Credit Default Swaps: All craft retreat!

Credit-default swaps (CDS) pose the greatest systemic risk to the worldwide financial system. Housing and oil may be what's pushing the U.S. into a recession currently, but the economy has a way of dealing with these kinds of shocks. Were the CDS market to suddenly collapse, it would truly threaten the very existence of the financial system.

Unfortunately, many commentators are focused on the wrong things when discussing risk in the CDS market. So let's look at what CDS are, what they are not, and why they pose such a risk.

A CDS is very much like a put on a particular credit. If a company defaults on its debt obligations, owners of CDS protection can, in effect, sell one of the defaulting company's bonds to the seller of protection at full face value. This is similar to an equity put, which gives the owner of the put the right to sell the stock to the seller of the put. Both a long CDS position and a long put position express a bearish view on the underlying security. Both can be used to hedge long exposure to the underlying.

Unlike equity options, CDS trade over-the-counter, where the CDS counter-party is an investment bank. This makes buying CDS protection a little like buying insurance: its only as good as the insurer.

So what happens if a major investment bank fails? The direct effect would be painful, to be sure, but probably not enough to threaten the system. Had Bear Stearns, for example, declared bankruptcy, any CDS with Bear as the counter-party would be worthless. Banks and others using CDS to hedge would need to either buy new CDS from another counter-party or risk going unhedged. As market conditions during the near collapse of Bear Stearns in March indicated, the cost of buying CDS protection would be elevated under such circumstances.

For example, imagine a bank has extended a credit line to Boston Properties (an office REIT). CDS on Boston Properties currently costs 115bps/year. Right around the Bear Stearns bailout, the same CDS was around 250bps/year. Say the bank bought CDS to protect against the REIT defaulting at 115. Subsequently a major investment bank runs into serious liquidity trouble. While nothing particular is happening with Boston Properties, the CDS widens to 250 due to contagion effects. That move in spread would result in approximately 6% gain on the CDS hedge for the bank. If the bank had bought $5 million in notional protection, they would be showing a $300,000 gain on the hedge. This means that if bank's counter-party were no longer solvent and the CDS deemed worthless, the bank would have "lost" the $300,000 gain. Put another way, if the bank were to replace the hedge at the former annual spread, it would cost $300,000 up front.

The notional value of all CDS is an oft-quoted figure, currently around $62 trillion. But its the replacement cost of the CDS that matters. In the above example, the bank wouldn't lose the $5 million notional protection unless Boston Properties went bankrupt simultaneous to the CDS counter-party. Moody's has calculated the replacement cost of all CDS outstanding at about $2 trillion. Given that the top 5 investment banks dominate the CDS market, the failure of any one bank would cost CDS holders hundreds of billions.

But it doesn't have to be that way.

For every long CDS position there must also be a short position. For every buyer of credit protection, there must be a seller as well. The overall net exposure to CDS is zero. That fact should be comforting, but alas, no single investment bank is net zero.

For example, a bank might buy protection from Merrill Lynch, leaving Merrill net short. Merrill might then look to cover their short by going long with Goldman Sachs. Goldman is now short, so they cover by buying protection from Bank of America. The system remains net zero, but each of those trades involve separately enforceable contracts. If any of the contracts are rendered unenforceable due to bankruptcy, it creates a problem.

Why should we tolerate this systemic risk when CDS trading could be centrally organized? Why not create a single counter-party which would always and forever have net zero exposure? In other words, why not force CDS trading to an exchange?

It couldn't be accomplished overnight. The exchange would need to be capitalized, customer margin requirements determined, as well as further homogenization of CDS contracts before the exchange would be possible. None of these problems are insurmountable. And the benefits to the system would be enormous.

