The cautionary tale of Jefferson County Alabama

Jefferson County Alabama's sewer authority was once considered among the most sophisticated issuers in municipal finance. Now they are on the brink of Chapter 9. What happened, and can it happen to other municipal issuers?

It all started when investment bankers cooked up a clever way to use derivatives to lower interest expense for municipal issuers. The municipality would sell auction-rate debt, then enter into a pay fixed, receive floating interest rate swap. For tax-exempt issuers, the floating end of the swap is either based on a percentage of LIBOR or the SIFMA Index, which is an index of floating rate municipal debt rates.

The result of these transactions was a synthetic fixed-rate bond. The initial floating liability had been turned into a fixed liability via the derivative transaction. Bankers were able to show that through these machinations, even after hefty fees to the investment bank, the issuer would realize a interest rate savings.

For Jefferson County, those savings were important. They had been ordered by a federal court to make significant upgrades to their sewer system to comply with environmental standards. As a result, there has been a 3-fold increase in sewer rates over the last 10 years. In fact, the sewer system became highly leveraged in an attempt to spread out construction costs over time, which in turn would prevent the pain (and political embarrassment) of even larger rate increases.

Historically, auction rate municipal debt had consistently reset at or very near the SIFMA rate, which in turn was always highly correlated with LIBOR. But the recent liquidity crisis changed all that. Starting in January, auction rate municipals began routinely failing, or at best, resetting at rates considerably higher than the SIFMA or LIBOR indices. In other words, the pay-floating side of the interest rate swap was substantially lower than the actual amount being paid by the sewer system.

Because the sewer system was so leveraged, the extra interest expense was more than their budget could bear. Had they been a stronger credit, the sewer system probably could have refinanced their auction-rate debt with variable rate put bonds. That structure offers investors a weekly put option, and therefore has not suffered the liquidity problems of auction-rate bonds. Or they might have been able to cancel the swap arrangements and refinance their debt as fixed rate. But because of the extreme leverage employed and the rapid deterioration of what balance sheet they had, these options were not viable.

S&P has lowered the Jefferson County Sewer bond rating to CCC, with Moody's currently rating the system at B3. The rating had been A with both agencies as recently as mid-February.

Is bankruptcy in the cards? Probably not. The County, which isn't legally responsible for the sewer bonds, has proposed to redirect sales tax revenue to the extent it is not needed for school construction. It is not clear whether this would be enough to satisfy the sewer systems debt service needs, primarily because of uncertainty surrounding their outstanding swap arrangements.

The sewer system's swap agreements require it to post collateral in the event of a credit rating downgrade. According to the Bond Buyer, that figure is currently $184 million, which the County has yet to post, and is now past due. The swaps counter-parties are unlikely to push the collateral issue too hard, as the bond documents indicate that the swap providers are subordinate to bond investors.

So it seems the most likely outcome will be that banks and the County will work out some sort of restructuring. It would likely involve the County pledging certain revenues, a refinancing of their $869 million in auction rate debt, and some sort of restructuring of their swap arrangements. So bankruptcy cannot be ruled out, but it does seem there are too many interested parties who would rather see another solution.

Could the same thing happen to other issuers? Absolutely. Fortunately for general market municipal investors, the confluence of events leading to Jefferson County's problems are indeed rare. Most of the biggest issuers of ARS are either student loan-related, where max rates are very low, or relatively strong issuers, such as the City of New York, who will be able to refinance without trouble. The problems are most likely to crop up with small issuers, particularly private non-profits (e.g. a hospital or private college), who have entered into onerous swaps. These are issuers with limited resources, and also lack the political support that a sewer system enjoys.

It is a bit worrisome for many municipal investors that an issuer can go from A to CCC in less than 30 days. Gee, maybe bond insurance isn't dead after all.

Synthetic ABS. Who needs 'em anyway?

Plans to create an auto loan ABS (asset-backed security) index, similar to the now infamous ABX index except for auto loans instead of home equity loans, were quietly scuttled last week. Creation of such an index would have allowed investors to buy and sell credit default swaps on a basket of auto loan securitizations, in effect, betting on the credit performance.

