Monday, September 24, 2007

You fixed us all pretty good

I've written several times about the CDO market. Let me begin by saying that I think that the CDO market is a net positive for the economy. Used properly, CDOs can be an effective means of spreading risk around in the economy.

However, the CDO market has played a central role in creating the sub-prime housing quagmire we are currently muddling through. Indeed, I believe the CDO market has a lot to do with the housing bubble itself. Let me talk a little about how the CDO market contributed to the sub-prime problem, as well as some ideas of how we can retain the good elements of the CDO market without the bad.

CDOs basically take a pool of risky credits and divide the credit risk up among different investors. Investors who want less credit risk buy the portions of the deal which get first priority on principal payments. Those who want more potential income choose riskier tranches. For a primer on CDOs, click here. Suffice to say that the concept of a CDO is based on the time tested idea that a diversified pool of risky assets tends to have a relatively predictable return pattern.

So what went wrong? It isn't that diversification of credit risk doesn't work. In my opinion, its more like something akin to the extrapolation problem in regression.

Let's say you are studying the effect of caffeine intake on focus. You get together 500 people, with 25% each drinking 0, 1, 2, and 3 cups of coffee over a 1 hour period. Then you ask each to take a series of tests to measure focus. For the sake of argument, let's say your results look something like this:

I'm completely making this up for an example, so these results look far too clean, but stay on target. I'm getting to my point. Anyway, the blue dots represent the range of results at each level of coffee intake and the red line is the median observation. We see that although each additional cup of coffee does improve focus, the marginal impact of that 3rd cup is pretty limited. So I'm sure those who do any amount of econometric work look at this chart and see a nice quadratic. And of course, that's no coincidence, since I used a quadratic equation to make the chart:

5 + 6C - C^2 + Err

Where C is the number of cups and Err is a random error term.

So let's say you divine that equation from your data. Even if your equation perfectly explains what happens to the average person who ingests 0-3 cups of coffee, the applications of the equation are still limited. For example, it tells you nothing about what happens if you drink 4 cups of coffee. Or if you take more than 1 hour to drink your coffee. Or the effect if you drink 4 cups every day for a year. Before I turn us back to the bond market, let me point out that this is freshman statistics stuff. CFA Level 1 stuff. Anyone who doesn't understand this should be banned from using Excel's regression function.

Now let's look at the sub-prime mortgage market. Remember that CDOs work by owning higher risk securities, then spreading the idiosyncratic (i.e., single security) risk out among many assets. So CDO managers are happy to own higher credit risk securities, so long as they believe they can effectively spread the risk out. Ergo, a CDO manager trying to create an ABS deal would be looking for higher risk/higher yielding residential mortgage deals. Managers started finding that the higher yielding items were pools issued by underwriters viewed as having weaker credit standards. Maybe these pools had a higher percentage of 100% (or higher) LTV and/or stated income loans. But as far as the CDO manager was concerned, that wasn't a problem, because that risk could be spread out in a very large portfolio of bonds.

How did s/he know how much in high LTV or low doc loans was prudent? Well, CDOs always assume some level of defaults will occur, and usually they can perform quite well at default levels a fair bit higher than the assumed level. But what they cannot withstand is a large number of defaults occurring over a short period of time. More on that in a minute. Anyway, if you want to avoid a large number of defaults all at once, you need credits with a low correlation. Fortunately (!?!) correlation was right up the alley of the quant wizards running CDO portfolios. Armed with reams of historical data, they calculated the delinquency correlation of high LTV, low doc, low FICO,etc. etc. loans with each other. What they found was the delinquency correlation was relatively low. So if you had one high LTV, low doc HELOC in Oregon, and another in Virginia, the odds of both defaulting was calculated to be quite low.

The ratings agencies took the same approach. Default probability and correlation are the keystones to CDO ratings. Not surprisingly, the ratings agency quants and the CDO manager quants used the same data and came to the same conclusions. ABS portfolios had fairly low calculated correlation. As far as ratings go, a low correlation suggested that a portfolio's realized default level would be more likely to fall within a small band, and less likely that a large number of defaults would occur in a single year. A quick note on the ratings agencies: notice they don't need to be biased to agree with the CDO managers on the approach. While I think conflict of interest is a major problem at the ratings agencies, I think the problem with the CDO market is deeper.

