Monday, June 30, 2008

Sir, monolines coming into our sector!

It hasn't been a great year for monolines, and Pershing Square Capital's Bill Ackman has been one of the main beneficiaries. He's famously made a kings ransom shorting MBIA, betting that losses on collateralized debt obligations and other asset-backed securities would eventually drive MBIA bankrupt.

But now he's set his sights on far more conservative Financial Security Assurance (FSA). As FSA is wholy owned by European banking giant Dexia, there is no stock to short. Instead Ackman has bought credit default swap (CDS) protection against FSA defaulting on its insurance obligations. Currently FSA is rated AAA/Aaa/AAA by S&P, Moody's, and Fitch respectively with a stable outlook by all three.

Ackman's revealed his position at a conference in New York on June 18. The market paid attention. The next day CDS on FSA had moved 200bps wider to 700bps/year for protection. It rallied into the 400bps area two days later when Dexia extended a $5 billion credit line to FSA, but has since moved back into the 700 area. For context, this morning Lehman Brothers CDS was +280 offer, Washington Mutual was +585. To get into the 700 area you have to look at names like National City.

Does FSA belong in the same category as Ambac and MBIA? I'm going to explore this in two parts, first on the liability side, then on the asset side. Here are the raw facts on insurance liabilities.

The following chart details the direct residential mortgage (RMBS) exposure from MBIA and Ambac (blue bars) and FSA (red bar). Each is expressed as a percentage of the firm's total claims paying resources. So for example, Ambac has exposure to home equity lines of credit at 216%, which means that if their entire HELOC exposure went to zero, the firm would exhaust their claims paying resources two times over. The figures are from S&P and the companies themselves.

So looking at this, FSA is no better than its more troubled competitors. However, when it comes to direct RMBS exposure, the story isn't quite as dire as it would initially seem. The monolines' generally insured senior positions in RMBS deals, meaning that other securities would absorb losses first. For example, FSA states that their typical subprime RMBS transaction has 20% subordination and 7% excess spread, or excess interest collected by the trust for benefit of senior bond holders. In their first quarter earnings release, FSA estimated that more than 45% of all subprime borrowers would have to default (in a given deal) in order for FSA to pay a single dollar in claims.

Will any transaction suffer 45% defaults? Some probably will, but all of them won't. And the second lien transactions (both closed-end and HELOCs) will likely enjoy no recovery upon default, so those loss severities will be worse. On the other hand, the monolines have the luxury of making payments on RMBS losses over time, i.e., there is no large principal payment which would come due all at once. So RMBS losses will be substantial to be sure, but its probably manageable. But that's not where the really big problem is.

The big problem is in collateralized debt obligations (CDOs).

The key to the CDO creation game was to create the maximum return to the equity holder while still earning a AAA rating for the senior-most holder. In creating CDOs using RMBS as collateral, the arranger generally used subordinated securities. And by subordinated, I mean the first ones to take losses when the underlying borrowers default. Today it is widely assumed that most subordinated sub-prime securities won't receive any principal at all, and many subordinated prime RMBS will suffer significant impairments. So a CDO made up of these subordinate securities, even the senior-most piece of the CDO, is likely to incur large losses.

Which brings us to our second chart, RMBS CDO exposure, again as a percentage of claims-paying resources.

The reality is that most of these RMBS-oriented CDOs are going to take losses of 30% or more. CDOs alone will likely sap the resources of Ambac and MBIA. But FSA's exposure to this sector is nominal. Even if they were to take 100% losses on their RMBS CDO portfolio, the impact on their solvency will be minor.

Remember that FSA is a subsidiary of Dexia, and therefore Ackman's bet isn't on the common stock. In the case of MBIA, Ackman was able to short the common. Even if MBIA is somehow able to pull through as a solvent company, Ackman's gains on shorting the stock will still be substantial. With FSA, he's long CDS protection, which only pay off in the event of a default, so Ackman's bet is not on a decline in profitability or loss of AAA ratings, but on bankruptcy. In fact, FSA could lose its AAA ratings and Dexia could give up on the financial guaranty business and put FSA into run-off, and as long as FSA never runs out of cash, Ackman's CDS will expire worthless. Sure, Ackman could gain on CDS widening. Maybe he's already cashed in his gains on FSA. But given the already wide spread on FSA CDS, if FSA doesn't have liquidity problems, it will be an expensive short.

The facts on the insured side just don't support FSA going the way of MBIA or Ambac, particularly when you limit the discussion purely to solvency. Next up, a look at FSA's investment portfolio. (Hint, that doesn't look as rosy.)

Wednesday, June 25, 2008

Economy to the Fed: I thought I told you to remain on the command ship

The Federal Reserve is set to announce its rate decision today, and is broadly expected to hold their Fed Funds target rate steady at 2%. However, despite the weak economic growth picture and continued pressure on the banking system, most traders now expect the Fed's next move will be a rate hike. Energy and food prices are creating substantial inflation, and the Fed must snuff it out, so the argument goes. Futures on Fed Funds suggest about a 40% chance of a hike at the August meeting, with at least one hike fully priced in by the December meeting. Indeed the 2-year Treasury yield, trading around 2.90%, suggests an aggressive path of Fed rate hikes in the near future.

