Friday, August 31, 2007

I don't like this...

I wrote extensively in the last couple weeks about the liquidity crisis, and made the case for Fed easing. See here and here. I got a lot of arguments from commenters that the Fed would somehow be bailing out someone by cutting now, thus creating a moral hazard problem (see this post as well as comments in previous links).

Then the Fed picked an option I didn't consider. Hell, I don't know anyone who did consider it. And I believe it was truly a stroke of genius. They tried to use the discount window to provide liquidity where it was needed (banks) but not where it wasn't (thus fueling inflation.)

Notice what was particularly genius about the discount window idea. Nobody really was getting bailed out. Therefore, in my not so humble opinion, no moral hazard issue. See the under capitalized mortgage originator who spent the last two years pumping out no-doc loans didn't get squat from the Fed. Hedge funds who leveraged the hell out of sub-prime MBS portfolios didn't get squat from the Fed. But the bank who might be hurting to find liquidity for a relatively benign ABCP program has an outlet to get short-term cash. No bank runs, but no bail out either.

I'll say this about the concept of moral hazard. As a parent, the idea is something you deal with all the time. If your kid does something wrong, there has to be consequences. If you tell your kid not to play with his food or he'll be punished, you have to follow through. Otherwise he'll assume that your threat of punishment is meaningless and you'll lose all control over his behavior.

Its the same thing with banks making bad loans. We can't simply have the government make the bank whole when a loan goes bad, because then the bank wouldn't have any incentive to do good credit work. In fact, the bank would be incented to just make as many loans as possible, with no regard for quality.

In my view, the discount window lending, or even Fed cuts, would not cause a moral hazard problem. I say this because I believe that individuals make decisions, not institutions. The individuals at New Century are all out of work. The guys running the BSAM hedge funds are all out of work. Its not like they are at home sitting on their couches watching CNBC and thanking the maker for wider use of the discount window.

And frankly, the suffering of others in the past doesn't seem to prevent the same basic mistakes in the future. Take the infamous Long-Term Capital Management. That fund sunk solely because it had too much leverage and couldn't withstand a short-term liquidity crunch. Sound like any stories you've heard lately?

So now to today's news that the Bush Administration wants to literally bail out some delinquent borrowers. I really don't like this move at all. I know what's currently being announced is limited in nature, but what they are proposing is to have FHA step in and insure timely payment of mortgage loans which are currently delinquent. I fear that Congress will move to expand programs of this sort. Now I think you are really sending the wrong signal to underwriters. To me this is exactly like threatening to send your kid to his room without dinner, then sneaking some pizza up there 10 minutes later.

Apparently the FHA proposal involves some 80,000 loans, which doesn't amount to much of anything. So maybe this is all just politics, if the program doesn't grow in scope. But I'm suspicious it will be growing. And I think this is just plain bad policy.

Thursday, August 30, 2007

I have been expecting you

How many Fed Funds cuts are priced in? At least 100bps. Below is the forward 3-month LIBOR rate based on Eurodollar futures. Note 3-month LIBOR is currently 5.58%.

  • 12/07: 5.12%
  • 3/08: 4.74%
  • 6/08: 4.60%
  • 9/08: 4.58%

I note that for longer dates, I don't like using the Fed Funds futures contract, as it tends to get pretty thin past 3 months or so. Thinly traded derivatives contracts are notoriously technical, which can lead you to make bad conclusions. For illustration, see the ABX.

Anyway, for what its worth, the JAN Fed Funds contract stands at 95.50, implying 4.50% funds. Also, the 2-year Treasury is currently 116bps through target Fed Funds. All these imply several cuts.

But as a portfolio manager, I don't get paid to interpret futures contracts, I get paid to make profitable bets. And now I believe the balance of risks is toward higher intermediate term rates. The 10-year Treasury is currently at 4.50%, or 75bps through Fed Funds. Under normal circumstances, there is a positive spread between the 10-year and Fed Funds. So using the classic arbitrage-free pricing theory, Fed Funds would have to average somewhat below 4.50% over the next 10-years to make owning the 10-year profitable.

This is an important point, because merely having more than 100bps of Fed Funds won't necessarily cause the 10-year to fall much. Going into 2001, it was widely expected the Fed would cut rates. According to Bloomberg's economist survey conducted in December 2000, the average economist expected approximately 75bps in cuts during 2001. In fact, the Fed cut 475bps. Quite a miss by the economists. But what happened to the 10-year?

(The orange line is the 10yr and the white is FF)

On 1/3 the Fed first cut for the first time. The 10-year closed at 5.16% on that day. By the end of the year the 10-year rate had fallen a whopping 11bps to 5.05%. This despite a serious recession, a terrible stock market, dramatically wider corporate bond spreads, and the 9/11 attacks.

To be sure, the 10-year fell more dramatically in 2002 and 2003 as the Fed kept cutting rates and a deflation scare set in. But my point is that in December 2000, several Fed cuts were priced in. So as the Fed actually did cut in 2001, all that happened was the curve steepened. The 10-year moved very little. Even as the Fed blew way past everyone's expectations, long-term rates remained stubbornly high. A long duration strategy would not have paid off, at least not unless it was coupled with a steepener stance as well.

So back to my point about the average Fed Funds rate being less than 4.50% to sustain a rally in the 10-year. Even if we imagine that the Fed cuts 150-200bps next year, we know that eventually the Fed will be back to hiking again. The market will assume that as well. That's what happened in 2001. The market saw the Fed actions as temporary, assuming that eventually rates would rise again. It was only when it became clear that Fed Funds was going to stay ultra low for a long period of time that the 10-year finally rallied significantly.

Even if Fed Funds gets quite low, like 3%, it has to stay there for a while to produce a long-term average below 4.5%. Fed Funds at 3% for 3 years then 5% for the remaining 7 years still produces an average rate of 4.4%.

This analysis is quite simplistic. I'll say that all my work on the macro situation points to a fairly weak economy in 2008. But at the same time, it doesn't suggest a weak enough situation to reproduce the deflation scare of 2002-2003. And I think that's what it will take to move the 10-year meaningfully lower.

Tuesday, August 28, 2007

That's impossible, even for a computer!

The three most denounced words in the investing vernacular these days are "mark to model." But let me clue you in on something.

Every bond portfolio is marked to model. Every mutual fund. Every UIT. Every brokerage account. Every portfolio manager. Every pension. Every hedge fund. Every bond portfolio in the whole damn world is marked to model.

"Wait a minute," you're probably thinking, "surely you jest! After all, you can't tell me that open-end mutual funds, which have to redeem shares at NAV on demand, can get away with mark to fantasy figures! Besides, they are mostly invested in more simple bonds, like Treasuries, agencies, corporates, munis, etc."

