Die Wanna Wanga

Get it?

Anyway, Thomson is reporting that Citigroup et. al are considering pulling out of financing the TXU LBO. If that happened, it would certainly change everything. Here is the math as to why this works, in theory. Bear in mind, I think this is incredibly unlikely, more on that later.

Let's say you bought $37 billion of a 10-year bond rated Ba2. Let's say that the high-yield market falls apart and the bond widens by 150bps. That bond probably declines in value by around 12%, or around $4.4 billion in losses.

Now let's say you retain an option to simply walk away from the bond and get all your money back by paying a $1 billion penalty. Sounds like a no-brainer right?

TXU's financiers face a similar problem. They made a bridge loan at a time when junk spreads were at all-time tights, and now that the market has moved markedly wider, that loan ain't looking so hot. Not only are they going to get hung with carrying the debt much longer than they wanted to, but they also stuck with a spread that really isn't adequate given today's market.

But LBO's usually have an out clause, by which either party can walk away by paying a large fee to the other party. If the banks were willing to pony up the break up fee, maybe they could get out of these loans.

Bank's may not really be marking-to-market loans in the same manner you might a portfolio of public bonds, but the economics aren't ultimately much different. If the bank could make new loans with 150bps more in spread today but their capital is tied up in the TXU bridge, that is a real economic problem. So it isn't just about paper losses. I believe if they really could get out of some of the financing deals by just paying the breakup fee, with no other repercussions, they would do it.

However, the world isn't that simple, is it? First of all, I believe KKR and TPG would have to agree to break up the deal. I don't believe (someone can correct me if they know better) that the banks have the right to force a breakup. Why would KKR and TPG agree to this? They still have too much cash, and now that the junk market is less hospitable, future deals are going to be tougher to come by. Why walk away from a deal where they've already secured cheap financing? $1 billion just wouldn't be enough to entice them.

Second, banks still want to make loans, they just want to do it at more favorable terms. But basically reneging on one of these LBO deals would cause potential future borrowers to stay away. The damage to reputation would be enormous.

Third, TXU is a relatively good credit to lend to. It's a utility with large real estate and other hard assets to its name. If banks are going to renege on a LBO deal, I'd think First Data or Alltel or Clear Channel would be better choices. None has assets as attractive as TXU. This morning I heard FDC CDS was 70bps tighter, for what that's worth. Didn't hear whether that followed through or not.

One popular theory is that the tumult in the credit market will lead to PE firms negotiating lower prices on the LBOs. Maybe. Particularly if the threat of banks pulling out becomes more credible. The PE firm may go back to someone like FDC and say look, we can't finance this thing any more at the same levels. Accept a lower price, or we're out. The target firm may be the one to blink and accept a lower price. Or a strategic buyer may emerge as an alternative.

So I doubt this is much more than Citi trying to negotiate better terms in light of changing market conditions. But it's a story that bears watching.

Don't make me destroy you

I love getting comments on this blog. I believe most of my readers are investment pros, academics or students, based on the quality of many of the comments. This blog has seen a consistent increase in the number of daily page views, and by extention, the number of comments. This has improved the level of discourse here, and made blogging that much more fund.

But there is one thing I absolutely will not tolerate, and that's ad hominem attacks in the comment section. Whether that's aimed at me or someone else. I don't care. I won't allow this blog to devolve into a kind of cable news-style yelling back and forth thing. I hate Hannity and Colmes, I hate Rush Limbaugh, I hate Bill O'Rielly, I hate Michael Moore, and I'm losing patience with Paul Krugman. These people are turning political debate into something with barely more intelligent than two guys arguing over the best sports team in a bar. Its OK when San Francisco Giants fans turn a blind eye to Barry Bonds' transgressions and cheer for him anyway. That's just sports. But its not OK when the debate over Iraq becomes a question of whether you are a coward who wants to cut and run or an imperialistic idiot who doesn't care about the death toll.

The blog world is full of people like this. Both writers and readers. They are merely cheerleaders. If I am a Republican and I merely champion every cause the Republicans support, how is that different from a cheerleader? Who merely cheers for their team regardless of whether they are ahead or behind, playing well or playing poorly, hustling or not, making smart plays or not, etc. Same goes for if I'm a Democrat and I just bash W no matter what he says. Especially if I bash him by calling his policies idiotic without any substantive discussion as to why they are idiotic. There are blogs out there, like Mark Thoma or Greg Mankiw, which profess a consistent partisan view, but do it intelligently, reasoning out their positions. This kind of writing is a net benefit to the world. Sean Hannity is not. He's dragging the world of political discourse down in the name of ratings. Its a free country, and people want to watch him apparently, so there's nothing I can do about it. But its a shame.

So you may think I'm over reacting to a single comment, but this is a real hot button with me. Today I get a comment that starts out with "What a dope you are." Then goes on to make various comments which indicate that the commenter didn't actually read the post carefully. Listen, things will stay civil and intellectual on Accrued Interest. I'm positive that the majority of readers want it this way. And frankly readers who want to play the Bill O'Rielly game are readers I don't need.

I won't let my blog become like this, no matter what it takes. If I have to disable comments, I will.