OK so we've all built highly complicated Monte Carlo simulations with carefully calculated correlation statistics. Meanwhile some of the most creative people on Wall Street were getting involved with the CDO market.They began to pepper the ratings agencies with new ideas, usually with the goal of decreasing the subordination (i.e., increasing the equity's leverage). The ratings agencies basically said "If you can make it pass our tests, you'll get your rating." So CDO managers began monkeying with things like IC and OC tests, PIK toggles, and other fun things. If the test could trigger at higher default rates and allow the deal to perform adequately, that would allow for less actual subordination while still getting the ratings desired. In turn, this meant that if everything went well, the equity return would be much greater.

Some readers will be happy to hear that in the overwhelming majority of cases, CDO managers retained some or all of the CDO equity. So when they strove to take on more leverage, they believed they were displaying confidence in their own models and managers. Most were actually putting their money where their model was.

Demand for higher-rated CDO tranches was very strong. Banks could buy insurance on AAA-rated CDO tranches from someone like MBIA at a price slightly less than the LIBOR spread offered on the CDO. The result would be something rated AAA with insurance on top of that at a net spread of, say, 5bps. Someone who can borrow through LIBOR, like a strong bank or someone with a CP program, could basically earn that 5bps for free. Hence the rise of the ABCP programs.

So demand for CDOs was hot and the CDO managers and investment banks were making great fees on creating them. The managers and the investment banks worked together to make sure adequate bonds were issued in order to feed the CDO machine. That meant investment banks were bidding aggressively to underwrite various types of bonds popular in CDOs, including sub-prime mortgage deals. Indirectly, this probably lead to the investment banks proving attractive warehouse lines to sub-prime mortgage originators, or even acquiring mortgage lenders outright. And remember, the CDO manager wants higher risk/higher yielding paper, so the most popular loans were going to be the more risky loans.

But for all the quantitative minds contributing to the CDO market, they seemed to forget Statistics 101. You see, the historical statistics on mortgage delinquencies were computed during a time when loans with over 100% LTV or stated income were rare. The rarity of the loans implied that those loans were only approved because there was a legitimate special situation suggesting the risk inherent in the loan was reasonable. The CDO quants extrapolated this data out, and concluded that no doc, high LTV, etc. were all good risks.

But history turned out to be no guide. Things were different this time. Stated income loans went from a rarity to commonplace. According to Bear Stearns, about half of the sub-prime loans made for home purchases in 2006 were either low or no doc loans. Half. That should have screamed out to everyone in the ABS business that gigantic amounts of fraud was being perpetrated. That half of all sub-prime borrowers had a legitimate reason for not fully documenting their income defies common sense.

Obviously if many borrowers who never should have been financed were getting loans, this caused the demand curve for housing to shift outward. Indeed, there is anecdotal evidence that many were using no doc loans for speculation purposes. Which obviously only fueled the already hot real estate market.

Notice that we don't need to make an assumption about HPA or interest rates to see that these borrowers were highly likely to default. If a banks are underwriting loans that are entirely fraudulent, no amount of HPA or falling rates are going to prevent a much higher default rate. Even if most of the fraudulent borrowers intended to pay off the loan, most fraudulent borrowers are going to be toast. That's just logical.

So it should have been obvious that the default rate on these loans was going to be very high. In fact, there is extensive evidence from other credit-types that when issuance becomes very high, default rates subsequently spike. One could imagine that the quality of potential borrowers never actually improves, so when more loans are being made, the marginal borrower is a weak one.

Anyway, so not only should the ratings agencies have seen that default rates on sub-prime MBS would rise, they should also have seen that the correlation would rise as well. For the same reason. If default rates are related to issuance levels, then when issuance is high, correlation is also high. The loans in Oregon and Virginia became more highly correlated because they were both underwritten with weak credit standards.

And the ratings agencies should have been in the perfect position to see this. They have the world's best databases on historical default rates. They should have used knowledge from other asset classes and applied it to the sub-prime MBS market. We've seen time and time again that huge increases in issuance result in greater defaults. From commercial real estate to manufactured housing to high-yield corporate bonds. Perhaps this is where the conflict of interest reared its ugly head. Maybe they willfully ignored this problem.

So how to improve the CDO market?