No, I don't jest. All those portfolios are marked to model. Consider the following:

  • There are 152,732 different US dollar denominated corporate bonds outstanding as of today, according to Bloomberg.
  • Between Fannie Mae, Freddie Mac, Federal Farm Credit Bank, and Federal Home Loan Bank, there are 21,989 different issues outstanding.
  • There are 1,269,428 different municipal bond issues outstanding.

How many of those trade on a given day? A very small percentage. According to TRACE, which is a system for tracking corporate bond trading, about 4,300 TRACE eligible corporate issues trade each day. That's less than 3% of the total corporate universe. I note that trading activity in non-TRACE eligible bonds is not publicly reported. According to the MSRB, about 14,900
municipal bonds trade each day, or just over 1% of the universe.

Wait... It gets worse. Not only do a small percentage trade each day, but many don't trade at all for extended periods of time. Of the 4,300 bonds that trade each day, its often a few very liquid issues that trade over and over. Even many very large issues, for instance Washington Mutual 5.125 '15, which is a $1 billion issue, trade rarely. That bond has had only one trade of over $1 million during all of August.

So tell me how anyone can claim they've "marked to market" when a large percentage of their bonds have no recent trades. If there is no trade, there is no "market" price to use. And we know that using the last price wouldn't make sense. First of all, we know the general level of rates changes every day. Plus spreads move constantly as well. Again, take Washington Mutual. We know they are right in the middle of the sub-prime mess, so whatever you think of the company, you know the bonds are going to move significantly from day to day. So using a trade on August 16 to value the bond on August 31 makes no sense at all.

Some try to claim that getting dealer desks to value your portfolio is "marking to market" but let's think about the incentives for a moment. Bond dealer firms are sales organizations. They are run by sales people. They are not in the business of pissing their customers off by giving weak marks. So while many bond managers use dealer marks, it can be very dicey. I can say from first hand experience that sometimes sales people are all to happy to throw your ball back onto the fairway and assume you're OK with that.

So we're left with pricing matrices. These aren't perfect either. I have access to several matrices, and its not uncommon to find substantial differences from one model to another, even on relatively simple bonds. By virtue of the large variance in estimated prices, we know the models aren't perfectly reflecting reality.

Obviously there is a difference between an ABS CDO and a generic corporate. But as someone who deals with the reality of mark to model every day, I'm telling you, its no different. Only different in your mind. It's the difficulty to model CDOs that makes it problematic, not the concept of mark to model.

Monday, August 27, 2007

You have controlled your fear

Are we safe from sub-prime contagion? For the moment. At least in terms of the unadulterated fear punishing credits of all sorts. It appears that the Fed's actions have had a significant calming effect on the market, as the last couple days have witnessed orderly trading in the credit markets.

So now the real trick is to find the opportunities. The following is a quick list of some housing/sub-prime related names and where the CDS is trading currently.

  • Bank of America: CDS = +35, Ratings = Aa1/AA, recently made a $2 billion investment in Countrywide.
  • HSBC: +52, Aa2/AA-, one of the first large banks to do a significant sub-prime related write down.
  • Goldman Sachs: +65, Aa3/AA-, large underwriter of CDO/MBS/everything else, but not especially hit by sub-prime problem.
  • PMI: +90, A1/A, provider of mortgage insurance.
  • Washington Mutual: +90, A2/A-, well-known mortgage originator, especially on West Coast, also has traditional bank operations.
  • Capital One: +95, A3/BBB+, credit card issuer, particular within lower income bracket.
  • Lehman Brothers: +105, A1/A+, operated a sub-prime originator, which was recently shuttered.
  • Bear Stearns: +115, A1/A+, suffered through some high-profile hedge fund failures.
  • MBIA: +125, Aa2/AA (corporate rating, insurance sub rated Aaa/AAA), insured some sub-prime/CDO deals.
  • H&R Block: +170, NR/BBB+ (neg. watch), owns a sub-prime lending unit, rumored to be a LBO candidate, going through a proxy battle.
  • Countrywide: +200, Baa3/A- (neg. watch with both), you know this story.
  • CIT Group: +200, A2/A, owns a home mortgage unit, viewed as possible takeover candidate ala SLM Corp.
  • Centex: +245, Baa2/BBB, large home builder.
  • GMAC: +545, Ba1/BB+, obviously have their own problems, but also exposed to consumer credit.
  • General Motors: +720, Caa1/B-, for perspective.
  • Residential Capital: +1000? (trading with points up front), Ba1 (neg. watch)/BBB-, former mortgage arm of GMAC.

For some additional perspective, here are the 3 largest non-finance IG issuers:

  • Verizon: +25, A3/A
  • Comcast: +41, Baa2/BBB+
  • Sprint Nextel: +46, Baa3/BBB

They are ordered from tightest to widest, but is this order of things correct? Are the tightest names really the safest? Are the widest names really most likely to go bankrupt? Feel free to post your own thoughts in the comments, I'll post my opinion in a day or two.

Friday, August 24, 2007

Annaly doesn't look so bad to me...

Annaly Capital Management's portfolio strategy is strong enough to pull the ears off a gundar. What their stock is inherently worth, that's something else.

Anyway, Annaly is relatively unique among public REITs. Their entire portfolio is agency-backed MBS. No credit risk at all. There are many private REITs that follow a similar strategy. Here is basically how it works

The REIT starts with capital of say, $10 million. Annaly is obviously much bigger, but I'll use simple numbers for simple math. Anyway, they borrow another $90 million short-term, then buy a $100 million portfolio of shorter-term MBS and CMOs, all GSE backed so all AAA/Aaa rated. I'm using 10/1, but I know various leverage is used by various firms. I think Annaly moves between 8 and 12x. The 10/1 might be done in the repo market, where the haircut on agency MBS is usually pretty light, or some other credit facility. A decent sized REIT is going to do enough trading where they can negotiate pretty good terms with dealers, at least that used to be true prior to recent problems. More on that in a minute.

Repo rates with MBS collateral are usually within a couple beeps of LIBOR. They are basically trying to put together a portfolio that can generate income in excess of their borrowing costs. Pretty simple, eh?

There are two basic risks the agency MBS REIT is taking. First is term risk. The REIT is usually borrowing at terms of 1 month. But their assets are mostly fixed rate, and even though the REIT is always getting principal cash flow from the portfolio, if short-term rates rise significantly its possible for the borrowing rate to exceed the interest rate on the portfolio. REITs can try to mitigate this risk one of two ways. Either they can buy shorter-duration MBS, like CMOs, balloons, hybrid ARMs or straight ARMs. Or they can buy hedges. Both are costly, however, and hedging MBS is difficult because of the optionality.

