The recent failures of many municipal bond auctions combined with the pulling of many expected municipal bond issuances has created more turmoil in the market related to the insurers.  The spike in rates has caused the cancellation of one bond offering planned for this week.  The Houston Independent School District said that it had withdrawn a planned $385.4 million municipal-bond issue, saying the rapid rise of interest rates had made the cost of such an offering prohibitively expensive.  For those who are unfamiliar, municipal issuers finance such things as hospitals, road construction, schools, sewer systems and sports facilities.  Local governments seek bond insurance to reduce the perceived risk of owning their debt. That can attract more investors, resulting in lower borrowing costs and saving taxpayers money. 

Now had the bond insurers not moved beyond their municipal bond insurance roots by insuring more leveraged and complicated securities most municipalities would not be facing higher borrowing costs on new issuances and refinancings.  To give everyone some idea of how bad things have become in the secondary market for municipal bonds check out these numbers from two recent WSJ articles here and here:

Municipal debt generally pays out interest that is 10% to 20% less than comparable U.S. Treasurys because holders don’t pay federal taxes on the interest income. Friday, top-rated 30-year municipal debt was yielding about 16% more than 30-year Treasurys, and two-year municipal notes were paying out 60% more than comparable Treasurys.

When the tax benefits are taken into account, the result is eye-popping yields. At an average yield of 5.14% on triple-A-rated 30-year municipal bonds, a California resident in the top federal income-tax bracket earns the equivalent of 8.72%.

As a result of that surprising forced selling, yields on debt from municipalities and other tax-exempt issuers jumped to their highest levels in history, when compared with safe debt issued by the U.S. government. The average AAA-rated, 30-year municipal bond yielded 5.14% Friday afternoon, compared with 4.42% on a U.S. Treasury 30-year bond.  In normal times, municipal-bond yields are much lower than Treasurys.

No wonder many veteran bond investors love the state of municipal bond, so long as they were not long before the sell-off (the average long-term national municipal-bond fund is down 3.83% this year).  These investors have little doubt they see the greatest buying opportunity of their careers.  Think about this trade, which only an institution could undertake, you go long against municipal notes and you financing by borrowing in the Repo market against your lower yielding Treasurys of comparable maturity.  Needless, to say The Prince is sure that many of the best brains in credit investing are now employing similar strategies or far more sophisticated strategies.  If you need evidence look at these quotes from the WSJ articles: 

Shelia Amoroso, a portfolio manager at Franklin Templeton Investments, says she has never seen anything like this in her 21 years in the market. "It’s a compelling buying opportunity."

Hugh McGuirk, head of the municipal-bond division at T. Rowe Price Group Inc., Friday bought bonds issued by the state of Florida yielding 5.85%. Two weeks ago they were at 5%. "We’ve been waiting for a market like this."

This puts the municipal market in the odd place of competition with struggling stocks. "Munis are offering a risk-adjusted return that probably exceeds equities under more normal circumstances," Cumberland Advisors said in a weekend market update.

A number of players said they also are looking at an area known as "pre-refunded" municipal debt, in which interest payments are effectively guaranteed by a pool of U.S. Treasurys or other government securities held in an escrow account.

Late Friday, the average 5-year pre-refunded bond yielded 3.23%, compared with 2.47% on a five-year Treasury. Throw in the tax benefit, and for a New Jersey resident, the pre-refunded debt pays the equivalent of a 5.31% yield on Treasurys. George Goncalves, an interest-rate strategist at Morgan Stanley, calls it "the dislocation of a lifetime." The market, he says, "has thrown out the good with the bad."

"The muni market is at relative values that I have not seen in my career before," said Evan Rourke, municipal-bond portfolio manager at MD Sass in New York. At current valuations, he said, investors can earn 5% or more on tax-exempt municipal bonds, roughly equivalent to an 8% taxable yield. "At that level, you’re approaching long-term [stock] returns," he said. 

Brokerage firms issued all-points bulletins to their sales forces Friday suggesting they send clients into municipal bonds. One Morgan Stanley strategist described it as "the dislocation of a lifetime." Bill Gross, managing director of Allianz SE’s Pacific Investment Management Co., or Pimco, said Friday the bond titan is moving out of Treasurys and corporate debt into the muni market.

It is worth noting that these municipal bonds do look attractive since the fundamentals have not changed.  The credit quality of municipal borrowers has not changed substantially even though the pricing in the secondary market for municipal debt has fallen off a cliff.  Default rates on municipal bonds tend to be low, even without the bond-insurer guarantees. S & P says municipal debt carrying a BBB rating has a long-term default rate of about 0.32% of outstanding bonds. That is lower even than the 0.6% default rate on AAA rated corporate bonds.  Buying municipal bonds looks better than buying high yield corporate debt, which also has exceptionally high yields right now, since corporate defaults may substantially rise in the wake of the credit crunch and slowing economy. 

