07/11/2002 Palpable Systemic Stress *

The unfolding Credit market dislocation took direct aim at the blue chips and financials this week. For the week, Dow, S&P500, and Transports were all hit for 7%. The Utilities were pounded for 10%. The Morgan Stanley Cyclical index dropped 8%, and the Morgan Stanley Consumer index sank 6%. The broader market was under pressure as well, as the small cap Russell 2000 declined 6% and the S&P400 Mid-Cap index dropped 7%. The NASDAQ 100 declined 6%, although technology stocks generally outperformed. The Morgan Stanley High Tech index declined only 2%, and the Semiconductors dropped 4%. The NASDAQ Telecommunications index actually gained almost 1% for the week. The biotech rout continues, with the major industry index dropping 7%. The financial stocks came under heavy selling pressure, with the AMEX Securities Broker/Dealer and S&P Banking indices dropping 7%. With bullion up about $4.50, the HUI Gold index jumped 12%.

The Treasury market melt-up went to new extremes. For the week, 2-year Treasury yields sank 36 basis points to 2.53%, while 5-year yields dropped 33 basis points to 3.76%. The 10-year Treasury enjoyed its biggest weekly gain since the crisis of October 1998, with yields sinking 29 basis points to 4.57%. The long-bond saw its yields drop 20 basis points to 5.33%. Benchmark mortgage-backs saw yields drop 22 basis points, while implied yields on agency futures sank 28 basis points. The yield on December Eurodollars dropped 24 basis points to 2.06%. The spread on Fannie Mae 5 3/8% 2011 note widened one to 52, while the benchmark 10-year dollar swap spread narrowed 3 to 52. The dollar remains under pressure, as the dollar index dropped more than 1% this week. Systemic stress, however, did appear to ease somewhat in Brazil and other emerging markets. Stress seemed to grow by the day at home.

A spokesman from the Office of Management and Budget today averred that the federal deficit may grow to $165 billion this year, up from January’s estimate of $106 billion. This compares to last year’s surplus of $127 billion. With government forecasts (Treasury Secretary O’Neill expects 3 to 3.5% growth through the fourth quarter) remaining quite upbeat, it does not take much imagination to envisage ballooning deficits. Bloomberg today report that “New York State’s personal and business tax collections were $234 million lower than projected from April through June,” with projection for fiscal year personal income tax declines of $2.51 billion.

Broad money supply declined $28.8 billion last week. Institutional money fund assets declined $24.5 billion, large time deposits dropped $13.8 billion, and Eurodollar deposits declined $6.2 billion. At the same time, savings deposits increased $8.1 billion and retail money market fund deposits increased $5 billion.

Second-quarter asset-backed security issuance of $95 billion was an all-time record. Year-to-date issuance of $184 billion was up 27% y-o-y. By major category, credit card receivable issuance of $36.5 billion was unchanged y-o-y. Auto loan-backed issuance increased 31% y-o-y to $45.6 billion. Notably, home equity loan-backed issuance of $72.9 billion was up 76% y-o-y. June home-equity issuance of $18 billion was second only to March’s record issuance. First-half adjustable rate home equity issuance was up almost 160% to $43.5 billion. Interestingly, y-t-d convertible security issuance of $42 billion is running down 27% from last year. This had been a key funding source for many companies that had limited financing options, and we continue to expect problems in this area of recent Credit excess.

July 11, 2002 – Standard & Poor’s “U.S. ABS Experiences Robust Negative Actions in First Half - - With such a predominance of negative rating actions initiated during the first half of 2002, highlighted by the 130 downgrades initiated in the second quarter alone, it’s worth noting that 57 ratings (25% of the total downgrades this year) were lowered to non-investment-grade levels (below triple-‘B’-minus). Also, 26% of the 232 negative rating actions initiated to date this year have resulted in ratings falling to or below the triple-‘C’-plus level. These downgrades significantly exceed the 26 upgrades initiated by Standard & Poor’s during the first half of 2002... The ABS sector experienced 15 defaults during the first half of 2002, which is nearly one-third of the total defaults witnessed by Standard & Poor’s on a historical basis through June 2002.”

