More on the Credit Default Swaps

I was watching Bloomberg this weekend and witnessed the interview of two money managers who were touting the market's compelling valuations. It was the same-old same-old. You know, stocks are cheap and this correction represents a buying opportunity.

I am just totally baffled by such arguments. This bear market is not about valuations or earnings! It is about the end of a credit cycle. A credit cycle that, up until now, had totally ignored risk. The "repricing of risk" was thrown around in August to explain the markets initial losses, but even though you do not hear it as much anymore, that process is still taking place. Just look at the credit default swap markets.

The other day I pointed out a post in the The Big Picture that quickly explained the lunacy in the monoline insurance biz. Today, I read an even more in depth piece by John Mauldin. Here is an excerpt from the article.

As noted above, I said three weeks ago that the big story for 2008 would be the counter-party risk for credit default swaps. That story is coming faster and larger than I thought. Bill Gross of Pimco suggests that the ultimate cost could be another $250 billion dollars on top of the $250-plus billion in subprime losses. That means we have only seen the tip of the iceberg in write-offs in the financial sector.

The real problem is the "monoline insurers" like ACA, Ambac, and MBIA. Here's a quick primer on how they work. Let's say you are a small municipality and want to borrow $10,000,000 for a bond offering to build a road or a water treatment plant. If you went to the market with your credit rating, it would be a low rating and the cost of the money would be high. But if you get one of the seven monoline insurers to guarantee your bond, then you get whatever their credit rating is. The fees for such insurance are lower than the savings you get on the bond, so everyone wins.

But over the years, most of the monocline insurers went from boring municipal bonds and jumped into the mortgage-backed security markets, selling credit default swaps that significantly juiced up their earnings. But it also added a lot of risk that they clearly, in hindsight, did not understand.

ACA has already seen its rating go from A to CCC, which is basically junk. This puts it out of business, as no one will pay to be rated as junk. ACA now has only $425 million in capital to cover the $69 billion in mortgage and corporate bonds they insure. Interestingly, they added $20 billion of that between April and September of last year. Talk about doubling down on a losing trade. Merrill wrote down almost $2 billion in bonds that were insured by ACA. They will not be alone.

Very scary stuff!!!

Source: More BLS BS by John Mauldin