  • Assume dynamic correlation. Don't just run a bland Monte Carlo. We have the computing power vary the default rate, recovery rate and the correlation within the simulation. Do it.
  • Use all information available, not just asset-specific. The financial markets are always inventing new structures, but certain basic principles remain. The ratings agencies know this, and should apply it.
  • Ratings should be based on subordination only. A structure relying entirely on subordination for its rating is less reliant on the models working than one that relies on coverage tests and excess spread. By this I mean, if there is 10% of the debt structure junior to my tranche, I know the deal can take about 10% in losses before I'm hit. But if there are a slew of IC/OC tests and other complexities, then that becomes muddled. Then it becomes a matter of how fast the losses come in, which means that the speed of losses needs to be correctly modeled. We need more humility in our modeling!
  • Deals should pay sequentially. CDO managers hate this idea, because paying down their most senior tranches also means paying down your lest expensive debt. But here again, a simple sequential pay structure makes gaming the models far more difficult.

I think these simple reforms can restore credibility to the CDO market, which will turn CDOs from a great threat to a powerful ally. We don't want to live in a world where only banks can make mortgage loans. Securitization is a good thing. But we need some culpability. Otherwise it will be a long time before we have a viable sub-prime market again. A long time.


Anonymous said...

Do you have any statistics available to illustrate how much of the current problem is simply panic as opposed to analysis?

I look, for instance, at the Moody's press release from September 20 and see:Moody's downgraded 25 tranches from 19 CDOs and placed 73 tranches from 27 CDOs on review for downgrade in August

• About 5% (239 by count) of all outstanding Moody's-rated SF CDOs continued to be on review for possible downgrade on August 31, 2007

• About 60% of those on review were on tranches rated Baa or below.

Which is a problem, certainly, but not ... yet ... a disaster.

Virtually all the statistics I see (for instance, in the IMF report released today, figure 1.8) refer to the number of downgrades, as opposed to the dollar value of the downgrades.

Additionally, I see from figure 1.6 of that report that while the 2006-vintage delinquencies are still skyrocketting, the 2005-vintage has (for now!) entered a downtrend.

Box 1.1 of the report is highly interesting and implies that mark-to-market losses to date exceed estimated total losses on all the underlying - and that is with what appears to me to be a very gloomy estimate of loss severity after default.

The report comments (pp 9-10):While many structured credit products were bought under the assumption that they would be held to maturity, those market participants who mark their securities to market have been (and will continue to be) forced to recognize much higher losses than those who do not mark their portfolios to market. So far, actual cash flow losses have been relatively small, suggesting that many highly rated structured credit products may have limited losses if held to maturity.

flow5 said...

"I want to reiterate one more time that I'm very concerned about the inflation risk."

In the current environment it is impossible to have a recession.

The "equation of exchange" P=MV/T embodies the truistic relationship between monetary flows (MVt) and the aggregate value of all monetary transactions. P represents the unit pries of all transactions; T, the number of "units" of all transactions; M, the volume of mmeans-of-payment money; V, the transactions rate of monetary flows; and MV, the volume of monetary flows.

While the usefulness of the equatons is somewhat diminished by the impossibility of quantifying P and T, the validity of the equation is not. Obviously, if the Fed allows the banking system to increase the money supply, ceteris paribus, (no change in V or T) prices will rise, etc.
real inflation
0.59... 0.31 2006-01-01
0.22... 0.11 2006-02-01
-0.14... -0.03 2006-03-01
-0.19... -0.07 2006-04-01
-0.22... -0.07 2006-05-01
-0.30... -0.02 2006-06-01
-0.13... -0.02 2006-07-01
-0.43... -0.18 2006-08-01
-0.40... -0.06 2006-09-01
-0.85... -0.18 2006-10-01
-0.29... -0.17 2006-11-01
0.12... -0.08 2006-12-01
0.37... 0.01 2007-01-01
-0.15... -0.11 2/1/2007
-0.36... -0.17 3/1/2007
-0.28... -0.10 4/1/2007
0.04... -0.09 5/1/2007
-0.04... -0.07 6/1/2007
0.16... -0.08 7/1/2007 reversal
0.14... -0.13 8/1/2007
-0.18... -0.09 9/1/2007
-0.28... -0.12 10/1/2007reversal
0.20... -0.16 11/1/2007
0.55... -0.19 12/1/2007
0.60... 0.06 1/1/2008
0.10... 0.01 2/1/2008
0.07... 0.04 3/1/2008
0.04... 0.02 4/1/2008
0.09... 0.04 5/1/2008
0.19... 0.05 6/1/2008
0.10... 0.10 7/1/2008
0.10... 0.05 8/1/2008
-0.10... 0.13 9/1/2008
-0.20... 0.10 10/1/2008
0.10... 0.00 11/1/2008
0.10 -0.07 12/1/2008

The absence of declining figures signifies a robust economy in 2008.
This is the "Holy Grail". It is inviolate & sacrosanct.

