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

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

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

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

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

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

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

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

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

And 15 once we reach Alderaan...

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Quick comment on Merrill Lynch's ABS CDO Sales

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

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

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

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

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

Bank Corporates: Obi Wan once thought as you do

OK, so we're more or less through bank earnings. We had some highlights (Wells Fargo) and some low lights (Wachovia, Washington Mutual). Overall, the good news is few banks saw an immediate need for fresh capital. The bad news is that credit losses continue unabated, with few signs of improvement. We also got a scare out of Fannie Mae and Freddie Mac, roiling the bond market and spurning a massive government bailout. Now that the long believed implicit backing has become explicit, the GSE's liquidity position looks strong.

So where do we go from here with credit spreads? While I acknowledge the possibility that we've bottomed in credit, I remain bearish.

First let's look back at the fall then rise of the markets around the time of the Bear Stearns collapse. We'll zero in on financial corporates and junk bonds (using the Lehman Brothers indices for both), as these are the high volatility areas of the bond market these days. For comparison, I've also thrown in financial stocks as measured by the Amex Financials Index (on which the XLF is based). This chart will cover January 1 through May 6.

For the corporate bond components, the graph shows the percentage excess return (or return of the bond less the return on Treasuries, think of it as your return with interest rate risk hedged away). For financial stocks, the total return in percentage is graphed. What we see is that financials hit a low at -20% on March 17 (the day after the Bear/JP Morgan "merger"). At that point, the bonds of financial companies had fallen 6.5% vs. Treasuries, and high yield had fallen 10.3%. Then of course there was the rebound in April and early May, but let's put that aside for a moment.

There are two things to notice here. First stocks, high-yield, and financial corporate bonds have all been highly correlated. Second, performance of bonds tends to be smoother than stocks, even after correcting for scale, because bond performance is all about survival and liquidity, as opposed to stock prices which are about growth.

Now let's look at the period from May 7 through July 24. To make an easy comparison, we'll reset all the returns to zero and go from there.

Here we see that for most of May and June our two corporate bond indices remained right around zero in terms of excess return. At the same time, financial stocks basically moved in a straight line down. Something had to give there, and eventually something did.

From May 7 to June 16, the financial corporate index had underperformed Treasury bonds by a whopping 8bps and high yield had actually outperformed by 127. From then until July 24, financial corporates underperformed Treasuries by 397bps and high-yield by 509bps.

Alright so where does this leave us? Looking in total from May 7 to July 24, financial stocks have fallen 23.6% whereas financial bonds have fallen 4.05% vs. government bonds. That's about a 6-1 ratio. As of March 17, financial stocks had fallen 20% and financial bonds 6.5%, for a 3-1 ratio.

To me that implies that financial bonds remain overvalued vis a vie the equity. Now the counter-argument would be that the June-July stock market sell-off was about equity dilution among banks. If banks sell more equity that actually benefits bondholders, and therefore bonds can remain tight even while the equity falls. I don't buy this argument. What's happened is that bank stocks have fallen to the point that public equity capital is unavailable. Troubled bank CEOs are more likely to roll the dice on recovering than dilute equity holders further. If bank stocks were to keep rallying, then indeed equity capital would come back into the picture, but that proves my point doesn't it? Stocks have to keep rallying to justify bond prices as they are.

Now its possible that stock and bond prices rally, with the former just moving more quickly. But rather than try to call a bottom, I'd rather wait to buy bank bonds when it looks like banks have more easy access to capital and/or it looks like loan losses are nearing a bottom. Right now I see neither.

WaMu: We don't have any choice

Here is my quick take on Washington Mutual. First the credit markets. CDS on WaMu are now trading 20 points up front, up from 14 yesterday. That's getting into Ambac territory.

I read a really interesting Merrill Lynch research report on option ARMs recently. It showed definitively that among big option ARM originators, WaMu had the strongest underwriting standards. In terms of loan-to-value, FICO, etc., WaMu had the strongest portfolio. Unfortunately, WaMu's option ARM portfolio was so large that it still looks like losses are going to be larger than they can handle.