Would the Fed hike rates with the economy growth and employment picture so weak? Their recent rhetoric would suggest they would. Nearly every speech by Federal Reserve board members and regional presidents during June has mentioned the problem of inflation expectations. Inflation expectations can be a self-fulfilling prophesy, and the Fed must act to prevent such expectations from becoming ingrained in consumers minds. In the late 1970's, as inflation ballooned, expectations for inflation became unhinged, forcing the Fed to tighten monetary policy in an unprecedented way, creating two recessions in the process.

The comparison between the late 1970's and today are particularly chilling. Both periods saw rising energy prices and a stagnant economy. Are we reliving those times?

A look at the correlation between the change in the overall price level (measured by the consumer price index (CPI)) vs. the same measure excluding food and energy (Core CPI) is revealing. If food and energy prices are rising because of loose monetary policy or the weak dollar, then the Core and total CPI figures should rise and fall at the same time. In other words, the correlation will be high.

1970 to 1982, was a period marked by predominantly rising energy costs. The "energy" portion of CPI rose at an annualized rate of 12.1% during this period. The correlation between total CPI and Core CPI was 72.7% when measured monthly and 89.5% when measured annually. Note that a perfect correlation of 100% would suggest that core and total CPI always moved in tandem, whereas a correlation of zero would indicate no relationship between the two figures.

1983 to 1999, was a period of mostly falling energy prices. During this period, energy CPI was a mere 0.1% on an annualized basis. Yet the correlation between total and Core CPI remained relatively high: 58.5% monthly and 85.8% annually.

So over a period of three decades, it was rare that a move in Core CPI would not be mirrored in headline CPI. If one was elevated, the other was elevated. If one was tame, the other was tame.

However, the 21st century hasn't followed the same pattern. From 2000-2008, the correlation between total CPI and Core CPI has broken down: only 7.6% measured monthly and 21.4% measured annually. This despite the energy portion of CPI rising at a 1970's style 9.5% annualized. During the current decade, there has been no particular relationship between total inflation and core inflation.

What does this mean? The data is telling you that rising energy and food prices have been due to supply and demand conditions in those markets. Not classic inflation, which is a monetary phenomenon. In other words, rising oil is indeed due to strong demand from emerging markets and a lack of new supply. Not the weak dollar or loose monetary policy.

The Fed can't do anything to create more oil or temper demand from China. The Fed can only influence the money supply. For the Fed react to a non-monetary phenomenon with a monetary response would be a colossal mistake. Especially when the economy and banking system are as weak as they are.

So the Fed will talk a good game to try to keep inflation expectations low. They might even hike by 25bps to keep inflation expectations under control. But a long series of hikes? No way. Not until the economic growth picture is improving.

This makes 2 to 5 year bonds very attractive, especially for investors holding large money market positions. 2-year Agency bonds are yielding over 3.5%, and 2-year municipals are in the 2.6% area. Both promise to out-yield money markets easily over the next two years should the Fed remain mostly out of the picture.

Sunday, June 22, 2008

Moody's Global Scale: The last remnants of the old ratings have been swept away

Bowing to significant political pressure, Moody's is set to change the way they rate municipal bonds. The change will result in thousands of upgrades, some perhaps many letter grades higher.

Historically, Moody's municipal bond ratings talked and walked like its ratings for other types of bonds: corporates, asset-backeds, etc. The top rating was Aaa, the lowest investment grade rating was Baa3, and so forth. But the default and recovery performance of municipals has been vastly different than other bond categories. For example, according to Moody's, between 1970 and 2006, about 1.3% of A-rated corporate bonds suffered a default within 10-years of issuance. However, only 0.03% of A-rated municipal bonds suffered defaults over the same time period. The ratings results were not even consistent within municipal bonds. Among Moody's rated general obligations (bonds backed by the full taxing power of a city, county, school district, or state) there was exactly one default from 1970 to 2006, whereas 0.4% of other municipal bond types defaulted.

Moody's has admitted that their municipal ratings aren't comparable to corporate or ABS ratings. However, in the past Moody's had contended that municipal bond investors appreciated the gradations of credit quality afforded by the municipal ratings scale. If Moody's used nothing but default expectation, virtually all general obligation municipals would be rated Aaa. It stands to reason that municipal investors value the differential between A1-rated California, Aa3-rated New York, and Aaa-rated Virginia. Something would clearly be lost if all three were rated Aaa.

However, recent stress in the municipal bond market has brought politics into the discussion. From auction-rates to bond insurers, the perceived safety of municipals has taken a hit. The collapse of several tender-option bond programs (a popular hedge fund strategy involving municipals) has dented demand for munis. More behind the scenes, municipalities are finding Wall Street less hospitable than in hears past. Bond insurance and bank letters-of-credit have become considerably more expensive. Wall Street firms are not as willing to buy bonds for their own accounts, increasing the cost of issuance.

Politicians, lead by Congressman Barney Frank and California Treasurer Bill Lockyer have been pressing the credit ratings agencies to rate municipal bonds based on expected loss only. A June 12 press release from the California Treasurer's office reflects the argument proffered by the issuers: "Lower ratings [for municipal bonds] have cost taxpayers billions of dollars in higher interest rates and bond insurance premiums." The theory is that there is a direct correlation between the ratings and the interest rate paid by the issuer.

