Hey, I don't get it.

Strange market yesterday. You had financial stocks significantly higher for most of the day, only to finish about 1.5% lower. That beat the market overall, which got crushed in the last two hours of trading when oil mysteriously spiked.


Also strange was movement in CDS. We saw the major bank/broker CDS unchanged on the day, but the IG CDX 6bps wider. I'd say that move in IG is consistent with a 2% decline in stocks, but with zero participation by financials, its weird.

The last strange thing was the lack of response from the Treasury market as stocks fell apart in the afternoon. Here is the intra-day chart.

You see the S&P (red) fall from 1285 around 2PM to 1261 by the end of the day. The 10-year was at 99-6 at 2PM and finished at 99-9. Hardly a flight to quality or any kind of fear trade. I think this illustrates that the long Treasury market is in a bear market due to inflation concern. Hence you see higher oil sap any bid that weak equities might have created. Today's early activity reiterates this view, as in-line non-farm payrolls produces a sell-off in longer bonds. Shorter bonds are flat to slightly higher.

I continue to think this inflation obsession is dumb. If you are one of the few who agrees, play the 2-5 year area of the curve, because no one wants to own 10's. The curve will steepen.

Barclays: Lehman, count me in

Rumors are swirling that Barclays will be buying Lehman. Barclays CDS moving wider, Lehman moving tighter. Not by enough to say a deal is a foregone conclusion, but there is a fair amount of detail to this rumor. Usually that means there is some truth to it.

If such a deal were to occur, Lehman CDS would certainly move tighter, but it wouldn't immediately be equal to Barclays (which is in the 120's, similar to BAC or WFC, Lehman is around 280). This deal may play out something like Countrywide, where questions about the deal's completion persist for weeks or months. CFC CDS has been running 100-200 bps above BAC's for most of the last 5 months. I'm just saying, trade on this rumor at your own risk.

In other news, CIT is selling their home lending unit for $1.5 billion. CDS is about 60bps tighter.

Ultimately we need to see these market pariah's dealt with one way or another. As long as all these question marks persist, the market won't move higher. Unfortunately, it isn't like Lehman and CIT are the last of the question marks. The path of least resistance is lower and wider, and that will continue until there is some catalyst the other way. I could imagine a scenario where bank earnings (which are coming this month) come out better than expected. One would suppose that actual expectations (not what the Street surveys are, but trader expectations) are quite low. But that's not my view, so I'm inclined to stay underweight in credit and short stocks.

Sir, monolines coming into our sector!

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

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

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

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

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



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

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

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

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

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



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

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

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

Economy to the Fed: I thought I told you to remain on the command ship

The Federal Reserve is set to announce its rate decision today, and is broadly expected to hold their Fed Funds target rate steady at 2%. However, despite the weak economic growth picture and continued pressure on the banking system, most traders now expect the Fed's next move will be a rate hike. Energy and food prices are creating substantial inflation, and the Fed must snuff it out, so the argument goes. Futures on Fed Funds suggest about a 40% chance of a hike at the August meeting, with at least one hike fully priced in by the December meeting. Indeed the 2-year Treasury yield, trading around 2.90%, suggests an aggressive path of Fed rate hikes in the near future.

Would the Fed hike rates with the economy growth and employment picture so weak? Their recent rhetoric would suggest they would. Nearly every speech by Federal Reserve board members and regional presidents during June has mentioned the problem of inflation expectations. Inflation expectations can be a self-fulfilling prophesy, and the Fed must act to prevent such expectations from becoming ingrained in consumers minds. In the late 1970's, as inflation ballooned, expectations for inflation became unhinged, forcing the Fed to tighten monetary policy in an unprecedented way, creating two recessions in the process.

The comparison between the late 1970's and today are particularly chilling. Both periods saw rising energy prices and a stagnant economy. Are we reliving those times?

A look at the correlation between the change in the overall price level (measured by the consumer price index (CPI)) vs. the same measure excluding food and energy (Core CPI) is revealing. If food and energy prices are rising because of loose monetary policy or the weak dollar, then the Core and total CPI figures should rise and fall at the same time. In other words, the correlation will be high.

1970 to 1982, was a period marked by predominantly rising energy costs. The "energy" portion of CPI rose at an annualized rate of 12.1% during this period. The correlation between total CPI and Core CPI was 72.7% when measured monthly and 89.5% when measured annually. Note that a perfect correlation of 100% would suggest that core and total CPI always moved in tandem, whereas a correlation of zero would indicate no relationship between the two figures.

1983 to 1999, was a period of mostly falling energy prices. During this period, energy CPI was a mere 0.1% on an annualized basis. Yet the correlation between total and Core CPI remained relatively high: 58.5% monthly and 85.8% annually.

So over a period of three decades, it was rare that a move in Core CPI would not be mirrored in headline CPI. If one was elevated, the other was elevated. If one was tame, the other was tame.

However, the 21st century hasn't followed the same pattern. From 2000-2008, the correlation between total CPI and Core CPI has broken down: only 7.6% measured monthly and 21.4% measured annually. This despite the energy portion of CPI rising at a 1970's style 9.5% annualized. During the current decade, there has been no particular relationship between total inflation and core inflation.