It looks to me like WaMu is digging itself in for a long fight. According to Bloomberg, WaMu has paid off most of their Fed Funds (and actually has sold nearly $2.75 billion). This means that they are actually lending short-term, which gives them a good deal of liquidity. They've also "pre-funded" short-term maturities. Overall, WaMu claims to have over $50 billion in liquidity and $7 billion in excess capital.

Now its been long speculated that J.P. Morgan was interested in WaMu. In fact, its been rumored that J.P. Morgan offered WaMu a take-under price just before WaMu got a capital infusion from TPG. I believe the price rumored was something like $7/share when the company was trading at $9. Now its probably too late, certainly too late for $7/share. Maybe Jamie Dimon would offer $1 and figure that the embedded losses in WaMu's loan portfolio would be worth expanding Morgan's retail reach. I don't know.

But I'm betting that WaMu takes a different tact. Put yourself in Kerry Killinger's shoes. Say, for the sake of argument, that Dimon offers $1/share. From Killinger's perspective, what's the difference between accepting $1 and going bankrupt?

On the other hand, it is possible, however likely, that WaMu can muddle through, and survive into 2010, what's the stock worth? Probably $10 or more. Consider that by that time home prices have probably bottomed and most of the losses in WaMu's portfolio will have been realized. So if they've survived it, the stock is worth much more than today.

Now, I think WaMu is probably toast. And I think the markets are going to behave badly while we worry about WaMu's future. But I also think WaMu is going to roll the dice and see if they can make it on their own.

And now young monoline... you will die

Sometimes life is unfair. Take, for example, Moody's Investor Service's ever changing criteria for a Aaa rating. On Monday, Moody's put both Assured Guaranty and FSA's Aaa rating on negative watch. This despite Assured Guaranty having excess capital, defined as 1.3 times Moody's assumed losses given a "stress" scenario, and FSA falling short by only $140 million. FSA, it should be noted, just secured a $5 billion line of credit with parent Dexia.

In both cases, Moody's cited declining use of bond insurance in general: "Bond insurance volumes in the municipal segment have also declined significantly, with insurance penetration rates dropping by a third or more." It seems Moody's has concerns that the decline of muni insurance in general is a negative for FSA and Assured Guaranty's long-term business models. Which is interesting since both FSA and Assured Guaranty have both increased their market share considerably. In Assured's case, they are writing substantially more business now than last year, and for FSA its at least close.

It still looks to me like FSA and Assured Guaranty have plenty of capital, especially given their lack of ABS CDO exposure. But it isn't my opinion that matters. So what should municipal investors do with their FSA and Assured Guaranty paper? And would a downgrade of either lead to an investment opportunity?

First, consider what "negative watch" means. In most cases, negative watch turns into a downgrade, unless some intervening event occurs. For FSA, its possible that Dexia contributes capital to bring FSA above Moody's target levels. But given that Assured is already above those levels, its not certain that a capital infusion would make any difference. So investors should assume that FSA and Assured Guaranty will be downgraded. I would also assume that S&P will eventually follow suit.

Within an existing portfolio, look at each credit in your municipal portfolio. Are there any that you own strictly because of the insurance? If so, you are probably best to get out now. Get the underlying rating of all your positions. If you are with a financial professional who cannot readily provide the underlyings... well, that should tell you something.

As far as looking for opportunities, they will be there for investors with long investment horizons. But be aware of liquidity. Institutional investors are going to be better sellers of insured bonds for some time to come. Scrutiny from the public (in the case of publicly reported portfolio) or from a board (in the case of insurance companies) will cause portfolio managers to shun bonds where a downgrade is expected. If you bid on a FSA insured bond today, the odds are fair that you are the only bidder. And what does that tell you about your ability to sell the bond yourself? If you are going to bid on a FSA insured bond, make sure you bid a price at which you are comfortable holding for the long-term.

Of course, if you do decide to look at a FSA insured bond, you need to look at the underlying rating. Until recently, the market didn't price A underlying bonds much differently than those with a AA underlying ratings. That's going to change in a big way. Investors will demand significantly more yield for an A-rated risk, even before FSA or Assured gets downgraded officially. Keep this in mind when bidding on bonds. Among non-insured bonds, the gap between A and AA is about 50bps, which is about 4% in price on a 10-year bond.

