purchased by Capital One) and I didn’t short MBIA and Ambac. Indeed I was tempted to go long (but fortunately I did not). I made money on a few interest rate shorts – but altogether it was not a profitable activity.

A few years ago the short end of the yield curve was at about 1%. The long end in the 4s and quasi-government guaranteed mortgages were in the high 5s. Borrowing short to buy Fannie Mae backed mortgages was the seeming no-lose trade. Everyone was on it. It didn’t even carry much credit risk because everyone knew the government backed Fannie.

However it carried – and still carries – massive interest rate risk. Everyone seemed to ignore that. My usual reaction – if everyone is doing something then it will probably lose you money. I would rather be on the other side.

Still I remain convinced that this is a theme that will play out. Warren Buffett says inflation is heating up – and he doesn’t stretch the duration of his assets.

There are good people who think inflation is highly unlikely. Paul Krugman (who I admire) suggests that Bernanke should ignore the inflation naysayers. Mish writes for ever on how inflation is not likely – see here and here for examples.

I will get back to this shortcoming one day soon.

John

GIGs and Ambac

Warning: Wonkish. Read only if you are interested in Ambac.

The Whitney Tilson post I wrote up on the weekend goes through the issues of GICs and MBIA. The story is that when a municipality raises a bond it doesn’t need all of it straight away. So the bond insurers (using their contacts with the municipalities) sold “guaranteed investment contracts”. These contracts were invested in primarily high-grade instruments (but not Treasuries). A guaranteed return was offered to the municipality. Withdrawal was usually limited to term giving MBIA several opportunities for profit by structuring investments to match total maturity schedules.

The problem for MBIA was that the GICs could be accelerated in the event of a ratings downgrade – either that or the company could be forced to post collateral. The collateral requirements are causing MBIA difficulties.

Ambac has also written GICs and they too can be accelerated. Here is the disclosure in the last annual filing. Note the section bolded by me which says that Ambac has “de-emphasized” this business for reasons primarily related to liquidity needs.

It is clearly a problem in the event of “well defined credit events” (which I presume is a ratings trigger). As to whether this ratings trigger is an issue for the stock: I report – you decide. As to whether these are ultimately parent company liabilities? I will leave that for another post. But if you want to know any earlier than that - read the statutory statements of the insurance subsidiaries.

Financial Services Liquidity. The principal uses of liquidity by Financial Services subsidiaries are payment of investment and payment agreement obligations, net obligations under interest rate, total return and currency swaps, operating expenses and income taxes. Management believes that its Financial Services liquidity needs can be funded from its operating cash flow, the maturity and sale of its invested assets and from time to time, by inter-company loans and repurchase agreement transactions. The principal sources of this segment’s liquidity are proceeds from issuance of investment agreements, net investment income, maturities or sales of securities from its investment portfolio and net receipts from interest rate, currency and total return swaps. The investment objectives with respect to the investment agreement business are preservation of capital by maintaining a minimum average quality rating of AA on invested assets, maximize the net interest rate spread as compared to investment agreements issued and to maintain a liquid floating rate investment portfolio, which includes short term investments, to minimize interest rate and liquidity risk. As of December 31, 2007, the investment agreement business floating rate investment portfolio approximates $6.3 billion or 84% of the investment portfolio related to the investment agreement business. Recently, Ambac decided to de-emphasize the Financial Services businesses. Ambac’s decision to decrease outstanding exposure to the financial services businesses was primarily due to the different liquidity needs of the business compared to the Financial Guarantee business, rating agency views relating to non-core businesses and to allow management to enhance its focus on the financial guarantee business. Ambac believes that this decision should not materially impact the Financial Services business liquidity.

Investment agreements subject Ambac to liquidity risk associated with unanticipated withdrawals of principal as allowed by the terms of the investment agreements. These unanticipated withdrawals could require Ambac to sell investment securities at a loss to the extent other funding sources are unavailable. Ambac utilizes several tools to manage liquidity risk including regular surveillance of the investment agreements for unscheduled withdrawals. In general, Ambac has characterized the portfolio of investment agreements into two broad categories, contingent and fixed withdrawal. As of December 31, 2007, approximately $4.5 billion relates to contingent withdrawal investment agreements. Contingent withdrawal transactions include contractual provisions that allow the investor to withdraw principal and require minimal notice to Ambac. The vast majority of these investment agreements can only be drawn in the event that well-defined, observable events have occurred, primarily credit events. As of December 31, 2007, approximately $3.3 billion relates to fixed withdrawal investment agreements, of which $1.8 billion include provisions where under certain circumstances our counterparty has the ability to withdraw funds during 2008.

Disclosure: I have just purchased a fair size holding in Ambac and a smaller holding in MBIA. I think it is possible (even likely) that both companies go to zero - but I do not think that they do so rapidly. Ambac in particular is trading at out-of-the-money option value only. My expectation of return is high - but I can't eat my expected return and it is entirely possible I will lose 100 percent of my investment. I will sell a fair bit of the position on any big rally. I do not want too many "told you so" emails if I stuff this one up. But then I will not gloat that much if I get it right.