I wasn't going to let you buy all the credit and take all the reward

Quite a rally yesterday. We started out weaker. The CDX-IG was as wide as 94-98, which is about 20bps wider, then traded to unchanged. Rescap CDS was 160bps tighter on the day. GM and Ford CDS were both more than 100bps tighter. Brokers were in as well after Morgan Stanley was upgraded to AA- by S&P. I guess S&P doesn't think much of broker-related contagion, but then again, the ratings agencies aren't known for being forward thinkers.

My sense from talking to people was that yesterday was a lot of short covering. That doesn't bode well for follow-through. Doesn't mean we sell off a ton, just that short-covering rallies don't usually last long. We need to see real buyers come in, which would suggest that someone sees value at these levels, in order to have a sustained rally. The story that Goldman is raising a new credit fund is good news along these lines, but we'll have to wait and see.

Meanwhile, MBS were on fire. Conventional 5.5%'s outperformed the 10 and 5 year by about 1/4 point, which is impressive given that swaps were only in about 1bps. This wasn't short-covering. I heard many real money accounts coming in for MBS all day, with 6% coupons being most popular. I note that the bond nearest par (currently the 6%) is always popular among your
mid-sized money manager as well as accounts where capital losses are a problem. So seeing that the middle of the stack is leading the way is a very good sign.

Today stock futures are up about 4 points as of this writing. One nice thing about being such a morning person is that you get to see the overnight activity first hand while you eat your Cheerios. Anyway, Pre-market activity has been very spotty, which suggest to me that Asian and European players are more interested in getting long US stocks than we are. Dunno what that means, just observing.

We're doomed

What happened? Just a few weeks ago, the bond market was flush with liquidity and sub-prime was an isolated problem. Now that seems like a long time ago and a market far, far away.


First, let's review some facts.

• The economy is still growing at a fairly strong pace outside of housing. Excluding bond market activity, there is little evidence that housing is causing problems in other areas of the economy.
• The only segment of the bond market where there have been actual disruption of cash flows remains the sub-prime ABS and ABS CDO markets.
• Both corporate defaults and corporate leverage remain low by historic standards.
• The factors causing liquidity to be so plentiful are still in tact, particularly over savings in Asia, easy money from Japan and China, and large cash flows to hedge funds and private equity.

Given these three facts, there are two logical explanations of for the violent collapse of credit spreads.

First, the bond market is anticipating that some or all of these factors will change for the worse. Consumer spending will finally slow, corporate defaults will rise, and foreigners will find U.S. investments less attractive.

Alternatively, you could argue that this is mostly technical. There is an extremely heavy high-yield calendar over the next several weeks. That coupled with a general discomfort with historically tight spreads and fear over sub-prime contagion causes real money accounts to back off corporate bonds entirely. Each basis point of widening seems to confirm the theory that spreads are "returning to normal" and causes more people to sell corporates.

I'm working through which scenario I find more credible. My instinct is the later, but the former can't be dismissed. Anyway, a key thing to remember is that corporate spreads will not rebound as quickly as they widened out. No matter what scenario you side with. Because corporate bonds are negatively skewed (i.e., your potential loss is always greater than your potential gain) fear will always linger in that market. This is as opposed to stocks, where greed can cause a more rapid rebound. More on this idea soon.

So I'd say the best case scenario for the short-term, meaning next couple weeks, is that corporate traders manage to feel out where there is an actual market, some bidders emerge, and the corporate market stabilizes. If this happens, and the stock market also rebounds, then corporates become a buy, on the theory that corps will catch up with stocks.

The worst case scenario? Uhhh...

I have a very bad feeling about this...

Thoughts on today.

• Today is a classic flight-to-quality pattern, where the curve steepens tremendously and anyone who doesn't control printing of US Dollars is lagging the Treasury market.
• I heard it was one of the most busy mornings in 10-years at large dealer desks.
• I'd say bid/ask spreads were widening, but that implies that there is a bid.
• CDX-HY (a basket CDS contract on a series of high-yield names) 30+ bps wider TODAY. Here is the graph through yesterday.

• I'm wondering if I'll have to repost this piece from 2/27 before the day is done.
• I'm busy playing liquidity provider today, but only on very very very high quality stuff. I might be the only one bidding.

I have a bad feeling about this...

Liquidity in the bond market, outside of Treasuries, was the worst I can remember since 2002. Absolutely nothing in the cash market was trading, particularly on the bid side. Supposedly CDS were well traded. But cash bonds bids were not in context with CDS, particularly for LBO or housing-related names.

The situation got so bad that bid lists of AAA-rated stuff were getting pulled for lack of bids. Dealers have become so skittish that they are unwilling to position anything.

There is an old Wall Street saying: the market can remain irrational longer than you can remain solvent. You see a bond trading at LIBOR +50 that should be LIBOR +25. Irrational! you say. But when there is no liquidity, you can wake up tomorrow and its LIBOR +75. Then next week its LIBOR +200. Irrational still perhaps, but you are out of a job anyway.

Why no serious buying on weakness? What happened to the global liquidity glut? I think that's a question yet to be answered. In the short-run, there is just no sponsorship. Real money accounts have been generally negative on the corporate basis for at least 18 months. If you are bearish on corporates primarily because they are tighter than historical averages, you are still bearish now. According to Lehman (if I can trust their numbers) the 10-year average Baa OAS is 165. Its currently 119.

