GE Capital and Credit Default Swaps: The Jump to Hyperspace

Some of the discussion on yesterday's post regarding GE Capital turned to the problem of credit default swaps. Back in October, I outlined some of the major problems as well as the potential solutions to the CDS problem. You can read that piece here if you'd like, but otherwise here is a quick summary of the problems:

1. CDS aren't really that liquid. In order for any market to be liquid, there needs to be a large numbers of buyers and sellers. In the old days, the big dealers were always willing to write CDS to their customers because the risk was easily passed off in some other manner. Either sell it to AIG (snicker) or put it into a synthetic CDO or some such. Today dealers aren't making a market the way they used to. They have their own credit problems to work out and aren't willing to leverage their balance sheet on this kind of trade.
2. Thus when an event leads investors to grow concerned about a company, everyone wants to buy CDS protection at once. Yet who is willing to sell? Goldman? Morgan Stanley? There aren't a lot of players left. And let me tell you something. If Goldman is willing to sell you the CDS, it won't be 10bps back. It will be 10 points back.
3. The problem becomes that much bigger with a name like GE Capital, which is so widely held. Goldman might be willing to quote you CDS on $10 million of some off-the-run name at a stupid price, but when the whole investing world wants protection on GE at once, its another story. No one has the balance sheet to accommodate the demand.
4. Exacerbating this problem is that bonds aren't easy to short. As a result, firms that write CDS are almost always writing naked.
5. Putting all this together, CDS are infinitely more manipulable than stocks. If I can't see where something is trading and at what volume, only that the quoted price is 10 points wider, my only conclusion is that the credit is cratering.

Many of these problems could be solved with exchange-traded CDS. This would open up the writing of CDS to a much wider audience. If it were done with regulated margin requirements, with the exchange acting as universal counter-party, there would be far less contagion risk related to a failed counter-party.

General Electric: Kobayashi Maru

Credit default swaps on GE Capital traded as wide as 20 points up front area this morning. For some color on what this means, in the days following Lehman's collapse, Goldman Sachs never traded this wide and Morgan Stanley might have ticked this wide, but only for a day or two.

In my opinion there are a number of things coming together to create this problem, beyond the obvious that GE was highly exposed to various areas of the economy now weakening. First, GE may have had a legitimate AAA-rated business model if one assumed that access to short-term financing was always and everywhere a given. Now that's obviously not the case. You simply can't make the case for any firm being rating AAA who needs constant access to short-term markets. That's even forgetting all about GE's exposures. So GE will be downgraded from AAA, its only a question of when and by how much.

On top of that, there are thousands of investors who bought GE securities over the years with the attitude that "hey, its AAA! What's the risk?" Some of those buyers had dumped the bonds over the course of the last year as it became increasingly obvious that GE would be impacted by the financial crisis. Bill Gross was saying as much on CNBC this morning. These buyers include everyone from big foreign investors to little retail accounts. And why can't I shake the feeling that it also includes Mr. Gross himself?

And remember that a lot of the same people got burned with AIG, which was also AAA-rated just a few years ago.

GE Capital's business model can be boiled down to this: every risk has a price, and we'll price every risk. Note that this was basically the same business model AIG was running. Maybe GE is running it better, but its the same idea. And that's not to say that GE is going to have the same fate as AIG. But consider the conundrum: GE has huge de facto leverage which it needs to reduce. But it cannot sell enough assets at today's distressed prices to actually reduce leverage. You'd like to think that if the assets are good, GE can just let time and normal cash flow solve their problem.

But that isn't a realistic option. First, if ratings agencies downgrade GE Capital enough they'll have to post additional collateral against existing contracts, and that's exactly what the proximate cause of AIG's collapse. Second, GE Capital really can't operate with less than a AA rating or so. The funding costs would be too high. Maybe they could get away with A, but certainly not BBB. But under current circumstances, I really think BBB is the right rating. Again, you'd like to think GE Capital could go into quasi-run off and eventually regain a decent credit rating, but I just don't think market conditions allow for that sort of slow transition.

