Friday, February 29, 2008

Auction Rate Securities: Hibernation sickness

Has all the good news on bond insurers improved the auction rate municipal bond market? Taking another look at the results of J.P. Morgan's auctions reveals that the ARS market is indeed thawing a bit. Morgan held 103 bond auctions on Tuesday, 47 of which failed. Looking a little deeper, however, and we see that all the failed auctions occurred where the bond had a relatively low "max rate." Remember that when an auction fails, there is some pre-determined rate at which the bond resets.

For example, some very strong credits failed on Tuesday, such as some New York Dorm Authority bonds with FSA insurance and a AA underlying rating. The failure had nothing to do with the credit, but for the fact that the "max rate" was only 4.688%. Holders of these bonds not only have zero liquidity, but an unexciting reset rate to boot.

Among the successful auctions, rates ranged from 4.00% to 10.24%, with a median rate of 6.755%. While these rate resets will not grab headlines like the 20%-type rates seen over the last couple weeks, 6.75% is still about 450bps higher than where money-market eligible munis are trading.

So while we might say the ARS market is starting to function on a certain level, there should be little doubt about its future. Municipal issuers are highly likely to refinance these securities over the next 3-6 months, either into traditional put-bond structures or long-term fixed-rate bonds. There may not be such a thing as an auction rate municipal market this time next year.

Worth noting that this doesn't seem to have anything to do with the improved picture for MBIA and Amabc, as the difference between failed and successful auctions seems to have everything to do with the available rate. In other words, it reads like there is capital available for non-liquid municipals as long as the rate is right. Insurance doesn't seem to matter.

Thursday, February 28, 2008

What does a AAA mean anyway?

S&P has affirmed MBIA's insurance sub's rating at AAA, and has removed it from negative watch. MBIA does remain on negative outlook. In credit ratings parlance, no longer being on watch means a downgrade is not imminent. The negative outlook reflects the simple fact that MBIA may well fail to regain a AAA-level reputation, regardless of the AAA rating. If they fail to regain their reputation, their business will not ultimately recover. But for financial institutions with exposure to MBIA, chief among which was Merrill Lynch, this is unequivocally good news.

S&P wasn't done doling out the good news. They also affirmed Ambac's AAA rating, although Ambac remains on negative watch. Normally negative watch indicates that a downgrade is imminent. In this case, however, S&P indicated that Ambac was about $400 million short of the capital level needed for a stable AAA rating. Therefore if Ambac is able to complete the capital infusion plan reportedly in the works, which will supposedly raise $3 billion, they should be able to retain their rating. Several reports indicated that the only thing holding up the negotiations between Ambac and the banks is a sign-off by the ratings agencies, and I'd say today's report from S&P tells us that at least one agency would indeed sign-off.

The market continues to be highly skeptical of these ratings. CDS on both MBIA and Ambac's AAA-rated insurance subs are still well over 300, roughly in line with BBB+ rated Washington Mutual, wider than A rated Bear Stearns.

Now we can quibble about S&P's methodology of estimating "stressed losses" on mortgage-related securities. For 2007 vintage tranched RMBS rated A or lower, S&P assumed at least a 84%+ loss rates on Alt-A and closed-end second mortgages, and home equity lines of credit. On first-lien sub-prime loans the loss rates are slightly better, no doubt owing to somewhat better recovery. The 2006 vintage loss estimates are similar, with some product worse and other product better.

On ABS CDOs, S&P assumed loss rates of around 60% on higher-rated collateral and 80% on lower-rated collateral for the '06 and '07 vintages. Given that the monolines generally only insured the most senior tranches of ABS CDOs, that probably puts the eventual monoline losses on these products in the 40% area.

So like I said, we can quibble about whether or not that represents a "stressed" scenario or not. The reality is, it doesn't matter what we think. If S&P says that Ambac and MBIA have enough capital to be called AAA, then they are AAA. Banks will now use AAA ratings when calculating their capital ratios. Money market funds can keep holding insured paper.

It especially doesn't matter what we think because neither Ambac nor MBIA is in any real danger of running out of cash in the near term. Ambac and MBIA reported over $18 and $35 billion in marketable securities respectively as of 4Q 2007. Plenty to pay any losses they are likely to incur over the next several quarters. So if the monolines aren't going to actually run out of cash, if they aren't actually going to go bankrupt, who is to say they aren't AAA?

And that's what bothers me. When you come down to it, the debate over whether the monolines should or should not be rated AAA is entirely subjective. We all agree that a AAA-rated bond should have a remote chance of taking losses, but how remote is remote? We all agree that a AAA-rated insurer should be able to withstand a 6-sigma event, but what constitutes a 6-sigma event? There is no single answer to these questions. Its subjective.