Which is a perfect segue way into the second risk, which is option risk. MBS have inherent options, as the borrower can refinance at any time without penalty. Before I talked about how interest rates rising would be a problem, and so it would follow that interest rates falling would be beneficial. Not really though, because as soon as rates fall, borrowers all refinance and pay off their loans. So because of the option risk, the problems inherent with rates rising are much worse than the benefit of rates falling. We call that negative convexity.

If you think about the two risks for a while, you'll realize there are two kinds of markets which are problematic for the agency MBS REIT. One is an inverted curve. Obviously if you are trying to play a simple carry game, you want a steep curve if at all possible. Second is a volatile interest rate market. We're not talking about up and down 20bps here. We're talking about 1994/1999/2003 type markets, where borrowing costs and investment rates fluctuate constantly. If rates fall then rapidly rise, you wind up with large numbers of refinancings which get reinvested at lower rates, only to see the REIT suffer through higher borrowing costs when rates rise again.

Despite all this, leveraged MBS portfolios have been successful for a long time. Not just REITs, but various types of banks and hedge funds play this same game.

All leveraged investors are going through a tough time right now, however. Lenders to leveraged investors are becoming more strict about the haircuts they allow. Since a lot of agency MBS buyers are also alt-A and sub-prime buyers, dealers are particularly leery of MBS as collateral for repo. They assume you have sub-prime in your portfolio someplace.

This is resulting in REITs and other leverage managers selling large amounts of agency MBS, particularly hybrid-ARMs. Of course, there is nothing wrong with the securities, merely an alteration in the credit standards. Of course, at the same time REITs are trying to sell, dealer desks are choking on inventory, with many sitting on ugly losses in sub-prime MBS. So dealers are not putting strong bids on the bonds for sale. This has caused agency MBS to widen substantially.

But other than credit standards, conditions are improving for the leveraged MBS strategy. First of all, wider spreads on MBS mean more interest in their portfolios. Second, the curve is finally got some slope to it, and with the Fed set to ease, LIBOR rates are probably going to decline. Finally, the optionality of MBS is actually declining as well. The spread between Treasury and mortgage borrowing rates is widening, meaning that mortgage borrowers are further away from a refi opportunity despite the mild rally in Treasury rates.

Plus borrowers who put less than 20% down initially will have a hard time refinancing any time soon, unless rates drop dramatically. It used to be that these borrowers had to pay mortgage insurance, but recently people have gotten second mortgages instead. Going forward, banks are going to be less willing to offer the second mortgage, and where they do, the rate will probably be higher. So the borrower will have to come up with the 20% in order to do the refinancing, or else pay higher costs. And given that HPA is likely to be weak for a few years, borrowers won't be able to rely on price appreciation to get to the 20%. They'll have to actually come up with the cash. Now if you didn't have the cash when you bought the place, the odds of you having the cash a year or two later are pretty low.

All that adds up to the optionality being less for MBS than was true just a year or two ago. MBS should become easier to hedge, and the negative convexity problem is abated.

Now, what does that mean for Annaly stock? I don't want to be in the position of making stock recommendations, because I don't follow the trading patters for Annaly, or any other stock, professionally. I can say, however, that Annaly's core strategy is solid, and conditions for their portfolio's future performance are improving. This rosy outlook may or may not be priced into their stock currently. I don't f'ing know.

Fair Disclosure: I don't own any mortgage REIT stocks. I do own MBS through client portfolios. And I think MBS are crappin' sweet!

Wednesday, August 22, 2007

This is our most desperate hour...

Many mortgage originators have declared bankruptcy in the last 6 months. The market is now placing a fair probability that Countrywide may be forced into liquidation in the coming months. A couple days ago, Countrywide bonds maturing in December 2007 could be bought with a 20% yield. Now they are a little better, around 13%, but obviously the market is concerned.

Corporate bond guys use the term "jump to default" to describe what might happen to Countrywide. On August 1, Countrywide's credit rating was a strong A-/A3, how could the company be so close to default so quickly? There is, not surprisingly, a lot of confusion in the main-stream media about Countrywide and their troubles. Below is a simple model for how specialty finance companies (like Countrywide) operate. I don't have intricate details about how Countrywide specifically finances their business, but this example should give the reader a fairly accurate idea of how things work.

Countrywide takes most of the mortgages it underwrites and sells them to investors in the secondary market. But they can't sell anything to the public until they have actual loans actually closed. Of course, at closing they have to actually write a check to the borrower, so somehow they have to come up with some cash.

One way firms like Countrywide can secure attractive financing, at least until recently, was by pledging some of their investment portfolio. This could be to back a credit line at a bank or to back a commercial paper program. Historically banks have always liked having specific assets pledged to secure a loan, because that prevents the borrower from taking on more loans and diluting the bank's recovery in liquidation or similarly selling off assets which could prove valuable in liquidation.

Let's assume that Countrywide wanted to make $30 billion in loans (which was their July production.) In order to raise that cash, let's say they pledge $30 billion of their investment portfolio (mostly mortgages) to an Asset-Backed CP program. Let's say that the term of the CP is 30 days. Then when the loans close, they sell those loans into the secondary market for $30 billion, and repay the CP. Their assets are then free and clear to do the whole thing over again next month.

But what happens if they can't sell the loans into the secondary market? The $30 billion they lent to home owners goes out the door, but they still have to pay off the CP. They might like to just roll over the CP, but now the value of their assets is in question. If the lenders can't value the assets being pledged, they are unlikely to make the loan.

Because of the long lead time in the mortgage business (you commit to a loan as much as 90 days ahead of actually paying out the cash), if Countrywide has $30 billion in CP outstanding, that's probably already being used to pay for loans originated in May and June. The $30 billion they committed to in July is yet to be funded. By that calculation, they would have something like $60 billion in cash needs. This is the figure estimated by Kenneth Bruce of Merrill Lynch in his August 15 report on CFC. Suddenly Countrywide is in desperate need of $60 billion but no one wants to lend them money. Maybe the only route they have left is to sell their investment portfolio. But even if the portfolio is relatively high-quality, the odds are good that any non-prime MBS will have at least a 5-10% discount from their par value. At least. And their liquid investment portfolio is only about $50 billion, again according to Merrill Lynch. So there is probably a $10 billion shortfall even before you assume any discount on their liquid assets.

So notice that the problem has nothing to do with suffering losses on bad loans, or insane leverage, or any of the other ills that have plagued the mortgage industry. Its simply that they cannot sell mortgages.