At the same time, Moody's and Standard & Poors are facing serious (and well-founded) claims of conflict of interest relating to CDO ratings. Moody's seems to have made a political calculation: it can't go back and re-rate CDOs, but it can give Barney Frank what he wants with municipals.

Investors should care for two reasons. First it appears that most municipal bonds will soon be upgraded by Moody's. It is not currently clear what the timing of the ratings revisions will be, but Moody's has previously published a guide to "mapping" municipal credits to the Global Scale. For direct obligations of States, anything rated A1 or higher on the muni scale would be Aaa on the Global Scale. That means every state would be Aaa except Louisiana. For other general obligations, including cities and counties, anything rated Aa3 or better would be upgraded to Aaa. A general obligation bond rated Baa3 would be upgraded to Aa3. Even riskier credits like hospitals would enjoy at least a 1-2 notch upgrade, according to Moody's mapping. (The complete report is available here, requires a free registration.)

That should be a near-term positive, especially for middle-rated credits. There is significantly more demand for A and Aa-rated bonds than for Baa-rated securities, owing largely to legal or policy restrictions. There might not be much immediate effect, particularly until S&P follows Moody's lead. But over time, expect liquidity and the spread for the upgraded bonds to improve. Also, expect S&P to follow suit. S&P faces the same political pressure as Moody's, and now that Moody's has made the move, S&P will be all but forced to acquiesce.

There is a likely negative, however. The high ratings standards for municipals encourages some measure of fiscal conservatism. This is especially true for Aaa-rated credits, where loss of the rating would be politically embarrassing. Of course, municipalities are downgraded all the time, but clearly local politicians would rather maintain their rating than not. If the overwhelming majority of general obligation issuers are going to be rated Aaa anyway, that incentive is greatly reduced. In other words, a state like Georgia (rated Aaa) is currently incented to maintain its austerity. But if they could slide all the way down to California's level (currently A1) and still be rated Aaa, they'll probably do it.

Thursday, June 19, 2008

I'll come right back and give you a hand!

Bill Ackman has gone long FSA CDS, in effect betting that FSA will go bankrupt. Its moved 200bps wider today (now 645/695). I want to write a detailed post comparing FSA, Ambac, and MBIA, so that's coming. But in the mean time, does anyone have anything more detailed on Ackman's case against FSA? If so, e-mail me: accruedint at

Ackman was obviously right about MBIA, but I have long contended that he's been getting too much credit for calling MBIA early. Some readers may remember he was short MBIA at Gotham Partners going all the way back to 2002, before MBIA was heavily involved in the shit that ultimately dragged them down. Don't get me wrong, kudos for him for all the money he's made on MBIA. I just bristle when I hear something like "he's been right about MBIA since 2002." His thesis from 2002 was wrong. His thesis in 2007 was dead on.

In other news, I've been contemplating some upgrades to the site, one of which would be to start using labels. Vote in the latest poll if this interests you.

Wednesday, June 18, 2008

Credit Default Swaps: All craft retreat!

Credit-default swaps (CDS) pose the greatest systemic risk to the worldwide financial system. Housing and oil may be what's pushing the U.S. into a recession currently, but the economy has a way of dealing with these kinds of shocks. Were the CDS market to suddenly collapse, it would truly threaten the very existence of the financial system.

Unfortunately, many commentators are focused on the wrong things when discussing risk in the CDS market. So let's look at what CDS are, what they are not, and why they pose such a risk.

A CDS is very much like a put on a particular credit. If a company defaults on its debt obligations, owners of CDS protection can, in effect, sell one of the defaulting company's bonds to the seller of protection at full face value. This is similar to an equity put, which gives the owner of the put the right to sell the stock to the seller of the put. Both a long CDS position and a long put position express a bearish view on the underlying security. Both can be used to hedge long exposure to the underlying.

Unlike equity options, CDS trade over-the-counter, where the CDS counter-party is an investment bank. This makes buying CDS protection a little like buying insurance: its only as good as the insurer.

So what happens if a major investment bank fails? The direct effect would be painful, to be sure, but probably not enough to threaten the system. Had Bear Stearns, for example, declared bankruptcy, any CDS with Bear as the counter-party would be worthless. Banks and others using CDS to hedge would need to either buy new CDS from another counter-party or risk going unhedged. As market conditions during the near collapse of Bear Stearns in March indicated, the cost of buying CDS protection would be elevated under such circumstances.

For example, imagine a bank has extended a credit line to Boston Properties (an office REIT). CDS on Boston Properties currently costs 115bps/year. Right around the Bear Stearns bailout, the same CDS was around 250bps/year. Say the bank bought CDS to protect against the REIT defaulting at 115. Subsequently a major investment bank runs into serious liquidity trouble. While nothing particular is happening with Boston Properties, the CDS widens to 250 due to contagion effects. That move in spread would result in approximately 6% gain on the CDS hedge for the bank. If the bank had bought $5 million in notional protection, they would be showing a $300,000 gain on the hedge. This means that if bank's counter-party were no longer solvent and the CDS deemed worthless, the bank would have "lost" the $300,000 gain. Put another way, if the bank were to replace the hedge at the former annual spread, it would cost $300,000 up front.

