More on municipal housing agencies

I got several comments here (and some at Calculated Risk ironically enough) on my post on state housing agencies. So here are some answers...

1) State housing agencies generally use either FHA or one of the GSE's lending standards. So there will be a large number of sub-prime borrowers who will not qualify and won't be helped by these programs.

2) Commenter Ben points out that FHA issuance has fallen off a cliff in the last few years. I mentioned in the original post that state housing agencies have also suffered large declines in their business. Fact is that the "creative" products were just more attractive to classic FHA/housing agency borrowers. Could there be a decent percentage of recent sub-prime borrowers who could have qualified under FHA guidelines but just choose a more creative mortgage? That's where the state agencies can help. How many borrowers? I don't know. But we can all agree the housing market is better off if they can refinance into a new mortgage versus if they go into foreclosure.

3) A commenter at Calculated Risk suggested that in order for this scheme to work, the state housing agencies would have to write off a chunk of loans. Not true. Ohio in particular has a very simple means of limiting its credit risk. After they do a series of loans, they package them and sell them to either Ginnie Mae or Fannie Mae. They use the proceeds to buy regular Ginnie Mae or Fannie Mae MBS securities. Therefore their entire portfolio is AAA/Aaa rated. What that means is that the Ohio agencies won't be writing off anything.

4) I mentioned that a primary reason why housing agencies can offer sub-prime borrowers below market rates or down payment assistance is that they enjoy a tremendous funding advantage over other lenders. This funding advantage exists even if the agency has to issue taxable bonds, as will be the case with this Ohio deal. Again, the reason why some deals are taxable has to do with IRS regulations. Anyway, state housing agencies have two things going for them when selling taxable bonds which tends to allow them to sell bonds at tighter spreads than banks. First, they are highly rated with almost no history of defaults. Second, they can use CMO tricks to decrease the funding cost. Without going into a long discussion of what that means, basically instead of just selling 30-year debt to fund 30-year mortgages, they actually sell a variety of maturities and allow some bonds to take more prepayment risk than others. Net of it all is a lower total cost of debt.

5) The Ohio refinancing deal offers a fixed rate of 6.75%. That's above market for prime borrowers, but probably below market for sub-prime. I'd conservatively estimate that Ohio's funding cost on this deal would be around 5.60% if they did it today. If we assume they let the servicer keep 50bps, they sell the portfolio to Ginnie Mae in exchange for GNMA 6% MBS, then they are making 65bps for no credit risk.

6) So while this is a bail out of sorts, because they are probably offering a better deal than the borrower could get otherwise, its a lot more free-market/tax payer friendly than one might think at a glance.

7) New Jersey is talking about starting a similar program.

Bail out?

Interesting story from Bloomberg news on Friday which past without too much notice. The bottom line is the Ohio Housing Finance Agency, which is a state agency, is offering low to middle income home owners the opportunity to refinance their ARM mortgage into a fixed rate mortgage at 6.75%. That's well above the Freddie Mac survey rate of 6.14%, so you can infer that this program is aimed at sub-prime borrowers.

Now, dear reader, I'm not a true expert on too many things, but I'll bet there are few bloggers out there who understand municipal housing bonds as well as I do. So here is what you need to know about this deal, and what it really means for the sub-prime market in general.

Many, if not most, states have some sort of housing agency. In terms of their single family programs, most operate a bit like Fannie Mae or Freddie Mac, offering to buy qualifying mortgages from originators. They may be involved with multi-family housing projects also, which is a whole other topic.

Unlike the GSE's, the state housing agency is generally pursuing some social goal as opposed to a profit. Most commonly in order for the borrower to qualify for the state agency program they must be below some income figure, be buying a house in a certain area (typically an area the state wants to revitalize), be a first-time buyer, etc. The agency may offer a program with a below market interest rate, or else offer a higher rate but favorable down payment assistance, or some such.

Despite the agency's altruistic intentions, these programs are usually wildly profitable. How you ask? Because as a state agency, they can issue tax-exempt debt. So let's say they have a program where borrowers with low incomes can get a 30-year mortgage at 6% with a mere 2% down payment. Risky loan right? Heck yeah. But the agency can issue tax-exempt debt to fund the program at say 4.5%. The agency is collecting 150bps of yield above their funding cost. You can suffer a whole lot of defaults when you are earning that kind of spread.

In fact, all the state housing agencies I've ever invested in aren't even taking that risk. They actually either buy private insurance, package the loans and sell them to someone like Ginnie Mae, or run their programs in conjunction with a FHA, VA or Department of Agriculture program. All of this results in the agency selling off the actual default risk to someone else, most often the U.S. Treasury. Notice that if they are selling the risk to the Feds, the loan usually has to pass FHA lending standards, which don't allow a lot of the creative lending options that are getting so much negative press today.

Note that in almost all cases, state housing agencies are stand alone entities. They have no backing from the state, nor do they receive any appropriated money from the state. They are able to subsidize risky borrowers entirely because of their massive funding advantage.

Enter the IRS. The tax code says that there is a limit to how much tax-exempt debt can be issued for the benefit of private individuals. That's exactly what we have here: these private individual borrowers are benefiting from either lower rates or relaxed lending standards. For this reason, often times, instead of being truly tax-exempt, housing bonds are sold as "AMT." That means that interest on the bond is tax exempt to any individual holder so long as the holder does not fall into Federal AMT tax status. In that case, the interest is fully taxable. Obviously the rate on a bond like that is higher than plain vanilla tax-exempt bonds, but only marginally so.

