Back in January 2008, Toomre Capital Markets LLC ("TCM") penned the post Option ARMs Spur New Worries. That post highlighted a number of other ticking credit bombs that were going to be effecting the Capital Markets in the coming months. Its chief focus was on the most toxic mortgage credit "bomb" of all: the Pay Option ARMs.

On Saturday December 6th 2008, The Los Angles Times and its writer E. Scott Reckard yet again return to this toxic subject in the article entitled Record 10% of U.S. Homeowners In Arrears Or Foreclosure. The subtitle of the article is "California, with 19% of new foreclosures in the third quarter, is a big contributor to the worsening picture." The prime culprit of this rise in the combined delinquency foreclosure rate are those Pay Option ARMs, given primarily to what were known as Prime borrowers and to a lesser extent to Sub-prime borrowers.

One might remember from the earlier TCM post: "Typically, 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."

Remember too 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." It has been said that "This is not a sub-prime crisis. This is a stated income crisis." In short, where Pay Options ARMs were most issued (Florida and California), evidence is accumulating that a significant portion of the spectacular rise in residential housing prices earlier this decade was driven by people who stated that they more financial income and assets than was truly the case.

From the above article, according to Jay Brinkmann, chief economist for the Mortgage Bankers Association, "California represents 13% of the loans in the country, but is recording 19% of all new foreclosures." One why might wonder why California is having so many more problems than other parts of the country. It is visible in the so-called "roll rate, which is defined as when one compares the number of newly delinquent loans in one quarter with the number of loans entering the foreclosure process in the subsequent quarter.

As Brinkman explained, That foreclosure "roll rate" was about 10% to 12% nationally in the 1990s and ran from 12% to 15% for most of this decade. The percentage is now 30% nationally but has reached 79% in California and 65% in Florida. "This is nothing like anything we've ever seen before," Brinkmann said. "We were shocked when we saw the California roll rates."

Toomre Capital Markets LLC (“TCM”) has been quite concerned about the future of mortgage finance in America. Back in July 2008, TCM created the post Fannie Mae, Freddie Mac and Future of Mortgage Finance. The key point of this post was the need for “the critical policy decision on the future of mortgage finance in the United States. TCM has highlighted this critical issue before. Until the late 1980s, the S&L's were the primary holders of mortgage debt. Commercial banks also have owned some mortgage debt (with significant capital haircuts). The relatively lower capital requirements and the ability to ‘turn’ the mortgage origination portfolios led to the rapid growth in securitization and the funding of mortgage debt through investors in the capital markets.”

Some four months later, the GSE’s have effectively been seized by the Federal government. Lehman Brothers has gone bankrupt. Merrill Lynch has agreed to be become part of Bank of America. And both Goldman Sachs and Morgan Stanley have become bank holding companies actively looking to attract deposits. As predicted in that July post, institutional investors have “gone on strike” against mortgage-backed securities (“MBS”). As a result, in the last week both residential and commercial mortgage backed securities have widened to extreme spreads against swap spreads. Those spreads narrowed considerably this week with the announcement that the Federal Reserve will be buying up to $100 billion in GSE debentures as well as $500 billion in agency pass-through securities.

Still, there is little discussion about the future of mortgage finance in America. In order for the American residential mortgage market to stabilize, there needs to be available financing for well-underwritten home mortgage loans. These purchases by the Federal Reserve are a temporary solution. There no longer is a savings and loan industry to provide the long-term holdings of MBS. The community and commercial banks are capital constrained and looking forward to greater losses on many types of loans as the credit crisis worsens becoming perhaps the worst recession since the Great Depression.

Part of the reason for the GSEs conservatorship was that it was deemed that their portfolios were too large for their capital bases, especially given projected future losses due to the decline in residential real estate prices. As mentioned above, the various traditional institutional investors who previously bought securitized MBS and their “sliced and diced derivates” such as CMOs, CDOs, and private pass-throughs are on a “buyer’s strike”. In many cases, these institutional investors also are trying to reduce their exposures to the mortgage sector.

