Wednesday, October 31, 2007

Well, short help is better than no help at all

Well the 204 readers who voted for a 25bps cut got it right. Prior to today's announcement, the market was widely expecting another cut in December. We'll see how the futures start trading after the release has been fully digested.

The real question is where do we go from here? I think the odds of several more cuts have risen substantially. Today's GDP report, and Hoenig's dissent not withstanding, the Fed is rightfully concerned about the strength of banks, and if weakness continues in that sector I'd expect the Fed to keep cutting. In essence this would allow banks to earn their way through any troubles through carry.

Commenters will cry out Moral Hazard! Moral Hazard! But having read Bernanke's academic work on the Great Depression, you can't help but think he'll err on the side of providing too much liquidity if the alternative is risking the banking system.

How many cuts we get exactly depends on the extent of the housing problem as well as how quickly it deteriorates. If home price appreciation was mildly negative for a year or two nationwide, then about flat for several years thereafter, that would be manageable without deep cuts in rates. If we see -10% each of the next two years, I think the Fed gets more aggressive.

What will be the consequences of more cuts? Well, a steeper curve to begin with. I'm bearish on the long bond, and would be cautious on loading up in the 10-year area. I'm focused on 3-7 year bonds.

The dollar will probably continue to struggle. If that can continue to prop up exports, that might help the housing problem by keeping people employed.

I think you will also see a rotation in both credit and stocks, back into financials and away from consumer cyclicals. The market will wake up the reality that consumer cyclical firms are the ones really vulnerable to an extended period of housing-driven weaker consumer spending.

Monday, October 29, 2007

Countrywide Profits: Difficult to See

Countrywide's surprising announcement on Friday that they expect to be profitable in 4Q and CY 2008 pushed the stock market higher and allowed financial bonds to tighten modestly. I'm of two minds on this development. Its not that I can't imagine how Countrywide could turn things around, its just predicated on a couple very big ifs.

First, its not that hard to imagine a scenario where mortgage lending profitability improves suddenly. This probably sounds hard to swallow for many readers, so remember... I'm saying its possible. What mortgage lenders have going for them is improved margins and decreased competition. Lenders with capacity to lend can pick what loans they want to underwrite, and can name their rate. I think its also safe to say that mortgage lenders will assume weak home price appreciation (HPA) when making new loans, insist on larger down payments, and be more weary of any kind of adjustable rate loan.

All this adds up to 2H 2007 and 2008 vintage loans being much more profitable than 2005-1H2007 vintage loans, assuming both were merely held on balance sheet. In other words, investing in mortgage loans should become more profitable. It is also likely that the Fed will steepen the yield curve in 2008, which should decrease the cost of funds for most banks and other finance companies, and improve lending profitability.

Of course, Countrywide has been doing more mortgage originating and less mortgage investing in recent years. It is less clear that the origination for securitization game will improve in profitability. Securitizing through the GSEs will remain perfectly viable, but not necessarily more profitable. If mortgage underwriting spreads widen, its unclear how much of that would be realized by the underwriter and how much by the GSE in the case of an Agency securitization. We can all agree that Freddie Mac and Fannie Mae's guarantee is more valuable today than in 2006, and I expect both will command a higher price for that guarantee. Plus we know that fewer mortgage loans overall will close in coming years vs. recent past. So even if the profit per loan is marginally higher when securitizing via Fannie Mae or Freddie Mac, volume will be way down.

In non-agency space, there will be similar issues. Even assuming loan margins improve in 2008, I'd expect most of that margin will be passed onto the ultimate investor. Following with my market-power theory from above, while its true that mortgage lenders have more market power than before, investors willing to buy non-Agency MBS have the ultimate market power at the moment. And I expect that will continue for a while, especially in subprime. For many young investment analysts, the Great Subprime Collapse of 2007 represents their first serious bear market in any product. They will carry this their whole career. Don't believe me? Find an analyst whose career started in 1985 or so and ask him/her about program trading.

Anyway, so the result will be that the pool of potential investors in subprime securities will be permanently smaller for a long time going forward. So based on the laws of supply and demand, the spreads on subprime bonds will have to stay wide, even if there is universal agreement that newer vintages are of better quality. Even if various improvements are made to the subordination of subprime ABS, and even if the market starts believing in AAA-rated MBS again, I still think the overall spreads on subprime deals will stay much wider than was the case in 2006.

There is another issue, and one that hasn't gotten a lot of play in the media. The highest quality subprime loans which will be underwritten in the next couple years will be mostly refinancings of ARM loans. Several lenders, including WaMu and Countrywide, have announced programs to offer below market fixed-rate loans to subprime borrowers who won't be able to afford their reset. Far from being altruistic, this is a loan modification to avoid foreclosure disguised as a refinancing. Not that there's anything wrong with that. I mean, it would seem like the best move for the bank, similar to our discussion of loan mods the other day. On top of that, there is the FHA Secure as well as several state-run programs, which will similarly skim off the best subprime loans. It may seem strange to describe a de facto loan mod as a strong borrower, but based on how these programs are being marketed, it sounds like only stronger borrowers will qualify. In other words, borrowers whose only problem is the rate reset as opposed to borrowers in more dire straights.

So back to Countrywide. I don't think they are in a good position to take advantage of higher loan margins. I think actual banks with actual balance sheets and better access to emergency liquidity are in stronger position to realize new opportunities in mortgage lending. On the other hand, if we assume that Countrywide underwrites nothing other than easily securitized stuff, and has indeed written down all its assets (including both loans and servicing rights) to their true value, then there is no reason why they shouldn't be profitable to some degree in the near future.

The big IF in the previous paragraph is the true value of their assets. By that I mean not the market value, but what those assets really turn out to be worth. We are living in a world where determining the value of mortgage assets is extremely difficult. We know that there are assets currently priced at 50 cents on the dollar which will eventually pay off in full. And we know there are assets similarly priced which will turn out to be worthless. If Countrywide has written down all their risky assets to x cents on the dollar, and on average, that's what those assets ventually pay out, then everything will be fine. If they realize x-y, then it may be several quarters before they're back in the black.

Finally, the thing that I don't like about Countrywide is their access to non-market capital. A bank can go to the Fed or to the Home Loan Banks and get emergency capital. So if WaMu or Fifth Third or US Bank or some other large retail bank were to have sudden trouble with securitization, they'd have options. Countrywide Bank is too small to consider it a realistic option to fund Countrywide's overall operation, and as we saw in August, Countrywide is subject to liquidity problems.

In terms of the market overall, both in credit and stocks, you'd hope that Countrywide delivers on their promise. If not, I think there will be a very negative reaction in both markets.

Disclosure: I own no Countrywide securities. I do own Washington Mutual and Wachovia bonds in client accounts, as well as various state housing agency debt.

Thursday, October 25, 2007

The Future of CDOs Episode I: Turn her around!

We've spent a lot of time talking about the CDO market, mainly because its one of my favorite subjects and its my damn blog. (Click here for a primer on how CDOs work.)

We stand at an important cross roads for CDOs. Banks, brokerages, and investors of various types have been hit hard by poor performance in the CDO product. I am on record as saying that CDOs were a primary source of helium for the housing market bubble. And yet I stand before you today to say that the CDO product is ultimately a positive for the economy. If we can figure out a way to eliminate some very deep and yet very solvable problems with how CDOs are structured and marketed, CDOs can be a source of liquidity and a very appropriate vehicle for various investors.

So this will be part one of a indeterminate series of solutions to the problems in the CDO market, and by extension, the ABS market. I don't want to spend a lot of time talking about what's gone wrong in the CDO market, because that's been pretty well covered. Also, I know that some of the solutions proposed below could not be implemented over night. Others would require investors to start demanding certain concessions from CDO arrangers. But hey, the beauty of the blogosphere is that an arrogant jerk like me gets a forum to preach his message. So here it goes.

