Posted by March 4, 2008
Ambac, the financial guaranty insurer, announced today its plan to recapitalize through an equity offering of $1 billion of common stock and $500 million of some type of preferred hybrid securities. Trading in the stock was suspended for about two hours prior to the release of the Offering Memorandum for these new securities. Of particular interest to me, was that the new issuance materials made no reference to splitting the company in two, effectively ruling out the “good insurer / bad insurer” scheme. 😊
Prior to the release of the Offering Memorandum, I saw an email from a dealer entitled, “This is what the market expects”. The document called for Ambac to issue a rights offering worth $2.5 billion that would enable existing common stock shareholders to buy more stock if they wanted. In addition, the market expected the memorandum to include $500 million in a preferred stock offering. Should existing shareholders not want to “double down” (essentially, choose to buy up these new rights and preferred stock, recapitalizing the firm), a consortium of banks was ready to buy whatever residual amount of stock that was left over.
What the market “got” vs. what it “expected” was $1.0 billion less of equity and no mention of a rights offering or a back-stop consortium. I don’t know why the existing shareholders might be reluctant to add to their investment in Ambac. It’s not like the stock price has been falling like a stone. Oh wait, it is. Regardless, Ambac’s stock trading resumed after the memorandum was released and by the end of the day the share price fell by 20%, with their CDS (credit derivative swap) spreads moving wider to a level of about 500 basis points. Hardly a ringing endorsement for a company that still holds a ‘AAA’ rating.
March 5 and 6, 2008
A London-based hedge fund named Peleton reportedly had to unwind last week because it couldn’t make margin calls to the dealer who was financing its “high quality” portfolio of mortgage securities. Unfortunately, in the current environment, a “high quality” mortgage portfolio is an oxymoron. If a borrower cannot meet a margin call, it means the securitized lender has the right to sell the collateral supporting the loan to try and get their money back. Selling assets, of course, lowers asset prices, which in turn exposes the market to additional margin calls, which then lowers asset prices even further, etc. These falling asset prices placed unwelcome pressure on Thornberg Mortgage, a publicly traded company that invested in, you guessed it, “high quality” mortgages. When Thornberg couldn’t meet its margin calls, the event triggered more forced selling by securitized lenders seeking to recoup their loans. More forced selling and still lower prices led to yet another entity, Carlyle Capital, to fail to meet a margin call. Of note, Carlyle invested only in “conforming mortgages”, that is, mortgages that are guaranteed by the two large government supported lenders, FNMA and Freddie Mac. Is nothing safe in the mortgage world?
With all this forced selling going on, dealers have started to increase their “haircuts” (the additional collateral above the amount of a loan that is needed to protect the lender from loss) when extending new financing to borrowers, which effectively tightens financial conditions and makes it more difficult to own mortgage-backed securities. To review, we now have an environment where the prices of mortgage assets are going down and some leveraged holders of mortgages can’t meet margin calls. This leads the lenders to sell the assets, which drives prices down further. These lower prices, combined with requests for higher margins (increased haircuts), leads to even more unmet margin calls, which leads to more forced selling, which leads to lower prices, which leads to … It doesn’t take a rocket scientist to see where this is going as credit spreads on everything relative to Treasury securities are starting to widen. Can anyone say, “liquidity squeeze?” August 2007 here we come … but wait! Here comes the Fed to the rescue!
March 7, 2008
Big news from the Fed this morning as it announces three separate actions to try and provide additional liquidity to the market. Go Fed!
# 1 – An increase in the Discount Window’s Term Auction Facility (TAF) auctions from $60 billion in outstanding balances to $100 billion. In the TAF, the Fed auctions collateral-backed short-term loans (effectively, money) to banks, which is a very direct away to add liquidity to the banking system. Before the Fed sends the money though, the winning bidders have to pledge sufficient collateral to the Fed’s Discount Window. Of note, the Fed’s Discount Window accepts a broad range of collateral. So, while some market participants are starting to shy away from taking FNMA and Freddie mortgages, the Fed is showing market leadership by accepting less liquid and lower quality collateral, including the assets that have suffered from margin-call-induced selling pressures the past few days. Go Fed!
#2 – The Fed is going to increase the size of its long-term repo (RP) book from $60 billion to $100 billion and increase the term of these operations from 7 days to 28 days. (When the Fed conducts a repo operation, it exchanges money for collateral thereby increasing the amount of money / reserves / liquidity in the system). Perhaps more importantly, all collateral types will be treated the same in these operations. Usually the Fed tries to be “market neutral” and applies the same credit differential as the market in valuing the relative attractiveness of propositions supported by Treasury, Agency, and Agency mortgage-backed securities (MBS). By not using the market differential, the Fed is saying, “I don’t know why you guys are so freaked out by plain vanilla MBS securities. For the time being, in these long-term repo transactions we’re offering, these MBS securities are the same as Treasuries to us”. Maybe this will free up a decent amount of the gridlock in the MBS financing market? Go Fed!
#3 – To make room on our balance sheet for these extra liquidity-providing operations, the Fed will sell at least $100 billion of Treasury securities. Again, while the rest of the market is dealing with a serious “flight-to-quality” sentiment (essentially, buying Treasury securities), the Fed is doing the opposite (selling Treasury securities) to try and chill out the markets. At least we’re paying attention. Go Fed!
The market seemed happy with the new Fed initiatives but only for about half of the trading session. By mid-afternoon, out of nowhere, sentiment turned broadly negative once again, leading equities to decline briskly. At the daily executive 4 pm briefing, the President of the New York Fed was canvassing the Markets Staff on their views on the effectiveness of the Fed’s three actions today, and pretty much everyone was negative, except me. I’m hoping the Fed’s actions are going to gain traction over the next couple of trading days. We’ll see.