When J.P. Morgan and the Fed bailed out Bear Stearns, many were concerned about the precedent set, as well as the moral hazard of creating an assumption of future bailouts. But the massive CDS counter-party exposure Bear had forced the Fed's hand. The Fed will not and cannot allow the system to fail. If we want to avoid Fed interference and the subsequent moral hazard, the best thing to do is to improve the system. A central CDS exchange would be a major step in the right direction.

News! on the March!

Obviously the Lehman story is dominating headlines. Lehman CDS has been all over the board this morning. I've seen it quoted as wide as +310 immediately after the news, most recently saw +270. For color, Lehman CDS hit a recent low of +135 on May 2 and was as wide as +450 on March 14. Those are closing levels not intra-day. Its been trading between 250 and 300 for the last several days.

The lack of contagion trading, at least at the open, is facinating. You've got Treasuries down, dollar stronger, swaps tighter, stocks higher. On one hand, you could say lower oil and stonger retail sales matters more than Lehman. You could also argue that Lehman's survival is all that matters to the broader market. Whether or not Lehman can grow their stock price is of no moment.

Still, I'm skeptical and would rather fade the rally.

New bond issue to watch is SLM Corp. 8.45% 2018. Sold initially at a dollar price of $98.03 or a spread of 465 over the 10 year. Sallie has been trading on dollar price for a while now, but not surprisingly has traded much stronger after Congress agreed to buy student loans from originators. Anyway, SLM was one of the poster children from the liquidity crisis, and this new issue may jump start activity in the name. (I'm long SLM, full disclosure). Anyway, the new issue was bid at $98.5 early this morning. Haven't seen any actual trades yet.

LIBOR our only hope? No... there is another!

ICAP's, the largest broker of inter-lender transactions, has developed their own measure of U.S. inter-bank lending rates, ostensibly to supplant LIBOR. The first survey of New York banks was conducted today, and resulted in a 3-month rate 1.7bps lower than LIBOR.

Backing up a minute, LIBOR is supposed to be a measure of where very large and highly rated banks can borrow. Recently the accuracy of LIBOR has been called into question, some have gone to far as to say manipulated. U.S.-based banks in particular have complained that LIBOR, as currently constructed, is destined to fail as an accurate measure of U.S. lending rates.

This is because LIBOR is set by surveying 16 banks as to where they think they could borrow in U.S. dollars for various terms ranging from overnight to 1-year. Of the 16, only 3 are actually American: Citigroup, J.P. Morgan, and Bank of America.

Enter ICAP. Their survey will involve U.S. firms only, and will ask where the bank would lend to a un-named A1/P1 borrower for terms of one and three months. Called the New York Funding Rate (NYFR), it was set for the first time today at 2.4646% for one-month and 2.7715% for three-months. LIBOR reset today at 2.47688% and 2.78813%. Both are a little better by 1bps in the ICAP survey.

So what does this mean? LIBOR has been rising, from about 2.64% in late May to its current 2.79%. That 15bps does not reflect an increased probability of Fed hikes, at least not entirely. It reflects continued concern over the health of banks.

The fact that the NYFR was set lower would indicate that U.S. inter-bank liquidity is slightly better than in Europe. This is consistent with a widely held view that the risks in U.S. banks have been better disclosed when compared to their European counter-parts.

The swaps market reacted favorably, with 2-year swaps falling by 2bps and the rest of the stack falling by about 5bps.

In my opinion, fear about LIBOR is yesterday's news. The Fed has supplied access to tremendous liquidity to both banks and primary dealers. As a result, the jump-to-default risk has been greatly reduced. But that hardly leaves me bullish on banks or brokers. Today's market troubles are about a real lack of earnings power among financials. Take Merrill's downgrade of Lehman Brothers today. The analyst (Guy Moskowski) said...

"We expect LEH to survive because its liquidity profile is strong and the Fed discount window is open... but current business and asset mix are just not well positioned for the current environment."

I think you could insert dozens of bank/broker tickers into that sentence. He also discusses Lehman's book value (currently $33/share) but with little earnings growth in the near term, why would anyone pay close to book for the stock?