Anyway, it is illegal for tax-exempt bonds to be sold for purposes of refinancing a mortgage. In other words, almost all housing agency programs are for home purchases only. Not for refinancings. Ohio will therefore have to sell fully taxable bonds for this program. They will still have a positive spread between their funding rate and the mortgage rate. I do a lot in the taxable municipal housing market, so I'd say that their funding level will be somewhere in the 10-year +100 area, so something like 5.60%. Since this program is going to have a 6.75% lending rate, its no problem. Still, after the agency either pays for mortgage insurance or sells the portfolio to Ginnie Mae, their profit will be relatively low.

But the impact on foreclosures in Ohio could be significant. One of the ultra-bearish scenarios for housing is that tighter credit standards at banks prevent ARM borrowers from refinancing into fixed rates. The borrower can't afford the reset, and the house going into foreclosure. If state housing agencies can step in an offer a middle ground, it could help tremendously.

Is it a bail out? Maybe, but this is the kind of program housing agencies have been offering to home buyers for a long time. The only thing that's going to be new here is the opportunity to refinance with a state housing agency program. Plus, tax payer money is not at risk here, at least not on the state level. Some Federal tax payer money is at risk at Ginnie Mae perhaps, but the amount is going to be pretty small in the scheme of the Federal budget.

I had lunch with the director of the Maryland Department of Housing and Community Development about 2 years ago. He complained about the fact that these new fangled mortgage products were taking away all their business. Traditionally, the first time home buyer with very little to put down and light credit history was a client of state housing agencies. Now the same borrower was opting for a interest-only or option ARM from someone like New Century. Whereas the housing agency might have only approved an ARM where the borrower could afford a maximum reset, and required at least 3% down, other lenders were offering zero down and approved based on the teaser rate.

So ironically, the sub-prime bust may be bringing better times to the state housing agencies. And I really think if more states follow Ohio's lead, it could have a very positive impact on foreclosures.

Dan Green understands...

Dan Green at the Mortgage Reports blog makes a good point in this post. Essentially this is why I put little weight in any given release. Ever.

Blackstone cashing in their chips...

I haven't said anything about the impending IPO of Blackstone, since it really isn't a bond story. However, the Wall Street Journal has this piece on how widening credit spreads impacts the economics of private equity deals.

The story broadly hints that Blackstone's partners are trying to get out while the getting is good. Here is my quick take. Private equity is a permanent part of a well functioning capital markets system. The big LBO's get the attention, but private equity is more broadly a source of high risk investment capital for various ventures that are too risky (or otherwise not a good fit) for banks, bond markets, or public equity to take.

That being said, there is a logical limit to how large a private equity firm can be and still deliver the big return numbers which are commensurate with the risk taken. In a period where credit is hard to come by, that size number is even smaller. So Blackstone's partners realize that their fee income is likely, at best, cresting. So why not use the positive sentiment towards the company to go public? As the WSJ article says, the company could use their shares to make diversifying acquisitions. Or else the partners simply get a huge payday.

Personally, I wouldn't touch the shares.

New home sales...

I don't have much to say on today's new home sales figure, except that its bad. In order for my "bad, but not that bad" scenario to play out, home sales have to continue at a reasonable pace. I'm not worried yet, but if I see a continuation of monthly declines in new home sales, I'm going to get nervous.

One question that always looms with any trade is deciding at what point the trade was wrong and you need to take you loss and walk away. As a money manager, I don't have any particular time horizon to deal with, as opposed to a prop trader who usually takes a hit on capital after a position becomes aged. Regardless, you have to think through what kind of evidence you need to know that your position isn't working. As I've said before, I have positions in some home builder bonds as well as Washington Mutual. Both are bets that the housing market will be "bad, but not too bad," and therefore current wide spreads on these bonds are not justified. Obviously there is a chance I'm wrong. If home builders aren't clearing their excess inventory, then I'm wrong on the home builders. Its not a loser trade yet (in fact, I've made money on the trade) but its on my radar screen.

One thing I won't be doing is doubling up here. That's not a strategy I like to pursue ever. A trade like that is almost always emotional, i.e., trying to "make up" your losses. Plus, after the double up, you inevitably wind up with the new position dominating your portfolio returns. That further clouds your judgement. Traders are human like anyone else, prone to emotion-driven decisions. The smart ones do whatever it takes to keep it cold and logical.

Not a sea change exactly... maybe a lake change...

Yesterday was an important day in coloring how 2007 will play out in the investment markets. The odds of some degree of Fed easing at some time increased dramatically. The yield curve, stock market, and swap spreads all had big moves. While you can't really call it a sea change, maybe a lake change. Or a tributary.

I'm watching the long-end of the Treasury curve for clues. Despite the big moves I mentioned above in various markets, the longer end of the Treasury curve had a tepid response, and today both the 10-year and 30-year are down slightly. In fact, the 30-year is down 9 ticks over the last 2 days, whereas the 5-year is up 4. If that trend continues, its telling you that we are only getting 1-2 cuts.