Anonymous said...

By including the most obvious varibles and ignoring or through simple ignorance of other highly correlated variables you can make most fits and distributions look uncorrelated or even normal. This doesn't make them so, and most of the hard work is in trying to find the correlated variables (not the uncorrelated ones). It borders on a science;^)

One correlated variable you haven't mentioned, and that I've heard was not particularly well modeled is housing appreciation. An assumption that housing never goes down makes not losing your principle pretty easy. It turns out prices can fall, and the same thing that gets the speculators gets their lenders.

I for one don't buy the idea that the best folks designing these models didn't realize the risk, they just figured they'd be just as necessary afterwards, as before they made their money :^\ Plenty of people have been calling this bubble for years.

Now for the question of inflating our way out of this. I hope that it works, though it won't be good for the CDO holders. The problem could be whether wages grow quickly enough to make the payments.

Now one thing I do agree about is that CDOs will become the junk bond of the next 2 decades, but we haven't seen the worst of this and won't for years.

Anonymous said...

loved your blog, but why no RSS?
now i have to sit down and read every single post, too little time too much to learn, damn!

Anonymous said...

Anonymous - I use Google RSS reader with the URL:


flow5 said...

"Goldman Sachs Group Inc., the world's biggest and most profitable securities firm, has good news for its competitors: The worst credit-market shakeout since 1998 is abating." - Bloomberg

" Today, at least two of Goldman's rivals also are ready to call the bottom, even after timing it wrong in June. Lehman's O'Meara said on Sept. 18 that ``we feel that the worst of this credit correction is behind us.'' Bear Stearns's Molinaro, who on Aug. 3 said the fixed-income market was ``about as bad as I have seen it'' in 22 years on Wall Street, declared last week that ``the worst is definitely behind us."

The data that is required for a perfect forecast was discontinued in Aug. 96. It's mirror is almost as good & has a perfect record for the last 94 years. Both time series represent "good theory" over inadequate facts. One encompasses all prices, even housing, and the other is just about as close.

The liquidity problems would be solved if you got the money creating depository institutions out of the savings business.

Oct is the bottom.

Anonymous said...

Very good post. You may want to factor in the fact that the equity tended to be paid out very quickly if the deal performed (and even under some stress) -- if memory serves, 5-7 years until return of investment. After that, it was all "gravy." People did understand that correlation was increasing and knew the risks; but (1) meeting plan (and paying bonuses) required doing more deals, not staying in cash; (2) given the length of time it takes for problems to turn into delinquencies to turn into losses, they had a reasonably expectation that the equity would be "out" before the problems hit; and (3) they didn't really bargain for housing price drops on the scale now being expected. I think the rating agencies, for example, probably mistakenly relied on housing prices suffering only a moderate drop.

Anonymous said...

one of your longest post, surely! as usual, a good read imho.

Since we are about 3 months to go before the year-end, what's your view on the US HY and HG market? any particular sector views/calls?

venkat said...

I could not understand how a PIK toggle adds credibility to a CDO. Does the initiation of a PIK toggle not indicate financial distress on the part of the borrower? I can understand why Over collateralization or better Interest coverage leads to a better rating. However, should the possibility of skipping a interest payment not lead to lower rating? I might have completely missed your point in this sentence. "The ratings agencies basically said "If you can make it pass our tests, you'll get your rating." So CDO managers began monkeying with things like IC and OC tests, PIK toggles, and other fun things."

Also I don’t see a lot of difference between OC and excess spread in terms of the relative security they offer to a senior CDO tranche. Does the excess spread not actually serve as OC?

I would appreciate if you can clarify these two issues to me. Thanks for one more informative post.

Accrued Interest said...

James: It depends on whether you believe the market or the ratings agencies. Even AAA-rated CDOs without specific problems are trading with $95 type prices. I also think Moody's and S&P are being cautious about downgrading CDOs before there are any actual losses in the deal.

My intention with this post was to state my view on the ratings and creation of CDOs because I think there is an over emphasis on the conflict of interest and HPA issues.

Accrued Interest said...

Joe Blo: I actually think the ratings agencies modeled the HPA issue reasonably. They Monte Carlo'ed both default rates and recovery rates, so some variability was allowed for. I think under most people's reasonable estimates for future HPA ranges, the variability they used was reasonable.

