Uncle John's Cabin

"It's the Monolines, Stupid!"

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To paraphrase a quote from a previous presidential race and put it in today's context, "It's the monolines, stupid!".

Warren Buffett today announced that he would be willing to take the muni bond liability off the hands on the monoline insurers (MBIA, Ambac etc.) While I watch the pundits argue this on TV, the Dow and all the major indices have spiked based mostly on this single piece of hope. (Disclaimer: I am not a financial wizard and cannot even come close to saying I understand the CDO market but I cannot contain myself by today's news and will try to explain why this is important in my view.) It is only hope and as is, the proposal will not likely happen without help on the other side of the equation as explained below but the markets are telling us exactly what they want. They want clarity. They want insurance. They want a backstop to the losses and a plan to get into recovery. Buffett's plan provides half of the solution. To examine the other side we need to examine the monolines and CDOs in some detail.

What's wrong with this economy? Well, that's pretty easy. Home prices are falling. Consumer spending accounts for about 70% of the economy, and they no longer have the means to use their homes as ATMs anymore to continue to spend at the rate they have been. Lenders have given out too much money, too liberally and are now and will continue to pay the price for this practice for a long time to come. To justify this and protect themselves from loss, they went to the monoline companies to get insurance for new financial instruments, called CDOs from the monolines whose main business until that point was insuring very safe, AAA rated muni bonds.

What is a CDO? If I understand this correctly (and it's quite possible I may be wrong, I'm no rocket scientist here), a CDO, is a bond consisting of asset backed mortgages wrapped up and sold as a AAA bond while the contents within the CDO is and should never have been rated triple A. There are certainly other credit derivatives involved in this mess as well but I will focus on what seems the be the biggest factor here, CDOs.

This new financial instrument (within what, the last 10 years?), and the insurance for them, has built a house of cards that ripple throughout the financial markets and the entire economy. Here's what happened in a simplified form as I understand it. Lenders originated loans to home buyers which were backed by the assets of the homes. Then, they wrapped these mortgages up into bundles as bonds and called them CDOs and sold them to various institutions. At some point, the monolines got involved and insured them as AAA rated bonds. Banks, mutual funds and even usually safe money market funds bought these for their interest rates. They are spread throughout the US and even the globe like cockroaches. (I'm not sure that's a fair comparison to the unloved cockroach.)

In the spring and summer of last year, as banks and lenders realized the assets in these CDOs were not worth what the bond was thought to be worth and started to write-down the value of these assets taking increasing larger and larger losses. As more subprime, alt-a and even prime borrowers started defaulting on their mortgages, in combination with falling home prices, more and more homes were being dumped on the home market in the form of foreclosures and short sales because the homes were not worth what was owed on them. This creates a cycle that continues to decrease the value of homes in neighborhoods where this is occurring making more people go upside down on their home loans depressing home prices even further.

OK, let's bring back the monoline companies. The banks and other institutions that hold these CDOs have to make claims to the insurance companies (the monolines) to cover their losses from foreclosures, short sales and auctions etc. These companies severely underestimated the possible losses that could be generated from the insurance they issued and now are struggling to keep enough capital to back these bonds and hold on to their own triple A ratings and have to continually raise cash as the losses mount. This ripples into even the lower risk assets, the muni bonds because the monolines insure them as well (for a nice profit.) The house of cards keeps collapsing as the possibility of the monolines lose their AAA ratings increases because many of the safe muni bonds which are in all kinds of restricted portfolios, including pension funds, mutual funds, money market funds etc that are mandated to only hold AAA rated bonds. If the monolines lose the AAA rating, these safe muni bonds will have to be sold (at a loss) all around the country.

This is what is creating the credit crisis, the credit freezing etc and the entire downfall of the economy and financial markets. Even the Fed cutting rates cannot stop this from happening.

Here's the cycle:

- house prices fall
- the consumer spends less
- the economy suffers from lower spending
- more loans go into default
- more insurance money is paid out by the monolines
- monolines become cash strapped and endanger their AAA ratings
- the value of the CDOs goes lower and banks have to write them down taking huge losses
- the banks can no longer sell the CDOs making them very illiquid - freezing the credit market
- the monolines start to lose their triple A ratings and muni bonds now have to be sold like junk bonds
- more and more houses go into default and get put on the market for reduced rates
- more houses and lower sales comps means lower home prices
- the consumer spends less
- the cycle repeats itself ad nausem.

Eventually the monolines will have to go out of business and declare bankruptcy causing the banks to continue to write down the CDO to virtually 0, creating more losses, more homes on the markets and less consumer spending.

So, why does Warren Buffett represent such hope to the markets even though the monolines will most likely not take him up on his offer to take the muni bond insurance portion of their business off their hands? His involvement with Berkshire Hathaway, has enough capital to back the muni bonds with no risk of losing it's triple A rating. This provides some sort of "backstop" if you will, for the market and taking other, safer bonds out of the equation of this death spiral.

The problem here is, what are the monlines left with if they lose the safest and most profitable potion of their business? Well, they have a little more capital to delay the downgrading of their bonds. Other than that, the spiral will just end quicker and they will fall into bankruptcy even faster.

Where's the solution? I have heard a couple of variations, and the one I like best of the "Cramer Solution". Jim Cramer suggested last month, that instead of a government stimulus package costing $150 billion that will do very little to fix the economy, the government should disband the monlines outright. They would sell the muni bond business to someone that has the cash to operate it like Warren Buffett and then guarantee the banks and other CDO holders 50 cents on the dollar for the insurance losses. This provides a "backstop" for the entire industry and economy. The figures tossed around were about 500 billion in possible losses for the CDO business. At 50 cents on the dollar, the government and tax payers are on the hook for up to a maximum of a $250 billion bailout. Now, that does not mean the government has to pay that money up front nor is it an absolute that this is a complete loss. It won't be. The government would most likely only end up with paying out over time, at most about half of what they were on the hook for, about $125 billion. That's less then current stimulus package that is about to be signed into law and it would be paid out over time.

The beauty of this deal is the value of the CDOs and their risk becomes a known quantity. The banks and other institutions can finally write down (or up) the value of these assets knowing at worst, they are worth half of their original value. Yes, the banks will take losses but the continual write-downs and unknown exposure and losses will end. The market abhors the uncertainty which the CDOs and their losses represent.

If such a plan were enacted, the market would probably shoot up 1000 points in a couple of days and stay there as a new bottom and start to recover. The housing economy would start to slowly rebuild as the rest of the fallout from the remaining people that cannot afford their homes will default but home prices will stop falling so fast and the spiral will be broken. Banks will start lending again (albeit more carefully) and homebuyers will enter the market again knowing the end is near. The CDO market will unfreeze and will become tradable and liquid again. The pension funds, retirement funds, money market and mutual funds will not have to sell those nice yielding tax free muni bonds. And, as a bonus, the government will probably earn some money back that was risked but not paid out as the housing market improves. (This was true during the SnL bailout in the 90s.)

This process would still take years to sort though the system but, it would provide what the equities markets and the home markets want so desperately, a clear path to recovery. Without fixing and more likely removing the monlines entirely, any recovery will take many more years of pain and frustration for everyone in this country and in many parts of the world.

In the end, if I were in a presidential/economic/recovery debate, I would turn that now famous line into "It's the monolines, stupid!"

/end rant
Uncle John