I got a call last week from Sean Egan of bond rater Egan Jones after I expressed doubt here about his much-bandied-about estimate that the financial guarantors need to raise $200 billion in new capital to keep their AAA credit rating.
Good for Egan. I’ve been known to rag on people a lot on this site; not many contact me afterward with good faith efforts to set me straight. Egan did, with an offer to walk me through how he came up with his number. So I opened my spread sheets, pulled out paper and pencil, and looked forward to an interesting, informative dialog.
Which then proceeded not to happen. After Egan explained his calculation and methodology (which, as you’ll see in a minute, is astonishingly simplistic), his answers to a couple of basic follow-up questions were terse, even defensive. Then the call just . . . ended. The whole thing lasted maybe ten minutes.
That’s it? I sat there dumbfounded. Is Egan Jones’ fixed-income analysis, so often celebrated in the media for its hard-headedness and skepticism, always this shallow? It can’t be. Please, it can’t be.
When it comes to Egan Jones’ assessment of the bond guarantors, here’s what passes for number crunching: Egan told me that he looked at each guarantor’s subprime mortgage and second lien exposure, and simply assumed 30% loss across the board. He then added up his estimates for all the guarantors, and arrived at $80 billion. Then he multiplied that by three, on the assumption that the rating agencies require three times anticipated losses to maintain a AAA rating. Then he took the result, $240 billion, and rounded it down to “over $200 billion” because it was such a big number.
Egan Jones simply can’t do work like this and call it “analysis.” Note, please, what Egan did not do:
He made no distinction by loan vintage.
He made no distinction by underwriter.
He made no distinction by geography.
He made no distinction by loan-to-value ratio.
He ignored terms of subordination embedded in the guarantee.
All of which is to say, he didn’t even do the basic work one would expect of a first-year mortgage-credit analyst. In fact, subprime mortgage credit quality varies enormously depending on factors such as loan vintage and underwriter. Believe me, I know that first-hand, because I’ve spent the bulk of my time over the past few weeks parsing through the subprime securitizations that underlie the ABX indexes of 2006 and 2007. You wouldn’t believe how different the numbers can be among securitizations.
And all that is just the public information that’s available. As a recognized rating agency, Egan Jones presumably has access to information that you and I don’t, that I assume would give him an even deeper understanding of what’s going on. Yet he didn’t rely on any of it—public or non-public.
(For that matter, I’m at a loss to understand where Egan came up with those 30% loss and three-time-maximum loss assumptions, either. Moody’s, who seems to be the most panicked among the three major agencies and has outdone itself lately in coming up with ever-more apocalyptic scenarios, only assumes 21% loss.)
Look, I don’t have a good guess as to where eventual losses will shake out. (Actually, I do, but I’m not sharing it.) But they won’t be anywhere near the level that would force the guarantors to go out and raise $200 billion. (For perspective the consortium of banks Eric Dinallo is pushing to set up a backstop for the monolines seems to think that $15 billion would solve the problem.)
We won’t find out for a couple of years if the firm simply does bad analysis or whether, as is not unknown on Wall Street, its revenue model depends on coming up with a bearish conclusion first and then doing the work second. In the meantime, let’s please stop throwing around this “over $200 billion in new capital needed” estimate. It’s the work of a fantasist.
Tom Brown is head of BankStocks.com.