Why was it canceled? Partially because of the severe drop off in securitizations of consumer loans generally, there aren't a lot of recent auto loan deals to put into an efficient index. But there is a deeper issue. Many market participants are now questioning the value of these CDS indices. It was once thought that a more easily traded index of CDS would help improve price discovery in the asset-backed market. But is that what's happening now?

The market is only going to efficiently price a security when there is reasonable two-way flow. In other words, when a price is reached where there is a reasonable number of traders on both the short and long side. Is this what's been happening with the ABX index? No. Whatever you think of where actual value is on various ABX contracts, it certainly isn't a two-way market. Buyers of protection have dominated that market for about a year now. Of course there has to be a seller if there is a buyer, but I've persistently heard that sellers of protection have overwhelmingly been either paired trades along the capital structure (e.g., long the 2007-1 BBB and short 2007-2 BBB) or short covering.

Now one can look at any of the specific structures in the ABX library and make a case that the price should be higher or lower. That isn't the point. The point is that the ABX never developed natural buyers of risk. Once home equity structures became distressed, there were some buyers of cash bonds. But these are the kinds of buyers who want to comb through the structures and carefully analyze every dollar of cash flow. That kind of buyer is looking for a cash-flow diamond in the rough. Selling protection on the ABX is a bet on home equity spreads in general tightening. That's not the kind of bet distressed buyers like to make.

Meanwhile, with so few home equity bonds actually trading, the ABX became the only means of estimating a market value on home loan bonds. So right or wrong, the ABX became the "mark to market" for pricing many different types of mortgage-related paper. Buyers who were careful to buy higher quality home equity paper complained, as they believed they had better structures than those on which the ABX is based. But it didn't matter since there were no new deals with which to compare, the ABX is all auditors had to use as a base.

The negative feedback was severe. (Notice I didn't say it was a "loop") Any real money buyer who tried buying high quality home equity paper saw their marks based on the lower-quality ABX. Portfolio managers are hard-pressed to buy bonds, regardless of the fundamental value, if the mark is going to be substantially lower. With no real money buyers and liquidity very poor, it became impossible to securitize any mortgage-related paper.

What would have been better for all involved is if the market had been allowed to price bonds individually based on individual risk characteristics. Perhaps the dislocation in the mortgage market was too severe for that to have realistically happened. But the ABX caused everything to be priced on a lowest-common-denominator basis. That really didn't help anyone other than the shorts.

So given all this, it seems obvious why various market participants aren't too eager to create another ABX monster. Its true that default rates on auto loans are likely to rise significantly, both due to normal recessionary pressure as well as the weak housing market. But its also true that auto loan deals have been priced to take much greater losses than home loan paper ever was. Home loans were always modeled with the assumption that the collateral was an appreciating asset. Car loans never made this assumption. In fact, Fitch estimates that most AAA-rated auto loan deals can withstand 20% unemployment.

So the street would rather auto loan securitizations stand on their own cash flow results, rather than suffer the slings and arrows of outrageous technicals. There is a right price for ABS risk. Maybe, just maybe, finding that right price will allow the securitization market to make a slow comeback, at least outside of home loans. That will be a critical next step for solidifying market liquidity.

The credit market's Bacta Tank

The market's reaction to Bear Stearn's demise has been impressive. The stock market story has been well-covered, but the credit market story is really the one to watch.

Right now we have two major themes in the credit markets. The first is a real economy recession, with a very weak housing market at its epicenter. The second is a battered financial sector, where strained capital and fear of spiraling contagion has caused a dearth of liquidity.

A real economy recession should legitimately cause the price of taking risk to rise. In the case of mortgage-related credit risk, for instance the ABX index, prices should obviously be drastically lower. This is the kind of risk pricing that capital markets can handle. In fact, that kind of risk pricing is exactly why capital markets are an important part of our free-market system. We need a market where various risks are correctly priced, as this helps to channel capital to areas where it is most needed.

But the second major theme is interfering with the market's ability to properly price risks. Potential buyers of risk, from hedge funds to banks to broker/dealers, became overextended during the credit bull market and now need to repair their their own balance sheets. No matter how attractive various pricing levels are, these buyers are are not a position to take advantage. Some of those that became overextended have been forced to unwind some or all of their positions. In many cases, such as the liquidation of municipal bond arbitrage programs, the problem had nothing to do with actual credit losses. But given the weak liquidity, any large scale selling caused prices to plunge.