The next couple days/weeks will be important as well. Do we continue to steepen? Does the stock market continue to rise? Do corporate bonds tighten? My bet is these trends continue. Your best performers will be in the 3-5 area of the curve, corporate and mortgage-backed bonds. I like new production 30yr 6%. This coupon is at-the-money, but if you buy that long/intermediate-term rates aren't falling, there will be no refinance risk. There could be some borrowers who refinance into ARMs or what not as the curve steepens, but short rates aren't likely to fall that dramatically. On top of that, low home price appreciation should result in less mobility, further depressing prepays.

Just as I suspected!

My pre-Fed post was dead on, and I don't mind crowing a bit about it. First a look at the actual statement. There are three key changes.

• Housing market was described as stabilizing in January. Now "adjustment in the housing sector is ongoing."
• Inflation had "improved modestly" back in January. Now inflation has "been somewhat elevated."
• The January statement said that "additional firming... may be needed." Today's statement drops that language entirely.

In isolation, you can't call it a "dovish" statement, but obviously given the market's move the street was expecting a hawkish statement. The Fed is setting us up for a summer time cut, and the market is loving it. The 2-10 slope is now dead flat (more than 6bps steeper on the day). The Dow is up 170 points. Swap and corporate spreads are tighter.

The market is telling you that a Fed cut or two will right our economic ship. That's what I've been saying for a while now.

Where to from here? Well, today's big move in the 2-year and the 2-10 slope will require a little time to digest. So its possible we give back a bit short-term. Over the course of the next few months, the question will become how many cuts do we get. If I'm right, and its only 1-3 cuts, then the 10-year will likely sell off from here, to the 4.7-4.9% range. The 2-year will sell off also, but probably only into the 4.6% range. The long bond should push 5%.

Ahead of the Fed

Should be a quiet day ahead of the Fed's announcement at 2:15. Everything I've heard says the street is set up for a hawkish statement, so if Bernanke's gang disappoints, look for a bull steepener.

Corporate bonds continue to struggle to get a bid. My read in talking to dealers is that there is a deluge of fast money buying protection. Very little real money selling cash bonds. I've also heard a lot of corporate traders were getting "tapped on the shoulder." That's bond geek speak for when a dealer firm's management orders a trader to lighten his/her risk.

I had thought that any weakness in corporates would be held in check by eager buyers on weakness. On the other hand, it was widely believed that real money was weary of spreads being so tight for most of 2006. If that's true, it explains why PM's haven't been buying on weakness here. My bet is that corporate spreads creep in over the next 6 months or so. Even after the fast money sellers of credit get out of the way, it takes actual buyers to bring spreads in. But I stand by the theory that there is nothing fundamentally wrong with the corporate market, and the same liquidity technicals that caused spreads to be so tight are still there. Based on how the market is acting now, it may take time for enough buyers to express interest to really move spreads, but I believe it will happen.

How the corporate market will react today to either a hawkish or dovish Fed is hard to say. I'd like to say that the corporate basis is oversold, so the bias is for it to tighten regardless. I believe the street is relatively light on cash bonds, so that also is a positive technical. My best bet is we tighten on a dovish Fed, because that lowers the odds of a recession. Whether we widen on a hawkish Fed? Again, I'd like to say no because of the technicals, but this market is trading a little haywire, so I don't have a lot of confidence in that opinion.

Jobs and Housing, or Chickens and Eggs

I got a couple comments on yesterday's post arguing my point #12 was off base. Here is the bit from yesterday:

12) Besides, nationwide the job situation remains strong. The long-term evidence is that job growth drives home sales. While we may be in a unique situation with home prices coming off a bubble, strong job growth should create a floor beyond which prices are unlikely to fall.

The two comments argued that A) Employment is a classic lagging indicator and B) Housing weakness could cause its own job decline through construction, mortgage brokers, etc.

Here is my take. Obviously employment generally is a lagging indicator. Lord knows I'm not disputing that.

But if you are going to make a case for a housing induced recession, you have to argue that home prices keep declining. So supply has to increase or demand decrease or some combination. I think I made a strong case that supply problems would be contained. You can disagree if you will, but point #12 was about demand. If you accept my case that supply will not expand, but still want to argue prices will fall, then you have to give me a story about declining demand. I said that demand is primarily a function of job growth, and I stand by that. Even in the recent boom periods, where speculation in hot markets played a big role in driving prices to unsustainable levels, those markets got hot in the first place because job growth was strong in those areas. Baltimore/Washington for example, has seen a huge inflow of jobs in the last several years. The result is that downtown Baltimore home prices went sky high. Yes, there were lots of speculators, but they didn't show up until the underlying demand for homes reached a certain level.

So I can agree that employment tends to be lagging, but if we theorize that weak housing demand will cause a recession, then I argue that job growth has to be weak first. You can't make the following progression:

1) Home prices fall because demand is weak.
2) Demand is weak because job growth is poor.
3) Job growth is poor because home prices are falling.

That's circular logic.

Now, home builders laying people off is another story. Home builders are going to lay off a lot of people (or construction companies will). But I'm hard pressed to say that will amount to recession-level unemployment. I'd say that mortgage companies had even fewer people employed.

Some people have tried to argue for larger numbers of people related to housing. I'm dubious about that. Normally they throw in all sorts of industries: materials, retailers, furniture manufacturers, etc. I'm not saying those sectors won't be hurt. I'm just saying I'm dubious that you can really parse out who has a job because of a housing boom and who doesn't. How many Home Depot employees are "housing related?" Well, the whole freakin' store is about home improvement. So do you say that all those people lose their jobs in a housing bust? I can't buy it.