That would be OK, except that credit ratings are so ingrained in our financial system. Everything from banking and insurance regulations, mutual funds, money markets, pension funds, debt service reserve accounts, etc. all depend on a ratings system to guide them. Try sometime sitting down and reading the SEC 2A-7 rule, which governs money market investments. The rules all but encourage managers to buy whatever they want as long as the instrument has the right rating and right maturity. And yet if 2007 taught us anything, its that credit ratings are just opinions. No matter how sophisticated the modeling and financial analysis, those opinions can be just plain wrong.

On Monday, the Dow rallied nearly 200 points, and credit spreads almost universally tightened. Why? Because a AAA rating for MBIA and Ambac means that banks won't have to pledge more capital against downgraded ABS. This gives them more capital to lend into the economy. No matter what you think of S&P's analysis, that's the reality. If that reality bothers you, perhaps your derision should not be aimed at S&P or MBIA, but at the banking regulations that are so heavily reliant on ratings.

Wednesday, February 27, 2008

S&P on the monolines: No problem. Why?

S&P and Moody's have now both affirmed MBIA. S&P also more or less said they would affirm Ambac as well if the reported $3 billion capital infusion is completed. MBIA's infamous 14% surplus note is now trading comfortably above par ($101 bid, $104 offer last night). So are we out of the woods with the monolines?

Well let's start by looking at S&P's methodology. In short, S&P will bestow a AAA rating if they believe an insurer can survive their "stressed" scenario. Here are their assumptions for various types of mortgage-related securities.

First, the cumulative losses for various types of loans. Note these are losses, not default rates. If you assume, say 50% recovery on first liens, then the default rates assumed would be roughly double what you see here. For some context, during the 2001 recession subprime default rates got as high as 9%, so clearly these loss rates are a multiple of historic norms, even during a recession.

Table 2 shows S&P's loss assumptions on direct RMBS transactions. That's where the monoline has insured a pool of loans directly, as opposed to a tranche of a RMBS transaction. So here a AAA-rated RMBS tranche means that S&P estimated the whole pool was worth a AAA at the outset.

Table 3 is starting to get to the real problems. What they mean by a "tranched" RMBS is one where there is a subordination credit enhancement. In other words, losses hit the lower-rated tranches first, and higher rated tranches only if the lower-rated pieces are completely wiped out.

You can't get much worse than those 2006-2007 loss levels, even on AA-rated tranches. Note that these loss levels will dictate the loss levels on ABS CDOs, which is table 4.

I noted in a previous post that CDOs was the monolines biggest exposure, so this table is the real kicker. Remember that the monolines basically only insured senior tranches of CDOs, so these loss rates would seem to represent an assumption that all the subordination will turn out to be worthless. When they say "high-grade" CDOs, they mean a CDO made up of ABS paper rated A or better. That does mean that the transaction is more leveraged, i.e., there is less subordination under the AAA-rated tranche. "Mezzanine" CDOs were usuallly made up of paper rated A or BBB. Since a lot of these mezz ABS pieces are turning out to be worthless, its not surprising that the CDOs are going to take huge losses. I'd say the only thing preventing these losses from being 100% is that most CDOs had more than just RMBS in them, and not all that paper will turn out to be worthless.

So all in all, I'd say that's a pretty stressful scenario.

Saturday, February 23, 2008

Monolines: Now witness the destructive power!

New CEO Jay Brown at MBIA is considering a good bank/bad bank split. We talked about this idea a bit with Ambac on Wednesday. Now let's talk a bit about the bigger picture. My view is that a split is a good idea for both shareholders and the economy. For shareholders, it preserves the part of their business which remains viable (muni insurance). As it is, neither Ambac nor MBIA will be able to write new business of any kind until their AAA/Aaa rating is stable, and that ain't happening without a ton of new capital or a split.

For the economy it would also be beneficial, in my estimation, because it would turn an unknown into a known. See, the market can deal with banks needing more capital, particularly if the new capital required is a known quantity. The market can't deal with capital needs being some wild unknown. Right now write downs and/or new capital needs related to monoline wrapped ABS is a wild unknown. Plus its a wild unknown how the contagion may spread to the municipal market. If the businesses were split, the capital situation for banks would come more into focus. Plus the problems in municipals would be all but eliminated. We'd turn a big unknown into a known, which is always good for markets, even if the known isn't good.

Which brings us to another question: how bad would it be for banks if all the monolines split their municipal and structured finance businesses?

To get to the bottom of this, let's look at Ambac and MBIA's "problem" bonds. These are the bonds trading at large discounts to their original value, and not just because of generalized weaker liquidity: closed-end second liens, home equity, sub-prime first liens, and ABS CDOs. Here is Ambac's exposure to "problem" bonds: (from Ambac's investment relations site)

  • Closed-end second liens: $5.3 billion
  • HELOC: $12 billion
  • Sub-prime first liens: $8.4 billion
  • ABS CDO: $32.2 billion
  • Closed-end second liens: $11.1 billion
  • HELOC: $11.7 billion
  • Sub-prime first liens: $4.7 billion
  • ABS CDO: $30.6 billion
That's a total of $116.1 billion.

