Its against my programming to call bottoms

Friday's discussion on bearish market sentiment was really great. Thanks for all who commented.

Most of the comments seemed to focus on stock prices. As a bond pro, I spend my time thinking more about yield spreads, both in credit and other sectors. As discussed many times (many, many, many times), there were two elements causing spreads to widen: poor liquidity and weaker economics.

Liquidity has improved dramatically since the Bear Stearns bailout. The feeling is totally different than in some of the other false rallies (in credit) we've experienced since September. Previously, any hiccup would cause spreads to move drastically wider. There were times when we moved a bit tighter, then some writedown would be announced, and it would all go to hell again. It isn't as though we haven't had hiccups the last couple weeks. The 200 point sell-off on GE's earnings is an example (I wrote about this here). Or Wachovia's need for more cash. Or Bank of America's weak earnings report. Now these events are taken in stride. Spreads have moved wider on certain days, but its controlled, more reasonable. Not panicky. I won't say that spreads (especially in CDS) aren't still volatile. The massive amount of shorts in CDS that have been or are being covered is seeing to that.

Plus the correlation of spreads has broken down. Now it isn't necessarily true that agency debt, MBS, and credit all move the same direction on any given day. Hell municipals had become highly correlated with credit spreads. Now it seems that these spreads are moving on their own supply and demand conditions, not on liquidity fear.

So am I calling a bottom? Well, I don't really invest that way, so if I didn't have a blog, I wouldn't really think about a "bottom" very much. I try to stick to fundamentals and spend only a little time on technicals. Liquidity is part of any fundamental analysis of a bond, so indeed it became tough to value many different bonds in recent months. And deep fundamental investors tend to be a little early, seeing the fundamentals shift and/or pricing (un)attractive before the market actually shifts.

But yeah, if you stick a gun to my head, I'd say we've seen the wides in credit spreads. Not because the economic problems are solved, but because liquidity has improved to the point that people are willing to be opportunistic. That will put a lid on how far investment-grade names will move before yield hungry investors come in. Issuers will be able to come to market with new issues, and the wheels of the credit market will continue to churn.

Ultra-Bears: I take it back!

I have a question for the bearish readers of Accrued Interest. I've corresponded with many of you and have heard many well-reasoned arguments for a bearish future. And here I'm not talking about those who think the recent stock rally has gone a bit too far and are looking for a 2% pullback. No. I'm talking about those who think that stocks will be lower over the next 2 years, or even longer.

So here is food for discussion in the comment section. If you are this kind of bear, what would convince you that you are wrong? In other words, what evidence could reasonably appear which would convince you that your bearish stance won't work out?

I ask this out of selfish motivations. The ultra-bears have been right so far. I mean, I was dismissive of some of the worst case scenarios which people presented over the last year or so. But on the other hand, I do not believe that things are so bad that we won't get through it. And I also think that the financial markets will recover faster and ahead of the economy as a whole. So remaining short, or even on the sidelines, is a dangerous game right now. And I want to hear from intelligent people who have actual money they are using to bet against the U.S. recovering.

And I want to hear what would convince you to cover your short and potentially go the other way. Because that's the true sign of a well-thought out trade. Everyone always has a reason why they make the trade, but a good trader also has an exit plan in case s/he is wrong. Let's hear it.

Rise Lord LIBOR!!

When trying to gauge the market's generalized view of counter-party risk, swap spreads are a good place to start. This is the spread between Treasury securities and the fixed leg of a plain-vanilla interest rate swap. Since there is necessarily some bank or brokerage as the counter-party of such a swap, the spread is a good indication of counter-party risk.



So it comes as little surprise that swap spreads have been elevated in recent months. 2-year swap spreads averaged 40bps during the first half of 2007, recently spiked above 100bps just before the Bear Stearns collapse. Afterwards, it declined into a more stable trading range in the low 80's.