My point is that rising LIBOR was more about jump-to-default risk, which I think has abated substantially. So that's yesterday's problem. Today's problem is that banks have plenty of credit losses coming and so that will be tying up capital. They can't be turning in strong earnings if they are using capital on REOs. They also are facing weaker net-interest margin should the Fed start hiking rates.

Now I'd have to think that if I could look into a crystal ball and know for a fact that Lehman Brothers would survive as an independent entity one year from now, then I'd bet the stock would be a good bit higher. I'd say the same think about National City or Washington Mutual or CIT. But the odds are fair that each of those firms will seek a stronger partner sometime in the near future, and the merger price won't make the stock worth owning.

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.

Monolines and Bank Write-downs: I wonder if your feelings on this matter are clear

The most important question regarding yesterday's downgrade of Ambac and MBIA is obviously not about munis but about ABS and CDOs. As readers undoubtedly know by now, banks and brokerages routinely purchased monoline insurance on ABS and CDO transactions. In CDO land, the trade was usually done on the senior-most tranche of the CDO, with the monoline writing a credit-default swap on the trade.

So the question is, what are bank's exposure? Are more writedowns in store? Let's talk this through.

If we assume that banks and brokerages have been correctly following accounting rules, they would have been marking-to-market their CDO exposures all along. Right? Alright, let's look at one of Ambac's uglier bonds in their CDO portfolio. Citation High Grade ABS 2006-1A A1. That's CITAT 2006-1A A1 or CUSIP 17289LAA7 for those who want to follow along on their Bloombergs.

This beauty was originally rated AAA/Aaa, but alas, its fallen on some hard times. On June 2 Moody's downgraded this tranche to B1 remaining on negative watch. The overcollateralization test on the A tranche is currently below 100%. Now I don't actually have offering documents on this bond, but this almost certainly means that the par value of the underlying collateral is now less than the outstanding Class A debt. Note that has nothing to do with the market value of anything. In other words, actual realized losses on the collateral have blown through all subordination. Originally the bond had about 14% subordinate to it, so realized losses are at least that large.

Now this Citation deal isn't as ugly as some others. As of March 31, 55% of the collateral is rated at least AA and another 20% is rated A. Now I hear tell ratings don't mean as much as they used to, but still, a large percentage of the collateral is performing OK.

Still, given the failure of the OC test, we can assume that without any support from Ambac, this bond would in deep doo doo. There is no way this bond is getting more than 75% of its principal back. However, had the market viewed Ambac as favorably as Moody's and S&P apparently did until just yesterday, the bond might still be trading near par. But of course, the markets have not assigned much value to Ambac's insurance for several months now. On top of that, we see that straight AAA-rated home equity paper in late 2006 (which generally speaking is better insulated than this CDO against losses) is trading in the mid 70's, and AA paper in the 30's. Could the bid on this thing possibly be more than $50? With or without Ambac insurance?

So now that Ambac has been downgraded, is there really any difference in the value of this bond? Is there really a lot more to be written down?

Of course, the above discussion has an "IF" the size of Ed McMahon's mansion. That is IF owners of this paper have been properly marking-to-market the paper. What I'm afraid may be happening in some cases is that the bond itself has been marked in the right neighborhood, but the CDS price has been marked as if there actually was a AAA counter-party. So a bank would price our Citation deal at $40 or whatever, but price the CDS contract from Ambac as if there was a large gain in it. Now that CDS isn't worthless, if for no other reason than run-off, but its sure not worth what it would be with Goldman Sachs as the counter-party.

An interesting twist on this story, and one that is probably helping to drive LIBOR and swaps spreads higher the last couple days. The AAA CDO/Monoline CDS combo trade was extremely popular with European banks. Perhaps the next round of big writedowns is coming from the Continent.