The beauty of securitization is that risk becomes dispersed, as opposed to dangerously concentrated in a few places. The downside is that it creates a disconnect between the initial decision makers on a risk and the ultimate bearers of that risk. In subprime loans, mortgage originators had no apparent incentive to make good loans as long as they knew they could sell the loan into a pool. The same would hold true for commercial loans. As long as the bank assumes the risk can be passed on to someone else, what's the motivation to make good loans?

There is a relatively simple solution here. Force loan originators to retain more risk. This could be achieved in a variety of ways. It should be noted that MBS originators generally retain a certain amount of risk, called the servicing spread, which is usually on the order of 50bps of coupon. In essence that means that when the loan is sold into a pool, the originator gets the PV of the loan's cash flows less 50bps of interest. In total dollar terms, that usually amounts to something like 2-3% of the loan's overall risk being retained by the servicer.

But here is the problem with the servicing spread model. It still allows for woefully undercapitalized firms to remain involved in the mortgage market. An originator like New Century could just keep pumping out enough loans to make up for whatever losses it was taking in servicing, or else just sell the servicing rights to a bigger bank. Management just assumed they would personally make enough money to live comfortably regardless of what eventually happened to the firm.

What would have worked better is if originators had to take risk on both the top and bottom of the capital structure. First, you increase the servicing spread to at least 100bps on non-GSE pools. Then servicers would be required to write a letter of credit on the senior-most tranche of the pool. A letter of credit (LOC) is in essence a guarantee to pay principal and interest if the pool defaults.

The result of this is that investors in so-called low risk tranches would become more aware of the credit worthiness of the originator. Investors would invariably prefer higher-rated originators over lower-rated ones, because the LOC attached would be more valuable. This would either force the lower-rated originators to improve their capital situation or get out of the business. This would also force originators to put their own necks on the line when it came to the pools they originate. Investors would have more confidence in the whole system, since they know that the originator is standing behind the loans they make. The originator's incentives are aligned with the investor.

The same concept could be applied to the non-residential ABS, where the structure could be exactly the same. In the bank loan world, the loans aren't typically tranched prior to being put into a CLO. But banks could still retain more of the loan as a "servicing fee" which would improve the alignment of risk.

Here is a modest proposal: the ratings agencies simply shouldn't rate CDOs at all.

Look, its better to know what you don't know than to think you know something that you actually don't know. You know? Basically by rating the senior CDO tranches Aaa/AAA, Moody's and S&P were saying that they knew those securities were very low risk. Too many investors took it as a given that Moody's and S&P understood the risks embedded in these structures. Now its clear that basically no one fully understood how quickly subprime lending could all fall apart. Its time for a little humility in modeling. Yes, Monte Carlo simulation is the best way to analyze CDO pools, and the 2007 experience will undoubtedly allow the quants to build better simulations. That's all fine. But let's face it, a model is just a model, it can never incorporate all the complexities of real life markets.

So if the ratings agencies would simply admit this, then investors would go into CDO investing knowing what we don't know. That isn't to say that the ratings agencies would have no role in the CDO market. They could provide independent information on the deal's legal elements and opine on the deal manager's qualifications. This would be quite useful to investors who generally don't understand the obtuse reams of lawyereese populating offering memoranda, and who don't have the time to do site visits would CDO managers.

Furthermore, the ratings agencies could still model CDO deals in their Monte Carlo simulators for a fee. Investors could then run the Monte Carlo themselves, inputting default and recovery rates, default patterns, and correlation as they see fit. Rather than getting one or two perspectives on what the default/recovery/correlation patterns should be, investors could impose their own stresses. Some of this capability is available on sites like ABSNet, but obtaining access to a deal can be difficult and expensive. It should be where investors can have access to deal modeling in an open and relatively inexpensive manner. The days of information on CDOs being closely guarded needs to end.

Eliminating formal ratings from the CDO world would also foster more competition among those offering credit analysis on a deal. Currently it costs between $500,000 and $1 million to get a CDO rated by both Moody's and S&P. If a CDO arranger only needed to hire one of the two, and the ratings agency merely commented on the perfection of the legal structure, and assured investors that the collateral manager is reputable, I'd say the cost of would drop to less than $100,000. The CDO arranger would then need to find multiple firms to model the deal's cash flow into a Monte Carlo simulator. But this may or may not be the big two ratings agencies. If investors were allowed to personally compare various simulations of a deal's performance, the barriers to entry in the ratings business would plummet. Investors could easily pick out a modeler who was too generous to the CDO arranger, because that model would stick out compared with others. Currently Moody's and S&P basically tells investors to "trust them." If the models were more open and the inputs were modifiable, then we wouldn't need to "trust" anyone. Trust creates a giant barrier to entry. Openness tears that barrier down.

Besides, if a deal really needs a rating, then obtaining either a LOC or insurance policy would be more appropriate. If someone like Bank of America wrote a LOC on a CDO tranche, then the tranche would be legitimately be Aa-rated, rather than having a phantom Aaa rating.

So hopefully this is a start. Look forward to your comments.

Tuesday, October 23, 2007

I want them alive... No modifications!

I've been thinking a lot about loan modifications, which is basically when a bank voluntarily agrees to alter the terms of a loan, and here I'm talking about a mortgage loan, in an attempt to avoid foreclosure.

No one has covered this issue better than Calculated Risk (for example: here but CR and Tanta have done many posts on the subject.) CR and others have spilled a fair amount of virtual ink on the problem that most mortgage loans which have been securitized either cannot be modified, there are severe limitations on modifications, or there is no single party motivated to choose modification.

This leads us to an unfortunate reality. In 2007, given that such a large percentage of loans are held in securitized form, loan modifications are harder than ever to achieve. And yet, given that rate resets are a big part of the subprime problem, its likely that loan mods would be more successful in limiting lender losses than in times past.

Other sites have done a fine job in covering this issue from the consumer's perspective. But AI is all about the cold hearted capitalists, and after all, bond holders are de facto lenders here. So I'm going to give some thoughts about loan modifications from the perspective of a CDO/ABS holder.

In the olden days, back when men were real men, women were real women, and banks were real banks, the negotiation of a loan modification could theoretically be held between all interested parties: the borrower and the lender could actually meet together and hammer something out. If the borrower fell hopelessly behind, the bank could decide whether foreclosure or the modification would result in the minimal loss to the bank.

The securitization business thrives on homogenization. So when it came to the issue of loan modifications, investors wanted strict rules about what could and could not be done. Remember that ABS and RMBS (and later CDOs) were built on complex mathematical models about default and recovery. If a servicer was too aggressive about making mods, then that would mess up the nice neat models. You know, quants get very cranky when you mess with their models...

Loan modifications were often not successful in avoiding eventual foreclosure. But in an investor pool with both senior and junior note holders, the timing of payments becomes a huge issue. Say a loan was modified such that the borrower stayed current for another 8 months but then fell back into arrears and was eventually foreclosed upon. If that loan was in an investor pool, then some of the payments made during the 8 months of modified payments likely went to junior note holders. Senior note holders had a legitimate gripe: had the loan simply been foreclosed upon, payments would have flowed to the senior note holders first, likely leaving nothing for junior note holders. In effect, the loan mod benefited junior note holders at the expense of senior note holders. This is particularly true in pools where there is any kind of trigger. Increased foreclosures may trip the trigger, which usually causes more cash to flow to senior note holders, where as loan mods may prevent a trigger, keeping the junior classes around for longer, soaking up cash.

This view was reiterated on a recent dealer conference call. The traders were advocating senior tranches of subprime pools from the worst originators. The argument went that pools with larger early payment defaults would cause the payment triggers to be tipped. This results in all cash flow being paid sequentially, with the most senior tranches getting all payments until completely paid off. Given that these kinds of bonds are trading at deep discounts and that the structure had substantial subordination to begin with, there is an opportunity for strong returns.

On the other hand, deals with fewer initial defaults and did not breech the trigger levels would continue to pay pro rata (proportionately to senior and subordinate tranches alike). However, despite relatively low initial defaults, odds are good that defaults will keep rising. Any cash paid out to junior tranches just leaves less for senior tranches down the road. If you are going to get to a high level of defaults anyway, the trader reasoned, why not do so where your tranche is getting all the cash flow?

