Who's the more foolish? The fool, or the fool who follows him?

I know, I know, I already used that title before...

Anyway, in the wake of Bill Gross claiming the ratings agencies were "fooled" into giving certain ratings on ABS CDO deals, I thought I'd give a little explanation of how the ratings process works in CDOs and my take on why it is breaking down now.

First let me say that just because bonds aren't performing well doesn't mean the rating agencies were wrong. For example, according to Moody's, historically there is a 2.5% chance a Aa-rated bond will default over 10-years. So the fact that any given Aa bond winds up defaulting doesn't mean that the rating was wrong to begin with. By extension, if the ratings agency believed a certain event was a low probability, just because that event comes to fruition, doesn't mean they weren't right about it being a low probability. If you are asked to predict the roll of two dice, what single number will you pick? 7 right? If you are asked to pick a 3 number range, you'd say 6-8 right? If the number rolled turns out to be 10, were you wrong in your prediction? If a priori, you correctly predict the odds, its still possible something unusual happens. That doesn't make your initial analysis wrong.

Now back to CDOs. The CDO rating process is very quantitative. Basically the process works like this. Each agency has their own Monte Carlo simulation software. They take a CDO portfolio, make certain assumptions about correlation of defaults, then use the Monte Carlo to figure out what the probability of suffering various levels of defaults.

The correlation of defaults is absolutely critical. If you have a portfolio of similar credits, the odds are good that several of them will default at once. Think of default probability as a two part function: a issue specific variable and a common variable among a group of issues. For example, if its GM and Ford, the common variable would be the health of the US auto market. We could extend this into a more complex function, where you might have GM, Ford, and Dollar General. GM and Ford are both impacted by the auto industry, but all three are impacted by general consumer spending.

The Monte Carlo simulation takes this correlation into account. The consequences of high correlation is that the results become very bimodal. There becomes a high probability of very low defaults or very high defaults. Keep this in mind for later.

Once we've established the expected level of defaults, the rating agencies then run a cash flow simulation of the CDO structure at various default levels. They used "stressed" default patterns, basically trying to bunch the defaults together to find the most stressful situation. They each have slightly different methods of interpreting the results. S&P and Fitch set a level of defaults at which a given tranche must survive (not default) to earn a given rating. Moody's sets an "expected loss" which means that they take the range of portfolio defaults, the level of loss at each default level, and do a probability weighting.

Where can this process break down? What's happening in the sub-prime market that is causing CDOs to perform so poorly? The obvious answer is "defaults are high, stupid!" Granted. Obviously high default levels can break a CDO. But if we were merely going through a high default period, I'd argue that doesn't amount to a "mistake" by the ratings agencies. They acknowledge in their models that there is a chance defaults come in high. Basically, they said its possible that you roll a 2, just not likely. Just because you actually do roll a 2, doesn't make the rating agencies wrong.

I argue that misinterpreting the correlation of defaults is the bigger problem. Two things happened in the sub-prime market to alter historical correlations. First, lending standards declined significantly. Second, interest rates got extremely low, then rose sharply. So questionable loans were being made, and since most sub-prime loans are 2/28, these weaker borrowers are (or will be soon) getting hit with huge payment shocks all at the same time. Therefore the correlation of defaults in this market is substantially higher than was assumed.

Thinking back to our multi-part default function, every bond in a portfolio of residential MBS has multiple common variables: interest rates, home prices, and employment trends. Even if we assume the rating agencies didn't know that sub-prime lending standards were weakening, anyone with a basic understanding of economics, real estate, or mortgage lending knew that loan performance was going to be, in part, a function of those three elements. While the inner workings of rating agencies Monte Carlo simulators are proprietary, I feel confident to say that the power of these common variables in creating high correlation was underestimated.

Commenter Chris among others has pointed out there should have been some caveat emptor here. He's 100% right. In fact, I talked to a Bear Stearns CDO trader about 2 years ago about ABS CDOs, and he said he liked the CLO market better specifically because he was worried about correlation of defaults in RMBS. Baa/BBB rated tranches of ABS CDOs have been trading cheaper than the same tranches in CLOs for several years. So its not like the correlation issue was a big secret.

I think this is another example of investors assuming that one Baa/BBB bond is the same as another just because the rating agency assigned the same rating. But the market traded Baa/BBB rated ABS CDO tranches far far cheaper than similarly rated CDOs with other collateral, or for that matter, plain vanilla corporate bonds. As an investor, you have to realize that stuff trades cheap for a reason. The market isn't stupid. Bill Gross may think the rating agencies are fools, but in this case, anyone who blindly follows them is the more foolish.