The notional value of all CDS is an oft-quoted figure, currently around $62 trillion. But its the replacement cost of the CDS that matters. In the above example, the bank wouldn't lose the $5 million notional protection unless Boston Properties went bankrupt simultaneous to the CDS counter-party. Moody's has calculated the replacement cost of all CDS outstanding at about $2 trillion. Given that the top 5 investment banks dominate the CDS market, the failure of any one bank would cost CDS holders hundreds of billions.

But it doesn't have to be that way.

For every long CDS position there must also be a short position. For every buyer of credit protection, there must be a seller as well. The overall net exposure to CDS is zero. That fact should be comforting, but alas, no single investment bank is net zero.

For example, a bank might buy protection from Merrill Lynch, leaving Merrill net short. Merrill might then look to cover their short by going long with Goldman Sachs. Goldman is now short, so they cover by buying protection from Bank of America. The system remains net zero, but each of those trades involve separately enforceable contracts. If any of the contracts are rendered unenforceable due to bankruptcy, it creates a problem.

Why should we tolerate this systemic risk when CDS trading could be centrally organized? Why not create a single counter-party which would always and forever have net zero exposure? In other words, why not force CDS trading to an exchange?

It couldn't be accomplished overnight. The exchange would need to be capitalized, customer margin requirements determined, as well as further homogenization of CDS contracts before the exchange would be possible. None of these problems are insurmountable. And the benefits to the system would be enormous.

When J.P. Morgan and the Fed bailed out Bear Stearns, many were concerned about the precedent set, as well as the moral hazard of creating an assumption of future bailouts. But the massive CDS counter-party exposure Bear had forced the Fed's hand. The Fed will not and cannot allow the system to fail. If we want to avoid Fed interference and the subsequent moral hazard, the best thing to do is to improve the system. A central CDS exchange would be a major step in the right direction.

Thursday, June 12, 2008

News! on the March!

Obviously the Lehman story is dominating headlines. Lehman CDS has been all over the board this morning. I've seen it quoted as wide as +310 immediately after the news, most recently saw +270. For color, Lehman CDS hit a recent low of +135 on May 2 and was as wide as +450 on March 14. Those are closing levels not intra-day. Its been trading between 250 and 300 for the last several days.

The lack of contagion trading, at least at the open, is facinating. You've got Treasuries down, dollar stronger, swaps tighter, stocks higher. On one hand, you could say lower oil and stonger retail sales matters more than Lehman. You could also argue that Lehman's survival is all that matters to the broader market. Whether or not Lehman can grow their stock price is of no moment.

Still, I'm skeptical and would rather fade the rally.

New bond issue to watch is SLM Corp. 8.45% 2018. Sold initially at a dollar price of $98.03 or a spread of 465 over the 10 year. Sallie has been trading on dollar price for a while now, but not surprisingly has traded much stronger after Congress agreed to buy student loans from originators. Anyway, SLM was one of the poster children from the liquidity crisis, and this new issue may jump start activity in the name. (I'm long SLM, full disclosure). Anyway, the new issue was bid at $98.5 early this morning. Haven't seen any actual trades yet.

Wednesday, June 11, 2008

LIBOR our only hope? No... there is another!

ICAP's, the largest broker of inter-lender transactions, has developed their own measure of U.S. inter-bank lending rates, ostensibly to supplant LIBOR. The first survey of New York banks was conducted today, and resulted in a 3-month rate 1.7bps lower than LIBOR.

Backing up a minute, LIBOR is supposed to be a measure of where very large and highly rated banks can borrow. Recently the accuracy of LIBOR has been called into question, some have gone to far as to say manipulated. U.S.-based banks in particular have complained that LIBOR, as currently constructed, is destined to fail as an accurate measure of U.S. lending rates.

This is because LIBOR is set by surveying 16 banks as to where they think they could borrow in U.S. dollars for various terms ranging from overnight to 1-year. Of the 16, only 3 are actually American: Citigroup, J.P. Morgan, and Bank of America.

Enter ICAP. Their survey will involve U.S. firms only, and will ask where the bank would lend to a un-named A1/P1 borrower for terms of one and three months. Called the New York Funding Rate (NYFR), it was set for the first time today at 2.4646% for one-month and 2.7715% for three-months. LIBOR reset today at 2.47688% and 2.78813%. Both are a little better by 1bps in the ICAP survey.

So what does this mean? LIBOR has been rising, from about 2.64% in late May to its current 2.79%. That 15bps does not reflect an increased probability of Fed hikes, at least not entirely. It reflects continued concern over the health of banks.

The fact that the NYFR was set lower would indicate that U.S. inter-bank liquidity is slightly better than in Europe. This is consistent with a widely held view that the risks in U.S. banks have been better disclosed when compared to their European counter-parts.

The swaps market reacted favorably, with 2-year swaps falling by 2bps and the rest of the stack falling by about 5bps.

In my opinion, fear about LIBOR is yesterday's news. The Fed has supplied access to tremendous liquidity to both banks and primary dealers. As a result, the jump-to-default risk has been greatly reduced. But that hardly leaves me bullish on banks or brokers. Today's market troubles are about a real lack of earnings power among financials. Take Merrill's downgrade of Lehman Brothers today. The analyst (Guy Moskowski) said...

"We expect LEH to survive because its liquidity profile is strong and the Fed discount window is open... but current business and asset mix are just not well positioned for the current environment."

