by Calculated Risk on 12/20/2007 10:59:00 AM

Update: Q&A added.

Brian sends along this preliminary transcript (unedited) from the Bear Stearns Q4 07 Conference Call:

Fixed income net revenue for the Fourth Quarter was a loss of $1.54 billion, down meaningful it from a gain of $1.1 billion earned in the November 2006 quarter. Sequentially, fixed income revenues also decreased when compared to the gain of $118 million earned in the August 2007 quarter. The quarters results include net inventory markdowns of $1.9 billion, which included the $1.2 billion loss previously disclosed on November 14th. During the quarter, the Company had gross inventory markdown s of mortgage assets of approximately $3.2 billion. Partially offsetting these losses were hedging gains of approximately 1.3 billion.

A large component of these losses were approximately $1 billion of losses incurred related to CDO's and the unwinding of CDO warehouse facilities where customer loss mitigation arrangements proved to be inadequate. At November 30th, all CDO warehouse positions have been unwound and collateral has been sold or hedged. Remaining net losses were experienced across our U.S. And international CDO Alt A and subprime mortgage loans and securities and commercial loan inventories, reflecting weakness in Global Market conditions.

At the end of November 2007, the Company had approximately $46 billion of mortgage and asset backed loans and securities. Included in the exposure are subprime mortgage loans of $500 million, representing 2007 vintage production and $1.1 billion of investment grade subprime securities and $200 million of below investment grade securities. ABS CDO exposures are approximately $750 million at the end of the quarter. Currently, our mortgage and asset backed inventories are approximately $43.6 billion, down 5 % from quarter end.

I should point out these balances represent gross asset values and net exposures are considerably lower. And in particular, net of hedges our ABS CDO and subprime positions are net short. At year-end, the Company held $7.8 billion of retained interest in our own MBS securitizations, a 19% decline from the $9.6 billion level at August 31. The non-investment grade portion of retained interest is $1.3 billion, down slightly from the August 31 levels.

The valuation of our mortgage positions reflects a combination of observable market data, the decline in the ABX indexes and our expectations of housing prices, defaults and cumulative losses. Accordingly while no assurances can be given as to future performance, we believe our mortgage positions have been conservatively valued in light of current market conditions and expected levels of defaults and cumulative loss estimates.

At November 30, 2007, approximately 7% of the firms assets were considered Level 3 assets. Given a lack of liquidity in the marketplace for many instruments, it's reasonable at some assets [that used] to be Level 2 assets would move to Level 3. While we haven't completed the review for the 10K disclosure, it is anticipated that the amount of Level 3 assets will increase by approximately $7 billion when compared to the August 31 amounts.

Q&A

Analyst (Lehman):
Okay, lastly, how much of the markdowns in fixed income were related to CMBS and Alt A during the quarter?
Bear Stearns:
Well, of the $1.9 billion in writedowns, as I said about a billion dollars of that came from the writedown of CDO's and the unwinding of the CDO warehouse. The balance of those losses of 900 million came from re valuation of our mortgage books, both our Alt A positions as well as commercials.

Analyst
Was one much bigger than the other there in terms of Alt A or commercial?
Bear Stearns
The Alt A and other mortgages were larger than the commercial

Analyst, (Sandler O’Neill)
Okay, and in the wake of rating agency finally taking action against a bond insurer yesterday -- can you talk a little bit about A) your exposure or your dependence upon bond insurers to get to net numbers versus gross numbers and secondarily, given your merchant banking investment in ACA, do you still own a portion of that? Can you give us any details on that?

Bear Stearns
Yeah. Start with ACA. It often gets confused because our merchant banking fund is an equity owner of ACA and often creating some confusion as to what our level of involvement is away from that. The equity investment, the exposure to the Company from our equity investment through the fund is not material and as it relates to counterparty credit exposures to ACA, those exposures are also quite benign and fully reserved and reflected in the earnings and we have no additional exposure to them so I think that that is quite well contained and behind us, whatever the exposure was. As it relates to other model lines, we have very little wrapped CDO credit exposure, almost none, and whatever exposure we have for them is typically limited our credit trading books and to some extent, municipal inventories.

Analyst
Is wrap tight protection maybe something historically you've been more dependent on and seeing the way things were going you reduced your exposure to it or has it typically been something you don't have a lot of dependence an?

Bear Stearns
It's typically something we don't have a lot of dependence on.

MarketWatch adds: Bear Stearns cut 1,400 jobs in fourth quarter, CFO says

Notice all the hedging and "net" discussion. If the counterparties blow up, Bear Stearns losses will be much larger. And look at the size of the overall mortgage portfolio: approximately $43.6 billion. Bear says these losses reflect "our expectations of housing prices, defaults and cumulative losses." I wish Bear would make public their house price forecast.

by Calculated Risk on 12/20/2007 10:27:00 AM

Update: Housing Wire has more news stories, and recommends this Nomura piece to understand CDOs squared.

