CDOs: The Future of Leveraged Fixed Income

Collateralized Debt Obligations (CDOs) have been the bane of Wall Street recently. Falling CDO prices have been a major player in the write downs at big brokerages and the near insolvency of monoline bond insurers. And yet the CDO structure will not only survive this period, but is likely to become the dominant means of leveraged investing in credits.

First, let's consider what a CDO is, and what it isn't. At its simplest, a CDO starts with a portfolio of credit-risky securities. The purchase of this portfolio is funded by the sale of a series of debt tranches. Payment to debt tranche holders follows a seniority scale, such that the senior-most debt holder gets paid first, then the next-most senior, and so on. Most CDOs have at least 4 or 5 levels of seniority among debt holders. If there is any cash flow left, it is paid to an equity holder. It is common for the equity holder to represent as little as 1-3% of the total structure.

It sounds complicated, but the core concept is quite simple. It is similar to how banks fund themselves: you have depositors, senior debt, subordinated debt, preferred stock, and equity. As long as everything is going well, all debt holders get paid what they are promised, and whatever is left over is what the equity holder owns. If the bank goes under, depositors get paid first, then senior debt, etc. A CDO is basically the same idea, except that whereas the bank would have to go bankrupt before the credit tiering came into play, a CDO will take losses on individual credits over time.

The senior-most tranche of a CDO was usually rated AAA. This piece would usually amount to 60-80% of the total CDO structure, or put another way, 20-40% of the cash flows were subordinate to this senior-most piece. This meant the structure could take on substantial losses before the AAA tranche would suffer any cash flow short-fall.

Several things went wrong for the CDO market over the last 18 months. Many CDOs were constructed from consumer loan-related securities. It was assumed that losses in consumer loans would have a relatively low correlation, that a home equity loan for a teacher in Sacramento would have no correlation with a loan to an auto mechanic in Orlando. That assumption proved disastrously false in 2007 and caused CDOs built from consumer loans to fall apart en masse.

But it wasn't really the failure of CDOs themselves that created so many problems. Take the collapse of the SIVs. In most cases, SIVs collapsed not because they took on too much in cash flow losses, but because no one would buy their commercial paper anymore. In other words, the SIV arbitrage relied on the continued confidence in the SIV portfolio. Once that confidence was gone, regardless of what was actually in the portfolio, the SIV was toast. The very same thing happened to countless hedge funds and other leveraged vehicles in recent months. Any vehicle that relies on short-term funding is banking entirely on the continued support of short-term investors. Once that's gone, the whole structure is destroyed. A CDO doesn't have this problem. Generally speaking, the funding of a CDO is locked in at issuance.

Let's compare and contrast for a moment. A CDO equity investor, the one who only gets whatever is left over after all debt holders have been paid, is making a highly leveraged bet on credit losses within the CDO's portfolio. But that's the only bet being made. An investor in a hedge fund relying on repo financing is making a bet on both the portfolio and continued access to financing. Why should investors make two bets when they could make only one?

In addition, if properly funded, CDOs are safer for the system compared with other types of leverage. A CDO is a closed loop. If CDO portfolio losses are greater than initially assumed, investors in that CDO will suffer, but there is no contagion effect. We don't find pockets of lenders to the CDO hidden here and there. Of course, if CDO debt tranche purchases were funded by borrowing, then that's a different story. But such borrowing is not inherent to the creation of CDOs.

CDOs also rely on a very well known and time-tested arbitrage, assuming the right kind of collateral is being used. Credit investments have highly skewed return distributions: either you'll get paid the promised rate, or the bond will default and you'll take a huge loss (this is termed negative skew). It is well established that investors detest large losses more than they lust after large gains. Therefore credit spreads almost always price in more interest than is warranted by default expectations alone. A CDO can therefore buy a portfolio of credit instruments, and if the correlation of defaults is relatively low, make arbitrage profits on the investors disdain for negative skew.

I'm not suggesting the CDO market will soon return to its salad days of 2006. There were a lot of overly complicated structures and even more poorly conceived collateral portfolios. But the CDO market is starting to make a comeback, with 26 CDO deals pricing in April and May. As long as there is demand for leveraged credit, there will be, and should be, a CDO market.

Bailouts, Wall Street, and the Bad Motivator

Bailout. To any believer in real honest-to-goodness capitalism, bailouts are an anathema. The way our system of economics is supposed to work, those that take risks and are successful are supposed to be rewarded, and those that fail are supposed to suffer the consequences. The system only works if there is both that upside and downside.

But in recent months, we've seen Bear Stearns bailed out. We've seen a "Hope for Homeowners Act" proposed in congress which will bailout certain borrowers. We've seen the Fed accept all sorts of collateral for loans. And if it comes to it, we will see the government bail out the GSEs as well.

So what happened to capitalism? Why couldn't we have just let Bear Stearns die? Or at least force them to seek a private transaction with no backing from the Fed?

The answer is that our financial system has become too intertwined. It has become too reliant on the continued solvency of all its players. Had Bear Stearns been allowed to fail, banks world wide would have lost their counter-party on various derivative transactions. A bank that assumed it had hedged some of its credit risk on a particular borrower would suddenly have all that credit risk back in its lap. I don't need to paint the picture as to the level of contagion that would ensue. I'm not even talking about fear here, merely that many financial institutions were relying on hedges in so many ways, that to suddenly lose a counter-party would be disastrous.

Let's say you allow Bear Stearns to fail and that caused XYZ bank to fail. Is that capitalism? Forcing XYZ to suffer for the sins of Bear Stearns? I posit that the ideal of pure capitalism becomes functionally impossible once financial institutions start relying on each other for survival. Capitalism is supposed to reward those that take good risks and punish those who take bad risks. What do we call it when our system might reward good risks, assuming all your counter-parties also take prudent risks?