Consider this: we haven't seen very large decreases in HPA yet, and most areas of the country are either advancing (slowly) or about flat. Flatish HPA was within the model's tolerance, I think. Now, things might get worse with HPA, but the problems we have right now are not all about weak HPA.

Plus consider this: in order to get a Moody's Aaa, you have to have a zero expected loss. That means that of all the Monte Carlo'ed scenarios, none can result in losses to the Aaa tranche. Again, a zero HPA environment was within the model's realm of possibility. Maybe they assigned too low a probability, but that's not why tranches were getting Aaa ratings.

Accrued Interest said...

Flow5: Friedman rules. Thanks as always for posting. I often don't comment because I rarely have much to add. But keep it up.

And thanks Goldman for letting us know the credit crunch is over. I can't wait for my Goldman coverage to call me with some shitty bond to buy...

Accrued Interest said...

Fred: I'm constructive on high-yield, but mostly because I don't see it getting much wider. I try to be greedy when the world is fearful and fearful when the world is greedy. FWIW, HY has had quite a run the last few days tho.

Accrued Interest said...

PIK stands for pay-in-kind. Any bonds with a PIK toggle allows for interest to be deferred and added on to the principal. Sounds very Sopranos doesn't it? Anyway, I believe Moody's allowed for a PIK on any Baa-rated bond. That meant that when modeling the deal, you could get away with suffering large losses if you eventually made it all back with interest. As far as Moody's was concerned, if you eventually paid out the PIKing bond, you never suffered a loss, and the bond would get its rating. That puts a heavy burden on recovery and reinvestment rates. Its just another thing where the model's accuracy was assumed to be greater than it really was.

Coverage tests and excess spread require time to work. If losses are incurred quickly, no excess spread has been built up. Subordination is hard and fast credit support.

Anonymous said...

Best post about mortgage problems that I have ever read. Ever.

Why did you wait so long to sound the tocsin?

Surely, you knew this 5 years ago.

fbeckenbauer said...

Here is Buffett writing on junk bonds in 1990:

"A kind of bastardized fallen angel burst onto the investment scene in the 1980s - "junk bonds" that were far below investment- grade when issued. As the decade progressed, new offerings of manufactured junk became ever junkier and ultimately the predictable outcome occurred: Junk bonds lived up to their name. In 1990 - even before the recession dealt its blows - the financial sky became dark with the bodies of failing corporations.
All of this seems impossible now. When these misdeeds were done, however, dagger-selling investment bankers pointed to the "scholarly" research of academics, which reported that over the years the higher interest rates received from low-grade bonds had more than compensated for their higher rate of default. Thus, said the friendly salesmen, a diversified portfolio of junk bonds would produce greater net returns than would a portfolio of high-grade bonds. (Beware of past-performance "proofs" in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.)

There was a flaw in the salesmen's logic - one that a first- year student in statistics is taught to recognize. An assumption was being made that the universe of newly-minted junk bonds was identical to the universe of low-grade fallen angels and that, therefore, the default experience of the latter group was meaningful in predicting the default experience of the new issues. (That was an error similar to checking the historical death rate from Kool-Aid before drinking the version served at Jonestown.)

The universes were of course dissimilar in several vital respects. For openers, the manager of a fallen angel almost invariably yearned to regain investment-grade status and worked toward that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing financiopath.

Wall Street cared little for such distinctions. As usual, the Street's enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce. Mountains of junk bonds were sold by those who didn't care to those who didn't think - and there was no shortage of either. "

Anonymous said...

One question, tddg:

" Otherwise it will be a long time before we have a viable sub-prime market again. "

Without throwing around invective.. why is this a bad thing? It means people with questionable credit people won't be able to receive loans.. but then again, those loans will never be repaid, so where's the harm?

I think the lack of a subprime market is a GOOD thing! Why do you disagree?

Unknown said...


One of your best posts ever. Excellent observations as always.


I have recently begun a study of Pritchard's work on monetary flows and I would be interested in corresponding with you regarding same. I am currently attempting to apply his work as described in "Money and Banking". Since you are the only person that I am aware of that has actively studied his work, I would be very interested in asking you a few questions regarding how you have dealt with certain challenges associated with applying P=MV/T. If you have the time, please contact me at Thank you.

Accrued Interest said...