So here are some of the questions that remain to be answered.
  • To what degree have banks already written down the value of these bonds? All indications are that structured finance bonds have been trading like there is no insurance for a while. So if the banks have truly been marking to market, there should be little actual write downs. We'll have to see whether that's actually been the case or not. If I had to bet, I'd bet that the brokerages did a better job than banks in handling write downs.
  • How much of this paper is held by U.S. banks vs. foreign banks? It was widely believed that European banks were big buyers of AAA-rated ABS CDO paper, and that they loved to get wraps on top of that. So it stands to reason that the CDO exposure may be heavily European.
  • How much of a downgrade would the wrapped paper suffer? The banks that hold this paper probably know the answer, since some of the CDS contracts were done privately. That means that the bond's public rating is a uninsured rating. It gets its "insured" treatment by virtue of a separately negotiated CDS contract. Other paper was wrapped when the bond was issued, and may or may not have an underlying rating.

As long as these questions linger, the credit market is going to continue to discount brokerage and bank bonds, which are currently at or near all-time wides. In addition, if banks are uncertain about their capital position, their willingness to lend will be compromised. In other words, we need come to some conclusion with the monolines before the economy can start moving forward.

Wednesday, February 20, 2008

Ambac: Breaking up is hard to do (but still your best choice)

Let's pretend you are the CEO of Ambac. I know, not an enviable job right now. Let's say for the sake of argument, that you really believe in your portfolio. Even though its obvious mortgage defaults will be considerably higher than originally projected, you believe your firm has done great credit work and negotiated the right subordination, and so your losses will be minimal. In other words, let's assume that you actually believe the kinds of things that real-life Ambac CEO Michael Callen has been publicly claiming.

Your problem is that the world at large just thinks your are in denial. That losses in sub prime securities, especially CDO-squareds, are going to suffer severe losses. There is tremendous pressure on Moody's and S&P to downgrade you. As it is, you are completely shut out from writing new municipal insurance business. Once you lose your AAA/Aaa rating, you will more or less be permanently barred from the muni market. There really won't be much hope of reviving your business from there, and you'll be forced into run-off.

This puts you in a difficult position. You believe you have a strong portfolio, but the market doesn't. Unlike other companies, you can't afford to simply tell the market to wait and see. You can't let time prove your point. You have to figure out a way to maintain that rating at all costs, and if something doesn't change right here and now, you will indeed lose that rating.

You are left with only one choice. Separate your good bank from your bad bank. In fact, the Wall Street Journal is reporting Ambac is in talks to do just that. You see, no one is questioning the viability of your muni insurance business. You'll be able to maintain your AAA/Aaa rating on muni insurance if it stands alone. That's your good bank. Then you can work on rebuilding trust with municipal issuers and investors, which will be a challenge. But armed with a AAA/Aaa rating, there is hope. With any other rating, its over.

Of course, that leaves your structured finance business, which is the bad bank. But if Ambac's management really and truly believes that the structured finance stuff was well-underwritten, then they should be comfortable creating a second insurance company which owns only the structured policies. If indeed this portfolio performs reasonably going forward, then the second insurance company will produce strong cash flow. Those structured finance policies require periodic payments to Ambac, so if the "bad bank" performs the way Ambac says it will, then the cash flow return should be attractive.

The challenges of making the split are numerous. There will likely be lawsuits by structured finance holders who logically want to keep the stronger muni business around to support their policies. So we'll see how it plays out. Since government regulators seem keen on providing aide to the muni market pronto, Ambac may get some legal cover if they manage to push this plan forward.

If they don't, then a New York imposed plan seems inevitable. I think its time for Ambac (and MBIA) shareholders to start thinking about how to make the best of a bad situation.

Tuesday, February 19, 2008

Clear your mind of questions

Its time to play ask the internet, because I honestly don't know the answer to this. With FGIC looking to break in two, and Ambac probably thinking the same, there is a question about what happens to their CDS. In other words, if we have a "good bank/bad bank" resolution, what happens to those who have bought protection against the whole bank?

Now I have not personally combed through a CDS contract, but I've got to think there are provisions for what happens in the event of various corporate actions. I mean, its not unheard of for companies to sell-off units so there has to be some established way of dealing with this. My guess it would depend on what the reference item is. My understanding is that under CDS contracts, an "event of default" is defined as the reference item defaulting. So if you have a CDS contract on Ambac, and the reference item is Ambac's 9.375 bonds due 8/1/11, the contract comes into force if that particular bond defaults.

If I'm right about that, it stands to reason that how the CDS would be treated given a split of Ambac depends on what happens to the reference items. I don't happen to know what the common reference item is for MBIA, FGIC or Ambac's well-traded CDS contracts. I also know there is a market for CDS on the insurance sub of these three companies. I have no idea what those reference items might be.

