March 11, 2008 10:14AM

The Spitzer Distraction

By Elizabeth MacDonald

That New York Governor Eliot Spitzer was caught planning to meet a prostitute in Washington, D.C., as first reported by the New York Times, presents a tale almost too rich with ironies.

It’s an amusing sideshow to those who came under Spitzer’s battle axe, a sideshow blast of entertainment for Wall Street struggling with one of the worst crises in its history.

The fear is it may create a distraction from what needs to be done. We’ve been dissecting the implications of this alleged sex scandal on Money for Breakfast and the rest of the Fox Business shows.

The ironies are rich.

That the governor was allegedly caught cheating with a prostitute when he once reveled in catching cheats in Wall Street research units prostituting themselves to their fellow investment bankers; that the announcement of the allegations came while the governor was giving a speech on family planning; that a prosecutor given to believing he could use the press to indict companies without benefit of the court process, who seemed to believe that an indictment is tantamount to a conviction, who now is all but convicted by the press he manipulated; that the governor now needs to beg mercy when he seemed to have none, shows that it’s a glaring understatement to say that truth sometimes is better than fiction.

A clean-up on Wall Street was desperately needed after the dot.com and tech bubble burst. Spitzer cracked down on Wall Street research operations tailoring reports to win sizable investment banking deals. He eventually hammered out a $1.4bn settlement with 10 Wall Street banks and brokerages, including Citigroup (C), Merrill Lynch (MER), Credit Suisse First Boston (CSGKF), Goldman Sachs (GS), Deutschebank (DB), Bear Stearns (BSC)

But Spitzer was criticized for being an intemperate, self-anointed crusader when he routinely convicted these companies, including American International Group (AIG), in the press via numerous leaks.

Spitzer got caught up in the type of regulatory dragnet he so loved, a joint FBI, Justice Department, Treasury Department and IRS crackdown on shell corporations, traditionally used for tax evasion, but now used for more nefarious things like money laundering and potentially terrorist activities, a problem I’ve written about before.

Oversight of shell corporations, now blooming like mushrooms here in the US and often set up by foreign operators, are largely left up to the states who do little to stop bad guys from opening shop here. The international prostitution ring that allegedly tripped up Spitzer was fronted by shell companies that took his money.

That Spitzer seemingly has blown both feet off not only will make it more difficult to conduct the state’s business, it also poses a distraction when serious repair work needs to be done in the markets.

The problem with the stock and credit markets is a solvency crisis gone viral. Anemic capital positions have left investment houses on life support.

This morning’s $200bn emergency move by central bankers to inject even more liquidity to chop up the ice in the markets has the Dow Jones Industrials up so far more than 260 points, but will it be enough?

Moody’s estimates 3.5mn people will lose their homes to foreclosure during this crisis. After dropping 9% last year, prices in 10 leading US cities are forecast to fall at least 18% by November this year, according to the Chicago Mercantile Exchange futures based on the S&P/Case-Shiller home price index.

The back story is this. Wall Street took a collection of sub prime mortgages that were owed by highly leveraged borrowers with bad credit records and, presto-change-o, magically altered them into marketable securities, buying a triple-A stamp of approval for these securities from the bond insurers, a rating IBM (IBM), Procter & Gamble (PG) and Coca-Cola (KO) do not enjoy.

All this created an unsustainable credit-driven boom, because, as one analyst put it, financial engineering can’t transform sows’ ears into silk purses.

As mortgage backed bonds and other securities plunge in value, lenders are demanding more in cash and assets, what are known as margin calls, to back up trades. That’s causing a graveyard spiral.

The Great Unwind has begun.

It’s not just the bond insurers, where Spitzer was active in hashing out a recapitalization plan. Buyout firms like the Blackstone Group and Kohlberg Kravis Roberts, lauded only a year ago for their deal-making magic, are seeing their profits collapse under the weight of debt as the credit crisis spreads.

Capital problems are behind more than 30,000 layoffs estimated coming at Citigroup (C), losses that won’t come all at once, but over two years. Layoffs, too, of about 5% of the workforce at Lehman Brothers Holdings (LEH), and Goldman Sachs (GS) are blamed on capital problems. Capital problems at Merrill Lynch are also seeing top executives being shown the door through early retirement packages.

Some 11,400 workers have already been laid off at Countrywide (CFC), which faces a severe capital drain. Countrywide is now being investigated by the Securities and Exchange Commission for civil violations, and by the FBI and the Justice Department over alleged criminal violations involving potential securities fraud.

Just a $37mn margin call, on the face of it seemingly small bore stuff at Carlyle Capital, the levered up fund owned by the Carlyle Group, and a $28mn margin call recently at jumbo loan seller Thornburg Capital are causing meltdowns in their shares.

Carlyle borrowed 28 to 32 times its assets to buy triple-A rated bonds backed by Fannie Mae and Freddie Mac, the big mortgage finance companies. It essentially borrowed anywhere from $28 to $32 of every $1 it had in its own money, leaving it with a tiny capital reserve cushion to meet a very thin $37mn margin call from seven of its 13 bank lenders. It’s already faced $482mn in margin calls from lenders in the second half of last year

Same story holds true for the levered up Thornburg Capital, the jumbo lender which saw shares lose half their value last week after it defaulted on a tiny $28mn margin call for more collateral from JPMorgan (JPM).

But the scariest issue facing the stock market now are the weak capital cushions at the bond insurers as well as at Fannie Mae and Freddie Mac.

It’s an issue I’ve flagged to you already in a prior blog (“There Will Be Bonds”) and I’ve reported on Money for Breakfast.