I think you could insert dozens of bank/broker tickers into that sentence. He also discusses Lehman's book value (currently $33/share) but with little earnings growth in the near term, why would anyone pay close to book for the stock?

My point is that rising LIBOR was more about jump-to-default risk, which I think has abated substantially. So that's yesterday's problem. Today's problem is that banks have plenty of credit losses coming and so that will be tying up capital. They can't be turning in strong earnings if they are using capital on REOs. They also are facing weaker net-interest margin should the Fed start hiking rates.

Now I'd have to think that if I could look into a crystal ball and know for a fact that Lehman Brothers would survive as an independent entity one year from now, then I'd bet the stock would be a good bit higher. I'd say the same think about National City or Washington Mutual or CIT. But the odds are fair that each of those firms will seek a stronger partner sometime in the near future, and the merger price won't make the stock worth owning.

Tuesday, June 10, 2008

How are bonds quoted?

By popular demand, welcome to yet another installment of Accrued Interest's How To series. This is on the subject of how bonds and various bond instruments are quoted. We'll go from the simple to the complicated, and even include a few derivative products. I know we get some readers who are primarily equity people, but lately have been trying to pay more attention to the bond market.

The Very Basics
Bonds pay interest based on a par amount. For example, if the coupon is 5%, it pays that 5% based on the par amount of the bond. The par amount is also the amount that the bond will pay at maturity. You could think of it as the principal of the bond.

When a bond is quoted in a dollar price, that price is a percentage of par. So a bond price of $104.312 is really 104.312% of the par amount.

Treasury Bonds
Unlike every where else in the world, the U.S. Treasury market still trades in fractions. It is assumed you know this when the bond is quoted, so you'll see it written as something like this...


That means that the bond's price is 98 and 4/32's, or 98.125% of par. Sometimes there is also a + added to the end. The + is worth 1/64. So if the price is 98-4+, that's 98 and 4.5/32. If you watch Bloomberg you may see yet more fractions thrown in there too. If you saw 98-4 1/8, that would be 98 and 4.125/32. In bond parlance, 1/32 is a "tick."

Treasury bills are quoted on a discount basis. I'm not going to get into this in deep detail, suffice to say that it isn't the same as a yield, but its usually in the ball park of the yield.

For the most part, TIPS and Agency MBS are also quoted in this manner.

Other bonds, when quoted in dollar price, are in fractions, but other than municipals and high-yield bonds, most other bonds are quoted in spread.

Bond Spreads
Plain vanilla agency and investment-grade corporate bonds typically are quoted on spread. Most commonly they are quoted based on the yield differential between the bond in question and the nearest benchmark Treasury in basis points. A "Benchmark" Treasury is the most recently auctioned Treasury of a certain maturity. Currently there are 2, 5, 10, and 30-year "benchmarks."

It is usually assumed you know what the benchmark is for a bond, but its not always obvious. For example, the HSBC 5.25 of 4/15 (That's an HSBC bond with a 5.25% coupon, maturing in April 2015), is generally quoted off the 10-year Treasury, not off the 5-year. Why? Who knows? The street tends to like to make bonds look tighter, and since the 10-year currently yields more than the 5-year, they tend to like to keep stuff against the 10-year as it ages.

Floating rate bonds trade on what's called a "discount margin" or the spread to the bond's floating index. If the index is 3-month LIBOR, the bond will be quoted on a spread to 3-month LIBOR. When calculating the dollar price, it is assumed that LIBOR resets at its current rate at next reset and then remains there for life.

Some fixed-rate bonds trade on a spread to "swaps." This can be indicated as N+(number) or S+(number) depending on what it is. CMBS usually trade this way. The "swap" rate is the rate on the fixed-leg of a plain-vanilla interest rate swap. Bloomberg calculates an interpolated swaps curve and this is what's usually used for pricing bonds. Bloomberg pretty much rules the bond world, in case you haven't noticed.

By the way, swap "spreads" are the difference between the swap rate and the corresponding Treasury rate. Since interest rate swaps almost always have some highly-rated financial institution as the counter-party, the swap spread rate is a good gauge of perceived credit risk of very highly-rated banks.

Municipals are usually just quoted in dollar price or yield. If you do see a spread, its probably versus the Municipal Market Data curve, or MMD. This curve only updates at the end of every day. Muni guys aren't the quickest of people...

Agency mortgage-backed bonds sometimes trade on a "To Be Announced" basis or TBA. Remember that MBS are backed by actual loans made to actual home owners. So its common that a lender would like to lock in the rate they can offer borrowers by pre-selling their loans to investors. Hence the TBA market.

Since most fixed-rate MBS are eligible for TBA delivery, bids and offers on specific pools trade on a spread versus TBA. For example a "seasoned" pool (or one that is older) might be more valued by the market than generic pools, and therefore more expensive. The spread is expressed not in yield but in dollar price difference, usually in ticks. So a seasoned pool might be +8 to TBA, or 8/32 more in dollar price than the generics.

Hybrid-ARM MBS trade on a Z-spread basis. This is a spread to the interpolated spot curve as calculated by Bloomberg. When calculating this it is assumed the bond will pay 15 CPR until the reset date, no matter what the coupon or structure. Its kind of stupid but that's what's done.