OK so back to loan mods. Investors objecting to loan mods really need to think this through, regardless of where you are on the capital structure. Say I own the senior most piece (originally rated Aaa) of a 2006 vintage subprime RMBS currently trading at $95. We know its trading at $95 because of default fears. Note that a $5 loss indicates about 125bps in spread widening. So for reference sake, let's say that the pool originally had a coupon of 5.5%, but at a dollar price of $95 would have a yield to average life of 6.75%.

Another way to think of the 125bps of spread widening is that if the same security was created today and priced at par, the coupon would have to be 125bps higher, or 6.75%. Or put another way, investors would pay $95 for a bond with a coupon 125bps lower, yet no default risk. Make sense? So if the senior bond holders were given the option of eliminating default risk in exchange for reducing their coupon by something less than 125bps, they'd likely accept.

Well subprime pool holders, this is your lucky day, because through the magic of loan mods, just such an exchange is possible. Say that half of a pool of MBS is going to reset in 2008 at levels 400bps above the teaser rate, and that these borrower will struggle to make. If these loans were all modified such that the reset was merely 200bps higher, then the net coupon on the deal will only be impaired by 100bps. And since the senior tranche is, say, 90% of the deal total, its coupon is only 90bps impaired!

I know the comments will be filled with two primary objections. First is moral hazard, but frankly we have two bad actors in this case. The borrower who probably should have known better, and the investor who really should have known better. Well, the originator too, but he's probably out of business anyway. The borrower is being given a little of a free pass, but the investor isn't seeing his loss taken away, merely reduced. I don't think investors in Aaa securities are going to have their losses reduced from 5% to 3.5% and consider themselves bailed out. A 3.5% credit loss in a Aaa security is still awful. I also don't think the borrower will walk away from this experience saying "What a great choice that ARM was..." If you see your interest rate go from 5% to 7%, I think that's plenty painful for borrowers to reconsider the ARM idea, the fact that it might have gone to 9% is besides the point. So I'm not buying the moral hazard issue.

Second is the fact that many modified loans wind up defaulting anyway, as stated earlier. This time is different, though. Because the borrower who got in trouble entirely because of a rate reset isn't the same as the classic delinquent borrower who merely can't keep a job or handle credit cards. Remember that all these subprime deals were priced assuming a certain level of defaults: a level consistent with the "classic" reasons for delinquency. If we could do enough loan mods to make the "classic" reason for default the most common reasons, then we'd have a better chance of containing the subprime contagion.

Monday, October 22, 2007

I wonder if your feelings on this matter are clear

Interesting last few trading days to say the least. First we had several banks report ugly earnings: Citigroup, Bank of America, J.P. Morgan, Wachovia, Wells Fargo, Washington Mutual, among others. Bank stocks are getting hit pretty hard. Since Citi is down over 24% YTD, Bank of America down 11% while the S&P is up about 7.5%. Both banks are down more than 7% since 10/15, when the MLEC plan was unveiled. The bank earnings seemed like non-news to me, at least in terms of the big picture. After all, what did we learn?

  • Most complained that the liquidity crunch had harmed their results.
  • Those involved in bridge loans took write downs.
  • Most rose their loan loss provisions related to consumer loans.
  • Their collective view of the housing market was poor.

None of this seems like new news to me. Plus we all know that when a public company is having a bad quarter, they usually go ahead and cram all the bad news into that quarter, so that subsequent quarters can look all that much better. And yet the market has taken it on the chin, both in credit and in stocks. And all the jobs report-driven euphoria of just two weeks ago has completely vanished.

Here are my takes. First, bank losses in sub-prime don't really worry me from a credit perspective. I think its relatively easy to get to the bottom on how much in sub-prime a bank has, and then you can make a reasonable judgment about how big a loss that might turn out to be. All of the large banks I mentioned above, yes even Washington Mutual, don't have enough direct sub-prime losses to add up to insolvency. And banks have a hell of a lot more access to liquidity, if for no other reason than the discount window, than straight finance companies like Countrywide or dare I say New Century. If all you care about is survival, big banks are still a good bet. The stocks are a harder call, because stock investors need growth of profits and these banks are going to be more balance sheet focused over the next several quarters and less income statement focused. I can't really say at what prices the banks are a good buy, because I don't follow them closely enough to say at what price zero profit growth is priced into the stock.

However, the SIV problem is potentially a space-station sized issue. Citi is the headliner here, but even their supposedly $80 billion in SIV sponsorship can't possibly amount to insolvency. However, something is amiss. The MLEC idea seems like a solution to a non-existent problem, and doesn't seem to solve any actual problems. Just makes me wonder what the banks know that we don't know. I'm beginning to suspect that we're digging in the wrong place by looking at losses within the SIVs. Maybe the real problem is with bank money market funds. Banks don't want to ever ever ever break the buck. Remember, most banking services are commodities to consumers. If consumers lose even a small amount on their money market fund, the bank can kiss that relationship good bye. And yet, banks legally have a hard time making up for losses within a money market fund out of their own pocket. Has to do with recourse. Anyway, maybe the MLEC is designed to prevent defaults on CP held by bank money markets, in essence by passing the risk on from the money market fund to the bank itself. Its so crazy it just might work!

Disclosure: I own bonds for Washington Mutual and Wachovia through client portfolios.

Wednesday, October 17, 2007

Yeah but who's going to fund it kid? You?

Some more thoughts on the MLEC... I still like SivieMae, but whatever.

According to Bear Stearns, who is the biggest lawyer on Wall Street BTW, the MLEC may take residential ABS, just not subprime ABS. They also claim that SIV assets break down thusly:

  • 43% financial institution debt (I'm guessing mostly TruPS)
  • 23% RMBS (~2% subprime)
  • 11% CDO (claiming only 1% is ABS CDOs, so bet that the rest are CLOs)
  • Remainder primarily various non-resi ABS.

TruPS is short for "Trust Preferred Stock." It's a kind of hybrid between preferred stock and debt (hence why they sometimes called "hybrids") that financial institutions use to increase their Tier 1 capital. But don't worry about all that, suffice to say that a TRUP is nothing more than subordinate bank/brokerage/insurance company debt.

So let's do a little math. Let's assume that media reports that the MLEC will only buy "highly rated" instruments translates to A and above. Note that I've heard some reports that it will be Aa and above, but we'll be conservative. So if we assume that global SIVs bought their paper at the beginning of the year, what kind of losses are we looking at?

TRUP paper spreads, like any corporate bond, depends greatly on who the issuer is. TRUPS are issued by large and small banks alike, with much of the smaller bank paper going into CDOs. According to Bear Stearns, A-rated CDOs of TRUPS are only 40bps wider YTD. Looking at some A-rated publicly traded TRUP issues, I think that's a little conservative but close. TRUP paper tends to be long-term (similar to preferred stock) so 40-70bps of widening is probably 3-7% in losses. Its possible that non-publicly traded paper would be weaker, but given that CDO spreads haven't moved much I'd say the 3-7% figure is about right.

We'll come back to RMBS paper...

A-rated CLO paper is about 200bps wider YTD according to various sources. AA-rated paper is about +150. Assuming a 8-year average life on the CLO paper, the loss there would be around 15%.

According to Merrill Lynch, auto loan, FFELP student loan and credit card ABS are all about 30bps wider YTD. On assets with 3-5 year average lives, that's a loss of around 1%. Private student loan paper is about 60bps wider, so that'd be a 2% loss, but that isn't that big a market.

RMBS paper is anybody's guess, because every piece is going to trade very differently. Looking at a couple so-called "generic A-rated home equity" indices I get widening of around +900. I can't take at face value Bear's assumption that only 2% of this paper is "subprime" because there is no single definition of subprime. For my money, in today's world, any low-doc loan is subprime, regardless of FICO. Anyway, we're looking at like 35-40% losses on this paper, if you believe the "generic" spread move. AA-paper is drastically better, probably having widened around 300bps, for losses in the 10-15% area.

OK so if we use Bear's percentage figures...

