Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
8:30 AM EST, Thursday, December 13, 2007: Don't
mess with things you don't understand; there's always a "gotcha."
Yesterday I wrote about the debt insurers and what a miserable future I thought
they were facing. Wrong! A reader wrote me based on his hands-on experience
in that industry. My conclusion from reading what he wrote and speaking with
him on the phone is that these three stocks may represent the
biggest contrarian play around. As he summed up on the phone,
"I firmly believe that people don't understand these companies." Here
are their charts, updated with yesterday's trading:
I read your column on Ambac and MBIA today with great interest and I realized
that after reading your column for so many years that you finally had a topic
about which I could bloviate.
In a prior job I had quite a bit of experience with Ambac's and MBIA's CDO
insurance operations. They were very good at what they did and had a strong
credit committee culture behind their process. They frequently negotiated
caps on the percentage amount of certain dodgy assets (including subprime)
allowed into the CDO transactions they insure. They were frequently stricter
than the rating agencies. Furthermore, they had their own models and would
frequently do things such as "we understand Moody's says 70% of this
is rated AAA but for this particular transaction we'll only insure the top
don't realize that the CDO deals in question will generally not "default"
until the very end of their lives. That is because as long as enough cash
is available from the assets to pay the interest on the AAA bonds only (it
doesn't matter if the lower rated tranches don't get paid) the deals by definition
will not default and Ambac and MBIA will not need to pay out on their insurance
policies. For this purpose, even principal received from the CDO assets can
be used to pay the interest on the CDO issued bonds. Subsequently, it is highly
unlikely that Ambac and MBIA will be required to pay out on an insurance policy
on even one CDO for a number of years - let's say five years (and it is highly
likely they never get hit). Five years is an eternity and a lot will happen
to these companies and to the economy in the next five years including a full
recovery from the current crisis. Bottom line - Ambac and MBIA generally insure
actual default triggered by an actual missed interest payment - not mark-to-market
risk or impairment risk or media headline risk - and CDO defaults have a large
(measured in years) time delay for default to occur.
CDOs by their
very nature rely on maintaining large amounts of diversity in the portfolio.
For example, one sector (such as subprime mortgages) cannot typically make
up more than 8%-12% of any portfolio. This kind of puts things in perspective
when Ambac and MBIA are only insuring the top 70% of any CDO. In simple, non-exact
terms, 60% of the assets in a CDO would have to default with a 50% recovery
(for a net loss of 30%) before Ambac and MBIA would be required to pay out
on their insurance policies (assuming an example transaction where they insure
the top 70%). I think that when people hear "subprime" they are
assuming that Ambac and MBIA are insuring transactions 100% backed by subprime.
This is highly unlikely as such a transaction would not achieve the diversity
required for CDO structures to exist. Think in terms of 8%-12% subprime or
even 25% if you insist but do not think in terms of 100%.
are insurance companies, Ambac and MBIA do not typically need to mark-to-market
their exposure. So, even if the bonds that they are insuring might trade down
to 90 or 80 or lower - there's no mark to market - Ambac and MBIA just sit
on the insurance policies and book their ongoing premiums as revenue. Of course
at some point they will need to review their reserves but adjustments to reserves
are required in much more limited circumstances than the adjustments that
a mark-to-market would require. Juxtapose this with Long Term Capital Management,
for example, which needed to mark-to-market its exposure essentially daily
as a condition to its borrowings. You can also compare this favorably to the
SIV's which essentially must mark-to-market quarterly as their short term
commercial paper borrowings come due and they have to refinance.
I think the
true risk to Ambac and MBIA over the near term is not liquidity (though they
will likely seek additional capital solely to prevent a downgrade from AAA
but not because they actually need it to service their ongoing commitments).
Rather, it is the loss of newly booked business as they wait out the crisis
- the number of new CDO policies they write has plummeted while the fickle
market decides whether it can trust them again. Unfortunately they don't have
Berkshire Hathaway's strength/reputation and cannot continue to write insurance
through a downturn the way Berkshire does (and reaps enormous profits for
doing so). Though, according to the Bloomberg article you cited, Ambac and
MBIA do seem to be pulling a Berkshire and are continuing insurance operations
in the municipal area - a telling fact. And, importantly, from a cashflow
perspective with respect to their CDO insurance business they can sit and
do nothing and collect the premiums from their existing policies and pay out
nothing on those existing policies for many years. Note that CDO insurance
premiums are typically paid over the life of the transaction - not upfront
- so the insurers will continue to have positive cashflow for a number of
years on even the worst transactions. Positive cashflow does not tend to cause
provide an analog to the current crisis - bond insurers insured many emerging
markets CDOs in 1997/1998 and though I cannot definitively say (the CDO market
is a private market with limited transparency) to my knowledge the insurers
did not have to pay out on an emerging markets CDO policy. So, how does Russia/Brazil/Nigeria/Argentina
risk in 1997 compare to subprime risk today?
I know it sounds
naive to say what I'm about to say in the second half of this paragraph when
the media and lots of other folks are calling the value of AAA ratings into
question and there is a current fashion for citing LTCM-style multiple sigma
events , Black Swans and fat tails. However, reams and reams of actual experience
(80+ years) and history and study are employed by Moody's and S&P to back-up
their definition of a AAA rating - simply though not exactly stated, that
definition is that a company (or CDO) rated AAA today has a 1 in 10,000 chance
of defaulting over the next 10 years. AAA ratings are supposed to take into
account such things as the Great Depression. Are we in a Great Depression?
And, don't you think that somebody at the rating agencies knows what low kurtosis
Even when the
rating agencies discuss the possibility of bond insurer downgrade publicly
they are doing so in the context of are these companies still a 1 in 10,000
probability of failing over the next ten years. The context is decidedly not
one of are these companies on the verge of failing over the next ten months.
