The Sting, Part 2  

The Business Spectator has another intriguing Alan Kohler column on the CDS menace (following on from this column last week) - Synthetic enhancement falls flat.

The most important task for the incoming US Treasury Secretary, Tim Geithner, when he eventually comes in (apart from cleaning up the horrible mess his predecessor left on the TARP) will be to figure out what to do with synthetic CDOs.

Specifically: who decides when the right number of defaults has occurred to trigger total loss on these investments, and then who blows the whistle to signal that it’s time for ownership of that money to be transferred.

Synthetic collateralised debt obligations, you’ll recall, are complex credit default swap instruments where the investment is lost if and when between seven and nine companies out of a list of – usually – 100, default on their debt. The total companies on all the synthetic CDOs, runs into several hundred.

For the banks that sold them they are insurance contracts – they get paid when there are nine defaults from the list. For the investors who bought them they are ticking time bombs as, one by one, the companies fall over.

Many Australian local councils and charities have bought them from Lehman Brothers’ local subsidiary Grange Securities.

Mostly those who bought them had no idea what they were buying. They were sold by spivs paid a commission and presented as investment-grade fixed-interest securities paying a premium over similarly rated alternatives. It was a bit like buying a house on an old toxic waste dump that has had a nice lawn planted on top.

In any case, those who actually knew what they were buying had no reason to suspect in 2006 that nine of the world’s largest and most solid corporations would go bust. Now it is an entirely different story.

Here is a form guide on 31 companies that have either defaulted already and are most likely to do. I am indebted to IMF Australia, the litigation funder that has been studying synthetic CDOs, which provided the basis of list below, which I have updated and expanded.

American International Group

The US government lent $US123 billion to AIG in September and October, and by all accounts this has blown out to $US150 billion. In return for that the government got 80 per cent of the company’s equity. The company is now selling assets in an attempt to repay the loan, and while it is unlikely to raise enough cash to do that, it won’t default unless the government decides to let it.

AMBAC (a monoline insurer)

Last week Ambac was downgraded again by both Standard and Poor’s and Moody’s and the stock price fell 30 per cent to 83 US cents (it was $US24.74 last November). Then on Thursday the price soared 80 per cent after the company paid $US1 billion to get out of four CDO guarantees worth $US3.5 billion. Reuters reported that research firm Friedman, Billings, Ramsey said Ambac's contract cancellations were "positive," but did not "answer ongoing business model concerns." Still a likely default.

Bear Stearns

Taken over by JPMorgan Chase in March. If JPMorgan defaults (see below) this would therefore result in two defaults.

Beazer Homes (home builder)

Its share price has crashed from $US9 in September to just above $US1 now as house building in the US has virtually stopped. It’s due to post its annual results on December 2. In the meantime the Securities and Exchange Commission is investigating the company over accounting procedures. The SEC alleges that it fraudulently altered its earnings and improperly recorded $US100 million in earnings in 2006. Likely to default.

Centex (home builder)

The company lost $US171.9 million in the September quarter and the shares have fallen from $US30 to $US5.50. Centex is now selling land to survive.

Citigroup

Who would have thought we would be raising questions about the survival of Citigroup, but we are. Two weeks ago the CEO Vikram Pandit made 52,000 job cuts and last week the shares responded by falling 60 per cent. As the New York Times reported last week, only two months ago Citigroup emerged from the wreckage of the financial crisis as one of the few titans left standing; now it is on its knees. The NYT attributes much of its problems to the failure of its takeover of Wachovia, after Wells Fargo swooped in with a higher offer. May be too big to be allowed to fail, though the government will probably have to do an AIG with it.

Countrywide (mortgage broker)

Swallowed by Bank of America, and apparently guilty of fraud and dishonesty. It is now the subject of many lawsuits, including from the State of California. As with Bear Stearns, if Bank of America defaults, it will cause two defaults; that seems unlikely, but anything’s possible these days.

Fannie Mae (mortgage wholesaler)

This company was placed into conservatorship by the Federal Housing Finance Agency in early September 2008. The board of directors and senior management were expelled. Shares representing 80 per cent of the company were issued to the government. Dividends were suspended. This company has defaulted on its debt.

FGIC (insurance company)

Sold most of its business to MBIA (see below) in August. Although this was a positive move, it left the company with a lot of residential mortgage backed securities and CDOs that were sinking in value. This company seems likely to default eventually.

Freddie Mac

Like Fannie Mae it was placed in conservatorship in September, which was an act of default.

FSA (insurance company)

This used to be owned by the Belgian-French bank Dexia, and was sold this month to Assured Guaranty Ltd. However, its future is neither assured nor guaranteed, and parent and new subsidiary are under financial stress. Fitch Ratings has commented that FSA is still a separate entity for the purposes on default calculations.

Genworth Financial (insurance company)

The company announced a third quarter loss and was downgraded by Moody’s. Last sighted trying to buy a bank so it could get its hands on some of the $US700 billion TARP money from the government. Unlikely to make it.

Goldman Sachs (investment bank, now bank)

Having applied and been granted bank status, Goldman Sachs is very unlikely to fail, although it is reporting losses and its share price has slumped. That latest plan is to issue debt guaranteed by the government body, FDIC.

