It was just a matter of time before it happened. With many big banks being stuck in the Subprime mess by taking large losses, and others being involved with lawsuits alleging unsuitable investments to municipalities which, after the collection of huge upfront fees, collapsed in value, private clients finally took notice.

The article “Ripe for the poaching” had this to say:

Credit Suisse, UBS, Merrill Lynch, and Citigroup, among other financial behemoths, are taking massive losses due to fallout in the credit markets. Credits Suisse Tuesday announced a write-down of nearly $3 billion that wiped a cool billion dollars from its profits.

Hence the danger of dealing with wealth-management factories. According to Russ Alan Prince and Hannah Shaw Grove, two wealth-industry experts, the No. 1 thing that high-net-worth individuals demand from their institutions is communication. Then, in terms of importance, they want trust. If big banks can’t offer these two attributes to clients then they’re in for an additional falloff in business.

[Emphasis added]

Read that last paragraph again. Isn’t communication and trust the most important aspect for anyone dealing with a banker or an investment management firm? I would add integrity to that list, however, given many published articles that seems to have moved way down the totem pole of values in favor of the almighty dollar. I guess the old axiom “you reap what you sow” still holds true.

In a follow up to yesterday’s post regarding bond insurers. CNN Money reports that any downgrades may cost banks billions in increased reserves:

Downgrades of bond insurers could require banks and securities firms to increase reserves by between $7 billion and $10 billion, rating agency Moody’s Investors Service estimated on Tuesday.

“We are currently evaluating these individual exposures to assess how institutions can absorb the additional counterparty reserves that might be required if one or more financial guarantors were downgraded,” the agency said in a statement.

Hmm, that last paragraph made me think about the responsibility ratings agencies have towards the public. Should they not act strictly on facts as the basis for downgrades rather than assessing what the impact might be and how institutions might be financially equipped to handle it?

This would be like saying that a real estate appraiser should consider the adverse impact on a seller’s finances if the appraisal comes in low. In my view, an honest “call it like it is” approach is preferable no matter what the consequences. Otherwise, where’s the integrity?

In the latest saga of bond insurers’ problem, Bloomberg reports that “Bond Insurer Split May Trigger Lawsuits:”

Regulators’ plans to break up bond insurers into “good” businesses covering municipal debt and “bad” businesses liable to subprime-related losses may trigger “years of litigation,” Bank of America Corp. analysts said.

New York-based Ambac Financial Group Inc., the second- largest bond insurer, may also seek a split, the Wall Street Journal reported today, citing a person familiar with the situation.

Not being an attorney, I certainly can’t comment on the legalities of such a break up. However, it sounds like a desperate attempt to keep a sinking ship afloat. I agree that a split would create a ‘good’ company and a ‘bad’ one.

It would appear that years of legal entanglement will be a sure thing, so why prolong the inevitable? If a company can not do business based on its model, has made grave mistakes or the model has become flawed, a natural conclusion might be that it should become road kill.

Based on the amount of reader e-mails I have received, I am amazed about how many investors are in hot pursuit of trying to pick a bottom in certain beaten down ETFs. Others are using an assortment of analysts and TV gurus to confirm their uncontrollable desires to enter the market and, hopefully, pick a declining investment (a loser) on the theory that once they made the purchase the downtrend is sure to reverse.

From my viewpoint as a trend tracker, both of those approaches, buying losers and listening to analysts, have no merit whatsoever. To make this more understandable, maybe I need to inject some sense of humor by quoting someone who has an opinion on the subject. Back in 2002, humorist Dave Barry said the following:

Enron stock was rated as “Can’t Miss” until it became clear that the company was in desperate trouble, at which point analysts lowered the rating to “Sure Thing.” Only when Enron went completely under did a few bold analysts demote its stock to the lowest possible Wall Street analyst rating, “Hot Buy.”

There is a lesson in this and it is this: Don’t go long when the trend is down and don’t enter into short positions when the trend is up. It’s not difficult yet so hard to do for many who are itching to do something—anything.

Next time, the desire to act tries to overcome your rational judgment, keep in mind that the safest strategy in this uncertain environment is to stand aside and wait for better conditions.

No matter where you look, and which online news service you scan, you are bombarded with stats about the declining housing market and the daily increase in the number of homes entering foreclosure. It’s not only happening in the bubble states (California, Nevada, Arizona, Florida) but nationwide as well.

Calculated Risk featured an update story on the subject in Georgia, while Mish over at Global Economic Trend Analysis reviewed Maryland, Virginia and D.C. housing issues.