July 11, 2002 - Standard & Poor’s - “High US CDO Rating Volatility in First 6 Months of 2002-- During the first half of 2002, Standard & Poor’s initiated a total of

61 rating actions in the CDO sector, including one upgrade, which was made on a CDO of RMBS (Residential Mortgage Backed Securities) deal. Most notable among the downgrades is the number of deals knocked from investment-grade status, as well as the number of CDO ratings collecting at the triple- ‘C’ level. Of the 60 lowered ratings, 23 (38% of CDO downgrades) were loweredfrom investment-grade (triple-‘B’-minus or higher) to non-investment-grade levels.

July 09, 2002 – “Moody’s Investors Service’s review of CDO exposure to Worldcom finds ‘significant exposure’ across the full spectrum of deal types in the US and Europe. The CDOs likely to sustain the worst credit deterioration will be investment grade, cash flow, and synthetic CDOs primarily because of their highly leveraged structures, Moody’s said. With over $30 billion of outstanding debt, Worldcom is a widely held position in CDO portfolios,’ said Moody’s Managing Director, Gus Harris. Worldcom’s ratings were downgraded by Moody’s on June 26, 2002, when its senior unsecured rating dropped to Ca. The sector with the largest number of deals exposed is the synthetic CDO sector, where 58 US and European transactions hold a par exposure approaching US$1 billion. About 30% of this synthetic exposure is denominated in Euros. Portfolio holdings range between 0.3% and 4.6%, Moody’s said. In addition, 54 speculative grade cash flow transactions hold a par exposure of US$ 166 million, according to the rating agency... Almost all the investment-grade cash flow CBOs rated by Moody’s had

Worldcom exposure... The extent of downgrade activity for the actively managed investment-grade deals, however, will depend on collateral manager reactions, Moody’s said. ‘Several deals are already very close to triggering early amortization tests.’”

July 10, 2002 – “Moody’s Investors Service announced today that it is placing on watch for possible downgrade two classes of Notes issued by Putnam CBO II, Limited. The affected tranches were: U.S. $256,000,000 6.875% Senior Secured Collateralized Notes Due 11/08/09 rated Aa3 and now placed on watch for possible downgrade and U.S. $60,500,000 7.65% Senior Secured Collateralized Notes Due 11/08/09, rated Caa1and now on watch for possible downgrade. Moody’s said that this action was prompted by deterioration in credit quality of the collateral pool underlying the transaction, along with several defaults in the collateral pool that have reduced the amount of subordination needed to preserve the current ratings. Moody’s also noted that additional concern is raised by the collateral pool’s concentration (approximately 1%) in Intermedia Communications, a WorldCom subsidiary.”

July 10, 2002 – “Moody’s Investors Service announced today that it has placed the credit default swaps issued by Parthenon CSO 2001-2 PLC under review for possible downgrade. The affected tranche of swaps is the €20.0 M CSO Series 2001-2 Credit Default Swaps, Tranche A, currently rated Aa2, and now on watch for possible downgrade. According to Moody’s, the review has been prompted by a deterioration in the credit quality of the reference pool, which includes exposure to WorldCom...”

July 10, 2002 – “Moody’s Investors Service has lowered to Ba2 from Baa3 the rating of the EUR 20,000,000 Credit Linked Floating Rate Notes due 2 August 2006 issued by Crediop Overseas Bank Limited. This rating action results from a deterioration of credit quality within the underlying reference portfolio, and especially the downgrade of Worldcom’s rating to Ca.”

July 10, 2002 – “Moody’s Investors Service has lowered to Caa1 from Ba2 the rating of the JPY1,200,000,000 Leveraged Credit Linked Notes due 12 May 2006 issued by Listore Company Limited, a special purpose company incorporated in Jersey. This rating action results from a deterioration of credit quality within the underlying reference Portfolio, and especially the downgrade of Worldcom's rating to Ca.”