Something has to give between the stock market and the corporate bond market. Since May 1, the Merrill Lynch High Yield Master index is down 4.7% in price return, while the S&P 500 is up 2.1%. If there is a repricing of risk, both markets should be performing poorly.

One possibility is that dealers are trying to work through their sub prime ABS/CDO positions, and its impairing capital. Broker/dealers are providers of liquidity in the bond market. In essence, they are market makers. Its rare that large trades are immediately crossed, which is a term for when the dealer buys a bond from one customer and sells it to another. Usually there it takes some time to find a buyer. Maybe an hour, maybe a month. Anyway, if dealers are unwilling to step in and bid on bonds, there may well be no bid to be had.

In that scenario, spreads have to widen. Because any time there is a motivated seller, they have to sell at a spread so attractive that someone, an end investor, steps up and buys it.

Another possibility is that this is all about the confluence of the heavy calendar in high-yield combined with slowing CLO creation. If that's all it is, then high-yield should be able to stabilize sometime in the fall or winter, once the supply is normalized. The stabilization might be at higher spreads, but I believe that stability will bring the CLO market back. I've maintained several times that if the CLO market can perform well through the sub-prime mess it will be viewed as a validation of the structure and solidify CLOs as an effective risk management tool for banks.

Alternatively, you could have some CLOs experience stress. This might be because one of the recent LBO firms goes bankrupt. Remember that CLOs in general are thought to have heavy exposure to LBO deals, so a bankruptcy would hit multiple CLOs. Remember that CLOs don't need to worry about spread widening. Just because their XYZ corp loan was made at LIBOR +200 and would now be +300 doesn't matter. CLOs (mostly) are cash-flow instruments only. As long as XYZ keeps paying P&I, everything is fine with the CLO. Remember also that CLO deals assume a certain level of defaults, so having some loans default is OK. In fact, CLOs generally have far less leverage than the ABS CDO deals that are currently stressed.

I'm biased to a more benign outcome to all this. Sub prime MBS was such a small percentage of the global fixed-income market, it seems odd to think that even a severe problem in that sector would create a lasting contagion. I think corporates (both IG and HY) settle in at levels near or slightly wider than current levels after a volatile 2-3 months. Buying opportunities will emerge among IG names that for whatever reason become targets of short-sellers or the media (MBIA, Bear Stearns, and Washington Mutual come to mind). There might also be opportunities among HY names caught up in the supply story, like Chrysler, Alltel, FDC etc., assuming those deals don't fall apart entirely. But if you are going to play that, have your resume in order. Those could be some serious bumpy rides.

How does a CMO work?

In response to some questions I've received, here is a quick explanation of how a CMO (collateralized mortgage obligation) works. I'll also talk about the difference between a CMO and a CDO.

In many ways, they are quite similar. A CMO takes a portfolio of MBS (mortgage-backed securities) and divies up the principal payments. A CDO takes a portfolio of credit-risky bonds and divies up the credit losses.

A CMO starts life as a portfolio of MBS. I'm going to use agency MBS in this example (REMIC is a term sometimes used), but whole loans are used also. Anyway, say its a portfolio of $100 million in Fannie Mae 30-year 6% MBS. The number of underlying pools could be anywhere from 1 to 1,000. The problem with MBS is that you never know when you are going to get your principal back, and in fact, you are going to get most of it back when interest rates turn against you. This is the primary reason why agency MBS offer such high yields vs. straight agency debentures.

Sometime in the mid-80's, investment banks realized that they could package MBS into a new set of securities with much more principal certainty. The initial CMO's were what's now called sequentials. In this structure, the entire portfolio of MBS would be divided into various tranches. As principal came in from prepayments, it would first go to pay down the A tranche. After the A tranche was completely paid off, the B tranche would start getting principal. Once B was completely paid off, C would start paying down. And so on.

The result was that the A tranche had a very low duration, while the C or D or E tranche was much longer. This worked because some buyers wanted low duration to protect principal, and were willing to pay up for it. Others wanted more reinvestment risk protection, and they were willing to pay up for the longer term bonds. In grand total, every one paid up a little over the MBS portfolios value by itself. CMO creation is therefore an arbitrage for dealers.

But that wasn't good enough. The longer tranches didn't always stay long-term. If there was a prepayment spike, what was advertised as a 10-year average life might become a 2-year average life. This was a problem since people who want long-term bonds usually want to lock in their rate, and the prepayment spike would only be happening if rates were low. So the bonds would be shortening exactly when you didn't want it to shorten.

So the CMO guys created stuff like "PAC" and "TAC" (Planned Amortization Class and Targeted Amortization Class). With the PAC structure, a tranche was created that would pay principal on a defined schedule as long as prepayments stayed within a pre-defined band. Of course, somebody has to get any prepayments that come in. So in order to make the PAC work, some other tranche had to absorb the difference between the "planned" principal due to the PAC holder and the actual principal that came into the deal. The tranches that absorb the differences are called "support." The deal is modeled such that the support bond can absorb all prepayment differentials so long as prepayments aren't faster or slower than the band.