Callable Bonds
Bonds with call features, most common with munis and agencies, are often just quoted with a yield instead of a spread. The yield quoted is the lower of the yield to maturity or yield to call, called yield to worst.

Sometimes agencies are quoted on an OAS or AOAS basis. OAS stands for "option-adjusted spread." On most callable bonds, the OAS is calculated against the LIBOR curve, but it could be calculated against anything. Common buyers of callable agencies include many yield-sensitive buyers, i.e., people who don't care about spreads, only about straight yield. Banks and credit unions are great examples. Hence callable agencies are more often just quoted on yield than other bonds.

Agencies which are callable on a single day only are quoted on an AOAS basis. Suffice to say this is an OAS curve based on Bloomberg's calculation of the agency curve itself.

Credit Default Swaps
CDS are quoted one of two ways: either as a spread or as "points up front." I won't go into the nitty gritty of CDS here. (I wrote more extensively about how CDS work here). Suffice to say that the buyer of a CDS is buying insurance against default. That buyer typically pays a percentage of the notional amount protected, which is the spread quoted. So if Lehman Brothers is quoted as 260, that means to buy protection on $1 million, you must pay $26,000 to the seller of protection each year. The payments are actually transmitted quarterly.

High yield bonds often trade as points up front. To buy protection on Ambac, for example, you have to pay 30 percentage points up front and 500bps per year. The quote would only reference the points up front, the 500bps is a given. The points paid up front is akin to the discount a cash bond would be trading at given a 5% coupon.

Unless otherwise stated, CDS quotes are for a 5-year term.

Hope that helps. If anyone has any other types of bonds that I haven't thought of, please post a comment or e-mail me accruedint at

Sunday, June 08, 2008

Monolines and Bank Write-downs: I wonder if your feelings on this matter are clear

The most important question regarding yesterday's downgrade of Ambac and MBIA is obviously not about munis but about ABS and CDOs. As readers undoubtedly know by now, banks and brokerages routinely purchased monoline insurance on ABS and CDO transactions. In CDO land, the trade was usually done on the senior-most tranche of the CDO, with the monoline writing a credit-default swap on the trade.

So the question is, what are bank's exposure? Are more writedowns in store? Let's talk this through.

If we assume that banks and brokerages have been correctly following accounting rules, they would have been marking-to-market their CDO exposures all along. Right? Alright, let's look at one of Ambac's uglier bonds in their CDO portfolio. Citation High Grade ABS 2006-1A A1. That's CITAT 2006-1A A1 or CUSIP 17289LAA7 for those who want to follow along on their Bloombergs.

This beauty was originally rated AAA/Aaa, but alas, its fallen on some hard times. On June 2 Moody's downgraded this tranche to B1 remaining on negative watch. The overcollateralization test on the A tranche is currently below 100%. Now I don't actually have offering documents on this bond, but this almost certainly means that the par value of the underlying collateral is now less than the outstanding Class A debt. Note that has nothing to do with the market value of anything. In other words, actual realized losses on the collateral have blown through all subordination. Originally the bond had about 14% subordinate to it, so realized losses are at least that large.

Now this Citation deal isn't as ugly as some others. As of March 31, 55% of the collateral is rated at least AA and another 20% is rated A. Now I hear tell ratings don't mean as much as they used to, but still, a large percentage of the collateral is performing OK.

Still, given the failure of the OC test, we can assume that without any support from Ambac, this bond would in deep doo doo. There is no way this bond is getting more than 75% of its principal back. However, had the market viewed Ambac as favorably as Moody's and S&P apparently did until just yesterday, the bond might still be trading near par. But of course, the markets have not assigned much value to Ambac's insurance for several months now. On top of that, we see that straight AAA-rated home equity paper in late 2006 (which generally speaking is better insulated than this CDO against losses) is trading in the mid 70's, and AA paper in the 30's. Could the bid on this thing possibly be more than $50? With or without Ambac insurance?

So now that Ambac has been downgraded, is there really any difference in the value of this bond? Is there really a lot more to be written down?

Of course, the above discussion has an "IF" the size of Ed McMahon's mansion. That is IF owners of this paper have been properly marking-to-market the paper. What I'm afraid may be happening in some cases is that the bond itself has been marked in the right neighborhood, but the CDS price has been marked as if there actually was a AAA counter-party. So a bank would price our Citation deal at $40 or whatever, but price the CDS contract from Ambac as if there was a large gain in it. Now that CDS isn't worthless, if for no other reason than run-off, but its sure not worth what it would be with Goldman Sachs as the counter-party.

An interesting twist on this story, and one that is probably helping to drive LIBOR and swaps spreads higher the last couple days. The AAA CDO/Monoline CDS combo trade was extremely popular with European banks. Perhaps the next round of big writedowns is coming from the Continent.

Thursday, June 05, 2008

S&P to Moody's: Well, I wasn't gonna let you get all the credit

S&P just downgraded Ambac and MBIA out of nowhere. Both now AA. Its hilarious how much the two ratings agencies parrot each other.

Here is the CDS story (all bid sides)...

Ambac Inc. 33 points (Opened @ 31)
Ambac Insurance 28 points (Opened @ 25)

MBIA Inc. 27 points (Opened @ 25)
MBIA Insurance 25.5 points (Opened @23.5)

Somehow MBIA's stock is actually up a couple pennies as I see it tick by. Stock market overall couldn't care less.