  • 43% financial institution paper with 5% losses.
  • 23% RMBS with 35% loss.
  • 11% CDO with 15% loss.
  • 23% Other (mostly ABS) with 1% loss.

That averages out to 12% in total losses. A bit higher than I guessed off the top of my head in my previous post, but then again I was assuming no RMBS paper would be allowed in the MLEC. If we ignored the RMBS, the remaining paper has a 5% average loss.

So now we wonder what kind of paper might be put into the MLEC. I think there are conflicting possibilities.

First you have to consider the Market for Lemons. This is the title of a 1970 paper by George Akerlof, who later won the Nobel Prize for similar work. For any students or young traders reading, this concept advanced is one of the most important concepts you can learn as a bond trader. Basically Akerlof's reasoning was as follows. In the used car market, the seller of the used car, presumably the current driver of the car, has much greater knowledge of the car's condition than any potential buyer of the car. If the car is a lemon, the seller will be particularly motivated to sell it. The buyer will be aware of this incentive, and put a high probability on the car being a lemon.

So the buyer's bid for the car will reflect the probability that the car is indeed a lemon. If the car is not a lemon, the seller will likely be unwilling to sell the car at a "distressed" price. Only if the car is a lemon will a trade occur.

The parallel to the bond market is obvious, particularly when we're talking about securitized products where limited information about the underlying loans is available. If we use the Lemon Theory of Pricing, and we assume the MLEC is only going to buy bonds at distressed levels, then SIVs will only sell distressed bonds into the MLEC. We'll have an adversely selected pool of assets backing MLEC's CP issuance.

On the other hand, we have to examine the roll of CP investors as well as non-SIV sponsoring banks participating in the MLEC. First, CP investors will likely examine the pool of assets backing the MLEC carefully. If the MLEC is coy about what assets are in there, I expect CP investors to assume the worst, and then MLEC's ABCP won't be any better than ABCP is currently. Maybe MLEC can get away with pointing to the guarantee by various banks but it isn't like those banks won't have something to say about the assets as well.

The guarantor banks, notably Bank of America and J.P. Morgan, are going to get a fee to insure the repayment of the ABCP, but neither was involved in the SIV market. As with all insurance policies, the idea is to never pay out. Especially since BofA and JPM aren't getting any side benefit from stability in the SIV world. So I doubt those banks would allow for weaker assets to be put into the MLEC, unless the MLEC acquired the assets at very attractive levels. That would turn the MLEC into a de facto vulture fund, which many have suggested will be the case.

So while we still don't know enough to draw conclusions, considering the motivations of the involved parties, I think we are getting closer. I think there are two broad possibilities:

First, the MLEC only buys very high quality assets, and avoids residential securities entirely. The SIVs will benefit because the sale of assets to the MLEC will give them a nice infusion of cash. The losses they incur as part of the sale will be marginally less than had they gone into the market themselves, but in real economic terms, this will be all but offset by the fees paid to create and insure the MLEC. If the assets are all viewed as very high quality, then I suspect MLEC won't have any trouble getting funding from CP issuers, and every one will hail its creation as a smashing success. However, the whole thing will be nothing other than a tool to obfuscate the balance sheets of SIV sponsors. The real economic benefit will be small, if any. Peripheral as Flow5 called it.

Second possibility is that, the MLEC becomes a vulture fund, with mostly weaker assets sold into it. In this case, the bank-owners will have to pledge a strong guarantee in order to lure investors to buy their CP. As long as CP investors view the MLEC as fully backed by a strong bank like Bank of America, there won't be a problem getting funding. But any kind of semi-backing or "moral obligation" won't fly. The SIVs will sell distressed assets at distressed prices, and the fee paid to the guarantors will be much larger. MLEC's owners will benefit from both the large fee as well as the large carry from these distressed securities. I don't know how the GAAP accounting of this scenario would work, but economically the SIVs selling assets would realize large losses. The broad economic benefit will be somewhat greater, because it might speed up the reemergence of non-agency mortgage underwriting, but I'd still call it peripheral.

In all, I'm still not convinced this whole plan has any real meaning to it. We'll see.

Monday, October 15, 2007

With our combined strength... Episode Two

Several weeks ago I wrote about a hypothetical plan to create a new entity, jointly owned by various banks, to buy some of the "hung bridge" LBO loans that banks are holding. While the idea was widely derided as an accounting gimmick, I wanted to point out that it didn't have to be anything as nefarious. Which isn't to say that it might have turned out that way, just that the so-called "LoanCo" plan could have been perfectly legitimate.

Fast forward to the now public plan to create a similar jointly owned entity to bail out the asset-backed commercial paper market (ABCP). I feel similarly about this plan on the surface. It doesn't have to be a balance sheet shell game. Such a plan could be set up as a perfectly legitimate attempt to come together for mutual benefit. The bank's could report the assets and liabilities of the joint venture on their books, or in a supplemental report if consolidation of the venture wouldn't be GAAP. After all, all these big banks make heavy use of the commercial paper market, and hence providing stability and assurance to that market benefits each of them. Even the Treasury Department's involvement isn't automatically offensive, if indeed all they did was invite the banks in question to Washington for some tea, biscuits and a nice chat.

Of course, what it could be and what it will be are two different things.

Anyway, here is how it sounds to me like this will work. First, a new entity will be formed, we'll call it SivieMae. SivieMae will be owned by various banks, which will have to infuse it with some amount of cash, although likely a very small amount. SivieMae will sell ABCP, which will carry what sounds like a joint and several guarantee from the owner banks. Given that the banks involved that have been made public are AA/Aa rated, SivieMae will carry a very strong credit rating, probably AAA/Aaa. For those who care about real bond trader shit, CP isn't rated using the same coding as bonds. The top rating is A-1+ for S&P and P-1 for Moody's. In most cases, AA/Aa or AAA/Aaa banks would both have a A-1+/P-1 CP rating.

Prior to selling the ABCP, SivieMae will have entered into agreements with various SIVs to buy certain assets. Some scheme will have to be cooked up to value the assets. Apparently SivieMae won't be buying mortgage-related securities, and if this is true then valuing the assets shouldn't be too difficult. Of course, if the assets are valued correctly, a significant loss will still be realized by the sellers, because even very strong non-resi ABS have widened significantly in recent months. The losses might only be like 1-2% of par, so if every one was being ethical about this, that loss would pass through to the bank that owned the SIV. Of course, if every one was being totally ethical, they'd hire an independent accounting firm to value the bonds to avoid self-dealing. But I haven't heard anyone talking about such a thing. So... We'll see how well the assets are indeed valued. Call me highly skeptical.

The banks issuing the guarantees on SivieMae's CP are going to do so for a fee. That's how someone like Bank of America who hasn't been in the SIV game is motivated to get involved. SivieMae will supposedly have a limited life, although I'm skeptical on that as well, perhaps as short as 1-year.

I don't have a problem with the concept behind SivieMae. I don't care about the banks collecting fees either. My problem is with Citi's position in all this. Let me quote another classic movie, and imagine this is Chuck Prince speaking to the other banks in one of Treasury's conference rooms:

"Times have changed. It's not like the old days, when we can do anything we want. A refusal is not the act of a friend. If [Bank of America and J.P Morgan] had all the [liquidity], and the [funding capacity] in New York, then he must share them, or let us others use them. He must let us draw the water from the well. Certainly he can present a bill for such services; after all... we are not Communists"

I'll bet most of AccruedInterest readers recognized that as Don Barzini's speech from the Godfather during a meeting of the Five Families. Consider the parallel here. In the movie, Barzini and his allies had ventured into the drug business, something that Corleone had steadfastly avoided. But because of Barzini and other's actions, the Corleone's were dragged into a costly war. The Corleone's ultimately couldn't avoid the problems of the narcotics trade no matter what they did.

Here we have some banks, particularly Citigroup, who were using off-balance sheet vehicles to increase their leverage. Other banks, such as Bank of America and J.P. Morgan, decided not to get involved, for whatever reason. Now Citi's structures are struggling to refinance their liabilities, and forced selling from various leveraged players is hurting every one. Those that choose to stay away from the SIV structures were still dragged down by the liquidity crunch. No matter what, the over leverage was going to end badly for every one.