I'm a believer that most recessions are the result of a credit crunch. So in my opinion, the best case for a recession stemming from subprime is that banks freeze up, similar to the 1990-1991 recession. I think this could be avoided by the Fed making 2-3 cuts from here. All the Fed has to do is prevent banks from cutting off funding for C&I and prime residential loans. The subprime problem will take a little time and a little pain to resolve, but shouldn't be recessionary.

How bad is subprime going to get?

There is a wide range of opinions on how bad subprime is going to get. Although the ABX index seems to have stabilized, its still trading at a distressed level. Corporate bonds have widened and stock prices have fallen. Bearish economists believe that delinquent subprime loans will turn into a large increase in homes for sale, further depressing home values. This will cause consumers generally to become pinched, not just those with poor credit, and lead to a recession.

While the bearish argument is logical, I find a more moderate scenario most compelling. Consider the following.

1) According to the MBA, 13.3% of all subprime mortgages are delinquent. The all-time low is 10.3%, so at worst, there are 3% more subprime mortgages delinquent today vs. years past.

2) In 2006, 3.9% of subprime mortgages were foreclosed upon. The June 2006 delinquency figure was 11.7%, so exactly 1/3 of the delinquent loans were foreclosed upon. This ratio has been relatively consistent over the last 3 years. If that ratio holds into the future, then the number of homes for sale due to foreclosure has only increased by 1%

3) If we assume that delinquencies increase by 50% in 2007, and half of those loans are foreclosed upon (as opposed to 1/3), then the foreclosure rate would increase from 3.9% to 10.0%. That's a marginal increase of 6.1%

4) Also according to the MBA, there are about 7.5 million homes with subprime mortgages. Units, not dollars.

5) Multiply the marginal increase in foreclosures by the homes with subprime mortgages, and you get 457,500 new units are for sale.

6) According to J.P. Morgan, there are 4.1 million new and existing homes for sale. So the new foreclosures result in an 11% increase in homes for sale.

7) We know that home builders are going to scale way back in 2007. Building permits have declined by 624,000 over the last 12 months. If we assume that this represents an eventual decline in homes available for sale, there would actually be a net decrease in home supply.

8) Of course, we know that there is a serious overhang in home inventory currently. But that has been a problem for several months now. The home builders are all reducing or eliminating building homes on spec. I believe its highly unlikely that new home building outpaces new home sales over the next year.

9) So it seems as though there will be little or no net increase in homes available for sale in 2007, even under a very bearish scenario for subprime foreclosures.

10) If there is no increase in supply, how can you estimate a large and pervasive decrease in home prices? I can believe that foreclosure sales will occur at relatively weak prices, and this might depress market prices somewhat. But with foreclosures accounting for something like 10% of all sales, its hard to envision the foreclosure discount effect as creating a large and pervasive change in prices.

11) What about tightening lending standards? Won't this cause a decrease in demand from first time home buyers? Perhaps, but I think a moderate decline in interest rates will overwhelm this effect. If the Fed does cut once or twice and the 10-year stays around 4.50%, mortgage rates will fall. First time home buyers with spotty credit might be priced out of the market, but low rates will price more prime borrowers into the market.

12) Besides, nationwide the job situation remains strong. The long-term evidence is that job growth drives home sales. While we may be in a unique situation with home prices coming off a bubble, strong job growth should create a floor beyond which prices are unlikely to fall.

No meaningful increase in supply, no meaningful decrease in demand. I think the housing market will suffer at worst a mild correction.

Told ya so...

At one point the Dow was down over 100 points yesterday, and we STILL couldn't get a strong bid in the 10-year. As the stock market recovered, the bond market sold off. In fact, it pretty much played out like I said it would in my Tuesday post.

Yesterday's market action has me more convinced that rates are headed higher on the long-end. I'm going to shorten duration modestly and increase my option risk.

I've also added Washington Mutual bonds. I know you housing bears are snickering, but WaMu is much more of a straight retail bank than casual observers realize. Their sub-debt just should not be trading like its Ba-rated. There is obvious headline risk here, and I won't be surprised if they widen more from here, but I really think there is 50bps of tightening possible in this name. There are very few investment grade bonds where that is possible.

Resistance holds for now...

Despite a 243 point sell off in the Dow, the 10-year couldn't break through 4.50% decisively. Meanwhile, the 2-10 inversion got smaller and smaller all day. Now -2bps. Was -8bps yesterday, and as low as -15bps in February.

If I were a betting man, which I am, I'd bet that the 10-year backs off a bit from here. Lately its been steeper on a rally, flatter on a sell-off, so I guess we'll back away from the -2bps slope as well. Like I said before, there isn't a lot of logic to the 10-year vs. Fed Funds slope to invert much beyond 75bps. I think that is creating big resistance around 4.50%, hence why I think we'll bounce off that level tomorrow.

Too much money was sitting on flattening trades, and I think those trades are currently getting squeezed out. So I think any flattening here (i.e., increase in inversion) will be met with unwind trades. I don't think we flatten any more than -8bps or so without some very positive economic news.

Interesting note that swap spreads were basically unchanged in the 10 and 30 year area. Normally we'd see widening of swap spreads with the stock market and corporates so weak. MBS also held in OK given it was such a huge rally in rates. I think both MBS and swaps are benefiting from the steeper curve.