Maybe capitalism is a religion where we've all fallen from the true faith. Maybe the Fed will always have to be there as a lender of last resort. But maybe we could make that last resort a little less common.

The first step is obvious. Credit-default swaps need to be exchanged-traded. Perhaps there needs to be some significant modifications to how CDS are structured in order to make this work. Fine. But given the myriad of derivatives and futures contracts that currently trade on exchanges, I can see no reason why the same cannot be done for CDS.

I imagine a system where the 20 or so largest banks and brokerages contribute cash to create the exchange. Or there could be seats on the exchange which were auctioned off. The exchange would then stand in the middle of all CDS contracts. Thus the failure of any one player in the CDS market wouldn't threaten the whole system.

Of course, if there is a single exchange there is also a single counter-party. But I argue this still is a reduction of risk to the system. Look, right now, the number of true market makers in CDS are very limited, probably around 10 or so. That means that for every CDS contract, there is a very limited number of firms standing on the other side. So as things stand, 1/10 of the $50 trillion CDS market could disappear if one of the current market makers goes down. Doesn't seem too wise does it? If you think about it that way, under the current system, tax payers are somewhat exposed to the demise of any of 10 different financial institutions. Would it really be so hard to capitalize an exchange such that it could withstand the failure of a small number of its members? And wouldn't the somewhat joint-and-several nature of an exchange improve confidence? Was anyone worried about the CBOE going under when BSC was in trouble?

There would be some relatively simple ways to bring such a thing about. What if banks were required to recognize the credit risk of their counter-parties directly? I.e., the capital needed to execute a private derivatives contract would be prohibitively large. I think back to banks needing to reserve for losses dealt to them by XLCA/FGIC/Ambac/MBIA's potential failure to perform on CDS contracts. Why not just make them reserve a larger amount for this possibility up front? Efforts to start an exchange would begin the next day.

I'd like to live in a world where Bear Stearns could have failed without it impacting better-managed institutions. Unfortunately I don't live in this world right now. But that shouldn't stop us from trying to move in that direction.

That thing's operational! (More on the GSE's)

Yesterday's post on the GSE's garnered a lot of great comments and I wanted to answer some of them in a new post, as I know the majority of Accrued Interest's readers come to us via RSS or e-mail. I'm not going to hit them all, but I'd encourage you to read all the comments for yourself.

First, I made some overly simplistic, and partially just plain wrong, statements about Freddie Mac's debt/asset situation. Read about that in a note at the end of yesterday's post.

Another persistent question is whether the GSEs would be solvent right now if not for the implicit support from the Treasury. Its an interesting question to ponder, but impossible to answer completely. That's because we don't know what the GSE's would look like if they didn't have government support. In other words, Fannie Mae and Freddie Mac would look very different today had they been founded as private companies and/or had the Treasury cut ties with them many years ago. They'd likely be a lot smaller, and probably would have focused in higher margin products. You know, like sub-prime.

But for the hell of it, let's consider the GSEs' solvency with the only variable being the market perception of government support. So we're holding their portfolio composition, loss situation, funding strategy, overall size, etc. all constant. What would that look like?

I'd say the closest parallel are mortgage insurers, like PMI and MGIC, in terms of access to capital. MGIC recently did a preferred equity offering, but generally speaking those firms would have a hard time doing straight debt offerings right now. Fannie or Freddie would have a couple things going for them, when compared with the mortgage insurers. The mortgage insurers' primary exposures are where the borrower didn't put 20% down. A portfolio like that is clearly riskier than Fannie Mae or Freddie Mac's. Freddie Mac's CLTV is 67%. Now there might be some silent seconds that they aren't counting, but still, its assuredly better than a straight mortgage insurer.

We know that the GSEs have recent done preferred offerings to raise capital. Would they have been able to complete those transactions without government support. Maybe, but surely not at the levels they got. See the terms of MGIC's convertible offering from April 1.

So I'd guess that they would be solvent, but it would be close. Damn close.

Would a government bailout be just too expensive, even for the Treasury? I don't think so. I think the Treasury could just directly guarantee their debt, (see Chrysler) which would have limited direct costs to the Treasury. Or they could simply have FHA buy a chunk of bad loans from the GSEs. There are several ways to work a bailout of the GSEs. I believe very strongly that tax payers are married to the GSEs, for better or worse.

Did Freddie Mac move their ABS portfolio into Level 3 because they didn't like the bid indications they were using for valuation? The company says no. Here is the quote from their earnings conference call:

Q: (From Paul Miller of FBR) ... There is a headline out there, talking about Freddie Mac Level 3 assets of $157 billion and I don't see that in any of your releases. I was just wondering is that true... and is that related at all to the markups of the trading securities...?

A: (Buddy Piszel, CFO) No, it is not Paul. We made a determination in the first quarter, that given how widely the pricing we were getting on the ABS portfolio, that it no longer made sense to leave that in Level 2.... We were still using the mean price that we were getting from the pricing services and the dealers. So we are not using a model price.... It has nothing to do with the trading portfolio.

So if you believe what he's saying, that means that the actual valuation would be the same either way. By moving to Level 3, they are saying they no longer believe the valuations represent "observable inputs."

What about mortgage insurers? Freddie has as presentation on this from March. I think the way to think about GSEs and MI is similar to a municipal bond portfolio and the monoline insurers. Losses will be a function of both the MI going down and the actual borrower going down. Plus the GSE would have a claim on the MI in run-off. On the other hand, MI exposure is substantial and should any of them go bankrupt (a strong possibility) it absolutely could result in considerably higher losses at the GSEs.

Finally, what's the "end game" here? Here is what I think we know. We know that new business written by the GSEs can be profitable, if loss rates on 2008 vintage loans are even close to historic norms. We also know that the real cash losses on the GSE portfolios are just beginning. Freddie Mac predicts their credit loss rate will double by 2009. The good news is that they've reserved for that. The bad news is that there are a hell of a lot of variables to those loss numbers.