Like the meeting of the Five Families in the Godfather, the Ten Banks have gotten together to hammer things out. But the banks aren't on equal footing are they? Citigroup really needs what Bank of America and J.P. Morgan have. There's no obvious reason why Bank of America or J.P. Morgan would help out Citigroup. Yes, LIBOR and CP spreads got very wide while quality asset
spreads got killed
(thus dragging everyone else down), but all that's improving on its own (or with help from the Fed). The mainstream media stories are acting as though the ABCP world needs rescuing, but really it doesn't. ABCP spreads have improved substantially and are moving in the right direction. I don't think investors are generally leery of ABCP as a concept, more what kinds of assets are backing the program. Besides, if JPM and BAC aren't involved in SIVs, what the hell do they care what happens in the ABCP world? Why wouldn't Jamie Dimon just tell Chuck Prince to go drive through a toll booth?

There are two possibilities. One is that the Treasury department strong-armed them. Second is that the fees were set at such a high level that it became an offer the other bank's couldn't refuse.

I'd guess it was more the latter than the former. I have no particular reason to discount the former, I just don't know what Paulson could offer/threaten BAC or JPM that would be as persuasive as a gigantic fee.

And if you think about it, although the stories say that Citi will get a fee as well, this will wind up working to where Citi pays a de facto fee to the other banks. Think about it. If Citi is the biggest seller of SIV assets, Citi will either own more of SivieMae than others, take large losses on the sale of assets to SivieMae, provide extra cash funding to SivieMae or some combination. Or something else perhaps, but I'm certain no bank will agree to put up their money to back Citi's mistakes without some concession. Like I said, the banks that avoided SIVs have all the power here, and if I know anything about Wall Street, its that those who have the power use it.

Anyway, so if Citi actually owns more of SivieMae but the banks equally guarantee its solvency (and equally collect fees) then Citi is de facto paying the fee to the other banks. In exchange, Citi gets to avoid bringing the SIVs onto their books, which would greatly impact their regulatory capital. I think it's the regulatory capital issue that is driving this proposal. If it were just about paper losses, I think Citi wouldn't be as concerned.

Now squint your eyes a little and what do you see? One bank paying another bank a fee to avoid reporting their complete assets and liabilities on their balance sheet. Now, when Vito Corleone pays a customs official a fee to not look in the blue container coming off that ship, that's called a bribe. What do we call this?

Friday, October 12, 2007

In this fund, you will find a new definition of pain

How's your bond mutual fund doing this year? Odds are good that if it isn't a Treasury fund, its underperforming the Lehman Aggregate. 86% of funds are behind that index though 9/30 according to Morningstar.

There are basically two things that have gone wrong for managers in 2007. One is underweighting Treasuries. And as I've written before, almost all managers are underweight Treasuries, even those who are bearish on credit. Managers are much more willing to own higher quality corporates and/or MBS if they're bearish on credit.

The reason is that overweighting Treasuries will invariably result in a portfolio with a lower yield than its benchmark. If you add the manager's fee with a weaker portfolio yield, the result is that the manager is starting the relative performance game from behind. In order to wind up outperforming when you have a lower yield than your benchmark, your bets have to work out quickly.

For example, assume that you are overweight Treasuries because you expect wider credit spreads. Say a 20% overweight costs you 25bps in yield versus the index. If your portfolio duration is 5 and the Treasuries in the index is 20% (about the same as the Aggregate) then the rest of the portfolio has to widen by 25bps in one year in order for you to break even. 25bps isn't a huge move, but it isn't a small one either.

If, however, it takes two years for the credit widening to occur, then you really need 50bps of widening, because you've suffered through the 25bps of negative carry for two years.

Alternatively, bearish managers could underweight Treasuries while simultaneously underweighting Baa-rated bonds. Normally one would expect Baa's to underperform Aa bonds in a credit widening. So the manager who overweights Aa at the expense of both Treasuries and Baa probably still outperforms when spreads widen. Plus this kind of strategy probably doesn't require a give up in income. So a manager following this strategy can be mildly bearish on credit for an extended period of time without having negative carry eat away at returns.

Given that nothing has worked this year other than owning Treasuries, the second strategy proved to be a miserable failure in 2007. Hence why 90% of managers are behind the Agg. For some managers, the higher quality trade still might be of some use to us. I'd say the odds are good that as time passes, we'll move toward a more normal relationship between high quality assets and Treasuries. So many of the underperforming managers will turn into better performers in the near future.

Then there are the fund managers who got mixed up in subprime bonds.

First there are the funds that dabbled in mostly Aaa-rated subprime pools, like Western Asset Core Bond. This fund finds itself in the bottom quartile of bond funds so far in 2007 owing in part to its high-yield exposure, but more so to its small subprime position. Its trailing the Lehman Aggregate by 190bps through 9/30.

But if you think that's bad, consider the case of the Regions Morgan Keegan Select Intermediate Bond Fund. Ostensibly this is intended to be a "normal" investment-grade bond fund. And yet its somehow lost over 21% so far in 2007. And you thought the Global Alpha fund was having a bad year! At least investing in a hedge fund you knew you were taking risk. This was supposed to be an investment grade bond fund. You know, where you don't take a lot of risk? You know, the safe part of your portfolio?

And here is the thing. As far as I can tell, the portfolio manager, Jim Kelsoe, hasn't been fired yet. What are they waiting for? This guy is truly having one of the worst years in the history of investment grade bond managers. I mean ever. I have never heard of anyone doing this badly with an all investment grade, no leverage fund. Seriously. Oh maybe Jim's stellar letter to investors convinced Morgan Keegan to keep him around. Read it for yourself. See if that would make you feel any better about losing 21% on your fund.

-21%! I just can't get over it. -21% and you still have your job! Check out this picture on the Regions website. Do you think this woman just read her statement saying she's lost 21% on her bond fund? I think she kind of has that sort of "holy shit I'm completely screwed" smirk. Like you are so shocked you don't know whether to laugh or cry. That photo was a good selection by the Regions folks.

Here is the sad part. There are probably investors who don't realize they've lost this much money yet. Mutual fund statements usually come every quarter or even every 6-months if there is no activity. People would be just now getting their September 30 statements. How would you like to see that? You're bond fund is bumping along with a $10ish NAV then all of a sudden its $7. Oh and the manager? Not fired, so don't worry. The same fine team who brought you all these losses will be back in on Monday, firing up their Bloombergs, ready to work for you. Oh and we went ahead and charged our expense ratio for this year directly out of the fund. Wouldn't want to trouble you with writing a check!

Thursday, October 11, 2007

There's no time for sorrows

A comment from a couple weeks ago has stuck in my mind, and having thought about it for a while, I wanted to give a more extensive answer. Here is the question:

Why did you wait so long to sound the tocsin?
Surely, you knew this 5 years ago.

I gave an immediate answer which you can read, in which I listed the things I was thinking about in relation to housing in recent years. But I think there is a deeper issue here and that is, what could we have known? What should we have known? I mean, just because it didn't occur to me (or Alan Greenspan) doesn't mean that the clues weren't there.

Now this is a dangerous exercise. It is very educational, however, to look back at your forecasts and trades to see what you missed and how you could have done better. When looking backward, one must be very careful to make an accurate assessment of what you could reasonably have concluded at some point in the past. It won't teach you anything to color your view of the past with knowledge you have now, but couldn't have had then. Human memories are notoriously inaccurate, particularly when colored by bias or outside influence. To wit, eyewitness (mis)identification is the leading cause of wrongful conviction in the U.S.

Anyway, since I haven't been blogging for the last 5 years, the only thing I can do is go back through notes, strategy memos, presentations, etc. to see what I thought in the past. Over the last few weeks, I've spent some time doing this, and here's where I've come out. I'd be interested to hear how the readers recall their thinking on housing over the same time period.

