Counter-Party Risk

Get used to hearing that phrase: Counter-Party Risk.

You will be hearing a lot of it in the coming year. Its one of the reasons I disagree with my friend Doug Kass about any bottom in Financials.

Consider this small concern: Given the enormous amount of hedging that was done by Investment Banks (Merrill, Morgan Stanley, JPM, Citi, etc.) if the  monoline insurers fail, well, then you are no longer hedged. So while some people are arguing that the write downs are now over, I am not quite so sure.

And that’s before we get to the issues of defaults which have yet to occur. These are problems in the near future, and they are likely to cause an ongoing set of dislocations. Hence, why I expect the financial sector bottom will be a long tedious   process.

But I digress. Back to the monolines and counter-party risk.

The AMBACs (ABK), MBIAs (MBI),  and FGICs (a GE/Blackrock company) of the world used to have a nice little business going. They wrote insurance on bonds that cities, states and municipalities issued. It was “the vig” on getting a triple AAA rating, and the premium more than paid for itself in reduced borrowing costs. A lovely, low risk business, with little defaults and a steady revenue stream. At one point in time, AMBAC had the highest revenue per employee on the planet.

That situation was obviously intolerable. So they brought in the financial engineers. Hey, we should be issuing insurance on Credit Default Swaps (CDS) — the premiums are much much bigger than boring old munis!

Any time you hear words to that effect, you know you are dealing with an idiot of the highest magnitude. Those are the equivalent to “Give me a match, I want to see if there is any gas in the tank.”

The monolines are not in trouble because Municipalities are defaulting on bond payments. (That’s waaaay in the future). The problem is they wrote insurance — taking in that fat premiums — without properly understanding the risk.

Greater reward requires greater risk. This is such a simple formula, yet I find myself repeating it again and again. How anyone fails to understand it, quite frankly, is beyond my comprehension. These were once great businesses, and now, there is the increasing chance –perhaps likelihood — they will be zeros.

Can you imagine Warren Buffet destroying such a delightfully simple, profitable business? Me neither. That’s why Berkshire is going to own this space in a few short years . . .


I’ve said it before, and I’ll repeat it again: To err is human, but it requires an MBA to create total clusterfuck . . .


Disclosure: A relative used to work at AMBAK, and now works at FGIC. We don’t really discuss work, and they were NOT consulted on anything in the commentary.


Default Fears Unnerve Markets
Partners in Credit Deals Face Big Write-Downs As Bond Insurer Teeters
WSJ, January 18, 2008; Page A1

The next banking crisis on the way
Jim Jubak
MSN, Jubak’s Journal, 1/18/2008 12:01 AM ET

Under Review: Ripple Effects Of Much Harsher Debt Ratings
WSJ, January 18, 2008; Page C1

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  1. cinefoz commented on Jan 18

    My guess, at this time, is that bond insurer defaults will cause the next big dip … probably in June or thereabout. Until then, the stock market recovery will begin.

    It’s contrary to human nature to clean out all the crap when it is most efficient. People put bad news and anything requiring deep thought or significant effort off as long as possible. Think of the pending insurer collapse as money in the bank for an astute trader.

    I’m wondering if there will be ginormous short covering today, making this one of the legendary recovery days that people will talk about for years?

  2. Stuart commented on Jan 18

    “That’s why Berkshire is going to own this space in a few short years . . .”

    And will do a fabulous job at it. A perfect add to the portfolio when it’s available.

  3. mikkel commented on Jan 18

    Speaking of counter-party risk, does any one have any idea if Goldman has been able to squeeze real money out of theirs or is it all on paper?

    Because if they are still deeply involved in their “hedging” and the other parties go bankrupt…

  4. Steve Barry commented on Jan 18

    B-Man delivers! Thanks Barry, we needed that blog entry badly.

    Yesterday I dumped a nice chunk of NY Muni Mutual funds I have had for years. Moved it into money markets. I wanted to be the first one out the door. I have a feeling I was right, as TLT soared yesterday and the muni funds were flat on the day.

  5. Stuart commented on Jan 18

    One other point, hedge funds were making a killing in the CDS market. We focus on AMBAC, MBIA and a few others, but ALOT of hedge funds are in the same position and the bond issuers face an immediate threat of default from these funds, particularly as their redemptions increase and returns further deteriorate. IMO, that is a larger risk than default by the publicly traded insurers such as MBIA.

  6. Old Ari commented on Jan 18

    Is anyone parasitic, on Berkshire Hathaway, buy a few shares, and sell shares, in the holding company?

  7. JAN commented on Jan 18

    Given the incredible leverage associated with these monkeys AAA ratings propagated through the bond markets, it would seem impossible that the Fed etc could allow them to fail.

