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Getting Close to Resolution

(January 31, 2008)

Dear Subscribers and Readers,

As everyone and his neighbors should know by now – and as we argued in last week's mid-week commentary – the Federal Reserve eased by 50 basis points yesterday.  More importantly, the Fed's accompanying statement was more dovish than what most analysts had expected, as the statement reasserted the Fed's stance to ease as aggressively as possible in order to stem the current “stress” in both the financial markets and the U.S. economy.  The word “inflation” was barely mentioned.  This came despite the fact that the new voting Governors are supposed to be more hawkish this year (as we discussed in our November 11, 2007 commentary).  As I mentioned in our MarketThoughts discussion forum earlier yesterday, the “hawks” can sound as hawkish as they want under normal market conditions.  But during times of market crises, Bernanke will rein them in and be the sole voice of the Fed.  One does not fight a fire or a war via committee or consensus.  That is what we witnessed (again) yesterday.

On a more immediate basis, most financial participants around the world are still focused over the fate of the bond insurers, namely MBIA and Ambac.  Make no mistake: By sending an open letter to MBIA's and Ambac's state insurance regulators, the SEC, and the Federal Reserve arguing why their losses have been understated and why they should cut their dividends immediately, and by posting his entire excel model (warning: this file is over 120 megs large) on the web, activist investor Bill Ackman is now trying to push this to resolution as quickly as possible.

In order to understand the market impact of this latest maneuver by Bill Ackman, we first need to ask the following questions:

  1. Why is Bill Ackman doing this, or put another way, what does he have to gain from this exercise?

  2. What kind of underlying assumptions did Bill Ackman utilize to obtain his loss estimates of $12.6 billion and $11.6 billion for MBIA and Ambac, respectively?

  3. What is the most likely resolution to this, shall we say, catastrophe?

First of all, we know that Bill Ackman's hedge fund, Pershing Square Capital Management, was up 22% in 2007 – with a significant amount of those profits coming from short positions or short bets (through credit default swaps or other derivative positions) against MBIA and Ambac Financial.  While we don't know what his short position is today, a recent Bloomberg article had stated that he stands to make an additional $500 million should both MBIA and Ambac go into liquidation, or in other words, should MBIA's and Ambac's equity shareholders be wiped out.  Assuming that he had put on a larger short position since the January 10th article, it is not inconceivable to us to assume an effective doubling of his short position since then – which means that he would stand to make $1 billion should MBIA and Ambac be liquidated.  Obviously, when one is making a huge bet such as this, one should not be leaving anything to chance.  That is why Bill Ackman is sending this letter to the folks at the negotiating or “bailout” table right now – and to invite other Wall Street analysts/hedge fund managers for feedback – in order to convince them that not only should this be resolved as possible, but most importantly, that any further capital injections from private investors or “bailout” (at least in its current form) would be futile, given his estimated $24.2 billion loss for both entities.

It appears what Ackman wants is a full public bailout that would wipe out the equity holders – a wipeout that would result in a huge payday for him and for many of Pershing Square's investors.  Make no mistake: Bill Ackman is purely targeting the bond insurers.  It is not in his best interest for either MBIA or Ambac to lose their triple A ratings and for the financial markets to effectively stop functioning, given that Pershing Capital is dependent on the financial markets to make money and to fund its (both long and short) positions.  Furthermore, it is not in his interest for the U.S. to enter a recession, given his $2 billion long position in Target (through common shares and derivative positions), $1 billion long position in McDonald's, $500 million position in Sears Holdings, and a $300 million long position in book retailers Barnes & Noble and Borders Group.  In other words, this is a very fine balancing act.  More importantly – and this is not so obvious – by targeting the bond insurers and forcing the Feds to make a quick decision of some kind, he is effectively forcing this to be resolved as quickly as possible.  Once this is resolved, much of the uncertainty in the financial markets will disappear – and presumably, this will lead to higher stock prices going forward, especially in Bill Ackman's long positions in the retail industry.

