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
SUSAN PULLIAM and SERENA NG
WSJ, January 18, 2008; Page A1
The next banking crisis on the way
MSN, Jubak’s Journal, 1/18/2008 12:01 AM ET
Under Review: Ripple Effects Of Much Harsher Debt Ratings
AARON LUCCHETTI and KAREN RICHARDSON
WSJ, January 18, 2008; Page C1