Also interesting was the strong performance by TIPS today. Early in the day you could blame the outperformance by TIPS on a strong day for the CRB (a widely followed commodity index). But by the end of the day, the CRB was actually down $1.83 (about 0.6%). Yet TIPS outperformed Treasuries by about 1/4 point in 10 and 30 years. I think the TIPS market is pricing in Fed cuts. Look, no matter what your inflation outlook is or your opinion about how tight monetary policy is currently, if you believe the Fed is cutting, that's bullish for inflation. If inflation is always and everywhere a monetary phenomenon, then more money = more inflation. Lower funds = more money. Ergo, ipso facto, ceteris paribus, TIPS rally.

Corps are getting hit hard. My prediction that financials would outperform industrials is looking pretty shitty right now. I clearly underestimated the impact of sub-prime on the finance sector generally. Well, check that. I underestimated the fear of contagion related to sub-prime. I had been suspicious of firms like NEW as well as sub-prime ABS for a while. Actually way too early on both, as I haven't had any exposure to that stuff for several years. But it sure feels like the market is throwing the whole finance sector out with the sub-prime bath water.

I still think finance will outperform industrials from here, I'm just not sure it will make up what its lost the last 3 weeks. Lehman's Intermediate Financials index has underperformed the Intermediate Industrial index by 46bps YTD through yesterday. I'd say financials are a buy here, but given that corporates generally are still pretty tight, it might be that everything keeps widening if the economy weakens. As a PM managing against an index, I'm going to stay long financials and am looking to add some housing sensitive bonds where I think sub-prime won't be an issue. Its going to add volatility in the short-run, but when fear is ruling the market, opportunities arise.

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Resistance is futile

It looks like we're going to test two important resistance levels. First, 4.50% on the 10-year. We did close below that a couple times in the last 2 weeks, but always by less than 1bps. Another leg of today's rally could blow through that level.

I think that resistance will hold for now. The fundamentals don't support an inversion of more than 75bps between funds and 10's. The market still believes that the curve will eventually have a "normal" slope. This means that in order to invert by more than 75bps, you have to believe the Fed is going to cut 5-6 times and leave rates at that level for most of the next 10-years. Not gonna happen.

The other important level is 2-10 slope at 0bps. Currently we're -5bps, so I doubt we test that level today. But I think its clear that the market is biased towards a steepener whenever the odds of a Fed cut improve. If the Fed were to remove their tightening bias at the March 21 meeting, I think we'd blow right through 0bps.

So that makes me bullish on 2's for now. My longer-term forecast is for a flat slope between FF and 2yr, so my bullish stance is very temporary.

How does a CDO work?

A CDO (collateralized debt obligation) is nothing more than a redistribution of credit risk, much in the same way a CMO is a redistribution of prepayment risk. This post will quickly go through the basic math of a CDO. For illustration purposes, I'm going to use a real ABS CDO featuring mostly RMBS as the base for the percentages of each tranche. I'm going to make some simplifications to the structure just to keep the example easy to understand. Regardless, this should be a pretty good basic lesson on how a CDO works and where the risks are. I'm going to use an ABS deal as my example, but any credit-risky security could be used. Also, I'm going to use fixed interest rates just for simplicity, but almost all CDOs are floating rate. Just that LIBOR is 5.30% and stays static over time.

We start with a $100 portfolio of ABS bonds which yield 7%. This is called the collateral portfolio. The collateral portfolio has a average rating of BBB. In order to fund the purchase of this portfolio, 5 different securities are sold. The amount, credit rating and interest rate of the first four are as follows.

$75 Class A, rated AAA, yields 5.51%
$10 Class B, rated AA, yields 5.80%
$5 Class C, rated A, yields 7.20%
$5 Class D, rated BBB, yields 9.00%

These are called the debt tranches. Some of you may notice that those yields for Class C and D are far in excess of what typical bonds with similar ratings yield.

The fifth security sold is the equity tranche. That is another $5. We'll get to the equity in a minute.

Why are the tranches rated differently? Because interest and principal are paid sequentially, starting with Class A and ending with the equity tranche. Only once Class A has been paid what its due does Class B get paid, and so on.

So our portfolio of bonds pays $7 per year in interest. The CDO then owes interest on the debt it sold:

Class A: $4.13
Class B: $0.58
Class C: $0.36
Class D: $0.45

That makes a total of $5.52. So there is $1.48 left over. In a deal like this, the manager probably charges around 0.20%, and there is another 0.05% for admin fees. So net of fees there is $1.23. That passes through to the equity. Notice the return on the equity is a quite attractive 24.6%. Now many times a portion of the excess spread is held aside to cover losses, but I'll ignore that for now.

So that's how it works if you have zero defaults, but of course, that's not going to happen. Let's say that 2% of the collateral portfolio defaults, and the recovery is 50%. So now there is $99 in the collateral portfolio with a 7% yield. Instead of having $7 in interest, we only have $6.93. So far, everything is fine, because we had $1.23 which we were paying the equity. Now we only have $1.16, but that's still over 20% IRR for the equity tranche.

Now let's say that the deal suffers 2% defaults per year for 10-years at which time principal on the debt tranches becomes due. So that's a total of 10% losses (2% x 50% recovery x 10 years). You've been able to cover interest costs all along, because even after $10 in principal losses, you are still have $6.30 interest earned vs. $5.52 interest costs plus $0.25 in fees. You're still $0.53 in the black.