This is also why I doubt they could do a spin-off of GE Capital. If GE combined is looking at a A-level rating, GE Capital alone would either get a much lower rating, or GE Inc. would have to pledge even more cash to GE Capital in the spin-off. On top of all that, from a shareholder perspective, if you believe in GE Capital long-term, why sell now when valuation is going to be at a minimum?

These kinds of no-win scenarios are an unfortunate consequence of current economic conditions. Firms need to rejigger their leverage and asset mix, but the problem is so universal that no one has the cash to transact. Then you have companies who probably could have survived had they been granted the luxury of time, but no such luxury is available.

What would really help GECC is for the TALF to be expanded such that GECC could unload assets at decent valuations into the secondary market. Or else the Aggregator Bank helps them out. Otherwise its difficult to see what good options GE has.

CDS could be fair and simple

On Friday, Jim Cramer lamented that a fair credit-default swap clearinghouse will be difficult to implement. But I'd argue that a simplified version of CDS could be easily created and listed on existing exchanges. (Click here for the basics of how CDS work...)

The first thing that's needed is homogenization. Currently CDS are liquid so long as there remains 5-years to termination. But as soon as a contract rolls to "off the run" liquidity disappears. That's a major reason why CDS contracts have ballooned to over $60 trillion in notional outstanding. No one actually terminates the contracts, they just buy offsetting contracts.

In addition, CDS are currently struck with various initial spreads. So one person might own Morgan Stanley CDS with a deal spread of 100bps, and someone else with 200bps, and another at 300bps. This also lends itself to illiquidity and poor price transparency.

Then there is the problem of defaults. When an issue defaults, the buyer of protection may deliver a bond to the seller of protection in exchange for par. Except when there are large-scale defaults, like in the case of Lehman or the GSEs, actual delivery of bonds is impractical. So they hold an auction to determine a theoretical value for all outstanding bonds, and that amount of cash is exchanged between sellers and buyers of CDS protection. The problem is that whole process creates a huge degree of uncertainty, and only lends to the feeling that CDS are too easily gamed.

But CDS wouldn't be hard to boil down to a very basic tradable contract. First you set all contracts with a 5% coupon paid quarterly. Second, the contracts have 5-year maturities, with new contracts created each year. Third, in the event of default, the seller of the contract pays the buyer 60 cents on the dollar. No actual bonds change hands. That's it.

The contract would trade based on the present value of the 5% coupons vs. the expected default probability of the referenced company. This may result in either the buyer or seller of protection making an initial cash payment to the other party. For those familiar with the vulgarities of CDS, it would be similar to how up-front contracts work now, except that it could cut both ways.

For example, take a relatively low risk company, say Johnson & Johnson. Let's say that you estimate the proper default spread given J&J's default risk is 0.6%. Since the contract stipulates a 5% annualized payment, the recipient of the 5% coupon (seller of protection)must make an initial payment to the buyer of protection. The opposite would be true for higher-risk companies, like General Motors or MBIA.

Perhaps the best part of this is that a simplier product could be more widely adopted. Sellers of protection would have a defined set of gain/loss scenarios if held to maturity. Currently CDS trade only among large institutions, but wider distribution would certainly improve liquidity and price transparency.

And contracts of this sort could be implemented by exchanges tomorrow. And we wouldn't need some massive new regulatory scheme for CDS. Just simplify the contracts and put it all on an exchange, and all kinds of problems just float away.

Now yes, we want to start winding down the massive number of CDS contracts outstanding, if for no other reason than to eliminate the systemic risk. That's easy enough. Tell banks that any non-exchange traded CDS contract has an additional risk weighting to account for counter-party risk. Banks will immediately start pairing off their CDS exposure and looking to replace it in the exchange-traded market. That would go a very long way to reducing current CDS notional outstanding in a very short period of time.

It can be done. Let's see if anyone actually wants to solve this problem or not.

Stock shorting isn't the problem. CDS are.

There has been much hubbub over the SEC's new naked short-selling rules. Now, I've got no problem with enforcing some basic short-selling rules, but it won't make a difference until something changes in the credit-default swap (CDS) market.

Let's stipulate that speculation and manipulation is part of the problem here. Let's stipulate that John Mack is right and that if Morgan Stanley were to go down, it would be solely because of short-selling.