As a result, classic investment analysis, pouring over 10K's and analyzing cash flows, has not been a winning strategy. Until very recently, investors who dabbled in anything that looked fundamentally "cheap" got burned. Sector after sector suffered historic spread widening amidst persistent forced selling. This created a negative feedback loop, as real money investors sit on the sidelines waiting for some semblance of calm before putting their cash to work.

The never few weeks will test whether that negative feedback loop has broken. Municipal yields have been falling. 10-year Fannie Mae debt spreads have dropped about 35bps since Friday, and are now as tight as they've been since early February. Agency MBS spreads are about where they were at the beginning of March. Brokerage CDS are actually tighter month-to-date.

This is important because it means that there are investors who bought good bonds on recent dips and enjoyed good results. This is what it will take to break the negative feedback loop in the bond market.

Whatever you think of where the economy is heading, the system needs efficient pricing of risk. Persistently bad technicals have been getting in the way of this healthy process. Watch interest rate swaps spreads, GSE debt spreads, and agency-backed MBS spreads to see if this follows through.

What I'm hearing...

• Bank and brokerage bonds continue to perform well. The most recent quotes I've seen on Lehman Brothers, for example, are as tight as I've seen over the last couple days. It doesn't look like they've backed off materially during this late-date stock market swoon. We'll see.
• CMBS spreads are moving much tighter today. I'm not big into that market, so I'm just throwing that out there for color.
• Credit spreads outside of finance appear to be mildly tighter, if anything.
• Swap spreads are mixed, with 2-year spreads 4bps wider while 10-year 3bps tighter. Agency spreads moving similarly.
• Deleveraging continues. All the big brokers know that the surest way to avoid a Bear Stearns problem is to make sure they aren't over exposed to hedge funds. Supposedly there have been several commodities-oriented funds which are selling today. Gold getting crushed. Haven't heard anything about equity-oriented funds but that might be part of what's going on today as well.
• Also hearing that good old John Merriweather's fund, JWM Partners, is down 20%+ in March. Supposedly had exposure to Carlyle.
• Agency MBS spreads are tighter today. News that FNM and FRE will be allowed to expand their portfolio may well be a game changer in the MBS world. Two weeks ago news like the JWM rumor would have just killed the MBS market.
• Put the deleveraging story and the stock market story together with the mildly tigher credit/MBS spread story and it doesn't seem to fit. I can only conclude that there aren't alot of hedge funds left that are both 1) net long credit and/or MBS and 2) haven't already been hit with margin calls.
• Also interesting to note that even hedge fund trades that have been working, e.g., long commodities, are getting hit by deleveraging. It may have merely been that the credit and MBS-oriented funds were the first to get hit by deleveraging.
• Speaking of popular hedge fund trades, my bet would be that fast money is net short investment-grade credit. That could be another reason why credit spreads have been resilient today.

I'd love to hear comments on what others are seeing today.

Update on the Precipice...

Some updates for those who don't sit in front of Bloombergs...

5-year brokerage bonds...
Lehman Brothers: Now, +560/540. Open, 625/595. Last trade on Friday was +510.
Goldman Sachs: Now, +280/260. Open, 290/280. Friday, 260.
Merrill Lynch: Now, +415/405. Open, 470/460. Friday, 400.
Morgan Stanley: Now, +330/310. Open, 350/340. No size trades on Friday, but seemed to be about +300.

Swap spreads continue to perform very well. 10-years 8 tighter today, 2-years 9 tighter. Agency spreads improving as well, 10-year Fannie's about 3 tighter than Friday, 2-year about 6 tighter.

Lehman is of course the name to watch. Here is what I've heard. Working against them is that they had the second largest mortgage exposure on the street (after Bear of course). Working for them is that they actually have more cash than their rivals. I've heard they have cash and near-cash of $100 billion which is 5 times what Bear supposedly had as of last week. According to one trader I was talking to, Goldman doesn't even have that much cash. I'm watching Lehman's credit spread much more closely than their stock. If their credit spread holds, that would indicate that the market believes in the Fed's lender-of-last-resort role. The stock might fall regardless, as all the brokers are probably going to have to lever down and that will hurt profits.