Hovnanian (home builder)

As with most US home builders in the list of 32 companies under pressure, Hovnanian is moving inexorably downwards. As at 10 November 2008, it was trading at $US3.36, down from above $US12 in May 2008. It is now being sued by Californian homeowners for fraud and breach of contract. Without government assistance, it is likely to fail.

JP Morgan

Shares fell 50 per cent last in sympathy with Citigroup, but probably too big to fail.

KB Homes (home builder)

A few months ago this company was trading at $US17.72. Since then, it has fallen as low as $US7, and is now $US8.02. In early November it cut its quarterly dividend by 75 per cent. As with all of the homebuilders this company will struggle through the housing downturn.

Lehman Brothers

Filed for bankruptcy on 15 September 2008, immediately causing a massive upheaval in financial markets. The company has $US613 billion in debt and is the third of these 30 companies to default. Investors are currently pushing for an independent investigation of fraudulent practices at the company.

Lennar (home builder)

This company is the second biggest homebuilder in the US and may be better positioned than most to survive a downturn.

Masco (home products)

Fitch has downgraded the company’s rating from BBB to BBB- and left the ratings on negative outlook. As the homebuilders struggle, those who supply them (such as Masco) will equally struggle.

MBIA (bond insurer)

On 5 November 2008, the company announced a third quarter loss of $US806 million. On 8 November 2008, Moody’s lowered the ratings on MBIA thus triggering payments by the company to third parties. Moody’s lowered the debt rating to junk level, citing a growing exposure to US mortgages. Without government intervention, it seems almost certain that this company will fail.

Merrill Lynch (investment bank)

On 14 September 2008, Bank of America announced that it had acquired Merrill Lynch subject to approval by regulators and shareholders. The company was sold for $US29 per share and the company is currently trading at $US8.34. It is down from over $US50 in May 2008. The acquisition of this company by Bank of America means that if Bank of America fails, then this will be a default by Bank of America, Countrywide and Merrill Lynch. Had Bank of America not made these two acquisitions, both Countrywide and Merrill Lynch would have failed by now.

MGIC (bond insurer)

On 17 October 2008, the company announced a third quarter loss of $US113 million after losses on Fannie Mae, Freddie Mac, Lehman Brothers and AIG. The company is currently trading at $US1.93, down from above $US10 two months ago. This company has a limited future unless the US government steps in to save it.

Morgan Stanley (investment bank)

The company’s shares have fallen from $US45 in September to $US10.05 today. It is clearly struggling but will not be permitted to fall, although it may be taken over by a stronger operator.

PMI (bond insurer)

On 3 November 2008, PMI announced a third quarter loss of $US229 million. The shares are down to $US1.37 from a high of $US17 and appear to be heading to oblivion unless the government intervenes. Local insurer QBE completed the acquisition of PMI Australia in late October.

Pulte Homes

Again, the shares have collapsed from above $US20 to $US7.12 in a couple of months. Analysts have recently started to downgrade this stock. In its quarterly report dated 6 November 2008, the company reported a net loss of $US280 million for the three months ended September 30, 2008. It will struggle to survive.

Radian Group (insurer)

The debt of this company has been reduced to junk status. Its shares are trading at $US1.50, down from as high as $US5.20 but are now back to $US3.32. Again, short of government intervention, this company seems doomed to failure.

Rescap (mortgage broker)

Rescap is owned by GMAC, which is itself in trouble. In turn, GMAC is owned by Cerebus and General Motors. Both of these firms are in trouble. In early September, Rescap announced it was shedding 60 per cent of its staff, having narrowly escaped bankruptcy. S&P has now downgraded both GMAC and Rescap to CC. On 5 November 2008, the Washington Post suggested that Rescap would fail. The newspaper quoted GMAC as the source of that information. It now appears that GMAC will not be required to support Rescap. In these circumstances, it seems almost certain that Rescap will fail. Rescap posted a third quarter loss of $US1.9 billion. This made a total loss for eight quarters of $US9 billion.

Standard Pacific (home builder)

On 30 October 2008, the company announced a third quarter loss of $US369 million.

UBS (investment bank)

This is one of the companies one would expect to survive the financial turmoil. In October, the company received a $US59.2 billion aid package from the Swiss government. This is the main reason why it is not likely to default. In European terms, it is too big to fail. The company has transferred the risk on $US60 billion of debt assets to the Swiss government. In the meantime, indictments could be issued against senior bank officers in the near future.

Washington Mutual (savings and loan company)

On 26 September 2008, this company became the largest US bank failure in history. After customers withdrew large sums, it was seized by the Office of Thrift Supervision and its branch network sold to JP Morgan. This is the fourth company to default in the list.

XL Capital (Monoline Insurer)

The debt of this company had been downgraded to junk status and the stock is trading at $US4.64, down from above $US20 in a couple of months. The chairman has been forced to sell to meet margin calls. The stock has been down 50 per cent one day and up 75 per cent the next. The company announced a loss of $US1.6 billion to 30 September 2008. This is another company whose future is cloudy without government intervention. (Its parent is now known as Syncora Holdings.)