The Market Ticker

Having just come back from a funeral of my only nephew, it seems appropriate to write about this (by the way, rest in peace Bryan.....)

ACA was downgraded from "A" to "CCC". In one move.

This also caused a cascade of downgrades on other bonds and in related actions, S&P also put MBIA and Ambac on "negative" watch.

This is extremely serious, and has come much more quickly than I expected.

The short version of what this means is:



You have to wonder why the markets would be rallying the last couple of days when there are nuclear weapons ticking out there. Indeed, you have to wonder why we're not already under 10,000 on the DOW.

Well, tonight you got a hint of what is to come. Few will understand the significance of this move, at least initially. Soon, everyone will, and not in a good way.

There will of course be people who will claim that these guys will be "bailed out."

The problem is, they can't be.

These insurers wrote tens of billions of dollars in swaps - insurance contracts basically - guaranteeing that bonds would not default.

Unfortunately, a large number of the bonds they wrote these contracts on are subprime mortgage related - either directly, or CDOs that are comprised of them.

Like most of the other "insurers", these firms have exposure that makes their market cap and cash position look at a bad joke.

For example, MBI has a market cap of $3.39 billion and cash of $3.92 billion. Yet it, along with the other "monolines", have insured hundreds of billions worth of bond issues.

Needless to say they can't possibly hope to pay off on any more than a tiny percentage of those issues.

Now the defaults are starting, and so are the downgrades.

The downgrades mean that these issuers can no longer write any more swap contracts. Their income stream will be cut off, at the same time that radically more defaults than planned for will occur.

I'm sure you've heard that Goldman has "hedged" off their risk, and this is why they made so much money while the other folks in the room lost. What you didn't probably understand is that so far this is all accounting fiction - nobody has actually given anyone any money on those hedges.

But now, those hedges are worthless. The risk, which was believed to have been laid off, was not really laid off. These companies never had a prayer in hell of actually performing on their obligations. Never.

Yet in the world of derivatives, if one person wins, the other lose.

So let's say that I have a $1 million dollar bond and I buy a swap guaranteeing it. Let's also say that the bond pays 7%, and I pay 1% (face) to insure it to maturity. Cool - I have 6% risk free, right?

Uh, not exactly.

What if the person I bought the swap from doesn't have the money when the bond defaults? Now I not only didn't make 6% risk free, I take the capital loss on the bond!

This is where we are today.

These investment banks have booked "earnings" and "revenues" that are based on the concept of the risk being "laid off" on these insurers. But these insurers can't actually pay on the hedges; in effect, the investment banks (and others) bought a blank piece of paper for their premium instead of actual insurance!

How did this happen?

It happened because all of these swaps are written over the counter and there is no regulation of capital ratios, nor are these swaps traded on a public exchange, nor is there any supervision of margin requirements!

When YOU buy a stock on margin you are only allowed to buy twice as much stock as you have CASH. That's 50% margin. If you trade futures, you can be levered up 20:1, but only an idiot gets close to that line, because the smallest move the wrong way generates an instant margin call.

But in the real world these guys wrote an essentially unlimited amount in swaps, even though they couldn't pay out on anything other than a tiny fraction. The ratings agencies claimed these were "AAA" securities, with a minuscule odds of default. They were wrong. There was no supervision of the margin capacity of these firms, so they're geared at 100 or even 200:1, or perhaps more.

Nobody knows for sure.

But what we do know for sure is that they won't be able to pay off on the defaults.

This will cascade through the banking, pension and other fund systems. It will totally screw municipalities who need to issue debt, as they won't be able to get the insurance any longer (not that its worth anything anyway.) It will cause restatements on investment bank and pension fund balance sheets (along with others), as they find that the "insurance" they bought that supposedly "guaranteed" their investments is worthless. It will impact capital ratios.

Exactly how far the cascade will go is indeterminate, but what is certain is that it is real, it will be bad, and it will hit in places where you don't expect it, along with the places you do.

In point of fact a large amount of the "earnings" in the S&P financials over the last couple of years have been due to the fact that these swaps stood "behind" this debt, and thus made it "good" where it might not otherwise be. This restatement means that not only will the S&Ps earnings fall precipitously over the next couple of years but the previous couple of years "earnings" were fictitious in part as well!

Nice eh?

If you're long stocks, bail now. The true degree of trouble that this will bring is unlikely to find immediate appreciation, but in the fullness of time (and not much of it either) it will be understood, likely with very violent downside results in the markets.

Here's your technical.