I had previously said I thought that municipal insurance would remain viable, despite the problems with FGIC, Ambac, and MBIA. I think the fact that a large percentage of new issues in 2008 have carried insurance bears that out. However, if Moody's (and S&P) cannot establish consistent guidelines for maintaining a top rating, then it will be impossible for insurers to plan for capital adequacy. Having the Aaa rating is crucial to that business, yet its unknown what the criteria will be from week to week. That's an impossible business to capitalize intelligently.

Ironically it won't be a lack of demand that kills muni insurance, but a lack of supply.

Agency MBS: You will be tempted by the yieldy side of the Force

Although agency mortgage-backed securities (MBS) have been beaten up the last couple days, avoid the temptation to jump in. Agency MBS spreads are not as attractive as they seem, and the technicals for MBS are horrible.

This has nothing to do with the financial condition of Fannie Mae or Freddie Mac. We'll have to see how the government bailout progresses. Perhaps just the act of allowing the GSEs access to the discount window will be enough to ensure liquidity. But by all indications, protecting the mortgage securitization market (i.e., keeping mortgage borrowing rates low) is a primary goal of any government action. It isn't credit quality which is behind this underweight call. Rather its plain old fashioned market conditions.

MBS analysis is more complex than for other investment-grade bonds, in that the yield on the security is highly depended on the pace of principal repayments. These payments primarily come from two sources: refinancings and housing turnover. Historically, refinancings were the primary driver of changes in mortgage payment speeds. Anytime interest rates would fall, borrowers would rush to refinance and thus pay off their old mortgage. Housing turnover was more consistent, as people tended to move from house to house based on life circumstances as opposed to macroeconomic events.

But times are anything but typical. Various conditions are coming together which will keep homeowners in their current residence far longer than historic norms. There is a large number of homeowners currently underwater on their mortgage, and an even larger number with less than 20% equity. Given that getting a mortgage with less than 20% down payment is difficult and very expensive right now, homeowners who currently have less than 20% equity would have to come up with a lot of cash in order to move to another home.

So the housing turnover element of mortgage principal payments is set to plummet. In addition, the same factors will prevent many refinancings. A borrower underwater on his current mortgage will not be able to refinance his loan just because rates fall 50bps.

This means that the average life of a mortgage is longer than is currently being assumed.

For example, a Fannie Mae 30-year 6% mortgage security currently has a nominal yield of 6.19% and an average life of 5 years. The average life is the median of a Bloomberg survey on prepayment estimates. That calculates to a nominal yield spread of 271bps.

Note that a 6% mortgage security is typically made up of borrowers with a 6.5% mortgage. Currently mortgage borrowing rates are 6.26%, according to Freddie Mac. Under normal conditions, one would assume that a 6.5% borrower is relatively close to a refinancing opportunity. Hence Wall Street prepayment models are assuming that this mortgage will pay principal slightly faster than this time last year.

More likely is that mortgages will prepay at historically slow rates. Cutting Wall Street's estimated prepayments in half, the mortgage's average life goes from 5 years to 9 years. Because the yield curve is so steep, that results in the yield spread falling to 219bps. If you cut Wall Street's estimate by a third, the spread falls to 202bps.

As investors come to terms with the extending average lives, prices are likely to fall rather than yield spreads contract. Holding the 271bps yield spread constant but extending the average life to 9 years causes the price to drop by over 3%.

Technicals for MBS remain ugly as well. Regional banks and credit unions were classically large buyers of agency MBS. But given the capital situation at banks, we are far more likely to see banks as net sellers of MBS over the next year. In addition, Fannie Mae and Freddie Mac will continue to dominate overall mortgage issuance, and both will be under political pressure to expand their guarantee business. This means more supply of agency MBS.

The best plays in MBS are securities where extension risk is limited. That's 15-year mortgages and hybrid-ARM securities. Both have a natural limit to how much interest rate risk can increase, given the shorter maturity/reset.

Preferred Stocks: These aren't the stocks your looking for

With Wells Fargo and J.P. Morgan sparking a big rally in banks, income hungry investors may be tempted to look to preferred stocks. Whatever you think of the future of financials, I think preferreds are a bad play.