Dear Bill Gross

I recently heard an interview you gave with Bloomberg Television. In that interview, you said that Moody's and S&P had been "fooled" in regards to ABS CDOs. I didn't hear, and I'm assuming this is because Bloomberg edited the program, who exactly did the fooling. Because I know you wouldn't make such an accusation without disclosing that PIMCO itself is a large issuer of CDOs. Perhaps Bloomberg's journalists aren't held to as high a standard of ethics as Chartered Financial Analysts such as you and I.

In order to correct this problem, I assume that you are currently calculating and will soon be releasing to the public exactly how much money you personally made from issuance of CDOs in your career.

Mr. Gross, you are the preeminent fixed income investment manager in the U.S., perhaps in the world, and you deserve all the respect which comes with that achievement. But when you go on television and deride practices when your firm was involved in same, it causes some viewers to question your veracity. By stating that you believe the ratings agencies were "fooled" in ABS CDOs, while at the same time, your firm marketed such products to the public, it certainly sounds as though your firm was doing the "fooling" and by extension, you were fooling the investment public.

Perhaps I have indeed misunderstood your statements. Perhaps you opposed CDO issuance within your firm but were unable to prevent it. If so, I sincerely apologize.

Sincerely,
Accrued Interest

If you were to rescue her the reward would be...

Apparently Home Depot's risk dial goes to 11, and the plan as sparked quite a discussion on whether financial engineering really creates shareholder value. Here is how I come out on it.

Investors have different risk tolerances. Some are happy to own a portfolio of Treasury bonds, or high-quality municipals, and nothing else. In essence, these investors are just looking to keep up with inflation.

But most investors need more. They need to see their portfolios grow in order to meet whatever needs they have. This is the primary reason to own stocks. Stocks carry considerably more risk of loss compared with high-quality bonds, but also have substantially higher expected return.

I believe it is therefore possible for a company to not carry enough risk. Or more to the point, not take enough risk to earn the kind of return I need to consider owning it.

Now, I don't follow Home Depot's stock closely enough to make a professional opinion on whether that is the case. So let's deal in hypotheticals. Let's say that ABC corp is currently earning a very consistent ROE of 7% with no leverage. Let's also say that the chance of bankruptcy over 10-years 2% (about equal to the historical figure for a Aa-rated company). So to make it simple math, there is a 98% chance of a 97% return (7% per year for 10-years) and a 2% chance of -100%. That's an expected return of 93%.

Now let's say that they can borrow an amount equal to 1/3 of their current equity and return it to shareholders as a special dividend. And let's say that after expenses of the new debt, that results in ROE of 10%. How much does the chance of bankruptcy really increase here? We assumed the company had very stable earnings. So double the risk? Triple? Let's use 7.5%, which is the historical figure for Baa-rated companies. If you assume 94% chance of 160% return and 7.5% of -100%, that's an expected return of 143%.

Most investors would rather the higher expected return, even if the variance of possible returns is greater. I say this with confidence, because most investors choose to own more stocks than bonds.

So the reward to shareholders of increasing risk? Maybe not more wealth than you can imagine, after all, I can imagine quite a bit. But if the question is "Does increasing financial risk serve shareholder interest?" I think the answer is "Sometimes, yes."

More on the CDO Put

I got a couple of great questions in the comments section on the CDO Put and since I'm a lazy blogger, I'll just make a new post out of them.

1) "... isn't it the same as saying that if a stock goes down, then everything else being equal, purchasing this stock at a lower price becomes more profitable, so money will flow to this stock and therefore there is a limit how far it can go down?"

No, because I'm speaking of new CDOs being created, not the price of existing CDO tranches. Also because the CDO Put doesn't really limit downside, merely create strong resistance at a certain point. See below.

2) "the cash flow is unchanged, but the present value of the cash flow (probably) changes (if you discount it at a rate including an appropriate risk spread). Couldn't you say the same thing about a traditional bond -- that the cash flow is unchanged when interest rates rise?"

In a way, yes. But a traditional bond is a single credit, or put more technically, its idiosyncratic risk. A CDO is a portfolio of credits, thus systemic risk. Idiosyncratic risk can rise tremendously, but systemic risk can logically only rise so much.