Bear in mind that the total prepayment risk of a portfolio of MBS cannot be reduced. So if someone gets less risk, someone must have more. In fact, in the ultra-simple case of a PAC with a single support bond matched up with it, if the PAC has only half the prepayment risk of the total portfolio, the support bond must have double the risk.

The CMO is still an arbitrage, but under the support bond system, the support buyer must be paid a ton of yield. The PAC buyer on the other hand has to pay up significantly for his prepayment protection.

The PACs tend to break down as well, however, when you go through a prepayment spike. When speeds get very fast, the support bond gets paid off. Once there is no support bond, then the PAC is absorbing all the prepayment variability of the MBS portfolio. So the PAC buyer pays up for reduced prepayment variance, but takes the risk that the support is eaten away and the bond winds up highly variable anyway. In other words, the PAC buyer pays up ahead of time and hopes that he gets what he paid for.

The key to understanding the CMO is understanding the arbitrage, so I'll go through it in a bit more detail. Let's say that Fannie Mae 30-year 6% MBS are at par. Let's say someone will pay $102 for a bond that has a 2-year average life with virtually no risk of it going longer. Now the dealer trying to create the CMO has $2 with which to create a support bond. If he can create the support at $98.25 (or costing the deal $1.75) then there is an arbitrage, and the CMO deal will be created.

Let's say we are using a portfolio of Fannie Mae 6.5% MBS. Let's assume these are trading at $103. So there might be someone who isn't so much worried about prepayment variability, but doesn't want to pay $103 and have the bond prepay away at $100. So they buy a CMO that has a stripped down coupon of, say 5.75% and pay $100 for it. In order to make that work, they need someone to pay them the extra $3 up front, and they have 75bps of extra yield to pay that person, but no principal.

So they create a tranche that in fact pays interest only (IO). Consider what this means. If the bond pays slow, the interest only buyer keeps getting interest. But if the bond pays fast, there won't be any interest to pay to the IO holder. IO's have very low dollar prices, like maybe $20, depending on the reference coupon. And the yield is usually very large, like 10%. But every time principal payments come in, the interest available declines. So in essence, the IO holder benefits from rising rates (rising rates=slow prepays). Hence IO's have negative duration (in the -20 area) and can be used for hedging purposes. Obviously the price/yield situation depends greatly on the coupon of the underlying MBS. If its a steep discount, the IO is worth more and yields less.

The opposite is a principal only, or PO, which has ginormously high duration. There are zillions of other types of CMO tranches, and the means by which support is created varies greatly.

A CMO is fundamentally similar to a CDO, in that the risk of a portfolio of bonds has been redistributed such that some buyers have far less risk and some have far more. The only difference is that the CMO is designed to redistribute prepayment risk, whereas the CDO is designed to redistribute default risk.

Now, matters are worse

Editor's Note: This post has been edited. Some of the data I had used on Lehman indices was incorrectly posted on Bloomberg, and therefore misreported in my post. Anyone using the Bloomberg index ticker LUMSER should be aware that data set is incorrect. I am working with Lehman to have it fixed. Use LD10ER instead. Anyway, the core of what I was writing stands, but now the data is corrected. My sincere apologies for the incorrect facts, and my thanks to reader FI PM for pointing out the problem.

Under-reported amidst all the sub-prime problems was the terrible performance of agency MBS during 2Q 2007. In fact, in terms of excess return, it was the worst quarter for the Lehman MBS index since 2003. Bear in mind we're talking about the AAA/Aaa rated Fannie Mae and Freddie Mac-backed securities. Not the credit-risky "whole loan" market that is making so many headlines.

Various reasons for the underperformance have been kicked around. In my opinion, it boils down to this. Prices are set by supply and demand. We know from various sources that supply growth has actually been slow this year. Mortgage debt increased by 1.54% in 1Q 2007, which was the slowest pace in 10 years.

So the problem is most likely on the demand side. I argue demand for bonds is made up of three simple factors:

1. System-wide liquidity. The more liquidity in the system, the more in demand bonds will be generally.
2. Yield competitiveness. A bond will always react to shifts in yield spreads for competing products. In other words bond sectors compete for the same dollars, so if one sector is widening more than others, money will tend to drift toward the widening sector, causing other sectors to widen as well.
3. Principal repayment certainty. For corporate bonds, this is default risk. For optionable bonds (like MBS), this is the timing of principal repayment.

So one or more of these factors is moving against MBS. Obviously #2 is a problem. Pretty much all credit-risky bonds have moved wider, which is forcing MBS spreads to widen in order to compete. Also #3 is a problem. Forward interest rate volatility is rising, due in part to uncertainty over whether stubborn inflation or growing sub-prime contagion will cause the Fed to move on way or another. With interest rates so uncertain, the path of MBS principal repayments is hard to gauge.

There is also the problem that we are in the midst of a truly unique housing market. MBS investors are rightly questioning the validity of prepayment models that have not dealt with a sustained period of negative HPA. Even if rates stay relatively constant, how mobile are home buyers going to be in the next 5-10 years? That's a more difficult question than it has been in the past.

All that being said, MBS represent an excellent buying opportunity, in my opinion. Historically, MBS have underperformed Treasuries by at least 50bps 9 times since 1990. All 9 times, MBS rebounded to produce positive excess return the following quarter, with average outperformance of 53bps.