On Home Price Appreciation (HPA):
In 2003 I got a question from a client about rising home values. This client feared that home prices would rise to a point where people couldn't afford homes any longer. I argued that this was illogical. Its impossible for a price to rise to where no one can afford it. As soon as that happens, the price must necessarily fall. I think my point stands, but had I married this point with some points below, I might have been a bit more bearish on housing.

Several times in the past I made the argument that home price declines were unlikely, because secondary market supply of homes was highly dependent on positive HPA. Here is my logic: Joe Blo buys a house for $100,000 plus fees of $5,000. He puts 10% down. If at some point in the future he wants to buy a $200,000 house, he'll need $20,000 to put down plus say $8,000 for fees. Most people would have a hard time coming up with that kind of cash unless they have some capital gain on their house. So if Joe can't sell his house at a price that allows him to move up to the more expensive house, then he'll probably just stay in his current home. That means that if HPA is abnormally low, supply will decline, creating a floor around zero HPA.

And I think this logic would have held if it hadn't been for speculators. The theory I advanced above depends on people buying a house for housing. If someone is buying a house as an "investment" then they can become a seller at any price. There is no more natural decline in supply. I think the official statistics on homes bought for investment don't tell the story either. I've heard enough anecdotal evidence of speculators lying about their intent when applying for a mortgage to believe it was fairly prevalent. I don't know what percentage of loans were labeled as "occupant" which were actually "investment" but its some positive number.

So my view for a long time, probably dating back as far as 2002, was that home prices were likely to level out, posting a few years of zero or near zero growth. As each year passed and home prices continued to rise quickly, I extended the period of zero growth I expected. So by late 2006 I was thinking home prices would be basically flat for 5 years or so. But I would not have expected significantly negative HPA nationwide. A few metro areas, sure, but not nationwide.

If you combine the points above: prices needing to be at a level where buyers can afford it, and that speculators were going to add supply pressure to home prices, you have to conclude that HPA will be weak. I won't go so far as to say I should have known that HPA would turn negative, but it was much more likely than I thought 2-3 years ago.

Ultimately my view that HPA will be flat for 5 years might turn out to be right, but we might go through some actual negative HPA for a couple years followed by modestly positive figures thereafter. I think my supply limitation idea is valid, and its preventing HPA from falling more severely in the short-term. But with both speculators and foreclosures putting constant pressure on prices, its going to be a tough couple years.

On Subprime Lending:
I've been cautious on consumer loans for a long time, more than 5 years. Its been a while since I got involved in any credit card or auto loan ABS deals. I didn't have a specific fear, it was more than I didn't like the rapid growth of consumer debt and figured there was better soil to till elsewhere. Besides, as I showed in my post the other day, it isn't like ABS spreads were screaming out that I had to own 'em.

Starting in 2004, two additional fears rose in my mind. First was ARM resets. The ultra low rates and steep yield curve in 2001-2003 had cause ARM lending to grow rapidly. Anyone could see that short term interest rates were going to rise at some point, and many households would be faced with large jumps in their mortgage payments.

I thought there would be two impacts of ARM resets. There would be some defaults. But I thought the bigger impact would be reduced consumer spending. I thought that most households would be able to afford the reset, but obviously they'd have to spend less on something else.

Looking at the timing of resets, I thought this problem would be spread out over time. Here is a chart Bear Stearns used in a conference I attended in January:

Since the resets are spread out over time, I assumed the economic impact would also be spread out over time. Our current problems are less about resets and more about poor subprime underwriting, and we haven't seen much in the way of declining consumer spending. But looking at this table its fair to note that more resets are coming, and this could have an impact on consumer spending in coming quarters.

The other problem is mortgage equity withdrawal (MEW). My concern about MEW goes back to 2003. In 2005, MEW was adding between 1-2% to GDP, depending on how you estimate MEW's impact. Given that I expected HPA to slow to a crawl, it seemed clear that MEW would all but disappear. In my mind, that alone could cause a recession.

Like the resets, MEW isn't our current problem. Based on how consumer spending has held up, I'm not sure MEW is going to cause as much of a problem as I once assumed.

On Mortgage Lenders and Homebuilders:
I was bearish on both mortgage companies and homebuilder credit as far back as 2003, mainly because I thought they'd see their business decline when housing finally cooled. Normally when business in a certain industry cools, some company finds it expanded too fast and winds up in serious trouble, if not bankruptcy. Until recently, bonds for these types of companies weren't especially cheap, so it seemed there was little reward and plenty of risk. Again, I didn't think that loan losses or liquidity would be the problem, I thought it would be business volume. Wrong.

General Economics:
So my view was mildly bearish on housing, and more seriously bearish on consumer spending. For much of 2005 and 2006 I tried to play this by being long duration. That didn't do much either way, as rates were range bound for most of that period. Late in 2006 I got more neutral, as I grew more concerned about inflation. I put on steepener bets which have worked out well.

I also tried to play this in MBS, which I believed would start prepaying slower. The logic was that with lower HPA there would be less cash-out refis as well as slower turnover. Both those things are happening, but because MBS spreads have widened so much, this trade has been a miserable failure. In fact, the slow down in speeds is likely to continue, as now consumers of all types are having more trouble getting mortgage loans period. Still, trade isn't working.

I thought credit was going to be vulnerable as well. If economic growth slowed, I thought this would cause spreads to widen, especially given that lower-quality spreads were trading near historic tight levels. I had this view from 2005 on, and played it by owning higher quality credits and non-credit, high quality spread product, like taxable municipals and GNMA CMBS. This was a miserable failure as well, not because my view on credit was wrong, but because the liquidity crunch hit my off-the-run type sectors harder than it did lower quality bonds. This gets back to my post on liquidity crunch vs. credit crunch.

So despite correctly calling a housing slowdown, I did not foresee that the subprime problem would become as serious as it turned out to be. It wasn't until early 2007 that the prevalence of low-doc loans became apparent to me. I knew it was happening, but I didn't not understand the extent. Given that Alan Greenspan himself didn't realize the same, I shouldn't feel so bad. I think there wasn't anyone keeping stats on such a thing, at least nothing that was widely published and/or timely.

And even once I saw subprime was going to be a bigger problem, I didn't imagine the type of liquidity crunch that developed. I don't think I would have ever predicted that subprime losses would have such a large contagion in such a short period of time. That makes the fact that my two more prominent trades got hit so hard by the liquidity crunch tough to swallow. Its an event exogenous to the bonds I own. Its purely technical. And yet I'm getting killed.

Tuesday, October 09, 2007

Bernanke Shot First

The Fed minutes touched off a bear flattener, which tells me the market is decreasing the overall degree of easing and/or the time period the Fed will leave rates at the cycle low. This is emphasized by the 2-year, which sits at 4.14% after having fallen as low as 3.83% on 9/10. The current rate on the 2-year is only 60bps below the current target rate, suggesting that the total amount of Fed easing will probably only be another 75bps or so.

The minutes themselves had a little something for every one. There was upbeat news on the economy overall, but housing was viewed as a strong drag. I think the portions the market was focused on where statements like this:

With credit markets expected to largely recover over coming quarters, growth of real GDP was projected to firm in 2009 to a pace a bit above the rate of growth of its potential. Incoming data on consumer price inflation that were slightly to the low side of the previous forecast, in combination with the easing of pressures on resource utilization in the current forecast, led the staff to trim slightly its forecast for core PCE inflation. Headline PCE inflation, which was boosted by sizable increases in energy and food prices earlier in the year, was expected to slow in 2008 and 2009.

My take away is as follows:

  • The Fed isn't going to keep cutting just because we have a credit crunch. They seem to view that problem as short-term.
  • GDP growth is likely to be pretty slow in 2008, but accelerate in 2009. If that forecast remains in tact, the Fed isn't like to cut aggressively in 2008, less the 2009 bounce create inflation pressure.
  • It sounds like they think food and energy prices will moderate just based on mean reversion. I didn't see any stronger justification for this view. I think the Fed wants this to be the case, since higher food and energy prices are threatening to solidify consumer expectations for higher inflation rates in the future. So their statements on moderating food and energy prices may be more purposeful talk than analysis.
  • I think their view on housing continues to get worse. However, if you read between the lines here, I think there are people on the committee who don't want to cut rates so long as housing is an isolated area of economic weakness. I think the reasons for ignoring isolated weakness in housing is akin to reasons why they're ignoring isolated rising prices in food and energy.