So why are municipal bonds so cheap?  The market chatter says that two hedge funds (Duration and 1861) have been doing recent forced selling (to meet margin calls on bad trades in other securities) by having their broker dealers shop sell lists of these hedge funds’ municipal securities for bids to their clients.  The WSJ remarks that, "in recent years hedge funds had flocked to a trading strategy that hinged on the normally reliable wide gap between yields on short-term and long-term municipal securities.  The hedge funds sought to profit from that gap by borrowing at the lower short-term rates, buying longer-term higher-rate municipal debt and pocketing the difference. They magnified this trade by borrowing heavily to make this bet, sometimes using 10 times debt for every dollar of investor money they were putting to work. At times they also layered on bets against U.S. Treasury securities."  This trade would be a terrible place to be lately since both sides of this trade would bleed money as Treasurys strengthen and Municipal debt weakens.  Clearly the weakening of municipal debt has been partially caused by the struggling bond insurers.  Yet, forced selling is playing a role.  However, if the likes of PIMCO start buying municipal bonds en masse then we can expect the yields to drop on the bonds.  The current pricing of municipal bonds related to Treasurys is about the clearest market inefficiency The Prince has ever observed.

Yet, what The Prince is most interested in right now is the future of insurance for municipal bonds.  Is it necessary?  Can it be used to achieve a lower cost of borrowing for municipalities, governments, school districts, and the like?  First, we have to ask if being in the business of insuring solely Municipal bonds right now is a good business.  Warren Buffet seems to think so.  He recently launched a bond insurer that would help state and local governments lower their borrowing costs, and possibly lure business from established rivals struggling with failing credit markets.  Berkshire Hathaway Assurance Corp guarantees the bonds that cities, counties and states use to finance public works.  The new company avoids investing in structured products, such as bonds backed by cash-generating assets such as mortgages and credit-card receipts.  Berkshire Hathaway Assurance Corp., or BHAC,  has effectively been taking market share from incumbents such as Ambac and MBIA which have been struggling to keep their triple-A credit ratings.  In recent days, rating agencies have bestowed triple-A ratings on municipal bonds insured by the new Berkshire venture, months before competitors and some analysts predicted. Last Friday, Maryland’s insurance department granted BHAC a license to do business in that state. The company has already guaranteed more than 100 municipal-bond offerings, including debt issued by New York City, where it received its first license.  The Prince would have to agree that business is good for an insurer with a strong balance sheet, that isn’t trying to raise new capital, and is not taking a six month hiatus from issuing new paper at the behest of the rating agencies.

If we accept as a first premise that issuing bonds with insurance issued by a well capitalized insurer does lower borrowing costs, then The Prince thinks he sees a better way to lower borrowing costs.  While The Prince is not an expert on this topic, he would love to get some feedback on this idea.  Why do we not see the big issuers of municipal bonds i.e. the Port Authority of New York and New Jersey, the State of California, tollways, etc., forming a coop together to issue insurance.  This coop would take the form of a public "utility".  Why give all the rents to Warren Buffet’s insurer or another insurer when the issuers can effectively cut the middle man out.  In theory, if we could get the top 100 issuers of municipal bonds to contribute capital to an entity controlled by the contributors that entity could then provide insurance to the members at a lower cost than private insurers.  The contributions would serve as the assets that would insure the bonds from default.  The effective borrowing costs for issuers would have to decline under this cooperative self-insurance scheme.  Under this scheme Tom Dresslar, spokesman for California state Treasurer Bill Lockyer, wouldn’t have to say "we’re prepared for higher rates than we’ve paid in the past."  California could buy insurance from this cooperative public "utility" entity which would lower the State of California’s cost of borrowing even when you consider the fact that California had to buy shares in the cooperative entity.  The market may be pricing insurance from unsound insurers as if it doesn’t exist right now but they could not ignore insurance issued by a well capitalized public "utility" like the one The Prince has outlined above.  If nothing else there would be serious savings for those that still want to issue debt that has insurance.  This is the case, because Before the bond-insurer crisis, bond insurers charged about 30% of the interest-rate savings an issuer would get.  This has climbed to about 80% or 90% as the bond insurers try to extract as much premium as possible. For the issuers, though, that has reduced the value of the coverage. 

If all the major issuers setup the scheme The Prince has discussed above, not only could they save the premium that insurers extract, but the value of their bonds’ insurance would not be subject to the poor business decisions of a third party bond insurer choosing to insure riskier non-municipal instruments.  All the questions in the market like those intoned by California’s deputy state treasurer, Paul Rosenstiel, "as to the value of insurance and whether it would save us money" would be silenced.  Please, to those who are more knowledgeable about this than The Prince, tell him why his scheme above would not work.  He wants to believe that a scheme as this simple can’t work in our time of sophisticated and evolved finance.

In case you haven’t been following the BAC-CFC deal closely, here is a summary of the shareholder actions that have transpired since the deal was announced.  First, there was SRM Global Fund with a 5% stake in Countrywide opposing the BAC deal .  This wasn’t big news because all the aforementioned reasons for deal to go through still held and it was accepted that SRM did not have enough allies to make its wishes come to fruition.  Then Legg Mason told us last week that they received approval to raise their stake in Countrywide to 25%, and their stake has already been increased up to 15% of the company.  Also, Capital World bought a 6.1% stake in Countrywide recently.  Capital World hasn’t specified whether they will take an activist role in trying to stall the deal but taking a stake that large must mean that they believe that the spread of the current price to the offer price (or the higher offer price if it is revised upwards) is attractive. 