So whether or not the GSEs can remain in business (without help) comes down to credit losses and access to financial markets. If the GSEs can keep raising new capital, there won't need to be any bailout orchestrated by the Treasury. I think that's the best tax payers can hope for.

How Safe are the GSE's?

Freddie Mac's earnings release from last week created quite a buzz. It was initially viewed as an unmitigated positive, but upon further review, we all realized Freddie's accounting is too opaque to draw any reasonable conclusions.

I do feel that there have been some mischaracterizations of reality around the blogosphere, and I thought Accrued Interest could help shed a little light on the situation. So here is a little Q&A on what this development really means to real investors.

Q: Freddie Mac is actually insolvent, right? I heard they had negative net worth.

A: If you define insolvency as negative net worth on paper, then yes. I don't know to whom such a calculation is relevant. Its a quirky statistic that is emblematic of their recent woes. But it isn't relevant to investment valuation.

Q: But if they are insolvent, that would mean the tax payers might have to bail them out!

A: Tax payers will have to bail out the GSE's if it comes to that. I have no doubt about that. But it only will come to that if the GSE's cannot fulfill their function as liquidity providers to mortgage originators. Right now that isn't a problem, despite the negative net worth.

One could argue that the GSE's are only able to fulfill that liquidity function because of implicit government support. I think that's probably true. But if you believe that, then it wouldn't matter how much money the GSE's lost as long as the market believed in their government support.

Q: Freddie Mac's senior debt rating is still AAA, which is about as much bullshit as Ambac. How can these guys keep losing money quarter after quarter and retain that rating?

Actually, through the miracle of subordination, debt holders are probably relatively safe, even without government support. To be sure, there is no way either GSE would earn a AAA rating without the implied government support. But consider the debt/asset situation at Freddie Mac:

Total Assets: $786 billion (eliminating their deferred tax asset)
Total Senior Debt: $755 billion
Total Sub/Preferred Equity: $19 billion

So in order for senior liabilities to be greater than assets, the asset pool would have to decline by about 4%. Freddie Mac's credit loss was at a 12bps rate in Q1 and their forecast is 18bps in 2008 and 20-25bps in 2009. Take the company's estimates with whatever brand of Kosher Salt you like, but consider the odds of them being wrong by a factor of 16. (See note at the end of this post)

Q: You just want to be lied to, don't you? How can you trust any of their asset valuations anyway? I heard its all Level 3 assets!

A: They have $157 billion in Level 3 assets.

Q: Every one on my message board knows that Level 3 assets are toxic waste. That would more than make up your 4%!

A: First of all, the concept of Level 1, 2, and 3 assets stems from FAS 157, which is summarized here for those who like primary sources. The idea was to categorize the means by which assets have been valued by management. Level 3 assets are those that have been priced using "unobservable" inputs.

Q: Aha! Unobservable means mark-to-make-believe!

A: Part of requiring the Level 3 disclosure was to allow investors to consider how much they want to trust asset valuations based on models, especially in a market like this. So if you want to discount the valuation of Level 3 assets, the new disclosure allows you to do so.

Q: OK, so how much should I discount the assets? 100% or just 80%?

A: Unfortunately, there is some debate as to what constitutes an unobservable input. In Freddie Mac's case, they had classically valued their ABS portfolio by getting dealer quotes, and therefore believed that suggested a Level 2 designation. However given the wide variance in dealer quotes, Freddie decided to move the assets to Level 3. I'd think of it this way: if the model inputs being used by dealers were "observable either directly or indirectly" (Level 2) it stands to reason that the various dealers would have similar observations, and thus similar prices. Since they didn't have similar prices, you have to conclude the model inputs are not readily observable.

Q: Sounds like you are leaning toward 100%.

A: The reality of the bond world isn't that simple. The fact is that the overwhelming majority of fixed income instruments rarely trade. Therefore almost all bonds held on any company's balance sheet are valued by a model. For that matter, bonds that are held in your run-of-the-mill investment-grade mutual fund are similarly valued by model. One could make a case that a very wide swath of bonds are valued with "unobservable" inputs.

For example, there are 1,082 tax-exempt municipals bonds rated below investment-grade by Moody's. Of these, only 307 have traded any time this year. Now I grant that there is some correlation among junk-rated muni spreads, but how comfortable would you feel about the valuation of some struggling nursing home deal in Wisconsin by examining the trading level of a convention center in Texas? According to the FASB "Adjustments to Level 2 inputs that are asset specific... might render the measurement a Level 3 measurement." Sounds like the valuation of rarely traded municipals would fall into Level 3.

Q: But Freddie Mac is getting their quotes from dealers! And Freddie Mac is one of the 5 or so best accounts to have as a bond salesman. The dealer firm is obviously biased.

A: Granted. But what's the alternative? You are talking about positions for which there is no trading market. The best you can do is ask someone what they might pay for it, and value it that way. Its biased, but the alternative would be for Freddie Mac to create their own model. Can you imagine the outrage on the interweb if that's how they valued their positions?

Besides, I'd bet that Freddie Mac thought that getting quotes from dealers was the only way to avoid Level 3 designation. Asking for a theoretical bid from a dealer could reasonably be considered an "observable input" thus allowing a Level 2 categorization. Only when it became obvious that the dealer community had no idea what to bid did Freddie move the assets to Level 3 designation.

Q: So when the dealer quotes were too low, Freddie changed their methodology! Its Enron all over again!

A: Actually Freddie Mac didn't change their methodology, merely moved their ABS portfolio into Level 3. They always valued their positions with dealer quotes. You are better off not obsessing over the Level 3 assets themselves, but rather the fact that no one seems to know what Freddie's assets are actually worth.

Q: I still don't trust their accounting.