Wachovia and negative amortisation

There is a press story here about how Wachovia is ceasing to orginate mortgages with negative amortisation features.

The headline:

SAN FRANCISCO (MarketWatch) -- Wachovia Corp. said on Monday that it won't offer mortgages with negative amortization features anymore, one of the main types of home loans offered by Golden West, the mortgage giant the bank acquired for $24 billion roughly two years ago.

This is a race: whose head is further in the sand, Wachovia or Barclays?

I wrote here how Fifth Third does not originate neg-am mortgages. Fifth Third (who have now contacted me) have not written such mortgages for years. The IR guy can't actually confirm that they ever wrote them.

Why are Fifth Third and Wachovia even mentioned in the same breath when it comes to difficult (multi) regional banks?

Search me.

Bond insurer – has airport to sell

I wrote about Sydney Airport here. Funnily enough various news source aggregators (such as Wikio) filed the article about a financial crash landing with real airplane crashes. Bronte Capital must have got a few perplexed visitors.

That said – my original post is pretty convincing on the notion that if air traffic in Sydney falls over any sustained period the airport will default.

I have no idea how sharply air-traffic will fall here. Air traffic is one of the most consistent of all variables. It just rises. The reason of course is that the cost of flying in real terms has fallen for decades. When I was a kid people who flew from Sydney to London were regarded with some awe – they were the “jet set”. Now they are “cattle class”. To fly to London cost AUD2000 and average household income was about AUD10000. It costs less in nominal terms to fly to London now...

But if the recent trend in oil prices is permanent and continuing the era of ever-rising air-traffic volumes is over. We will again refer to people who fly long-haul as the jet-set.

There is some listed subordinate debt in Sydney Airport – the so called SKIES (see my last post). Beyond that are a AUD3.7 billion of medium term notes of which AUD2.9 billion is drawn and AUD884 million of inflation indexed bonds with two maturities (2020 and 2030). My sting: all these instruments are insured by Ambac and MBIA.

I see the advert: Bond insurer – selling airport in glitzy long-haul destination.

If oil goes to $400 they will take a loss on this. But otherwise it should be fine.

Whitney Tilson on MBIA

There is a great Whitney Tilson post on MBIA on Seeking Alpha.

To me the key difference between the AA guarantors and the AAA guarantors was that by-and-large the new players in this industry (such as ACA Capital Holdings) had to post lots of collateral in the event of problems - accelerating liquidity concerns and hence bankruptcy. The AAA guarantors by-and-large had to pay when the liability fell due.

This is a huge difference. I have argued several times (see here and here) that the price of various bits of paper in the secondary market is irrational. However I have no idea what the rational price is. Nor does anyone else - not the shorts, not the longs - not anyone.

If you have to mark to market the books of financial institutions they are almost all insolvent. There is an enormous amount of paper that is 20 bid, 90 offered, price you could actually get something closer to 20. If you have to collateralise based on actual values you could get in a trade now (or sell illiquid assets to buy liquid ones for use as eligible collateral) you are stuffed. Simply stuffed.

But if you can sit it out then you are possibly OK. The reason - the defaults might be much lower than currently anticipated in market pricing. Regular readers will know my view is that defaults will be lower than current market prices. I just don't know how much lower and hence I don't know what the end-game is for someone who is levered to this stuff but does not need to post collateral.

ACA Capital Holdings had contracts that demanded it posted collateral and that smashed them up - simply smashed them. Their website is indicative of what happened to the company. But the case for Ambac and MBIA was that by-and-large they did not have to post collateral and hence had hope.

However we now know that MBIA in particular has large collateral requirements. I know of a few more contracts that potentially involve collateral at MBIA. Cumulatively they matter a great deal.

If you are thinking about the bond insurers as a buy (and I am) the collateral requirements are the critical issue. If you don't have collateral requirements then the end points are all that matter. If the things you have insured default at a (much) lower rate than the market currently thinks (something that is possible) then you will make money.

For now you have the hope of much lower end-point defaults. Hope means the stocks have value. Option value only - but as the end outcome is a long way away and a lot of things can happen there should be quite a lot of option value. [One possibility for instance - there is a lot of inflation over say ten years which reduces the real value of the liabilities or increases the nominal value of the assets that back them. That could be a blessing to a bond insurer.]

If you have collateral requirements then end-point solvency is not all that matters. You need to be continuously solvent and on current market prices you are not solvent right now. Whitney Tilson's article is the first widely available and easy to follow discussion of the collateral requirements of MBIA. And this is the critical issue for the stock. Read it.