From Bloomberg: MBIA Bond Risk Soars on $8.1 Billion CDO Disclosure

MBIA Inc. tumbled ... after the world's biggest bond insurer revealed that it guarantees $8.1 billion of collateralized debt obligations repackaging other CDOs and securities linked to subprime mortgages.
...
MBIA posted a document on its Web site late yesterday showing it insured the so-called CDOs-squared, a potentially riskier form of security than what the company typically guarantees. Rising defaults on subprime mortgages packaged into securities have led to bond downgrades and threatened MBIA's AAA guaranty rating.

``We are shocked management withheld this information for as long as it did,'' Ken Zerbe, an analyst with Morgan Stanley in New York, wrote in a report yesterday. ``MBIA simply did not disclose arguably the riskiest parts of its CDO portfolio to investors.''

by Calculated Risk on 12/20/2007 09:46:00 AM

From the WSJ: Mortgage Bets Bite Bear Stearns

Bear Stearns Cos. posted its first quarterly loss in its 84-year history on higher-than-projected $1.9 billion in mortgage write-downs.

A billion here, a billion there ...

by Tanta on 12/20/2007 09:23:00 AM

From the New York Times:

The Federal Reserve said on Wednesday that it had collected bids from 93 financial institutions in its first auction of short-term credit, a turnout that suggested banks might be more inclined to borrow from the Fed under its auction-based system.

Banks have typically feared negative reactions from investors when borrowing directly from the Fed, which some interpret as a sign of weakness. The auction, announced last week, tries to combat that stigma by offering banks the opportunity to borrow directly from the central bank in an anonymous forum and at a lower-than-usual interest rate.

God, grant me the capital to accept the things I cannot change; the reserves to change the things I can; and the Fed Auction when all that blows up. Amen.

by Calculated Risk on 12/19/2007 06:29:00 PM

From Bloomberg: S&P Cuts Alt-A Mortgage Bonds; Analysts Warn on Prime

Standard & Poor's reduced its ratings on about $7 billion of Alt-A mortgage securities, citing a sustained surge in delinquencies during the past five months on loans considered a step above subprime.
...
Since July, late payments on Alt-A loans in bonds issued in 2005 have increased 37.3 percent to 8.62 percent, while delinquencies for such mortgages in 2006 securities rose 62.1 percent to 11.64 percent, S&P said.

The article also has some analyst comments on prime loans:

Prime ``jumbo'' mortgages from recent years packaged into securities also have rising delinquencies that may create losses among some bonds with investment-grade ratings, according to reports yesterday by New York-based securities analysts at Credit Suisse Group and UBS AG. ...

``It's not just a subprime problem,'' Joshua Rosner, managing director at New York-based research firm Graham Fisher & Co., said ...

We are all subprime now.

by Calculated Risk on 12/19/2007 04:18:00 PM

From Bloomberg: D.R. Horton Credit Ratings Cut to Junk Status by Moody's (hat tip Matt)

D.R. Horton Inc., the fourth-largest U.S. homebuilder ... ratings were lowered to Ba1 on concern that a housing recovery won't begin before 2009 ...

The public builder BKs are coming. I'm not saying Horton will go BK, but more of the public builders probably will (like Levitt & Sons). There is simply too much capacity in the industry, plus too much debt, too much inventory, and poor demographics for housing in general. The next few years will be very difficult for the homebuilders, and I suspect 2008 will make 2007 look like a good year.

by Calculated Risk on 12/19/2007 01:44:00 PM

From Richmond Fed President Jeffrey Lacker: Economic Outlook

Since August ... the inflation picture has deteriorated. In September and October, the overall PCE price index rose at a 3.3 percent annual rate, and the core index rose at a 2.6 percent rate. Judging by the closely related consumer price index, the numbers for November will be even worse. Now these numbers do display transitory swings, so I wouldn't extrapolate them forward indefinitely. Still, I have to say that I am uncomfortable with the inflation picture, and disappointed that the improvement we saw earlier this year was not more lasting.

I am also troubled by the lengthy divergence we've seen between overall and core inflation. Some of you may recall that core inflation was devised in the 1970s to filter out some of the more volatile consumer prices to get a better read on inflation trends. For several decades, core inflation seemed to work well due to the fact that food and energy prices had no clear trend relative to the overall price level. In the last few years, though, overall inflation has been persistently above core inflation, and few observers expect oil prices to go back below $20 per barrel. Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation. Going forward, markets expect oil prices to back off slightly from their current level, and I hope they are right. If energy prices fail to decline, monetary policy decisions will be that much more difficult in 2008.

Lacker isn't currently a voting member of the FOMC, and last year he voted against holding the Fed Funds rate steady several times:

Voting against was Jeffrey M. Lacker, who preferred an increase of 25 basis points in the federal funds rate target at this meeting.

So we need to keep Lacker's comments in perspective; he is more hawkish on inflation than most of the FOMC members.