Also, remember that the Fed isn't trying to "solve" anything. In other words, the Fed's near-term goals do not include preventing home prices (or even stock prices) from falling. The Fed's goal is to make sure that the system continues to function. If the stock market stabilizes, that would be a sign the Fed's actions are working. But a better sign would be that bank CDS spreads stabilize. That's what we need to watch now.

The Precipice

There is a lot about the Bear Stearns bailout story we don't yet know, so I don't have too much to say about it. Obviously the $2/share price tag is the scariest part. Anyway, I thought I'd throw out some stuff from my markets that you might not see elsewhere.

• Clearly if Bear Stearns was only worth $2/share, then Lehman and the other brokers are worth far less than what they were worth on Friday. And that doesn't have anything to do with their actual assets or liabilities, but that if someone else needs a bailout, its going to look similar to the JPM/BSC deal. So even if you assume that the odds of another firm needing a bailout are relatively low (say 10%), that's a 10% chance that the firm is worth essentially zero.
• Why the hell is Bear stock trading at $4?!? Now I'll admit that there is a chance that another buyer would have paid more for BSC. But I can't imagine another buyer emerging now. By all accounts, the Fed orchestrated this from start to finish. I mean, J.C. Flowers was a bidder, but would the Fed want J.C. Flowers to have bought Bear? Hell no. J.P. Morgan was one of just a handful of financial institutions in the world that would bring unquestioned stability to Bear's balance sheet. Once the Fed got JPM involved, the Fed wasn't going to let anyone other than JPM to finish the deal.
• As I'm writing this, the Dow is down 20 and the S&P is only down 10. Nothing, nothing, would surprise me today. Down 500? Up 200? Who knows? What we have is a tug of war. Traders betting on things getting worse. The Fed and Treasury are trying to draw a line in the sand, telling the market they won't let either banks nor primary dealers fail as long as they still have decent assets to pledge as collateral. The Traders have momentum on their side, the Fed has gigantic piles of cash on their side.
• Speaking of the Fed's weapons, someday when we really know everything about what really happened at Bear Stearns, it will be interesting to see whether Bear would have survived if they had access to the discount window and/or the TSLF. In other words, had the Fed acted quicker to extend liquidity to dealers, would be have been better off?
• Spreads on interest rate swaps, which is viewed as a broad measure of counter-party risk, are substantially tighter today, about -5bps on 10-year swaps and -7 on 2-year swaps. Doesn't sound like much, but that's a pretty big move for swaps.
• Freddie Mac and Fannie Mae debt spreads are also tighter, but only by 1-2bps.
• Agency MBS are performing in-line with Treasuries. That's encouraging, as MBS rarely keep up with Treasuries when rates are falling.
• Credit spreads are definitively wider, but I'm hearing there is little conviction either way in cash bonds. I will say that I wouldn't be a buyer of protection against any of the big banks or brokerages here. The Fed just delivered a big middle finger to people who bet against Bear Stearns. If you want to bet against brokerages, the stock is a much smarter bet. The Fed doesn't give a fuck if a stock falls 50%. They have basically unlimited power to prevent a bankruptcy.
• Moody's affirmed Lehman's A1 rating this morning, after Lehman secured a $3 billion credit line on Friday. This doesn't mean very much, even forgetting the ratings agencies recent poor record on rating mortgage deals. The problems brokerages are facing today have nothing to do with the normal financial ratio-type analysis that the ratings agencies do. In fact, for a guy like me who likes to pour over financial statements when making an investment decision, analyzing credits now is next to impossible.
• Lehman and Goldman's earnings reports tomorrow are probably the most important earnings reports for the broad economy of my career.
• We're going to get 100bps tomorrow.

Good luck to Bear Stearns employees.

Do you think that after what you did to Han we're going to trust you?

The S&P piece that got the market excited is available here, you have to register but its free. I mentioned some points about writedowns in this post. Basically I think that the most big U.S. brokers have substantially written down what they need to. Doesn't mean they have zero writedowns going forward, just that what they do have will be smaller. My view on this has been bolstered by recent comments from Vakrim Pandit and John Thain, both saying they wouldn't seek more outside capital, as well as Alan Schwartz saying that Bear Stearns' balance sheet was unchanged from the previous quarter. I mean, Schwartz can't come out and say that the balance sheet was unchanged from last quarter on CNBC on March 12, then reveal a $1 billion writedown when they announce earnings on March 20.