But if anyone out there (CDS Trader, I'm looking at you) knows the answers to any of these questions, please enlighten the group.

Monday, February 18, 2008

J.P. Morgan's ARS Book: A lack of vision

Results of J.P. Morgan's ARS auctions Thursday were fascinating. 50 out of 93 auctions failed, with the "failure" interest rate ranging from 3.41% to 15%. The average among the "failed" bonds was 5.26%. Remember that if an auction fails, there is some mandatory "failure" rate, which varies greatly. My understanding is that a lot of student loan issues have relatively low failure rates, and that's borne out in the J.P. Morgan list. J.P. Morgan shows 12 failed student loan issues, one of which reset at 12%, but the rest reset below 6% despite the failures.

The failures are only half the story, though. Among the "successful" auctions, the average rate was 8.69%, with 14 "successful" issues resetting above 10%. That tells me there are buyers out there who are willing to buy these bonds, and are bidding just below the mandatory failure rate.

There was absolutely no rhyme or reason to what failed vs. succeeded and what rates resulted. The City of New York (rated Aa3/AA) had three issues auctioned, all three of which were fully tax-exempt. The rates were 5%, 5.25%, and 6%. Energy Northwest, a municipal power provider in Washington State, which is rated Aaa/AA-, had their ARS fail, and got a rate of 6.23%. Meanwhile, at one healthcare institution with a Baa3 rating and Radian insurance had their auction succeed with a 4.67% yield.

Several dealers, including UBS and Merrill Lynch are publicly stating they will not necessarily support ARS by buying bonds at auction. As has been discussed, in the past it was common for dealers to step up and buy the ARS to prevent an auction failure. But right now the volumes of failing bonds are just too great, and capital is too constrained. I'm certain the dealers are worried about lawsuits, with investors claiming they were told the bonds could be sold at each auction date without question, which is of course not the case. I don't know how anyone is going to sue when no one has actually lost any money so far, but we'll see.

Meanwhile, I've received many e-mails from people interested in how one can play these ARS failures. One interesting idea is closed-end funds. Most closed-end bond funds are leveraged, usually in the 1.2-1.5x area, and they commonly use auction-rate preferred to create this leverage. Obviously if the ARS reset at 10%, and the fund is buying municipal securities which yield 4%, that's not a good situation. But let's think about closed-end ARS for a second. The closed-end fund has pledged its portfolio of bonds to preferred shareholders. Let's say its a $150 million portfolio of munis, $50 million of which was bought with proceeds from the auction-rate preferred (i.e., 1.5x leverage). But really that means the preferred holders are covered 3 times over: $50 million in debt covered by $150 million in assets. Really that's safer than any single muni issuer.

And yet closed-end muni funds are getting hammered, with several falling more than 5% today. I looked at the worst performers on the day, all of which had leverage created with auction-rate preferreds with 7-day auctions. The highest reset number I found was 3.3%. Excuse me if I don't panic.

Friday, February 15, 2008

When $800 billion you reinsure, look as good you will not!

This just in: Warren Buffett is pretty smart. Wednesday, the Oracle of Omaha offered to reinsure the entire municipal book of FGIC, Ambac, and MBIA, some $800 billion in bonds, in exchange for 150% of the "unearned" premium on those insurance policies. No word on whether he also asked for a pound of flesh or any one's first born.

Anyway, it was pretty obvious from the beginning that none of the monolines would be very keen to such a plan. By accepting, the monolines would be ceding the best part of their business, leaving only the shaky structured finance business remaining. On CNBC yesterday, Buffett tried to explain that the plan would be a net increase in capital for the monolines, so in theory the monolines would be able to keep their gilt-edged rating. Somehow he managed to keep a straight face. While technically the monolines may have more free capital after ceding the munis, the remaining portfolio would be substantially more risky, and I doubt the new capital ratios would please the ratings agencies. For what its worth, Ambac has already told Buffett thanks but no thanks.

But political pressure is growing. Wednesday, the Port Authority of New York and New Jersey, which owns the World Trade Center site as well as operates the PATH train system, had $100 million in Auction Rate Securities fail at auction. This resulted in a 20% coupon for the coming week. In the scheme of things, having to pay an annualized rate of 20% for one week isn't the end of the world, but its an unnecessary expense for the Authority, not to mention embarrassing. I note that the Authority has an A1 ratings from Moody's and a AA- rating from S&P, so it isn't as though there is a credit problem with the Authority. Its that the monoline insurer problem has holders of ARS panicking. The New York Metropolitan Transportation Authority, which operates New York City's subway and bus system has also suffered an auction failure.

These governmental agencies will manage the current problem easily enough. ARS are generally callable on any auction date, so relatively strong credits like the Port Authority will be able to just call the ARS and issue new bonds with some other structure. But the refinancing won't erase the embarrassment of having an auction failure. Governmental agencies, including the Port Authority, will start putting increasing pressure on the New York insurance regulators to resolve this matter once and for all.