Toomre Capital Markets LLC has long suspected that the securitization process will be key to answering this quandary about where longer-term mortgages should be financed in America. There is a critical problem that has been displayed in how that business was conducted prior to the current credit crisis. As a loan moved from the mortgage originator to the mortgage wholesaler to a warehouse facility to Wall Street and eventually on to institutional investors (blessed of course with a high-grade by one or more of the rating agencies), no one had a vested interest in the quality of the underlying mortgage loan. For several months now, it has been clearly understood that for the securitization process to restart, each part of the process will need to have some “skin in the game.”

Toomre Capital Markets LLC ("TCM") has been quite busy during the past few weeks on client work ahead of the summer vacation period. As a result, there has been limited time to update this blog. Today's news of the Treasury Department's defense of the struggling GSE's known as Fannie Mae and Freddie Mac though deserves some comment.

That both of these GSE's need to be supported in at least an oral sense is more than a ripple in the Capital Markets pond. It is much more like a major wave. Just what the final cost to tax payers will be remains to be seen. TCM suspects that the final bill will not be known until well after residential home prices stabilize and even begin to appreciate again. No doubt, though, the costs will be significant.

Lost in all of the GSE consternation is the lack of discussion about the critical policy decision on the future of mortgage finance in the United States. TCM has highlighted this critical issue before. Until the late 1980s, the S&L's were the primary holders of mortgage debt. Commercial banks also have owned some mortgage debt (with significant capital haircuts). The relatively lower capital requirements and the ability to "turn" the mortgage origination portfolios led to the rapid growth in securitization and the funding of mortgage debt through investors in the capital markets.

CNBC Television personality Jim Cramer penned an article on Thursday, June 5^th 2008 entitled Why Own Lehman? In that article he said that No, he did not think that Lehman Brothers was going under. "It's got a great franchise with a good cash position, reduced leverage, much better management than Bear [Stearns] and a buyback that's kicking in that wouldn't if things were as bad as the bears make it out to be." The questioner then apparently asked if Cramer would buy the Lehman Brothers stock. Cramer said, "Why the heck would I do that? To catch a 2- or 3-point rally? There is no earnings power at Lehman."

Toomre Capital Markets LLC ("TCM") normally approaches such pronouncements from television pundits with a healthy dose of skepticism. However in this case, Jim Cramer is right on. The article continues:

I explained that some stocks are neither longs nor shorts -- that, to me, is Lehman. There's no reason to short it, because I don't think it is going under but many are betting that way, and there is no reason to go long it, because the place is set up for a period of big fees from fixed-income products, from structured products, but clients have at last figured out that they will lose their jobs if they keep buying this nonsense.

And that's really the rub. These places have oodles of high-priced salespeople, tons of them, and they are all being paid fortunes to sell products that don't work. They sell broken vacuum cleaners with no warranties.

It is that stark.

I know that anyone in brokerage is always reluctant to admit that structured products really have no value or are too risky, that they're just a way to figure out how to take a little extra per million -- a fraction, but they do add up. But that's what happened to a lot of these great firms that got fixed-income-heavy. There isn't enough money to be made selling regular commodity fixed-income products, so you have to talk people into buying things they shouldn't that they don't understand.

That game is over. But the people are still there, as is the overhead. Without this stuff, I don't know how you make a lot of money at an investment firm, particularly when you have decided to shrink your balance sheet and make fewer loans. Some can get away with it: Bank of America BAC, for instance, because it has a deposit base (same reason Wachovia WB is worth something, but I don't want to own it, either), doesn't need to rely on structured products to make some money.

LEH? I just don't see how they can deliver $5-6 earnings power anymore. Worse, I can't even figure out what they could earn in this environment. The franchise isn't too dicey, just the earnings estimates.