My bearish view on intermediate term rates remains in tact. I still think the 10-year is rich at 4.65%. The 2-year is close to fair value if not slightly cheap.

Saturday, October 06, 2007

Job Growth? This economy must be hotter than I thought!

Non-farm payrolls grew by 110,000 in September, which is probably a bit below the long-term job growth required to keep up with population growth, usually estimated to be about 150,000/mo. The big story is that August's figure was revised from -4,000 to +89,000. Again, neither increase is impressive, but against the backdrop of a very weak housing market, even decent job growth is most impressive.

Now this doesn't mean the economy is strengthening, particularly if you consider the decline in temporary employment. But it does mean it isn't quite as weak as we thought.

The take away is that the Fed can take a more modest approach to rate cuts, if they so desire. I think the odds of no move in October has risen substantially. Although if you take into account Donald Kohn's comments yesterday...

"We had been holding the federal funds rate at 5.25%, well above the expected rate of inflation, in part to compensate for what had been very narrow yield spreads and readily available credit."

To me that says that Kohn, and likely his colleagues, viewed 5.25% as restrictive with a goal of pushing credit spreads wider. It would seem that they've accomplished this goal, for the moment, and that would leave the door open for more cuts. We'll see.

Meanwhile, there was sure a lot of lawyering going on across the blogosphere. One of the reoccurring themes here on AI is that too many investors act like lawyers, arguing their case from a predetermined point of view, and seeking out facts that support that point of view. Good investors act more like detectives, starting with an open mind and letting the evidence lead them to a conclusion.

Nouriel Roubini and Barry Ritholtz's posts on yesterday's NFP release both smack of lawyering. Both harped on the large increase in teaching/education jobs, which is a legitimate albeit limited point. If changes in the school calendar made measuring teaching jobs difficult, then indeed July and August reports were understated. So the bad news we thought we were getting in those months really wasn't as bad as we thought. I note that neither blogger wrote one word about the education job issue after either the July or August report. (Here's Roubini and here's Ritholtz here and here.)

In both cases, I can't help but feel as though the writer is looking for bearish news to report. When August jobs was reported as negative, both sounded the alarm that a hard landing was coming. But when August was revised higher because of a legitimate discrepancy in the data both bloggers dismissed the revision as a mere data discrepancy. You can't have it both ways. The truth is that the job situation is better than we had thought.

And it isn't even as though this job report disproves the bearish case. Hardly! Employment is usually a lagging indicator first of all, and second of all the weak temporary employment numbers can't be ignored. And most importantly, we need faster job growth to keep up with population growth in the long-term. So if you have a bearish view, this data point won't necessarily coax you out of your cave.

But I think if you really want to make money in the investment game, drop your bearish (or bullish) view. And then examine the data with an open mind. Instead of imposing your own viewpoint, try instead to think along with the Fed. Read what they say, and then read between the lines of their statements. You'll find that your ability to forecast will improve dramatically.

Friday, October 05, 2007

Non-Residential ABS: No, no problem. Why?

A e-mailer asked me about non-residential ABS. This paper has been hit pretty hard, and I agree with the e-mailer who characterized the move as "odd and irrational." Anyway, here is a chart.

The blue line is auto-loans, the green is student loans, and the red is credit cards. All are AAA-rated, floating rate, and 2-years to maturity. The quote is in spread to LIBOR. The source is Merrill Lynch.

We can see that this paper has been trading right around LIBOR flat for years. The next graph goes back to 2000.
Notice no major move in this stuff in response to the 2001-2002 credit crunch. Or 9/11. Or even the 2005 downgrade of everything auto.

So why has this paper moved wider in this credit cycle but not the much worse 2001-2002 cycle?

The obvious theory is that the current period has more to do with consumer credit than 2001-2002. Back then corporate bond spreads moved dramatically wider as investors questioned the accuracy of financial reports. This time it has less to do with corporate health and more to do with poor credit standards in consumer lending.

And I think its logical to conclude that if consumer lending practices were getting sloppy in home loans, why not other loans? Put another way, if CDO demand was so strong as to encourage mortgage lenders to throw caution to the wind, the same effect should have encouraged other lenders to act the same way.

Interestingly, however, it appears this isn't what's happened. I did a little unscientific research into the composition of ABS CDOs in 2007 by looking back at all of the marketing materials I was sent in 2007. I found 10 deals (remember that basically all ABS CDO issuance dried up in June), none of which had a significant exposure to non-residential paper. A few had a bucket for "ABS CDOs" but didn't see any where that bucket was more than 10%.

Econometrics professors reading this blog, please forgive the sloppy statistics here, but I figure if out of 10 deals picked out of a hat, none of them had any non-resi ABS, then its likely that ABS CDO collateral overall was dominated by residential paper. Anyone who's seen hard stats on this, let me know.

Why would CDO collateral be primarily resi ABS? Wouldn't adding other types of consumer loans improve the correlation? Well I'd argue that auto loan, student loan, and credit card paper was too tight to interest CDO managers. Remember that a CDO needs wide spreads. He doesn't need to own a bucket of higher credit quality paper, because s/he figures credit losses can be managed within the structure. And as I've said before, both the managers and the ratings agencies grossly miss-estimated the correlation of residential loans.

A fair concern is that the default rate on all consumer loans is likely to rise. When HPA was very strong, consumers could get out of debt by doing a cash-out refi. We all saw the "consolidate your debts" commercials. Now that HPA's fire has gone out of the universe, the "debt consolidation" option is all but extinct.

So while my broad view is that most ABS has plenty of subordination to withstand a modestly higher default rate, there is a non-zero probability that we've all underestimated how much consumers were using their homes to bail themselves out. I'm personally involved in enough other sectors which have widened similarly which don't suffer from the possibility, however likely, that consumers will be even weaker than I currently think.

One option is FFELP student loan paper, which is U.S. Government guaranteed. I think the rate is about 5-10bps tighter than that student loan paper shown in the graph, but 5-10bps to eliminate credit risk ain't bad.

Thursday, October 04, 2007

This is madness!

Spreads on everything except sub-prime stuff has been racing in. And its got me a little nervous that a true mania in credit might develop.

First the bad news: The ABX 2007-1 BBB- keeps hitting new lows...
Hard to hold out a lot of hope for Baa-rated sub-prime pools. I saw a pool offered by Goldman Sachs at a dollar price of $10 yesterday. It was originally rated Baa, now C. It was a 2006 vintage, so the loans are probably less than 2 years old. Just for fun I ran it through some modeling and found that if the current delinquency rate (15%) turns into a default rate, and the recovery is around 50% (generous), even at a $10 principal price you'd still wind up losing money. Bear in mind since the loans were probably less than 2 years old, there probably haven't been any resets yet! I didn't spend a lot of time on this particular piece so this is hardly complete analysis, but the point here is that there is a lot of shit out there that ain't coming back.

Meanwhile, asset-backed CP rates are improving dramatically. The following compares ABCP vs. 3-month LIBOR:

The ABCP rate is from the Fed's H15 release, and its only been tracked since 2006. But you can see that there was virtually no volatility in this rate until suddenly there was. This graph combined with the next graph on amount outstanding in ABCP:

ABCP outstanding looks a bit Beggar's Canyon back home eh? If you think about these two graphs together, my belief is that most of the bad actors in this space have been denied access to the CP market. So spreads are tighter on ABCP because the only issuers left are the stronger issuers. I'm hearing its mostly corporate guaranteed paper, i.e., a strong bank who has put a corporate guarantee on the SIV or whatever conduit has issued the CP. I think its important to realize that the concept of ABCP isn't a bad one. Hell, I think a lot of investors would prefer to have their CP backed directly by quality assets as opposed to being subject to corporate shenanigans. Currently the definition of "quality" has come into question, and the ABCP market is suffering for it, but in the long run, the ABCP market should be fine. That being said, I'm a little surprised its improved this much this fast. Its getting me just a little nervous

High yield corporate spreads have moved much tighter as well:

That's two years worth of data. Obviously this shows the big downward trend in spreads. I've said that I was constructive on high-yield, and I am still. But there is potential here for a mania phase to develop. Let me draw out a scenario...

