Harry Newton's In Search of The Perfect Investment
Technology Investor. Auction Rate Securities. Auction Rate Preferreds.
For today's column
on Auction Rate Preferreds.
9:00 AM EST Thursday, April 10, 2008: I've
been reading a bunch of macro economic reports -- high-level overview statistics.
They're depressing. Jobs lost. Dollar declining. Huge and growing government
deficits. Corporate earnings stagnant (with occasional exceptions). Cost of
living skyrocketing (fuel, food, healthcare). Pessimistic consumers. Pessimistic
CEOs. And a declining stockmarket (particular gruesome in tech stocks). The
there are the company reports. We're moving into earnings season. It looks brutal,
with only occasional glimmers in agriculture, mining and oil services. (Oil
is now over $110.) Hence my continued recommendations -- gold (GLD), silver
(SLV) and Australian mining stocks like BHP and Rio Tinto (and other smaller
ones I've mentioned before).
worst part of all this is what the Credit Crunch is doing to the economy.
Lenders are not lending. Borrowers are not borrowing. And without money, they're
not building, expanding and in some cases, even surviving. (This is obviously
too harsh. But I'm making a point. Stick with me.)
Wall Street used
to have two businesses -- investment banking and helping its clients make money.
Note, I said "used to." In recent years, Wall Street has figured
the way to make serious money is to gamble. This chart sums it all. Look at
Bear Stearns (pre-collapse). It borrowed $30 for every $1 it had. .
2007 Conde Nast Portfolio Magazine
Think about what
that means for little old you and me. We invest $3, borrow $90 and buy $93 of
a surefire stock. One horrible day in the stockmarket (like the ones we've been
having recently) our surefire stock drops $3 -- or 3.23%. Bingo, we've wiped
out our entire net worth and we're broke. Stony broke. Now imagine it drops
$4. Not only are we broke, but we owe $1. Fortunately, if you're Bear Stearns,
the Federal Government (using your and my tax dollars) will step in and save
you. If you're you and me, you'll stew for the rest of your life in debtors
prison on some godforsaken island.
Who in their right
mind would borrow thirty times their net worth only to invest it in some surefire
thing? And Wall Street has the chutzpah to lecture me on risk management!
You think I'm
crazy? I now want you to read this piece from April 14 BusinessWeek.
If this doesn't make your hair stand on end, keep reading. I have another surprise
a Bond Insurer
used ACA to hide loads of subprime risk. It workeduntil the tiny company
secret behind the mortgage mess: It turns out that Wall Street generally didn't
buy insurance on subprime bonds to protect against default. Instead, many
big banks used the policies to play one set of accounting rules against another.
of the game were bigger profits for banks, more money to continue cranking
out securities built on risky subprime mortgages, and far less clarity about
the banks' true exposure to the toxic investments. The mess left by insurer
ACA Financial Guaranty (ACAH), which collapsed in December, is now revealing
just how critical the bond insurers' role was in the mortgage market. In essence,
ACA and the rest of the industry helped spur the boom to new heights, extending
it far beyond its natural end point.
For years the
bond insurers operated in relative obscurity. They mostly sold guarantees
on basic municipal debt, paying out claims in the rare case a bond defaulted.
But as competition increased, companies moved into more exotic products with
bigger profits, including the risky securities known as collateralized debt
obligations that invested in subprime loans and other assets. ACAthe
fledgling outfit that got a new lease on life back in 2004 from an investment
by Bear Stearnstook it to extremes. By 2007 CDOs and other types of
exotic securities accounted for 90% of its portfolio, compared with 36% for
MBIA, the nation's largest bond insurer.
With such an
outsize exposure to hazardous debt, tiny ACA has become a focal point for
the frenzy surrounding the bond insurers, which together guaranteed more than
$800 billion in complex securities, including subprime assets. ACA's implosion
in December sent shock waves across the market and forced big banks to take
$6billion in losses. Regulators, in turn, feared that other insurers would
suffer similar fates, triggering more losses and aggravating the credit crunch.
Today, ACA lies in ruins, its business under the watch of Maryland state insurance
regulators. But the story of its rise and fall sheds much light on a little-known
industry that continues to cause concern among regulators, investors, and
rating agencies. A BusinessWeek analysis reveals the insurers' guarantees
turned out to be little more than a subprime shell game, one that has prompted
at least one lawsuit so far. ACA declined to comment.
insurance promoted confidence among regulators. The deals appeared to be another
way to spread the risk that borrowers would default on the underlying mortgages.