Jim Cramer puts much more bluntly what Toomre Capital Markets LLC has been struggling with as illustrated by the post Value of the Investment Banking Franchises?? Just what can these investment banking franchises earn in the post credit-crunch environment where there is limited demand for structured finance, mortgage securities, and complex derivatives and where they must operate with sharply decreased leverage and more limited proprietary trading operations? The regulatory changes that are going to be forthcoming as a result of the credit crunch are as of yet unknown. However, surely there will be increased capital charges under Basel II for what are classified as "trading positions."

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.

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?

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!!!

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 some readers are aware, Toomre Capital Markets LLC ("TCM") is one of the few Capital Markets consultancies with considerable experience in one arcane sector of the securitization markets called insurance-linked securities. Lars Toomre was originally retained in 1997 by what is now known as Munich Re America, Inc. to help that subsidiary of Munich Re thrash out what strategies to pursue in the convergence of the capital markets and more traditional insurance markets driven by fortuitous loss. Partly as a result of that initial strategy work, American Re Financial Products was established to pursue three major initiatives:

• Finite reinsurance (now much discredited after the abuses exposed by the AIG/General Re finite reinsurance abuse scandal)
• Reinsurance of credit enhancement mono-line insurance companies and other credit enhancement opportunities primarily originating from world-wide project finance needs (now shut down due to Munich Re's downgrade from AAA to A in 2001), and
• Creation of American Re Capital Markets to create, underwrite and trade in various insurance-related opportunities such as future film production securitizations, weather derivatives, insurance-linked securities, guarantees of index total rates of return, insurance swaps, the hedging of Enterprise Risk Management exposures and the secondary trading of various property and casualty, health and life insurance policies (now part of Munich Re Capital Markets operation in New York City).

Lars Toomre ended up joining Munich Re to help establish American Re Capital Markets where he focused on weather derivatives, enterprise risk management and other odd-ball initiatives with "hair on them". One of the odd-ball type of requests that periodically would come across the Capital Markets desk concerned "What would Munich Re want to pay for a particular insurance policy (or sometimes portfolio of insurance policies) in the secondary market?" Some of these requests concerned structured settlements, some concerned viatical insurance and some were marketed as "life settlements". Generally, the insurance broker was looking for a better price than what the leading aggregators of the day (generally JG Wentworth or General Re Financial Products) were willing to pay. The type of policy and details within caused the valuations from various sources to often vary considerably.

Some people have asked why bother with all the complications of acquiring a portfolio of life insurance policies in the secondary market or a diversified portfolio of P&C risks? In short, the answer is that the returns from such diversified portfolios do not correlate with the returns from more traditional investment sectors such as equity, fixed-income, currencies or commodities. Hence, some of the smartest diversified investment companies (like Berkshire Hathaway, PIMCO, Citadel Investments and Greenlight Capital) have made some very significant allocations to insurance, insurance derivatives and insurance-linked securities, particularly because of how this sector risk increases their risk-adjusted returns (as calculated by such measures as the Sharpe Ratio).

On Monday, November 26th 2007, The Wall Street Journal published a front-page article entitled An Insurance Man Builds A Lively Business in Death written by Liam Pleven and Rachel Emma Silverman. This article describes in quite some detail how life settlement contracts are acquired and some of the pratfalls of dealing with retail clientele that have primary life insurers and regulators warily circling this rapidly expanding industry.

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?

The Stamford, Connecticut chapter of the Professional Risk Managers' International Association ("PRMIA") held a very informative meeting on Wednesday, November 7th 2007 entitled "The Emperors' New Clothes?: After the Credit Crunch, What's the Future of Structured Credit, Financial Guarantors and Rating Agencies". Toomre Capital Markets LLC ("TCM") thought this was one of the most informative industry events yet and strongly recommends that the reader pay close attention to the incestuous circle of structured credit, financial guarantors and rating agencies. The speakers were:

• James Chanos – Managing Partner, Kynikos Assocaiates
• William Ackman – Managing Member, Pershing Sqaure Capital
• Edward Grebeck – CEO, Tempus Advisors

Some readers no doubt will recognize James Chanos and his fund Kynikos Associates as one of the most prominent short-seller hedge funds. Bill Ackman and his hedge fund Pershing Square Capital are primarily focused on the long side, but does have substantial short interest in the financial institution, rating agency and financial guarantor sectors. Bill is perhaps most well known for his excellent (and very negative) research report on MBIA from several years ago. The FORTUNE magazine article from May 16, 2005 entitled The Mystery of The $890 Billion Insurer has more information.

