Particularly in recent weeks, Toomre Capital Markets LLC ("TCM") has been extremely busy helping a client implement a custom financial application that is quite complex and truly a modern distributed system. The data, tools, work rules and analytics embedded within this new application are certainly cutting-edge and should help this client further extend their leadership in their particular sector of the financial markets. What is more, this new system should allow this client to truly take their business to the next level on a real-time basis with true Enterprise Risk Management.

TCM primarily assisted this client with some custom analytic code written in the MATLAB technical programming language that takes advantage of that specialized language's strengths with arrays and mathematical calculations as well as a quite powerful set of graphical user interface ("GUI") tools. Like the original Collateralized Mortgage Obligation ("CMO") code that Lars and Aldon wrote at Lehman Brothers more than twenty years ago, this new analytic code allows for the real-time pricing and sensitivity analysis of a relatively new type of cash flow that ultimately will be securitized should the securitization markets revive. The input variations to the analytic model are almost infinite and allow for the effective pricing of many variations of life insurance policies.

One of the noted strengths of the Toomre Capital Markets LLC team is helping our clients connect the hidden dots of financial information, risk management and structured finance modeling. We are especially good at uncovering and honing in on that crucial information or aspect of a financial model that is a key to value / risk determination. If the reader's organization needs some assistance in this area, with their financial models or specifically with detailed MATLAB financial modeling, please feel to contact us so that we might discuss your issues further. As the above client notes, TCM is particularly adept of dealing with those complex financial problems with lots of "hair balls."

Late on Thursday April 3^rd 2008, news emerged that c/a>, a former president of troubled Swiss bank UBS AG, is pushing for a potential break-up of the bank, according to a letter Mr. Arnold and his London investment firm Olivant Advisers Ltd. in London have sent to UBS's board late on this date. Mr. Arnold served as president of UBS in 2001 before departing the bank after a dispute with current Chairman Marcel Ospel. This is a surprise move and is likely to accelerate changes at UBS, particularly regarding its investment banking division.

Luqman Arnold is quite a credible individual. After leaving UBS, Mr. Arnold joined U.K. lender Abbey National PLC as executive before overseeing the sale of Abbey to Spain's Banco Santander SA. As The Wall Street Journal details, today Mr. Arnold's firm Olivant Advisers Ltd. specializes in financial services.

The Financial Times Alphaville blog is a worthy read. On Wednesday, January 16th 2007, it is particularly so. Toomre Capital Markets LLC ("TCM") thanks that site for the significant news that S&P again is in the process of readjusting its structured finance risk models. S&P last adjusted its risk models back at the end of October 2007.

Alphaville relays "In a late press release, S&P announced it was adjusting its cumulative loss measure on 2006 subprime collateral to 19 per cent - up from 14 per cent:

We revised our expected losses for the 2006 vintage subprime collateral to 19% from 14%, as delinquencies continue to rise, and we will recalculate lifetime loss expectations for all vintages of U.S. RMBS. Additional losses are projected to result directly for the additional delinquencies and defaults.

The implications of this small change are significant. Many RMBS are structured on something akin to 70% Senior / 20% Mezzanine / 10% Junk/Equity. As a result, S&P is effectively saying that all of the subordinated debt/equity and close to half of the typical mezzanine will be wiped out. The ratings of the senior classes are also more suspect although they are likely to remain investment grade.

Toomre Capital Markets LLC ("TCM") is simply amazed. How the heck does an institution like the combined Citicorp/Salomon Brothers lose $17.4 billion dollars on its CDO and subprime mortgage positions? In just one quarter!!!! Maybe it is just TCM, but does not anyone really care about how abysmally, shitty, horrible, horrendous this bank's risk management controls have been?

Toomre Capital Markets LLC ("TCM") has previously written about the other ticking credit bombs that will affect the Capital Markets in the coming months. TCM posts to review include Estimated Investment Bank Fourth Quarter Earnings??, Where is Value in Structured Mortgage Products? – Early December 2007 edition and Incestuous Mix: Structured Credit, Financial Guarantors and Rating Agencies.

