Mispriced Risk Everywhere You Look

Reinsurance giant Swiss Re is reporting a $1.1 bln loss after insuring swaps.

Swiss Re's credit solutions division had put together protection to insure an unnamed company against a "remote risk of loss" -- a loss that materialized as Standard & Poor's and Moody's Investors Services slashed the ratings of a variety of debt instruments last month and as liquidity dried up in more exotic asset classes.

Analysts on a conference call questioned why a company better known for determining the risks of hurricanes and floods was in the business of providing insurance against market moves -- and how management came to consider the loss possibility as "remote."

Swiss Re emphasized that these were not rogue trades -- "the transactions were approved by the relevant internal risk committees with the appropriate levels of delegated authority," the company said.

The odds of this happening were relatively easy to predict given the lax lending standards in the housing sector that lasted for years. Swiss Re simply miscalculated risk much the same way that Citigroup (C), JPMorgan (JPM), Merrill Lynch (MER), Bear Stearns (BSC), and a plethora of other companies miscalculated risk.

Many companies such as Ambac (ABK) and MBIA (MBI) are still in complete denial of the risks even as shares sink on further write-down fears.

The shares of MBIA and Ambac dropped on Monday amid concerns the two largest stand-alone bond insurers would have to write down assets further after Swiss Re, the world's biggest reinsurer, wrote down similar assets to zero.

"We don't foresee any actual losses in this portfolio, so we would expect this (write-down) to reverse itself over time," said Chuck Chaplin, MBIA's chief financial officer, on a conference call last month.

My Comment: Even though Swiss Re described the possibility of any loss as "remote" those assets were written down to $0. With that in mind, I suggest the possibility of no losses at MBIA is remote.

MBIA has about $6.8 billion of capital and about $130.9 billion of CDO exposure, which is in turn only a portion of its overall portfolio. Write-downs of only a few large deals could wipe out the insurer's capital base. MBIA's shares have fallen 53 percent this year and Ambac's have fallen 71 percent.

My Comment: MBIA is clearly undercapitalized. And they are not alone. It is an enormously deflationary force headed into what figures to be a severe consumer led recession.

"At the end of the day, because I don't believe we can analyze all the risks in their portfolio, opinions on these stocks will be based on your opinion of management, and I think these guys have an incredibly strong track record," said KBW's Dunn.

My Comment: It is stunning that anyone could suggest risks are slight because of track record. In every credit bubble track records are good until they aren't. Look at the stunning track record of homebuilders from 2002-2005. In 2007 those track records went out the window. Indeed, track records are flying out the window everywhere you look: Citigroup, Merrill Lynch, Bear Stearns, etc. The latter had two hedge funds go to zero.

Dunn is making the same two mistakes that every company mentioned above made:

• Placing complete trust in models based on track records and trends over too short a period of time.
• Not understanding the significance of a secular peak in lax lending standards and how that might play out.

Mispriced risk is blowing up everywhere you look. The more interesting facet is the denial by corporations and analysts alike as to what the ongoing risks are.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com
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