But what about paying off the principal on the debt tranches? You only have $90 in principal left in your portfolio to pay off $95 in debt. If that were the end of the story, Class A would get paid its $75, then Class B its $10, then Class C its $5, and Class D would default, and get no principal at all.

Now you might say, net-of-recovery losses of 1% doesn't seem too extreme. How the hell would the Class D tranche get an investment grade rating? There are a couple of things that complicate the math, and make the Class D tranche a little safer. First, there are usually two coverage tests which CDO's calculate: interest coverage (IC) and overcollateralization (OC). The IC test has the total interest earned in the numerator, and the total interest cost of a given tranche and all tranches senior as the denominator plus fees. So in our case, the IC on Class B at the onset of the deal would be $7/($0.58+$4.13+$0.25)=141%. Some trigger is set for how high that number needs to be for each tranche and if the actual number is lower than the trigger, some remedy is required. For example, it might be that money that would have gone to the equity is used to pay down some of the debt tranches. Since the size of the collateral portfolio is the same but the size of the debt is lower, the IC calculation improves.

The OC test is similar, except the numerator is the principal value of the portfolio and the denominator is the outstanding amount of a given tranche and all bonds senior. So for Class B at the outset, the OC test would be $100/($75+$10)=118%. Here again, some trigger level is established when the deal is sold, and if the OC falls below that trigger, some remedy is required.

The triggers are usually higher for more senior tranches. So the top tranches aren't just protected by the extra cash flow of the deal, but also by the fact that if anything starts to go wrong, cash flow will be diverted from other tranches. The trigger levels also tend to be higher in deals with riskier collateral. A deal with all BB-rated bank loans will have higher IC and OC tests compared with an investment grade resi ABS deal.

Now you can see how freakin' complicated the cash flow can get. It becomes extremely hard to determine what default level would sink a given tranche. For example, a tranche may be able to survive 5% annual defaults for all 10-years, but might not be able to survive 10% defaults in year 2. A relatively high level of defaults spread out over time is more easily cured through the excess interest the deal collects. But a spike in defaults would usually result in more senior tranches being paid down, and there might not be enough left over to pay principal on more junior classes.

Another complication is the recovery rate. It is often true that the weaker credits in the deal also recovery at a lower rate. For example, you might have a deal that is 50% prime RMBS and 50% B/C Home Equity. That might have an average recovery rate of 50%, because the prime RMBS recovers at 75% and the B/C Home Equity recovers at 25%. But since the B/C stuff is more likely to default, who cares what the "average" recovery is? The only thing that matters is the recovery on the bonds that actually default.

The interest spread is probably uneven as well. For example, if the whole deal yields 7%, it might be that the 50% prime RMBS is at 6.5% and the B/C is at 7.5%. So if a B/C piece defaults, there is a larger decline in overall interest earned than what the straight average yield would imply.

So CDOs can get pretty complicated, and its impossible to say just how many defaults it will take to sink a given tranche. The concern should be with buyers of BBB and A-rated tranches of sub-prime residential deals. If there is a large default spike in 2007-2008, and recovery rates come in much lower than expected, these tranches will likely perform poorly. If you are an equity investor... well... good luck.

Nevermind...

Remember that huge repricing of risk? The assumption the Fed's hand was going to be forced by subprime? Today's market movement is tempering a lot of that.

• Corporate bonds are staging an impressive rally. Most IG names are 8-10 tighter than wides.
• Curve is re-inverting. Today 2-10's were -8. Got as tight as 0.
• Funds futures backing off. Now most likely cut isn't until August.

Nothing is transpiring which is causing me to question my forecast I made in January. I made a short-term duration play a couple weeks ago, which worked out nicely, and now I'm backing off. I still think the Fed cuts late in the year once or twice, which will allow the curve to steepen out. I also think there is too much liquidity to allow spreads in general to widen dramatically.

I'm shocked, shocked to find that subprime is in this CDO!

This story from the Wall Street Journal is tough to swallow. The gist is that some European CDO buyers are surprised to find out that their CDO of ABS has significant sub-prime exposure. I don't know whether to laugh or to cry. I laugh because these people must be like the Keystone Kops of portfolio managers. I cry because these people undoubtedly run bigger portfolios than I do.

1. If you've never seen marketing docs for a CDO, I'm here to tell you the allowable securities are spelled out quite clearly. How much you wanna bet that if we pull the offering docs from the CDOs in question there is a page titled Expected Portfolio Mix? And on that page there is a pretty pie chart that has a nice big blue slice labeled B/C Home Equity?

2. I don't have any stats on this, but the overwhelming majority of ABS CDO's I've seen have a big chunk of subprime residential MBS. In order to construct a CDO, you need higher-yielding bonds. In the ABS world, sub-prime residential gives you both the yield and the issuance volume needed to do a large CDO. There are ABS CDOs done with speciality sectors, but I've got to believe that the majority include sub-prime MBS.

So given #1 and #2, in order for an investor to be surprised there was sub-prime in his CDO, s/he did not read the marketing documents, and was unaware of the common structure of securities s/he was buying. In other words, they didn't understand the sector, nor did they bother reading anything to learn more.

On top of this, a CDO investment is all about the riskiest part of the collateral. For those who don't deal in the CDO market, here is a quick overview on how CDO's work.