A: Neither do I. Its clear that derivative accounting according to GAAP doesn't reflect the reality of Fannie Mae or Freddie Mac's business. My best guess is that Freddie's recent figures were aided in a non-economic way by accounting practices. But who knows? I really don't feel like I have a good handle on it.

And guess what? I'd feel exactly the same way if they had zero Level 3 assets.

So what's the point here? Any financial firm involved in fixed income securities and related derivatives is likely to have significant Level 3 assets. Reflexively assuming this means the firm is involved in shady securities is lazy analysis. The hysteria over Freddie's Level 3 assets is misplaced. Thoughtful analysis as to why Freddie Mac felt compelled to move their assets into Level 3 is what's needed. Its a little spooky to consider that Freddie Mac can't get a good value on their securities, that their dealer evaluations varied so much. That's the more important point in analyzing Freddie's balance sheet.

Note
This calculation as presented here is not entirely accurate, primarily because I erroneously equated the credit loss percentage as if it were a percentage of assets, but in fact it is a percentage of Freddie Mac's guarantee portfolio. That's what I get for trying to put together a back-of-the-envelope example, but there is no excuse for publishing something like this.

I probably shouldn't have included the example at all, as it was a very simplistic calculation, and honestly, it probably took away from my bigger point that FRE and FNM's accounting is a mystery. I mean, I tried to argue the opacity of their books, then I used their books to make a point.

On top of that, I quoted their credit loss percentage of their guarantee portfolio vs. their asset base, which was totally wrong on my part. My idea was to value the company's debt from an asset liquidation perspective but the introduction of the credit loss percentage wasn't the right metric.

The more accurate way to look at it is that the company expects $3.1 billion in credit losses in 2008 vs. the gap between assets and debt of $31 billion. So if you imagine credit losses as requiring cash to flow out the door, we'd need 10x the 2008 credit loss level (with no positive cash flow in the interim) for the debt/asset ratio to fall below 1.

Now that could be coupled with losses in their investment portfolio. That's an area that's difficult to forecast, because I just don't know whether they've properly written down their assets or not.

You know better than to trust a strange statistic!

Stock futures got a little bump, and bond prices took a dive, immediately after Friday's better-than-expected housing start number. Things reversed themselves later in the day, but still, the initial reaction was that number was good news. I don't get it. The housing start statistic really tells us nothing about how close we are to the end of the housing slide.

Let's think about the progression of a housing recovery. We know prices can't start climbing again until there is more demand than there is inventory at a given price point. Right now its is clear that supply and demand are not balanced and therefore prices must keep falling. Normally we might assume that either supply or demand could change in order to resolve the imbalance. But given the exceptionally tight lending standards in the residential mortgage market, demand will be capped for some time to come. So the solution has to come from supply.

Marginal supply is coming from two primary places. First is foreclosures. Second is new home construction. We know that foreclosures are increasing, and anecdotal evidence suggests that servicers are so busy that they aren't able to keep pace with foreclosures they "should be" doing. So foreclosures aren't about to bottom. Government intervention could have a huge impact on foreclosures, and I don't want to get into a debate on the wisdom of intervention. Suffice to say that the impact of any intervention may be many months away.

So in order to see a decline in housing supply we need new home construction to slow to a crawl. So to me, higher housing starts numbers are disappointing. The news that much of today's jump in starts is related to multi-family projects is more encouraging. Yes, I know that will be a drag on GDP growth, but the sooner we clear out the excess housing supply, the sooner we can get to a more normal housing market. That's sure worth a couple ticks on GDP.

The question now is, where are we in the inventory reduction process? The Census Bureau reports that new home inventory has fallen from 570,000 units at its peak to 460,000 units now. FTN economist Chris Low estimates that inventories have to get to 305,000 before we bottom out. The less building, the faster we get there, but still to drop another 155,000 units from inventories will take at least a year. Probably more like two.

We might be near a bottom in terms of the direct drag on GDP from residential construction. Residential investment's share of GDP peaked at 6.3% and has fallen to 3.8% in Q1. The all time low in this figure was 3.2% in 1982. We certainly could set a new bottom in this cycle, but it won't go to zero. So we probably only have 1% or so of a continued drag from residential construction left. That's all well and good, but I think we'd all agree that's a small part of the story. The bigger story is about the indirect effects on consumer spending. But this direct effect is the only element of the bust that housing starts is any indicator. Pay housing starts no mind.

Your overconfidence is your weakness

Apparently everything is doing just swimmingly. So much so that the Fed is going to hike rates later this year. Check out Fed Fund implied rates for the October meeting...



And for December...

So by December the odds of any rate cut are near zero, and there is a 60% chance of some kind of rate hike. Don't buy it. Instead buy the 2-year. Look, I think I'm a relatively optimistic guy, but the housing bust will take time to work through. In the mean time, consumer spending will be pinched and that will ultimately prove disinflationary. I know I got a violent reaction in the comments to yesterday's post on this subject, but I just can't buy that the money supply is expanding with banks universally pulling back on credit.

Meanwhile agricultural commodities continue to fall, which really belies the "oil is up because of the dollar" argument. Here is the chart...

While agriculture is still way up for the last 12-months and therefore should continue to pressure retail food prices for a while, this trend is a net positive for inflation expectations.

Anyway, former credit market pariah iStar Financial is coming with a new unsecured bond deal today. About a 30bps new issue concession, which isn't too bad all things considered. Swap spreads are crashing in, with 2-year swaps falling 6bps in the last 2 days, and hitting its lowest level since 4/7.

I continue to trade my personal money from the short side in stocks, if anyone cares.

These aren't the prices you're looking for...

Inflation has become a dominant theme in investment markets recently. There is considerable debate over what measure of inflation is the best one. My fellow blogger Barry Ritholtz has derisively referred to "Core" figures as "inflation minus inflation" in the past.