Also Lehman CDS is gapping in, about 50bps tighter right now.

Wednesday, June 04, 2008

Monolines: Let me see you with my own eyes

That snapping sound you hear is the last ray of hope for MBIA and Ambac shareholders. Moody's put both on negative watch today, which tells you a downgrade is inevitable.

On Ambac they say...

Moody's stated that the ratings review was prompted, in part, by concerns about the deterioration in ABK's financial flexibility since the company's $1.5 billion capital raise in March 2008, as evidenced by the substantial decline in the firm's market capitalization and high current spreads on its debt securities, making it increasingly difficult to economically address potential shortfalls in the company's capital position should markets continue to worsen. Additionally, there is meaningful uncertainty surrounding Ambac's ability to regain market acceptance and underwriting traction within its target markets.

On MBIA...
Moody's said that recent mortgage performance data, and MBIA's own reported first quarter results, are indicative of continued deterioration within the guarantor's insured portfolio. As part of its review, Moody's will evaluate the effect that mortgage-related stress, particularly with respect to MBIA's second lien mortgage and ABS CDO exposures, could have on the firm's risk-adjusted capital adequacy position. Moody's said that it will also review other areas of the portfolio that may be susceptible to economic slowdown.

The logical question is, why now? I mean, the marketplace widely discounted either company's ability to remain AAA for several months.

Perhaps the answer lies in their share prices. On MBIA: "...the significant decline in MBIA's stock price since February is making it increasingly challenging for MBIA to economically address capital shortfalls by raising new equity..."

And Ambac: "...the substantial decline in the firm's market capitalization and high current spreads on its debt securities, making it increasingly difficult to economically address potential shortfalls in the company's capital position should markets continue to worsen..."

Moody's also mentioned regaining investor confidence, which "concerned" the ratings agency. Its way beyond concerning. There is no hope of either company ever regaining the confidence of investors so long as there is significant RMBS and CDO exposure.

No further evidence of this is needed beyond the CDS market. Credit default swaps on Ambac's insurance subsidiary is currently bid at 23 points up front and 500bps/year. MBIA is 19.75 points up front. That means that in order to be protected against Ambac defaulting on any of their insurance obligations, the cost is 23% of the amount protected. On 4/30, Ambac was 730bps/year (nothing up front) and MBIA was 710bps.

Now for the so what?

Currently the municipal market puts no value on Ambac or MBIA insurance. Really since at least January. The only value put to Assured Guaranty or FSA insurance is for liquidity, not as a credit replacement. So I don't think this changes much for the muni market. If there is an actual downgrade there may be some forced selling, but from what I've heard, most of those who would be forced sellers have done so already. Because, you know, every one saw this coming.

The impact on financial institutions holding ABS/CDO paper is a little less clear. Before the advent of the TSLF and TAF, the markets were very much attuned to the goings on with MBIA and Ambac. Now that capital is a little easier to come by, it seems as though the markets are less worried about the monoline insurers. Today is a perfect example. The Dow moved from about 12,480 just before the news to 12,402 just after the news. Now 78 points is a decent move in about 45 mins. But compare that to February 22, the day there were mere rumors of an Ambac bailout. The Dow went from 12,155 (down over 130 points on the day) to close at 12,381.

Given that all CDS contracts are supposed to be marked to market, and that ABS/CDO insurance was always done in the form of a CDS, financial institutions should have been valuing those CDS with the counter-party in mind. I guess we'll see how true that is. Looking at the CDS on their insurance arms, the insurance should be considered near worthless.

Of course, not entirely worthless. If regulators deem either (or both) MBIA and Ambac insolvent, they'll go into run-off. Most of the run-off circumstances I'm aware of have been voluntary. As in a company just doesn't want to be in the auto-insurance business or whatever so they put it into run-off. I'm not sure anyone really knows how the run-off of a bond insurer will play out. Currently both MBIA and Ambac have substantial cash and investments, and could likely last in run-off for several years. Maybe even in perpetuity. If any readers have access to research on how the run-off would work, please e-mail me (accruedint at

Meanwhile, MBIA Chief Jay Brown says they might start a new insurer with some of the capital MBIA raised back in February. I can't comment on how this might work legally, but if he could pull it off, it might just work. MBIA isn't such a pariah that they couldn't come back into the market if they managed to shed the non-muni exposure. I dunno what odds to give this, but at least its possible to generate some value to shareholders with such a plan. Ambac seems to be content to stick its fingers in its ears and sing the Star Spangled Banner as oppose to think of anything beneficial to its shareholders.

The bottom line is that we're finally getting to the reality of the monoline situation. They aren't going to be able to generate any new business in their current form. Finally the ratings agencies are acknowledging this. The mask has come off.

(By the way, the relevant lines are... "But you'll die" and "Nothing can stop that now.")

Lehman Brothers: Destructive power greater than half the starfleet

What to make of the fact that Lehman was apparently buying their own stock in the open market yesterday? Who knows. I think its supposed to send a signal that management remains confident, but no one is buying it. What seems more likely is that Lehman is close to a deal to sell shares to a private buyer (Korea?) and was trying to defend the price.