But in the last week, spreads appear to be spiking again, having risen 13bps in the last three trading days, from 83 to 96bps on Thursday, and briefly crossing +100bps. (On the chart, Libor is in orange and 2-year swaps in white).







Is it a return of the liquidity crunch? Its a bit of a conundrum, because most other indicators have been pointing the other way. The VIX has declined over 3 points in the this week. The CDX indices are significantly tighter: investment grade -19bps this week and high yield -56bps. Bank and brokerage CDS are also markedly tighter. Wachovia and Citigroup are both about 25bps tighter, Lehman, Merrill, and Morgan Stanley are all at least 30bps tighter.


Perhaps the answer lies in some wishful thinking on the part of European banks. According to the Wall Street Journal, official Libor fixings have not reflected the real cost of intra-bank borrowing. 3-month Libor, for example, was fixed at 2.73% on Wednesday, but I have been hearing actual bank lending is happening at levels more like 3%. This had lead some to question whether the banks that help set Libor are being entirely honest about the levels being supplied.

This morning, 3-month Libor was fixed at 2.91%, suggesting that maybe these banks are starting to fess up.

I'm not going to comment on potential manipulation, since I'm in no position to speculate on such a thing. But Libor has been rising lately. After falling to 2.54% on March 18, the same day the Fed cut its target rate by 75bps, Libor has steadily risen to this moring's level of 2.91%. That obviously has an impact on swap spreads.



Since 3-month Libor is the floating side of a plain-vanilla swap, and Libor has been rising, it follows that the fixed side must rise as well. That explains why swap spreads are moving. But its doesn't explain why Libor itself has been rising, especially if it really should be even higher. How to reconcile the lack of liquidity implied by rising Libor with otherwise tighter credit spreads?

I think this signals a shift in the credit cycle. Until now the focus has been primarily on structured products: SIV, CDO, ABS, etc. Those are primarily the domain of the large financial institutions. I.e., the names that trade in CDS routinely, that get reported on CNBC every day, and by the way, the same names that have been taking all the write downs. The Lehman's and Citi's and Merrill's.

Maybe tighter CDS spreads in these names is indicating that those institutions have taken (or reserved for) most of the losses they are likely to take. But what about smaller banks? The regional and local banks that may never have been involved in a CDO, but might also have a lot more risk in a single borrower or category of borrowers. Perhaps 2.90% is in the right ballpark for Lloyds Bank, who is part of the Libor survey, but not for the local bank in Norwich.

And what about Europe in general? Libor is set by a survey of 16 banks, only two of which are American. It has long been said that Libor is really a indication of where European banks can borrow in U.S. dollars. So rising Libor may say more about tight liquidity in Europe than in the U.S. A combination of tough liquidity in Europe and among smaller banks would explain the divergence between CDS spreads and Libor spreads.


To me, this sends two cautions. First, it should remind anyone who thinks the liquidity crunch is over, that it ain't. Liquidity does seem to be improving in the U.S. bond market, which is a very positive sign. So maybe the worst case scenario has been taken out. But this will be a long process.

Second, it should caution those who are short the dollar. If the next phase of the credit crunch hits Europe as hard as it hits the U.S., then we may see the Bank of England and the European Central Bank get more aggressive with rate cuts. Indeed today there are stories that the BoE is working on a plan to inject more liquidity into the banking system. That would ease pressure on the dollar. Given how popular short dollar trades have been, any reversal may be violent.

By the way... please vote in the new polls. I'm curious.

Wachovia vs. Retail Sales: FIGHT!

I haven't read enough on Wachovia to make a lucid commentary. I'll only say that I'm suspicious when a bank shows a relatively small loss, but decides to raise a very large amount of cash.

Anyway, Wachovia bonds opened up mildly wider, say 3bps, but wound up about 6bps tighter on the day. Now about 20bps tighter than 3/31.

