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?

As The Wall Street Journal reported in the article Hard-hit Morgan Stanley Gets $5 Billion From China, Morgan Stanley's fourth quarter 2007 earnings report was simply horrendous. On Wednesday December 19th 2007, Morgan Stanley announced a "$9.4 billion write-down for its fiscal fourth quarter on U.S. subprime and other mortgage investments. Morgan Stanley posted a net loss of $3.59 billion for the fiscal fourth quarter ended Nov. 30, compared with net income of $2.21 billion in the same period a year earlier."

Perhaps Toomre Capital Markets LLC ("TCM") is a bit naïve. However, does not $9.4 billion seem a bit large? The write-down translates into losses each and every one of the approximately sixty-one trading days in the quarter of more than $154 million. Maybe Wall Street has really changed in the last decade, but TCM suspects that Morgan Stanley executives have had far fewer days when the gross revenues from the fixed-income trading floor exceeded $150 million in a single day. The spin put out by Morgan Stanley is that these losses resulted from one desk of traders in the firm's mortgage trading area.

Toomre Capital Markets LLC and others wonder how such a small group could be allowed to take so much risk that approximately ten percent of the firm needed to be sold for $5 billion to the Chinese sovereign fund, China Investment Corporation ("CIC"), to stabilize its capital levels. In former days when the Wall Street firms were run as partnerships, there was considerably more emphasis placed on prudent risk management and the relative size of illiquid positions since it was the partners' personal wealth that was at risk should something go awry. As public corporations, it is not at all clear where responsibility for prudent risk management really lies. Yes, supposedly senior managements like those at Morgan Stanley are nominally responsible, but who besides CEO John Mack really suffered as a result of this $9.4 billion write-down? Other areas of Morgan Stanley supposedly are receiving healthy bonuses so the real losers yet again appear to be the common equity shareholders who have relatively little say in how the investment bank is run.

In the post Merrill Lynch reorganizes trading businesses into integrated FICC division, Toomre Capital Markets LLC ("TCM") has previously written about the July 2006 changes at Merrill Lynch that resulted in the dismissal of some of its most experienced fixed-income professionals. The TCM post Merrill Lynch's Stan O'Neal: Why Is He Even Still Employed? expanded upon how the Merrill Lynch CDO positions subsequently ballooned to approximately $35 billion (from something like $3 billion in June 2006). That same post dated October 26, 2007 went on to elaborate how Merrill Lynch shareholders must yearn for the days when a true bond market professional like Jeffrey Kronthal oversaw the Merrill Lynch CDO business.

On Monday December 17th 2007, Merrill Lynch made a very pointed "fuck-you" statement to former CEO Stan O'Neal by bringing back Jeffery Kronthal as a consultant to help navigate and unwind their mortgage mess. As New York Magazine's Intelligencer blog reports, "Kronthal's new role at Merrill will be fixing the mess his old boss made; he's been hired, according to Merrill co-pres Gregory Fleming, to "advise on the firm's fixed-income business and risk management." The job is temporary — Kronthal has his own hedge fund launching in mid-2008 — but the gesture is still meaningful, as many have said that had Kronthal and the other sacked fixed-income veterans not left, the bank might not be in the shape it is today."

A true indication of the high esteem in which Jeffery Kronthal is held was demonstrated by his reception on the Merrill Lynch trading floor upon his return: a standing ovation. As this Wall Street Journal article reports, "Mr. Kronthal, 53 years old, received a standing ovation when he appeared on a Merrill trading floor yesterday, people at the firm said. After Mr. Kronthal and three other executives departed in 2006, Merrill kept ever-greater amounts of mortgage assets on its books after debt underwritings, believing their high credit rating meant they were unlikely to generate losses."

In light of the UBS announcement about its $10 billion write-down of subprime mortgages and CDO securities, Toomre Capital Markets LLC ("TCM") has been asked what one should expect from this week's fourth quarter earnings reports from Bear Stearns, Goldman Sachs, Lehman Brothers and Morgan Stanley. Clearly, since August 31st 2007 and the end of their respective third-quarter results, the volume of transactions in these investment banks' massive fixed-income sales and trading divisions have slowed as market participants world-wide started to adjust to the subprime mortgage crisis and the credit crunch. However, other than declining top line revenues from customer activity, TCM does not have a clue. Just what is owned on the opaque balance sheets, how the valuation of those assets have changed during the credit market debacle and what the proprietary trading desks have done is relatively unknown. In short, the results are a crap-shot and there is high potential for more negative surprises.

On Monday December 10th 2007, Goldman Sachs analyst William Toanona reduced his earnings estimates for Goldman's three competitors: Bear Stearns, Lehman Brothers and Morgan Stanley. According to this Businessweek report, Tanona lowered his estimate on Bear Stearns to a loss of $2.25 per share from a previous estimate for a loss of $1.60 per share; he reduced his Lehman Brothers estimate to $1.35 per share, down from his previous estimate of $1.85 per share; and he cut his fiscal fourth-quarter earnings estimate for Morgan Stanley to a loss of 25 cents per share from a previous estimate of earnings of 32 cents per share. Apparently, Goldman Sach's new estimates for Lehman and Bear Stearns are below the expectations of analysts polled by Thomson Financial.

"November appears to have been a very challenging environment, rivaling the August timeframe," Tanona wrote. "The credit markets were particularly challenging as liquidity dried up, spreads widened and underwriting activity dropped dramatically."

Toomre Capital Markets LLC wonders what insight these investment banking firms will give to other ticking mortgage "time-bombs" such as home equity loans, option ARMs and the Alt-A mortgage sector. With liquidity virtually non-existent, spreads widening significantly and underwriting activity virtually stagnant, TCM wonders what light the various investment bank managements will provide about their earnings outlook for 2008. With Wells Fargo taking its write down on a prime home-equity loan portfolio and UBS announcing another $10 billion dollars in subprime and CDO write-downs, one probably should take any earnings guidance with a healthy dose suspicion. The next few days certainly should be interesting and quite volatile!!!

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.