On Monday January 14th 2008, The Los Angeles Times published yet another excellent article written by E. Scott Reckard. This one is entitled Adjustable loans spur new worries and has more details on the most toxic mortgage credit "bomb" of all: the Pay Option ARMs. Typcially, these Pay Option ARMs present the mortgage borrowers with a choice every month during the first five years of the loan: pay the interest due and some of the principal; pay interest only, leaving the loan balance untouched; or pay less than the interest due, making the loan balance rise. Then, at the end of the five year option period, the loan is reset to fully pay-off with a fully indexed adjustable interest rate.

Since many of the mortgage borrowers elect to pay less than the amount that will fully amortize the mortgage and the effect of fully indexing the interest rate from the typical more "teaser" initial rate, when Pay Option ARMs are reset, they almost always require a higher principal and interest ("P&I") payment than initially was required. Sometimes these reset P&I payments are as much as two or even three times what the borrower was originally paying on the mortgage each month. If the borrower elects only to pay interest only during the initial months and the balance rises above a set percentage of the original loan amount, the reset process can occur earlier as soon as three years.

This LA Times article suggests that the second tide of the mortgage defaults are about to start. After reviewing data from mortgage industry data trackers, the author concludes that Pay Option ARM borrowers -- "most of whom boast respectable and often top-tier credit scores and appear to have substantial incomes and home equity" – are having severe delinquency problems that are tied to the loose lending practices that inundated the sub-prime business. Pay Option ARM loans often were granted on the basis of stated income, not proof of a borrower's income, giving rise to their nickname, "liar's loans."

"This is not a sub-prime crisis. This is a stated income crisis," said Robert Simpson, chief executive of Investors Mortgage Asset Recovery Co. in Irvine, which works with lenders, insurers and investors to recover losses related to mortgage fraud. "Simpson said loan officers routinely inflated earnings of workers with regular paychecks. On some written requests to confirm a borrower's employment, officers would specify that an employer should not provide a salary figure, he said." As a result, borrowers often overstated either their income or their assets.

The article references Mortgage Asset Research Institute in Reston, Virginia, which investigates lending fraud. Apparently one of that firm's customers checked one hundred stated-income loans against tax documents and found that nine in 10 of them overstated income by at least 5%. "More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%," the institute reported, saying the Pay Option ARM mortgages clearly deserve their "liar's loan" handle.

Oh no… Why is it a surprise to hear that Wall Street has been selling to CMO securities to retail investors in these times of sharply reduced liquidity? And now Wall Street's regulators need to investigate?

As this Wall Street Journal article suggests, "Securities regulators, broadening their review of Wall Street's role in the mortgage industry, have asked several brokerage firms for information about the marketing and sale of mortgage-related products, specifically those sold to individual investors." Apparently, The Financial Industry Regulatory Authority ("FINRA"), Wall Street's self-regulatory body, last month sent letters to firms asking for documents, including marketing materials, a list of supervisory policies and procedures, and descriptions of how collateralized mortgage obligations were valued. These letters, part of an on-going "sweep" operation directed at more than a dozen Wall Street firms, asks for PowerPoint presentations, sales scripts and detailed customer-account information from June 30, 2006, through July 31, 2007.

The WSJ article discloses that FNRA "specifically asks for offering documents on products sold, created or distributed during the months of March and June 2007." Toomre Capital Markets LLC ("TCM") notes with interest that those months just happen to coincide with the quarter ends for three of the largest Wall Street entities with both large retail brokerage personnel and the biggest CDO losses from aggressive underwriting – UBS, Merrill Lynch and Citigroup. Could these firms and others possibly have tried to cram as much CMO (and CDO) product down less sophisticated retail channels ahead of their earnings reports? No, Wall Street never would do such a thing…

Toomre Capital Markets LLC ("TCM") has long been concerned about the opaqueness of the Credit Default Swap market. As this market sector has exploded in size in the past decade, TCM has feared that some losses from these credit derivative instruments may be hidden from investors, regulators and counterparties. Hence, the soundness of the global financial system might well be less sound than what international regulators, rating agencies and large financial institutions might think.