It was the sort of rationalization that encouraged a host of bad lending decisions
all along the mortgage food chain. "If the insurers weren't there, you
would have questioned [CDOs] a lot more," says Nicolas Vassalli, managing
director at hedge fund firm Structured Portfolio Management.
the bond policies only masked the inevitable subprime stink, until it became
too overwhelming by late 2007. In November, ACA's parent company reported
$1 billion in losses for the third quarter. Standard & Poor's (MHC) put
the insurer under review, slashing its credit rating from A to CCC a month
later. The downgrade forced the insurer to come up with more collateral to
show it could pay potential claims, under the terms of its agreements with
banks. ACA didn't have the funds to make good on those deals, prompting Merrill
Lynch (MER), UBS, CIBC (CM), Australia & New Zealand Banking Group, and
other clients to take big losses on the policies. Australia & New Zealand
Bank said its bonds remain solid, even without insurance. UBS and CIBC declined
What's more, Wall Street may face a fresh round of losses. That's because
ACA also insured $43 billion worth of securities backed by risky corporate
loans and bonds, like the ones used to fund the flurry of buyouts in recent
years. Those investments could be the next in line to sour, a turn made more
likely by the weak state of the economy. If those securities go bad, banks
would have to take more writedowns, squeezing the credit markets even further.
NURSING HOMES AND CASINOS
ACA barely figured
on the financial scene four years ago. The company, which was called American
Capital Access when it was founded in 1997 by a former executive of credit-rating
agency Fitch Ratings, searched in vain for a profitable niche. For years ACA
largely wrote insurance on low-rated municipal bonds for projects like nursing
homes and Native American casinos.
losses from troubled mobile home bonds, it scrambled to raise more capital
through an initial public offering in 2004. But the insurer had to abort the
plan when it came to light that then-CEO Michael Satz had a lingering personal
income tax issue from a previous job. Bear Stearns seized on the opportunity,
stepping in to buy roughly one-third of the insurer for $105 million. The
bank then installed one of its own executives as chairman and hired Alan S.
Roseman, a bond insurance veteran, as chief. Almost immediately, Roseman began
to push ACA into CDO insurance, an area his predecessor, Satz, had only begun
Why would banks
buy insurance on AAA securities, especially from ACA, which had only an A
rating? That would be akin to homeowners at the top of the hill purchasing
flood insurance from a company at the side of a river. If a flood did happen,
the insurer wouldn't be around to pay any claims.
lies in the complexities of accounting rules. Both banks and insurance companies
report earnings to investors under what's known as generally accepted accounting
principles (GAAP). But insurers also follow another set of guidelines, used
by state insurance regulators and applied in key areas by credit-rating agencies.
In the case
of CDO insurancetechnically called credit default swapspart of
the appeal lies in the differences between the two accounting regimes. GAAP
tends to require companies to value securities at prices in the market. Under
those so-called mark-to-market rules, banks have to report losses on the investments
each quarter even if they're only on paper. Insurance rules, by comparison,
make firms only declare losses if it looks as if the bond is permanently damaged
and they'll have to pay a claim.
out to be a sort of accounting arbitrage, allowing banks to take advantage
of that different set of rules. By using it, they could offload the price
risk to insurers' books to avoid suffering a hit to earnings if the bonds
dropped in value. "Bond insurance was an accounting strategy," says
former ACA chief Satz, now the founder of an online startup called BarterQuest.
"It reduced banks' mark-to-market worries."
banks another advantage: It allowed them to execute what's known as a negative-basis
trade, a strategy that essentially lets banks book profits on CDOs up front,
even though they haven't collected the money yet and might never do so.
Here's how it
worked: Say a bank bought a security that paid an interest rate that was 0.5
percentage points above a benchmark rate. Then it went out and purchased insurance
on the bond that cost 0.2 percentage points above a benchmark rate. After
doing so, the bank could book the difference between the interest payments
and the insurance premiums, the 0.3-point spread, across the life of the bondusually
5 to 10 years. Banks recorded those illusory profits in the quarter they took
out the insurance.
Overall, the deals boosted banks' profits and reduced the amount of capital
they had to set aside on their books for the securities. That freed up money
for banks to funnel back into subprime securities. Merrill, which churned
out more CDOs than any other Wall Street firm during the last two years of
the boom, was a big ACA client. "It's another example of the moral hazard
that people behave differently when they have insurance," says Frank
Partnoy, a former Wall Street derivatives trader who is now a professor at
the University of San Diego School of Law. "The banks kept making CDOs
because they had the ability to hedge with insurance."