Let's have some perspective and credit the rating agencies with at minimum
From what I
read, I know that smart people such as William Ackman at Pershing Square have
strong views on MBIA and I do not claim here to refute their contentions.
Rather, I restrict my own comments to the nature of the risks that Ambac and
MBIA are taking in their CDO businesses and not necessarily the whole picture
like I assume they are. I should also note that the media implies that Pershing
Square has made a large amount of money with its view. In addition, my knowledge
of the municipal business (a large part of Ambac's and MBIA's business) is
But from what
I know about the CDO business that seems to be the root of Ambac and MBIA's
troubles I would be strongly inclined to wait Ambac and MBIA out for a while
and then pick up some shares after it seems like their stock prices have turned
a corner. Don't try to catch the bottom - maybe let them go up 20% or 30%
before you buy. Don't get greedy - there will be plenty of more upside after
the initial 20% or 30%. I've got more research to do but this is certainly
I do not currently have any exposure (long or short) to any of the companies
mentioned in this email.
our financials discussion: Another reader writes:
be to sure about your shorting of the XLF or putting the charts up of those
companies that insure muni debt and for several reasons.....1) as you well
know most good muni paper is probably AA rated by itself but bc folks want
"insured" AAA paper. So the underwriters go out and have the paper
insured for a smaller yield to the buyer....the chance of muni defaulting
on AA paper is very low...folks need to ask their broker what the underlying
rating of the muni bonds are that they own..I in fact think it is a great
time to be buying muni paper as it is almost trading at yield parity w/ ST
treasuries..... and I am even going long some of the bond insurers ( I guess
that is what makes a market huh!)
2) The time to short these things was anytime in the past 6-12 months... but
not now.....lots of folks are jumping on the short side and I think it will/is
becoming a crowded trade...they eventually have to buy back those shares and
the short squeeze will be fast and fierce...hence the current volatility in
the financial markets ... sell one day buy back the next day etc...repeat...go
long and then sell the next day!
3) I wouldn't be so happy as a New Yorker (insert financial community) and
all the pending layoffs that will be coming in the financial sector from the
fallout out of asset repricing CDO's/SIVs/subprime loans etc......Wall Street
will be laying off some of those highbrow bankers and traders and even back
office folks...who is going to buy their overpriced tiny apartments?
Europeans/Asians because their money goes farther!? ha...."sorry but
remember something is only worth what someone is willing to pay for it...
not what you might think it is worth or what is was worth last week"
that applies for all assets too!
4) Things are really bad out here in the Midwest! MI/OH/IL (we might even
already be in a recession...unemployment in MI over 6% and 5.9% in OH...probably
higher but who really knows)
we didn't even have the crazy housing appreciation that you folks enjoyed
in the past 5-7 years and our housing market is collapsing..(too much inventory,
folks can't get loans/credit crunch)
I know tons of folks who are stuck with two houses/two mortgages....urge your
readers that if they want to move to sell first then buy....I shudder to think
what will happen to home/apt prices on the "gold coasts" when the
correction finally comes to town. (it is a zero sum game)
5) don't fight the FED(who I happen to believe are clueless to how bad it
is out there (a la Cramer) and are always much to slow to lower rates).....My
guess is rates this time next year will be in the low to 3.25 % range....historically
not a good time to short financial sector when the fed is easing
6) anyone who thinks that this credit crises/mortgage collapse/housing correction
isn't going to slow GDP/maybe even cause a recession hasn't talked to anyone
trying to sell a house, selling cars or appliances, or the mortgage brokers
who are getting laid off...not to mention the brokers trying to place paper
in the market (what about all those service economy jobs that make up 75%
of workforce?....man I should have become a doctor.)
7) are you giddy?, do you find yourself saying "I told you so" about
the housing/financial stocks collapsing then its time to start covering your
shorts.......do you feel sick to your stomach? want to puke at the complete
meltdown in the financial sector? do read story after story in the mainstream
media about all the above, did hear how today one brokerage company says its
best short idea for 2008 is a stock that has fallen 40-50% this year....hello?
where were you guys making that call 40-50% higher....time to buy!
too much doom and gloom...but I love this market
I could be wrong and have the right to change my opinion
Beating my unfavorite horse: My favorite PC
gadget is VTBook which powers two external monitors, giving me four in total.
I cannot live without my monitors. VTBook won't run on Vista. Nor will Vista
drive my six printers, all of which are old, but work just fine. Stay away from
an important communications lesson here.
Little Johnny watched his daddy's car pass by the school playground and go into
the woods. Curious he followed the car and saw Daddy and Aunt Jane in a passionate
embrace. Little Johnny found this so exciting that he could not contain himself
as he ran home and started to tell his mother.
was at the playground and I saw Daddy's car go into the woods with Aunt Jane.
I went back to look and he was giving Aunt Jane a big kiss, then he helped her
take off her shirt. Then Aunt Jane helped Daddy take his pants off, then Aunt
At this point
Mommy cut him off and said, "Johnny, this is such an interesting story,
suppose you save the rest of it for supper time.
I want to see the look on Daddy's face when you tell it tonight."
At the dinner
table, Mommy asked little Johnny to tell his story. Johnny started his story,
"I was at the playground and I saw Daddy's car go into the woods with Aunt
Jane. I went back to look and he was giving Aunt Jane a big kiss, then he helped
her take off her shirt.
Then Aunt Jane
helped Daddy take his pants off, then Aunt Jane and Daddy started doing the
same thing that Mommy and Uncle Bill do when Daddy goes on a business trip.."
you need to listen to the whole story before you interrupt.
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
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