Additionally, Bill Miller of Legg Mason in a note to investors indicates that he is not in favor of Countrywide sale at the current prices believing that Countrywide’s infrastructure/market position/market share are worth more than what BAC is offering.  The Prince has said that the deal consummated at such a low price will be long-term accretive to BAC.  So he can see Miller’s argument that BAC is getting CFC too cheaply but the strongest argument that Countrywide is being sold too cheaply is the absence of any other bidders.  Miller, whose Legg Mason Value Trust fund is already the single biggest investor in Countrywide, said the Office of Thrift Supervision gave him the right to raise the fund’s stake on January 18.  Oddly enough, CFC has put a so-called poison pill in place that makes it potentially prohibitive for Miller to raise his stake above 15 percent, he said in a letter released on Tuesday.  If CFC wants to discourage activist investors or new bidders then putting a poison pill defense in would make sense for CFC management but not for CFC shareholders (The Prince doesn’t find this surprising since CFC has regularly done right by management at the expense of shareholders, witness the share sales that are now be investigated by the SEC).  What does trouble me about Miller’s logic and my own is that if CFC was such a great turnaround candidate why wouldn’t be see the PE shops (even absent financing), other banks, other mortgage originators, and even foreign investors making higher bids for Countrywide.  The lack of competing higher bids does suggest that Countrywide may actually be valued properly by Bank of America’s offer price.

Obviously given the fact that CFC’s powerful institutional shareholders are willing to go activist on the deal there is room for investors to buy CFC and short BAC in hopes that a new higher bid will emerge or BAC will be forced to raise its bid.  Even if a higher offer isn’t made an investor could still benefit from appreciation in CFC as other investors interpret the actions of the large activist investors or if the deal closes at the offer price.  Arohan points out that he see the most likely result is that BAC sweetens it offer by offering more BAC shares per share of CFC.  He also reminds us that the possibility for CFC to declare bankruptcy is still looming out there.  The Prince tends to disagree with this argument.  CFC wouldn’t go bankrupt with an offer from BAC on the table.  CFC might become insolvent if it losses its ability to obtain short term credit especially if the FHLB cuts it off.  The Prince doesn’t see the FHLB cutting CFC off.  Also, for other debt holders in CFC forcing CFC into bankruptcy if it became insolvent would not serve their interests, since they would recover less on their bonds if bankruptcy is forced than if the left the company alone to be subsumed by BAC.  Some of CFC’s corporate debt may actually be paid off at higher par values than it is currently trading in the secondary market by BAC as part of the merger.

If you interpret the developments on the ground the same way The Prince does and you have a high tolerance for risk then you should short BAC and buy CFC.  If you want an alternative strategy for playing this strategy check out this post by Arohan.

A relevant quote from Bill Miller:

"What makes the decision puzzling is that the company was seeing solid deposit growth, has no apparent capital problems, was not forced by the regulators to seek a merger partner, and is in sufficiently sound condition to have declared its regular quarterly dividend at the end of January," Miller wrote. The portfolio manager said the Federal Reserve cutting interest rates sharply after the deal was announced was "quite beneficial to Countrywide by reducing its costs of deposits, and by setting off a wave of refinancings that should significantly increase its loan production." Miller said Legg Mason Capital Management has increased its holdings to about 86 million shares of Countrywide, or 14.9% of shares outstanding. "We will support the deal if we believe it is in the best interests of shareholders to sell to Bank of America, and we will vote against it if we believe greater value can be achieved by having Countrywide remain independent," he wrote.

An excerpt from a news story by Marketwatch (bold and underline added by The Prince):

Countrywide reported a loss of $422 million for the fourth quarter on Tuesday, a more than twice the consensus view of analysts the previous week. The loss was the first in the company’s 25-year history, with overdue loans increasing to 7.2% from 4.6% and more than a third of its subprime loans in active default.  That was a marked departure from Mozilo’s pledge two months ago that he would return the lender to profitability by the end of the year.  But is Countrywide getting out just as conditions for lenders begin to improve?  The company has recently seen an uptick in deposits at its savings bank and should reap the rewards of Fannie Mae and Freddie Mac’s new ability to purchase jumbo loans.  In addition, a spate of new interest rate cuts introduced by the Federal Reserve could make the borrowing environment even more hospitable to strapped lenders. Gordon also points out that the value of Countrywide’s existing loan origination and loan servicing platforms alone make it a very valuable asset.  "There is a big shortage of loan servicers right now, and at this price, they basically gave it to them for nothing," Gordon said.  The infrastructure and existing loan portfolio that Bank of America inherit as part of the deal would make it the nation’s largest mortgage lender, a significant leap from the fifth place spot the bank held in 2007. Analysts estimate that if the deal does go through, B. of A. will eventually oversee or originate close 25% of all home mortgages.  Close to 90% of the mortgage business is now in the hands of the top 25 lenders, making an acquisition on the scale of Countrywide’s unlikely to come along any time soon. Still, there are opportunities for smart bargains.  "A lot of the consolidation that happens in ‘08 will be through bankruptcy," he said. These could provide valuable sales of piecemeal assets, allowing many banks and lenders to snap up essential origination and servicing platforms at bargain basement prices.  It may be for this reason precisely that Bank of America is staying firm in its resolve to go through with the deal. CEO Kenneth Lewis told a New York audience that despite the significantly larger losses, the bank will forge ahead with the acquisition, saying that the original deal is still "a go."  Lewis’s confidence could be rewarded, analysts said, as there are few possible suitors sitting on the sidelines.  "I’d be hard pressed to say there’s a better buyer out there," Gordon said.