For fun, here is how you calculate the two month PCE and core PCE inflation rates that Lacker mentioned. Using monthly data from Table 2.3.4U. (link shows quarterly data), we see that the PCE price index (line 1) in August was 117.711 and 118.356 in October. For the annualized rate from a two month period, first divide 118.356/117.711 = 1.00548. Take that to the 6th power (2 months = 1/6 of a year) and subtract 1. That gives 3.33% (Lacker rounded to 3.3%).

For the Core PCE inflation rate (line 23), the August number was 114.591, October was 115.074. So the annualized rate for two months was (115.074/114.591)^6 - 1 = 2.56% (Lacker rounded to 2.6%).

Finally, this graph shows the "lengthy divergence" between the PCE and core PCE inflation rates.

Click on graph for larger image.

Note that this graph is of the year-over-year change, and Lacker was talking about the two month annualized rate of change. The annualized rate over the last two months is higher, so the picture has definitely deteriorated.

The "lengthy divergence" (blue above red) has been mostly due to the rapid increase in oil prices.

by Calculated Risk on 12/19/2007 12:06:00 PM

From the WSJ: Ratings Move Roil Bond Insurers

The first potential casualty that went public was Canadian Imperial Bank of Commerce, which said it is a hedge counterparty with ACA Financial on about $3.5 billion in U.S. subprime real estate. CIBC said it could report a large fiscal first-quarter charge related to ACA Financial's rating cut and its ability to remain as a viable counterparty.

The informed speculation was that CIBC's counterparty was ACA. That was confirmed by CIBC this morning. See: Counterparty Risk: CIBC and ACA. Others will be lining up at the confessional.

by Calculated Risk on 12/19/2007 11:55:00 AM

Here is the S&P Report: Detailed Results Of Subprime Stress Test Of Financial Guarantors Some excerpts from the company specific comments:

Ambac Assurance Corp.
We affirmed the 'AAA' financial strength and financial enhancement ratings of Ambac Assurance and the 'AA' debt ratings of Ambac Financial Group, Inc. but the outlooks have been changed to negative. ...

CIFG Financial Guaranty
We have affirmed the 'AAA' financial strength rating of CIFG and the outlook remains negative. ...

Financial Guaranty Insurance Co.
The ratings of FGIC and FGIC Corp. are placed on CreditWatch with negative implications. Our most recent analysis of the company's non-prime RMBS and CDO of ABS exposure indicates a level of losses which would result in its capital position falling below our 'AAA' requirements. ...

MBIA Insurance Corporation
The outlook on MBIA and MBIA Inc.'s financial strength and debt ratings is changed to negative and their ratings affirmed. The outlook change is warranted because of the absolute size of stress scenario losses relative to the adjusted capital cushion of $2.75 billion. ...

XL Capital Assurance Inc./XL Financial Assurance Ltd.
We revised the outlook on XLCA, XLFA, and Security Capital Assurance Ltd.'s financial strength and debt ratings to negative, while affirming the respective ratings. ...

ACA Financial Guaranty Corp.
The financial strength and financial enhancement ratings on ACA are lowered to 'CCC' and placed on CreditWatch Developing. The lower rating reflects the substantial excess-of-modeled stress test losses of nearly $2.2 billion over the company's adjusted capital cushion at Dec. 31, 2007 of approximately $650 million. While ACA has been diligently working to address contingent liquidity concerns, it has not focused significantly on raising additional capital. Lower new business activity during this period of rating uncertainty is a positive from a capital adequacy standpoint but the incremental improvement is not sufficient to close the gap between stress losses and the capital cushion. The magnitude of the gap is large enough to create significant doubt that the company could possibly access sufficient hard capital resources to resolve the problem. CreditWatch Developing acknowledges the possibility that the company may be able to modify its obligations to its counterparties but reflects the real possibility that the counterparties will require the company to post significant collateral going forward.

by Calculated Risk on 12/19/2007 11:28:00 AM

Update: Only news story I could find so far from Reuters: S&P cuts ACA to "CCC" junk, acts on 6 bond insurers

Press Release: S&P Takes Rtg Actions On Six Bond Insurers (no link, hat tip Brian)

Standard & Poor's Ratings Services today announced various ratings actions on six financial guaranty insurance companies.

The rating actions were prompted by worsening expectations for the performance of insured nonprime residential mortgage backed securities and CDOs of asset backed securities. Based upon current stress test analysis, the details of which are being published simultaneously with this release, the affected companies may experience claims and/or capital consumptive negative rating transitions such that their capital resources may no longer be sufficient at their respective rating levels. Another consideration in the analysis, if there is a capital shortfall, is the magnitude of the shortfall and the extent to which the company has raised or is planning to raise new capital, and the viability of that capital plan.

Standard & Poor's will host a teleconference today at 3 p.m. EST.

... Our analysis of the impact of the ratings actions announced today is ongoing. We expect to post lists of affected structured finance issues later today. As we complete our analysis during the next few weeks, we may publish additional ratings changes.

ACA cut to CCC from A, AMBAC and MBIA outlooks revised to negative from stable. More to come ...