So Buffett becomes the bird in hand, something these governmental agencies can point to and ask "why aren't you making that happen?" Perhaps it won't be his specific plan, maybe it will be something along the same lines worked out by the group of bankers that the Insurance Department has been talking to in recent weeks. But the combination of heavy political pressure and a viable private sector solution will be too difficult to ignore. A deal will be worked out to insulate the municipal bond market.

Blue Harvest

I have now gotten 5 e-mails plus commenters asking about closed-end funds. I disclose that I play in closed-end funds a fair amount, and I doubled my position today. These funds can be kind of thin, so I don't want to talk about what I actually bought, but here was my process. You'll need Bloomberg, although there are probably other ways to skin the same cat...

1) Run a FSRC. Select all closed-end funds with the objective type being municipal. Should be 265 of them.

2) Once the search is displayed, hit the "Edit" tab, and select "Search Display." Then you can pick various measures of short-term price movement. I went with 1-Day Total Return (Last Close) and 1-Day Total Return (Real Time) although now that the market is closed you can probably just select 2-Day Total Return. Bloomberg won't let you sort by any real-time column, that's why I used the Last Close option.

3) Once you find a fund you like, type in the equity ticker, then RELS. So for example, XYZ Equity RELS . Option 19 will display all preferreds associated with that fund. If there is more than one, then look at each of them separately.

4) Once you have the preferred loaded, type DES, then pick option #2 (Floating Rates). That will tell you what the recent auction history has been as well as what the current level is.

5) Once I established that there was no problem with any auctions, I went ahead and bought the fund.

Now, you really have to understand the consequences of the fund's leverage as well as how thin CEF can be before buying. Its not unusual for these things to have like 1-2% bid/ask spreads so be careful. Remember, I'm not recommending anything, merely telling you what I've done.

Wednesday, February 13, 2008

Bond insurance: Do muni investors still care?

We know the monoline insurance business has been one of the great flaming disasters of the Great Subprime Collapse of 2007. Unlike some other businesses which have taken big losses, like mortgage lenders or brokerages, its not clear the world really needs bond insurers at all. We know that there will be such a business as home building in 2010, but are we so sure anyone will want bond insurance in 2010?

Let's look at the monoline insurer's bread-and-butter (municipals) for some guidance. According to data from Thomson Financial, only about 28% of municipal bonds issued in January carried insurance from a monoline insurer. That's down from 46% in 2007. Meanwhile, according to Merrill Lynch, new insurance was dominated by FSA and to a lesser extent, Assured Guaranty. FSA insured $3.8 billion of new issues, about 70% of all new issue munis which carried insurance. Assured picked up most of the remainder ($1.3 billion or 23% of new insured issuers).

The argument against insured municipals is pretty simple. Municipal default rates are extremely low, with most issues backed directly or indirectly by state and local governments. Issues backed by operating entities (e.g., private hospitals) are not commonly insured. So why buy insurance against a security that very rarely defaults?

And yet until recently, municipal bond buyers routinely demanded bond insurance. Why? Individual municipal credits are difficult to analyze. Its hard to get up-to-date financial information on some small school district in Indiana. Bond insurance (it was thought) eliminated the need for analyzing specific credits. Instead, the buyer could rely on the insurance policy to cover the small possibility of a default.

This attitude hasn't changed. Muni buyers are the same people they've always been. Put it another way: what percentage of muni fund managers wish the insurer problems would just go away, that we could go back to the old way of doing things?

And maybe we can go back. This morning, Warren Buffett was on CNBC outlining a plan to reinsure $800 billion in municipal bonds currently insured by FGIC, Ambac, and MBIA. In theory that would make the insurance problem (from muni buyer's perspective) just go away. He said that one insurer already turned down his plan, but his proposal remains significant. It means that there is private sector capital ready to get into the municipal insurance business.

The fact is that confidence in insurance has never been lower, and yet buyers continue to demand insurance at all tells you something. MBIA and Ambac may never be able to regain AAA levels of confidence, but municipal bond insurance as a concept will survive.

Tuesday, February 12, 2008

Auction Rate Munis: Clumsy as they are stupid

The auction rate market is getting worse as the media is giving it more and more play. Today I heard Citigroup had at least two issues within my home state of Maryland where the auction rate was 10%. Three interesting notes on these two particular issues...

  • Both are insured, but one was FSA and the other was CIFG.
  • In both cases the underlying issuer has an "A" rating. One is a hospital system and the other is a water and sewer utility.
  • The auctions didn't fail, the 10% level was the rate garnered at auction.

I reiterate what I said the other day. There aren't any particular problems with municipal credit quality. Part of the problem is that ARS holders assumed that the auction facility assured they could get out. But there was never any such assurance. Now people are hearing that they own something that might have zero liquidity, literally, and they are panicking.