As I said in Tuesday's comments, however, that doesn't mean we're out of the woods and the credit bear market is over. It just means that we enter a new phase in the healing process. See, dealer capital is going to be constrained for a while here. I personally wonder if constrained capital wasn't part of the reason why the 10-year auction was lackluster. That means liquidity in all areas of fixed income will be less than you'd otherwise expect. That's the world we're going to be living in for the next year or two regardless of what else happens to the economy.

Anyway, so people love to talk about what inning we're in when it comes to the subprime crisis. But let's be more positive about it, shall we? We're in the first inning of the healing process. The subprime contagion has decimated broker/dealer capital. That phase is probably wrapping up. We've also seen the contagion all but eliminate SIV-based ABCP and auction-rate securities. So that phase is over too.

The contagion tried to really wreck the municipal bond market, but the early indications are that market is starting to function more normally. The contagion is also trying to really wreck the agency MBS market, but even in the face of Carlyle's liquidation, MBS spreads actually tightened today. So maybe, maybe, that's another area where the contagion will be contained.

To say things are getting better is a bad way of thinking about it. The data continues to be bad. But in order to move forward, we've got to contain the contagion. Once the unbridled fear subsides, then we can get to the business of properly pricing various risks. We're getting there. Slowly.

It's just a dead animal

Rumors that Bear Stearns was having liquidity problems sent the credit markets reeling on Monday, and briefly had Bear's stock bucking yesterday's dramatic rally. I heard (could not confirm) that Bear CDS briefly hit 1,100. By late afternoon it had settled down to about 600. On Friday Bear CDS was around 465.

Now I'm not here to say whether Bear Stearns has liquidity problems or not. The recovery in both the stock and bond market for Bear paper would indicate that they probably don't. But this kind of panicky trading is exactly why its hard to own financial bonds right now. I mean, anyone who had traded through bear markets knows that the rumor mill becomes very active. Right now everyone is nervous. The longs are nervous because they've been losing money and/or under performing their index for months now. I'm sure there are many portfolio managers and/or traders worried about losing their jobs over poor performance.

The shorts are nervous too. Right now corporate credit spreads are at all-time wides. That means that getting short a credit is expensive to begin with. For example, if you assume Bear Stearns CDS is at 600, that means it will cost you 6% of your notional bet annually to short Bear Stearns. In order to make up 6% in carry costs, you need something like a 175bps widening of the CDS spread. Now obviously 175bps of widening is possible given that it moved to 1,000 in a day, and if the move happens quickly then you don't incur the whole 6% in carry costs. Still, it comes to the point where you have to really bet they are going bankrupt, not just going to have problems.

On top of that, with spreads at all-time wides, the shorts know that spreads (speaking generally) are bound to tighten at some point. When this might happen is any one's guess, but its clear that the risk/reward of a generalized credit short is getting harder and harder.

So amidst all this nervousness, it seems that Wall Street starts giving more credence to rumors. In the last 5 trading days we've gone from a rumor that Treasury was going to guarantee GSE debt (scaring the shorts) to a rumor that Bear Stearns was teetering (scaring the longs) to a rumor that WaMu would get a capital infusion from Warren Buffett (scaring the shorts again). Look for more of the same in the coming months.

What will bring an end to the credit bear market?

So readers seem to want to hear about what I think could end this credit bear market. Of course I wrote most of this before the Dow surged 300 points today. And hey, maybe this will mark the bottom of the credit market. We'll see. I for one am not pouring into financial bonds right now, and I'm betting neither are a lot of real money buyers. Ironically, in talking to fixed-income portfolio managers and traders, it is almost universally held that credit spreads for investment-grade corporate bonds are too wide. That in 12-24 months bond spreads will have tightened significantly. And yet the same people are also very cautious about adding positions right now. In other words, people who believe certain bonds are fundamentally cheap are unwilling to actually buy the same bonds. Hence the severe bear market in corporate bonds continues.

What would bring an end to this bear market? Simple. Bear markets end when the market runs out of sellers. More on this in a bit. First, let's look at what won't end the bear market.