Did I see this coming 5 years ago? Yes and no. I was very negative on consumer credit bonds for basically the last 10 years. So I always avoided auto loan, credit card, HELOC, and non-agency MBS paper. The spreads on that stuff was never that great, and I have long been concerned about high consumer debt levels.

Now my concern was more about weak performance in whatever pools I'd wind up buying. Not some calamity.

I was worried about HPA 5 years ago as well. But my view was that an overheated housing market was self-correcting. If housing prices didn't rise, people would stay in their houses longer. That would cause supply to drop enough to keep HPA from going significantly negative in nominal terms. I underestimated the impact of speculators.

I also underestimated how bad credit standards became. It was only last year that I became aware that as much as half of all sub-prime loans were lim doc. That's when I became much more negative on sub-prime. And honestly, I wasn't that far behind the curve. I believe sub-prime credit standards rapidly deteriorated in 2005 and 2006, and statistics on loan orginiations were not widely reported.

Accrued Interest said...

And this isn't my first post on sub-prime...

Accrued Interest said...

Anon @8:53: I do disagree. Historically, the overwhelming majority of sub-prime mortgages are repaid in full. The current situation is the anomaly. In fact, if I were a bank who had adequate liquidity and balance sheet space, I'd be ramping up my sub-prime business. Because right now I can pick and choose my borrowers, and I can set the rate where I feel comfortable. In other words, I think the survivors of this sub-prime meltdown are going to be quite profitable.

Accrued Interest said...

FBeck: Thanks very much for this passage. Its a perfect comparison to what's going on now. I think the growing pains HY suffered in the early 90's are a good guide to how the CDO market is going to perform over the next 3 years.

Anonymous said...

tddg: your 9:24a link was chopped off.. could you use tinyurl to repost it? Thanks!

Anonymous said...

@anon 9:43 AM

Here is a link to the truncated link in tddg 9:24AM's post.

Anonymous said...

Great post.

Where do you see the leverage loan / HY market heading over the next 12-18 months? One can make a fairly similar argument about the LBO market for the past two years, as marginal companies were able to refi their way out of trouble and new deals being set up with very high leverage. Of course, current arb spreads on pending deals point to some of this (100%+ IRR on the Tribune deal), but how much do you think this is priced in?

Anonymous said...

According to Professor John C. Coffee, Jr.'s testimony to the Senate CRA hearings,

Looking at the default rate on Moody’s lowest investment grade rating (Baa), two financial economists recently reported that the five year cumulative default rate on corporate bonds receiving a Baa rating from Moody’s between 1983 and 2005 was only 2.2%, but the same five year cumulative default rate for CDO’s receiving the same Baa rating from Moody’s between 1993 and 2005 was 24%—more than ten times higher.4 Moody’s informs me that they consider the default or impairment rate for 2005 to be aberrational for several reasons,5 and they have advised me that the comparable five-year cumulative default rates ending in 2006 (as opposed to 2005) were 2.1% for corporate bonds and 17% for CDOs. But even on their preferred comparative basis, the ratio is still over 8 to 1 (as opposed to over 10 to 1).

It's not clear to me, however, whether dollars or deals are being counted.

Accrued Interest said...

Anon 10:59: I'm of two minds. First, the leveraged loan market would seem to have been supported (perhaps artificially) by strong demand for CLOs. On the other hand, high yield bond issuance was pretty steady from 2003-2006, and 2007 will likely be in the same context of about $180 billion in issuance. So I'm not sure we're seeing as large an increase in corporate debt as we were in mortgage debt. And by that I mean literally, I'm not sure. I don't have hard numbers on bank loans.

Accrued Interest said...

James: Great link. I read the testimony. As far as the 24% figure, I immediately thought of the CBO market, which went completely to shit in 2002. It took a couple of years for the Baa-bonds to actually default, obviously, but that CBO figure is all tied up in the Enron/Worldcom period.

Worth noting that issuance in CBOs never recovered.

Accrued Interest said...

Another point on Moody's. For everything other than municipals, Moody's aims to have the same "expected loss" rate for any bond with a given rating. Obviously they don't always succeed.

flow5 said...


Joseph Granville writes the Granville letter. He was making a couple million dollars per year with subscriptions. On Sept. 81 he was prepared to call a market turn. His subscibers beat him to it rendering it useless.

If what I know wasn't so valuable then I would gladly tell the world. I'll think about it. I think it is extremely funny that no one believes in such a thing as the "Gospel". Of course it seems illogical & thus everyone is a doubting thomas. Really, the whole thing makes me angry.