    $20-50B their way, from whatever under the table deals, could save a Hindenburg situation.

  8. Michael commented on Jan 18

    Also, SIV debt comes up for refinancing at the end of this month. Not going to be pretty since all of this stuff is now on the balance sheet. Still don’t think financials bottom long term until one of the major money center banks has to be nationalized.

  9. scorpio commented on Jan 18

    yes, foreign fresh capital injections into marquee names like C make no difference in the long run unless ALL counter-parties receive somewhat comparable fresh support. chain as strong as its weakest link

  10. Winston Munn commented on Jan 18

    With the reaction to possible rate cuts and a stimulus package, it appears market psychology has entered the bargaining phase.

    Next stop: depressive stage when the reality of the amount of non-funded hedges starts impacting balance sheets.

  11. Stuart commented on Jan 18

    Very good write-up in the financial times this morning on this matter. A rather chilling quote at the end of it.

    Jamie Dimon, chief executive of JPMorgan, said this week when asked about bond insurers: “What [worries me] is if one of these entities doesn’t make it . . . the secondary effect . . . I think could be pretty terrible.”

  12. PureGuesswork commented on Jan 18

    Is it a symptom of the current mood that no one seems to have noticed the piece Saskia Scholtes and Gillian Tett published in the Jan 10 FT? In it they detailed that the numbers Bill Gross has been putting out for possible losses in the CDS market might be a tad overstated.
    Key quote:
    “It could also be that $45,000bn overstates the real credit risk. Banks and other investors typically conduct offsetting trades in the CDS market, which tend to get counted twice. When the figures are netted, real gross exposure often falls by about 80% or more, according to the Bank for International Settlements.
    “Indeed, a 2007 ISDA survey of credit risk found the ‘real’ credit exposure of the largest derivatives dealers to their biggest counterparties averaged just 6% of notional exposures after accounting for netting and other factors. If Gross’s default assumptions are applied to the ISDA figure, impending CDS losses for protection sellers are nearer to $17bn — not $250 bn.”

  13. Brian commented on Jan 18

    I agree that it is early to call a bottom in financials. Among the risks out there are:

    home equity (still not fully discounted by the street)
    credit card portfolios
    construction loans (regional banks)
    commercial real estate (and CMBS)
    leveraged loan (and CLO)
    tender option bond back up lines (muni funds)

    In particular, there appears to be a cascade of weakening credit in the consumer sector. Mortgage credit provided a fix for a broad range of consumer credit risks and masked a significant consumer credit problem. We are now seeing the fallout in credit cards, auto loans and student loans in geographies that have the worst housing problems.

  14. Stuart commented on Jan 18


    ARMONK, N.Y.–(BUSINESS WIRE)–MBIA Inc. (NYSE: MBI – News) announced that Moody’s Investors Service yesterday placed the Aaa insurance financial strength ratings of MBIA Insurance Corporation (“MBIA” or the “Insurance Company”) and its insurance affiliates, the Aa2 ratings of its newly issued Surplus Notes, and the Aa3 ratings of the junior obligations of the Insurance Company and the senior debt of MBIA Inc. on review for possible downgrade.
    MBIA said that it was surprised by Moody’s action in light of the rating agency’s recent public statements on the Company’s capital plan and last week’s Aa2 rating of the Surplus Notes. MBIA reaffirms its intention to continue working towards stabilizing its Triple-A ratings from all three rating agencies and addressing Moody’s remaining concerns.

  15. VJ commented on Jan 18

    So while some people are arguing that the write downs are now over, I am not quite so sure.

    Those claiming the write-downs are over are the same ones who claimed the housing market bottomed in the Winter of 2007… Er, the Spring of 2007… Ah, the Summer of 2007… the Fall of 2007?… definitely the Winter of 2008…

  16. IwantToKnow commented on Jan 18

    Does anyone understand “Structured Products”? The one’s that wall street is pushing out the door to clients in mass right now. Some have principal protection others offer all the upside with limited downside. They are structured that 85% is a zero coup liability of the issuing bank and 15% in options of calls and puts for the guarantee.

    What is the counter party risk in these?

  17. D.H. commented on Jan 18

    I used to like Doug Kass. Now he is just another bobble head who may have a nugget to offer now and then.

    I am very disappointed in the past week’s worth of articles he has posted, starting with the “Trust me. There will be an emergency rate cut in a moment” (paraphrase). Then he herded his followers into XLF before C earnings (SPLAT: egg on the face). Then he herded them into C before MER earnings (SPLAT: egg on the face). And now he has been wasting ink back peddling with little quips about how one of his extolled mentors one told him about [fill in something that justifies his reckless recommendations about XLF and C].

    Basically, Kass committed the following fatal errors:

    1) He jumped head first into a “hot tip.” Isn’t this the number one worst thing to do in every investment book ever written?