During the trading hours of November 7th, equities in the financial sector were under considerable pressure. This pressure is primarily tied to the great uncertainty about just what are Collateralized Debt Obligations worth, where the resulting large losses are buried and what are the secondary repercussions of the sub-prime meltdown, such as SIVs, option ARMs, and commercial mortgage credit-worthiness. After the close, American International Group ("AIG") reported 3rd quarter results that fell short of expectations primarily due to their losses from the mortgage markets. Then, Morgan Stanley ("MS") pre-announced that it be taking a $3.7 billion in losses in its proprietary trading businesses tied to principal investments in CDOs and other sub-prime mortgage-backed securities. (This amount may change over the balance of November until the end of Morgan Stanley's year end.)

Against this backdrop, James Chanos and William Ackman suggested that the markets are still in the early innings of this mortgage credit crunch process. Whereas some analysts have been suggesting as many as 1.5 to 2.0 million families may lose their residencies due to foreclosure in this mortgage credit cycle, their collective view is that the base level of foreclosures will be much worse, perhaps approaching 3.5 million or even 4.0 million incidents. They suggested that the collective market does not yet appreciate that things could get that bad nor have financial professionals begun to fully appreciate some of the national political repercussions of so many people losing their homes.

Toomre Capital Markets LLC ("TCM") has been extremely concerned about the Structured Investment Vehicle ("SIVs") and their large holdings in supposedly safe collateral such as Super Senior, AAA-rated and AA-rated Collateralized Debt Obligations ("CDOs"). On Wednesday November 7th 2007, Moody's started the final crash of the SIV market with ratings action on $33 billion in SIVs, including several SIVs affiliated with Citigroup.

According to this news article, "'SIV senior note ratings continue to be vulnerable to the unprecedented large and sustained declines in portfolio value combined with a prolonged inability to refinance maturing debt,' Moody's said. … SIVs would be hurt by 'further deterioration in the market value of the portfolio,' resulting in losses on capital and senior notes if they have to sell holdings in an unfavorable market."

Specifically, Moody's downgraded the SIV called Victoria Finance Ltd. Further, Moody's placed on review for possible downgrade several other SIVs including:

• Harrier Finance Funding Ltd.
• Orion Finance Corp.
• Carrera Capital Finance Ltd.
• Beta Finance Corp.
• Centauri Corp.
• Dorada Corp.
• Tango Finance Ltd.
• Asscher Finance Ltd.
• Cullinan Finance Ltd.
• White Pine Corp.
• Hudson-Thames Capital Ltd.
• Nightingale Finance Ltd.
• Links Finance Corp. and
• Premier Asset Collateralized Entity Ltd.

The SIVs Beta, Centauri and Dorada are three of the seven SIVs that Citigroup manages and were placed on credit watch for possible (and likely probable) downgrade. The reader should remember that Citigroup had pledged that it would provide up to $10 billion in credit support to its SIVs. According to this Bloomberg article, Citigroup already has drawn down $7.6 billion of this credit support facility as of month-end October.

Toomre Capital Markets LLC is a specialist in structured finance and risk management. Any potential clients or service providers (like fiduciaries, accountants and/or legal advisors) are welcome to contact TCM at the information below for how Lars Toomre or Aldon Hynes can help your organization in these times of extreme stress. Please feel free to contact us or leave any thoughts or comments.