1 The Carlyle Group $32.5 billion
2 Kohlberg Kravis Roberts $31.1 billion
3 Goldman Sachs Principal Investment Area $31 billion
4 The Blackstone Group $28.36 billion
5 TPG $23.5 billion
6 Permira $21.47 billion
7 Apax Partners $18.85 billion
8 Bain Capital $17.3 billion
9 Providence Equity Partners $16.36 billion
10 CVC Capital Partners $15.65 billion
11 Cinven $15.07 billion
12 Apollo Management $13.9 billion
13 3i Group $13.37 billion $
14 Warburg Pincus $13.3 billion
15 Terra Firma Capital Partners $12.9 billion
16 Hellman & Friedman $12 billion
17 CCMP Capital $11.7 billion
18 General Atlantic $11.4 billion
19 Silver Lake Partners $11 billion
20 Teachers’ Private Capital $10.78 billion

Basically, the jist of the story is that CS is earning more than UBS for the first time in 10 years mainly as a result of UBS’ missteps in the recent credit crisis and weakness is some of its main businesses.  CS was able to avoid the writedowns that forced UBS to report the biggest quarterly loss by a bank at 12.5bn francs.  The bank will give details about its loss on Valentine’s Day.

In the last year the investment banking unit at UBS has struggled.  Many attribute their poor performance to the departure of veteran rainmaker Ken Moelis.  Moelis setup a new firm by his name which is competing in LA with UBS LA.  He also took his top deputies with him and many of his ex-DLJ co-workers.  UBS has cut about 1,500 jobs in its securities business and probably still has a headcount that is too large given current market conditions.  UBS also has lower profit margins in banking than CS which will serve CS well if a slowdown in M&A is on the horizon or has already begun.  Private banking revenues have also not grown as fast as competitors in a business where UBS has normally been a standout.  IUBS is still the world’s largest asset manager.

Credit Suisse was going in gangbusters in 2007 with advisory roles on many of the largest sponsor related transactions.  Sponsors and Leveraged Finance had banner years at CS and are now considered among the top groups in the industry in these areas.  Even accounting for losses on leveraged loans the investment banking business had a wonderful year.  If you need more proof Credit Suisse was recognized as the "Global Investment Bank of the Year" in The Banker magazine’s annual Global Investment Banking Awards published in October 2007.  Credit Suisse also won three house awards, including Best Leveraged Finance House, Best High Yield Bond House^, and Best Convertibles House.  To lend more prestige to its investment banking division, in 2007 CS also ranked #6 and #4 in worldwide and U.S. completed M&A based on imputed fees.

CS also significantly brought down its mortgage and CDO exposure in the spring.  They historically were not a big player in mortgages or structuring so it is unclear how much exposure they initially had.  They were also early on seeing problems with origination.  In 2006 and 2007 the bank significantly reduced the amount of mortgage paper it issued.  It interesting to consider that First Boston (acquired by CS) along with Salomon Brothers were the original creators of the collateralized mortgage obligation a precursor to MBS and CDO securities and one of the most important financial innovations of the 1980s. 

The numbers simply speak for themselves.  UBS reported on Jan 30 it had a loss of 4.4bn francs in 2007 while CS is expected to post a profit of  8.65bn francs.

The trouble at UBS has caused the bank to seek shareholders’ approval to sell 13 billion francs in bonds that will convert to shares to investors in Singapore and the Middle East.  UBS stock is down 50 percent in the past twelve months, while Credit Suisse is down 36 percent.

Credit Suisse is certainly decimating UBS in investment banking globally and is growing its private wealth business faster.  Credit Suisse’s current fortune is surprising when you consider that this bank was in crisis as recently as 2002. 

Economic News

RGE Monitor - This is simply the best site for aggregating what economists are saying about the domestic and international economies.  The pieces are of extremely high quality and it is a great place to look for emerging trends for you to exploit through investments.

The Big Picture - Another fabulous site focusing on economic and financial commentary.  The analysis is usually rich with new insights and very sophisticated.

Calculated Risk - Covers economics and the financial market.  Always offers useful commentary backed up with graphs and statistics.  Does some pretty interesting calculations trying to estimate writedowns and the values of various assets.

General Market and M&A News

New York Times Dealbook

FT Alphaville

WSJ Marketbeat

Bloomberg

Commentary and Investing

Abnormal Returns - The links they regularly provide help the reader hone in on the best commentary of the day. 

Howard Lindzon - My favorite investing blog.  His commentary is always interesting and the interaction with his readers on his trades is excellent.  He is also one of the creators of WallStrip.

Intelligent Speculator - Recently launched site that focuses on value investing with a slightly speculative edge.  Presents some interesting trade ideas for stocks that look undervalued based on varying metrics.

La Contra - Fascinating blog presenting contrarian investment ideas.

Fat Pitch Financials - Site that offers the tools to make you a better value investor.

The Street - Daily does of financial commentary from experts of various quality.

Seeking Alpha - The best aggregator of commentary and investing ideas on the web.

Private Equity and Dealmaking

Going Private - I just love the way Equity Private writes.  The writer’s quick wit and years of experience make this blog a fascinating read.  The writing is superb and the original insights are fascinating.  The Prince’s goal is to write like Equity Private.  I have a long ways to go and a lot of experience to gain before I can reach that goal.

Blogging Buyouts - Good for blurbs on various Private Equity news.  Site doesn’t have much new material right now as LBO game is on hold because of lack of financing.  However, I’m sure they will start covering the difficulty that PE firms are having with the firms they bought at ridiculous multiples at the peak.