But if you thinking as an investor, and are reading this site looking for trading ideas, the answer to the inflation debate is obvious. Inflation is what the Fed thinks it is. Period.

What do I mean? First of all, think about why you care about inflation, again thinking solely in terms of trading strategies. You care because inflation influences monetary policy and interest rates. You care because higher inflation will cause the Fed to hike rates, causing a myriad of ripple effects throughout the economy.

Thinking in those terms, its clear that the measure of inflation you should care most about is the same measure the Fed cares most about. Currently that is Core PCE. Some other measures are gaining popularity within the Fed, including the Median CPI, calculated by the Cleveland Fed and the Trimmed Mean PCE, calculated by the Dallas Fed. Both the Cleveland Fed President Sandra Pianalto and Dallas Fed President Richard Fisher are currently voting members of the FOMC. So if they care, you should care.

But what about rapidly rising food and energy costs? As far as the Fed is concerned, those cost increases results in an increase in the cost of living, but not inflation in the monetary sense. Remember that the Fed is in charge of the money supply. The theory goes that if every consumer suddenly had more money to spend (because the money supply increased) and the supply of goods were held constant, the price of all goods would have to increase.

Thinking about inflation in those terms, Core-style measures make sense. Trimmed Mean and Median make even more sense. Because you are trying to measure a generalized movement in prices, not movements that are the result of specific supply and demand factors for a given good. A perfect example is the effect of ethanol requirements on food prices. Clearly ethanol is crowding out other food production, creating upward pressure on food prices. And yet this effect has nothing to do with the money supply and therefore isn't the Fed's problem.

Express all the outrage you want over the rising cost of living. As long as the Fed doesn't think its their problem, it isn't going to influence their decisions. If it doesn't influence their decisions, should it influence your trading? No.

The Fed will continue to be more concerned with the current recession and less concerned with inflation. Fed economists realize that its difficult to get rising inflation without rising wages. Its simple supply and demand. If consumers don't have more money to spend, they can't bid up the price of goods. Its simple math. Hence as long as wage growth remains tepid we can conclude that food and energy price increases have to do with supply and demand in those markets and not generalized inflation.

What about the dollar? I believe a depreciation of the dollar can be a symptom of inflation. Obviously a dollar that buys fewer goods is the very definition of inflation. But the trading value of the dollar is influenced by various things, most notably interest rate differentials. Interest rates are low in the U.S. and high in Europe. Dollar gets weaker. Through in the account deficits and you have plenty of reasons for dollar weakness. Besides, whatever happens with the dollar, we still need consumer spending to increase in nominal terms to make the basic math of inflation work.

What about M1? M2? or M3? Economists have soured on these measures in recent years as changes in banking as well as foreign holdings of cash have rendered simple measures of the money supply invalid. But I'll indulge those who hang on to the classics. Let's assume the Fed prints $10,000 in new cash for every man, woman, and child in the U.S. and just gives it away. But all that cash just gets stuffed under citizen's mattresses and never sees the light of day. Do we have any inflation? Granted, this is a silly example, but it drives home the point: if consumers don't spend, we don't have any inflation. And consumers won't increase their spending unless they are seeing an increase in wages.

And we know the trend in wages: down. While job losses to date have been relatively minor, negative job growth is negative job growth. Besides that, the historical trend has been for job losses to continue even after the recession is over. I haven't even mentioned home prices yet, which are destroying wealth and will continue to hamper spending. Consumers are going to remain pinched for the next 1-2 years, perhaps longer. Its just not too likely generalized inflation will accelerate given this backdrop.

Am I dismissing food and energy price increases as meaningless? No, just saying that rising prices in those markets don't have anything to do with money, and therefore won't influence the Fed's decisions. Want to do something about energy costs? Buy a hybrid car. Want to do something about food prices? Write your congressman. The Fed ain't going to help.

Freddie Mac and CPI: You've had a busy day!

Treasury bonds got hit hard yesterday after retail sales posted a decent gain. I continue to be confounded by the recent spate of non-recessionary economic figures. But with housing showing no signs of bottoming in the near term, I'm sticking with a recessionary view.

This morning Freddie Mac reported a loss that was less than expected. I plan to post more on this as I read more detail. I really want to understand how Fannie Mae posts such a bad number yet Freddie manages to post a more mild loss. In other words, either Fannie is really doing something wrong or Freddie's numbers aren't all they seem to be. The stock was up 8% overseas. I'm going to try to hear the conference call today and will post what I think. Please post your comments.

Offsetting this was a slightly better than expected CPI number (Core 0.1% vs. exp. of 0.2%). Treasuries had been down 1/2 point before the number and are now flat. Technicals remain crappy for intermediate bonds so I'm cautious. On the upside (in yield), I think the next technical level on 10's should be at 4.05, although 4% might wind up being a psychological level and thus producing some resistance there. On the downside, as proven in recent days, we can easily slide into the 3.70's on a short-term move. I feel like we have some gaps to fill between 3.88 and 3.95%.

Meanwhile the BBA has "put LIBOR under review" and will announce any changes on May 30. People I've talked to think more New York banks will be added to the US $ survey, which I'd think would cause LIBOR to post a bit lower. Anyway, angst over LIBOR continues, and is pressuring swap spreads. 2-year spreads moved almost 4bps wider yesterday and are another 1.5bps wider today.

When we heard about Alderaan...

Yesterday's market sell off walked and talked a little like the fear trading that dominated the first quarter of 2008. Particularly the sudden drop in the stock market around 2:30 with no real explanation looked a little spooky. Recent market rallies in both stocks and credit have been 100% about a modest decline in risk aversion. The belief was that the worst case scenario had been taken off the table, so while the real economy isn't good, the panicky market gyrations were no longer justified. Could that improved sentiment reverse? Was yesterday the start of something bad?