3) (This is the important one). "If spreads widen, it’s presumably because the price of risk is going up. If the price of risk is going up, then the required return on the very high risk, highly levered equity tranches should go way, way, way up. So the fact that the actual return goes way, way, way up doesn’t necessarily make it a better deal. Quantitatively, it may turn out to be true, given reasonable risk-aversion parameters, etc., that it does become a better deal, but proving that would require a lot of messy math (and a bit of economic theory)."

This is right, and the consequences of what my economist friend is saying is that the CDO Put will only hold so long as it is viewed that default risk is relatively contained.

Let's say that credit spreads generally move 30bps wider, and that improves CDO equity returns by 250bps. The extra 250bps is attractive enough to sell the equity, and certainly CDO managers and IB's are happy to make fees, so the CDO engine revs up and creates new demand for credit, thus preventing spreads from drifting wider.

However, let's say that credit spreads are 300bps wider because there is widespread fear of deflation and accounting fraud (see 2001-2002). CDO equity can't get cheap enough and the CDO engine goes into park.

Witness sub-prime related deals today. According to Merrill Lynch the following are "base case" CDO equity return. This is not the actual return, but more the hypothetical return based on where collateral spreads and debt tranches are. I watch this closely and have come to think of it as the "advertised" CDO equity return. In other words, that's the return a generic CDO "would produce" if defaults come in at a historical average level, and hence indicative of what model returns CDOs are being marketed with.

For Mezz Structured Finance (which are mostly residential MBS), the 2006 average was 11.6%. Today it is 65.4%. Let me say that again.

Today it is 65.4%.

This number is so ridiculous as to be meaningless. It is telling you that one could create a new CDO of sub-prime MBS and if defaults were historically normal and if recovery was historically normal, the equity would return over 65%.

By demanding such an outrageously high base-case return, the market is saying they expect defaults and recovery to be substantially worse than historical norm.

Does this disprove the CDO put? No, it just means there are limits. Once the market is tossing out historical norms for defaults and recovery, the CDO put is no more. That's what's happened in the sub-prime market.

But nothing of the like is happening in the loan market. That's because the broad market doesn't expect a wide contagion from sub-prime. So although credit spreads have widened modestly since February, CDO spreads, from AAA to equity are unchanged.

The world of awash in liquidity, and the CDO market is part of that. As long as there are buyers of the AAA and equity tranches, the CDO market will continue to support credit spreads.

The CDO Put

In a recent post, I off-handedly mentioned the "CDO Put." Basically, the CDO put, as I'm using it, refers to the fact that wider credit spreads result in making CDO creation easier. Thus a minor widening event will be met with increased CDO issuance, thus creating a back-stop to spreads.

Here's how it works. Let's say that the spread on BB-rated bank loans is LIBOR +250bps. So if I have a $100 million portfolio of these loans, I'm earning LIBOR +$2.5 million every year.

Now let's say that I can build a CDO of these securities with the following traches:

65% AAA (LIBOR +25)
8% AA (LIBOR +50)
8% A (LIBOR +80)
9% BBB (LIBOR +250)
10% Equity

That comes out to annual interest cost of LIBOR +$490,000. So we should have over $2 million left over to cover admin costs, cover defaults, and pay equity holders.

What happens if credit spreads widen? Well, we'd logically assume that the spread between AAA and BBB (or BB) bonds would widen. So let's say that the BB loan market is now +350bps. Let's say that the debt tranches on a new CDO deal widen as well:

65% AAA (LIBOR +35)
8% AA (LIBOR +80)
8% A (LIBOR +120)
9% BBB (LIBOR +350)
10% Equity

So now the annual interest cost is $700,000, a 43% increase. But now interest collected is $3.5 million. Now we have $2.2 million left over for costs, losses, and equity holders. So the net-net is that the CDO deal is more profitable as spreads wider.

If spreads in the loan market track spreads for similar-rated tranches in the CDO market, its a mathematical certainty that wider spreads will improve CDO economics, all else held equal. Thats because the CDO will always be issuing higher-rated debt than the collateral its buying. The basic arbitrage of a CDO is the spread between the lower-rated collateral and the higher-rated debt. Put another way, its the arbitrage of owning a portfolio of weak credits which collectively can garner a higher rating.