No doubt, you have heard about the major efforts by banks and mortgage companies with the blessing of the U.S. government to freeze the foreclosure process for 30 days and/or renegotiate acceptable loan terms with individual borrowers. With some 2.4 million mortgages resetting over the next couple of years, this amounts to a Herculean effort.

If you have gotten the impression that the main purpose of this mission is to rescue homeowners, then you are mistaken. Yes, some borrowers will be helped, many will not. The main purpose is to rescue the banks/lenders from drowning in foreclosed properties. Anytime a lender takes back a home in today’s market, it’s a losing proposition.

Let’s take a simplified example in which I am the lender and you are the borrower. Let’s assume that I made a loan on your home a few years ago for $400k. Your home is currently worth only $300k, which means you are unable to refinance or sell without adding any cash of your own. Note, that this loan was made as a ‘qualified’ loan and not of the Subprime variety but that you are facing a resetting of the adjustable payment.

As many homeowners in this situation, walking away sounds like a plausible solution as you recognize that your choices are limited. You contact me to inform me to ask as to where to send the key to the home as you will be vacating.

Since I have just taken back a few other houses, I don’t really want to end up with another headache. Right now, your loan is an income producing asset on my balance sheet. If you stop payments, this turns into a liability for me, since I borrowed the original funds from an investor to whom I am obligated for the term of the loan.

My goal now is to find out what you can afford to pay and get you to keep on paying it. The old payment was comfortable and you might like my proposal of keeping that intact by me giving you a 2-year extension. What’s the benefit to you other than that you get to remain in the house? None, really, but look at what I as the lender gained:

1. I am still collecting a payment, although lower, on an overvalued asset

2. I don’t have to foreclose, which takes at least 120 days, during which I would not receive payments

3. Once I own the property, I will have to aggressively market it to hopefully sell it at $300k

4. If I finally sell it at $300k, I will have selling expenses of some $23k, netting me only $277k

5. During the marketing and escrow period, I will not collect any interest payments either

6. When all is said and done, my original $400k loan returns to me some $277k at best not counting lost interest payments and fix up costs

As you can see from this small example, negotiating with borrowers to keep them paying on an over inflated asset will do nothing for them, but will do everything for me as the lender.

If you think all these re-negotiation efforts are about helping you as the borrower, think again. It’s not about you; it’s about saving lending institutions that will have to write down assets so fast when considering REOs (Real Estate Owned) in huge numbers, that the liability column on their balance sheets may grow to be larger than the asset side. That, of course, would mean another bank bites the dust.

Even if you extend the same loan terms to troubled borrowers by 2 years, or freeze foreclosure proceedings by 30 days, it will only delay not solve the moment of reckoning.

From my point of view, there are only 2 solutions to this problem. Bring back the garbage loans with low initial payments or give every borrower in distress a $100k/year raise. Yeah right, either one of those are likely to happen.

One of the many terms you’ve been reading about is Credit Default Swaps (CDS). They represent a market that is currently valued at some $50 trillion (yes, trillion, not billion) and can, given today’s counter party risk, which I alluded to in a recent post, affect the markets very negatively given the right circumstances.

So what on earth are CDSs and how do they work? Minyanville had this explanation:

The CDS is economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who, for a fee, indemnifies the protection buyer against credit losses. The CDS market has grown exponentially to current outstandings of around $50 trillion. Even eliminating double counting in the volumes, the figures are impressive, especially when you considered that the market was less than $1 trillion as of 2001. However, the size of the market (which has attracted much attention) is not the major issue.

In the case of actual defaults the CDS market may provide significant employment to a whole galaxy of lawyers trying to figure out whether and how the contract should work. There is the risk that contract may not always provide buyers of protection with the hedge against loss that they assumed they would receive.

To me, it’s a huge pyramid game that totally depends on the opposing parties making good on their promises to cover their end of the bargain. What is unknown is how many parties to these contracts will actually be able to fulfill their obligations given the current credit mess and the fact that many participants are capital impaired.

I have no idea how this will play out, but it would seem that if only 5% of these “bets” go bad, that will be $2.5 trillion worth of “transaction” that have to be covered somehow. It will take only one Black Swan event, such as a major bank failure, to get the ball rolling and push the economy into unchartered territory with unknown consequences.

I am not trying to be negative here, just realistic. We’ve witnessed the quick unraveling of the subprime/housing market and its effect on the credit markets with many banks struggling to raise capital to stay afloat. That result was caused by negative numbers in the billions; what if there are trillions involved?