Why would this be? Its more than just mean reversion. First of all, if its increased volatility that pushes MBS wider, the fact is that vol can't logically keep rising indefinitely. Second, increased vol is often an indicator of heightened risk premia. Since the downside for a corporate (default) is much worse than MBS (pays too slow or too fast), its logical that if risk premia continue to rise, corporate bonds will eventually widen more so than MBS. If the volatility subsides without any economic weakness, then MBS are going to revert, and since they initially underperformed they are likely to outperform during the reversion.

Ultimately, very few long-term bond investors want to own too many Treasuries. If credit fears persist, these buyers will look to MBS. Until this happens, I'm happy to clip the coupon.

Fair disclosure. I have a very large portfolio of MBS. Of course, its a $10 trillion market. Oh, and I get like 600 page views/day. Maybe a few more on aggregators. So while I am indeed speaking from position, don't over estimate my powers.

Find the controls that extend the bridge!

"Hung bridge" was a term I don't think I had heard before a few days ago, but the concept is easy enough. When a private equity firm wants to do a LBO, they may plan to secure a bank loan, sell bonds or both. If get a bank loan, they can privately talk to the banks about securing the loan before making the LBO public. But obviously they cannot do the same for a public bond offering. Hence at what rate and under what terms they can complete the bond offering is an unknown. Its possible that conditions are such that they cannot get the bond deal done at all, or at least at a rate that makes the economics of the LBO work.

In order to mitigate this risk, private equity firms negotiate a plan B: a bridge loan. Basically this is meant to be a short-term loan that will "bridge" the gap between when the acquisition closes and when the bond issue proceeds are available. This allows the private equity firm flexibility as to when go to market with the bond issue.

Usually a bridge loan is easy money for a bank. Generally they get a commitment fee up front, plus interest, and the loan is usually only outstanding a matter of weeks before permanent financing is in place. Easy money that is until the acquirer can't go to market with the bond. In that case, the acquirer can keep the bridge outstanding for an extended period of time (e.g., up to 10 years in Alltel's case) albeit with various terms and/or rate step ups imposed.

Because bridge loans were seen as easy money by banks, the market to make such loans became very competitive. Not surprisingly, when banks were falling all over themselves to make these loans, they became more and more willing to accept borrower-friendly terms.

Now, they're coming through! The high-yield calendar is flooded with LBO-related offerings. In August alone it is expected that First Data, Clear Channel, Biomet, and ACS will all come to market with multi-billion dollar bond issues. That doesn't even get into Home Depot, Alltel, Chrysler, and Sallie Mae which could well be coming to market soon as well. That has high-yield spreads widening rapidly, and investors starting to demand more stringent covenants. Stringent covenants can be a problem for LBO transactions, since there is often existing debt covenants to deal with as well.

Anyway, so now banks are growing concerned that these bridge loans are going to turn into term financing. Yesterday Jamie Dimon (JP Morgan CEO) said that he expects "semi-dramatic" debt repricing, and also said the firm was marking down its "hung bridges" significantly. How something can be "semi-dramatic" is one question, but that aside, for Dimon to speak so openly about it tells you something. I believe when you hear a public company CEO talk about how bad things are in one line of their business, its often to get people in the mindset that either 1) its far worse than analysts currently think and they need to adjust their estimates, or 2) things are going to keep getting worse, so be prepared for me to keep using this as an excuse for why earnings aren't higher.

The high-yield market is going to suffer because of this supply problem. Remember, even if no bond deal is ever consummated, the bank will likely buy CDS protection, and that will keep the market soft for a while.

My view is that high-yield stabilizes near here, although probably just a bit wider. Once the supply problem is past, the market will remain skittish. Historically, high-yield tends to widen much faster than tighten. Plus the supply problem will not suddenly pass, it will just get lighter sometime after September. Third, many market participants were growing weary of the historically tight levels anyway, and I'll bet they are loathe to jump back in with both feet, even after the recent widening. The Merrill Lynch High Yield Master was as tight as +241 on 6/5, and is now +320. I think there will be plenty of buyers between +350 and +400, but I see it as being a stabilizing point, as opposed to a tightening possibility.

Maybe the high-yield market just needs a little kiss. For luck.

Revenge of the Street

In what feels like old news, Bear Stearns told investors that their troubled High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund have "very little" and "effectively no" value remaining respectively. It had been whispered for a couple weeks that the funds were going to be worth between 0-10 cents on the dollar, so there is little surprise here.

A couple weeks ago I was trying to do the math of how Bear's funds could have lost so much money. Obviously not knowing the actual bonds held and the real leverage, I had to make some educated guesses. But there were enough people who I knew that had some knowledge of the situation that coupled with media reports, I thought I could get pretty close. I estimated that the Enhanced Leverage Fund was about 18x levered, and the Structured Credit Fund was about 10x.

The market for structured finance AAA-rated CDO's is about 10bps wider for senior stuff and about 100bps wider for junior stuff. While there were media reports that Bear was getting 30 cents on the dollar for the items, that just didn't fit with what was going on in the market generally. Remember that ABS CDO's usually have a spread duration in the 3-4 range, if not lower. So even if you assume their entire portfolio was 100bps wider, they should have only lost something like 60-70% of value, not 100%.