Now, Countrywide may be able to sell some of their mortgages, and they have been able to tap existing bank credit lines to avoid an imminent cash crunch. They could choose to drastically reduce production and slowly sell off assets, but if they get rid of all their assets, what's left for lenders? If they go down the asset sale road, they may have trouble getting their credit lines re-approved even if the market for mortgage loans recovers.

So while Countrywide's core business is weak, it's the sort of weakness most companies could weather. We know that mortgage underwriting is a long-term viable business. But because Countrywide faces this constant need to refinance itself, the liquidity crunch could cause a jump to default.

Enter Warren Buffett. Consider the scenario I just described: long-term Countrywide is a powerful player in a long-term viable business who is getting squeezed due to short-term problems. Someone who is looking to buy a nice asset on the cheap and who has adequate access to capital to ride out the liquidity crunch. That means that Countrywide, at a certain price, is a
very attractive takeover candidate. Hence the Buffett rumors. His history of getting involved (or trying to) in Salomon Brothers and Long-Term Capital Management has a lot of parallels. If he is willing to suffer a little short-term pain, he could own a dominant player in the mortgage business when things finally improve.

Help us, Oracle of Omaha... You're our only hope.

UPDATE: No... there is another... Bank of America Invests $2 billion in Countrywide

Tuesday, August 21, 2007

I don't know... fly casual

On the eve of Iraq War II: Bush's Revenge, I remember reading about the city council of Berkeley California holding a vote on whether or not we should go to war. I'm sure we could have chalked this up to political grandstanding for the councils mostly liberal constituency, but at the time the whole thing just stuck me as funny. First of all, it was a guarantee that the city council of Berkeley was going to vote against the war. Second, it was a guarantee that the vote would make no difference at all.

That brings us to the matter of not-yet-closed LBOs. Shareholders approved JC Flowers et. al.'s purchase of SLM Corp for $60/share on the 15th. Today, Tribune's shareholders similarly voted for the $34/share buyout offer from Sam Zell. These votes promise to go much like the Berkeley war vote. SLM in particular, whose stock was trading at $47ish before the vote, so there was little doubt shareholders would vote for the $60/share proposal. But whether or not the deal is consummated appears entirely up to the consortium of banks and private equity firms. Since the deal was first struck, two things have happened to significantly change the economics of the SLM deal, as well as other LBOs. First the high-yield market has been obliterated. Second, banks are becoming less willing to extend leverage.

The subsidy cut by Congress may be the excuse used if Flowers and co. try to back out of the deal. But its a hostile bond market that is causing these deals problems.

There is a larger question here. The widening of high-yield spreads impacts all of the LBO deals that have been struck recently but not yet funded. A quick look at the stocks of the sellers shows a widening gap between the announced purchase price and the trading level. Is this telling you some of these deals will wind up being canceled?

Doubtful. Private equity still has a ton of cash. They need to put it to work. Backing out of a deal is clearly not their first choice.

A better option would be to use the potential of cancellation as leverage to lower the purchase price. The sellers would likely be amiable. Take Sallie Mae. It isn't like anyone else is going to offer $60. With the stock trading at $48, shareholders would probably jump on an offer of $54. Recent stories that banks hung with bridge loans might be willing to pay the break up fee only increases private equity's leverage.

TXU is another example. They are telling shareholders that if the LBO isn't completed, they'd likely breakup the company, and they do not believe they'll realize the same value. TPG and KKR might not have a good enough excuse to negotiate the TXU price lower, but TXU's stock (about 8.5% below the deal price) is trading like there is some possibility of a break up or renegotiation.

The Alltel and First Data deals will be interesting to follow as well. Like TXU, either of these companies could be sold off to strategic buyers at a lower price. In each case, shareholders are going to be highly motivated to get a deal done. At this point, ANY deal will suffice.

I don't know anyone who works someplace like KKR or Blackstone. I can imagine that there is a bit more stress there than was the case 6 months ago. The liquidity crunch is increasing the odds that one of these deals doesn't work, and of so they'd better get out out of there pretty quick. But there is no way for private equity to keep their distance without looking like they are keeping their distance. After all, the investors in their funds expect strong returns, which isn't going to happen so long as their money is stuck in cash. I imagine Stephen Schwarzman is walking the halls telling his people "Hey, how about a little optimism?"

You do have your moments

The stock market was lower most of Monday, and yet the investment-grade credit market managed to stay mostly unchanged. Actually most names were tighter, including financials, but compared to the volatility of the last two weeks, today is downright boring. Late in the day stocks rallied and finished modestly higher, but I don't think this had a big effect on spreads.

Ben Bernanke can go ahead a crack a half-smile. While Friday's announcement about the discount rate sent the stocks and credits soaring, that was no test. I believe strongly that the Fed has little interest in propping up the stock market, or for that matter, pushing general credit spreads tighter. So to see the markets improve markedly after their announcement was no test.

It was the sense of panic that the Fed was looking to ease. It was the extrapolation of sub-prime losses to infinity that the Fed was looking to quash. So today's calm in the market has got to make the FOMC happy, if only for a day.

Some items worth noting about the market after the discount rate cut:

1) The 2-year is currently over 100bps below target Fed funds. The 5-year is about 75bps through FF. I'm feeling bearish at those levels. The market is (almost) universally thinking target rate cut in September. I agree, but how many cuts will it take for the curve to rally much from here? I say more than 100bps worth, and I don't thank that's happening. Again, I liken this to 1998. After the Fed was done cutting thrice in the fall of 1998, the entire yield curve moved substantially higher during 1999.

2) There are some massive technicals in MBS right now, even in agency stuff. Banks and dealers are tightening their repo haircuts and/or cutting credit lines. Many leveraged players (especially REITs and hedge funds) are having to sell (at whatever price) to be incompliance. If you traffic in bonds that REITs like, such as hybrid arms, the selling pressure may continue for a while.

3) I never thought I'd say this, but today's t-bill auction brought some much-needed supply to that market. Investors are moving en masse out of Prime money markets and money market alternatives and into government money markets. All that cash moving at once has the yield on 4-week bills falling below 2%. Honestly, though, I can't blame money market investors looking to get out of anything that could possibly have ABSCP. I think many investors will eventually realize they are better off in like 2-year Agencies that money markets. Or a short-term investment-grade corporate mutual fund. That will normalize the t-bill market. Dunno how long that will take.

4) Long-term tax-exempt municipal bonds rated AA/Aa or better are widely available at or above the 30-year Treasury rate. Its called a liquidity premium, but its become awful expensive.