Today’s report of preliminary July consumer confidence from the University of Michigan was much weaker than expected (86.5 vs. expectations of 93). It was an interesting report, as Current Conditions declined only slightly from June to 99. The Economic Outlook, however, sunk 9.4 points to 78.5, the lowest reading since November. This report is consistent with our view that consumer spending remains relatively firm. Yet this news could prove a key harbinger for a coming downside economic surprise. The weekly retail sales reports from Instinet Research Redbook and Bank of Tokyo-Mitsubishi both had sales up a resilient 3.7% y-o-y. Moreover, the Mortgage Banker’s Association weekly application index had purchase applications up 8% for the week (up 36% y-o-y) and refis about unchanged (up 118% y-o-y). It is our view, however, that the unfolding Credit market dislocation will lead to the first general tightening of Credit conditions since the early 1990s. We suspect that yesterday’s increase in initial jobless claims may usher in another round of job losses.

While the focus in the financial media and general news is on accounting and corporate governance issues, it is rather amazing that there is virtually no mention of problems in the Credit system. We are at the brink of systemic crisis, yet no one seems to be paying attention. It is our view that severe Credit market problems are now the leading factor driving the financial markets. This week there was clearly another escalation of the unfolding dislocation, with a broad number of stocks sensitive to the health of the capital markets coming under intense selling pressure. The S&P Automobile Manufacturing index, for example, sank 15% this week. It is worth noting that GM has total liabilities of $303 billion, with shareholder’s equity of about $20 billion. Ford has total liabilities of $263 billion, with shareholder’s equity of $13 billion. Both companies have large financial services subsidiaries and are major Credit market players. The Philadelphia Utility index sank almost 10% this week. Unfortunately, the long boom and move toward financial “sophistication” saw many players in this stodgy old industry morph into aggressive derivative traders and financial players. This is now coming home to roost, with potentially systemic ramifications.

Bank stocks also came under heavy selling pressure this week, along with financial stocks generally. The NYSE Financial index dropped 5%. It appears that the marketplace is finally coming to appreciate the systemic nature of the unfolding dislocation. The stocks of the Credit insurers were sold aggressively. Consumer finance stocks were weak basically across the board, despite what were relatively robust earnings from the small number of companies that have reported.

Credit card behemoth MBNA reported quarterly earnings up 21% year-over-year. Managed receivables increased $4.6 billion, or 19% annualized, to almost $100 billion (mailings were up 61% y-o-y, with many holders apparently cashing those MBNA checks arriving in the mailbox). MBNA added 5 million new customers during the quarter (7.4 million for the first half). “The typical new customer has a $72,000 annual household income, has been employed for 11 years, owns a home, and has a 17-year history of paying bills promptly” (almost as if sound Credits grow on trees...). We wish we could be as sanguine about the quality of the Credits, but we are in a very dangerous period. Managed delinquencies declined from 4.97% to 4.80% during the quarter. Net credit losses increased from 5.00% to 5.09%, although the company reduced its quarterly provision for losses to $275 million from the first quarter’s $359 million (y-o-y $322 million). Interestingly, the company’s own portfolio of receivables jumped $2.4 billion during the quarter to $16.5 billion. Year-over-year, total assets jumped 17% to $40.4 billion, while deposit liabilities were up 9% to $24.8 billion. It is not comforting to see such aggressive lending growth by an industry leader as we head into what will be considerable financial and economic tumult.

Mortgage insurer MGIC reported net income up 6% y-o-y, although aggressive stock buybacks (2.3 million shares repurchased during the quarter) had earnings per share rising 8%. The quarter saw the company write $21.8 billion of new insurance, with mortgage insurance in force increasing to $194.5 billion (up 13% y-o-y). At the end of the quarter, 3.60% of loans were delinquent, up from the first quarter’s 3.46%, and up meaningfully from last year’s 2.75%. The actual number of delinquent loans increased 43% y-o-y, while company loss reserves increased 5%. Year-over-year, total assets were up 19%, with other assets growing 22%.

Interestingly, other revenues jumped 72% y-o-y to $39 million, which more than explained the $9 million y-o-y increase in Income Before Tax (to $75.6 million). This strong performance was largely the result of joint venture C-BASS (Credit Based Asset Servicing and Securitization LLC). One analyst referred to C-BASS as “MTG’s subprime servicing subsidiary,” but that just doesn’t do justice. According to the company’s most recent 10-K, “C-BASS engages in the acquisition and resolution of delinquent single-family residential mortgage loans. C-BASS also purchases and sells mortgage-backed securities, interests in real estate mortgage investment conduits residuals and performs mortgage loan servicing. In addition, C-BASS issues mortgage-backed debt securities collateralized by mortgage loans and mortgage securities.” C-BASS is joint ventured owned 46% by MGIC, 46%, by mortgage insurer Radian, and 8% by C-BASS management.