Now please please contact me if you have done a similar run through Ambac. I have not - but I knew of far less that was collateralised at Ambac than MBIA. And that matters. It's why I sometimes think I want to punt on Ambac. [Indeed I have at various times - but have hedged the position shorting Ambac debt and made good profits by sheer luck. Those were not super speculative positions. Buying Ambac common without shorting the debt is a massively speculative position.]



John

A note - the saga of MBIA saying for years that they had few collateral requirements and then revealing billions of dollars worth of them tells you about trusting management. I can't just ring up Ambac management and ask them about collateral requirements. If you had done that with MBIA you got creamed.

Indeed some very fine fund managers got creamed doing precisely that.

Ronald Regan was right: "trust but verify".

=======================

Post script: I do not agree with everything that Whitney Tilson writes in his Seeking Alpha article. I strongly disagree with his assertion that MBIA has an obligation to downstream the $900 million sitting in the parent company. The buyers of guarantees from MBIA purchased them backed by stated regulatory assets of MBIA's insurance subsidiary not the MBIA parent company. I see no reason why MBIA parent company should increase those regulatory assets unless they are contractually obliged to do so.

Of course Whitney (talking his book) has a different view. I have a suggestion: next time Whitney invests in a stock that goes to zero he should pour more of his clients' money in just to make the creditors happy. (He argues that MBIA should do this with shareholder capital and its insurance subsidiary). If Whitney acts as irrationally as he is demanding the management of MBIA act then I am sure the creditors of his bankrupt investment would thank him.

For once - and perhaps the first time - I find myself strongly agreeing with Tom Brown of Bankstocks.com. [I can't tell you how many times I have thought Tom is speaking nonsense.]

Drink deeply of the poison: another look at Fifth Third Bank

Fifth Third was a well run bank with a cult following. Now it is up on hard times. I have looked at it numerous times with an eye to buying it - but never purchased. I blogged about that here.

I was so blinded by the past glories of the company that I couldn't even make money shorting it.

The true believers however really drank the Kool-Aid. In 2000 it was priced it at 7 times tangible book plus excess capital.

So now I am back having a look at Fifth Third. Investor Relations didn't return my email (which is disappointing) but so far I have positives and negatives.

The biggest negative is location. It is big in tough states - having three of its state concentrations in three of the worst five states for property foreclosure.

The second biggest problem is an huge error of judgement on behalf of the management. They spent a large part of 2007 drinking the Kool-Aid themselves repurchasing $1.1 billion in shares at seemingly low prices during 2007 only to issue a billion in converts at even lower prices in 2008. They paid an average price above $40 a share and issued around $10.

There is a phrase for that. Its called believing your body odour is perfume.

But at the moment I want to accentuate the positive. There is plenty of positive - and some of it reflects well on management.

This post focuses on the origination of mortgages with negative amortisation features and high loan to valuation ratios.

Fifth Third and Negative Amortisation loans

The 2007 annual report includes the following paragraph:

The Bancorp does not originate mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest

That tends to cheer you up in this environment.

The 2006 annual report was slightly different:

The Bancorp does not currently originate mortgage loans that permit principal payment deferral or payments that are less than the accruing interest.

The "does not currrently" line also appears in the 2005 annual report.

So sometime they stopped originating that sort of loan - and they did it years before the credit crisis broke. In other-words management did not lose their minds as all about them lost theirs.

High loan to valuation mortgages

Another indication of quality management was that they slowed origination of high loan to valuation mortgages much earlier than most of their competitors. They have a category for mortgages with a loan to valuation ratio above 80 percent and no mortgage insurance. Mortgage originations for this were as follows:

2004 1286 million
2005 1245 million
2006 679 million
2007 265 million

The company slowed its origination in this category from mid 2005 and slowed it dramatically before the credit crisis hit. That reflects very well on management. Very well indeed.

So given this - I could drink the Kool-Aid. If you dear reader see good reasons to stop me please let me know. I write this blog at least in part for the comments and emails - and I don't get enough of them.

Meanwhile: memo to IR - its good to return phone calls and emails.



John

Citigroup thinks Barclays needs more

Well you don't say:

June 27 (Bloomberg) -- Barclays Plc, Britain's fourth-biggest bank, may need an additional 9 billion pounds ($17.9 billion) to absorb credit-related writedowns and bring its capital in line with U.K. peers, Citigroup Inc. said.
The London-based bank will raise 4.5 billion pounds in a share sale announced earlier this week, lifting its core-equity Tier 1 capital ratio to 5.8 percent from slightly below 5 percent, said London-based analysts led by Tom Rayner in a research note today. That will lag behind Royal Bank of Scotland Group Plc and make Barclays Europe's ninth weakest bank in terms of capital, said Rayner, who has a ``sell'' rating on the stock.
``With credit market conditions continuing to deteriorate globally, we believe it is simply a matter of time before further significant writedowns are taken,'' Rayner said.
Barclays spokesman Alistair Smith couldn't immediately be reached for comment.

Sack Bob Diamond. Sack him now.