When the economy improves?
Nope. During the 2000-2002 credit bear market, the economy was already on the upswing by 4Q 2001, but credit spreads didn't peak until 4Q 2002. At that time, accounting scandals (Enron, Worldcom, etc.) caused investors to lose confidence in financial statements in general. Any company which made the most minor of accounting restatements saw their bond spreads widen dramatically. Fear of accounting surprises kept credit investors away.

The current market might turn out to be similar. Even if the economy starts to rebound at some point in 2008, fear that subprime losses will pop up in unexpected places may keep spreads wide.

When banks and broker/dealers have adequately written down subprime securities and loans?
Nah. See, we won't know when that's happened. Consider...

• We don't know what the right number is for losses. $300 billion? $400 billion? $800 billion? Even if there were $400 billion in write downs already, there'd be plenty of commentators claiming more write downs were coming.
• We don't know how much of the eventual write downs are held in private hands, and therefore will never show up in a public tally.
• Some of the losses which will hit public companies will come in the form of failed hedge funds. The losses at the hedge fund are really part of the subprime tally, but may not be reported as such by the bank/brokerage.
• The accounting treatment for various subprime exposed positions differs. There won't be explicit "write downs" for all of the eventual losses.

The bottom line is that write downs are going to continue. Some firms may have already written down and/or sold all their impaired positions, others probably have a long way to go. But even if, say, Morgan Stanley announces zero RMBS writedowns when they next report earnings, market sentiment is so negative that people won't believe them. After all, when Morgan Stanley reported 4Q earnings they announced that they only had $1.8 billion in subprime exposure, suggesting that possible future write downs would, at worst, be small. That's hardly stemmed the spread widening in Morgan Stanley bonds.

When housing prices bottom?
That's not it either. Again, we contemporaneously know when prices have bottomed. For one, most data on home prices had a serious lag, for example, the Case Shiller figures are two months old by the time we get them. Besides, we'd need several reports of moderating price declines before anyone would believe the market had bottomed. Imagine what would happen if the next Case-Shiller report showed that prices were flat in the last month. Would anyone really believe the housing crisis was over? Or would you figure that we hit a lull and price declines would soon continue?

The same would be true for other housing health indicators, such as default rates on mortgage loans. We'll need several months to know we've bottomed. By then it might be too late to be in credit.

When confidence in the financial system returns?
Uh uh. Just like every bear market, confidence doesn't return all at once. No one will make an announcement that now the banking system is perfectly stable and its OK to buy credit. By the time confidence is restored, credit spreads will be dramatically tighter.

When buyers start nibbling in credit?
I don't think so. Whenever someone sells a bond, someone must be buying it. So it isn't like there are no buyers at all. Plus from November on we've heard of plenty of stories of smart portfolio managers coming in to buy credit, MBS, commercial MBS, bank loans, etc. Unfortunately, every single time anyone has nibbled on anything, they've gotten crushed. Just last week, Bill Gross was reportedly buying CMBS, as well as Thornburg MBS. So people have been and will continue to nibble on these beat up securities.

The problem has been that there are so many willing sellers, and not just of highly distressed subprime or LBO bank loans, but of plan vanilla corporate bonds. Every time a modicum of demand emerges, its met with even larger selling.

So spreads won't tighten until sellers are exhausted. That may take a while longer. The maturation of the CDS market has made it easier and cheaper than ever to bet against a credit. At some point the cost of buying CDS protection will give short-sellers pause, but for now the momentum is so strong against credit, that the quarterly CDS contract payments must seem like a minor inconvenience. But the time will come where fast money decides that credit is oversold. Buying protection won't seem like such an easy trade.

The bottom line is that you have to look at the fundamentals of a given credit. If you think a bond is paying you the right amount to own it, then buy it. Otherwise, move on to something else. Trying to time the bottom in this market will be unusually difficult.

Return of Capital

Investors are more worried about return of capital these days, and not as much with return on capital. This most starkly evidenced by the nominal yield on 2-year Treasury Inflation Protected bonds is currently negative, about -0.72%. This means that buyers of this bond are happy to accept negative real returns over the next two years. Obviously investors would only accept such a situation during a time when fear is at extreme levels.