Others have been concerned too. The Australian has started off the 2008 New Year with a rather ominously entitled article Forget CDOs, Is is Time for CDSs. The article starts with "If 2007 was the year of the CDO, the latest acronym to loom dark and large on the financial markets' horizon for 2008 is the CDS. And the CDS (credit default swap) is shaping up to be far more noxious than its little derivative brother, the CDO - a spliced and diced bundle of mortgages known as a collateralized debt obligation that sent Wall Street into a tailspin last August when the market for low-grade US mortgages froze over. At least Warren Buffett seems to think so. After the world's top two bond insurers were scolded with [the threat of] a ratings downgrade last month and told to go and raise some capital, the visionary Buffett revealed last Friday that he was to set up a bond insurance business." [emphasis added]

The key point of this article is that "the murmur among the cognoscenti is that an implosion in the CDS market could do serious damage to the international banking system." They have slightly misquoted Warren Buffett who did say "We felt that, in many cases, the prices that people were charging were inappropriate." What Mr. Buffett was referring to was the cost of credit enhancement insurance to ensure that a municipality's debt was paid on a timely and ultimate basis that is part and parcel of a AAA/Aaa rating. He was not referring to the prices of CDS transactions. However, the article authors were correct that the crux of the problem is that there is not only price transparency but there also are problems about reserving and regulation.

Back on March 1st 2007, Toomre Capital Markets LLC ("TCM") created a post entitled Where is Value in Sub-Prime Mortgage Market? In recent days, UBS has announced a further write-down of $10 billion in sub-prime mortgages and CDO securities; London-based HSBC, Paris-based Societe Generale and Germany's WestLB have all rescued their sponsored SIVs either by taking them on to the balance sheet or providing credit lines that ensure that all of the outstanding senior commercial paper will be repaid; and MBIA has announced a $1 billion investment by Warburg Pincus LLC that for at least for a few weeks will help ensured that MBIA maintains its AAA credit enhancement rating. Late on Monday December 10th 2007, Washington Mutual, the United States' largest savings and loan by market value, declared that it was exiting the subprime mortgage business, eliminating another 3,150 jobs and raising some $2.5 billion dollars in additional capital through the issuance of convertible shares.

Based on the recent TCM posts about the perils of reaching for yield and some the enormous losses various financial institutions are taking from their subprime and CDO security activities, a couple of investors have asked Lars Toomre to go back and update his thoughts on that Where is Value in Sub-Prime Mortgage Market? post. Hence, a few hours ahead of the release of Lehman Brothers 4th quarter 2007 earnings release, here goes:

Clearly, Lehman Brothers was wrong back in late February arguing that the sell-off in the ABX index was way overdone. From their historically very tight levels around the start of 2007, the risk premiums for all types of credit investments have dramatically increased. For all practical purposes, the mortgage sector has virtually stopped trading and those risk premiums are now more of a "pick 'em" variety.

So where is value from here? As Lars has preached in many different conversations and written comments, the trade-off from going from a liquid to an illiquid position requires a very significant yield pick-up and recognition that one must be able to live with the illiquid investment for five years or more. Given that criteria, most, if not all, mortgage investments are still not trading cheaply enough to justify going illiquid. Hence, Lars Toomre would recommend that interested institutions remain more in a seller mode than an acquisition mode when considering structured mortgage investments.

As The Wall Street Journal reminded investors, home prices will need to fall about 30 percent to restore their historic relationship to inflation, rents and incomes. Hence, Toomre Capital Markets LLC would urge that investors avoid the mortgage sector for at least another six months as housing prices continue to decline. Whether the popping of the housing bubble will take five or six years as Jim Rogers has argued remains to be seen.

However, clearly the full effects of cheap and easy mortgage credit are not fully reflected in mortgage security valuations. Make a point of following just how badly home equity loans, Pay Option ARMs, other intermediate and hybrid ARMs and the Alt-A security sector will decline in the coming months. While there no doubt will be periodic spikes as people perceive the housing market is bottoming, remember that a 30% price decline is going to turn almost all of these mortgage types into "upside down" positions with borrowers having negative equity in their homes.

An interesting question is just how prevalent the "jingle mail" phenomena will become. Also, remember that the housing price bubble is beginning to deflate during a period of relatively healthy employment. Just imagine how bad the delinquency and default statistics would be if the United States economy were to enter a "normal" recession.

As before, thoughts and comments are most welcome.

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!!!