The truth is that CDO spreads are wider than generic bond spreads. I mean, a generic FRN with say AA rating and 8 years to maturity (a typical average life for a CDO tranche) would be in the 15-20bps range. But AA CDO tranches are much wider, usually in the 40-50bps area. AAA (and even AA) CDS spreads are usually less than 10bps. But the AAA tranche of CDOs of CDS is far wider, the most recent I saw was around 40bps.

So if investors lose confidence in CDO technology, spreads could widen in CDO tranches beyond where generic collateral spreads are going, destroying the CDO put. So far, the CDO market has held up beautifully in the face of the meltdown in sub-prime. CDO investors should be very encouraged. There shouldn't be any reason why CLOs should widen just because too many mortgage brokers were too aggressive with their credit standards.

Another thing to bear in mind is that the soundness of a CDO is not dependant in any way on the movement in credit spreads. By this I mean, if you buy a CDO today and spread for the collateral widen, and defaults don't actually increase, the cash flow of the CDO is unchanged. If you imagine that credit events, like LBOs, will cause spreads to widen, but actual defaults will remain relatively low, CDOs are probably better investments than traditional bonds.

HD's DIY LBO

Home Depot announced they would use the $10 billion they are getting from the sale of HD Supply as well as another $12 billion from debt sales to buy back about 1/3 of their shares. Let's call it the do-it-yourself LBO. Instead of waiting around for private equity to form a (possibly hostile) bid for the languishing stock, they went ahead and levered up on their own.

I'm hearing this will put leverage in the 2.5x area. I've also heard Moody's plans to downgrade Home Depot to Baa1 (from Aa3) and S&P to BBB+ (from A+).

I'm surprised there hasn't been more of this going on, and maybe Home Depot will usher in a wave of similar transactions. There are many companies that have no real need for as strong a credit rating as they currently have. I'd say most A-rated retailers, some A-rated telecoms, several technology firms (Cisco comes to mind), etc. A company like Cisco is particularly interesting (I have no position either way), because its stock price has been pretty weak, and they currently have a A-rating, but I can't think of why they wouldn't do just fine at BB.

The Home Depot transaction finally puts to bed the myth that size of the company protects bond holders from leveraging transactions. If a very large company like Home Depot can do this, there's no reason why someone even bigger, like Cisco couldn't do it also. Particularly since in a DIY LBO, you don't have to do it all at once. Cisco could sell $5 billion in debt this year, another $5 billion next year, do a spinoff here and there, and it adds up to a substantial leveraging. There was never the problem that actual LBO's face when doing very large transactions: namely a very large bond deal swamping the market and making the spread widen.

It also is example number 4,312,789 that bond holders are always stock holder's bitches.

Who's scruffy looking?

Let me throw this out to the blogosphere.


There are two major reasons why a bond gets downgraded from investment grade to junk.

• The firm's operations are performing poorly.
• The firm chooses to increase leverage, for example through a LBO-type transaction.

So let's assume we have a firm currently rated A. They have $1.2 billion in operating profit and $300 million in annual debt service. The firm has $2.5 billion in expenses, $3.7 billion in revenue, and no non-debt liabilities. Let's say that if they increase leverage to 1.5x coverage, that would result in a junk rating. Obviously in real life, there is no magic interest coverage level that results in any given rating, so this is merely illustrative.

Let's consider two scenarios.

First, the company decides to increase leverage such that debt service is equal to $800 million, but operations are unchanged. That results in 1.5x coverage and a junk rating. But let's consider what's really happened here. The company took a look at its operations, and decided, by its own volition, that they could afford to be more aggressive with their financing. Sure, the margin of error is now much lower, and so the junk rating is justified, but given that the operating situation is stable, there is no imminent danger of default.

Contrast this with a second scenario, where revenue starts falling because of lackluster sales. If the company suffered a permanent decline in revenue of about 20% with no change in expenses, debt service would fall to 1.5x, and the firm loses its investment grade rating.

So what's the difference? In either case, a relatively small decline in revenue will result in net losses, and obviously continued net losses will lead to a default. But in one of the two scenarios, the company is failing to execute their basic strategy. In the other, they have simply chosen a more aggressive strategy. Which seems more dangerous to you?

So this begs the question, does the market go too far when repricing companies who are subject to sudden increases in leverage. Right now, Alltel bonds are trading cheaper than Ford Motor Credit, and I argue these two companies are good examples of each of the two scenarios described above. Ford is failing to execute. Alltel has made a strategic decision.