Take as an example Wachovia Capital Trust "B" Preferred. These have a $25 par amount and a 6.375% coupon, and have traded today in the $14.50 area. At that price, the preferred has a yield of 10.99%. That's a nice juicy income number to be sure. And hey, you might reason that Wachovia is a large bank with access to liquidity from various sources, not the least of which is the Fed. Plus it has been mentioned as a takeover candidate several times, so if they really got into a liquidity crunch, they'd probably choose a low-ball merger offer over bankruptcy.

All that's probably right. But consider the risk/reward of preferred stock compared with other opportunities. First the upside. If you think market sentiment is overly negative and that a given bank will be able to earn their way out of capital problems, you should buy the common. Wachovia stock was trading in the $30/share area as recently as May, compared with less than $13 now. So the upside for a bank like Wachovia, if indeed conditions improve, is a multiple of its current price.

Compare that with the preferred trade. The "B" preferreds were initially sold on February 8, 2007, near the peak for the credit markets. In order for the preferred's price to get back to its $25 offering level, credit conditions would need to return to pre-sub prime levels. That's not going to happen any time in the next couple years. In fact, comparable J.P. Morgan preferreds trade in the $21 area. So logically, the best possible intermediate-term upside for the Wachovia preferreds is about 50%, versus maybe 300% for the common.

Now compare the downside for both trades. If Wachovia were to go bankrupt, both would be worth zero. At a retail bank, there are too many other stakeholders ahead of preferred holders, namely depositors and senior bond holders, for preferred shareholders to expect anything in bankruptcy.

Same downside but better upside with common stock. Seems like a no-brainer.

Now some argue that the income from preferred shares cushions your downside. Sure, given enough time. But the reality of this market is that any given bank are either going to survive this next year and thrive, or they aren't. Within the next year or so there will be "burnout" on the 2005-2007 vintage home loans. In other words, all the loans that are going to go bust will have gone bust. The unknown is how deep the losses will be and which banks will be hit the hardest.

So if a given bank survives the next year, odds are its share price is much higher, and its preferred price is mildly higher. If it doesn't make it, then you are wiped out either way.

If you are looking for income and want to limit downside, then senior bonds make much more sense. I am not a buyer of bank bonds here, but at least the risk/reward is better aligned. Senior bond holders should enjoy significant recovery if a bank is liquidated.

Finally, be especially careful with preferred shares of Fannie Mae and Freddie Mac. How preferred shareholders will be treated in the event of a full government takeover is a complete unknown. I'd guess preferred shareholders would be okay, but its not something any of us can asses objectively, and therefore you have to stay away.

(No position in Wachovia. My firm owns senior debt of Fannie Mae and Freddie Mac)

Wells Fargo: Not so wounded as we were led to believe

I had been thinking we'd get a post-bank earnings rally, and Wells Fargo's not-so-bad earnings report got me off on the right foot. CDS on WFC fell 25bps, with other banks 10ish tighter.

Now this is mostly short-covering, I'm sure. You have Wells Fargo, the most staid bank in the country, rallying 30% in a single day. Only panicky shorts can cause such a sudden shift in a name like Wells. Hell, the whole S&P Financials sector is up over 10%.

If you need further proof that its a short-covering rally, consider the alternative. Investors are pouring into financial shares because they suddenly have confidence in the banking system.

Now just because its a short-covering rally doesn't mean it couldn't mark a Bottom (tm). This bear market isn't going to end with investors suddenly having confidence in financials. It will end when shorting financials doesn't seem like an easy trade any more. And no, Mr. Cox, it isn't the short-sellers fault. Short interest is so high because there is a lot of stuff worth shorting. So you can't get a bull market in anything until the shorts get out of the way.

So is it a Bottom (tm)? Who knows. My view is that we'll bottom when it is viewed that the big banks and brokers don't need more capital. I think it will take at least another quarter of earnings reports for the market to get that kind of confidence. Obviously oil and monetary policy could get in the way as well.

Anyway, we'll see how J.P. Morgan and Merrill Lynch come out tomorrow. I expect a good market reaction either way after J.P Morgan's numbers. Merrill is more risky. Continue to be short duration.