But there are two factors which exacerbated losses in these funds. First, apparently the funds increased their long protection position in the ABX BBB- index in early March. While recently the ABX has been hitting new lows, in March and April it rallied substantially.

This is a classic case of a highly technical move overwhelming what would have been a good fundamental play. Had Bear been given enough time for the technicals of the ABX to wash out, the hedge would have worked fine and the funds would probably still be in business, or at least would have been able to close before being wiped out. But as it happened, the hedge added to losses instead of protecting against them.

Then there is the matter of the Long Term Capital Management bailout. For those who don't know the story, here is the quick version. In the fall of 1998, things were so bad at LTCM that it really did threaten the stability of the entire financial system. Alan Greenspan got together all the heads of the big Wall Street firms, most of whom were LTCM's creditors, and basically locked them in a room until they agreed to buy all of LTCM's positions. This prevented LTCM from continuing its fire sale that was wreaking havoc on the Street. You can imagine how difficult that was: here was the most powerful men in all of finance being forced to take on positions that anyone would have agreed were dangerous, all in the name of some greater good. Wall Street isn't used to working for a greater good.

One firm refused to participate: Bear Stearns.

Not only did Bear skip out on what was likely the most painful, difficult, humiliating and frightening decision many of the men involved ever made, they in essence got a free ride on the result. Shortly after the bailout, the financial markets calmed down and within 6 months or so, most markets were back to where they were before the crisis. Bear benefited from that calm, but didn't take on the risk to make it happen. It was like all of Wall Street saw the river was going to over flow and struggled to pile up the sand bags. But one of their neighbors just sat inside his nice dry house sipping coffee while everyone else did the work. He knew that because everyone else was out there, his house would be spared anyway. Why do the work?

So I've heard from multiple sources that when Bear Stearns was going through their own private Long Term, the rest of Wall Street decided it was time for revenge. Normally when there are large bid lists of any kind, Street firms can do one of two things. They can either try to find customers who want to buy the bonds directly, or the brokerage can buy the bonds themselves first and then find customers to buy. Generally it depends on whether the firm wants to take the risk of owning the bonds, which normally results in bigger profits but with it the potential of loss. By soliciting customer bids initially, they just sell the bonds to the customer immediately. No risk, but generally a smaller markup for the dealer.

So you'd think with all the problems with the subprime market, dealers would be loathe to make lots of bids on subprime CDOs without having customers in hand. But supposedly when BSAM's bid list came out, big players like PIMCO or Western Asset were not shown the list. The Street bid everything directly. Lo and behold! The bids come in at ridiculously weak levels. Levels that eventually forced Bear Stearns to bail out its own fund, much in the way the rest of the Street bailed out LTCM in 1998.

Oh the irony.

(Note, Reader Robert points out that Lehman did not participate in the LTCM bailout either)

Are Treasury Rates too Volatile?

Econbrowser thinks so, in a very nice post here. Please read Dr. Hamilton's comments as they are up to his normal high quality.

I disagreed with his (and the paper he referenced) conclusion however. Here is the comment I left:

I agree that if you assume a model of risk neutral, single decision investors with limited choices, the bond market is more volatile than it should be.

But in reality, Treasury rates reflect various economic elements, only one of which is future inflation. The real Treasury rate is a function of perceived opportunity cost of investing money.

When there are ample profitable investments available, relatively low Treasury rates seem unattractive, driving the real Treasury rate higher. When investment opportunities are scarce, funds flow toward the Treasury market.

This is in part a function of investors changing perception of risk. For example, when default risk is perceived to be low, investors may choose to own high-risk junk bonds and eschew Treasury bonds. But when default risk is perceived to be high, the opposite will happen. Or if prospects for the stock market are perceived to be strong, low Treasury yields seem inadequate. Etc. etc.

The varying view of risk and opportunities world wide alters every day. So for the yield on the 10-year Treasury to move 5-10bps on a given day suddenly doesn't seem so surprising.

Furthermore, a large percentage of bond holders do not hold bonds for profit. Many are holding for hedging or asset-liability purposes. This alters demand for rates product. Hedgers particularly can cause movement in rates to accelerate.

I'd be easy to say this is a case of academia not understanding reality, but it isn't that. I think here we have a model which produces less volatility than is observed, but that is only because the base assumptions eliminate many of the reasons for the volatility. I think it would be possible to create a model which could indeed account for market volatility.

Run, Morgan, Run!

Here is my quick take on the Sallie Mae news. For those who haven't heard, the synopsis is that J.C. Flowers, Friedman Fleischer & Lowe, Bank of America, and J.P. Morgan have informed Sallie Mae that pending legislation "could result in a failure of the conditions to the closing of the merger to be satisfied."

When the deal was first announced, it was widely reported that the private equity buyers could opt out of the deal if congress cut the subsidy for student loans beyond what the President had already proposed. That now appears to be probable.

I have two thoughts on this. First, if the acquiring group still wants to own Sallie Mae, they will simply use this as a means of negotiating down the price. Bond holders would wind up in a similar spot.