As many readers know, I own Alltel bonds, so I'm obviously biased. But forget about the specifics of the Alltel/Ford comparison. Conceptually, I'd rather own the LBO story than the fallen angel story. I'd always rather own the company that choose their situation than the one where the situation was trust upon them.

So I open it up to the blogosphere. Why does the market seemingly treat both these situations the same, when one sure seems more scruffy looking than the other? Why don't high yield buyers view LBO situations as superior to other firms? I'd love to hear the case for why the market acts as it does, either in the comments here or on other blogs. I've love for someone to prove me wrong here.

So... you got your reward and you're just leaving then?

In a move that surprises most Australian aboriginals and some (but not all) long-term coma victims, a high-profile hedge fund focused in the sub-prime mortgage area is liquidating. Bear Stearns put about $3.8 billion in bonds out for the bid today, a little bigger than your average BWIC. According to various people I've talked to, the bonds are predominantly AAA floaters, so despite the sub-prime stigma, these are pretty clean bonds which should garner demand from various types of investors.

I understand that Bear has riskier assets in the fund, called the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund. When these are to be sold, I don't know. Some of the CDO equity the fund was holding has already been liquidated.

This is classic Wall Street. Hang around while the product is hot, create as much in fees as you can, invent new structures or create your own investing vehicles if you have to, and cash your chips in at the first sign of trouble. You can decry it all you want, and I'm sure people like Tanta will, but I'm pretty sure that's how Wall Street has been operating since the days when there was actually a wall to keep the injuns out.

Anyway, let's talk about something more interesting.

Any time a hedge fund is liquidating, people start to think about Long Term Capital Management, and how much of a mess that created for the market. The Bear fund, which has about $500 million in capital, just isn't large enough to cause an LTCM type disaster on its own. But I think there are some real parallels to LTCM and what's going on in sub-prime today.

Long Term's primary bet was that markets would always be fairly efficient. I remember reading a quote from one of their partners, I think it was Merton, who described their strategy as picking up nickels the market was leaving behind. Their models consistently lead them to believe that owning a wide variety of high-risk assets would result in a low risk portfolio, which could then be levered 100-1.

In the fall of 1998, due in part to the Russian debt crisis, the market's risk appetite diminished markedly. This resulted in risk assets in all corners of the world to fall in value, from Taiwan to Brazil. Suddenly, assets which would have seemed to have no fundamental correlation were displaying a very high correlation. LTCM was suffering losses on everything at once, and their leverage was so high that the whole thing fell apart rapidly.

There are many parallels in various sub-prime strategies, be it CDO's, hedge funds, or REITs. First, the leverage is usually very high, because the spreads on most sub-prime securities just aren't that great. The majority of sub-prime backed bonds in the market today are investment-grade. In order to make the sexy returns the hedge fund crowd is looking for, you've got to leverage this stuff. Second, the correlation in sub-prime performance is converging toward 1. Whereas we might have once thought that the performance of a random loan in Ohio versus one in California had a low correlation, the pervasiveness of weak underwriting standards has changed that. In addition, the pervasiveness of adjustable-rate mortgages and the extreme upward move in interest rates is also creating a large degree of stress on a high percentage of loans, regardless of geographics or other factors.

As readers of this blog no doubt know, the unwinding of LTCM was extremely painful for the market. The types of bonds they owned were already trading weak, and their positions were leaking into the street. So the street was just killing their positions. When it came time to actually liquidate, the bids were scarce. The contagion was significant, if short-lived.

So are there any sub-prime funds large enough to cause a LTCM-type result? Maybe not. But its really not that hard to imagine a major contagion scenario:

1) A large number of investors in higher quality CDO tranches (A and AA) are burned by sub-prime defaults.

2) This causes a re-pricing of CDO spreads, and causes a drastic slow-down in deal flow.

3) In turn, this eliminates the "CDO Put" in the credit market. This is where any widening of credit spreads made forming new CDO's that much more attractive, thus creating a back-stop for spreads generally. If the CDO market disappears, even temporarily, this "put" is gone.

In that scenario, we finally see the widening of credit spreads everyone's been waiting for. And given that real money has been so reluctant to over-weight high-yield, the widening could be quite dramatic.

For the moment, I don't see this actually happening without the sub-prime default rate rising even higher than most expect. It takes a lot for A or AA-investors to start taking losses. And as long as the A and AA investors are mostly untouched, then a high level of defaults really just validates CDO technology rather than cause the market to question it. Watch the delinquency reports, though.

