Investigation is implied in our mandate

In the post from Thursday, I argued that the current recession is the result of classic over investment, in this case in housing. This brings up the very important question of why we had an over investment in housing. (I'm posting a new poll on this subject, but first, you read.)

The potential suspects I'm going to consider are: the GSEs, the Fed's low interest rate policy in 2002-2003, and the rise of structured finance, especially CDOs.

First, one suspect I'm immediately tossing out. Lack of government regulation on lending. There is a perfectly legitimate argument that regulation was too lax. But I'd rather investigate why banks were so willing to underwrite so many sketchy mortgages. Because if there was some perverse incentive to lend money recklessly, then no regulatory scheme would have prevented it. Had mortgage regulations been more stringent, the lending would have flowed someplace else anyway.

GSEs
Blaming the GSEs is complicated, because the GSEs have been around a very long time. It is undeniably true that without the GSEs there wouldn't have been as much supply of available funds for loans. But in my opinion, the GSEs incremental impact on loanable funds didn't wildly change from 2001-2007. In fact, the evidence is that the GSE's market share declined during this period, as other types of securitization gained in popularity. More on that later.

1% Fed Funds in 2003
This is a popular argument, that ultra low rates lead to ultra easy liquidity. Plus ultra low government bond yields lead investors to aggressively seek out higher yielding investments.

There is something to this, but to me it doesn't explain why availability of mortgage capital actually accelerated in 2004-2006 as interest rates were rising.

Structured Finance
I argued, over a year ago, that CDOs were the primary culprit in causing the sub-prime problem. Consider: why were mortgage brokers willing to underwrite every loan they saw? Because they knew they could sell the loan. Who was the buyer? Structured finance.

On the lower end of the credit spectrum, structured finance created the leverage. On the top end of the credit spectrum, banks levered their positions through SIVs. All that liquidity flowed right into mortgages, and thus into houses.

Now, you could argue that 1% Fed Funds helped to create demand for structured finance. Sure. There is plenty of inter-related issues here. But in my opinion, without CDOs, the Fed's interest rate policies wouldn't have caused the housing bubble we're seeing now. I'd also argue that low volatility, not low interest rates, were the primary reason why structured finance flourished. The Fed can't really be blamed for creating a low volatility environment, after all, that's their job.

If readers have other potential suspects, go ahead and post a comment.

Ambac: Perhaps she could still be of some use to us

Hot on the heals of Security Capital's agreement with Merrill Lynch to unwind 8 credit-default swaps (CDS), Ambac and Citigroup have reached a similar agreement. The arrangement has Ambac paying Citigroup $850 million to terminate approximately $1.4 billion of a CDS referencing an so-called CDO-squared transaction.

Collateralized Debt Obligations (CDO) with asset-backed securities (ABS) as collateral, a category which includes CDO-squareds, are the primary problem facing monoline insurers. While the monolines face losses beyond their initial expectations on a variety of structured finance transactions, monolines senior position in these transactions are limiting actual losses. ABS CDOs were creating using mezzanine ABS securities, many of which are already suffering massive losses.

These agreements to terminate CDS are a major positive for the monoline insurers, at least in terms of solvency. It turns an unknown into a known. Ambac's loss on the CDS in question was an unknown. Some even believed Ambac would take a total loss on the transaction. Now their loss position is known: $850 million. That's the end of it.

Beyond that is the fact that Ambac had actually written the position down by $1 billion. So the company will be booking a $150 million gain. This proves, with an actual trade, that in at least one case Ambac was being conservative in its valuation of liabilities. While not proving anything per se, its fair to interpret this as a significant positive in terms of Ambac's future mark-to-market losses.

Finanally, this should improve the capital situation at Ambac Assurance. Not only will the company record a $150 million gain, but it has eliminated a significant source of loss uncertainty.

This is all great news for municipal bond holders. If Ambac and other monolines can stabilize, even at non-AAA ratings, the market will once again see municipal insurance as having some positive value. Currently bonds insured by any of the downgraded insurers are trading as though the insurance has negative value. So any sort of stabilization would probably cause these bonds to appreciate in value.

However, I'm weary of the run-up in Ambac's stock price. The day of the announcement the stock had risen over 60% at one point, and closed Monday even higher. In order for common shareholders to get value out of Ambac, the company will have to resume writing policies. While they might be able to do reinsurance with a AA rating, the opportunities will be limited.

Could Ambac regain a AAA rating? Consider Moody's rationale for putting FSA and Assured Guaranty on negative watch, namely uncertainty surrounding the future of monoline insurance in general. So even if Ambac, or other insurers, could significantly improve their capital situation, unless it is clear to the ratings agencies that Ambac's franchise is in tact and they can resume writing new policies, they will not regain a top credit rating.