Update on USA CDS

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

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

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

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

The GSEs: Even Yoda cannot see their fate

This is a bond market blog. Fannie Mae and Freddie Mac are dominant players the bond market. Not only are they the biggest non-Treasury issuers of straight debt securities, mortgage-backed bonds guaranteed by the two mortgage giants represent over 30% of the total taxable bond market. Therefore the problems at the GSEs probably touches just about every investor directly in a way few other companies would.

While delinquencies on their guarantee portfolio remain relatively small (0.81% for Freddie Mac and 1.22% for Fannie Mae), the fact is that both companies employ tremendous leverage, and therefore losses even mildly above historic norms are likely to put huge pressure on the company's equity. In addition, Freddie Mac is yet to complete the $5.5 billion capital raise they promised in May, and given market conditions, this will be all but impossible without government intervention. So I'm not here to challenge the plunging share price of either Fannie Mae or Freddie Mac.

I also don't feel like commenting on the bailout plan, other than to say that its a sad day for free markets. I see the Treasury as between a rock and a Depression, and has selected the rock. I'd have done the same. I don't blame Treasury so much as I lament that its come to this. Exactly who to blame for this or what could have been done differently in the past is a discussion for another time.

There are two somewhat unrelated things I want to comment on. First is this stupidity about FAS 140. FAS 140 has nothing to do with anything. Or at least, it should have nothing to do with anything. An upcoming revision to FAS 140 will tighten the rules about off-balance sheet accounting. Based on how both GSEs currently operate, this would probably require both Fannie Mae and Freddie Mac to bring their guarantee portfolio on balance sheet. Under current statues, the GSEs minimum capital required is 0.45% of of their guarantee portfolio and 2.5% of their aggregate on-balance sheet assets. So taken literally, the GSEs capital requirements would increase dramatically if their entire $4.5 trillion guarantee portfolio were brought on balance sheet. The commonly reported number is $43 billion for Fannie Mae and $38 billion for Freddie Mac.

Of course, its ridiculous to think that regulators would allow an accounting rule change to dictate the GSEs minimum capital. Economically the GSEs are no more or less safe whether this stuff is on balance sheet or off. Its especially ridiculous given that a capital infusion of that level would be impossible to achieve in almost any market, much less now. And the GSEs alternative would be to sell massive amounts of MBS on their books, which would benefit exactly no one. Indeed OFHEO director James Lockhart has said point blank that FAS 140 should not apply to the GSEs and that accounting changes would not drive a capital change.

The second is where we should go from here with the GSEs. I will ignore what the Libertarian in me would like to see and thinking about what could happen. In other words, we should take it as a given that the base mission of the GSEs will remain as is. Congress wants to see some entity out there which can promote home ownership and help stabilize the mortgage market.

My idea would be to break up Fannie Mae and Freddie Mac into several, smaller entities. Say we make it 10 different companies, which I'll just call the "Macs." The $4.5 trillion guarantee portfolio would be divided equally among the Macs, not by geography, but more or less randomly, with some effort made to be sure the quality of each loan portfolio is roughly the same.

All of the Macs would be given a credit line with the Treasury equal to 10% of their guarantee portfolio. Any amounts drawn on the line would be at some small spread to LIBOR, say 3-month LIBOR + 20bps. This would in essense ensure liquidity at each of the Macs while at the same time giving them a strong incentive to use private funding, which would almost certainly be at a better rate than LIBOR +20. Note that historically, Fannie Mae and Freddie Mac debt has traded at LIBOR minus 20 or so.

The Macs capital adequacy could be managed more like a bank's. And there would be a stipulation that if the Macs capital fell to a certain level, the Treasury would take over operations, not unlike the FDIC taking over a failing bank. There could then be something similar to a bankruptcy procedure, but with the Treasury credit line ensuring that some mass contagion did not ensue.

What's the advantages here? First of all, no one Mac would be too big to fail. If one of the Macs f'ed up their hedging or some such, the government could liquidate shareholders relatively easily. Second, there would be a more known procedure for what happens in event of a Mac failure. Third, having several Macs would encourage competition among them, which would probably drive mortgage rates down. As it is, Freddie and Fannie are dictating terms of the mortgage lending business.