5) Countrywide paper maturing in December 2007 could have been bought at $95, or like a 25% annualized yield, on Thursday. Before you say that's ridiculous, consider the situation. By December, either Countrywide has figured out a way to finance themselves or they haven't. If it's the former, they're probably in fine shape. If it's the later, they're bankrupt. Finance companies are more likely than any other type to be suddenly bankrupt, since they are constantly in need of cash.

6) There is a rumor this morning that Warren Buffett could buy parts of Countrywide. I believe he would at least look at them. Remember he offered to buy LTCM the morning of the Fed bail out, so the guy is comfortable with rescue attempts.

7) Bernanke, Paulson and Dodd are meeting today at 10AM. Market will be waiting for this meeting, as there is yet more rumors that the Fed cuts today. I doubt it very seriously.

Thursday, August 16, 2007

Fear leads to suffering

I have argued strongly in this space for a Fed cut the last few days. Looking at trading activity the last several days, the Fed had in fact moved their target rate to 5.00%. So, at least temporarily, the Fed has in fact cut rates. Today it seems that trading has resumed at 5.25%.

I've received a fair number of comments arguing against the Fed cut. They have almost all been quality comments with what seem like reasoned positions. Some of the comments, however, seem to misunderstand either the case I'm making for Fed intervention or what the effects of a Fed easing might be for financial markets. So I thought I'd take a little time to clarify my view in the form of a Q&A.

1) When you say the market is highly illiquid, what does that mean exactly?

Right now its impossible to trade large numbers of bonds. I'm not talking about housing related stuff. I mean its impossible to trade many plain vanilla bonds. Those you can trade have become much more expensive to trade, because the bid/ask is wider.

For anything housing related, forget it. There are no bids.

2) Why should I care about illiquidity?

The problem comes in where good bonds cannot be sold at any price. Read that last sentence carefully. It isn't the Fed's problem if risk spreads widen. It isn't the Fed's problem if bonds default. It isn't the Fed's problem if banks make bad loans. It is a problem if good bonds cannot be sold at any price.

If a bank has underwritten a series of fixed-rate, fully documented, first lien, prime jumbo mortgages but cannot sell them into the bond market, then they have to keep the loans on their balance sheet. That takes up capital that would otherwise be used for other loans. Basically the jumbo mortgage market grinds to a complete standstill.

3) But the conforming limit is $417,000! Why should we care about bailing out these fat cat home owners? They were stupid enough to buy into a bubble market! Why not just let the price of homes fall and solve the problem that way?

First of all, middle-class homes in many large metropolitan areas, particularly on the East Coast and California, are north of $500,000. So jumbo loans are not just for the rich.

Second, the "let the price fall" idea is fine and good, but there still needs to be a functioning market in order for that solution to work. For example, let's say I bought my house for $700,000 last year. Let's assume that price was too high, merely the result of a housing bubble in my area. But what should the house really be worth? We can't know unless the market is allowed to function. Maybe $650,000. Maybe $600,000. Maybe $400,000. If no one can get a mortgage against the property, then I can't sell the house at all.

The corollary to the tech bubble would be to conclude that everyone who bought Yahoo stock in 1999 were idiots. We should therefore shut down the NASDAQ entirely. Don't allow those greedy tech stock buyers to sell their stock at a loss. Don't allow them to trade it at all. Does that make any sense?

4) (Actual comment from Darth Toll who wins the "Best Screen name" award for 2007, in response to me comparing the market to an irrational bank run)

Are you trying to say that there is no logical basis for this fear, kind of like a "the only thing we have to fear is fear itself" thing?

The fear surrounding sub-prime securities is well founded, obviously. The fear surrounding homebuilders is well founded. The fear surrounding prime mortgages with full income documentation and 20% cash down payments is unfounded. Well, maybe not completely unfounded. Maybe those bonds should trade wider than they have in the past because the likely recovery rate is a bit lower (due to weak HPA) than history. But for there to be absolutely no liquidity? Untradable at any price? The housing market just isn't that bad people. Not every mortgage underwritten in 2007 is going to default. It really is time to separate legitimate fears from pure paranoia.

5) Why should the Fed cut rates to bail out sub-prime lenders/homebuilders/hedge funds? If they made bad loans, why shouldn't they just go bankrupt? Banks should learn a lesson about making bad loans.

The Fed injecting liquidity won't do a damn thing to help hedge funds and/or financial institutions suffering real losses from bad loans. New Century is bankrupt and they are staying bankrupt. BSAM's funds are worthless and they are staying worthless.

Nothing the Fed is going to do will make delinquent borrowers current again. Maybe lowering interest rates will prevent a small number of defaults because resets will be lower, but all of these NINA and liar loans are going to go bad no matter what. I mean, there are loans that go bad and there are just bad loans. No one is going to save banks that made too many bad loans.

But say there is a prime mortgage originator who borrows short-term to underwrite their loans? Now they cannot securitize their prime jumbo loans, and therefore cannot repay their short-term facility. Do we want to drive institutions like this bankrupt merely because the market fears all mortgages? What "lesson" is that teaching and to whom?

6) Easing policy now is too risky. The Fed will just create another bubble, basically delaying the ultimate pain. Why not just take our lumps now and get on with it?

This is a very fair question, and a tough one to counter. I keep thinking back to 1998, which as I've written has a lot of parallels to today. In July 1998, the Fed had a tightening bias. In September they cut 25 bps. In October they cut another 25bps intra meeting, then cut again at the November meeting. By spring the LTCM crisis had largely passed, and credit spreads
had mostly recovered. In June 1999 they were hiking again.

Some say the Fed exacerbated the tech bubble by cutting in 1998. I disagree. As evidence I look at credit spreads, which widened substantially in the Fall of 1998 and never got close to pre-LTCM levels until 2004. It wasn't easy money in the debt markets that allowed the tech bubble to continue. Now we will never know whether they Fed could have engineered a better outcome during the tech bubble had they taking an alternative approach. So it might be fun to debate, but I think we can agree there will never be a real "answer."

While we're on the subject of Long-Term Capital Management, that "bail out" that the Fed engineered was only a real bail out of the financial system, not a bail out of the fund. The fund shareholders were wiped out. The bail out really only prevented contagion as well as protecting the creditors from suffering through a liquidity crunch as they all tried to beat each other to the door.

Please feel free to comment.

Wednesday, August 15, 2007

Retail is easily freightened, but they will soon be back

Illiquidity is hitting some strange parts of the bond market. Consider one place about as far from sub-prime MBS as possible: municipal bond funds. The graphic below is the average premium (negative being a discount) on closed-end municipal funds.