Bank/broker stocks got hammered today on the theory that Wachovia's writedown portends ugly things for upcoming earnings. There might have been an element of concern that more banks would be issuing new common shares as well. I am 100% with this line of thinking. Banks and brokers are going to take a long time to rejigger the business model. Its possible that this quarter is the last of the big writedowns, but that we see mediocre earnings growth from here. Therefore in order to buy bank/brokerage stocks, the valuation really has to be right.

In the credit complex, the big names were mostly unchanged to slightly tighter. Lehman unchanged, Citi unchanged, Merrill unchanged. Actually Lehman and Merrill's subnotes were quoted 5bps tighter on the day. Just glancing at CDS runs, it looks like more names are wider than not, although all moves are pretty small.

MBS were wider by about 6bps as swaps were 5bps wider. That's an unusually large move for swaps by recent standards. I haven't found anyone who seems to have a compelling theory as to why. Smells like people altering their hedges for whatever reason.

Treasuries were weak too, and steepened by 3bps. I still like steepener trades. The Fed isn't going to be hiking for several months, and that should anchor the short end. But as the economy starts to bottom out, inflation will become the bigger concern, pushing longer rates higher. That ain't happening tomorrow, but it will happen.

General Electric: The Krayt Dragon Call

Today was a very unusual day, when contrasted against the rest of 2008. We saw stocks get hammered mostly on GE's earnings, but in the bond world, spread product did OK. I see the CDX.IG about 1bp wider, and the CDX.HY 3bps tighter. CDS on GE itself moved 9bps wider, with similar moves for the brokers.

Swap spreads were unchanged. MBS and agency debt both about 1bps wider.

The municipal curve flattened, 10-yr rates fell 7bps and 30-yr fell 9bps. That compares favorably to Treasuries which fell 7bps and 5bps respectively.

Anyway, this is all notable because for most of 2008, anytime there was bad economic news, spread product of all sorts got hammered. I did a quick look at the other days in 2008 when the Dow fell 200 points or more, and then looked at what happened to the CDX.HY.

Pre-Bear Stearns Day
1/2 Dow -221, CDX +15
1/4 Dow -256, CDX +27
1/8 Dow -238, CDX -1
1/11 Dow -245, CDX -5
1/15 Dow -277, CDX +8
1/17 Dow -307, CDX +14
2/5 Dow -370, CDX +31
2/29 Dow -316, CDX +22
3/6 Dow -215, CDX +24

Post-Bear Stearns Day

3/19 Dow -293, CDX -25
4/11 Dow -256, CDX -4

That makes +15 the median move on the CDX.HY given a 200 point drop in the Dow pre Bear Stearns. I'm pretty sure if we did the same exercise for more staid securities, like municipals or agency MBS, we'd see a similar pattern, where severe days in stocks almost always resulted in ugly days for spread bonds.

This seems to support the idea that the liquidity crisis is slowly lifting. It isn't over, mind you, but its on the right path. We're left with a real economy recession, and the markets need to work out what the right price should be for various risks in a world where liquidity is slowly improving but the real economy is declining.

Today's move looks like pricing a real economy recession, rather than a financial crisis. Not great news for the stock investors reading this blog, but relatively good news for those hoping to avoid another Great Depression.

Rescap: Why are you still here?

In the last couple days, two particularly troubled mortgage originators got some good news on the capital front. Yesterday, Washington Mutual announced they will receive a $7 billion cash infusion with private equity firm TPG as the lead investor. To put the size of the capital infusion in perspective, WaMu's market cap was only about $9 billion as of Friday.

Along with announcing the new cash, WaMu also announced they were increasing their loss provision to $3.5 billion and expect 1Q net charge-offs of approximately $1.4 billion. Note that as of 12/31, WaMu's loan loss provision was $1.5 billion. So they have in essence charged off their entire previous loan loss provision and on top of that, have found another $3.5 billion in expected losses. Is it just me or does something not ring true here? Do we really believe that WaMu only saw $1.5 billion in losses on their loan portfolio in December, but then suddenly see $3.5 billion now? If I recall, the outlook for home prices was pretty negative in December as well, so it seems curious that the bank would see such a surge in expected losses now but not then.