Now I know this isn't a complete plan, but I'm interested to hear comments on what we should do with the GSEs. I encourage everyone to remain within the realm of realism. There will be such a thing as a GSE in the future. So let's consider what they will look like.

Maybe it's another drill

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

Draw your own conclusions. I've drawn mine.

A New Monoline: Its our only hope

On Tuesday, Ambac announced it is making progress on recapitalizing its Connie Lee subsidiary. This sent Ambac and MBIA's stock prices soaring (+52% and 22% respectively) and their credit-default swaps plunging (about 6 points each). CDS on both company's insurance arms are now 20 points below the wides. What are their plans for recapitalization and what does it mean for municipal bond investors?

Both Ambac and MBIA are facing three grim realities:

1. They cannot raise enough new capital to regain a AAA/Aaa rating, especially since the ratings agencies have shifted their focus away from capital adequacy and onto financial flexibility.

2. They cannot write new business without a top rating.

3. It will take at least two years before the extent of their residential mortgage losses are known. Even given a very favorable outcome, too much time will have past for them to rebuild their franchises.

There is a faint glimmer of hope, however. Despite all the problems monolines have faced recently, there is continued demand for municipal bond insurance. During the first quarter, about 24% of new municipal issues carried insurance. Down from the historical norm of 50% or so, but still a reasonable market. So if Ambac or MBIA could just start fresh, there is some chance they'd be able to rebuild their reputations for financial strength. Its probably a long shot, but its not impossible.

The plan to get this fresh start is relatively simple. Ambac Financial Group (the parent company) plans to transfer $850 million out of Ambac Assurance Corp., which is their primary insurance subsidiary. This is made possible, ironically, because Ambac Assurance has reduced capital needs now that they are only rated Aa3/AA. The cash would go to Connie Lee, which is in essence a dormant registered insurance sub. In theory Connie Lee could operate with its own assets and liabilities, with its own relation to Ambac's current insurance operation being a common holding company owner. Hence there would be no mortgage exposure at Connie Lee. This would presumably allow for a AAA/Aaa rating and possibly the ability to write new municipal bond policies. MBIA's plans are substantively similar.

Where does that leave existing policy holders? At one time, there was talk that the new insurance subsidiary would reinsure all the existing municipal bond policies. In effect, transferring existing municipal insurance from Ambac Assurance to Connie Lee. This was legally complicated, as it would have in effect benefited one class of policy holders (munis) at the expense of another (structured finance). There would be lawsuits and the plan would get tied up in court for years. So now it appears that this kind of plan is dead in the water. Therefore even if Ambac is able to capitalize Connie Lee and get a fresh AAA/Aaa rating, there will be no direct benefit to current Ambac policy holders. In fact, Ambac Assurance will lose $850 million in capital in the process, putting existing policy holders in a somewhat weaker position.

On the other hand, if the plan were to actually work, if Connie Lee is able to start writing a reasonable amount of new muni business and therefore Ambac Financial is able to remain solvent, existing municipal bond holders will probably benefit. Over time, Ambac's structured finance exposure will dwindle, either because they realize losses or because the underlying bonds pay off. If indeed the parent company survives this process, they may be able to regain a top rating, or perhaps merge the existing Ambac Assurance with Connie Lee and regain a AAA/Aaa rating that way. Again, MBIA's plan would work similarly.

What are the odds the plan will work? It depends on how the market perceives Connie Lee vs. Ambac. Does the market think that Ambac's poor credit work was to blame? Or will the market separate the poor judgement Ambac showed in the structured finance market from their decisions in the municipal market? It will probably take Connie Lee accepting a relatively low premium and/or insuring weaker credits at least at first. Then slowly repairing their reputation. The odds are against them, but like I say, not impossible.

So how should muni investors treat Ambac and MBIA insured bonds? The reality is that any bond with an Ambac or MBIA (as well as FGIC, XLCA or CIFG) insurance is trading weaker than the underlying rating would imply. In other words, bonds are trading as though there is a penalty for once carrying Ambac or MBIA insurance. While this would seem to present a buying opportunity, be sure you can handle the illiquidity. Many institutional municipal buyers don't want to explain to their clients why they hold so much MBIA paper, so even at higher yields, bids can be hard to come by. I wouldn't expect the "penalty" to go away any time soon, so buyers of this kind fo paper need to have a long time horizon.