Epicurean Dealmaker - More wonderful writing that you can’t find anywhere else.  Incredibly interesting with a great sense of humor.

Wall Street Fun

Dealbreaker

Wall Street Folly

The All Nighter

BankersBall

Wall Street Oasis

WallStrip

The purchase of MBNA for $35Bn in cash and stock made BofA one of the largest credit card issuers.  The acquisition of MBNA provided Bank of America a leading credit card issuer worldwide. The combined Bank of America Card Services organization, including the former MBNA, now has more than 40 million U.S. accounts and nearly $140 billion in outstanding balances.  Many feared that there would be serious culture class between Bank of America’s down-to-earth customer service culture and MBNA’s flashy nuevo rich executives.  It turned out that the management teams achieved amazing success integrating MBNA into Bank of America’s systems and culture.  The acquisition of MBNA will certainly be seen as one of the top financial services acquisitions in-terms of realizing value for shareholders.  The acquisition also fits with Bank of America’s focus on the U.S. while its competitors look abroad for growth.  Bank of America’s recent acquisition of ABN Amro North America and LaSalle for $21Bn was just completed in October so the results of this acquisition cannot be judged yet.  This acquisition pushed Bank of America to $1.7 trillion in assets.

The acquisition of Countrywide was a longtime coming.  In August Bank of America announced a $2 billion dollar repurchase agreement with CFC.  The purchase of preferred stock was arranged to provide a return of 7.25% per annum and provides the option to purchase common stock at a price of $18 per share.  Last week Bank of America announced it would buy Countrywide Financial for $4 billion. This acquisition will give the bank a substantial market share of the mortgage business, and access to Countrywide’s expertise, technology, and employees for servicing mortgages.  The Prince contends that the servicing operation and the market share of Countrywide are worth far more than $4bn.  When you consider that Countrywide provides mortgage servicing for nine million mortgages valued at $1.4 trillion as of December 31, 2007 it is hard to imagine that this source of steady income doesn’t have a discounted value higher than $4bn.  Bank of America will shop around the parts of Countrywide’s mortgage portfolio they don’t want to hold and get rid of it.  They will be left with a firm that is poised to regain market share once the mortgage market turns around and do a substantial business in refinancings as rates continue to drop through The Feds actions.

The Prince shorted CFC and IMB (then NDE) back in the spring and closed his position this summer, so why would he suggest that BofA is making a great investment?  BofA getting the right of first refusal as a stipulation to its initial convertible preferred investment definitively was a strong signal that Countrywide was in-play.  Countrywide has great assets and amazing reach. They technology and infrastructure for originating mortgages is second to none.  Selling a mortgage to someone will also allow BofA to create sticky relationships with that customer which will lead to cross-selling.  The possibility for market share gains is enormous for Countrywide.  Most of the specialist and smaller mortgages originators have left the market or went out of business.  Countrywide is going to capture that share and be in a better position in the future.  This deal brings Bank of America close to a dominant position in the mortgage market.  The mortgage market is cyclical and it will recover.  At that point Bank of America will look prescient.

Now there are some downside risks for BofA.   The deal increases BofA’s dependence on a slowing U.S. market.  It is buying a mortgage book that continues to deteriorate.  Countrywide also faces a slew of lawsuits over its marketing of subprime loans.  Regardless of these risks the price is alluring when we consider that it is 1/8th CFC’s market value a few months ago.  Countrywide originally got into this mess by an over-reliance on short-term wholesale funding and fast-rising delinquencies subprime, Alt-A, and prime mortgages.   It was under suspicion of becoming insolvent.  This business is about confidence, and Wall Street did not believe CFC’s claims to have excess liquidity.  Everyone was worried that Countrywide would default on a ton of derivatives contracts it had struck with them. This would of triggered a huge problem for all of Countrywide’s counterparties to derivative contracts.  Bank of America bailed everyone out but in the end BofA will profit from getting Countrywide for cheap.  Ken Lewis pretty much summed it up when he said, "Where there are challenges there are also opportunities,” after he announced the deal.

Make no mistake, BofA will take some short term pain for a long-term gain that The Prince believes will be much larger.  According to the WSJ out of nearly $80 billion in loans held for investment by CFC, 75 percent are second-lien HELs and option ARMs.  Both of these types of loans are getting killed and will continue to get worse.  Calculated Risk did a nice job covering the pain BofA would experience and suggested portfolio losses could approach $10 billion.  Some like Robert Shiller, in an interview with Bloomberg, claims that BofA is making a terrible mistake buying CFC.  He said that, "We are in the aftermath of the biggest housing boom in US history, in world history.  As prices fall and more mortgages are underwater, even prime borrowers will have incentive to default.  People who lose their job in a recession, even if they want to keep paying their mortgage, won’t."  The Prince agrees that more housing/mortgage pain is to come but for a strategic buyer like Bank of America the long-term gains will dwarf what they paid Countrywide.

This deal also helps BofA gain favor with regulators.  BofA will see advantages beyond a potential lift to its mortgage business.  The lets it go over the 10% deposit ceiling because a bank can do so if it is through a takeover of another bank with a thrift charter (CFC has this).  And the takeover will make it look good with regulators and politicians who want to see the markets calm.  Many commentators have been calling Bank of America’s investment a gamble that Countrywide is getting out of the woods.  When The Prince weighs the positives and the downsides this investment acquisition seems like a winner with small appropriate risks to BofA.  Countrywide has the best distribution system for originations in the industry and that is worth way more than $4bn.