But there might be something a bit more nefarious going on here. Let's say you are Jamie Dimon. Your bank has several bridge loans for LBOs either outstanding or pending, and some of the deals are looking iffy. You had made the loans assuming you'd get taken out by a bond issue, but with high-yield spreads on the rise, that assumption is looking questionable. Ideally, you'd try to reduce your exposure to these bridges, but to renege on a bridge loan, or to try to work some loophole to get out, would damage the bank's reputation. You'd be shut out of the bridge loan business for the next 10 years. You don't want that, all you want is to lighten up.

But you do have one deal, Sallie Mae, where there is a likely change in the legal environment which alters target's basic business. Clearly with a reduced government subsidy, SLM isn't worth as much. If you could convince your partners (one of which, Bank of America, is in the same boat) to cancel the deal, then you achieve your goal of lightening up without damaging your reputation.

Maybe that has nothing to do with the recent communique between the parties involved, but worth thinking about.

Fair disclosure: I own a small SLM position. My goal is to hoodwink the entire bond market by writing this post on my tiny little blog. To throw you off my trail, I'm starting by suggesting that this news won't help bond holders at all. Oh, and I hate puppy dogs.

The choice is yours but I warn you not to underestimate my power

Let's say you have to make a loan, and you have two applicants. Luckily, you happen to be the proud owner of a semi-functional crystal ball. While it cannot tell you the future exactly (always in motion the future is) but it can give you certain facts about your potential borrowers.

The first borrower is willing to pay a rate of 6.35% for a 10-year term. He will pay interest only until maturity but cannot pay principal early. According to your crystal ball, there is a 4.7% chance he defaults, and if he does default, his assets will be worth 36 cents on the dollar.

The second potential borrower will pay a rate of 6.25%, but your crystal ball shows there is no chance of default. He will pay principal monthly on a 30-year amortization schedule, but can also prepay principal at any time. Obviously the odds are good that the principal repayment will occur at a time when interest rates are lower than current levels.

The first exposes you to default risk but not reinvestment risk. The second exposes you to reinvestment risk but not default risk. Which would you rather take on?

It depends on how you feel about skewness. Bonds with default risk are said to be negatively skewed. Basically this means that there is a large chance of a small return, and a small chance of a large loss. The probability-weighted average return for the first loan is close to the stated rate (something like 5.94% depending on when the default occurs), but many investors are so adverse to the -64% loss scenario, that they are unwilling to accept the relatively attractive "average" return.

By contrast, the second borrower will return the stated rate, but in exchange for that certainty, we are allowing the borrower to play interest rates against us. Let's make a relatively simple assumption: if interest rates fall 75bps or more, the borrower will refinance the loan. Let's further say that the odds of rates falling by 75bps in year 1 is 10%, but the odds increase by 20% per year, so year 2 is 30%, year 3 is 50% and so on. This is roughly consistent with a normally distributed rate pattern. The odds that rates fall by at least 75bps at some point rises to 100% by year 5. Once rates eventually fall that 75bps, we assume reinvestment in another loan 75bps lower in yield (or 5.50%).

To make things simple, we'll measure yields and odds at the end of each year. For instance, since there is a 10% chance the loan is paid off after year 1, during year 2, you have a 10% chance of earning 5.50% and a 90% chance of earning 6.25%. In year 3, its 30% that you earn only 5.50% and 70% of 6.25%, etc.

Your weighted-average return (5.87%) is actually slightly less than loan #1 (5.94%). But notice that your worst-case scenario is your bond is called at the beginning of year 2. You'd earn 6.25% for one year then 5.50% for five years, or a total return of 5.60%.

As you've undoubtedly figured out, loan #1 is a corporate bond (with stats based on a Baa-rating), and loan #2 is an agency mortgage-backed security (MBS).

Obviously this analysis is simplistic. MBS don't pay off all at once, and you rarely buy them at par. So you really have a myriad of possibilities, and any kind of probability-weighted analysis gets very messy. But no matter how you draw up the rate possibilities, your worst case scenario is a minor impairment in your realized yield. With the corporate bond, you worst case scenario is you lose 60% of your investment.

Many investment managers eschew MBS or else manage the sector passively, choosing instead to focus on credit analysis. I think many are put off by the "myriad of possibilities" in MBS, while they believe they can control credit risk. I question this attitude. While there are infinite cashflow possibilities with MBS, many scenarios have very similar results. Its relatively easy to group your potential results together and come up with a manageable set of possibilities.

Meanwhile, the credit of a corporation is always a moving target. The company with consistent cash flow and modest leverage seems like a great credit, until they are purchased in a LBO. The company with conservative management seems like a great credit, until the CEO is replaced with someone more aggressive because the stock was lagging. The company with valuable hard assets seems like a great credit, until they pledge those assets to secure a bank line. The company with diversified lines of business seems like a great credit, until they do a series of spin-offs.

The global need for yield remains strong. With all this fear surrounding the economy, which would you rather own?

Dangerous to your hedge fund, Commander, not to this portfolio

Are AAA CDOs trading at 30 cents on the dollar? Are AAA-rated CDOs much riskier than other AAA assets? Are AAA CDOs getting downgraded? Is the CDO market falling apart?

No, maybe but not by much, no, and no.