In other news, Residential Capital, of "Lost another loan to Ditech" fame, got help from erstwhile parent GMAC in retiring $1.2 billion of debt. It was a very unusual transaction, where GMAC apparently bought the debt in the open market, at approximately 50 cents on the dollar. GMAC then traded the newly purchased debt to Rescap in exchange for preferred shares paying 13%. Rescap then retired the debt.

Monday, as news of the WaMu infusion was reported, Washington Mutual bonds tightened 100bps. WaMu's 7.25% issue due in 2017 is now bid at 575bps over Treasuries, about 250bps tighter than its recent wides. Rescap saw their 6.125% notes due this November rise 9 points to $85.

Given the disconnect between their words (i.e., their previous loss reserve) and their actions (raising $7 billion in cash), I can't get involved in the bond or the stock. But as skeptical as I might be about Washington Mutual's mortgage loan portfolio, the fact is that WaMu has a viable retail banking franchise which, if they have enough capital to withstand the onslaught of mortgage-related losses, should allow the bank to survive.

Rescap, on the other hand, has an obsolete business model. Its a non-bank mortgage origination firm. Is that a viable business model going forward? I really don't think so. To see what I mean, consider the following analogy. Forget about the legacy losses on poorly underwritten loans during the bubble years. Imagine you have the opportunity to start a new company, and your two choices are a retail bank covering high-growth areas in the west and northwest. Or you could start a mortgage originator with effectively no access to bank-type liquidity. Its obvious which you'd choose. So for my money, even forgetting about the loan losses which will inevitably hit Rescap, there just is no light at the end of the tunnel for them. No franchise worth saving.

As far as I'm concerned, this $7 billion may well save Washington Mutual. But GMAC is just throwing good money after bad with Rescap. Investors should avoid Rescap bonds, and watch out for high-yield mutual funds with significant Rescap exposure.

What of reports of unemployment massing near Sullust?

The reality is we are almost certainly in a recession right now. Friday's employment figures join a long line of coincident indicators supporting that conclusion.

The question is, how much should we really care about coincident indicators at this point? Readers of Accrued Interest are mostly investors, trying to figure out what to buy and sell. We aren't economists at the NBER trying to date the business cycle. Economic releases that tell us about the current state of the economy just aren't very valuable for investors.

Take unemployment. The historic data supports unemployment as a lagging indicator, especially for recoveries. For recessions, it has historically been a coincident to lagging indicator. A quick look at the 2001 recession shows what I mean. The following graph shows unemployment (red) and the S&P 500 (blue) from October 1999 to December 2003.



First let's focus on unemployment. From October 1999 to December 2000, the unemployment rate was between 4.1 and 3.9 every month. No leading indication that the economy (or the market) was about to turn south. During the official recession, March-November 2001, unemployment moved from 4.3 to 5.5.

Even after the economy started to recover, employment kept getting worse. Unemployment didn't actually peak until June 2003 at 6.3%, two full years after the recession was over.

So what's my point? The utility of an economic indicator, as a trader, can come in two ways. Either the number has predictive value, or correctly predicting the number can indicate how to trade the market. In other words, either you can use the number as an input predict future events. Or you can try to predict the number itself and then trade the market accordingly.

The last point is what I call the Crystal Ball test. That is, if you could be given advance knowledge of an economic statistic, say 6-months out, would that knowledge give you a trading advantage?

The 2001 recession shows that unemployment fails this test. Notice the two red shaded areas. In both cases unemployment was stable, but the stock market was falling precipitously. Then in the green shaded area unemployment takes another leg higher, yet the stock market rallied sharply.