The CDO sells debt to the public and uses the proceeds to buy a portfolio of bonds. CDO debt is sold in various tranches. Each tranche gets paid sequentially from the most senior to the most junior. In a simple CDO structure, there might be 4 tranches. Class A gets paid interest and principal first, then Class B, then Class C, then Class D. If there is anything left over, that amount passes through to an equity holder. You can see that if the collateral portfolio starts to take credit losses, there might not be enough money to pay the more junior classes.

Usually the higher quality the portfolio, the smaller the junior classes are as a percentage of the whole structure. For example, if the collateral portfolio has an average rating of Ba2, the Senior tranche might be 65% of the total structure. However, if the average rating is A3, the Senior tranche is probably something like 90%. The percentage of the structure which is junior to your bonds is called subordination. Obviously the more subordination you have, the safer your bond is.

Most ABS deals have very little subordination. If the most Senior bond has only 10% subordination, than the Class C might only have 2-3%. Let's assume (as is common) that the Class C tranche was rated A when the deal was sold, and had 3% subordination.

So we know that if the deal suffers 3% losses (not defaults, but losses) immediately, then your A-rated bond now has zero subordination, and every subsequent loss will hit your tranche directly. In real life, losses don't happen on day 1, so I'm being overly simplistic by using 3%. But you get the picture. Losses don't have to be that large in order for investment-grade bonds to start taking hits to principal.

Sticking with the 3% number to keep the math simple, let's assume that subprime home equity has a 50% recovery rate. Furthermore, let's assume the collateral in the CDO is 80% prime MBS and 20% subprime. The investor might say "Hey, I only have 20% subprime exposure." Wrong. Because you only have 3% subordination. If recovery is 50%, then 6% defaults eliminate all your subordination. The 80% in prime MBS doesn't protect you if the 20% in subprime defaults at a high rate.

Now imagine you've bought 10 A-rated CDO deals which have a mix of credit cards, auto loans, student loans, and other ABS. But each of them has around 20% in subprime MBS. Well guess what? If subprime defaults at a high rate, its possible that all 10 of your CDO's will wind up defaulting at the same time. Diversified portfolio? Hardly. Because a CDO investment is all about the riskiest part of the collateral. You could own 1,000 different deals, if the riskiest part of each deal is the same, you have no diversity.

So these investors did not understand the nature of the structure they were buying, did not know what the underlying collateral was, and did not read the marketing documents to try to find out.

Now, please excuse me while I call my broker to short European bank stocks.

News you can't use

D.R. Horton CEO Donald Tomnitz said 2007 is going to "suck." What is this? The Lou Holtz school of management? I know all the home builders are trying to keep expectations down for 2007. But do you think they had a meeting about how blunt they could be? Did anyone consider hiring Gallagher to smash a watermelon with "2007" written on it?

In other non-news, Fitch has downgraded New Century's servicer rating. Are all the horses out now? OK good. Someone call in the ratings agencies to close the barn door. That seems to be what they're best at.

Following the bouncing risk sentiment...

Stocks are bouncing higher today, and credit spreads are moving tighter.

I think this will play out like spring of 2005. What, you don't remember the momentous market moves of spring 2005? Its funny how marketeers seem to remember all the times it crashes and burns much more clearly than the times it smooths itself out. And here's a secret: the later happens more often.

So to counter all the old saws about 1987 or 1998, here is a story about 2005. At the time, General Motors was one of the top 2 investment grade corporate bond issuers. On May 5, S&P downgraded their corporate debt to junk status. Moody's soon followed. Because GM was a major holding of almost every core-style bond manager in the U.S., and because a large percentage of these holders became forced sellers when it was downgraded, the bonds got absolutely crushed.

The whole credit basis was getting whacked. Not that GM had anything to do with Comcast or Verizon, but everything was getting wider. Many market pundits had complained that corporate spreads generally had become too tight after huge rallies in 2003 and 2004. So many fearful investors took the excuse to shed credit risk indiscriminately.

The irony is that the fundamental problems ratings agencies cited when downgrading GM weren't really news. They were losing share to foreign manufacturers. They had huge legacy costs. They had an image problem with consumers. Their profit per car was declining. All this had been well known about GM for years. In fact, I attended a conference on credit analysis in February of 2003 at which the cocktail discussion among us geeky bond analysts was how in the world GM still had an investment-grade rating.

Given how well-known their problem was, why did the downgrade cause such a ruckus? Great question, but no easy answer.

Anyway, as we all know, by the end of 2005, credit spreads had rebounded nicely. And they continued to rally in 2006. Now its hard to fathom that GM was investment grade so recently, isn't it?

So now let's compare this story to the sub-prime story.

1) Just like 2005, today credits like Comcast and Verizon are getting wider ostensibly because of fears related to a credit which has nothing to do with either company. Then it was GM, now its sub-prime.

2) Just like 2005, the problems in sub-prime had been well known and oft discussed for a while prior to any actual credit event. A quick search of any financial newspaper going back to 2004 would show pundits expressing concern about sub-prime borrowers qualifying based on teaser rates. Or borrowing with limited documentation. Or borrowing 100% of the value of the house. I defy you to find the serious analyst who predicted there would never again be a period of rising sub-prime default rates.

3) And yet, just like 2005, the reaction to a widely anticipated event was quite violent.

4) Just like 2005, the vast wall of liquidity eventually brought spreads back in, and by mid 2008, spreads were back to where they were at the beginning of 2007.

Or so my crystal ball says.