If it is the "Gospel", then it is worth billions. And it is the "Gospel".

I have a very low opinion of economists. Pritchard was different. He was unquestionably the smartest man I ever met and I grew up amongst intelligent people. Both my parents were doctors and both taught medicine, etc.

Leland Pritchard was my friend. I only got to know him after he retired. He explained many theories to me over the phone. I believed every single thing he said. I built the time series by hand (before computers). I did some grunt work & across came the "Gospel". It's remedial but Pritchard's other propositions aren't. You should be able to figure it out from my posts.

I'll give you another example:

11/1/1997..... 0.22..... 0.00
12/1/1997..... 0.61......0.05
1/1/1998...... 0.42.......0.3
2/1/1998...... 0.02......-.02
3/1/1998...... 0.12.....-0.04
4/1/1998...... 0.09......0.08
6/1/1998...... 0.01.....-0.01
11/1/1998..... 0.06......-0.2
12/1/1998..... 0.19.....-0.09

Several people have compared today to 1998, i.e., LTCM, etc.

The increasingly negative rate-of-change in monetary flows (MVt) (both in real-gdp & inflation) from May until Oct. 1998 demonstates the extremely flawed monetary policy pursued by Alan Greenspan. This is the history of all economic crisis since 1942.

flow5 said...

Another example: 1987 - unexplained?

On Sept. 4 the Fed raised (1) the discount rate 1/2 percent to 6, and (2) the federal funds rate 1/2 percent to 7.25 (up from 5.875 percent in Jan). On Sept. 30 fed funds spiked at 8.38; fell to 7.30 by Oct. 7; then rose to a peak of 7.61 Oct 19 (Black Monday).

At the same time, (Sept. & Oct 87), the decline in the proxy for real-gdp (its rate of change) plummeted (A RECORD SINCE ITS INCEPTION IN 1918). The quantity of legal reserves bottomed in the bi-weekly period ending 10/21/87. This was the trigger.

At the time, the 30 year conventional mortgage yielded 11.26 percent, up from 8.49 percent in Jan. 87, and moody's 30 year AAA corporate bonds yielded 11.06 percent on 10/19/87, up from 9.37 in Jan. 87.

The preceding tight monetary policy and the sharp reduction in legal reserves, had forced all interest rates up in the short run (when inflation and real-gdp were subsiding).

And the banks scrambled for reserves at the end of their maintenance period - to support their loans-deposits (contemporaneous reserve requirements were in effect exacerbating the shortfall and response time). Apparently a significant number of banks, or large banks with large reserve deficiencies, tried to settle their obligations at the last moment.

Black Monday's trigger was obscured because the decline in monetary flows (MVt) overlapped Qtr3 & Qtr4 GDP (quarterly reports are used by the Bureau of Economic Analysis to measure gross domestic product – not monthly).

The Fed quickly reversed their policy when the markets panicked, i.e., they brought the volume legal reserves back into alignment.

11/1/1986..... 0.96.....0.5
12/1/1986..... 1.15.....0.6
1/1/1987...... 1.1.....0.78
2/1/1987...... 0.77....0.6
3/1/1987...... 0.45....0.54
4/1/1987...... 0.57....0.62
5/1/1987...... 0.66....0.58
6/1/1987...... 0.51....0.54
7/1/1987...... 0.51....0.55
8/1/1987...... 0.22....0.47

The United States has the largest national economy in the world, with a GDP for 2006 of 13.21 trillion dollars. Fed 27, 2007 didn't start in China, it started here. That's why the Shanghai market dropped 6.5% May 30 2007 without affecting other world markets.

Anonymous said...

@flow5 I've posted two comments on your DIDMCA post, if you'd be good enough to take a quick glance.

Anonymous said...

Good write up. So, how does this end? Lots of chatter about the recent downgrades causing event of default (eod) and subsequent forced liquidations of cdo deals. Seems like lot of different languages in these deals in terms of actual losses vs rating downgrades causing haircuts that then trigger eod. Any thoughts?

Accrued Interest said...

I think the end game is that sub-prime related deals will become deep value plays. Some will go to zero, some very senior bonds will actually pay off in full. Some will be bought for 10 cents on the dollar, collect 3 years worth of coupons before it goes bust, but the buyer makes a little money anyway. Some will be bought for 10 cents on the dollar and make no interest payments at all. Its going to be that kind of game.