Turn to the bond insurers. The stock market is waiting on news whether or not one of the bond insurers will go bankrupt, or whether all will survive and keep their triple-A rating, a rating they’ve built their entire existence on.

Bond insurers are a key linchpin that prevents the financial markets from caving in. They save banks, investors and taxpayers money by keeping company and state borrowing costs low. If a bond does default, the bond insurers take over paying out the principal and interest, payments that dribble out over the remaining lifespan of the bond.

Bond insurers MBIA and Ambac guarantee yield on $1.2tn in municipal and corporate debt. But they got into trouble and may lose their triple-A ratings after increasingly insuring Frankenstein subprime securities tossed off by the housing crisis.

If the bond insurers lose their triple-A rating, corporate and muni bonds will have to offer more in the way of yields to lure investors, costing investors and taxpayers hundreds of billions of dollars in extra shareholder capital and higher taxes. “We sell promises for a living,” admitted Joseph Brown, chairman and chief executive of MBIA told the Financial Times.

Promises that are life-threatening. MBIA faces potential losses of $13.7bn. William Ackman, who runs Pershing Square Capital Management and is short the bond insurers, estimates MBIA and Ambac each face $11.6bn in exposures to toxic subprime securities and collateralized debt obligations. He estimates that the total universe of asset-backed securities CDOs is about 534 deals from 2005 to 2007, and that these deals alone will rack up losses of about $231bn, a total of some $27.5bn at the bond insurers.

In their defense, both MBIA and Ambac say they have $17bn and $14bn respectively in capital reserves. That’s a total of $31bn to support a $1.5tn book of business.

And I’ve already reported to you that, on closer inspection these capital reserve numbers are terrifyingly weak. About half of these capital reserves are really just more debt in the form of credit lines, as well as insurance premiums these bond insurers haven’t earned yet as the bonds are still outstanding, and premiums that the two estimate they’ll get from bonds they’ll insure in the future, money that’s not even in the door yet (see my earlier blog, “There Will be Bonds”).

Ambac is now struggling to bolster its triple-A credit ratings, by going into the market with another highly dilutive equity offering to raise $1.5bn, nearly twice its market cap.

As Dennis Gartman of the Gartman Letter asks dryly: “We ask all who believe that Ambac really is once again a [triple] AAA corporation to please send in your applications for Cleveland Browns season tickets immediately, for your naïve faith is genuine and should be rewarded.”

And for its part MBIA has raised more capital. But now its CEO, Joseph Brown, has decided to pick a fight with Fitch, which has put MBIA’s triple-A rating under review, while S&P and Moody’s has reaffirmed its rating. He recently wrote Fitch telling the credit rating agency to stop issuing ratings on six of its business units, because his company has “very little idea” why Fitch’s model produces ever-changing charges “when there is no obvious change in our circumstance or in the credit market at large,” blaming Fitch for causing “serious volatility” in how the Armonk, N.Y.-based company is viewed in the equity markets.

Brown did admit that: “Make no mistake about it, we wrote some business that in hindsight we wish we hadn’t, and those decisions have certainly had an impact on the market’s confidence in MBIA.”

In a letter to Brown, Fitch CEO Stephen Joynt responded that MBIA had asked Fitch to “return or destroy” key portfolio information “and discontinue all use of that information in proceeding with our rating analysis. He then said it appeared to be “‘disingenuous at best” for MBIA to have said, as it did last week, that it intends “to work with Fitch to perform the analysis needed to rate [MBIA’s] debt securities.”

Now for the big mortgage finance companies. Freddie Mac (FRE) and Fannie Mae (FNM) each have about $45bn in capital reserves to support a $2.4tn book of business, up from just $136bn in capital reserves in 1990. Both say their capital bases have a cushion of about $3.9bn above the minimum required by regulation, both aver that all is fine.

“Except that Freddie is holding $100bn in subprime asset-backed securities in its portfolio, while Fannie has $74bn or so,” notes Ed Yardeni, an economist. He adds too that 21% of Freddie’s $100bn in subprime assets are 60 days delinquent or more, with 40% of those on watch for a downgrade.

And Barron’s writes that $13bn of Fannie’s $45.4bn net worth consists of deferred tax assets that only have value if Fannie earns enough money in the future to offset them against profits. Fannie though has been booking record losses from the housing crisis, forestalling the use of those assets.

Which is why Fannie and Freddie are also moving rapidly to shore up their capital reserves, including doing even more dilutive equity offerings.

Meanwhile, Fannie Mae backs “the Homesaver Advance” program, where Fannie will lend each delinquent borrower as much as $15,000 over 15 years, unsecured, no collateral needed, to clear their debts.

All that’s needed to get the $15,000?

“A verbal confirmation of financial capacity.” That’s it.

Fannie is working to reduce the number of delinquent loans by shoveling more money at delinquent borrowers, Yardeni adds dryly, money they can get with more “no doc” loans that started the problem in the first place.

Spitzer footnote: It’s Lent, being raised a Catholic girl, someone who has eaten her fair share of fish sticks on Fridays and who doesn’t like the ukelele mass, and someone who has lapsed in so many myriad and interesting ways, I must confess:

Maybe I’m crazy, maybe I have a lot of Catholic guilt (ok I do), but I believe that any job that involves the public trust is a vocation. Be it a job in elected office or any job in the media. It is a call to duty, it is a call to serve. Our military who lay down their lives to protect us understands this. Our law enforcement officials who work so hard to protect us understand this.

Market regulators, too, try to protect us, not enough to be sure, and Spitzer over-the-top version of rough justice won many enemies. But the broader point is that, if the Spitzer allegations are proven true, they should rightly offend the good people out there who treat their jobs as a vocation. You the public deserve no less.