Toomre Capital Markets LLC ("TCM") made a post back on November 3rd 2007 entitled UBS Has a "SMALL" VaR Risk Modeling Problem. A key point in that post regarded how badly the UBS investment bank' risk management area missed in the calculation of the bank's economic risks. For instance, the third-quarter UBS economic report card revealed that the bank's trading areas had sixteen trading days out of sixty-three or so where the daily losses exceeded that projected by the daily Value-at-Risk ("VaR") at the 99% confidence interval level. With the December 10th 2007 announcement of its additional $10 billlion in losses at UBS, no doubt there will be a number of days during the fourth quarter where the actual losses will exceed the calculated VaR. An interesting question still to be answered is how many days did they miss on?

Probably the most key parameter for any VaR model is volatility, both in the size of positions and in the prices at which those positions are marked. Likely, a key reason why the UBS risk management area missed on so many days during the third quarter is that their volatility estimates of prices were simply averages of the last five years of observations and did not give extra weight to the recent period when prices began to deviate significantly from the near par prices. CDO prices have now been declining for several months and there is considerable question about what the heck CDOs are worth and what should be used in various analytical risk models.

For counter-parties and investors, a key question remains after the $10 billion write-down announcement at UBS. What amount of subprime investments and CDOs does UBS still own, and perhaps even more importantly, where are they now valued?

Like many other capital markets and fixed-income specialists, Toomre Capital Markets LLC ("TCM") has been shocked at how relatively "off-sides" various investment and global commercial banks had themselves positioned at the onset of the current subprime crisis and resulting credit crunch. What is now known as UBS and Citigroup are successor companies of brokerage firms that previously employed both Aldon Hynes and Lars Toomre in their structured finance areas. As it is said, ten billion dollars is more than a few shekels. How both UBS and Citigroup managed to lose more than TEN BILLION dollars from their CDO and sub-prime activities is truly amazing!

On Monday December 10th 2007, the Swiss banking giant UBS announced that it will write down the valuation of its CDO and sub-prime holdings by a further $10 billion dollars, likely leading to a loss for the fourth quarter and potentially wiping out all of its profits for the 2007 calendar year. To replenish its "Europe's largest bank by assets plans to raise 13 billion Swiss francs ($11.5 billion) selling bonds that will convert into shares to Singapore's Government Investment Corp. and an unidentified Middle Eastern investor, Chairman Marcel Ospel said on a conference call with reporters today." Market participants have speculated that the unidentified investor may be Abu Dhabi Investment Authority, which had also invested in Citigroup Inc., or the government of Oman.

The Wall Street Journal reports "'Our losses in the U.S. mortgage securities market are substantial but could have been absorbed by our earnings and capital base,' UBS Chairman Marcel Ospel said in a statement. 'Nevertheless, it is important to always maintain a notably strong capital position to support the continued growth of our wealth management business, which is the largest generator of value to UBS shareholders.'"

Marketwatch.com has further details on the UBS write-down. UBS CEO Marcel Rohner apparently said, "Conditions in the U.S. mortgage and housing markets have continued to deteriorate, and we have updated our loss assumptions to the levels implied by the current distressed market for mortgage securities… In the last several months, continued speculation about the ultimate value of our subprime holdings -- which remains unknowable -- has been distracting… In our judgment these write-downs will create maximum clarity on this issue and will have the effect of substantially eliminating speculation." Mr. Rohner also confirmed market speculation that the investment banking arm will focus more on supporting the asset and wealth management units. "In future, we will make certain that our investment banking operations grow by concentrating on serving the needs of institutional and corporate clients," he said.

Toomre Capital Markets LLC has one question though: Why the heck did UBS and Citigroup stray from their previous focus on serving customer needs? Were the enormous profits of Goldman Sachs (and the competitive need to keep up with the proverbial "Jones'es") so seductive that management threw all good judgment to the wind? Shareholders yet again are paying for the "heads management and employees win, tails everyone loses" behavior of Wall Street. Let TCM ask the question, "Is any young person (with less experience than a full economic cycle) really worth paying more than a few hundred thousand dollars per year?"

As frequent readers of this Insight section are keenly aware, Toomre Capital Markets LLC ("TCM") has long been worried by the irrationality of the United States and European fixed-income markets. (See, for example, the February 5th 2007 post It's All Fun and Games Until Someone Gets Hurt.) In recent days, more news has emerged of some of the perils from irrationally stretching for yield and return.