But here is a serious question that I honestly don't know the answer. Lehman reports earnings the week of June 16. Obviously the people directing purchase of Lehman shares have significant knowledge of what that earnings report looks like. We aren't talking about a run-of-the-mill earnings announcement here, where the question is whether EPS beats the street consensus by 2 cents or not. If Lehman has a significant writedown to announce, senior management already knows it. If they don't, management knows this too.

So given all that, why wouldn't this activity constitute insider trading?

Let's say, for the sake of argument, that Lehman actually has much better results coming that people think. Hey, anythings possible right? Maybe they indeed took losses on some CMBS hedges, as has been widely reported, but lucked into some gains on some other hedges. I'm not saying it happened, this is just for discussion.

So if indeed that's what happened, Lehman management is buying Lehman stock knowing it will rise in the near term. Management wouldn't be allowed to buy shares just before earnings for their personal accounts. But somehow the company can buy shares?

It smells fishy either way doesn't it? They are either just trying to prop up the price a little before a large equity sale. Or they are buying shares with insider knowledge.

Anyway, I know we have readers from the SEC and the Fed. And we have lots of other people more familiar with insider trading rules than I. Someone please explain how they are allowed to do this.

Tuesday, June 03, 2008

Lehman Brothers to the Market: Your destiny lies with me!

Our discussion of Bear Stearns' collapse (check out the comments, some really good stuff there) and what may or may not have prevented it is not entirely academic. Witness the trials and tribulations of Lehman Brothers, the new Dark Lord of the Credit Crisis. Today the Wall Street Journal is reporting that Lehman is looking to raise $3-4 billion in new capital, probably via straight common equity. Lehman has come out saying they don't "need" to raise capital, but they aren't ruling it out. If you read the Journal piece closely, you can see that Lehman isn't really contradicting the story. The Journal says...

"The amount of new capital under consideration suggests Lehman's quarterly loss could be larger than the $300 million or so that some analysts have been expecting."

So the possibility of Lehman's loss being exceptionally large is speculation on the Journal's part. Perfectly reasonable speculation, but speculation none-the-less. Lehman's non-denial denial, if it can be believed, only implies that they won't be forced to raise new capital because their losses are so large.

Getting back to Bear Stearns. The preponderance of evidence is that Bear Stearns would have been profitable in 1Q 2008. And yet they were about to be bankrupt mere days before reporting that profit. It is clear that Bear Stearns would have been able to continue operating had they been able to remain liquid.

According to the Wall Street Journal's excellent 3-part series on Bear's collapse, Bear Stearns CEO Alan Schwartz was confused and frustrated by the persistent rumors about his firm. He knew they had big mortgage exposure, but seemed to believe they were strong enough to get through it. But according to the Journal, as early as December, Bear's trading partners were growing uneasy. PIMCO told Bear to raise equity after nearly demanding an unwind of billions in trades, according to the story.

Its downright criminal that Schwartz continued to ignore these warnings. It may have been mere rumors that took Bear down, but Bear (and the Cayne/Schwartz team specifically) stuck their heads in the sand and refused to do anything to quell the rumors. Consider the apparent sequence of events:

  • Trading partners tell Bear they are uneasy and want to see more equity capital.
  • Bear does nothing.
  • It starts getting around the investment community that Bear is too leveraged, but won't raise capital.
  • The conclusion is that Bear's management is either deeply in denial about their condition or they are unable to raise capital.

That sequence is more or less known at this point. Note that even if one were to assume that Schwartz had been right, and Bear did have plenty of cash/hedges to offset mortgage losses, it wouldn't have mattered. Take the most positive possible spin on what seems to have happened next, and Bear is still toast.

  • Bear's lenders hear the concerns that PIMCO and others have. (Again, taking the most positive spin possible) Lenders don't necessarily think Bear is in immediate trouble, but still don't want to be caught as the last ones out if things turn south. Lenders like Rabobank decide not to renew short-term lending programs.
  • Prime brokerage clients, realizing that prime brokerage is a completely fungible service, have all risk and no reward by sticking with Bear. Note that they don't have to be panicking in order to reach this conclusion. If there is a 1 in a thousand chance of a disaster, with no reward for the 999/1000 outcome, why take that risk? These accounts start pulling out.
  • A classic bank run ensues.

But what would have happened if Bear Stearns had bolstered their capital base back in November or December? We'll never know, of course, but there certainly is a pretty good chance their major trading partners and lenders would have felt more comfortable. More confident. And more confidence is all it would have taken.

Back to Lehman. Some readers may remember that in 1998, during the Long-Term Capital Management collapse, Lehman was supposedly teetering. At the time, Lehman took the tact of simply denying the rumors. According to various reports I've read, ten and current Lehman CEO Richard Fuld wants to be more aggressive this time around. The firm has already raised $6 billion in new capital (vs. writedowns of $3.3 billion). Its sounding like whether or not they have big losses to report, they are looking to raise more.

I for one really hope they do. And I hope they do it via straight common equity. Because the more Wall Street accelerates their deleveraging, the sooner the financial system can regain solid footing. Lehman seems to understand that a stable financial system is better for their bottom line, and hence short-term pain of equity dilution will ultimately be in their long-run interests.

I also hope that Lehman and others move to write down what needs to be written down. Bear Stearns collapsed because no one understood what they owned and what risks they had courted. The more Wall Street's stuff gets written down, the less the public will worry about it, and the less chance we'll see another run on the bank.