Well, we speak bonds here, and there are some interesting, and maybe telling, indicators from the bond markets. First, CDS moved significantly wider yesterday. The CDX.IG.10 index (which is a basket of investment-grade CDS) moved 10bps wider, the biggest single day widening since April 8. I haven't seen the final CDX number, but should be 1-2bps wider today. That would mark the fourth day in a row in which the IG index moved wider. I'd characterize a single-day move of 10bps as pretty extreme, although during the January-March period, there were several 20bps single-day moves.

Brokerage credits, which were at the epicentre of the fear trades, were also wider on Wednesday. Lehman +5, Merrill +6, Morgan Stanley +3 and Goldman +7. Broker paper was largely unchanged today. Here is were the movement didn't look much like the pre-Bear Stearns world, with brokerage paper outperforming the market generally.

Cash bonds, which you may remember are those things with coupons and maturities that people used to trade in the olden days, were little changed. Lehman's new senior 10-year note was bid as tight as +275 and as wide as +290 on Tuesday, but settled in at +285 and was stuck there through Wednesday and Thursday. When you see cash bonds unchanged and CDS wider, its most likely that fast money is pushing the market. Real money tends to buy cash bonds, fast money tends to play in derivatives. That seems especially true given that the CDX indices underperformed typically high beta individual names.

Meanwhile, non-credit spreads were well-behaved. Interest rate swap spreads were tighter, with both the 2 and 10-year spread moving about 1.5bps tighter, and followed through today moving another 3bps tighter. Fannie Mae senior debt spreads, which had moved about 6bps wider on Tuesday after their ugly earnings report, moved 3bps tigher on Wednesday and another 3bps tighter on Tuesday.

So what's the conclusion? The Fed really changed the game when they bailed out Bear Stearns and opened their balance sheet up to the remaining investment banks. The "run on the bank" scenario has been rendered impossible. So a return to the fear trading of January-March wouldn't make a lot of sense.

A better explanation is that the market is struggling to price a world where liquidity is improving but real economics are deteriorating. It felt to me like the market, especially stocks, had become a bit too optimistic in recent days, with some even talking like we won't have any recession at all.

Don't confuse economic data that's "better than expected" with "good." Now if you ask me where the stock and credit markets will be in a year, I'd say both will be better than today. Looking one year out, we'll probably be through this recession, housing will have bottomed, and there will be much more earnings clarity. But in the near term, I think we need a little more of a recession concession.

Clumsy and Random Thoughts

I wish I had time to write extended and thoughtful pieces on each of these thoughts. And hey, if my ad revenue increases by a mere factor of 50 I can probably quit my job and just write all the time!

• It seems increasingly obvious that Bank of America is buying Countrywide for reasons beyond normal economics (which is what I had thought when it was announced). I suspect that CFC has significant liabilities to BAC which makes the de facto price BAC is paying less than the $7/share. Of course, that doesn't explain why they don't try to negotiate something lower now. Anyway, I'm really pissed off about Bank of America's claim of "no assurance" about Countrywide's debt. I'm not a holder of anything related to either company, so its really nothing to me. But its total bullshit that Bank of America could gain the economic benefit of owning Countrywide without the economic risk. This is exactly like the SIV mentality. Just keep Countrywide as a off-balance sheet, highly leveraged mortgage play! When has a plan like that gone wrong?
• I think the markets are too optimistic right now. We've seen very few economic reports which indicate actual strength. Most have indicated things are better than expected. And look, that's fine. We've gone from deep recession with a banking crisis to a mild recession with banks successfully raising capital. Great. But I don't buy why the S&P will keep moving higher without economic reports which are actually good. Same goes for Treasuries, especially 5 years and in. I think they are oversold. For what its worth, I personally bought some S&P puts near the close yesterday.
• Credit is tougher because its coming off such a huge trough. So I don't feel like getting short credit even though I acknowledge that should the S&P pull back 5% or so that spreads will almost have to widen. I just think the fundamentals behind credit are too good to fool around with short-term technicals. I feel like you run a serious risk of getting your fingers blown off.
• On Treasuries: one problem is that technicals are pretty bad. There might be psychological support around 4% on 10's, but its broken decisively through the 120 MA after bouncing a couple times off the 3.87 level. I saw 3.90% as significant resistance, but its trying to break that today as well. Then I don't see anything between here and 4.07%. Plus you have plain old supply coming, with a 10-year auction today. So I think the play in the short-term is a bear steepener, but that's purely on technicals.
• No one really knows why Fannie Mae rallied on ugly earnings. The most logical answer is OFHEO's annoucement that they'd be lifting some capital restrictions, which should make FNM more profitable in the future. It fits with the fact that Fannie Mae debt spreads widened modestly from about +55 on 10-year senior bonds to about +60. I think you can't discount short covering as part of the problem. We might be in a place where shorting mortgage-exposed companies just ain't going to work.
• UBS is exiting the muni business, and are looking to sell the unit. They were the #3 underwriter, so it would have to be someone quite large to buy the business. Let's see, who among the large dealers doesn't have much in munis? I know! Bear Stear--... Er... Actually I don't know who the hell will buy UBS' muni unit. If they do want to make a move they need to do it fast. Otherwise rivals will start picking off the best muni bankers one by one until finally there is nothing left of the unit worth buying. One reader and I had a off-line chat about this and he suggested that there could be a re-regionalization movement in municipals. In other words, a movement away from consolidation in New York and toward mid-sized dealers gaining more power in that market. Lately spreads (meaning commission spreads) have been wider, especially in secondary trading. If that keeps up, look for regional brokerages to benefit.
• I'm watching the MCDX closely. I think if the 5-year hits 50 or so, its a screaming sell.

MCDX: Once munis start down the dark path...