An interesting wrinkle to this story. There are lots of people who would be willing to take a chance on the credits which are involved in failed auctions. Problem is that the upside isn't that great. I mean, let's say you are looking the A-rated hospital. Sure the 10% auction coupon looks great. But that 10% may only be there for the next 28 days. It isn't like you can buy the bonds at a steep discount on the hopes that the problem resolves itself in a few months. In fact, if the problem resolves itself, then the auction will reset much lower, making the bond less attractive.

To see what I mean, contrast what's going on with ARS vs. long-term fixed-rate munis. We know fixed-rate munis are trading weaker than they would be without the insurance problems. But nothing is trading at 10%. In other words, the two issues Citi currently has would probably yield somewhere in the 4.25-4.75% range if they were fixed-rate issues.

I want to say more on the Buffett proposal, which I'll do when I have more time. I'm surprised the stock market reacted as favorably as it did, but I disagree with those who have been saying "it only helps munis so who cares." The fact is that Citigroup has pledged capital to holding these two ARS I mentioned, and probably dozens more. Its an area of contagion that just doesn't have to be. There's absolutely nothing wrong with these ARS.

So if someone comes in and basically makes the whole muni insurance problem go away, then that's one element of the contagion that's contained. I mean, we know the subprime problem is with us, and will be with us for a while. The market can price that problem. We can price declining home values. We can price damn near anything, but we can't price unknown and ever widening contagion. So in order to get to a bottom in risky assets, we need to get to a place where the contagion stops widening.

Of course, the old saying holds: no one is going to ring a bell when this has happened. But I think getting a solution to the municipal problem is a step in the right direction.

Saturday, February 09, 2008

Long Treasuries: Not much there.

So what happened to the 30-year yesterday? The obvious answer is that the Treasury's 30-Year Auction was not well received. That does indeed appear to be the proximate cause of the big sell-off, as things really got going at 1PM Eastern. But a bad auction really can't explain a 3 1/2 point move.

Consider the facts. The Treasury announces to the entire galaxy that its selling $9 billion in 30-year bonds. They get a yield of 4.449%. According to Bloomberg News, the pre-auction trading had indicated the yield would be 4.41%, indicating the actual results were a 4bps miss. Did the auction go poorly? It sure did. Not only was it a 4bps miss in yield, but 89% of it was purchased by dealer firms, which indicates that actual end buyers only stepped up for 11% of the sale.

But what happened next can't fully be explained by those auction results. The 30-year continued to sell off, rising another 10bps in yield to 4.558, or -1.6% in price, over the next hour. It strains logic to say that the Treasury holds an auction, the price is somewhat disappointing, so therefore the price should be an additional 1.6% lower.

Further consider that the 3 1/2 point drop in the 30-year was the largest single day move since April 2004. So what happened in April '04? That was the day that the Labor Department reported that the economy added 334,000 jobs in March of 2004, after only having added 27,000 in February. That data point convinced the market that the Fed was ready to hike rates, then at 1%, which indeed it did that June.

Contrasting the significance of that event with yesterday's auction result, and it becomes more apparent that something more is afoot.

Perhaps the rumor that the ISM services index was miscalculated? Released on Tuesday at a recessionary reading of 41.9, the figure spurned a 370-point plunge in the Dow. The specific rumor of a data error was debunked, but Greg Ip reported on the Wall Street Journal's website that other measures of the service sector don't look as dire. Perhaps this means there was no calculation error per se, but still the released figure was understated for some other reason, which will later come out in revisions.

The ISM story fits a 3 1/2 point sell-off better than a weak auction. Treasury yields at current levels can only be supported if the Fed holds interest rates low for an extended period of time and inflation doesn't become a problem. Traders know this is a very fine line to walk, and confidence in Bernanke's ability to walk that line is, well, not as strong as it could be. It will probably take a pretty stiff recession to keep inflation low despite highly accomodative monetary policy. Tuesday's ISM report supported the idea that we are already in a recession, and therefore supported rates at their current levels. But if it turns out we aren't in a recession, the Fed will have to make a rapid reversal of policy to combat inflation. If so, long rates will be the big loser.

Now I still think the Fed is headed back to 1%. I might be wrong, but until that happens, I'm happy to own duration in the middle of the curve.

But the long bond becomes a question of risk/reward. The 30-year Treasury is within 30bps of its all-time low in yield. So if it is a drawn out period of easy money, and somehow we avoid inflation, that's probably your upside. But if either inflation becomes a problem or the economy is stronger than we think, your downside is much larger.

Tuesday, February 05, 2008

You have failed me for the last time, Auction Rate Municipals!

I've received several e-mails in the last couple days about municipal auction rate securities, after auction failures in both Nevada and Georgetown University. The e-mails ask three important questions.

1) What the hell is an auction rate security?
2) Why the hell are the auctions failing?
3) How much should we panic?

Well fortunately, its all pretty simple. When municipal issuers want to sell variable-rate debt, they normally do it one of two ways. One is called a Variable Rate Demand Note (VRDN), and the other is called an Auction Rate Security (ARS). Both work pretty similarly. I'll describe the auction bonds in detail because those are making news.