To make that claim, you have to assume that pressure from short-sellers is feeding upon itself. That Morgan's falling stock price is creating panic, bringing out more sellers and causing more panic. But if you really want to create panic, the CDS market is a better choice. In stocks, you can always offer a stock below the current price, and that may spook people. But the CDS market is traded over the counter. The trading volumes are unknown. Bid and offer sizes are unknown. In such an environment, anyone can throw any bid or offer out there and move the market.

In addition, buyers and sellers need to be matched in this market. In a time when there are few sellers of protection (the seller is effectively long a credit), eager buyers of protection can move the CDS market wider extremely rapidly. The general lack of knowledge about the CDS market doesn't help either. Media reports suggesting that a particular "expected" default rate is predicted by a certain CDS trading level shows a complete misunderstanding of the CDS market.

What could be done? The first step would be to move CDS trading to an exchange. This would allow for more disclosure and less mystery. It would also reduce all the country-party confusion that has surrounded AIG and Lehman and eliminate the need for novation.

Second, make the CDS contracts more standardized. Currently many CDS players don't actually close out their contracts, but rather buy off setting contracts. As a result, any given contract becomes less liquid than it really should be, which makes price discovery all the more difficult.

Another step would be for market makers in CDS to increase the margin requirements on CDS trades. Margin requirements on CDS are set by individual investment banks, but there is no reason why there couldn't be a coordinated effort on this. Increasing collateral requirements would force protection buyers to be more judicious about which names they short. By the way, having an exchange would make monitoring collateral requirements much easier.

There may be other solutions to the CDS problem, some of which will take time. But the steps I've outlined could get done quickly. And they need to be.

MCDX: We had better start the evacuation

A few months ago I heralded the MCDX as a potential game changer in the muni market. I'm afraid its failed to live up to its potential, and arbitragers are likely to step in and push it into oblivion.

For those who did not read the original article, the MCDX is credit default swap (CDS) index of 50 municipal credits. By buying (or selling) the index, you are in effect buying (or selling) equal portions of 50 different protection contracts. If one of the credits within the MCDX defaults, the buyer of protection delivers a qualified obligation of the defaulted credit to the seller of protection. In return the seller of protection pays 100% of the face value. The par amount of the bond delivered is equal to 1/50th of the original notional amount.

The current 5-year MCDX spread is 86.25bps. This means that in order to buy $10 million in default protection against the 50 names in the MCDX, investors make the equivalent of $86,250 in annual payments, assuming a new contract were created today.

Historically, defaults on municipal credits have been very rare, particularly in comparison to corporate credits. According to Moody's, there was only 1 default of a "general obligation" (GO) municipal (meaning a state or local government with taxing authority) from 1970 to 2006, and that default was cured in 15 days. Among investment-grade, non-GO municipal bonds, only 0.29% defaulted within 10-years of issuance, according to Moody's. This compares with 2.09% of investment-grade corporate bonds.

However, the weak economy generally, and declining property tax collections specifically, could result in unusual pressure on municipal credits. Yet, the particular credits within the MCDX are among the safest in the market. Property taxes are usually collected by states, but distributed primarily to cities, counties and school districts. While other revenue sources, from income and sales taxes to toll collections are likely to be impacted by the current economy, those revenues are likely to follow a more typical recessionary pattern, which municipalities have weathered in the past. The MCDX includes only 4 cities (New York, Los Angeles, Phoenix, and Columbus, OH), one county (Clark County, NV), and one school district (Los Angeles).

So perhaps municipal default rates will rise in the future. But wouldn't we expect corporate default rates to rise as well? Compare the MCDX with the CDX IG, an index of 125 investment-grade corporate credits. The CDX IG closed on Wednesday at a spread of 144bps.

Using standard recovery assumptions for both indices (80% for munis, 40% for corporates), one can calculate the expected default rate based on each index's current spread. The graph below shows the cumulative expected default rate based on current spreads for both indices.

