Saturday, February 2, 2008

Is it just me, or ... ?

I apologize that this is a little off topic, but it’s Saturday and I just can’t understand this.

From today’s (and recent days) Wall Street Journal: The rating agencies (S&P, Fitch, etc.) rated some of the subprime, Alt-A and prime mortgage backed investments, as “AAA” investments, the highest possible rating. Monoline insurers like Ambac and MBIA, wrote insurance policies guaranteeing the credit quality of some of the mortgage backed investments. The rating agencies, in turn, gave “AAA” ratings to the monoline insurers. With AAA ratings on both the underlying investments and the insurance companies, investors all over the world (Citibank, UBS, Deutsche Bank, Bank of China, Sumitomo Bank, etc.) bought the mortgage backed investments.

As we all know now, Murphy’s Law prevailed over the mighty computer models of Wall Street, and mortgage backed investments have tanked. So, somewhat belatedly, the rating agencies are lowering the ratings of many of those mortgage backed investments. Each time a bank’s mortgage backed investment receives a lower rating, the bank would normally reduce the value of the investment on the bank’s books. Thus, the massive write-downs we have seen recently on Wall Street. This has also increased the exposure of the monoline insurers to potential claims, and the rating agencies are lowering the ratings of the insurers (or threatening to).

Now, to prevent another $70 billion in bank write-downs that might arise if the rating agencies lower the ratings on the monoline insurers, the banks are working on a bailout plan (the banks call it “recapitalization”) of the monoline insurers. One of the tentative plans is for the banks to invest about $1 billion in MBIA to increase its capital. So in other words, the banks are investing $1 billion in the monoline insurers to prop them up so that S&P doesn’t lower the insurers’ ratings and the banks don’t have to take $70 billion more write-downs.

Now, from the banks perspective, investing $1 billion to save $70 billion is cheap insurance, but if the mortgage backed investments are really worth $70 billion less (without AAA insurance), how is an extra $1 billion of insurance going to really make a difference against $70 billion in claims? I’m just an average guy on the street and this doesn’t pass the smell test for me, yet it appears that the SEC and Federal Reserve are okay with it.


anon1137 said...

Good point. Just goes to show how tenuous our banking system really is. It's all based on confidence and trust, and everyone is scratching everyone else's back.

None of these institutions have gold bars in the basement. The only thing backing this stuff up is bombs.

G Spot1 said...

You will drive yourself crazy trying to make sense of this.

What they are trying to do is pretty simple: The banks are putting cash into the bond insurers so that they can maintain the fiction that their toxic investments are still insured by, so they don't have to write down their investments due to their insurer's inability to pay.

Yes, it is as stupid as it sounds. It is a house of cards that will come tumbling down.

The source of all this is mark to market accounting. In essence, companies value these mortgage investments on their books at whatever value they could get today on the market. But where those investments are hard to value because the market for them is illiquid, they use modeling to determine their value (Yes, it is easy to imagine the prospect of abuse of this system, or just simple errors in judgment, that would cause investments to be overvalued. See Enron). The companies then report the value changes quarter to quarter as gain or loss. They get the accountants to test and write off on the valuations and the SEC is likely to accept that, although in theory they can ask questions.

Even with the recent writedowns the values the banks have valued their toxic subprime loans at values far higher than they could get if they liquidated them today. Think 80 cents on the dollar vs. 20 cents. Part of that difference is the fact that their investments are supposedly insured, so the banks will never realize the full losses.

But if the insurers can't pay....

snoop dog said...

How many times can they loan out a dollar?Seems like all this insurance and cdo crap is for the birds.Charles ponzi would be proud.

Patient Renter said...

"the mighty computer models of Wall Street"

Haha. Like Fitch's mighty ratings model that assumed perpetual house value increases? Yea those Wall Street guys are geniuses alright.

As to your question, I don't have a good answer, but regarding the Federal Reserve being okay with the bank funded bailout I have to point out:

*Of course* the Federal Reserve is okay with this plan. The banks ARE the Federal Reserve. Don't forget, they constitute the shareholders of the member branches. They'll get whatever they want from the Federal Reserve.