Disclosure: The Prince does not own BAC or CFC.  The Prince does own SKF.  

	1) Dom Pérignon 1999 International Wine Cellar(93) - The Wine Advocate(96) Could we really start with anything else?  This is probably the most recognized vintage champagne in the world.  This champagne is just so classic and debonair.  Its taste and its presentation just ooze smoothness. This wine is radiant, pure and vibrant. It is a story of seduction and sensuality.  This wine is full of life, with a fresh nose that dances through a spiral of aromas, blending hints of angelica, dried flowers, pineapple, coconut, cinnamon, cocoa and tobacco. With a fullness in the mouth, its earthy, smoky, pearly complexity rises to the surface, underscored by the vibrant warmth of peppery spice. The sensation of intensity develops and melts into a deep, rounded heart, with a fruity, exotic maturity and a slight touch of aniseed. This sensation, almost unsettling, is even more pronounced in the finish, while the notes of spice, still present, remain discreet, with toasted, iodine flavors.
	2) Vueve Clicquot La Grande Dame 1998 Wine & Spirits(95) This Pinot Noir and Chardonnay blend has a pale gold color with jade glints. It is crystal clear, with unbelievably fine bubbles. On the nose the typical Chardonnay characteristics come to the fore, with the arrival of floral and mineral aromas.  By agitating the wine, scents of candied fruit  and sweet almond emerge, to reappear later in the mouth. After rotating the wine for a few minutes more, rare notes such as peaty malt, tobacco and delicate herbs, are gradually unveiled. This aromatic, impressively complex bouquet is confirmed in the mouth. On the palate, the wine is clear-cut and pure, perfectly balanced with a delightful silky smoothness. It has a lace-like construction, has a long, lively, and structured finish. This wine has unbelievable aging potential. This is the quintessence of the Veuve Clicquot style and reaches a peak of refinement, without losing its legendary strength produced by a blend including nearly two-thirds of Pinot Noir. The contrast of depth and brightness, or intensity and weightlessness creates a sense of harmonic resonance in this wine. All the aromatics are potent, from the scent of rising bread dough to the red skin of an apple, all the corresponding flavors rich yet refreshing. The firmness of the acidity seems to add briskness to the mousse, leaving a clean, chiseled impression of the chalk soils in which this grew. Once in a while, there is a young beauty who will age into a more profound older beauty.
	3) Dom Pérignon Rosé 1996 Wine Enthusiast(95) For the lady bankers out this is the first of two rosés that I had to throw in for good measure.  Although, this first Rosé definitely has something for the fellas if you care to peak at the latest ads for this product featuring photos of Eva Herzigova by Karl Lagerfeld.  I also posted some eye candy for the ladies of Brad Kroenig. Who wouldn’t want to come home to a $400 bottle of Rosé in Eva’s hands in your apartment. That’s enough distraction from the champagne.  Even considering the marketing, this a fantastic Rosé.  It has the lightheartedness and vibrancy of the Pinot Noir grape while still maintaining the balance between the Chardonnay and Pinot Noir.  This play of contrasts reaches such a degree of density and sophistication that it achieves a wonderful harmony.  The color of this is amazing.  It is a bright, amber-tinged pink with pinpoint bubbles.  It is deep, smoky and complex, with a kaleidoscopic bouquet incorporating wild strawberry, peach, apricot, chestnut honey and cured meat. It also features powerful flavors of orange peel, raspberry, redcurrant, baking spice and smoked meat and gentle supporting acidity. It has a slowly building impression of acidity that suggests this will be a long ager.  It should drink well for 20-25 years, possibly longer.  Notes of crushed rocks, honeysuckle, lemon oil, orange marmalade, and white pear provide a stunning aromatic display as well as palate impression. Great acidity and huge flavor intensity backed up by vibrant acidity make this an exquisite Champagne.  As usual, a stunning Champagne." Many have called this one of the greatest modern vintages of Champagne.
	Veuve Clicquot La Grande Dame Rosé 1998 The second Rosé on The Prince’s list is still pretty pricey but is less well known and is probably easier to get your hands on.  This is a luminous, deep goldish red with a persistent fine mousse. The rich, intense nose displays notes of dried fruits, like black figs and dates, and mild spices such as vanilla in harmony with a softer, almost creamy base. On the palate the texture is deep and tightly woven. The structure of the pinot noir is perfectly rounded. Gracious notes of black cherries and raspberries dominate the finish. The exceptional flavor and taste of this truly great Champagne make it a magnificent accompaniment to fine cuisine.  The Prince drank this at Bouley.  This is a vintage that will age very well.
	Veuve Clicquot Brut Yellow Label WN(92) - WS(90) This has got to be The Prince’s favorite non-vintage champagne and it certainly has fans all over the world.  It is the only non-vintage champagne worthy of The Prince’s palate,  I rung in the 4th of July watching fireworks from my apartment sharing a bottle of this with my girlfriend.  It was a great night and this is a wonderful champagne.  The value is amazing considering this is one of the most affordable french non-vintages that is readily available at most shops.  Now, remember The Prince only cares about value when it comes to stocks and in champagne he only wants the best.  This is Clicquot’s signature non-vintage and The Prince loves its crispness and full flavors.  This is a classic dry Champagne and is a blend of two-thirds black grapes (Pinot Noir and Pinot Meunier) and one-third Chardonnay.  The black grapes give it body and the Chardonnay makes it genteel.  The Prince would certainly choose this over more expensive bottles when it comes to taste but The Prince is more concerned with showing off so if he’s in public he is probably not going to be drinking non-vintage champagne even if he prefers it in private.  Regardless, this is the gold standard for non-vintage Champagne every single year when it hits the stores.  Its nutty, rich, creamy, and complex taste make this a superb Champagne.

