Tuesday, October 16, 2007

The Land Of Misfit Trades

The idea of setting up a “super-conduit” to address problems with off-balance sheet units, such as structured investment vehicles and conduits, emerged three weeks ago, when the US Treasury summoned leading bankers to discuss ways of reviving the mortgage-backed securities market and tackling the threats posed by the vehicles. That situation posed wider concerns, as the SIVs and conduits are linked to some of the world’s largest banks and financial institutions. The issue was highlighted in August when it emerged that two German banks, IKB and Sachsen LB, had, in effect, imploded as a result of an inability to fund their SIVs.

Past experience at a proprietary trading firm sheds some light on to the downside of the creation of this type of vehicle. At this firm the two top traders had access to moving trades to an "error" account. Long before Enron, just after the market close, creative accounting on the fly would move some trades to this "error" account. The trades moved were at times errors. An error might be a trade that wasn't properly marked as a short sell, or if a trader oversold a position. The errors were few and far between. The majority of activity in these error accounts came from moving losing trades from firm accounts . This is really just the same as taking money out of your left pocket and putting into your right pocket, but it does serve a purpose. It makes it possible to show positive results in specific accounts, while hiding the truth to be dealt with at a later date. This was done to show an investor in the firm the success of the trading accounts on a day to day basis, and hoping that magic would occur and solve the deficit in these "error" accounts.

In the end, all things come out in the wash. Short term this might seem like a good idea for large banks to get together and pool assets to keep the commercial lending market liquid. It could lead to more bad lending which will just cause an even greater problem. It is also now going to add to uncertainty and confusion when evaluating the earnings of these institutions. Valuing these instruments now is very difficult. The idea of breaking them up and repackaging them seems like a nice idea, but it will lead to more and more creative accounting and earnings uncertainty.

Below is a weekly chart of the S&P Banking Index. It shows what looks like a heavy triangle that coincides with the uncertainty and weakness in the banking sector.

S&P Bank Index

The financial stocks make of a predominately large portion of the S&P 500 Index. Below is a chart of the S&P 500 showing the declining volume as the market has reached its July high.

S&P 500 Index

Another chart of the S&P 500 Index shows the advance decline moving average along with the percentage of stocks trading above their 40 day moving averages.

Three companies that could add some insight to when the mortgage market has bottomed are the mortgage insurance stocks. Below are three with brief descriptions and charts.

RDN - Radian Group

Radian Group, Inc., through its subsidiaries and affiliates, operates as a credit enhancement company that provides credit protection products and financial services to mortgage lenders and other financial institutions. It operates in three segments: Mortgage Insurance, Financial Guaranty, and Financial Services. The Mortgage Insurance segment provides credit-related insurance coverage principally through private mortgage insurance, and risk management services to mortgage lending institutions located in the United States and internationally. The Financial Guaranty Insurance segment insures and reinsures credit-based risks. It provides insurance of public finance obligations, structured finance obligations, financial solutions products, and reinsurance of domestic and international public finance obligations. The Financial Services segment specializes in credit-sensitive, residential mortgage assets and residential mortgage-backed securities, as well as in credit card and bankruptcy-plan consumer assets. The company's customers include mortgage originators, such as mortgage bankers, mortgage brokers, commercial banks, and savings institutions; and financial institutions. Radian Group was founded in 1977. It was formerly known as CMAC Investment Corporation and changed its name to Radian Group, Inc. in 1999. The company and is headquartered in Philadelphia, Pennsylvania.

PMI- PMI Group

The PMI Group, Inc., through its subsidiaries, provides credit enhancement products that promote homeownership. It operates in four segments: U.S. Mortgage Insurance Operations, International Operations, Financial Guaranty, and Other. The U.S. Mortgage Insurance Operations segment provides residential mortgage insurance and structured finance products to mortgage lenders, savings institutions, commercial banks, capital market participants, and investors in the United States. The International Operations segment offers mortgage insurance and credit enhancement products, including primary mortgage insurance, structured portfolio products, and reinsurance products to lending institutions, as well as for residential mortgage-backed securitizations in Australia, New Zealand, the European Union, and Hong Kong. The Financial Guaranty segment provides financial guaranty insurance for public finance and structured finance obligations; and offers credit enhancement solutions that enable municipal and asset-backed issuers to facilitate access to capital markets. It provides direct insurance to issuers and lenders, and reinsurance to financial guarantors. The Other segment engages in contract underwriting operations. The company was founded in 1972 and is headquartered in Walnut Creek, California.

MTG- Mgic Investment Corp.

MGIC Investment Corporation, through its subsidiary, provides private mortgage insurance to the home mortgage lending industry in the United States. The private mortgage insurance covers residential first mortgage loans and expands home ownership opportunities by enabling people to purchase homes. The private mortgage includes primary and pool mortgage insurances. Its primary insurance provides mortgage default protection on individual loans and covers unpaid loan principal, delinquent interest, and various expenses associated with the default and subsequent foreclosure, and generally apply to owner occupied, first mortgage loans on one-to-four family homes, including condominiums. The primary insurance may be written on a flow basis, in which loans are insured in individual, loan-by-loan transactions, or may be written on a bulk basis, in which each loan in a portfolio of loans is individually insured in a single and bulk transaction. The Pool insurance is used as an additional credit enhancement for certain secondary market mortgage transactions; and covers the loss on a defaulted mortgage loan that exceeds the claim payment under the primary coverage. The company also provides various mortgage services for the mortgage finance industry, such as contract underwriting, portfolio retention, and secondary marketing of mortgage-related assets. In addition, it provides Internet portal that enables mortgage originators to access products and services of wholesalers, investors, and vendors necessary to make a home mortgage loan, as well as provides hosting, design, and marketing solutions for mortgage originators and real estate agents. The company serves originators of residential mortgage loans, such as mortgage bankers, savings institutions, commercial banks, mortgage brokers, credit unions, and various lenders. MGIC Investment was founded in 1984 and is headquartered in Milwaukee, Wisconsin.

Great article on Citigroup's conference call.

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