S&P to Moody's: Well, I wasn't gonna let you get all the credit

S&P just downgraded Ambac and MBIA out of nowhere. Both now AA. Its hilarious how much the two ratings agencies parrot each other.

Here is the CDS story (all bid sides)...

Ambac Inc. 33 points (Opened @ 31)
Ambac Insurance 28 points (Opened @ 25)

MBIA Inc. 27 points (Opened @ 25)
MBIA Insurance 25.5 points (Opened @23.5)

Somehow MBIA's stock is actually up a couple pennies as I see it tick by. Stock market overall couldn't care less.

Also Lehman CDS is gapping in, about 50bps tighter right now.

Monolines: Let me see you with my own eyes

That snapping sound you hear is the last ray of hope for MBIA and Ambac shareholders. Moody's put both on negative watch today, which tells you a downgrade is inevitable.

On Ambac they say...

Moody's stated that the ratings review was prompted, in part, by concerns about the deterioration in ABK's financial flexibility since the company's $1.5 billion capital raise in March 2008, as evidenced by the substantial decline in the firm's market capitalization and high current spreads on its debt securities, making it increasingly difficult to economically address potential shortfalls in the company's capital position should markets continue to worsen. Additionally, there is meaningful uncertainty surrounding Ambac's ability to regain market acceptance and underwriting traction within its target markets.

On MBIA...
Moody's said that recent mortgage performance data, and MBIA's own reported first quarter results, are indicative of continued deterioration within the guarantor's insured portfolio. As part of its review, Moody's will evaluate the effect that mortgage-related stress, particularly with respect to MBIA's second lien mortgage and ABS CDO exposures, could have on the firm's risk-adjusted capital adequacy position. Moody's said that it will also review other areas of the portfolio that may be susceptible to economic slowdown.

The logical question is, why now? I mean, the marketplace widely discounted either company's ability to remain AAA for several months.

Perhaps the answer lies in their share prices. On MBIA: "...the significant decline in MBIA's stock price since February is making it increasingly challenging for MBIA to economically address capital shortfalls by raising new equity..."

And Ambac: "...the substantial decline in the firm's market capitalization and high current spreads on its debt securities, making it increasingly difficult to economically address potential shortfalls in the company's capital position should markets continue to worsen..."

Moody's also mentioned regaining investor confidence, which "concerned" the ratings agency. Its way beyond concerning. There is no hope of either company ever regaining the confidence of investors so long as there is significant RMBS and CDO exposure.

No further evidence of this is needed beyond the CDS market. Credit default swaps on Ambac's insurance subsidiary is currently bid at 23 points up front and 500bps/year. MBIA is 19.75 points up front. That means that in order to be protected against Ambac defaulting on any of their insurance obligations, the cost is 23% of the amount protected. On 4/30, Ambac was 730bps/year (nothing up front) and MBIA was 710bps.

Now for the so what?

Currently the municipal market puts no value on Ambac or MBIA insurance. Really since at least January. The only value put to Assured Guaranty or FSA insurance is for liquidity, not as a credit replacement. So I don't think this changes much for the muni market. If there is an actual downgrade there may be some forced selling, but from what I've heard, most of those who would be forced sellers have done so already. Because, you know, every one saw this coming.

The impact on financial institutions holding ABS/CDO paper is a little less clear. Before the advent of the TSLF and TAF, the markets were very much attuned to the goings on with MBIA and Ambac. Now that capital is a little easier to come by, it seems as though the markets are less worried about the monoline insurers. Today is a perfect example. The Dow moved from about 12,480 just before the news to 12,402 just after the news. Now 78 points is a decent move in about 45 mins. But compare that to February 22, the day there were mere rumors of an Ambac bailout. The Dow went from 12,155 (down over 130 points on the day) to close at 12,381.

Given that all CDS contracts are supposed to be marked to market, and that ABS/CDO insurance was always done in the form of a CDS, financial institutions should have been valuing those CDS with the counter-party in mind. I guess we'll see how true that is. Looking at the CDS on their insurance arms, the insurance should be considered near worthless.