As players like
Merrill rushed to do deals in the final months of the mortgage binge, they
began to take out multiple insurance policies from different vendors for the
same CDO pool. For example, according to industry sources, Merrill purchased
guarantees in 2007 from both MBIA and ACA on pieces of a $1.5billion CDO called
Forge ABS High Grade I, one of Merrill biggest's deals. At least seven other
Merrill CDOs from that year were insured by different companies.
In doing so,
Merrill and other banks created yet another set of entanglements, giving an
increasing number of players a stake in the fate of a single CDO. Those interconnected
relationships are the subject of recent lawsuits between Merrill Lynch and
another bond insurer the bank used, Security Capital Assurance. "Merrill
Lynch aggressively marketed [pieces of its] CDOs up and down Wall Street...desperate
to get these off its books," the insurer says in a Mar. 31 counterclaim.
The suit also quotes an e-mail from a Merrill salesperson that calls the insurance
"a very nice deal and a big help to [Merrill]." Merrill, which is
suing SCA over a contract dispute, says the counterclaim is without merit
and "makes assumptions that are very simply wrong."
deals made everyone happy at first. Fees from the complex investments ran
high for risks that seemed remote. The debt ACA guaranteed was the cream of
the crop, with top-quality, AAA ratings that signaled the bonds would rarely,
if ever, stop making payments. In fact, the bonds were designed to make their
regular interest payments even if the underlying loans lost 30% to 50% of
their value. "Most people saw this as a risk-free business," says
Christopher Whalen, managing director of consultancy Institutional Risk Analytics.
ACA ramped up
its coverage of CDOs to the very end. It was practically the only type of
insurance the firm sold in 2006; that year, ACA wrote $25 billion of coverage
on CDOs, compared with $1 billion on munis. Nearly a third of its total CDO
portfolio had the taint of subprime.
When the credit
market began to retreat, ACA charged ahead. In the first six months of 2007,
ACA wrote $22 billion of insurance on CDOs, nearly double the amount in the
same period a year earlier. Roseman remained undaunted, even after the bankruptcy
of two Bear Stearns hedge funds sparked a global credit crisis last summer:
"We're looking pretty positively on structured credit throughout the
remainder of the year," Roseman said in an Aug. 1 conference call. "Pricing
opportunities have expanded dramatically."
But as mortgage
delinquencies mounted, the accounting arbitrage began to grow poisonous for
ACA. By insurance industry standards, ACA showed a $20 million gain in the
first half of 2007 as well as the third quarter of that year. The earnings
statements of ACA's parent company, which reports to shareholders under GAAP,
told an entirely different story. Those losses hit $82 million in the first
half and totaled $1 billion in the third quarter.
The last remnants
of the accounting illusion vanished on Dec. 19. That day, nearly a year after
the housing downturn began, S&P cut ACA's credit rating. The losses from
subprime securities, which once seemed to be only market gyrations, had become
inevitable by S&P's standards. The insurer is currently on life support,
alive only through the concessions of its clients, who have not enforced the
terms of the deals and forced the insurer to cough up more money. The banks
have given ACA a reprieve through Apr. 23 while they reassess whether to pull
ARPS disaster. $360 billion is tied up in failed
auction rate securities. That's more than three times the economic boost
Congress is about to send us to save the economy. On my web site, www.AuctionRatePreferreds.org,
I've asked people for stories of how their locked-up monies are affecting their
lives. I've received dozens of emails. Most repeat a familiar story: They asked
their broker for an ultra-safe, cash-like place to temporarily store their money.
Brokers lied to them and dumped them into ARPS. And their now locked-up monies
are now affecting their ability to buy a new house, a new business, expand the
existing one, etc. I've received dozens of stories. The most heartbreaking came
in this morning:
Thank you for
your web site.
I am a single
women who by good fortune was able to purchase a home 10 years ago with money
from my mother's estate. I have worked in the non profit sector my whole professional
life - in service to others. I sold my home in 2007 because I was getting
nervous about the economy and as a single woman wanted to be cash strong and
debt free. I made a very nice gain on the house and put the cash with Wachovia
-- all the money I have and it truly was/is my financial future and retirement.
I wanted to buy a new house with cash and have no mortgage, so I put the money
with Wachovia while I looked for a house.
and strongly told the brokers that I wanted the money to be in cash only,
money market. Seven days after I had placed my money at Wachovia I got a call.