    2) He gambled by getting into stocks right before earnings — not a great risk-reward for the savvy investor and another classic “do not” in almost every classic investing book.

    Lastly, the one thing Kass had going for him was that he was a realist with a bear lean. Now he is just a sucker who put out recommendations like Kudlow on the thesis that the worst is behind us (which it is clearly not). I for one was expecting a much more prudent call and scalable approach from Kass. I surely wasn’t expecting him to call some sort of bottom only 3 months into a downtrending market while Wall Street and housing is clearly still a mess …

    Oh well. And if his firm truly was the one that loaded up on XLF calls before Kass wrote his hot tip article, then he is just another marketing man. But I do not know if this is true, just my skeptical assumption.

  18. egghat commented on Jan 18

    What really strikes me …

    The muni-bonds that have been insured are low risk. But as they were insured nobody ever rated them. So when the insurance breaks nobody knows how hig/low the risk is. And not knowing the risk is the core reason why the CDO market has totally collapsed. Nobody knows the risk, nobody wants to buy. I see another avalanche coming …

    If I were Bush/Bernanke I’d take the insurance for all muni-bonds. All. And let the CDOs and the credit insurers got to hell. But you have saved one market, which is *really* big, that doesn’t go to hell. Yes, taxpayers money. But, munis that go bancrupt a taxpayers money as well.

    bye egghat

  19. jmf commented on Jan 18

    Moin from Germany,

    Wall Street Finest at its best….

    Banc of America Securities analyst Tamara Kravec cut her rating on the bond insurance sector to neutral from overweight because leading companies in the business will likely have their AAA ratings cut. She downgraded shares of Ambac Financial MBIA Inc & Security Capital Assurance to neutral from buy. Bond insurers are “facing an unprecedented loss event driven by the sharp housing downturn,” the analyst wrote in a note to investors. “The perfect storm took time to brew, but it hit hard and fast when it came – much harder and faster than we expected.” Ambac shares rose 7.5% to $6.71, MBIA fell 21% to $7.32 and Security Capital declined 1.6% to $1.79

    Well done…..

  20. jag commented on Jan 18

    “Hey, we should be issuing insurance on Credit Default Swaps (CDS)” – actually, weren’t the monolines actually in the business of issuing Credit Default Swaps, which themselves are the form of insurance against defaults by CDOs and other junky bonds?

    I don’t why or how you would insure a CDS…


    Inartfully phrased on my part — you are correct — it should read, “Lets get into the CDS biz.”

    The title “Counter-Party RIsk” refered to the monoline insurers as the OTHER side of the trade for those who (wanted to be) hedged.

    but I think people understood what I meant . . .

  21. jag commented on Jan 18

    Also: I still don’t think that there is any reason to worry about the muni market. Investors have got to be insanely stupid to believe that losing Ambac’s wrappers makes munis significantly more expensive… at best, any panic in the muni market from fund managers who can “only hold AAA” will create some great buying opportunities.

    Munis are the least likely part of the bond market to see mass defaults.

  22. Big E commented on Jan 18

    Until the munis start defaulting on bonds in 1-3 years because of falling revenue (lack of commercial/residential property taxes, sales taxes, etc).

    It’s very easy to set up a scenario where you watch these so called “safe” areas fall like dominos.

  23. v commented on Jan 18

    For those who think Bill Gross’ estimate is overstated, the off-setting being mention to negate some of the loss doesn’t quite work symmetrically, as being assumed.

    For more info, check out this F. Salmon (who also initially gets it wrong) post on the issue, *AND especially* the comments in which a couple of finance experts (Clavell and Waldman) properly detail the risks and how net off-sets (to mitigate losses) are far from a sure thing.

    Here’s the link: CDS Arms Race …

  24. Schizohedron commented on Jan 18

    Two quotes from William S. Burroughs seem apt:

    “The junk merchant doesn’t sell his product to the consumer, he sells the consumer to his product. He does not improve and simplify his merchandise. He degrades and simplifies the client.”

    “Hustlers of the world, there is one Mark you cannot beat: The Mark Inside…”

  25. mhm commented on Jan 18

    “I don’t why or how you would insure a CDS…”

    Glad you asked. There is no easy or direct answer but you can get a cue here:

    Parimutuel betting (from the French language: pari mutuel, mutual betting) is a betting system in which all bets of a particular type are placed together in a pool; taxes and a house “take” or “vig” are removed, and payoff odds are calculated by sharing the pool among all placed bets.

    The real question is what will be left on the pool for winner…

  26. Pat Gorup commented on Jan 18

    Yes, other sites I cruise through have lists of S**T coming down the pike and how it might effect the global economy, oh forgot…we’re delinked. LOL That is why I keep thinking that the indices are going lower from here. What a great buying opportunity that will be in ’09.