Of course, not entirely worthless. If regulators deem either (or both) MBIA and Ambac insolvent, they'll go into run-off. Most of the run-off circumstances I'm aware of have been voluntary. As in a company just doesn't want to be in the auto-insurance business or whatever so they put it into run-off. I'm not sure anyone really knows how the run-off of a bond insurer will play out. Currently both MBIA and Ambac have substantial cash and investments, and could likely last in run-off for several years. Maybe even in perpetuity. If any readers have access to research on how the run-off would work, please e-mail me (accruedint at gmail.com).

Meanwhile, MBIA Chief Jay Brown says they might start a new insurer with some of the capital MBIA raised back in February. I can't comment on how this might work legally, but if he could pull it off, it might just work. MBIA isn't such a pariah that they couldn't come back into the market if they managed to shed the non-muni exposure. I dunno what odds to give this, but at least its possible to generate some value to shareholders with such a plan. Ambac seems to be content to stick its fingers in its ears and sing the Star Spangled Banner as oppose to think of anything beneficial to its shareholders.

The bottom line is that we're finally getting to the reality of the monoline situation. They aren't going to be able to generate any new business in their current form. Finally the ratings agencies are acknowledging this. The mask has come off.

(By the way, the relevant lines are... "But you'll die" and "Nothing can stop that now.")

Lehman Brothers: Destructive power greater than half the starfleet

What to make of the fact that Lehman was apparently buying their own stock in the open market yesterday? Who knows. I think its supposed to send a signal that management remains confident, but no one is buying it. What seems more likely is that Lehman is close to a deal to sell shares to a private buyer (Korea?) and was trying to defend the price.

But here is a serious question that I honestly don't know the answer. Lehman reports earnings the week of June 16. Obviously the people directing purchase of Lehman shares have significant knowledge of what that earnings report looks like. We aren't talking about a run-of-the-mill earnings announcement here, where the question is whether EPS beats the street consensus by 2 cents or not. If Lehman has a significant writedown to announce, senior management already knows it. If they don't, management knows this too.

So given all that, why wouldn't this activity constitute insider trading?

Let's say, for the sake of argument, that Lehman actually has much better results coming that people think. Hey, anythings possible right? Maybe they indeed took losses on some CMBS hedges, as has been widely reported, but lucked into some gains on some other hedges. I'm not saying it happened, this is just for discussion.

So if indeed that's what happened, Lehman management is buying Lehman stock knowing it will rise in the near term. Management wouldn't be allowed to buy shares just before earnings for their personal accounts. But somehow the company can buy shares?

It smells fishy either way doesn't it? They are either just trying to prop up the price a little before a large equity sale. Or they are buying shares with insider knowledge.

Anyway, I know we have readers from the SEC and the Fed. And we have lots of other people more familiar with insider trading rules than I. Someone please explain how they are allowed to do this.

Lehman Brothers to the Market: Your destiny lies with me!

Our discussion of Bear Stearns' collapse (check out the comments, some really good stuff there) and what may or may not have prevented it is not entirely academic. Witness the trials and tribulations of Lehman Brothers, the new Dark Lord of the Credit Crisis. Today the Wall Street Journal is reporting that Lehman is looking to raise $3-4 billion in new capital, probably via straight common equity. Lehman has come out saying they don't "need" to raise capital, but they aren't ruling it out. If you read the Journal piece closely, you can see that Lehman isn't really contradicting the story. The Journal says...

"The amount of new capital under consideration suggests Lehman's quarterly loss could be larger than the $300 million or so that some analysts have been expecting."

So the possibility of Lehman's loss being exceptionally large is speculation on the Journal's part. Perfectly reasonable speculation, but speculation none-the-less. Lehman's non-denial denial, if it can be believed, only implies that they won't be forced to raise new capital because their losses are so large.