Merrill Lynch: We can pay you 2,000 now...

Merrill Lynch's surprise announcement on Monday that they were selling $31 billion (par) of ABS CDOs and raising $8.5 billion in common equity has financial CDS moving tighter. Credit default swaps (CDS) on Merrill are 80bps tighter since the news (from 350 to 270). Lehman Brothers is 50 bps tighter and Morgan Stanley is 30bps tighter. Merrill's cash bonds now about 35bps tighter over the last two days, with other broker bonds 2-10 tighter. The pattern of CDS being much more volatile than cash bonds has been common during the last year, as CDS tend to be the favored vehicle of fast money.

To understand why ABS CDOs which were originally super-senior could possibly be worth 22 cents on the dollar, read this post about the danger of "structure squared."

Monoline insurers are seeing an even bigger reaction. Along with the Merrill news, Security Capital (SCA) and erstwhile parent XL Capital agreed to further cut ties between the two companies. XL had previously agreed to reinsure and/or cover certain losses incurred by SCA. The two companies agreed to extinguish those agreements in exchange for $1.8 billion in cash transferred from XL to SCA. This effectively rescues SCA from likely insolvency. Separately, SCA and Merrill agreed to terminate $3.7 billion notional of CDS in exchange for $500 million in cash.

The CDS on insurance subsidiaries of all the monoline insurers are performing very well on this news. SCA CDS has fallen 10 points (equivalent to a 10% gain vs. par on a cash bond) from 33 points to 23 points. FGIC fell 6 points (to 43), MBIA fell 7.5 points (to 25), and Ambac fell 6 points (to 17).

Merrill Lynch will be providing 75% non-recourse funding to Lone Star (the buyer of the ABS CDOs). I think the correct way to interpret this is that Merrill has not shed itself of ultimate default risk. They have, however, shed themselves of mark-to-market risk. Further, some are saying that the financing indicates that the securities sold are really worth 5.5/cents vs. par (25% times the stated sale price of $22). I don't think that's the correct interpretation. The financing indicates retention of risk, not the ultimate trading value of the securities. Its common for dealers to fund client investments, and I don't think that should have a bearing on the valuation of the securities.

So what's the trade? Merrill had by far the largest exposure to ABS CDOs as well as monolines among big dealers. Citigroup was the other. Lehman, Morgan Stanley and Goldman Sachs have little to none. So the fact that Merrill Lynch has set a market for their ABS CDOs at 22 cents on the dollar matters more for Citigroup than any other big bank. ABS CDOs were also very popular among European banks.

In addition, CDS trading has been extremely volatile in recent months. Should this capital raise by Merrill touch off a short-covering rally in CDS, expect the rally in CDS to far outstrip any rally in cash bonds. Eventually cash bonds will be dragged along, as cheaper CDS protection eventually creates an arbitrage in cash bonds. Long-term buyers should watch the CDS market before putting money into cash bonds.

Finally the deal between SCA and Merrill Lynch may create a template for the workout of other CDS contracts on structured finance products. That may indeed be the glimmer of hope that some of the downgraded monolines have been looking for. The most impacted will be MBIA, which was Merrill Lynch's favored insurer. Don't get carried away with optimism here. I'd say that the odds of these companies surviving, as in, making it through run-off, have gone up slightly in the wake of this news. But I wouldn't say the stocks are worth much more.

Quick comment on Merrill Lynch's ABS CDO Sales

Here are some quick comments on Merrill Lynch's sale of ABS CDOs.

First, don't confuse ABS CDOs with other types of structured finance, or even other types of mortgage securities. ABS CDOs were truly the most toxic, most dangerous securities ever to carry the AAA rating. This post describes the problem of structure squared best. Its also explained here and here.

Second, I hate the phrase "worst is over." What does that even mean? If you sell a bond for 22% of par, by definition the worst is over. Its already lost 78 points, it can't lose another 78 points! So here we have CNBC claiming that traders are betting the "worst is over." Whatever.

What's really happening is that shorts in stocks and CDS got scared. Look, the odds are high that Merrill Lynch will still be around after this is all over. And we know that Merrill has a profitable brokerage business that is going to be worth a hell of a lot more than $20/share when this is all over. That goes doubly for a less impacted name like Bank of America, and even more so for the whole XLF index. That stuff isn't going to zero. So at some point, if you are short those names, you are going to want out. Given that real money is no where to be found, when the shorts want out, the market is going to move in a big way.

One of these short squeezes is going to mark an actual Bottom (tm). As AI readers know, I hate the sport of Bottom Calling, so I'm staying out of that fray. But a Bottom (tm) is coming someday.