  27. FT Woods commented on Jan 18

    Too many secret handshakes.

    Stupid question. Does counter-party risk intersect with what’s been going on with reinsurance and off balance sheet loans to inflate profits?

    Berkshire Hathaway bought General Reinsurance (GenRe) so the company isn’t immune to being deceived.

    Fitch Comments on Indictment of Former General Reinsurance Executives

    On Feb. 2, 2006, a federal grand jury indicted Ronald Ferguson, General Reinsurance’s former CEO; Elizabeth Monrad, the former CFO; and Robert Graham, the former assistant general counsel on various criminal charges including conspiracy to commit securities fraud, securities fraud, causing false statements to be made to the SEC, wire fraud and mail fraud. The DOJ alleges that the defendants, along with Christian Milton, former vice president of reinsurance for American International Group (AIG), engaged in a fraudulent scheme to make it appear as though AIG had increased its loss reserves.

    Also see: Justice Dept Drops Massive fraud Case

  28. PureGuesswork commented on Jan 18


    The point of the FT article was not that the offsets might not fail to protect the original position, but that the offset is treated as a separate position and an added risk. The offset (hedge) may fail to protect against losses in the original position, but it will not double the exposure.

  29. Sandra commented on Jan 18

    I believe FGIC is owned by PMI, BlackSTONE (not Rock which is part of Merrill now) and Cypress. I didn’t think GE was a part of that, but I could be wrong. Maybe that should be corrected.

    I agree that the counterparty chain is the next weak link to fall and the result could be massive. One of the things that often gets overlooked when talking about the CDS industry is the incredible operational issues that have to be solved. Often, even the big banks don’t realize when a default has happened and fail to make the claim for payment in a timely way. The swaps are often “backed to back” with swaps with another counterparty, and it just takes one to go bankrupt (like an ACA) to cause a big unexpected loss. You think you are hedged, but you’re not if your counterparty can pay you, but you are on the hook.

  30. jaym commented on Jan 18

    Libor has come back into line (The FED is doing its job —surprised) ….$150 trillion of derivatives is financed on LIBOR plus RE resets . Treasury / NYFED are fully aware of the counter party risk (who isn’t) ….arrangements being made on a contingency basis. Yes, the monolines are going out, look at their bonds!—look for a bailout…did I mention NYFED

    We rally from here into early March—enjoy it—we should get strong reaction rally off this leg one down on Dow Theory.

    Oh Mr Ritholtz stay off of Kudlow’s “info-tainment” show doesn’t do your street cred any good.

  31. Al Czervik commented on Jan 18

    BR: “A lovely, low risk business, with little defaults and a steady revenue stream. At one point in time, AMBAC had the highest revenue per employee on the planet.

    That situation was obviously intolerable.”

    Superb Barry. I hope your readers appreciate your talent for writing dry comedy.

  32. donna commented on Jan 18

    Ambac Financial Group Inc. scrapped a plan to raise equity capital after the bond insurer’s shares plunged 70 percent in the past two days, putting its AAA credit rating in jeopardy.

    Without new money, New York-based Ambac risks losing the top ranking it depends on to sell bond insurance. Ambac, the second- largest financial guarantor, may have to stop writing insurance or sell itself, said Robert Haines, an analyst at CreditSights Inc., a bond research firm in New York.

    “This is a stunning development,” Haines said. Ambac will probably be downgraded by Moody’s Investors Service and Fitch Ratings, Haines said.

  33. james commented on Jan 19

    Doug Kass seemed to be saying (last night on Kudlow) that the financials have bottomed, but with the huge proviso that there was absolutely no choice but to have a massive government bailout of the monolines. Otherwise financials go to 0.

  34. badhaikuguy commented on Jan 19

    “But I am telling them that the Country as a whole is “Sound” and that all those whose heads are solid are bound to get back into the market again, I tell ’em that this Country is bigger than Wall Street and if they don’t believe it I show ’em the map.”

    Will Rogers

  35. The Big Picture commented on Jan 23

    Read it here first: CDO Lust Undercut AAA Success

    Last week, we discussed the foolish shift among the monolines from staid Bond insurers to derivative dab blers in Counter-Party Risk. Now Bloomberg has picked up the same meme:Municipal bond insurers such as MBIA Inc. and Ambac Financial Group Inc. had…

  36. The Big Picture commented on Jan 29

    Monoline Insurance: There’s a New Sheriff in Town…

    The monoline insurers — the firms that issued default insurance on muni bonds that never default — have been buried by more than a trillion dollars worth of derivative bets, more than 10% of which have gone bad. That $130 Billion worth of CDO/CDS exp…

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