As you can see, the MCDX is trading at levels that imply nearly 20% of the municipals in the index will default within 5 years. Again, it seems likely that municipal credits will be more stressed than in years past, but given that the credits within the index are only mildly exposed to property taxes, a 20% default rate seems unlikely.

In addition, because of the stronger recovery expected in municipals, the current spread levels imply greater default levels for municipals than investment-grade corporate bonds. This is tough to imagine. We know consumers will be pinched, but given a choice between paying their taxes (and avoiding jail) versus buying goods from corporate America, I think its obvious which way people will go.

So why not sell protection on the MCDX versus a half as large long protection position in the CDX IG? The trade would be slightly positive carry, and your only bet would be that losses among the 50 municipals are less than half of the 125 corporates in the CDX IG. Or if recovery is similar to historic norms, then merely that municipal defaults will be about the same as corporate defaults. Whatever your view of the economy, this should be a relatively easy trade.

I think at some point, arbitragers will put this trade on, and it will expose a lack of deep liquidity in the contract. Talking to various traders, it looks like much of the trading in the MCDX has been macro hedgers, not betting on munis in particular, but using municipals as a means of hedging against a disaster event. But at current levels, the hedge is too expensive, and given a little positive momentum, it will be exposed as such.

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.

And 15 once we reach Alderaan...

Today Ambac is out with news that they too have reached an agreement to terminate a CDS contract with Citigroup. The CDS had $1.4 billion notional and was settled for a payment of $850 million. On Monday, Security Capital reached a similar agreement with Merrill Lynch on 8 CDS, canceling $3.7 billion in CDS for a payment of $500 million.

Remember that a CDS is nothing more than an exchange of risk. One party agrees to pay a periodic fee, while the other party agrees to make up any lost cash flow on a referenced security.
So let's say you enter into a plain vanilla CDS contract referencing Kraft. Let's say its $10 million notional and the deal spread is 76bps (about what Kraft is right now.) Now let's say that the spread on Kraft CDS widens to 100bps. Your contract at 76bps has some positive cash value (about $110,000 on $10 million notional), because of the movement in spreads.

Why? Because you currently own protection on Kraft and only have to pay $19,000/quarter for that protection (76bps * 10 million / 4). Anyone who wants to buy protection now has to pay $25,000/quarter (100bps *10 million /4). Through the magic of Bloomberg, we can calculate what your contract is worth: about $110,000. This means that someone would be willing to pay up front $110,000 to "buy" your lower protection payments.

Now let's say Ambac was the counter-party on your Kraft CDS, and Ambac wants out of the trade. Maybe you are happy to monetize your profits so when they offer you $110,000 you agree.

The media headlines would say that Ambac had exited their $10 million in Kraft risk in exchange for a payment of $110,000.

Now let's look at the deal cut by SCA and Merrill Lynch. Since CDS on the ABS CDOs in question don't trade regularly, we can't tell what the "fair value" actually is. Safe to say that the deal between SCA and Merrill was in part a distressed exchange. If we look at the AAA tranches of the ABX index, the prices range from $88 to $44. It is my contention that ABS CDOs, even if they include large non-RMBS exposure, can't possibly be worth more than the ABX, assuming we're controlling for vintage.

We know that SCA paid Merrill approximately 13.5% of the CDS notional value. That'd imply a dollar price on the CDOs of $86.5. Its not quite that simple, but its close. Anyway, if the price range of the ABX is $88 to $44, the right value of these CDO positions is no better than $60. Probably more like $30. So you'd say that Merrill's acceptance of $500 million is anywhere from 1/3 to 1/5 of what they'd have received from a well capitalized counter-party. Admittedly, I'm completely wagging these numbers, but it's safe to say this was a distressed exchange.

Update on USA CDS

I've gotten many e-mails about CDS on the United States. I was able to find a Bloomberg ticker for the figure most often quoted (the 10-year): CT786916. Use the Currency key to bring it up. Not much history but you can at least follow it from here on in.

Anyway, heard the spread widened 2bps today to 22bps. That's not on Bloomberg yet.

This morning showed some real panic trading, with broker CDS 30bps wider across the board (not just Lehman this time!) But are now mostly unchanged. CNBC is lapping up this "change" in short-selling rules, but I think its just a wildly oversold market in both stocks and credit, especially in CDS, which have been leading the charge.