Sir, it's quite possible this market is not entirely stable

Remember in 2002-2003 when the market would rally a little, then accelerate, and every one blamed mortgage servicer hedging their portfolio? I'm becoming strongly suspicious something similar is happening right now. Maybe not just servicers either, but various leveraged MBS buyers. Take a look at recent volatility in 10-year swap spreads...

This spread represents the difference between the 10yr Treasury and the fixed leg of a 10yr plain vanilla interest rate swap. For some background, an interest rate swaps are the most common means of eliminating interest rate risk for leveraged MBS investors.

As interest rates rise, the duration of a mortgage loan increases. Higher rates make refinancing less attractive, as well decreasing the borrower's overall mobility. So when interest rates rise, hedged MBS investors need to own more hedges in order to eliminate duration risk. To see why, imagine that duration of your MBS portfolio starts at 3. You have pay fixed swaps outstanding that have a -3 duration. So the net is zero.

Now interest rates rise and the duration of your MBS portfolio is now 4. The swaps won't change appreciably, so now you need to find another -1 in swaps. Increasing your pay fixed swaps has the same effect as selling bonds. If there is overwhelming demand for the pay fixed side of swaps, the rate has to rise to entice investors to receive fixed. Just like when there is overwhelming supply of bonds, bond yields have to rise.

Back to the graph. Visually, you can see that the swap spread has widened substantially, and the intra-day volatility is noticeably higher over the last 5 sessions or so. That would sure suggest that there is increasing demand for pay fixed, and it looks to me like these players are driving the market. For example, on Friday, when the 10-year oscillated from down 3/4 to up 1/4, swap spreads ranged from +65 to +60. On that day, when the Treasury market was weakest, swap spreads were at their widest and vice versa.

Consider that if the Treasury market was leading the swap market, the opposite would be true. The Treasury rate would rise faster than the swaps market and spreads would seem to compress. When the Treasury was rallying, swaps would lag and spreads would seem to widen.
So what if I'm right? Its just like any other technical influence. Once its out of the market, the market must then search around for the right fundamental price. In this case, we'd likely see a very quick, but probably small, rally. Then it really will depend on where the Fed is going. Which I think we'd all agree, is becoming a tougher and tougher call.

So what else might you do? You could make a bet on swaps tightening, which I think is a no-brainer. Its an easy bet to put on, because just about all high-quality spread sectors are swap-correlated.

The other way to play it is to go long MBS. MBS spreads have widened even faster than swaps, I'd say due to selling by leveraged buyers. Stands to reason: if you need to get your duration down, you can either increase your hedge or decrease your long position. At the very least, no one in that group is buying MBS, and its been widely reported that dealers came into May with very large positions.

So we are in for a volatile market, but hell, that's how traders make money.

Not entirely stable? I'm glad you're here to tell us these things.

Lies, damn lies, and PIMCO Newsletters

Dear reader, you know I have nothing but your best interests at heart. And I know that most of my readers are bond market pros, so this will come as no surprise to you. But to the other readers, who maybe are focused on the stock market or who are amateur students of investing, let me give you one piece of advice:

Assume Bill Gross is lying. At all times. He may be the world's preeminent bond manager, but when he talks about the bond market, ignore him entirely. Tony Soprano is more likely to give you an honest opinion on interest rates.

Yesterday, word came out that Gross had told a group of PIMCO portfolio managers that he had become a "bear market manager." This according to Reuters. Today he tells CNBC that the Fed will cut in 6-9 months and that he's still quite bullish on short-term bonds. This kind of thing creates a bit of an uproar among those not aware of Mr. Gross' constantly burning pants.

The PIMCO Total Return fund has an excellent long-term history, but the strategy is completely opaque. Its full of derivatives, so getting your hands on what his duration or spread position might be at any time is impossible. That's not an indictment of derivatives, just a fact. A fact that frees Gross to make shit up every time he's interviewed without consequence. I wonder if they have meetings trying to come up with a well-articulated opinion that is opposite of what he really thinks.

As an aside, most bond guys make most of their alpha through strategies other than interest rate anticipation. So while CNBC sees a bond guy and can't think of anything to talk about other than the Fed, its a little more complicated.

Even a dead cat bounces... but what about a dead Fed cut?

Those who got long last night betting on a dead cat bounce are... well... dead this morning before they even finish their coffee. 10-year is down nearly 3/4. Wouldn't surprise me if this bounced a little from here today, but I feel pretty confident there are no real money buyers right now.