But investors won't accept negative real returns forever. And the fear levels have created some very easy opportunities to outperform Treasury yields. No, I'm not talking about MBIA's 14% surplus note or sub-prime closed-end second lien bullshit. Take Ginnie Mae (GNMA) mortgage-backed securities (MBS). GNMA securities are backed by the full-faith and credit of the U.S. Government, so the credit quality is exactly the same as a Treasury bond. The cash flow for these securities is equal to the cash flow that is paid by borrowers, so when a borrower sends in $1 of interest, bond holders get that $1 of interest. If they pay $1 of principal, $1 of principal is repaid to bond holders (well, not exactly, but close enough). If any borrower defaults, Ginnie Mae buys the loan out of the pool, returning 100% of the principal amount to bond holders.

As of Thursday close, GNMA securities with a 6% coupon based on 30-year fixed-rate mortgage loans were trading about $101.5. What your yield would be depends on how quickly the bond repays principal. Since principal is repaid at $100, faster repayments would lower your return.

So let's look at how fast prepayments might occur. At the height of the refi wave in 2004, GNMA 6% mortgages prepaid principal at a 44% annualized clip. If that prepayment rate reoccurred over the next 12 months, assuming a zero reinvestment rate, investors would earn 3.72%. Hey! That might actually keep up with inflation!

Of course, the mortgage market is quite different today versus 2004. First of all, 30-year fixed mortgage rates fell as low as 5.45%. Today we're still stuck just over 6%. Second, mortgage credit was very easy to come by. Today? Its the worst mortgage credit environment in generations. So the odds of seeing 44% prepayments seems unlikely. In fact, prepayment rates over the last 6 months have ranged from 9.5 to 15.6%, with an average of 12.9%. If prepayment rates stayed at 12.9% over the next 12 months, the GNMA investor would earn 5.19%. Don't look now, but that yield level is higher than 5-year Goldman Sachs, Wachovia, or Bank of America paper. By the way, if you are feeling frisky, the yields on Fannie Mae or Freddie Mac guaranteed MBS are even higher.

Of course, I say you'd "earn" 3.72% or 5.19% in yield, but what about price return? Indeed, MBS prices have suffered particularly over the last 6 weeks amidst horrible technicals. Leveraged MBS players are seeing their allowed margins reduced. Mortgage originators sold like mad in late February to try to get ahead of more expensive Freddie Mac and Fannie Mae pricing. Banks are not adding to positions, if not selling themselves. MBS prices fell about 1/2 of a point Thursday(while Treasuries rose more than 1/2 of a point) after the story hit that Thornburg had been served with a default notice. They recovered a bit on Friday.

On the positive side, supply technicals are excellent. You may have heard that housing turnover is extremely low, and bank credit is extremely tight. There won't be a flood of mortgage supply for the market to swallow.

So yes, perhaps the technicals of MBS are difficult right now, but the fundamentals are excellent. Maybe the demand for MBS will come in the form of money managers and retail investors who finally tire of Treasury yields below 2%. How long it will take before this happens is any one's guess. But if you are going to be a fundamental investor, you can't be overly concerned with waiting for a bottom. Similar to what happened in municipals, eventually buyers come in to buy when the value proposition becomes easy to understand. I think MBS have reached this point.

Municipal Bonds: Yeeeeaaaaahooooooo!

Municipal bond yields are falling fast after hitting record highs versus Treasury bonds on Friday. Late last week, municipal arbitrage funds were being hit with margin calls, as their hedges were rapidly moving against them. This lead to billions of dollars in forced selling, which when pushed on the relatively illiquid municipal market, caused prices to plummet. On Friday, high quality municipals were widely available at spreads of 100bps or more above Treasury rates. Typically municipals yield about 80% of Treasury rates.

Initially word on the street was that these historic levels were enticing hedge funds and other non-traditional muni buyers (even Bill Gross) to buy tax-exempt munis. This was good news and bad news of course. It meant that there was indeed capital in the system to ensure that the muni market would clear. The bad news was that these non-traditional buyers would only be around as long as muni prices were stupid cheap. In other words, this was fast money, and fast money never sparks a persistent rally. Fast money is always looking to take its profit and get out. At best, these non-traditional buyers would merely prevent the muni market from going lower still.