Now don't go accusing me of calling a Bottom (tm) here, but I do think there is a strong possibility of a relief rally after bank earnings. I'm staying short in duration.

Maybe it's another drill

This is the first time in my career that I truly believe U.S. Treasury bonds sold off on credit concern. By this I mean, the credit of the U.S. Government. Long time readers know I'm not an alarmist type, and I'm sure not saying the United States is going belly up, but credit default swaps on the United States of America moved 11bps wider today (from 9bps to 20bps). The 10-year Treasury moved 15bps higher. All on a day when people are scared shitless and there should have been strong demand for "risk-free" assets.

Draw your own conclusions. I've drawn mine.

Sir, monolines coming into our sector!

It hasn't been a great year for monolines, and Pershing Square Capital's Bill Ackman has been one of the main beneficiaries. He's famously made a kings ransom shorting MBIA, betting that losses on collateralized debt obligations and other asset-backed securities would eventually drive MBIA bankrupt.

But now he's set his sights on far more conservative Financial Security Assurance (FSA). As FSA is wholy owned by European banking giant Dexia, there is no stock to short. Instead Ackman has bought credit default swap (CDS) protection against FSA defaulting on its insurance obligations. Currently FSA is rated AAA/Aaa/AAA by S&P, Moody's, and Fitch respectively with a stable outlook by all three.

Ackman's revealed his position at a conference in New York on June 18. The market paid attention. The next day CDS on FSA had moved 200bps wider to 700bps/year for protection. It rallied into the 400bps area two days later when Dexia extended a $5 billion credit line to FSA, but has since moved back into the 700 area. For context, this morning Lehman Brothers CDS was +280 offer, Washington Mutual was +585. To get into the 700 area you have to look at names like National City.

Does FSA belong in the same category as Ambac and MBIA? I'm going to explore this in two parts, first on the liability side, then on the asset side. Here are the raw facts on insurance liabilities.

The following chart details the direct residential mortgage (RMBS) exposure from MBIA and Ambac (blue bars) and FSA (red bar). Each is expressed as a percentage of the firm's total claims paying resources. So for example, Ambac has exposure to home equity lines of credit at 216%, which means that if their entire HELOC exposure went to zero, the firm would exhaust their claims paying resources two times over. The figures are from S&P and the companies themselves.



So looking at this, FSA is no better than its more troubled competitors. However, when it comes to direct RMBS exposure, the story isn't quite as dire as it would initially seem. The monolines' generally insured senior positions in RMBS deals, meaning that other securities would absorb losses first. For example, FSA states that their typical subprime RMBS transaction has 20% subordination and 7% excess spread, or excess interest collected by the trust for benefit of senior bond holders. In their first quarter earnings release, FSA estimated that more than 45% of all subprime borrowers would have to default (in a given deal) in order for FSA to pay a single dollar in claims.

Will any transaction suffer 45% defaults? Some probably will, but all of them won't. And the second lien transactions (both closed-end and HELOCs) will likely enjoy no recovery upon default, so those loss severities will be worse. On the other hand, the monolines have the luxury of making payments on RMBS losses over time, i.e., there is no large principal payment which would come due all at once. So RMBS losses will be substantial to be sure, but its probably manageable. But that's not where the really big problem is.

The big problem is in collateralized debt obligations (CDOs).

The key to the CDO creation game was to create the maximum return to the equity holder while still earning a AAA rating for the senior-most holder. In creating CDOs using RMBS as collateral, the arranger generally used subordinated securities. And by subordinated, I mean the first ones to take losses when the underlying borrowers default. Today it is widely assumed that most subordinated sub-prime securities won't receive any principal at all, and many subordinated prime RMBS will suffer significant impairments. So a CDO made up of these subordinate securities, even the senior-most piece of the CDO, is likely to incur large losses.

Which brings us to our second chart, RMBS CDO exposure, again as a percentage of claims-paying resources.