As far as MBIA or Ambac debt, proceed with extreme caution. Both companies are in Hail Mary mode, as current conditions have left them with very few options. In such situations, bond holders are not given much consideration by management. Preferred shareholders are in particularly precarious position, as they sit behind both insurance policy holders and senior debt holders.

The common stocks of both companies saw a significant short-covering bounce. One has to wonder about the wisdom of shorting a stock trading at $1 anyway. Common shareholders should view these latest plans as a last-ditch effort to create any kind of value for shareholders. Given that is the situation management is in, nothing more needs to be said about the risk of owning the common.

Clumsy and Random Thoughts

• It is feeling very panicky right now, in that the market is moving suddenly and without proximate reasons. Unfortunately, the panic is legitimate. No one knows what a GSE bailout will look like.
• But you shouldn't conclude that a bailout would be difficult. Read this post. I stand by everything I said then.
• There are also rumors that PIMCO and SAC were not trading with Lehman. Both PIMCO and SAC have denied the rumor. Worth noting that PIMCO was one of the first to stop trading with Bear Stearns. Anyway, neither has reason to deny the rumor other than that the rumor isn't true.
• The more panicky things get, the more likely we get a relief rally after bank earnings are out. Odds are good that it will be a mixed bag, with some banks looking particularly ugly (Wachovia this morning warned of a huge loss) and others will be bad but not that bad. I mean, take a look at short interest on the NYSE...

• That being said, I don't think we can get a sustained rally (in credit or equities) until the market thinks it knows the outcome of both bank capital raising and home price declines. Now that will happen before housing has actually bottomed, because the market will look forward and conclude the worst is behind us.
• So I'm still vastly underweight credit generally and financials specifically. I've cut duration in an attempt to play a post-bank rally, but I'm just too chicken shit to buy a bunch of bank paper here.

Stagflation: I can't shake it! I can't shake it!

Thursday's employment report paints a pretty bleak picture of the economy. Consumers are already facing a massive wealth drag from housing, and now more and more are facing lay-offs as well. Yet somehow the consensus is for rising inflation. The 1-year inflation expectation, based on TIPS trading levels, is currently 4.31%, up from 2.24% at the beginning of the year. The weak economy and the relatively high inflation outlook has some uttering the S-word: stagflation.

The pervasive inflation talk in the media may be hard to ignore, but ignore it you should. The conditions for a real inflation spike just aren't in place, and making investment decisions with an inflationary view will wind up costing you money.

First, let's talk briefly about what inflation really means to economists. It isn't rising cost of living, which is probably how the average person thinks of inflation. Clearly with energy and food prices rising, the cost of living is going up. But inflation is defined as too many dollars chasing too few goods. In other words, inflation is always and everywhere a monetary phenomenon, the result of the intersection of money supply and money demand. Surging oil prices due to increased demand from China is not inflation. Higher cost of living? Sure. Inflation, no.

Unfortunately, measuring the effective money supply and demand is nearly impossible. But what we can do is estimate how much money people have to spend vs. how many goods are being produced. This should get at how many dollars are in the hands of consumers versus how many goods those dollars are being chased. A combination of unit labor costs and productivity should do the trick. The following chart compares Unit Labor Costs, Non-Farm Productivity, and Total CPI (all from the Bureau of Labor Statistics). We'll specifically look at 1974, 1979, and 1980 (the three double-digit inflation years) as well as 2007 and 2008 (annualized Year-To-Date).



We see that labor costs surged (blue bar) in the 1970's inflation spike, while productivity (yellow bar) waned. So it was costing more per unit of labor, and each unit of labor was producing less. Sure sounds like too many dollars chasing too few goods. Looking at 2007 and 2008, we don't see the same pattern. Unit labor costs advanced at a modest pace, while productivity has been robust.

Another definition of inflation is a pervasive rise in prices over time. In the 1970's, we certainly saw large price increases across a wide variety of goods. Today, not so much. The chart below is a histogram of CPI components for the same years as above. Again, the data is from the BLS, and again, the 2008 data is annualized.