But the initial read was apparently wrong. On Monday, retail buyers (i.e., mom and pop investors) started coming out of the woodwork to buy bonds. The State of California came with a $1.7 billion deal on Monday. Demand was so strong that the underwriter cut the interest rate by 15bps across the board, and still $1 billion of the deal was done retail. Now maybe there has been $1 billion of a deal done retail in the past, but I sure as hell don't remember ever hearing of such a thing. Smith Barney, Citigroup's retail brokerage arm, supposedly had the best day for selling municipal bonds in their entire history on Monday. One large dealer I talk to regularly said they had sold every bond in their inventory by 11AM.

Overall, municipal bond rates are probably 15bps lower today than on Friday, while Treasury rates are about 15bps higher. Strong retail demand is critical for improvement in the muni market. First it means that long-term buyers are soaking up the massive supply hitting the market. Second it means that long-term buyers have not lost confidence in municipals amidst the bond insurer problems.

So what happened to the arb fund selling? I've heard that the arb funds had to meet margin calls on Friday, but seem to now have adequate margin to move forward. That being said, we are still seeing selling from arb funds, but its coming in the form of smaller lists of offerings as opposed to bid lists. The difference is the degree of desperation. A bid list means you need cash now, an offering list means you will sell bonds but only if you get your price.

The bottom line is that the muni market looks a lot stronger than I initiall expected.

What the hell is going on with munis?

To understand what's happening in munis, and why its got so many people worried, you first have to understand how it used to work. You know, way back in early 2007.

When a municipality wanted to do a bond issue, they would hire an investment bank, who would normally invite other investment banks into the deal to help sell it. Not unlike what happens with corporate bond or even equity IPOs. The lead investment bank would decide on an interest rate it thought was the right level to sell the bonds. They'd set the level a little higher than the market, in the hopes of selling the deal quickly. Remember that a municipal bond issue is underwritten, meaning that the investment bank has committed to buy the issue from the municipality, and is taking the risk that they can sell the deal to the public.

Way back in early 2007, that risk seemed like no big deal. If a bond deal didn't sell in its entirety, the dealer would just put the bonds out on its retail system and sell them to mom and pop $5,000 at a time. Given the underwriting fee the investment bank earned, the risk of holding low volatility municipals for a week or so made a lot of sense.

Fast forward to today. Investment banks are generally strapped for capital. What capital they do have is not being heavily allocated to a low margin area like municipals. And a lot of the dealers' municipal capital is tied up in auction rate bonds.

So what happens when an investment banks is trying to underwrite a municipal deal but have been told not to use any of the firm's capital? They have to "pre-sell" the entire issue, meaning that the bank's customers have committed to the deal before the official sale. No big deal, right? Just set the price a little higher than the market, just like muni underwriters have been doing for years, and demand will come, right?

Well, not so fast. New issue muni supply is extremely large right now: over $8.4 billion in new issues are expected next week. A lot of that is auction-rate securities being refinanced. On top of that, there has been consistent selling from various municipal arbitrage strategies, such as tender-option programs. These strategies have been squeezed by bad hedges and insurer-related downgrades, and are currently flooding the market with bid lists.

Normal muni demand from mutual funds, insurance companies, and mom and pop investors just can't keep up with that kind of selling. And with dealers unwilling to inventory bonds themselves, that means that they have to make new deals so cheap as to entice non-traditional muni buyers into the market. In other words, vulture investors. The same people who have stepped in to buy auction-rate munis yielding 8% are now being invited into the fixed-rate muni market.

What's the result? Friday it was possible to buy 5-year pre-refunded municipals (which are backed by Treasury bonds held in escrow) at yields in the 3.50's. In other words, around 80bps higher than Treasury rates. That is literally Treasury credit at a 80bps spread to Treasuries tax-exempt. Dozens of large new issue municipal deals came at significant spreads to Treasury rates.

The hedge funds are smelling blood in the water, and are moving in quickly. I've heard from multiple sources that non-traditional muni buyers, from hedge funds to taxable bond investors, lifted everything in the street yesterday. That's good news and bad news of course. It means that the muni market is indeed clearing. But it also means that muni rates can't move substantially lower (at least versus Treasury rates) until we get through this glut of new issue supply created by auction-rate refinancings and arb selling. These vulture investors don't really represent new demand for munis long-term, merely that if the street is going to absolutely give away municipals, there are buyers who will take them.

A trader I talked to today told one of his hedge fund clients that municipals were feeling like a falling knife. The customer responded that the ABX index was a falling knife. This is at worst a butter knife.