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Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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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 65%".

Most people 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%.

Because they 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 liquidity problems.

History does 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 is?

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 some prowess.

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 very limited.

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 my plan.

Disclosure -- I do not currently have any exposure (long or short) to any of the companies mentioned in this email.

Continuing our financials discussion: Another reader writes:

I wouldn't 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? 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 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!

good luck
too much doom and gloom...but I love this market
I could be wrong and have the right to change my opinion


Vista: 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 Vista.

There's 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.

"Mommy,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..."

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.."

Mommy fainted!

Moral: Sometimes 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 is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.

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