However, as we have mentioned all along, “nothing is obvious.”  As both Barron's and Tom Brown have stated, the business model of these “monoline insurers” only requires them to make interest and principal payments should the original issuer fail to pay those claims.  That is, in the event of a payment or permanent default, the monoline insurers do not need to make the payments upfront – rather, these payments will be stretched over the life of the bonds backing up the securities that MBIA and Ambac have insured.  Therefore, while Ackman's numbers may be correct on a face value basis, his estimated losses on a present value basis may only be half as much – assuming a discount rate of 5% with a 30-year constant payout stream.  Moreover, while I have not attempted to “play around” with his model (in his open letter, he claims it could take as long as 30 minutes to re-run the model with a 3.4 Ghz Intel Dual Core workstation, and since I am typing this on my puny 2.0 Ghz Intel Dual Core laptop, this would take me nearly an hour to run), Ackman does discuss some of the broad assumptions that he used to model MBIA's and Ambac's losses.

Looking at the assumptions is important.  We could argue the details of Ackman's calculations all day, but undeniably, the source of greatest sensitivity of his numbers come from his assumptions, as my example of a 5% discount rate with a 30-year constant payout stream example can attest to.  In his letter and model, we know that Ackman is using the following broad assumptions: A LIBOR rate of 3.3%, with a 10% housing price decline in 2008, another 10% in 2009, and a flat housing price from 2010 to 2012, for those mortgages with a 2006 vintage.  Both these variables are very important and extremely sensitive.  For example, in a report published on Monday, Bank of America's Jeffrey Rosenberg calculated that with a Fed Funds and a LIBOR rate at 3% (which is where they are after yesterday's rate cut), subprime ARM borrowers who are going to see their rates reset this year will, on average, only see an 8% increase in their mortgage payments, compared to a 33% increase prior to the current easing cycle.  Assuming another 50 basis point rate cut on March 18th, Bernanke would have accomplished what the Administration, Congress, and our regulators failed to do: Freeze interest rates and mortgage payments for those whose subprime mortgages will reset this year.  Make no mistake: A LIBOR assumption of 3.3% versus 2.5% could and would make a huge difference in estimating mortgage payment defaults and delinquencies going forward.  My inclination is that Bill Ackman's estimated losses reflects more of a “doomsday” scenario, and is not the scenario that has the greatest likelihood of occurring.  This is another reason why Mr. Ackman is sending his open letter to the Feds – to try to convince them of the high possibility of his “doomsday” scenario.  If it was an inevitable outcome, then Ackman could arguably go on vacation for a few months and wait for his gains to pile up in the meantime.

In response to question 3), this one thing is for sure: With Ackman's open letter to the Feds, it is now clear that a resolution will occur sooner rather than later.  My guess is no later than two weeks, although I have to admit that this is a conservative timeline.  Unlike previous credit crunches, there are now many so-called “vulture investors” sitting on the sidelines aside from the sovereign wealth funds.  In many instances, many of these investors have set up shop since late 2006 to take advantage of what they saw was the inevitable credit crunch.  Moreover, the largest pension funds in the country – such as CalPERS ($250 billion in assets) and CalSTRS ($100 billion in assets) – have made it clear that they also want to participate in these funding deals going forward, as many of them have been seeking all kinds of alternative investments in order to “juice up” their returns.  In other words, while the chances of a bank consortium bailout are small (especially given that much of their capital base had been depleted), the chances of a private bailout is still pretty good – at least as of right now.  More importantly, in the event that a private solution is not available, there will be a public one, or most likely, a bailout utilizing private resources but with a large amount of public incentives.  Most importantly for our subscribers, any solution would go a long way in easing the current uncertainty in the global financial markets – which in all likelihood, would lead to a benign re-rating of global stock prices.

As for where we should go “look for the bargains,” I have previously discussed Japan.  Following are some charts, courtesy of Goldman Sachs, that needs no explanation.  I will discuss the Japanese stock market in more detail in this weekend's commentary.

Ratio of listed firms trading below book value approaching historical high

Dividend yield exceeds the JGB yield

Signing off,

Henry To, CFA

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