Did you like this posts?  Don’t worry.  The Prince will be posting wine tasting notes, a list of his favorite single malt whiskies, and the tequilas he loves over the next month.  Only one word can really describe these posts, "Lifestyle".  You can also expect to see lists and reviews of some of The Prince’s favorite nightspots and restaurants in New York and San Francisco.  Join The Prince as he gives you a glimpse into the Wall Street lifestyle.  What will The Prince be drinking on New Year’s.  You will just have to swing by the luxury apartment on Park Avenue where he will be celebrating to see.

The Prince "In His Dreams"

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Home prices in 10 major metropolitan areas in October were down 6.7% from a year earlier, according to the S&P/Case-Shiller home-price indexes.  That exceeded the previous record year-to-year decline of 6.3% in April 1991, when the economy was emerging from a recession.  Some economists say that the decline is a signal that the market is making a necessary adjustment, pushing prices back closer to Americans’ ability to pay.  The realtor lobby’s economist believes that prices will bottom out beginning in 2009 but most investment bank economists see the bottom closer to 2010.  That would put the correction not even half over.  I tend to side with the bank economists since I believe that resets on ARM mortgages will continue to pressure on prices since lenders taking out ARM mortgages were the marginal buyers of housing.

The effect this will have on the American consumer is the biggest takeaway from the housing data.  It has rarely paid to bet against the American consumer but in this case I think playing that trend will yield a great return.  As homeowners are unable to take out more home equity or refinance for more cash they will cut down on spending (See my related story on the drop-off in women’s clothing purchases).  Remember that consumer spending accounts for about 70% of economic activity in the U.S.  It has an enormous effect on revenues and profits for U.S. and foreign firms through the multiplier effect.  There is no doubt in the Prince’s mind that growth is going to slow as consumer spending slows.  Recent numbers from the government have claimed that consumer spending is healthy but I think that those numbers are lagging behind current conditions.  Holiday sales were weak and many investors are taking that out on discretionary consumer stocks’ prices.

But the recovery of the housing market is a gradual process because the boom put prices out of reach with incomes. The Case-Shiller index showed home prices jumping 74% in the six years through 2006. During the same period, U.S. median household income rose 15%.  That made housing unaffordable for many Americans but more aggressive lending still allowed many to get into homes. 

It is not at all surpassing that the Case-Shiller index showed that some of the fastest declines in home prices are in metropolitan areas that were among the hottest during the boom. Prices were down 12.4% from a year earlier in Miami, 11.1% in San Diego, and 10.7% in Las Vegas.  Home prices are still up from a year ago in some places, such as Seattle and Charlotte, N.C. And people who bought their homes several years ago still typically are sitting on sizable gains in most of the country (Take a look at the chart above if you need proof).  The boom more than doubled prices in many populous areas near the coasts. This happened because of unusually low interest rates, which slashed the cost of monthly mortgage payments.  Home sales began to slow in mid-2005 then prices leveled off before starting declining in 2006.

Over the past year, mortgage defaults have soared, leading to rapid growth in foreclosures.  Foreclosed homes are being listed for much lower amounts than homes for sale by real sellers.  If you are seller in a market with high foreclosures you are not going to get anywhere’s near what you expect.  It will take some time for expectations to adjust.  I remember what my favorite economics professor used to say, "Expectations are Everything".  Nothing sums up the housing market better right now.  Inventories of unsold homes remain very high and may increase in the new year as lenders dump more foreclosed houses on the market. The number of detached single-family homes listed for sale in October was enough to last 10 months at the current sales rate, according to the National Association of Realtors. That was more than double the level of two years ago and the highest since 1985.As the market adjusts, single-family housing starts have fallen 55% from their January 2006 peak to a seasonally adjusted annual rate of 829,000.  More pressure on prices is coming from homebuilders, because builders are aggressively chopping prices to clear inventories.  Recent cuts by builders may have reduced demand in the short term because they encourage potential buyers to expect further discounts.

The mortgage market also needs to adjust further. Most of the funding for home loans comes from investors who buy securities backed by bundles of mortgages. Since August, many of those investors have shunned the market amid fears of rising defaults. As a result, lenders generally are focusing on loans that can be sold to government-sponsored investors Fannie Mae or Freddie Mac, or insured by the Federal Housing Administration. Jumbo loans, above $417,000, which can’t be sold to Fannie or Freddie, have grown much more expensive, deterring buyers in high-cost areas.  Prices are going to get hit by how tough it is to get a mortgage because there is a much smaller supply of buyers that qualify given tougher standards.  The current scarcity of funds available for mortgage lending creates a chicken-and-egg situation, says Prof. Leamer. Investors who provide funding for home loans don’t want to commit more money until they believe the housing market is getting better. But it’s hard for the housing market to rebound as long as mortgage credit is tight. Lower prices eventually will break this impasse, by luring buyers back into the market and reassuring investors that the market is finding a bottom, he says.