The reality is that most of these RMBS-oriented CDOs are going to take losses of 30% or more. CDOs alone will likely sap the resources of Ambac and MBIA. But FSA's exposure to this sector is nominal. Even if they were to take 100% losses on their RMBS CDO portfolio, the impact on their solvency will be minor.

Remember that FSA is a subsidiary of Dexia, and therefore Ackman's bet isn't on the common stock. In the case of MBIA, Ackman was able to short the common. Even if MBIA is somehow able to pull through as a solvent company, Ackman's gains on shorting the stock will still be substantial. With FSA, he's long CDS protection, which only pay off in the event of a default, so Ackman's bet is not on a decline in profitability or loss of AAA ratings, but on bankruptcy. In fact, FSA could lose its AAA ratings and Dexia could give up on the financial guaranty business and put FSA into run-off, and as long as FSA never runs out of cash, Ackman's CDS will expire worthless. Sure, Ackman could gain on CDS widening. Maybe he's already cashed in his gains on FSA. But given the already wide spread on FSA CDS, if FSA doesn't have liquidity problems, it will be an expensive short.

The facts on the insured side just don't support FSA going the way of MBIA or Ambac, particularly when you limit the discussion purely to solvency. Next up, a look at FSA's investment portfolio. (Hint, that doesn't look as rosy.)

I'll come right back and give you a hand!

Bill Ackman has gone long FSA CDS, in effect betting that FSA will go bankrupt. Its moved 200bps wider today (now 645/695). I want to write a detailed post comparing FSA, Ambac, and MBIA, so that's coming. But in the mean time, does anyone have anything more detailed on Ackman's case against FSA? If so, e-mail me: accruedint at gmail.com.

Ackman was obviously right about MBIA, but I have long contended that he's been getting too much credit for calling MBIA early. Some readers may remember he was short MBIA at Gotham Partners going all the way back to 2002, before MBIA was heavily involved in the shit that ultimately dragged them down. Don't get me wrong, kudos for him for all the money he's made on MBIA. I just bristle when I hear something like "he's been right about MBIA since 2002." His thesis from 2002 was wrong. His thesis in 2007 was dead on.

In other news, I've been contemplating some upgrades to the site, one of which would be to start using labels. Vote in the latest poll if this interests you.

How are bonds quoted?

By popular demand, welcome to yet another installment of Accrued Interest's How To series. This is on the subject of how bonds and various bond instruments are quoted. We'll go from the simple to the complicated, and even include a few derivative products. I know we get some readers who are primarily equity people, but lately have been trying to pay more attention to the bond market.

The Very Basics
Bonds pay interest based on a par amount. For example, if the coupon is 5%, it pays that 5% based on the par amount of the bond. The par amount is also the amount that the bond will pay at maturity. You could think of it as the principal of the bond.

When a bond is quoted in a dollar price, that price is a percentage of par. So a bond price of $104.312 is really 104.312% of the par amount.

Treasury Bonds
Unlike every where else in the world, the U.S. Treasury market still trades in fractions. It is assumed you know this when the bond is quoted, so you'll see it written as something like this...

98-4

That means that the bond's price is 98 and 4/32's, or 98.125% of par. Sometimes there is also a + added to the end. The + is worth 1/64. So if the price is 98-4+, that's 98 and 4.5/32. If you watch Bloomberg you may see yet more fractions thrown in there too. If you saw 98-4 1/8, that would be 98 and 4.125/32. In bond parlance, 1/32 is a "tick."

Treasury bills are quoted on a discount basis. I'm not going to get into this in deep detail, suffice to say that it isn't the same as a yield, but its usually in the ball park of the yield.

For the most part, TIPS and Agency MBS are also quoted in this manner.

Other bonds, when quoted in dollar price, are in fractions, but other than municipals and high-yield bonds, most other bonds are quoted in spread.

Bond Spreads
Plain vanilla agency and investment-grade corporate bonds typically are quoted on spread. Most commonly they are quoted based on the yield differential between the bond in question and the nearest benchmark Treasury in basis points. A "Benchmark" Treasury is the most recently auctioned Treasury of a certain maturity. Currently there are 2, 5, 10, and 30-year "benchmarks."