There has been a lot of misreporting about the CDO market, much of which involves lumping all types of CDOs together, when the problems are really concentrated in a single area. The following is a graph of AAA CDO spreads for the last 6-months. Without looking at the legend, you should see that a specific area of the CDO market is in trouble...

For background, please read this and this. I want to first point out that in order for the most senior tranche in most CDO deals to default, a hell of a lot has to happen. High-yield Collateralized Loan Obligations (or CLOs, which is the green line above) normally have 25% or so of subordination. So in order for the AAA senior tranche to fail, at least 25% of the collateral has to default.

But wait, there's more!

You assume you'll recover something in bankruptcy, so defaults have to be even higher.

But wait, there's more!

The deal has triggers, which divert cash away from junior tranches for the benefit of senior tranches. So when defaults start rising, interest that would have gone to a junior tranche is actually used to pay down the AAA tranche.

The fact is that AAA rated CDOs with no sub-prime exposure are showing no sign of distress.

Now, let's turn to ABS deals, which is where the sub-prime problem is. There are two basic types: High-grade (red and yellow lines above) which invest in investment grade pieces of ABS. Most of these deals I've seen have average ratings of A. The other type is Mezzanine (or Mezz, blue line above). These invest in BBB and BB ABS pieces.

Remember that a CDO of ABS is structure on top of structure. By this I mean, ABS are often tranched, where there are junior and senior bonds. So let's assume you build a portfolio of ABS, all of which are junior tranches rated BBB. Then you make a CDO out of that portfolio. The junior tranche of your CDO is backed by junior tranches of a ABS deal. Structure on top of structure.

Both the CDO structure and the ABS structure cause defaults to hit your junior tranches first and your senior tranches only after the junior tranches have been wiped out. So let's say that 10% defaults wipes out a BBB-rated ABS tranche. If that's held in a CDO portfolio, that's a defaulted bond in the CDO. What if the same thing happens to all the BBB-rated CDOs within the CDO? Suddenly 10% sub-prime defaults nationwide turns into 100% defaults in the CDO!

Now, that's not going to happen to many CDO deals, because few are actually 100% sub-prime RMBS, and you'd never see exactly the same defaults in every ABS piece you hold. So no one is going to suffer 100% defaults. But this does serve as an example of how defaults get amplified when you have structure on top of structure.

Consider how different the situation is if the CDO owns all A-rated bonds. Maybe those need 20% underlying defaults before they fail. While 10% might seem pretty reasonable, 20% is far less likely. This is why the senior AAA tranche in high-grade structured finance CDOs are performing just fine, while the junior AAA tranche isn't.

Presently few (if any) AAA CDOs are getting downgraded in the wake of this sub-prime mess, but the market is telling you that many will be. Whether defaults actually turn out to be bad enough to sink any AAA tranches remains to be seen.

The Emperor does not share your optimistic appraisal of the situation

At the beginning of the year, I wrote out my basic forecast for 2007. Now that we're closing in on the All-Star break, it seems like a good time to review what's working and what's not.

On housing, I had this to say...

Housing will weigh on the economy in 2007, in terms of lost jobs from construction and reduced mortgage equity extraction. However home price declines will be modest in most areas and the housing market will clearly be recovering by the end of the year. Business investment will remain strong, and this will help keep any decline in consumer spending from causing a more severe slowdown in overall growth.

Housing has been bad, but hasn't really leaked into the general economy yet. I still think it will. Home prices are declining, but nationwide, the price declines have been indeed modest. My thought that the market would be "clearly recovering" by year-end seems unlikely, however.

On the Fed...

Once it becomes clear inflation is slowing, the Fed will make two cuts. The first will likely be in June and the second most likely in August. At that point, the market will price in no further Fed action for some time.

The economy is doing better than I thought, and so these cuts haven't happened, and probably won't until Spring '08, but I'm still thinking a cut is the next move.

On Treasuries...

[The 10-year will finish at] 4.90%...For most of the year, the 10-year will hang around 4.50%, possibly rallying even further, but once it becomes clear the Fed is done (probably 4Q) the 10-year rate will move rapidly higher.

I was right that the 10-year would sell off once it was clear the Fed was done, I was just wrong about there being a cut or two first. I recommended a neutral duration anyway, so no money made or lost here. On the slope, I predicted a +20 slope between 2's and 10's. The steepener call has worked out nicely.

On Corporates...

[Investment grade] Mildly wider, outperforms Treasuries.While I see corporate profits remaining fairly strong, corporate spreads will likely suffer due to increased supply and continued shareholder-friendly activity. However, the widening will not be enough to overwhelm the income effect. Financials will outperform industrials.

Corporates have indeed widened mildly, but financials have underperformed. Shareholder activity has indeed weighed on industrial spreads, but the sub-prime problem has weighed on financials even more.

On MBS spreads...

Tighter. MBS will benefit from increased buying by foreigners and banks, and supply will remain tight as housing activity is light.

I was dead wrong on this. MBS have moved wider almost all year, partially on higher vol, and partially because Asian buying has been light.

Later this week, I'll post on where I think we go from here. Here is the preview:

• Fed cuts come back into the picture
• Rates rally, curve gets steeper
• High quality financials rally
• High yield continues to struggle
• Housing remains anemic
• MBS tighten as foreign liquidity comes back into this market