MBS Pricing Issues and a Bank Bailout of Bond Insurers: Two Sides of the Same Coin

What are banks’ structured investment portfolios really worth? It is a question I’ve been asking for a long, long time. And I still don’t have a good answer today because disclosure and valuation practices are both inconsistent and poor. All I know is that many Wall Street firms are continuing to layer on more and more capital, only to write it off in subsequent weeks and months. When this daisy-chain of events will stop is unclear. But two recent stories in the Wall Street Journal drove home a very simple point: all eyes are trained on two upstream sources of the subprime debacle, rating agencies and bond insurers, with profound implications for the most publicly damaged of all institutions - the banks. And the banks, in an effort to try and protect the value of the portfolios that have been the leading cause of capital destruction, are now potentially in arms with a plan to support the bond insurers. From yesterday’s WSJ:

A group of major banks is racing against a deadline as they work on a possible bailout of the No. 2 bond insurer.

The banks are seeking to preserve the top-notch credit
rating of Ambac Financial Group Inc., which has been put at risk by the
snowballing impact of downgrades on mortgage bonds. This in turn makes
the bond insurers’ positions more precarious.

If the bond insurers are downgraded, Wall Street could
face an additional $40 billion to $70 billion in losses on top of the
$100 billion it has already suffered.

The crisis illustrates the symbiotic relationship between the
bond-rating firms and the bond insurers, which include Ambac and the
No. 1, MBIA
Inc. This relationship proved very lucrative during the boom time for
the housing market, but now their interests are diverging, and the
resulting spiral could lead to billions more in losses.

Symbiotic? One might call it conflicted. And this house of cards is now weighing heavily on the banks with the largest subprime exposures, who have the most to lose in the event that the top bond insurers lose their AAA ratings, the bonds they’ve insured plummet further in value and another wave of massive write-downs depletes their capital bases. So aside from raising yet more money from the sovereign wealth funds and other deep-pocketed institutions, what is a bank to do? How about pull an LTCM along with a passel of their ailing peers? Anything to stave off the inevitable, no? But the entire issue of mis-marking MBS portfolios has been chasing the industry since a trader at UBS’s externalized hedge fund platform, Dillon Read, was vilified and then fired for wanting to mark portfolios at realistic, market-clearing values and not where senior management wanted them to be marked. Another piece from Saturday’s WSJ:

Federal criminal prosecutors in New York are investigating whether UBS
AG misled investors by booking inflated prices of mortgage bonds it
held despite knowledge that the valuations had dropped, according to
people familiar with the matter.

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In the SEC’s UBS investigation, the agency is examining, among other
things, a situation last year in which a trader at a now-defunct hedge
fund of UBS’s Dillon Read unit was confronted and then ousted after he
valued mortgage securities at prices below the value assigned to the
same securities elsewhere at UBS. In late October, the SEC interviewed
the Dillon Read trader following a front-page article in The Wall
Street Journal detailing the incident, according to a person close to
the situation. The SEC has issued subpoenas in the UBS probe since,
according to a person familiar with the matter.

Suffice it to say, this is a hot topic among regulators and market-watchers of all stripes. So what to make of the bank’s plan to bail out Ambac? Is this something other than window-dressing or simply delaying the inevitable? Is this just a vehicle for perpetuating the mis-marking bank portfolios by essentially parking the liabilities on bond insurers’ balance sheets?

There have been so many analogies to LTCM as of late but Ambac is yet another example of a coordinated attempt to stave off the destruction of an entity for the perceived good of the broader market. The question is: how much of this move is based on true economics versus balance sheet presentation and perception? The LTCM bail-out was, without question, based on economics; buy time for the liquidity crisis to pass and exit the portfolio in a controlled, rational manner. An Ambac bail-out, however, may not be one of economics. The collateral may be permanently impaired, rendering the injection of bank capital merely a vehicle for back-ending bank losses from residual holdings of busted MBS. And this wouldn’t be good, as taking the bitter pill now and saving shareholders the cost of throwing good money after bad may well total in the tens of billions of dollars. This is real money. It simply isn’t worth paying that kind of a fee to keep problems off-balance sheet or, in this case, to delay the writing down of portfolio holdings that are highly likely to be written down in the future.

My hope is that the bank consortia is thinking clearly about this issue, and that the motivations are that of economics and not of being economical with the truth. Because this could end up being both a public relations and a financial disaster, two things the banks and their stakeholders most assuredly do not need.

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COMMENT:

AUTHOR: Lacidar

EMAIL: lacidar@lacidar.com

URL: 

DATE: 02/05/2008 08:21:27 PM

The forces you have identified and illustrated present a problem so large that the risk potential or risk paths could actually become a geometric progression of risk events (defaults and therefore losses). 

A competitive solution is clearly not available and while many will call for regulation…that will not help at this point as the damage is done…

So what  is on the horizon?  First”a la” the LTCM crisis, the “boys” will be called to a roundtable and Paulson and Bernake will basically say: “You have weeks…not months…to prepare for the inevitable.”  

And so it will go… yes markets will fall, but in an orderly fashion as these things go…. the Fed will direct this orderly collapse.

There are few other alternatives at this point. There is simply not enough billions to borrow from abroad.  

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COMMENT:

AUTHOR: RAUTION

EMAIL: rjaiswal@willamette.edu

URL: 

DATE: 02/06/2008 05:26:24 AM

I agree that the banks are injecting money from various sources and writting off their losses. In this regards there are two things that we need to take into account. First, these losses has already occured and cannot be reversed but can only be delayed. Second, bank needs money to continue to operate so that it can cover all its losses in due time. So instead of comming up with strict rules and skepticism it is essential that banks are promoted to continue operations to get back to their normal cash flow. It will help the economy to spur as well as banks to recover its losses. 

Steps taken by FED and states to boost money in the system along with stabilising interest rates for martgage payers will help banks from adding more losses to their account and continue with steady flow of money from the home owners.

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