"You have a lot of cash and I can get you a better interest rate and
the only difference is you just have to give me up to 7 days notice to access
the cash" I was repeatedly assured that this was a totally safe, totally
cash placement with the only differences being a slightly higher interest
rate and 7 day notice.
I never gave
my brokers ANY other information except SAFE, CASH, ACCESSIBLE. I never was
informed of ARPS, auctions, put options, and the potential of failed auctions.
Does this sound familiar? I repeatedly asked the broker if this was cash,
as I only wanted cash with total safety of the principal. Well, as you know
I was not in cash I was in ARPS. Yes,my statements said I was in Short Term
Preferred (that is Wachovia's justification for not doing anything). I thought
it meant a money market like CD. I am not the professional - I thought they
were but I was very wrong.
It is interesting
that you congratulate Wachovia as I have received nothing but double talk,
denial and silence from the branch manager I am involved with and their corporate
attorney. I filed a formal complaint and Wachovia's attorney who just let
me know (without interviewing me - just the branch manager and brokers) that
the brokers did nothing wrong and it was all because the market collapsed
without any ability of the brokers to predict the failures and my statements
said Short Term Preferred so Wachovia's judgment is that it was beyond their
control and my statement showed Short Term Preferred - too bad so sad for
I retired from non profit work to go back to school for a teaching degree.
So, as far as your question goes here is what I have stopped doing and have
given up beside being in a constant state of panic especially with a tax bill
due by the 15th (what a joke huh - I have to pay capital gains on money I
can't access!) So here is what I have given up or stopped doing:
+ I have canceled
my land line phone
+ I have stopped going out to eat ( I have gone out to eat 1 times since February
22nd it is now April 9th)
+ I have not bought a book, a piece of clothing or any other non essential
+ I have canceled by golf membership
+ I canceled a medical procedure because I did not want to spend the $100
+ I canceled a large week long vacation to celebrate my 50th birthday
+ I am seriously considering whether I can continue with my graduate school
work (I will have to make that decision by the end of April)
+ I am not going to the movies
+ I keep all of my lights off as much as possible to save on electricity,
I literally use candles more than the lights
+ I was in the market for buying a home but have stopped looking
+ I was in the market to buy a new car but have stopped looking
+ I have cut back on driving and only drive when I absolutely must
+ I have cut back on food and only buy what I need to survive (vegetables,
dairy etc). I have cut my food bill by 40% since February
+ I have moved out of a paid storage unit and am now storing my belongings
temporarily in a friend's garage
+ I have stopped buying family/friends presents and only get cards
+ I changed my hair cutting place (3 years going to the same person) to go
some much cheaper and I go only 1x every 2 months
+ I stopped going to the chiropractor (I have a bad back from a sports injury)
+ I stopped getting weekly massages (I have a bad back from a sports injury)
life has stopped! I do nothing except the minimum to survive. I just want
my life back - thanks for everything that you are doing. It is the only place
I have found any real hope or help.
to download a YouTube video: This is the dumbest thing. YouTube don't
want you to download their videos to show to your friends. They want you to
send them the URL address and make your friends watch it on YouTube's web site.
Dumb. You'll find a zillion"video download" software on the Internet.
But none works. Except... Harry to the rescue ... Go to TechCrunch,
drop the YouTube address in and hit Get Video. It will drop the video
onto your hard drive. You then add the extension .FLV onto the end of the file's
name and use a video player program called VLC
This system doesn't
work for other video sites. I'm still looking. Anyone got any ideas?
A patriotic man was boasting about his sister who disguised herself
as a man and joined the Marines.
a minute," his friend interrupted, "She will have to dress with the
boys and shower the boys."
the man admitted."
they find out?"
The man shrugged,
best insurance company
Two old ladies are sitting on the porch at the old folk's home. One
turned to the other and asked "Martha, you were married a long time, did
you and your husband have mutual orgasm?"
The other little
old lady sat and rocked for a minute and said, "No, no, I think we had
This column is about my personal search for the perfect
investment. I don't give investment advice. For that you have to be registered
with regulatory authorities, which I am not. I am a reporter and an investor.
I make my daily column -- Monday through Friday -- freely available for three
reasons: Writing is good for sorting things out in my brain. Second, the column
is research for a book I'm writing called "In Search of the Perfect
Investment." Third, I encourage my readers to send me their ideas,
concerns and experiences. That way we can all learn together. My email address
is . You can't
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