From the people who brought you the ABX, now comes the MCDX, a basket of municipal credit default swaps (CDS). The index will begin trading on May 6 with three, five, and ten year tenors. Markit set the coupon for the MCDX last Thursday night at 35, 35, and 40bps respectively. It started trading today, and traded wider, closing at 42bps for the 5yr tenor and 48bps for the 10-year.

This is a potential game changer in the municipal market. First, we'll go over what the MCDX is, and then how it might change municipals forever.

The MCDX is going to be very similar to the CDX or ABX indices currently trading. It will represent a basket of 50 equally weighted municipal CDS. You can see the list of credits here. These will be recognized by municipal traders as more or less the 50 largest regular issuers of bonds. There are a few AAA credits in there, but mostly AA and A-rated credits. If rated on Moody's Global Scale, the one where Moody's attempts to match muni ratings with corporate ratings, almost all of these issues would be AAA.

There are 26 "general obligation" issuers. These issuers have the legal authority to levy taxes and have pledged their full taxing power to bond holders. 21 of these are states, the other 5 are local municipalities: New York, Los Angeles, Los Angeles School District, Phoenix, and Clark County Nevada.

There are also 24 "revenue" issuers, who don't have any taxing power. The items in the MCDX are of the "essential service" variety, including water and sewer systems, public power, and transportation. The term "essential service" implies that while the issuer does not have taxing power, the local government would have a strong incentive to ensure continued operation. Tobacco and health care issuers are explicitly excluded from the index.

Here is how the index works. A buyer of protection on the MCDX has essentially bought equal amounts of protection on the 50 names in the index. So a $10 million notional trade in the MCDX is de facto $200,000 in protection on each of the 50 names. Should any of the names default, the buyer of protection would deliver an eligible obligation of the issuer to the seller of protection at par. Markit has provided a list of CUSIPs as examples of eligible obligations. Any bond which is pari passu with the listed CUSIP would be eligible.

So why should you care? To date, trading in municipal CDS has been very light, and with good reason. Default rates of general obligation and essential service municipals are almost non-existent. There is a limited number of large and frequent issuers outside of these two categories. So demand from hedgers for specific names is light. There might be demand from speculators who want to bet on the contagion hitting munis. But such a buyer would prefer to make a generalized bet on municipal credit as opposed to picking out individual credits.

The MCDX solves both these problems. Trading desks who want to hedge against municipal credit spreads generally widening can use the basket as a on-going hedge. It wouldn't really matter if the particular names in the index don't match the names the desk owns, since the hedge is really a macro/contagion position. If California runs into major budget problems, odds are that New York CDS would widen at the same time. Obviously this is a better product for a speculator who wants to bet on a broad municipal contagion. So the MCDX is bound to be a hell of a lot more liquid than the single name market ever was.

The implications for the muni market are huge. First of all, it would seem the MCDX will more or less dictate the price of muni bond insurance. It will also heavily influence the spread between insured and uninsured munis. I've heard some talk that such a product would be another nail in the muni insurance coffin, but not so fast. The muni market will remain retail driven, and mom-and-pop investors don't buy CDS. They will still demand insurance.

The MCDX will also heavily influence how munis trade on a given day, especially in institutional size. If dealer desks start using the MCDX to hedge their books, then the daily movement in the index will become part of their P&L. In other sectors, when traders hedges are up, they are a little more willing to cut the price on their long position. The same will happen in munis. If the MCDX is 3bps wider on the day, traders will be willing to sell their bonds 3bps wider too. Well, maybe 2bps anyway. Traders aren't generous people.

It could also start to chip away at some of the old habits of muni buyers. Today municipals are traded mostly on yield. Even if the Treasury bond market is mildly up on the day, muni traders usually don't mark their positions higher. If the MCDX becomes heavily used as a hedging vehicle, traders will want to quote their offerings in terms of their hedges. Thus you are likely to see offering levels altered more often, and possibly even starting to be quoted on spread.

Right off the bat, it almost has to widen. There are going to be more natural buyers of protection (anyone who has a large muni portfolio) than sellers (speculators). So I wouldn't read too much into the movement of the first month of trading. Given that the natural sellers of the MCDX are probably mostly hedge funds and prop desks, I expect municipals to be permanently more correlated with corporate bonds.

All participants in the muni market should become familiar with the MCDX, even if you have no intention of actually trading it. Like the CDX and the ABX before, it has strong potential to alter the market substantially.

Corporate Spreads: You truly belong here among the clouds

My last post created a fair amount of e-mail response (for some reason not much in the comments), but one Anonymous poster did some work based on Moody's data from 1960, and came up with +140 as a "fair value" CDS level. Obviously that's wildly different from my +34 number. For those who didn't read my post, I wasn't claiming that +34 was the right level for corporate bonds, merely that an anticipated increase in defaults due to the current recession doesn't really suggest much widening in investment-grade.

Now I know AI's readers love to dive deep into the data, so here is Moody's default rates from 1960-2006.

The tiny blue lines are actual investment-grade defaults. That never gets above 0.51%. I've only included that because if I didn't, someone would ask. The relevant number for IG investors is the "All-Rated" number, which is in red. See, if you buy an investment-grade bond, odds are good that it would get downgraded to junk before it actually defaults. So looking at IG defaults only sort of hides the reality. The All-Rated number basically shows you defaults as a percentage of all bonds. Now that probably overstated IG defaults, but better to be conservative in a study like this.

Anyway, I've highlights three spikes: 1970, 1990, and 2001. This supports the idea that defaults tend to be centered around periods of poor economics. Not surprising.

My analysis was based on a 4.6% 10-year cumulative default rate. This is based on the default rate for bonds which were rated Baa at the beginning of any 10-year period within Moody's study period. Given that none of the actual spikes in my graphic are over 4.6% (and that the graphic includes all bonds), I think my spike analysis is valid. Its at least a fair illustration.