  1. High Yield spreads "correct" from unusually tight spreads in response to problems with sub-prime mortgage loans. (already happened)
  2. HY spreads rapidly tighten back, not quite all the way to the previous tights, but maybe half way.
  3. People start justifying the move by claiming that the HY market never had anything to do with sub-prime anyway. So, they'll claim, the widening of HY spreads was not fundamentally justified.
  4. HY spreads keep tightening, blowing through all-time tight levels. This encourages more borrowers to come to market. LBO and covenant light deals re-emerge.
  5. This causes the same problem we had in sub-prime: too many deals. Marginal borrowers are always the weakest borrowers, be it consumer or commercial loans.
  6. Default levels rise significantly, and HY spreads gap out tremendously. See 2001.
According to Moody's, 32.7% of speculative-grade bonds default over a 10-year period. And the average corporate bond realizes 36% recovery after default. So a diversified portfolio of high-yield bonds has an expected loss rate of about 21% over 10-years. So to use simple math, if high-yield spreads fall to 210bps over Treasuries, the expected value of a high-yield portfolio is no better than a portfolio of Treasuries. Since obviously an investor in high-yield should expect some risk premium beyond just expected loss rates, there is some point above 210bps where value becomes very poor for high-yield.

So at 400+bps, there is value to high-yield. But be cautious. If a mania phase develops, don't fall for it. I'll be happy to unload my high-yield position at 300bps or so and watch the mania from the sidelines.

Tuesday, October 02, 2007

The Phantom Menace (update)

Last week I asked the readership to help me find good papers on the subject of a dollar decline. I thank everyone who sent me a suggested paper. Please continue to e-mail me interesting pieces at accruedint AT

Here are some of the highlights.

Paul Krugman "Will There be a Dollar Crisis?" Economic Policy July 2007.

Dr. Krugman has become more and more political, which is too bad from my perspective, since I think it has colored how people view his work. Say what you will about his politics, he has been one of the preeminent international economists for going on 3 decades.

Anyway, one of Krugman's strengths is his writing skill. I find his papers to be much more readable than most academics, without sacrificing weight. So this paper is a great read for anyone who isn't an economics PhD. Anyway, you can read his conclusions for yourself. I can't get past what seems like a core assumption of Krugman's in this piece.

Basically he says that there is a certain level of foreign indebtedness that's just plain unsustainable. Therefore the current account can't stay negative indefinitely. In order to correct this imbalance, the dollar must decline. None of these points are controversial.

If the dollar must decline, Krugman figures, why are investors still pouring money into U.S. assets? In other words, it sure looks like foreign investors in U.S. assets are buying investments with negative expected return. Krugman concludes that investors must be "myopic." Basically blindly buying U.S. assets while ignoring the fundamentals problem of our currency imbalance.

This sure sounds like a "the market is dumb" argument, and while Krugman himself cautions that second-guessing markets is dangerous, his "myopic" assumption is key to the idea that the dollar will suddenly fall. I learned a long time ago to beware the academic pedaling a model which is supposed to be smarter than the market. Now Paul Krugman isn't just any academic, but still, we must be cautious. And I don't have any particular reason to believe investors aren't myopic, but I also don't have any reasons why the are myopic. It seems just as likely that investors are reacting to something the models aren't modeling.

A couple other papers I found particularly valuable:

(Hat tip: Venkat) Jeffrey A. Frankel and Andrew K. Rose "Current Crashes in Emerging Markets: An Empirical Treatment" Board of Governors of the Federal Reserve System, International Finance Discussion Papers. January 1996.

Christopher Gust and Nathan Sheets "The Adjustment of Global External Imbalances: Does Partial Exchange Rate Pass-Through to Trade Prices Matter?" Board of Governors of the Federal Reserve System, International Finance Discussion Papers. January 2006.

FYI, there are many good papers from the Fed on this topic, which can be found here.

I'm continuing to focus on this area, so the conclusions here are hardly my last word.

Monday, October 01, 2007

Inflation statistics can deceive you, don't trust them

The Big Picture, authored by Barry Ritholtz is one of the most popular investment blogs going, and I often find Barry's work enlightening. But his obsession with "inflation ex-inflation" has got to stop. There are some good comments from Brad DeLong and KNZN on their respective blogs, but I feel compelled to chime in.

A central bank's job is to manage the money supply. Anything that has nothing to do with the money supply isn't the Fed's job. Keep that in mind.

Now let's assume that quantity demanded for a given good is expressed as a function of...

D = f (P, O, T, Y)

Where P is the price of the good, O is the price of other goods (compliments and substitutes), T is consumer tastes and preferences, and Y is nominal income. Note that Y is the only variable that would impact all goods in the same direction at the same time.

Thinking about the classic demand curve, changes in P cause movement along the demand curve, while O, T, and Y cause the demand curve to shift. Hopefully most of AI's readers took freshman microeconomics, and this all seems very elementary.

Now let's say that preference for some good, say corn, rises. Maybe Congress has increased the subsidy for ethanol, let's just say. Supply of corn is short-term inelastic, because it takes time to plant and harvest new corn crop. So the demand curve shifts outward, supply doesn't change much (if at all) and therefore the price of corn rises.

Now consumers of corn for food (as opposed to ethanol) will probably rotate into other food products, to the extent that corn has substitutes. So demand for wheat might expand, due to the O factor. And since wheat probably also has a fairly inelastic short-term supply curve, the price of wheat also rises.

So we have food prices rising, but having nothing to do with the money supply. Therefore reacting to this chain of events ain't the Fed's job. It makes no more sense to ask the farmer where to peg overnight bank loans than to ask the Fed to control agriculture prices.

Inflation comes from an increase in the money supply. If there is just more money floating around, this would manifest itself as a increase in Y. And remember that Y impacts all goods at the same time in the same direction. Perhaps not to the same extent, but at least in the same direction.

So let's say that in conjunction with the rising price of corn, the effective money supply has also expanded by 5%. Everyone has 5% more to spend, which causes all prices to rise by 5%. But corn and other food products actually rise by more than 5%, because of the shift in tastes. And somewhere some other price has to fall, or not rise as much, because the extra money being spent on food isn't getting spent someplace else.

Anyway, the Fed's problem is the 5% expansion in the money supply, not the increased demand for corn. Unfortunately, its difficult to peg exactly what the effective money supply is. And in real life, all goods face constantly shifting supply and demand curves. So the Fed faces a challenge in determining whether the money supply is increasing at a faster or slower rate than is desired.

In a perfect world, the Fed would look at a subset of goods for which O, T and the supply curve were all constant. It really wouldn't matter how representative those goods were, because the only thing that would cause the price to shift would be Y. The Fed could then determine if the change in price of this basket of goods was optimal knowing that the price change was due to changes in the money supply.

Of course, in real life, no such products exist. So the next best option is to strip out products which are known to have unstable supply and demand curves. This was originally the impetus for creating the "Core" CPI and PCE measures. Another way to handle this is to assume that the most volatile prices in a given period are being influenced by good-specific supply and demand factors and strip those out, whatever they might be. This is the idea behind the Dallas Fed's Trimmed Mean PCE and the Cleveland Fed's Median CPI estimate.

If the Fed is going to pick an inflation measure to target, we want them to target something that in most closely aligned with shifts in money supply and shifts in money supply alone.

Its fair for someone to say that their household bills are rising at a faster rate than any of the core inflation measures. Some of the items that have been rising in price most lately have been repeat consumables, like gas and food. But the Fed isn't targeting cost-of-living. It can't. So if you want to blame the media for ignoring cost of living in reporting on "core" inflation measures, fine. But don't blame the Fed.

Its not their job.