Auction rate securities usually have long-term maturities, 30-years or more. The rate is determined by auction, which is conducted by a broker/dealer firm, often called the "remarketing agent." The auctions occur at regular intervals, commonly every 28 days. Potential buyers give the dealer a rate at which they would buy some amount of the bonds. Current owners of the bonds can also put in a rate in which they'd sell, although typically those that want to sell just tell the dealer to sell at any rate. The seller gets par no matter where the rate is set. The rate is set at the lowest rate which clears the market.

ARS are sold to investors who want to take very little risk. While the auction process and the ability to sell bonds at par within a few weeks assures that interest rate risk is low, other means are needed to mitigate credit risk.

Most commonly, a bank is brought in to provide liquidity support. In general, the bank provides full credit support, assuming the issuer hasn't already defaulted. As a result of this, investors in ARS don't have to worry that the issuer will have enough cash on hand to handle sales of their bonds. As long as the issuer is current on its interest payments, the bank will provide cash for normal redemptions of bonds. Think of it like a line of credit.

Here is where things get a little weird. Sometimes the issuer of a ARS was a little more sketchy credit. The bank was only willing to provide liquidity if there was some additional credit support. No problem, thought the municipal bond bankers! We'll bring in a monoline insurer! The bank would therefore agree to provide liquidity so long as the bond insurer was rated at some minimal credit rating level. What that level is depends on the deal. Might be AA, might be A. I haven't seen any that were actually AAA but they could be out there.

But what happens if the unthinkable happens? A monoline insurer gets downgraded? Well, the bank's liquidity agreement becomes null and void. Where does that leave bond holders? It leaves them with no credit support at all. Only the issuer itself would remain.

For most ARS buyers, that's not acceptable. ARS buyers tend to be money-market like investors, who have zero desire to take on credit risk. So what are those bond holders doing? They are selling the bond back to the remarketing agent! See, while the insurers still have a AAA or even AA rating, the liquidity facility is probably still in force. So ARS owners know they can get out now. They don't know they'll be able to get out at the next auction, 28 days later.

Notice this problem would only apply to ARS with dual credit support. ARS with just a straight liquidity facility wouldn't have a provision relating to insurer downgrades, so there are no problems. So what might have seemed like an extra layer of support turns out to be a loaded gun pointed at your head. The phrase "That's no moon" comes to mind.

So clearly we have more sellers than buyers. Of course, such a situation can happen on any given auction period, where it just happens to be that more sellers show up than buyers by happenstance. In this situation, the remarketer would normally take the extra bonds onto its own books, figuring they can sell them to investors in the coming days.

But this is not a typical situation. Dealers are unusually capital constrained, making them less willing to take bonds onto their books. And the uncertainty of credit support makes it very difficult to sell the bonds, even at elevated interest rates.

The result? A failed auction. That simply means there weren't enough buyers to accommodate sellers, and therefore not all bonds offered for sale were sold. In such a case, the bond documents dictate some maximum interest rate at which the bonds reset. In the case of the Nevada Power deal which failed, the rate was 6.75%. Consider that is a tax-exempt rate, and would be something like 350bps over LIBOR. Non-problem ARS are currently yielding less than 3%.

Remember if you are a holder of this problem ARS paper, you may be stuck with your bonds for a little while, but you are getting paid a handsome yield on a bond where the ultimate credit (the issuer) isn't a problem. At least not right now.

Obviously for a bond issuer who is not having operational problems, having to pay an extra 3-4% on your bonds doesn't sit too well. So what can be done? Well, typically ARS are callable on any auction date, which means that issuers of this paper are going to refinance their debt (without Ambac insurance thank you very much) en masse in the coming months.

The big "so what" on all this? Well, it turns out to not be a very big deal. Issuers will wind up having to pay a fee to their investment banker to refinance the debt, but that's manageable. Some issuers may use this occasion to call their variable rate debt and sell fixed rate debt instead, given that interest rates are low. Assuming the debt is indeed refinanced, the ARS holders who are currently "stuck" will get taken out when the bonds are called.

You can decide for yourself how much you want to panic.

Sunday, February 03, 2008

Our negotiations will not fail!

According to various reports, the New York State Insurance Department is meeting with various banks and dealer firms, trying to broker some kind of bailout for Ambac. One proposal being floated is for banks with exposure to insured structured finance deals to infuse the insurers with new capital. The theory goes that banks and brokerages would be forced to take new write downs in the event the insurers are downgraded, and therefore they might be better off putting up cash now to avoid the write down.

On its surface, this would seem like a mere balance sheet gambit, with little economic consequence. If XYZ bank puts up $1 billion in capital to bond insurers to avoid $1 billion in write downs, it might seem like they are no different economically. Accounting wise, they'd get to record the investment as an asset, whereas a write down is just a loss.