So anyway, I've asked the Anonymous poster to elaborate on his study, because it sounds like he's done some good work, and yet come to a conclusion that's radically different from mine.

If anyone would like an Excel copy of Moody's 2006 default study, e-mail me. accruedint *at* gmail.com.

What are corporate bonds worth in a recession?

Corporate bonds just finished one of their best months in recent history. Coming off the historic wide spread levels of March, investment-grade corporate bonds tightened by 38bps during April, according to Lehman Brothers, outperforming Treasury bonds by 245bps. That's the best monthly performance for corporate bonds since 1988.

And yet its widely acknowledged that the real economy is quite weak, and corporate defaults will invariably rise as the economy falls into recession. So how can corporate bonds tighten given the economic backdrop?


The short answer is that there is one price for corporate bonds under a liquidity crisis and another under a bad economy. So we're transitioning from the former to the later.

See, the reality is that for investment-grade corporate bonds, liquidity matters much more than run-of-the-mill economics. To see what I mean, consider this simple valuation model for a generic Baa-rate corporate bond.

According to Moody's, the average 10-year cumulative default rate for a Baa-rated issue is 4.6%. In other words, buy a random portfolio of Baa-rated bonds and hold them blindly for 10-years, you'd expect 4.6% to default. The average recovery rate given default for unsecured bonds is 38%. So over 10-years, you'd expect 4.6% of your Baa bonds to default, giving you expected credit losses of 2.85% (4.6% defaults times 62% loss given default).

If default risk were evenly distributed over time, one would have an expected credit loss of 0.285% per year for 10-years. This implies that if corporate bonds were to pay a mere 28.5bps above the risk-free rate, that would, exactly compensate an investor for default risk. Of course, we know that corporate bonds don't trade anywhere near that level, but hold that thought for now. We'll get back to that.

In reality, defaults do not occur evenly over time, but are more likely during period of weak economics. So let's say that the 4.6% default rate is the right cumulative number, but that all those defaults happen in a single year. In other words, over our 10-year horizon, one of those years is a recession, and all the defaults happen in that one year. We could then do a simple discounting calculation to figure the NPV of the expected loss.

We assume that for every $100 par, the investor will suffer $2.85 in credit losses in the recession year. Let's further assume that under normal circumstances, investors assume that there will be a recession at some point during the 10-year horizon, but are unsure as to when it might occur, and therefore assume it will happen in the 5th year. Using the current 10-year swap rate (4.48%) as the base rate, the portfolio of corporate bonds would have to pay a spread of 27bps above the base rate to compensate for credit losses in the 5th year.

Here is my math, in case you want to check it.



Now let's assume that the recession happens in the first year. If the losses are accelerated into the first year, the required spread rises. But only by 7bps. The required spread goes from 27bps to 34bps.
I know, I know. You are getting ready to fire off a nasty comment, claiming some kind of witchcraft over these numbers. OK, think about it logically. Investment-grade companies typically have reasonable balance sheets and relatively stable business models. Otherwise they wouldn't be investment-grade. Take companies like Comcast or Kraft or FedEx. All Baa-rated. Have the odds of these companies going bankrupt really increased by a large degree just because we've entered a recession?

Of course, 34bps isn't even in the ballpark of where corporate bonds have historically traded, even in good times. That's because in real life, investors demand a spread that compensates them for expected credit losses and the uncertainty surrounding credit losses. In a recession, its that uncertainty that rises. So realistically, the spread should change by more than just 7bps as we enter recession.


But don't kid yourself about how high spreads should be just because GDP growth is weak. According to Lehman Brothers, the average investment grade bond spread is now 218bps, 50bps tighter than the all-time wides hit on March 17.

But spreads are still 115bps above their long-term average. Despite how far corporate bonds have come, there is plenty of room to move tighter. Plenty.

But spreads are still 115bps above their long-term average.

Despite how far corporate bonds have come, there is plenty of room to move tighter. Plenty.

After the number: Strong am I with the Force, but not that strong

So much for my morning prediction. There is extensive commentary on the street that says this number isn't strong by any means. The manufacturing report also showed a lot of inventory building and was positively impacted by higher oil prices. So none of these reports are good. I think the flattish stock market now makes more sense than how we opened.

What I said in April still stands. I think employment is the most over-rated statistic as far as making investment decisions.

That being said, if job losses putz around at -75,000 for a few months and then recover, that would be a very mild recession. I think the recovery will be tepid, slowed by both Fed hikes and consumer weakness. Consumers are going to have to spend a long time repairing their balance sheets.

So the bottom line is that I'm willing to add duration in spread product at higher rate levels. I'm starting to sour on the steepener trade, and will move to a flattener outright if we keep seeing better economic numbers.

Ahead of Non-Farm Payrolls

I'm feeling a bit bullish on rates ahead of payrolls today. The markets feel a little too sanguine about the recession we're current in, and so I think a NFP number that's even in-line with the forecast (-75k) will cause rates to rally a bit. I expect a steepener.

The ADP report actually showed a gain of 10,000 jobs on Wednesday, which I don't give much credence. BUT... if it were to be that NFP came out with a similar number, then it means I'm wrong about a significant recession. If that happens, I'm backing way off on duration, and would expect a big flattener. Call it a 2% probability event, but an event I'm ready to act on if it happens.

Meanwhile there is a story out there that Bank of America might not back Countrywide's debt post merger. Not sure how that could work legally, but CFC CDS is about 40bps wider (from a 170 to 210 on the offer side). Looks like their cash bonds are 1 point lower across the board.

Buying in corporate bonds has been very impressive the last 2 days. On the 30th, I kind of dismissed it as just month-end buying, but it seemed to continue yesterday. We saw bigger days as the real meltdown was fading, in mid March and early April. But this week hasn't given us any real news, and still demand is strong. Its a good sign. LIBOR and swap spreads have been drifting lower as well. More detailed commentary after the number...