For anyone who doesn't know, a closed-end fund is just like an open end mutual fund, except that the number of shares are fixed. Closed-end funds trade on exchanges just like stocks. Therefore if you want to buy into the fund, you have to find someone to sell to you. Therefore its possible (and in fact almost always the case) that the fund trades at a price significantly different from its net asset value. If the fund has a 5% premium, that means that you have to pay 105% of the net-asset value of the fund. More commonly, closed-end funds trade at a discount. Why that is the case is a debate for another time.

I track the premium on muni funds as an indicator of retail demand. Since there aren't a lot of new closed-end funds being created, the movement of the premium is entirely due to demand for the funds. And because retail are the primary investors in closed-end funds, its a good indicator.

Generally the premium has a strong seasonal element. Retail tends to have cash needs around tax time and around year-end. So closed-end funds tend to fade a bit during these periods. You can see this on the graph. But the sudden swoon starting at the end of June is highly unusual. Why have muni investors been dumping their closed-end funds?

I have an interesting theory: deleveraging. Let's say that I'm a high-net worth individual worth around $10 million. So I've got some closed-end funds and some regular municipals with my broker. But I also invested in this cool hedge fund my broker told me about. It is very exclusive and I loved talking about it at the club. I didn't really understand what it was invested in, but it had to do with mortgages and leverage. Anyway, its returns were great... until suddenly I got a letter saying withdrawals have been suspended. Now I need to make a margin call because that New Century stock I bought isn't working out too great. What am I going to sell?

When almost everything you own is performing like shit, and you get a margin call, you become forced to sell something. Invariably people sell something that is doing OK. We're seeing this in the institutional market, and I think the closed-end funds are telling us this is happening in the retail market as well.

By the way, if you think plain vanilla muni closed-end funds are performing poorly, try high-yield funds! Some of that stuff is down 40-50%, and I'm not talking about MBS-related funds either. There is panic on Main Street as well as Wall Street!

Fair Disclosure: I own some closed-end funds personally. Please bear in mind that closed-end funds are far more volatile than they should logically be and trading volume is often very thin. Do not get involved unless you understand the consequences of these two factors.

Tuesday, August 14, 2007

I have altered the deal. Pray I do not alter it further.

Say you are sitting at home, relaxing on the couch after a tough day in the market. You've just settled in with a nice glass of wine to watch a TiVO'ed episode of "Top Chef" when you get a knock on the door. "A caller? At this hour?" you say.

You open the door to find a stocky man wearing a short-sleeved button down shirt. By the look of the name embroidered on the shirt, the man's name is George. But your eyes move quickly away from George and to his partner, who appears to be rigging a tow cable to your car. You are understandably a bit panicked. "What the hell is going on? Why is he trying to tow my car?" you exclaim.

"Sir," George begins, "we've come to repossess your car."

"Repossess? I just bought this car last month. I haven't missed a payment. Hell, a payment hasn't even come due yet!"

"Well sir, you see, your loan value is too large."

"I'm sorry, what?" You assume you misheard him, as you were distracted by George's partner putting a nice scratch in your bumper with his hook.

"I said your loan value is too large."

You stare at him blankly for a moment. "You're saying my car is too expensive?"

"No, I said your loan was too large."

"But I just negotiated the terms of the loan a few weeks ago. I put 10% down exactly as was negotiated."

"Well, the finance company has decided that loans of your size are too large." George is clearly becoming exasperated at your inability to see his point.

"Why the hell did they approve the loan in the first place?" You are feeling an increasing sense of urgency as George's partner has finished hooking up your car to his truck.

"Well, at the time the loan seemed appropriate. Now, it seems too risky."

"Look, I make very good money. I have an impeccable credit score. There is no reason why I shouldn't be given a loan for this car."

George is a little perturbed. "That isn't the point sir. We recently took very large losses on car loans just like yours."

"You're telling me people are buying luxury cars and defaulting on the first payment?"

"Yes. And we can't take the chance you do the same. After all, those borrowers in default all made good money as well. Or at least they claimed to make good money. Turns out they were all penniless." George shakes his head. "How were we to know?"

"You mean they forged their W2's?"

"No. But they promised us they made enough money to pay the loan. And really, they seemed like honest people."

"You took their word for it? Look I have pay stubs. Tax returns. Bank statements. Whatever you want!"

George obviously doesn't appreciate your insinuation. "Sir, we simply cannot afford to take losses on your loan too. We'll be taking your car now. Good day."

OK, so obviously this story is a joke. But what would happen if this story were real? What if auto finance companies would no longer lend for cars above a certain price? Basically there would be no more luxury car market.

Today, liquidity is so bad in the mortgage market that banks cannot securitize high-quality prime loans that are above the Fannie Mae/Freddie Mac conforming limit ($417,000). To put that in perspective, I'd say most single-family homes in nice neighborhoods the suburbs of most East Coast cities are over that price. I'm sure large portions of California and Florida are as well. If this poor liquidity in secondary MBS continues, there will be no loans available to buy these homes. Consider the consequences. No market at for housing transactions in the largest population centers in the U.S. Someone wrote in a comment that the housing crunch could never cause another Depression, but honestly. What if there were no market for homes in the entire East Coast. Not lower prices. No market at all.

Our economy is dependent on credit. Let me reiterate. D-E-P-E-N-D-E-N-T. A very large percentage of economic activity in the U.S. is done on credit. If credit is unavailable, the economy shuts down.

There are two simple solutions. First, raise the conforming limit for Fannie Mae and Freddie Mac and allow both to increase their portfolio size. Second, make it possible for banks to retain quality loans on their balance sheet in cases where they cannot sell the loans. This prevents a liquidity crunch from taking down an otherwise sound financial institution. How to do this?

Pour money into the financial system. Fire up the printing presses Ben. Hang a neon sign above the discount window that says "Eat At Ben's!"

This is not a bail out of the sub prime problem. Not at all. This is making sure that sound banks have enough liquidity to remain in business, even when a normal source of liquidity is shut off.

There was a rumor today that the Fed was going to cut rates. As in today. Obviously that didn't happen. But if this seizing up of the market continues, mark my words, the Fed will cut.

Oh shooda...

Rumors are flying that the Fed will cut the target rate today. Make of it what you will.

Monday, August 13, 2007

I don't have time to discuss this in committee!

Fed funds futures now indicate a decent chance of an inter-meeting cut in the target rate. My instinct is that this won't happen. I think Friday's late-day rally in both the stock market generally and Countrywide CDS/stock specifically indicate that the Fed's reaction so far is having an effect. I don't think they'll take the extreme measure of actually cutting their target rate inter-meeting unless there is more bad news.

Futures trading is not really at odds with this view. If future price in, say 25% chance of an inter-meeting cut, one could view this as a 25% chance that some piece of bad news comes out between now and month-end. I think the media often reports this as though 25% of traders think there will be a cut and 75% don't. But in reality, everyone is playing the odds game.