Vol is back. At least for now. I seem to remember thinking that back on February 27 and it turned out not so much. Anyway, swap spreads are gapping wider. The 10 year swap is now at +62 after being as low as +53 in May.

Slope is back. Remember when 2-10 was inverted? You know... way back on Tuesday? We're around +18 now. Hit +20 overnight.

I'm not sure what to do here. I feel like the risk/reward of a outright bearish rate stance is becoming poor. I also think people sometimes make their worst trading decisions when the market is rapidly moving, especially if its moving against them. Sometimes its good to step back, get neutral, and think things through.

I think the right call is to get net short the market but add some out of the money calls to protect against a sudden rally. I'm working on other ideas.

Capitulate or die

Today's bond market is a classic capitulation.

Before today, the Treasury market seemed anemic, declining 18 out of 28 trading days since May 1. But each day's trading was fairly benign. The worst single day was +6bps in yield. Technically, I read this as there being very few real-money buyers, but at the same time, not too many sellers (real or fast). So whenever there was a seller, s/he'd push yields a little higher,
but in an orderly fashion.

Meanwhile, it seemed some PM's were hoping against hope that the forecast for rate cuts was still in tact. It seems clear from the stock market action in April and May that this was still the case. I am guilty here also. As recently as May 4 I said I still believed in a Fed cut. And maybe their next move is a cut, but the market clearly believes there won't be any cut for a long while. There just isn't any evidence that the economy is weakening in a way that will ease inflation pressure.

I had thought the Fed would cut once or twice to ease pressure on the banking system. This is rapidly becoming not an option. Central banks around the world are tightening, which will cause the dollar to weaken, all else being equal. A weaker dollar is inflationary (your dollar buys fewer goods, which is the very definition of inflation). To think of it in terms of monetarism, higher interest rates abroad causes capital to flow out of the U.S. If capital flows out, consumable dollars must flow in. Another way to think of this is simple goods competition. If the dollar weakens versus the yen, then Japanese goods are more expensive. Consumers will either accept the higher cost Japanese good (inflation) or buy the domestic good which had been higher priced but is now more competitive (inflation either way.)

So if foreign central banks are tightening, and the Fed just wants to stay neutral, they have to raise rates. To wit, the Fed has never cut rates any time when all three of the Bank of England, the European Central Bank, and the Bank of Japan had hiked rates within the previous 6 months. Nor has the Fed ever hiked when all three were cutting. In fact, when 2 of the 3 were moving in the same direction, there was only two instances (June and August 1999, so really only one) where the Fed bucked the trend. At that time the Fed was hiking as the stock market was roaring. By November, both the ECB and BOE changed course and where hiking rates as well.

Where does this leave the bond market? I've become decidedly more bearish.

1) If the next move by the Fed is a hike, or even if the odds are even for a hike or cut, there should be a positive slope between Fed Funds and the 10-year Treasury. Right now, that slope is still negative. I'd say the minimum level for the 10-year now becomes 5.35%. Probably higher.

2) Corporate and MBS spreads are moving significantly wider. I think its smart to watch this for a good entry point. As I've said before, I don't buy the Asia is getting out of the U.S. market argument. Corporates are more dangerous than MBS, because a Fed-induced recession could cause corporate spreads to widen irrespective of global liquidity.

3) The technicals look very over-sold here. So entering into a short now is tough. As David Andrew Taylor wrote in a recent post, its usually poor investment management to get too worried about timing. But as I said in starting off this post, today looks like a classic capitulation. By that I mean, it looks like there were many accounts who were long the bond market and had been hanging on despite recent weakness. But there comes a time when those longs "capitulate," i.e., give in to where the market seems to be going. This is a textbook capitulation, where a couple weeks of an anemic market culminate in a severe sell-off. Technically, a capitulation is a reversal sign. Take that as you will, I have a firm policy of never making a trade which is contrary to my fundamental view based on technical conditions.

Unfortunately for me, I've been working on various creative bearish strategies and then today happened. So while I did have a small duration underweight, which is helping, had this happened next week, I would have made more out of it. You can't win, but there are alternatives to fighting.

Labor force participation...

Having a new baby in my house is putting a serious crimp on my blog reading. But anyway, I came across this from Macroblog on labor force participation. I thought it was first rate analysis, as per usual from that first rate blog. I won't rehash it here, you should go to his site and give him more hits.