Correction or Bear Market?

The S&P 500 is down 13 points, which seems small compared to recent days, but is a fair-sized move. Yet the 10-year is actually down 1/2 tick. During the 2000-2002 bear market, it was very rare that both the stock and Treasury market would move in the same direction.

Of course, one day doesn't mean a damn thing. Maybe the stock market will close tomorrow down another 3% and the 10-year will be at 4.35%. But right now there are a couple market moves that are pricing in a high probability of a true bear market.

• The CDX.IG index moved out 7bps over the last week. That's starting at 30bps and moving to 37, so its a fair-sized move.
• The CDX high-yield indices moved 30bps (BB) and 45bps (B) wider last week.
• Fed Funds Futures have rallied substantially. According to the Cleveland Fed's calculations, the odds of a cut in May is around 30%, and a cut by June is around 50% using futures trading prices.
• The slope of the Treasury curve has shifted dramatically. 2-10 slope was -13bps on 2/26. Now -2bps. This is notable because a steepening slope implies Fed cuts are coming soon.

Based on recent market moves, I think there are good opportunities in MBS and corporates. If you don't believe a recession is coming, but think the Fed may be willing to do 1-2 tweak cuts, then you believe interest rate vol will calm down from here. That's good for MBS. Buyers can just collect the nice big coupon without worrying about a big refi incentive. For both corps and MBS, the giant wall of liquidity isn't going anywhere. That will keep demand for quality spread product high. I think the brokers look particularly cheap now. They've widened out on jitters about sub-prime and high market volatility, but nothing happening today is fundamentally different than other problems Wall Street has faced in the past. I really think Lehman Brothers, Goldman Sachs, Merrill Lynch etc., have a reasonable handle on their risk and will manage though any period of high volatility.

Gold?

It drives me insane when I hear people say gold is a conservative investment, for example, this article in the WSJ. To be fair, I don't think the author is necessarily saying gold is safe, but plenty is implied.

I'll debunk this myth very quickly, because I don't feel like wasting my time.

1) Gold has very little intrinsic value. Gold's use in industry is limited, and its use for jewelry does not justify its price. Gold is used as a means of speculation, and that's why its price is so high. Well, that and the fact that super villains are always trying to steal it.

2) Besides, the intrinsic value = conservative argument is never applied to other commodities, like oil or orange juice. Why not? Because pirates never plundered orange juice? People are still suspicious of a Trading Places scenario? I have no idea.

3) Gold suffered through a 20 year bear market from 1980 until just a couple years ago. For most of 1980, gold was above $600. For most of the 1990's, gold was below $300, so if you bought in 1980, you'd be carrying a 50% loss for most of that period. How could any investment with that kind of history be considered conservative? Are people distracted by the shiny colors?

4) Gold is really a bet against your local currency. Basically if your local currency depreciates, then it will take more of it to buy anything, including gold. But does anyone tout currency futures as a conservative investment? And why not? Xenophobia? Who knows?

My point here is not that gold is over or undervalued here. My point is calling is conservative is ridiculous.

Fear will keep the local systems in line...

OK so the other day when I claimed it wasn't a real flight to quality... never mind. Fear is gripping the bond market. Its causing spreads on all products to move substantially wider, from MBS to corporates to even agencies.

Forget the little rally in stocks yesterday. Forget the little sell-off in bonds yesterday. For at least the next week or so, the market will remain extremely skittish. And only Treasury holders like vol. Fear will prevent any bond sector from keeping up with Treasuries over the next several sessions. So whether rates are up or down, everything will lag the Treasury market.

Are there opportunities here? Heck yeah. All you have to do is separate the real possibilities from the fear. Oh yes, it sounds simple. But its very very very very hard. When the market is gripped by fear, you are either playing momentum or being contrarian. I like to think of myself as more of a contrarian than anything else. But at times like this, being contrarian is harder than ever. Consider the following on contrarion investing.

1) The irrational can get even more irrational. Consider the case of the ABX index. I wrote that it seemed out of wack with fundamentals when it was priced at $80. Then it went to $60 in a matter of days. As a trader, particularly if you're leveraged like most CDS players are, a 20 point drop is hard to stomach. You can't help but question your view, and you might just bag the trade. If you aren't prepared to accept this kind of outcome, you can't play the contrarian game.

2) When you are a contrarian, every one thinks you are wrong. Its a tautology. Unless every one disagrees with you, you aren't a contrarian. But the thing is, you are going to hear very reasoned arguments from intelligent people about why you are wrong. Look, the market isn't dumb, so if every one has a certain view, its bound to be compelling. You have to be prepared to consider consenting opinions, but not allow their ubiquity to color your analysis.

3) A contrarian's career is always at risk. This is a reality of the investment business, particularly at large mutual fund firms. If you are wrong, but every one else is wrong too, your fund will still score decent Morningstar ratings, and Lipper rankings, and your investors will likely stick with you. But if you are wrong and every one else is right, you're fired. Oh and after the big mutual fund company fires you, good luck finding another job in investment management. That's a one-way ticket to a job as a retail broker. If you work for a big firm, you have to be prepared to accept this risk when making contrarian bets.

4) It isn't being contrarian to simply bet against the trend. Making any investment on the basis of a trend alone is a roll of the dice, unless you really know what you're doing. Betting on a reversal for no reason other than "it can't keep going in this direction forever" is flat out irresponsible.