Banks, mortgage bondholders, and in our opinion the entire housing market just got a victory. The Senate defeated a bill that would allow judges to modify terms of mortgages in bankruptcy proceedings.

We have been of the opinion for some time that passage of this legislation would throw yet another wrench into tight credit markets and slow the eventual recovery in housing. Why? The end buyers of mortgage securities are one of the most important links in the securitization engine. Securitization (turning loans into bonds) allows mortgage credit to grow and flow freely around the globe. If judges were granted the ability to arbitrarily change contractual mortgage terms, balances, limit foreclosures etc, mortgage bond buyers will be less likely to purchase mortgage based debt in the future. Or, they will simply demand higher interest rates to compensate for the increased risk of a third party changing the terms of their bond during their ownership.  This of course will raise  mortgage costs,  and slow the flow of capital, and continue to depress home prices even further.

Warren Buffet said, “Be greedy when people are fearful and be fearful when people are greedy.” Implicit in that statement is what good value oriented investors have always known. When people get greedy and bid prices higher, the potential rate of return goes down and risk goes up. When investors are fearful and selling assets wholesale, a margin of safety exists and the potential for higher returns rises.

Is there a way to measure the price of risk or level of fear in the market place? At Berkshire, we have felt for some time the stock market tends to be a little more manic and irrational than the credit markets. Therefore, we look to certain credit indicators to attempt to quantify either the level of fear or the level of complacency in the market.

Credit Default Swaps: A Useful “Fear Barometer?”
One good method to calibrate the “price of risk” is to observe the action of credit default swaps. Credit default swaps are derivative instruments that act like insurance policies on the debt obligations of major companies. In a typical swap transaction, an owner of a bond seeking to insure it pays a premium (usually as a % of the amount insured) to the seller of insurance (known as the counterparty). If the issuer goes bankrupt, the seller of the insurance is obligated to pay the principal and interest. While swaps are technically private contracts (not securities) and trade over the counter, the market for swaps is vast, highly liquid and the quotes on premiums are readily available.

Below is an illustration of what it has cost over the last 12 months to insure various obligations of debt of various brokerage firms. Brokerage swaps are good proxies for fear in the market, since many of these firms are right in the center of the credit crisis.

Source: Bloomberg Finance, LP.

As early as June 2007, when all was quiet on the housing front, it cost less than one half of a percent to insure debt from the likes of Lehman, Merrill and Bear Stearns. Swaps indicated investor complacency and low returns for the risks which were about to ensue. When Bear Stearns announced it needed to declare bankruptcy, the cost of insuring debt skyrocketed to over 700 basis points (7%). In sympathy, Lehman widened to over 400 basis points (4%) and Merrill to over 300 basis points (3%). It was much like the aftermath of Hurricane Katrina, whereby insurers demanded huge premiums to insure against future hurricanes. In this case, the swaps provide insurance against financial hurricanes (provided of course the counterparty makes good on his obligation). Markets have quieted since then and much of the panic appears to have left. While not a perfect indicator (swap markets can go berserk too!), observing trends can yield clues into market sentiment.

High Profile Wall Street Clash
A careful observer of the chart will notice that swaps tied to Lehman’s debt has started to spike back out, meaning, counterparties are getting nervous and demanding higher insurance premiums to insure the debt. Why? In what has all the trappings of great Wall Street theatre, hedge fund manager David Einhorn, who is known for detailed research has called into question the accounting practices of Lehman Brothers. At the Ira W. Shohn Investment Research Conference he gave a speech titled “Accounting Ingenuity” and he outlined why he is short the stock. Lehman’s stock declined 2.7% after Mr. Einhorn’s remarks.¹

In addition to his short position, (as of May 21, 2008) his comments have also been directly pointed at Lehman’s high profile CFO, Erin Callan. Two well respected titans of finance are going head to head. Both have been quite candid in their views.

Mr. Einhorn has claimed that Lehman is not being generous enough in its write down of certain Collateralized Debt Obligations. Mr. Einhorn questions how during the peak of the credit crunch, Lehman’s portfolio of $6.5 billion CDO’s (of which 25% are rated below investment grade) could be written down by only $200 million. Mr. Einhorn also contends there is a discrepancy in the reconciliation of Lehman’s level three assets between the conference call on March 18 and the filing of the 10k 8 weeks later. One indicates a loss of $875 million and one shows a gain of $228 million. Mr. Einhorn also questions how Lehman’s level three assets of corporate equities can post a $722 million dollar gain during a quarter when the stock market was down 10%.

Ms. Callan has been highly vocal and aggressive trying to assuage investor concerns about Lehman’s financial health. Lehman vehemently rebuts Mr. Einhorn by saying he takes certain data points out of context and spins them into a position that self fulfills his short position in the stock.

Mr. Einhorn’s research is not always correct. At one point he was vocal in advocating ownership in New Century Financial, a subprime mortgage company which went bankrupt. Mr. Einhorn is also currently promoting a new book: “Fooling Some of the People All of the Time: A Long Short Story.”²

How the markets digests the reality of Lehman’s financial picture has broad implications. At a base level, markets run on confidence, and it was the loss of confidence that sent Bear Stearns spiraling downward. Swap spreads exploded which made it very expensive to hedge paper issued by Bear. Unable to raise more capital, the leverage started to unwind and the viscous cycle started to feed upon itself. The markets could ill afford another torpedo to a venerable firm like Lehman. So who is right – Mr. Einhorn or Ms. Callan? Lehman reports earnings the week of June 18th. The swap markets are already tuning in.
Gerard Mihalick, CFA

¹ The entire text of Mr. Einhorn’s remarks, which is quite interesting, can be found at http://foolingsomepeople.com/main/about-david/recent-talks.html
² David Einhorn, Joel Greenblatt (Foreword by); Fooling Some of the People All of the Time: A Long, Short Story, Wiley, John & Sons, Incorporated, May 2008.

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