Continuing from the 10-K: “C-BASS’s results of operations are affected by the timing of these securitization transactions. Substantially all of C-BASS’s mortgage-related assets do not have readily ascertainable market values and, as a result, their value for financial statement purposes is estimated by the management of C-BASS. This valuation is made by C-BASS management in connection with each release of financial statements. In the case of assets that are residual interests in securitizations, these estimates reflect the net present value of the future cash flows from these assets, which in turn depend on, among other things, estimates of the level of losses on the underlying mortgages and prepayment activity by the mortgage borrowers. Market value adjustments could impact C-BASS’s results of operations and the Company’s share of those results.”

C-BASS ended 2001 with assets of $1.3 billion. From FitchRatings: “C-BASS’s general business strategy involves targeted investment in “scratch and dent” subperforming and nonperforming whole loans, subprime whole loans, subordinate RMBS, and servicing rights... C-BASS’s 29 securitizations to date include a variety of residential mortgage collateral products, with deals involving subprime product, including C-BASS CBO I, C-BASS CBO II, and C-BASS CBO III. C-BASS always retains the subordinated risk interests in its securitizations...C-BASS’s current access to financing totals more than $1 billion, including a commercial paper vehicle, subordinated debt, and more than $1 billion in committed secured facilities.”

In our view, C-BASS is the epitome of what we don’t like about the current environment. First of all, MGIC, with its $195 billion mortgage insurance exposure ($3.2 billion of shareholder’s equity), is a key player in a stressed U.S. financial system. With company Credit losses escalating, along with the significant risk of a serious downturn after years of extreme mortgage finance excess, MGIC should today be building loss reserves and paring risk in non-core insurance businesses. They are doing the opposite. They are aggressively buying back stock, skimping on reserves, and raising their risk profile significantly with the aggressive growth of ventures like C-BASS.

C-BASS, formed in 1996, acquires subprime and non-performing mortgage/MBS, credit card, manufacture housing loans, and other very suspect Credits. It then creates special purpose vehicles (CDOs/collateralized debt obligations) and issues asset-backed securities (mostly top-rated securities). C-BASS retains the “subordinated interests” in its securitizations, meaning it keeps the difference between the interest paid to the holders of the securitizations and the cash flows received from the risky portfolio – while protecting the (senior) securitization “tranches” by accepting the first risk of large defaults. In the event of larger than expected portfolio losses, little interest (cash flow) would be available for C-BASS after the holders of the securitizations are paid. The value of their residuals would suffer accordingly. As a leveraged player in high-risk assets, such an entity could see its access to finance constrained in a tumultuous environment.

We mention C-BASS this week because it is a rather interesting example of “mark-to-model” – or where management determines that value of highly volatile and uncertain securities. Owning 8% of the company, C-BASS management would be expected to have an incentive to accept rather optimistic estimates for future defaults and Credit losses. Such optimistic assumptions can have a tremendous impact on the calculated “gain on sale” at the time CDOs are structured and securitizations sold (the net present value of residuals over the long-life of the portfolio) and the value of held residuals. These gains, then, become especially attractive to MGIC and Radian now dealing with rapidly rising Credit Losses.

C-BASS has been an especially eager issuer this year, with more than $700 million securities sold. We certainly don’t believe it is wise today to be aggressively taking “subordinated interests” in highly risky subprime Credits, and we would be suspect of gain calculations on these types of residuals. These are exactly the types of contemporary structures that make it too easy to create “profits” that could easily come back as major losses and writedowns in the type of Credit environment we envision going forward. Our concern for the valuation of residual interests in risky Credits is only heightened after the implosion of NextBank, and festering problems at Providian, Metris and elsewhere. While virtually everyone’s attention is directed at punishing corporate wrongdoers, we fear that scant attention is being paid to continued reckless activities throughout mortgage finance. We are especially troubled to see such aggressive risk-taking by the mortgage-insurers. They have more than enough risk already.