I am not crazy about using the Case-Shiller Index because I believe that it is a lagging indicator.  I think things are going to get much worse.  Just look at the chart below from Credit Suisse.  It basically shows the notional value of mortgages that will reset on different dates.  Many of these are forced resets that are written into the mortgage documents.  Out to month 24 gets us to January 2009 with another big wave starting shortly thereafter.  Many of the people in these ARMs (Adjustable Rates Mortgages) are not going to be able to refinance to rates that are affordable and will default.  This paper that was issued with lax standards is going to be affecting the mortgage market for 3 to 4 years as foreclosures linked to it continue.  Look at subprime ARM resets through Jan 2009 and it is easy to see that we haven’t really even hit the peak of Subprime ARM resets.  It is going to get worse before it gets better.  Then look at the wave of Option, Alt-A, and Unsecuritized ARM coming after Jan 09.

ARM resets are going to have a huge impact especially if housing prices continue to fall in hot markets and/or sales continue to slow.  This is because people will have negative equity and be unable to refinance which leads to foreclosure.  If the housing market continues to deteriorate ARM resets on higher quality ( i.e. not subprime) ARMs like Option ARM and Alt-A ARM will be even more painful since it is more likely that people will not see the appreciation in home value they were anticipating when they took these ARM mortgages out.  Without that appreciation the may not be able to refinance or keep up with their unaffordable mortgage payments.  Get ready for more pain in housing, The Prince guarantees it.

More Trouble in suburbia is Coming!  A for sale sign in every yard and every other house in foreclosure.

The producer of the original film, Edward Pressman, has signed a deal with Hollywood studio 20th Century Fox to develop a sequel. The title is a line that Gekko speaks to Bud Fox on a brick cell-phone after claiming he made a few million trading gold in Hong Kong overnight.  Gekko’s maxims like "lunch? lunch is for wimps" and "greed, for lack of a better word, is good" are featured on this site’s first page randomly each day.  The movie was never a huge commercial success but it has a cult like following among professionals on Wall Street.  In fact, the movie’s fame has grown so much that the studio re-released a 20th anniversary Wall Street with extra features this year.  Douglas said he wouldn’t mind if he never had "one more drunken Wall Street broker come up and say, ‘You’re the man!’.  Screenwriter Stephen Schiff (Lolita, True Crime) is currently working on the script and is expected to complete it by the end of the year.  Unfortunately, Oliver Stone will not be returning to direct, despite Douglas and the producer hounding him.  Charlie Sheen, who played Gekko’s protégé Bud Fox, is also not expected to appear, as it seems there is no part for his character in the script.  

For those who haven’t seen the movie (shame on you), Wall Street’s ending piece saw Gekko about to swap his tailored suits for a prison jumpsuit, after Fox sold him out. But according to Douglas, it is unlikely that jail time would have softened the raider with a penchant for suspenders and hair gel. "I don’t think he’s much different. He’s just had more time to think about what to do," Douglas told The New York Times.  The Prince doubts the sequel will be as good as the original but if it makes money it will be a success.  Remember, "It’s all about bucks, kid. The rest is conversation."

The Prince’s Wall Street Montage

It is safe to say that the mega-buyouts we have been seeing over the last few years are gone for awhile.  Sponsor activity will be much lower in 2008 and this will have a negative impact on investment banking activity and revenue.  Keep in mind that private equity firms are the most lucrative clients for investment banks because they do so many transactions.

Kravis of KKR

This summer when the leveraged loan markets closed many banks started to re-negotiate their commitments to the private equity clients for LBOs that were in the pipeline.  Some private equity firms played ball and some didn’t.  Those that played ball thought it was better to give in on terms to win favor with the investment banks and to stabilize the market for LBO related bank loans and high yield debt.  Many of these private equity firms even went out and bought high yield debt and bank loans, when they were trading way off of par, in hopes of realizing a profit when the market realized that it had punished these LBO credits too much.  Some firms didn’t play ball and many a senior banker kept saying that these firms would be punished next time the credit markets opened up.

I don’t really believe that for a minute.  Once the PE firms start paying fees again, there is no way that firms like KKR, that was ruthless on terms, are going to get shutout. It may be the case that they don’t get the most aggressive terms going forward or don’t get first look on sell-sides, but they are still going to get kid glove treatment by The Street.

Schwarzman of Blackstone

In a similar vein, I don’t think that Private Equity firms walking away from buyouts right now will hurt their ability to do deals in the future.  Goldman and KKR walking away from Harman and Cerberus walking away from United Rentals (at least trying to walk away before the legal battle began and a settlement appeared on the horizon), is not going to stop private equity from concluding deals in the future.  When the LBO cycle kicks back into high gear business sellers are going to be motivated by how much money they are going to get from the highest bidder.  If that happens to be a private equity firm, they are not going to shut out the PE firm because the PE firm wants a MAC and a low break-up fee.  Wall Street has a short memory and so do shareholders of companies on the block.  Money talks and bullshit walks.  Private equity firms’ money will continue to talk and the wall street firms and sellers are not going to walk away.

UBS does more than 1,689,000 transactions a day. The firm deals in almost every asset class and trades across almost every region. That is a lot of testosterone in one room, then again, it is a big room.

To see all the photos and a gallery of the trading floor go here.

At: 12/06  7:55:54

This is old but it always makes me laugh.