A couple random thoughts on the subject:

• We have to accept that the labor force participation rate will be declining over the next couple decades. The aging population assures this, I think. We should not misinterpret this as despondent workers or general economic weakness.
• The declining labor participation of teenagers is logical to me. If more are in school, fewer are working. I don't know how the DOL counts part-time employees.
• Some of the long-term trends that resulted in greater labor force participation in the last 2-3 decades or so are probably ending. For example, David's graphs show greater participation among the 55+ group, which likely reflects improved health of older workers. But that trend can't continue indefinitely. We aren't headed for a future where 80-year olds are a major part of the labor force. At least not soon.
• Also in the 1960's and 1970's, the participation of women greatly increased, but this appears to have leveled off.

But what are the consequences for interest rates? Beats me.

Don't worry, she'll hold together

Like leverage? CDO equity is for you. As discussed in an earlier post titled How do CDOs Work? CDO equity can be very risky. Many times, CDO equity has de facto leverage of 20-100 times. On top of that, CDO collateral is often made up of weak credit quality instruments, such as junk-rated bank loans, CMBS, or sub-prime RMBS.

One would expect the returns of CDO equity deals to be highly volatile, but a recent report from Citigroup might surprise you. They found that CDO equity return volatility is not consistent across deal types. The following table is from a May 30 report titled US CDO Equity Returns - Our Fourth Update.

Mezz ABS generally means asset-backed bonds rated A and lower, but in this case, probably concentrated in BBB and lower stuff.

Bank loans sure seem to carry the day. Most CLO's ("collateralized loan obligation" -- the term used for bank loan CDO's), have average ratings in the B or BB area, so this is dicey stuff. Why are the returns so consistent?

A big part of it can be found in the recovery statistics for bank loans. According to the 2005 Moody's default study, senior secured bank loans had an average recovery rate of 70% from 1982-2005. That means that given a default, the lender recovered 70% of principal on average. For senior unsecured loans, the figure is 58%. Compare that with bonds, where the senior secured recovery was 52% and the unsecured a mere 36%.

There is reason to believe that recovery rates are more consistent over time than default rates. Moody's doesn't publish historical figures for bank loans, but taking a look at default and recovery for bonds paints an interesting picture. See the graph below.

I adjusted the scales such that the percentage variance from the median was approximately equal. Visually, this shows you that among bonds, the recovery rate is much more consistent than the default rate. To put numbers to it, the percentage standard deviation of default rates from 1982 to 2005 was 61% versus only 23% for recovery rates.

Its logical that recovery rates would be more consistent and predictable than default rates. Corporate default rates have historically been a function of the business cycle and degree of credit availability. Classically, credit is widely available when the economy is booming, but towards the end of the boom cycle, banks and bond holders start making poor loans. When the economy turns, the projects funded start to struggle, and withing 2-3 years, default rates spike up. Note that the actual recession may be over (e.g., the spike in 2002) but that doesn't mean that the default spike was not a result of a weakening economy.

On the other hand, the types of assets that used for recovery, such as real estate and equipment, tend to have more consistent value in liquidation. Although the graph above shows that recovery is actually weakest exactly when defaults are high, this is a marginal difference. The lender still winds up with decent recovery.

So back to CDO equity holders. Even though the default rate of a loan portfolio may be highly variable, the fact that recovery is so strong mitigates the losses. So the CDO waterfall is more likely to stay in tact, and therefore pay the equity holder a solid return.

Now you might ask, if its all about recovery, why doesn't the ABS and CRE deals perform just as well?

• Although all ABS are technically securitized by some sort of cash flow, you have to really think about how secured the cash flow itself is. Many ABS (particularly the mezzanine stuff) is backed by unsecured loans (like credit cards, student loans), second liens (like HELOC), or depreciating assets (like car or boat loans).
• ABS is also thought to have a higher default correlation compared with bank loans. In other words, particularly with consumer ABS, the defaults tend to occur all at once, which tends to stress a CDO. Think about the current situation in subprime as an example of how this might happen. A HELOC deal might have almost no defaults for a couple years, then suddenly is slammed with consumer balance sheets weaken.
• Commercial real estate probably has the same correlation problem. When a bank makes an operation cash flow loan with real estate as collateral, the real estate value is secondary. With a CRE deal, the real estate is primary.

Do you hear me baby? Hold together.