Conclusion? During the last recession, unemployment predicted nothing useful to investors. Even had you been given a crystal ball and knew for a fact what future unemployment figures would be, it still wouldn't have consistently indicated the right market trade. In fact it often would have given you the wrong indication.

Of course, there is no sense denying reality. The first Friday of each month, when employment statistics are released, has become a high volatility day. So its a fact that employment is a market mover in the short term. But I strongly caution investors against putting too much weight on rising unemployment. The market is always forward looking, and may already be looking past ugly employment numbers.

Through the Bloomberg, credit spreads you will see

Credit Market Resources for non-bond investors

I've received several e-mails in recent weeks asking how one can follow goings on in the credit market if one is not a bond trader. Its true that it can be very difficult to follow bond spreads if you aren't active in corporate bonds. Dealer firms are loathe to give out information to non-customers, even to customers of a different department. After all, information arbitrage is the name of their game.

Anyway, here is a good place to start.

The CDX Index
The best place to follow general corporate bond spreads is by watching the CDX indices. The CDX is actually a series of credit default swap baskets. The two most important ones (in my opinion) are called "IG" for investment-grade, and "HY" for high-yield.

The indices are coded as follows: CDX.NA.IG.10, which stands for the North America, Investment Grade, index, 10th series.

Other versions of CDX include XO (cross-over), HVOL (high volatility IG names), HY (high yield), BB (BB-rated high-yield), B (B-rated high-yield), and EM (emerging markets).

Accessing the CDX: Non-Bloomberg Edition
The CDX is calculated by Markit, and is available here. You can click through the name of each index for graph of each index. I like to watch the spread, as opposed to the price, since the spread can be tracked as the indices roll over (i.e., there is a new series created every 6-months), whereas the price cannot.

The rolling over makes, it can be hard to follow over longer periods of time. For reference, the CDX.IG.9 was +139 and the HY.9 was +671 at the end of March.

You can find the names within the index by clicking the index name, then clicking "Constituents."

Markit only updates this daily, and it very late in the day by the time they actually do the updating.

Accessing the CDX: Bloomberg Edition
On Bloomberg, type GCDS

On the top left (the first drop down) select "CDS Indexes."

In the second drop down, immediately to the right, will be dozens of options, including all the CDX versions. This will show where the CDS are for each of the constituents.

If you want to see the index itself, select "Region, Sector, Rating" in the first box, skip over to the third box, and go all the way down to #38 (you'll have to hit Page Down) "CDX Indices." That will give you the level on the index itself. On the far right, you'll see check boxes, which allows you to run the graph on as many or as few of the indices as you like.

Bloomberg does update this page intra-day.

By the way, GCDS is a great way to watch CDS levels on various bonds, but beware. Bloomberg isn't necessarily accurate down to the last 5bps on CDS levels, especially for fast-moving names. For bonds which are trading with points-up-front, forget it. Bloomberg doesn't seem to understand those bonds at all. But broadly speaking, it gets the direction right.

Hope this helps.

They're digging in the wrong place!

I'm shocked by the bond markets initial reaction to the non-farm payroll report. As I write this the 10-year is up about 1/8 and the 2-year is flat. I would have guessed the 10-year to jump 1/2 a point given the NFP result. I'd also have expected a steepener, not a flattener.

Meanwhile stock futures are holding in OK, mildly positive.

Personally I've always felt that NFP was an over-rated statistic. Job growth is a well-known lagging indicator, whereas investment markets tend to be forward indicators. So as an investor, you'd think the NFP number isn't very useful. Despite this, the market continues to put a high value on the release, so you're left with little choice but to follow it closely yourself.

The way I handle it is to ignore jobs figures when thinking about longer-term moves, but when timing your moves, you can't ignore the first Friday of the month.

Anyway, credit spreads continue to move tighter. The CDX was in 9bps over night. I suppose that's the bigger deal, and that's why the Treasury market isn't able to move higher, at least at the outset.

If Treasuries were to finish lower today, I think that would be a very bearish signal for rates.