I think there is an excellent buying opportunity in high-quality spread product. Don't forget that a high percentage of money invested in the bond market is leveraged in some manner. Not just hedge funds, but insurance companies, bank assets, broker/dealers, REITs, etc., all are leveraged one way or another. When leveraged players take losses, they often have to reduce their leverage. In a market plagued by poor liquidity, one is forced to sell what is sellable. That's going to be Treasuries first. But if you don't hold Treasuries, then you have to sell your Agencies, MBS, high-quality CMBS/corporates, etc.

But when the dust settles, real money is going to want to own spread product. Plus if the curve can steepen, it will strengthen the position of REIT and bank players to enter the MBS market. So the products that widened merely because liquidity is poor get tighter rapidly.

Before Thursday and Friday's problems, this scenario was playing out in MBS and high-quality corporate bonds. But I still think there is more money to be made in these sectors.

Friday, August 10, 2007

I'm Ben Bernanke, I'm here to rescue you!

My post from Monday caught a lot of flak from commenters, but I'm feeling quite vindicated today. I argued there that the Fed would be paying close attention to illiquidity in the bond market, and they would do well to express a willingness to cut rates if need be to restore liquidity.

They didn't say as much as I had hoped, but it appears events may force their hand. Yesterday's collapse of liquidity in Europe and the disturbing announcement from Countrywide are forcing central banks around the world to pump liquidity into the financial system.

First, a clarification what is meant when the media reports that the Fed (and ECB, BoJ) were adding liquidity yesterday. The Fed adds liquidity almost every day, so the fact that they injected some money isn't surprising. What happened yesterday was so many banks wanted to borrow that it pushed the trading level of Fed Funds well above the Fed's target of 5.25%. This is unusual, and therefore the amount of reserves the Fed added was much larger than usual.

Second, a not-so-bold statement, that I'm sure many will disagree with: the Fed will not let Countrywide fail solely because they are denied access to the debt markets.

For those who don't believe me, particularly those who argue that the Fed is a bunch of hard core inflation hawks, I ask you to read Bernanke's academic work from before he was with the Fed. He did a ton of work on the Depression, and his belief is that the Depression was basically a result of a liquidity crunch. After joining the Fed, he famously told Milton Friedman "Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

What's happening with Countrywide is very similar to a bank run. And the Fed has the power to inject enough liquidity to stem the run. Mark my words, they will do it. The futures now price in a cut for September. Many are saying there will be an emergency cut before then. Whether the emergency cut happens will depend on how events unfold, but don't let the inflation hawk rhetoric fool you. Ben Bernanke will not risk another depression by sitting on his hands. Not when he has the tools to address the problem now.

Wednesday, August 08, 2007

China: We have powerful reserves... You're going to regret this

China believes their reserves are now the ultimate power in the universe, and some are suggesting they use them.

According to this story, China is threatening to use its huge dollar reserves as a weapon to counteract protectionist rhetoric from Congress. This was given as a reason for the sell-off in Treasuries today.

I've written on the Asia effect on rates before.

The Telegraph story calls this the "nuclear" option. I think that term is apt. There are several parallels to launching a nuclear attack.

1) Both will cause devastating damage to the target nation.
2) There will be repercussions for the attacker, e.g., political, economic etc.
3) Nations tend to use threats like this as leverage, perhaps never intending to use them.

What would happen if China tried to crush the dollar? First of all, U.S. interest rates would rise substantially. U.S. consumers would have less purchasing power, both because financing would be expensive and because foreign goods would become pricier. As a major exporter to the U.S., a weaker U.S. consumer would not be in China's best interests.

I think the unwinding of the flight to quality has a lot more to do with today's Treasury sell-off. I know the auction didn't go so well, and some people were claiming that was China-related. But with spread product ripping tighter, and the Fed sounding pretty damn hawkish, rates are still too low.

Monday, August 06, 2007

Large leak, very dangerous

The severe illiquidity in corporate bonds of the last several days is no doubt concerning the Federal Reserve. After all, the Fed is the ultimate provider of liquidity, and Bernanke himself has publicly professed his belief that it was a liquidity crunch that perpetuated the Great Depression. Today, there is considerable debate over what the Fed will (or should) say about recent turmoil in the bond market tomorrow.

I think the Fed has been concerned with how tight spreads (and how loose credit standards) had become recently. Not only in the residential mortgage market, but in the corporate loan/bond market as well. Over investment and the subsequent need for a repositioning of capital is a common reason for recessions. So on one hand, many Fed economists are likely relieved to see credit conditions moving toward more normal conditions.

However, the severity of the credit crunch is concerning, and I'm certain Bernanke and Co. are watching carefully. Remember in the fall of 1998, when Long-Term Capital Management collapsed, Greenspan cut rates aggressively to stave off a liquidity crisis. By June of 1999, the Fed was hiking again. That was an obvious case of the Fed cutting to prevent a even wider contagion. This also is a classic example of the so-called Greenspan Put, which was the widely held belief that Greenspan was willing to bail out financial markets with easy money. Didn't happen in 2000-2002, but I digress.

Will there be a Bernanke Put? Tomorrow will tell us a lot. If Bernanke and his economist minions are sufficiently worried about the recent credit crunch, then they mention it in their statement. This would set up the possibility of a cut if things get worse. In turn, this would create considerable comfort in the credit markets. The shorts would get worried that a Fed cut will restore liquidity. The value buyers would see Fed cuts as limiting their downside. I really think a little nod in the credit market's direction by the Fed would go a long way. We don't need credit spreads to tighten, but we need stability. If the credit market can't stabilize, it really threatens to create a serious recession.

I will note, however, that there are a lot of traders expecting some mention of credit conditions in Tuesday's statement. So it may be that some degree of "nodding" is priced in. If so, then it will take more than one Fed statement to actually have any effect. In fact, I'm bearish on Treasuries tomorrow regardless. A dovish Fed statement would ease the flight to quality, while a hawkish statement takes away some of the cuts currently priced in.

I assure you, we are quite safe from your CDOs here

In 2001, when Enron and Worldcom's accounting scandals were rocking the corporate bond market, the question on every one's lips was "who's next?" Who else might be hiding devastating losses in off-balance sheet vehicles? Who else might have booked phantom revenue? Who else was going to go from an A-rated to bankrupt in a matter of months? Companies with even mildly complex financial structures were pounded by aggressive short-selling. I remember intermediate Time Warner bonds trading with a $70 dollar price.