It is usually assumed you know what the benchmark is for a bond, but its not always obvious. For example, the HSBC 5.25 of 4/15 (That's an HSBC bond with a 5.25% coupon, maturing in April 2015), is generally quoted off the 10-year Treasury, not off the 5-year. Why? Who knows? The street tends to like to make bonds look tighter, and since the 10-year currently yields more than the 5-year, they tend to like to keep stuff against the 10-year as it ages.

Floating rate bonds trade on what's called a "discount margin" or the spread to the bond's floating index. If the index is 3-month LIBOR, the bond will be quoted on a spread to 3-month LIBOR. When calculating the dollar price, it is assumed that LIBOR resets at its current rate at next reset and then remains there for life.

Some fixed-rate bonds trade on a spread to "swaps." This can be indicated as N+(number) or S+(number) depending on what it is. CMBS usually trade this way. The "swap" rate is the rate on the fixed-leg of a plain-vanilla interest rate swap. Bloomberg calculates an interpolated swaps curve and this is what's usually used for pricing bonds. Bloomberg pretty much rules the bond world, in case you haven't noticed.

By the way, swap "spreads" are the difference between the swap rate and the corresponding Treasury rate. Since interest rate swaps almost always have some highly-rated financial institution as the counter-party, the swap spread rate is a good gauge of perceived credit risk of very highly-rated banks.

Municipals are usually just quoted in dollar price or yield. If you do see a spread, its probably versus the Municipal Market Data curve, or MMD. This curve only updates at the end of every day. Muni guys aren't the quickest of people...

MBS and TBA
Agency mortgage-backed bonds sometimes trade on a "To Be Announced" basis or TBA. Remember that MBS are backed by actual loans made to actual home owners. So its common that a lender would like to lock in the rate they can offer borrowers by pre-selling their loans to investors. Hence the TBA market.

Since most fixed-rate MBS are eligible for TBA delivery, bids and offers on specific pools trade on a spread versus TBA. For example a "seasoned" pool (or one that is older) might be more valued by the market than generic pools, and therefore more expensive. The spread is expressed not in yield but in dollar price difference, usually in ticks. So a seasoned pool might be +8 to TBA, or 8/32 more in dollar price than the generics.

Hybrid-ARM MBS trade on a Z-spread basis. This is a spread to the interpolated spot curve as calculated by Bloomberg. When calculating this it is assumed the bond will pay 15 CPR until the reset date, no matter what the coupon or structure. Its kind of stupid but that's what's done.

Callable Bonds
Bonds with call features, most common with munis and agencies, are often just quoted with a yield instead of a spread. The yield quoted is the lower of the yield to maturity or yield to call, called yield to worst.

Sometimes agencies are quoted on an OAS or AOAS basis. OAS stands for "option-adjusted spread." On most callable bonds, the OAS is calculated against the LIBOR curve, but it could be calculated against anything. Common buyers of callable agencies include many yield-sensitive buyers, i.e., people who don't care about spreads, only about straight yield. Banks and credit unions are great examples. Hence callable agencies are more often just quoted on yield than other bonds.

Agencies which are callable on a single day only are quoted on an AOAS basis. Suffice to say this is an OAS curve based on Bloomberg's calculation of the agency curve itself.

Credit Default Swaps
CDS are quoted one of two ways: either as a spread or as "points up front." I won't go into the nitty gritty of CDS here. (I wrote more extensively about how CDS work here). Suffice to say that the buyer of a CDS is buying insurance against default. That buyer typically pays a percentage of the notional amount protected, which is the spread quoted. So if Lehman Brothers is quoted as 260, that means to buy protection on $1 million, you must pay $26,000 to the seller of protection each year. The payments are actually transmitted quarterly.

High yield bonds often trade as points up front. To buy protection on Ambac, for example, you have to pay 30 percentage points up front and 500bps per year. The quote would only reference the points up front, the 500bps is a given. The points paid up front is akin to the discount a cash bond would be trading at given a 5% coupon.

Unless otherwise stated, CDS quotes are for a 5-year term.

Hope that helps. If anyone has any other types of bonds that I haven't thought of, please post a comment or e-mail me accruedint at gmail.com.

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.