Toomre Capital Markets LLC

While Lars Toomre at Toomre Capital Markets LLC was preparing the following post about Lehman Brothers being concerned about its liquidity amidst the Bear Stearns liquidity fallout, the United States Federal Reserve has stepped forward to attempt to settle the Capital Markets ahead of Monday's possible St. Patrick's Day Massacre. Specifically, the Federal Reserve has done the following:

1. Immediately cut the primary lending rate from 3.50% to 3.25%, and
2. Authorized the New York Federal Reserve Bank to create a new lending program for primary dealers to provide funding for those involved in the securitization markets.

This second step clearly is intended to keep the likes of Morgan Stanley, Merrill Lynch, Goldman Sachs and Lehman Brothers liquid in the event that the critical repurchase market seizes up further (like it was starting to do on last Thursday and Friday). This second move likely will somewhat ease the pressure that the major investment banks were going to be feeling on Monday morning. The critical question is Will this be enough in a world where the markets truly go to an all sellers state???

Back on November 8th 2007, Toomre Capital Markets LLC ("TCM") posted a note entitled Incestuous Mix: Structured Credit, Financial Guarantors and Rating Agencies. Over the weeks since, there has been considerable web traffic from people looking for more information on how structured credit (like sub-prime mortgages and CDOs), financial guarantors (like ACA, MBIA, Ambac and FGIC) and the rating agencies (like S&P, Moody's and Fitch) interact. Then, in the last day, traffic about this subject has dramatically spiked with news about ACA's downgrade by S&P and MBIA's very belated disclosure about its "small" CDO^2 insurance portfolio.

As this Marketwatch article explains, MBIA disclosed on Thursday, December 20th 2007 that it has $8.14 billion of exposure to complex credit products known as CDO squareds (also known as CDO^2). Such CDO transactions are generally even more leveraged in their exposure to the credit risk that underlies each of the CDO transactions that since May have been causing such massive losses to many financial institutions. One might think that such a large exposure just might be relevant to investors in its common stock and bonds that include MBIA guarantees!!

For those who are not familiar with the details of structured finance, CDO^2s use as collateral tranches from other CDOs and then the CDO^2 collateral is further tranched into various classes that have differing exposure to credit losses. Generally, the underlying CDO tranches in a CDO^2 deal were those that an underwriter had the most difficulty in selling outright. As a result, many CDO^2 collateral tranches are what are referred to as mezzanine CDO tranches which originally were rated close to the very bottom end of the investment grade spectrum. The assumption behind tranching a CDO and CDO^2 is that the collateral is not highly correlated. In fact, the market has come to understand that almost all sub-prime mortgage collateral is both correlated with other issues from the same year and that the level of both defaults and expected losses are higher than the rating agencies originally projected when rating these structured finance transactions. The net effect of both increasing the expected loss percentages and increasing the correlation between the various collateral tranches is that CDO^2 transactions generally will have higher losses than CDO transactions with similar underlying "raw" collateral.

Why this exposure was not disclosed earlier is almost criminal. As Ken Zerbe, an analyst at Morgan Stanley, wrote in a note to clients, "We are shocked that management withheld this information for as long as it did. MBIA simply did not disclose arguably the riskiest parts of its CDO portfolio to investors." The MBIA stock promptly tanked more than 26% to close at $19.95 for the day. Clearly investors have expressed what they thought of this very belated disclosure and it clearly had a dramatic impact on MBIA's valuation.

Toomre Capital Markets LLC would strongly urge the financial regulators to investigate why this key information was not disclosed earlier and hopefully charge those responsible for this omission. Some reader may recall that MBIA also was at the center of another financial scandal when it entered into what was deemed an improper reinsurance transaction to hide losses from the default of the debt that it insured for a large health care system. TCM has previously written about this MBIA transgression in the post MBIA Nears Settlement. Politely, it is becoming more and more apparent that MBIA has a corporate culture that seems to stretch judgment calls to the border of illegal. Is it not time for the senior management of MBIA to be replaced?

In recent days, what Toomre Capital Markets LLC ("TCM") considers to be two of the most challenging Chief Risk Officer ("CRO") roles in the financial services sector have been filled. Both JP Morgan Chase with its considerable Credit Default Swap ("CDS"), leveraged loan and other large derivative exposures and Citigroup with its kitchen-sink collection of issues have named new CROs.

On Monday November 26th 2007, JPMorgan Chase announced that former Goldman Sachs managing director and chief administrative officer, Mr. Barry Zubrow, had been hired as its Chief Risk Officer. Starting December 1st, Mr. Zubrow will be reporting directly to CEO Jamie Dimon and will be a member of JP Morgan's Operating Committee. Earlier in his career, Mr. Zubrow was Chief Credit Officer and co-head of the Goldman Sachs risk committee that oversaw that investment bank's strong risk culture which is credited with helping Goldman Sachs steer clear of much of the losses associated with this year's subprime meltdown.