What does this mean? The data is telling you that rising energy and food prices have been due to supply and demand conditions in those markets. Not classic inflation, which is a monetary phenomenon. In other words, rising oil is indeed due to strong demand from emerging markets and a lack of new supply. Not the weak dollar or loose monetary policy.

The Fed can't do anything to create more oil or temper demand from China. The Fed can only influence the money supply. For the Fed react to a non-monetary phenomenon with a monetary response would be a colossal mistake. Especially when the economy and banking system are as weak as they are.

So the Fed will talk a good game to try to keep inflation expectations low. They might even hike by 25bps to keep inflation expectations under control. But a long series of hikes? No way. Not until the economic growth picture is improving.

This makes 2 to 5 year bonds very attractive, especially for investors holding large money market positions. 2-year Agency bonds are yielding over 3.5%, and 2-year municipals are in the 2.6% area. Both promise to out-yield money markets easily over the next two years should the Fed remain mostly out of the picture.

Moody's Global Scale: The last remnants of the old ratings have been swept away

Bowing to significant political pressure, Moody's is set to change the way they rate municipal bonds. The change will result in thousands of upgrades, some perhaps many letter grades higher.

Historically, Moody's municipal bond ratings talked and walked like its ratings for other types of bonds: corporates, asset-backeds, etc. The top rating was Aaa, the lowest investment grade rating was Baa3, and so forth. But the default and recovery performance of municipals has been vastly different than other bond categories. For example, according to Moody's, between 1970 and 2006, about 1.3% of A-rated corporate bonds suffered a default within 10-years of issuance. However, only 0.03% of A-rated municipal bonds suffered defaults over the same time period. The ratings results were not even consistent within municipal bonds. Among Moody's rated general obligations (bonds backed by the full taxing power of a city, county, school district, or state) there was exactly one default from 1970 to 2006, whereas 0.4% of other municipal bond types defaulted.

Moody's has admitted that their municipal ratings aren't comparable to corporate or ABS ratings. However, in the past Moody's had contended that municipal bond investors appreciated the gradations of credit quality afforded by the municipal ratings scale. If Moody's used nothing but default expectation, virtually all general obligation municipals would be rated Aaa. It stands to reason that municipal investors value the differential between A1-rated California, Aa3-rated New York, and Aaa-rated Virginia. Something would clearly be lost if all three were rated Aaa.

However, recent stress in the municipal bond market has brought politics into the discussion. From auction-rates to bond insurers, the perceived safety of municipals has taken a hit. The collapse of several tender-option bond programs (a popular hedge fund strategy involving municipals) has dented demand for munis. More behind the scenes, municipalities are finding Wall Street less hospitable than in hears past. Bond insurance and bank letters-of-credit have become considerably more expensive. Wall Street firms are not as willing to buy bonds for their own accounts, increasing the cost of issuance.

Politicians, lead by Congressman Barney Frank and California Treasurer Bill Lockyer have been pressing the credit ratings agencies to rate municipal bonds based on expected loss only. A June 12 press release from the California Treasurer's office reflects the argument proffered by the issuers: "Lower ratings [for municipal bonds] have cost taxpayers billions of dollars in higher interest rates and bond insurance premiums." The theory is that there is a direct correlation between the ratings and the interest rate paid by the issuer.

At the same time, Moody's and Standard & Poors are facing serious (and well-founded) claims of conflict of interest relating to CDO ratings. Moody's seems to have made a political calculation: it can't go back and re-rate CDOs, but it can give Barney Frank what he wants with municipals.

Investors should care for two reasons. First it appears that most municipal bonds will soon be upgraded by Moody's. It is not currently clear what the timing of the ratings revisions will be, but Moody's has previously published a guide to "mapping" municipal credits to the Global Scale. For direct obligations of States, anything rated A1 or higher on the muni scale would be Aaa on the Global Scale. That means every state would be Aaa except Louisiana. For other general obligations, including cities and counties, anything rated Aa3 or better would be upgraded to Aaa. A general obligation bond rated Baa3 would be upgraded to Aa3. Even riskier credits like hospitals would enjoy at least a 1-2 notch upgrade, according to Moody's mapping. (The complete report is available here, requires a free registration.)

That should be a near-term positive, especially for middle-rated credits. There is significantly more demand for A and Aa-rated bonds than for Baa-rated securities, owing largely to legal or policy restrictions. There might not be much immediate effect, particularly until S&P follows Moody's lead. But over time, expect liquidity and the spread for the upgraded bonds to improve. Also, expect S&P to follow suit. S&P faces the same political pressure as Moody's, and now that Moody's has made the move, S&P will be all but forced to acquiesce.

There is a likely negative, however. The high ratings standards for municipals encourages some measure of fiscal conservatism. This is especially true for Aaa-rated credits, where loss of the rating would be politically embarrassing. Of course, municipalities are downgraded all the time, but clearly local politicians would rather maintain their rating than not. If the overwhelming majority of general obligation issuers are going to be rated Aaa anyway, that incentive is greatly reduced. In other words, a state like Georgia (rated Aaa) is currently incented to maintain its austerity. But if they could slide all the way down to California's level (currently A1) and still be rated Aaa, they'll probably do it.

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

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

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

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

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.