But here is the thing. No one is claiming that the monolines are actually running out of cash today. The actual cash paid out on structured finance deals to date has been small. In fact, based on the way the insurance contracts were structured (called a pay-as-you-go credit default swap), its likely that actual cash payments would occur slowly over time.

I'm not dismissing the impairments in Ambac or MBIA's portfolio just because little cash has actually been paid out. The write downs are real. But if the AAA rating were not so key to their business, if it were merely a cash flow business, the situation would be vastly different.

And that's just the thing. If a group of banks could put enough cash into Ambac and MBIA to maintain the AAA, then it really would become a cash flow issue. The write downs today would turn into in real cash losses over many years. The banking system would have time to absorb those losses, rather than suffer large write downs right now.

No wonder regulators are pushing such a plan. The question for any bank considering involvement is how big the capital infusion has to be. I've heard numbers ranging from $3 billion to $15 billion. One of those numbers would be easy for Wall Street to take on. The other would be tough given today's capital constrained environment.

What about a government bailout? If the Fed and the Treasury really thought the failure of MBIA and Ambac were a threat to the financial system, a bailout of their insurance arms would be relatively cheap by historic standards. Consider that the government could simply take over the insurers and pay out losses over time. In any given year, the losses would be small enough to get lost in the enormity of the Federal budget. Compared to the bailout of the S&L's, it would be a drop in the bucket.

Current shareholders of MBIA and Ambac may find themselves diluted to oblivion in any bailout situation. If it winds up being a full-blown government bailout, shareholders will almost certainly be toast.

Friday, February 01, 2008

SLM Corp: We've got to give him more time!

I'm going to give you four companies. I'll give you their business, but not the name of the company. I'll also give you their credit default swap level. The level quoted indicates the cost, in basis points, of buying protection against the company defaulting. The higher (wider) the spread, the riskier the market perceives that company. Quotes are as of January 29.

#1 Largest U.S. home builder by market cap. CDS is at 400bps.
#2 West coast Regional bank which was once one of the largest sub-prime lenders. CDS level is 325bps.
#3 Monoline credit card company, marketed primarily to modest income consumers. CDS is 330bps.
#4 Dominant lender in a growing market, unrelated to housing. 87% of their loan portfolio is 97% U.S. Government guaranteed. CDS spread is 420bps.

The companies? #1 is D.R. Horton, #2 is Washington Mutual, #3 is Capital One, and #4 is good old Sallie Mae.

Sallie has sure put bond holders through some tough times over the last 12 months. The now defunct LBO, originally announced in April of last year, slammed Sallie's credit costs. In between then and now, Sallie has suffered some very real operating problems, namely changes in the FFELP program which renders the Department of Education program less profitable. On top of that, the securitization market has fallen apart. While its still possible to securitize student loans (Sallie did a new deal in January), the spread has gone from LIBOR flat to something in the area of LIBOR +65. This is all pinching margins, and slowing earnings growth.

Its time for the markets to separate the slower earnings story (stock holder's problem) with credit worthiness (bond holder's problem.) The earnings growth story is weak. The credit story is still pretty strong, especially given the fat spread available on the credit.

Sallie Mae has a lot going for it in terms of liquidity. First is SLM's large FFELP student loan portfolio, currently $109 billion. This could easily be securitized or pledged to a bank should the company need liquidity. Second, SLM just announced a new $31 billion liquidity facility, which replaces the one provided by J.P. Morgan and Bank of America in conjunction with the LBO. SLM's total debt is currently $147 billion, or only about $7 billion more than the sum of the liquidity facility and the student loan portfolio.

Will SLM face higher loan losses in the next couple years? Probably. Look, all consumer lenders benefited from rising home prices, as consumers who got into debt trouble were often able to HELOC their way out of it. Now all consumer lenders are going to see higher defaults as the housing market takes the Home Equity option away. But given that private loans are only 13% of SLM's business, it seems like a manageable problem.

It seems especially manageable when you compare SLM's situation to that of other credits trading tighter, and yet more directly impacted by weaker housing and weaker consumer balance sheets. It just seems the macro picture for Capital One, Washington Mutual, and D.R. Horton is much weaker compared with Sallie Mae.

Perhaps the wide spread is a simple case of bond vigilantism. Bond holders are refusing to get back into the SLM pool after being burned by the proposed LBO. But does anyone seriously expect another LBO? Remember that the original LBO banked entirely on SLM's ability to securitize new loans at cheap levels. That was theory behind why SLM could get away with a junk rating, as it would have recieved had the LBO been consummated. Cheap securitization now seems like something out of a dream.

To top it all off, SLM management has a stated goal of getting back to an "A" rating. The liquidity situation in the market generally probably has to improve in order for that to happen, so an upgrade in bond rating might be a little ways off. But still, at these prices, SLM bonds/CDS look very attractive.

(Disclosure, I own SLM bonds through client portfolios.)