Apparently, CEO JPMorgan Jamie Dimon had been fulfilling this role for the bank since former CRO Don Wilson retired at the end of 2006. JPMorgan's recent performance during the credit market turmoil suggests that, unlike former Merrill Lynch CEO Stan O'Neal who apparently was off playing golf on many business days during the summer seizures, Jamie DImon was very much hands on (like Goldman Sachs CEO Lloyd Blankfein and Lehman Brothers CEO Dick Fuld were widely reported to be). Is it any wonder then that JPMorgan, Goldman Sachs and Lehman Brothers have fared relatively well during the mortgage credit crunch, especially when compared to Citigroup, Merrill Lynch, and Bear Stearns?

On Thursday November 8th 2007 at 12:40 EST, Bloomberg News ran this little story by Cecile Gutscher: Insured CDOs May Have AAA Ratings Cut Four Levels, Fitch Says. Toomre Capital Markets LLC just three hours earlier posted a note entitled Incestuous Mix: Structured Credit, Financial Guarantors and Rating Agencies that was focusing on what might happen if the financial guarantors were downgraded.

Apparently, if you were an investor in collateralized debt obligations that were rated AAA because of guarantees issued by bond insurers including MBIA Inc. and Ambac Financial Group, Fitch Ratings has now decided that the credit ratings may be cut in one swell swoop by as much as four rating levels. According to this Bloomberg article, Fitch rating analyst Thomas Abruzzo said in an interview today that "We expect there could be situations that could lead to downgrades of three to four notches on insured structured-finance CDO transactions."

New York-based Fitch said Nov. 5 it may lower the top ratings of bond insurers after a review that takes into account the CDOs they guarantee. Any bond insurer that fails the new test may be downgraded within a month unless the company is able to raise more capital. ``The bond insurers themselves remain AAA but there is the potential that companies could fall short of capital and also be downgraded, but we don't expect below the AA category,'' Abruzzo said. AA is the third-highest investment grade.

Oh well… There goes another linchpin under the high-grade bond market. No longer can one buy an insured bond and assume that the bond will remain in its original rating category throughout its life cycle. Perhaps someone can now suggest what credit enhanced bonds are really worth??? Does a AAA credit rating really mean anything??? Shouldn't AAA-rated structured finance transactions trade more cheaply than AA-rated corporate debt, or maybe even A-rated corporate debt? Or maybe it really is worth JUNK???

After all, one has to use one of those modern computers to calculate the value of the structured finance security? There is no absolutely transparency like there is in whether a company might be able to pay back its debts! The structured finance market used to have some degree of trust. With these dramatic ratings downgrades in portfolios that traditionally have seen small changes in principal value, is there any question about why there is a complete breakdown in reputation and trust? Widows and orphans bought high-grade bonds because of their high quality and predictable cash flows. What is a rating worth if it can go from AAA to BB on one Friday afternoon? What the heck good is bond insurance if a rating agency can suddenly bring down the rating of the insurer and all of the insured bonds that it backs? In short, What good is a credit rating?

While listening to the November 8th 2007 testimony of Federal Reserve Chairman Ben Bernanke and the follow-on questions from members of the United States Senate and House of Representatives, Toomre Capital Markets LLC ("TCM") was very struck by a looming and incredibly important effect of the on-going sub-prime mortgage credit crisis. From the remarks of the Senators and Representatives, it is clear that the financial services industry is about to undergo one of its periodic periods of unpredictable political change driven by populist outrage.

It is virtually impossible to predict what might result from the messiness of the political process. However, with potentially millions (yes, millions!!!) of constituents losing their homes to the foreclosure process so that the eventual sale proceeds can be passed through to structured finance security interests, there will be changes. Perhaps the personal bankruptcy code might be changed again? Perhaps Congress might change after-the-fact some significant terms of the securitization process which depends either on timely payment of principal and interest or some cure of the underlying delinquency/default to make the security holders near whole? Perhaps the populist outcry may lead the political process to get into another of the Have's vis-à-vis Have not's battles?

Toomre Capital Markets LLC has no idea of where the populist outrage will lead. However, one thing is very clear: major change is afoot. The key implication for investors in the coming months is that liquidity and being able to be nimble will be key. Also, no doubt there will be sharp and dramatic moves as investors react to one or another political proposal, both in America and from overseas, particularly in the Far East. Hence, another key theme will be a pick-up in volatility and a need to perform enterprise risk management on a real time basis. The value of embedded options in securities and derivative contracts are going to take on increased importance and no doubt another generation of portfolio managers and investors are going to be surprised by how quickly things can change.

Toomre Capital Markets LLC would suggest that a period of greater uncertainty lies ahead. How one manages money in such an environment or produce absolute return will change from how return has been created in the recent past. Just what those changes will be remains to be seen. However, there will be significant change. Reader thoughts and comments are welcome.