Today is playing out very similarly, although so far on a smaller scale. There are traders combing through the market place looking for anyone with sub-prime exposure. Be it as originator or investor, the punishment bond issues are taking for having any association with the RMBS market is indiscriminate.

My favorite victim here is MBIA. CDS for MBIA have gotten killed lately, rising from a low of 19bps on 2/7 to 232bps today. It traded below 50bps as recently as June 14.

MBIA's basic business is to insure bonds. Just like GEICO pays its customers cash if their car gets totaled, MBIA pays its customers cash if their bond defaults.

MBIA business was originally insuring municipal bond issues (the name used to be Municipal Bond Insurance Association). Today this remains their primary business. Now, let me let you in on a little secret. Municipal bonds never default. Ever. Well not never, but damn close. According to Moody's, about 2.23% of all investment grade corporate bond issues default within 10 years. A mere 0.06% of investment grade municipals default. And this isn't a coincidence of municipals having higher average credit quality. Baa corporate bonds default at a 4.89% rate over 10-years, while Baa municipals default at 0.13% rate.

So of all par value insured by MBIA, 65% are municipal bonds. The other 35% are structured finance, including CDOs, RMBS, and CMBS. 7.5% of their total portfolio is in RMBS. 10% of this is in sub-prime, or about 0.75% of their total portfolio.

Within their CDO portfolio, which is 17.5% of the total, 21% (4% of total portfolio) is in "Multi-Sector CDOs." This is where the company categorizes ABS-related deals that could have sub-prime exposure.

Let's step back for a moment and talk about why MBIA is involved in the structured finance market at all. A large percentage of AAA-rated CDOs are put into what's called a negative basis trade. This is normally works as follows.

  • Investor borrows at LIBOR+5.
  • Buys a AAA-rated CDO at LIBOR +30.
  • Buys an insurance policy from MBIA which costs 10bps (structured like a CDS).

So they make 30bps over LIBOR on the asset, and they have 15bps in costs, for a 15bps profit. So its no surprise that 95% of MBIA's CDO portfolio is AAA-rated, and another 4.5% is rated AA.

Within their sub-prime RMBS portfolio, the results aren't quite as stark: 81% AAA-rated, 5% rated AA, 3% A and 4% BBB. About 7% is below investment grade.

So let's assume things are really extremely bad. Let's say that everything in their sub-prime and ABS CDO portfolios not rated AAA is worthless, and that within the next year, they will have to make good on the insurance policies written. How much in losses would they be taking?

The answer is $1.2 billion. At the end of June, MBIA had over $33 billion in marketable securities.

Would an impairment of $1.2 billion of assets result in a downgrade of their insurance subsidiary below AAA? That's the real question. If MBIA lost their AAA rating, they would effectively lose all competitiveness. FGIC, AMBAC, FSA and others basically provide the same service. Very few would be interested in buying an insurance policy on a bond to get less than a AAA rating.

I'm highly skeptical MBIA will suffer a downgrade. First of all, they have $500 million in loss reserves. Plus, bear in mind that if their investment portfolio earns a conservative rate of return of 5%, they'd earn $1.6 billion in interest income per year. Plus once they pay out on the sub-prime insurance policies, they quality of their portfolio would theoretically be better, not worse. So taking $1.2 billion in sub-prime losses would sure hurt earnings, but it would hardly cause a liquidity problem with MBIA.

But what about the argument that many of these AAA-rated sub-prime deals should never have been AAA in the first place. OK, but MBIA doesn't have to pay out on an insurance policy because it gets downgraded. Only if it defaults. And with the most senior portion of a CDO, there may actually be recovery in the event of default. Once you get to the point where the most senior tranche is in default, all cash flows belong to that tranche. So the odds of a AAA bond actually being worthless are very low indeed.

What about those Bear Stearns hedge funds that went bust? Weren't they mostly in high-grade ABS and CDO's? Yes, but they had mark-to-market problems, causing margin calls. They also suffered due to poor hedging on the fund's part. MBIA would never suffer a margin call, because they have only issued an insurance policy. They don't actually own securities. So even if the value of the insurance policy (in effect a long credit position) declines, there is no risk of the mark-to-market decline turning into a liquidity crisis.

Perhaps my overconfidence is my weakness.

Fair disclosure: I don't own any MBIA corporate securities, although my firm owns many MBIA insured municipal bonds.

Wednesday, August 01, 2007

That's not true...

This story from Bloomberg is highly misleading. Basically it says that major brokerages are trading as though they are junk, according to credit default swaps and Moody's Market Implied Ratings system. The story specifically mentions Bear Stearns, Goldman Sachs, Lehman Brothers, and Merrill Lynch.

I know a little about Moody's Market Implied system, but anyone who knows more is welcome to explain it in the comments section. This system is entirely separate from their actual ratings process. It takes real-life trading spreads and attempts to estimate what kind of rating is "implied" from that spread.

While I understand the spirit of Moody's Implied Rating system, I don't know the actual calculation methodology. Regardless, the concept is simple enough. Take how a bond is currently trading, ignoring the rating. Then look at what other bonds are trading with that kind of spread and see what the ratings are. Alternatively, you could draw a "credit curve" by marking the
spread of a typical Aaa-rated bond, the Aa-rated, etc. You take the trading level of a given bond and see where on the "curve" the bond would fall.

OK, back to the brokers story. The claim that the four brokers mentioned are equal to junk is hard for me to understand. Here are CDS as of 7/31 on the broker group according to Bloomberg.

Bear Stearns: 97
Goldman Sachs: 79
Lehman Brothers: 91
Merrill Lynch: 82

Here are CDS quotes for the top 10 names in the Merrill Lynch High Yield Master index.

Ford: 445
GM: 644
Charter Communications: 958
El Paso: 278
MGM Mirage: 448
Williams Cos.: 184
R.H. Donnelley: 465
Chesapeake Energy: 248
Freeport-McMoran: 117
Clear Channel Communications: 603

Note that the widest brokerage name (Bear) is 20 bps tighter than the tightest high-yield name (Freeport). The story also mentions Xerox, which is quoted at 95. OK, so you found one high-yield name that's trading around where Bear Stearns is. I don't know what that proves, really. Xerox is a relatively small issuer, outside of the top 50 in the index.

We could alternatively look to look at the spread of an index of BB-rated bonds. Currently the asset-swap spread (which is the best comparison to CDS) on the Merrill Lynch BB index is 232.

We could look at the CDX-High Yield index, which is a good comparison because it's a CDS contract but on a basket of high-yield names. That spread on 7/31 was 498.

So I just don't know where Moody's and Bloomberg are getting the notion that a CDS contract trading around 100 is equivalent to junk. Not only is that not true, that's impossible.