For instance, the Ahead of the Tape column written by Tom Lauricella in the December 3rd 2007 edition of The Wall Street Journal details some of the problems now facing one of the Florida state-run investment pools called Florida's Local Government Pool. This relatively short-term "safe" investment fund was the largest state sponsored co-mingled pool until recently. For instance, during 2006, it produced a yield of about 5.4% whereas the average money-market fund yielded 4.8%. Part of their success in delivering a higher yield was investments in the commercial paper issued by several Structured Investment Vehicles ("SIVs") including those issued by KKR Atlantic Funding Trust, KKR Pacific Funding Trust, Ottimo Funding and Axon Financial Funding. Apparently, the majority, if not all, of these SIV commercial paper positions were sold to the State of Florida State Board of Administration by Lehman Brothers.

The problem is that these SIV commercial paper investments have now gone into default. When this information was reported to the state administration officials in mid-November, certain municipalities withdrew large amounts of funds from the pool. As a result, the pool which was approximately $27 billion as of September 30th 2007, has shrunk to about $14 billion when redemptions were suspended on November 29th to prevent a further run on the fund. Last week, the state hired Blackrock to provide an independent financial review of the local government investment pool for the State Board of Administration.

According the Orlando Sentinel, "BlackRock executives flew into Tallahassee Monday morning and were scheduled to meet with the chiefs of staff for Gov. Charlie Crist, Attorney General Bill McCollum and CFO Alex Sink today. The firm will make its final recommendations at the SBA's regular meeting Tuesday."

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?

Toomre Capital Markets LLC ("TCM") earlier in 2007 was quite worried about liquidity risk and the level of risk premiums that investors were assuming through their various investment strategies in the proverbial search of yield or return. Interested readers might perhaps want to reread the February 12th 2007 TCM post entitled Hedge Funds, Investment Banks and the Value of Liquidity? where we wrote:

Economic times presently are pretty good world-wide. When the inevitable turn in the vastly more inter-connected global economy next comes, credit spreads surely will widen and the valuation of various financial instruments will come under stress. Are hedge funds (and by proxy the investment banks) prepared for coming "Great Unwind" forecast by Mr. Stiamann and Knips? Some hedge funds inevitably will do very well then, while others will fail, perhaps as spectacularly as Amaranth Advisors did in September 2006.

The financial markets now are full of much liquidity. Are investors, speculators and their bankers appreciating and pricing in liquidity risk? Toomre Capital Markets LLC would suggest that liquidity risk presently is greatly under-valued in the search for "alpha", absolute return and portfolio yield. The stretch to get ten percent return (after fees) appears to be making rational people start to do irrational things.

Sadly, many institutional investors did not heed this warning about the then insane pricing of liquidity risk. Over the past week, Lars Toomre has had the chance to catch up some of his much neglected reading. Several stories in particular are noteworthy in the context of liquidity risk and the consequences of reaching for yield. Lars will try to complete write-ups in the next few days about several of these sad tales to remind future investors of the consequences of investing in something not well understood for the promise of that incremental return or enhanced yield.

On Monday November 19th 2007, Swiss Re, the world's largest reinsurer, announced that it had lost 1.2 billion Swiss francs (or $1.07 billion U.S. dollars) on two credit default swap contracts in October after the U.S. subprime mortgage crash and Collateralized Debt Obligation ("CDO") devaluations roiled debt markets worldwide. The losses occurred on two credit-default swap contracts that the Swiss Re financial services division sold to protect its clients against declines in investments backed mostly by mortgages.

Toomre Capital Markets LLC ("TCM") wonders why Swiss Re was taking on such large notional swap contracts since they are so far removed from Swiss Re's primary business of reinsuring traditional property and casualty risks. Lars Toomre previously worked in the American Re Financial Products group (part of the Munich Re group) and does not recall any traditional insurers with such large notional amount needs.

On the other hand, TCM is aware of one group of insurers that surely would have liked to have had access to the reinsurer balance sheets: the mono-line financial guaranty companies like Ambac, FGIC and MBIA. Did these mono-line insurers lay off some of their subprime and CDO risk to Swiss Re financial products? If so, the recoveries due to these credit default swaps surely would help the capital situation at whichever mono-line insurers entered into such risk transfer strategies.