What a strange person!

I'm getting some weird messages over my Bloomberg. There are words and phrases I cannot translate like, "I have buyers of corporate bonds" and "Broker paper on fire." What is this "rally" you speak of?

Don't get me wrong, one week does not a bottom make. But as evidenced by the relatively attractive terms Lehman was able to get on their convertible preferred, things do seem like they are thawing. There are real money buyers of credit starting to emerge.

Anyway, as much as I'd like to believe in a bottom in credits, we need to get through mid April with some strength. April is going to be a key month for bank/finance earnings (translation, writedowns) Here are some earnings dates to mark on your calendar. Remember that these firms are reporting for the quarter ending 3/31, which includes the ugliness of January and March, but not November.

April 15: Washington Mutual. The weakest of the big retail banks. I think they need to post a reasonable increase in their loss reserve or the market is going to punish them. They obviously have a weak portfolio of loans, and they need to convince us that they are being proactive about it. A small increase in loss reserve would come off like they're trying to fake their way through. Clearly not what the market wants to see.

Edit 4/8: WaMu basically pre-announced their earnings along with their new capital plan on 4/8.

April 17: Merrill Lynch. With 3 of their biggest competitors posting relatively strong earnings, the bar is set a little higher for MER. There are whispers that MER has more writedowns to post.

April 18: Citigroup, Bank of America, Wachovia. This should give us some interesting information on how prime loans are performing. It may also shed some light on the CFC/BAC deal.

Edit 4/8: BAC will announce 4/21

April 22: National City, SLM Corp. NCC is kind of like a smaller Washington Mutual. The difference is that WaMu is mostly west coast, where unemployment is low but the housing market bubble burst is hitting hardest. Nat City is more rust belt, where unemployment is high, but the housing market never got as hot. If WaMu's numbers impress the market, it might not matter much what Nat City does, at least from a bigger picture perspective.

Edit 4/8: SLM will announce 4/16 after market.

April 24: iStar Financial. Not a company on many people's radar, but its one of the biggest monoline commercial real estate lenders. They have a very large portfolio of condo developments, so their performance will be a good indicator as to how far the contagion has spread into commercial real estate.

Edit 4/8: SFI will report 5/2.

This is going to be a critical month.

April Fool's Rally

You can all see that stocks are moving higher. I'm also hearing that there are real money bids for IG corporates. Treasuries are getting crushed.

MBS are about 8bps tighter, with Fannie Mae 6% MBS outperforming the 5-year Treasury by 1/2 point.

Lehman paper is also gapping tighter, after they raised $4 billion in capital in a convertible preferred deal. The terms are being viewed as favorable, with a 7.25% coupon and a convert price of $49.87. It looks like senior bonds are about 50bps tighter today, and 200bps tighter than the day of the Bear bailout.

Less heralded was MGIC raising capital at surprisingly attractive terms. I thought a mortgage insurer would have had to pay through the nose, but all in all, 9% and a 20% convert premium isn't too terrible. Contrast that with what Citi paid ADIA: 11% and no conversion premium.

I've lowered my portfolio duration, and am likely to lower it further in coming days. I'm also not sure the Fed has more than 25bps in cuts left, and once they stop cutting, I expect a V-shaped move in short-term rates. More discussion to come.

The cautionary tale of Jefferson County Alabama

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

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

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

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

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

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

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

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

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

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

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

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

Synthetic ABS. Who needs 'em anyway?

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

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

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

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

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

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

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

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

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

The credit market's Bacta Tank

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

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

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

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

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

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

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

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

What I'm hearing...

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

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

Update on the Precipice...

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

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

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

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

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

The Precipice

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

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

Good luck to Bear Stearns employees.

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

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

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

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

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

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

It's just a dead animal

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

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

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

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

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

What will bring an end to the credit bear market?

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

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

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

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

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

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

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

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

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

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

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

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

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

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