Getting back to Bear Stearns. The preponderance of evidence is that Bear Stearns would have been profitable in 1Q 2008. And yet they were about to be bankrupt mere days before reporting that profit. It is clear that Bear Stearns would have been able to continue operating had they been able to remain liquid.

According to the Wall Street Journal's excellent 3-part series on Bear's collapse, Bear Stearns CEO Alan Schwartz was confused and frustrated by the persistent rumors about his firm. He knew they had big mortgage exposure, but seemed to believe they were strong enough to get through it. But according to the Journal, as early as December, Bear's trading partners were growing uneasy. PIMCO told Bear to raise equity after nearly demanding an unwind of billions in trades, according to the story.

Its downright criminal that Schwartz continued to ignore these warnings. It may have been mere rumors that took Bear down, but Bear (and the Cayne/Schwartz team specifically) stuck their heads in the sand and refused to do anything to quell the rumors. Consider the apparent sequence of events:

• Trading partners tell Bear they are uneasy and want to see more equity capital.
• Bear does nothing.
• It starts getting around the investment community that Bear is too leveraged, but won't raise capital.
• The conclusion is that Bear's management is either deeply in denial about their condition or they are unable to raise capital.

That sequence is more or less known at this point. Note that even if one were to assume that Schwartz had been right, and Bear did have plenty of cash/hedges to offset mortgage losses, it wouldn't have mattered. Take the most positive possible spin on what seems to have happened next, and Bear is still toast.

• Bear's lenders hear the concerns that PIMCO and others have. (Again, taking the most positive spin possible) Lenders don't necessarily think Bear is in immediate trouble, but still don't want to be caught as the last ones out if things turn south. Lenders like Rabobank decide not to renew short-term lending programs.
• Prime brokerage clients, realizing that prime brokerage is a completely fungible service, have all risk and no reward by sticking with Bear. Note that they don't have to be panicking in order to reach this conclusion. If there is a 1 in a thousand chance of a disaster, with no reward for the 999/1000 outcome, why take that risk? These accounts start pulling out.
• A classic bank run ensues.

But what would have happened if Bear Stearns had bolstered their capital base back in November or December? We'll never know, of course, but there certainly is a pretty good chance their major trading partners and lenders would have felt more comfortable. More confident. And more confidence is all it would have taken.

Back to Lehman. Some readers may remember that in 1998, during the Long-Term Capital Management collapse, Lehman was supposedly teetering. At the time, Lehman took the tact of simply denying the rumors. According to various reports I've read, ten and current Lehman CEO Richard Fuld wants to be more aggressive this time around. The firm has already raised $6 billion in new capital (vs. writedowns of $3.3 billion). Its sounding like whether or not they have big losses to report, they are looking to raise more.

I for one really hope they do. And I hope they do it via straight common equity. Because the more Wall Street accelerates their deleveraging, the sooner the financial system can regain solid footing. Lehman seems to understand that a stable financial system is better for their bottom line, and hence short-term pain of equity dilution will ultimately be in their long-run interests.

I also hope that Lehman and others move to write down what needs to be written down. Bear Stearns collapsed because no one understood what they owned and what risks they had courted. The more Wall Street's stuff gets written down, the less the public will worry about it, and the less chance we'll see another run on the bank.

CDOs: The Future of Leveraged Fixed Income

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

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

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

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

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

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

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

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

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

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

Bailouts, Wall Street, and the Bad Motivator

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

How Safe are the GSE's?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Q: Sounds like you are leaning toward 100%.

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

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

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

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

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

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

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

Q: I still don't trust their accounting.

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

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

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

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

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

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

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

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

You know better than to trust a strange statistic!

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

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

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

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

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

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

Your overconfidence is your weakness

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



And for December...

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

When we heard about Alderaan...

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

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

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

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

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

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

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

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

Clumsy and Random Thoughts

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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