To build this chart, each CPI component was categorized based on its percentage change, with the groupings done in 5% increments. The bars show the percentage of all components which registered a change within the indicated range. For example, in 1974, 74% of all CPI components clocked at least a 10% price increase, whereas only 2% showed a price decline. 1979 and 1980 showed a similar pattern, with at least 90% of all items showing a 5% increase or more.

Today's pattern is completely different. So far in 2008, the distribution of price increases is more evenly distributed. If inflation were on the rise because of loose monetary policy, or a weaker dollar, the price of everything would be rising at once. That just isn't the case right now.

Finally one needs to consider the impact of contracting consumer credit. Part of the effective money supply is how much banks are willing to lend to consumers. When the Fed cuts interest rates, it is in part trying to encourage borrowing to expand the money supply. But it is clear that consumers access to credit will be tight for the foreseeable future, mitigating any direct impact from the Fed's actions.

There is scant evidence that we're currently experiencing monetary inflation. And therefore it is unlikely we'll see any Fed hikes in the near future. Yet Fed Funds futures still price about an 80% chance of a hike by October. Investors holding on to cash hoping to see better investment rates in the future will be in for a long wait. There are much better opportunities in 2-5 year bonds, both in municipals and high-quality taxables.

Moral Hazard: I dunno... I can imagine quite a bit

In reading my post from Monday on mortgage bailouts, one commenter mentioned moral hazard. I feel like this is becoming an over-used term, and I'd like to state Accrued Interest's official position on the subject.

According to the most authoritative source I could find (Wikipedia)...

"Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions."

Any time risk has shifted in any way from one party to another there is potential for moral hazard. Someone who has health insurance that pays for all prescriptions probably winds up using more prescription drugs. That's one example of moral hazard.

In the case of a bailout, it is usually not the bailout itself, but the implication of the bailout. Its the precedent set that is problematic. So for example, when a rich kid crashes Daddy's car into the neighbor's tree, and Daddy just buys another one, the kid makes an assumption about the future. He assumes that Daddy will keep bailing him out of jams.

So let's look at two simplified examples of a housing-related bailout. In one corner, let's say that banks are forced to write down all upside down mortgages by 20% and in exchange, the government agrees to take all subsequent losses on the loans. The banks who made bad loans suffer a good deal from this, but perhaps not as much as they would have otherwise. This isn't exactly Daddy buying them a new car. More like Daddy paying for the damage the kid did, but making him ride the bus to school from then on. We can debate whether those are adequate consequences or not, but certainly the banks didn't expect to take a 20% loss on those loans when they first made them.

The same goes for bond holders. They suffer losses much greater than they anticipated when they bought the bond. Maybe not as large as might have otherwise been, but still large.

The borrowers who took out loans they knew they couldn't afford get completely bailed out here. Maybe they don't get a new car, but Daddy's repairs the old one and things continue as they had before. The borrower gets something for nothing.

Now compare that with some program that encourages people to buy foreclosed homes in a big way. What you've done is alter the demand curve for homes by making them both more affordable for end buyers and making a buy to rent investment more attractive.

In this case, the borrower is probably no better off. S/he was already foreclosed upon. He really doesn't care what happens to his house after that. The bank is clearly better off, because they get a better price on their REO portfolio. Investors too. Both have their loss severity reduced.

But all the guilty parties wind up suffering a fair amount under such a plan. In other words, every one involved regrets their actions.

Now let's take a step back. We know that the government is going to interfere in the housing market. No matter what is done, there will be moral hazard involved. I'd like to see moral hazard limited by making sure that all involved in the mortgage lending process suffer to a significant degree. We want everyone involved to be saying (sarcastically) to themselves "This is some rescue!"

What we don't want is for either the lender or the lendee to say, "That wasn't such a chore now was it?" We don't want one party to bear all the risk, nor to have the government take away all the pain from any one group of participants.

You can reduce the supply of foreclosed properties either by preventing the foreclosure or by having someone buy the foreclosed properties. Any program which prevents foreclosures is benefiting the lendee at either the lender or the tax payer's expense. By encouraging investors to buy foreclosed properties, you are giving the primary benefits to an uninvolved third party.

I think that translates to less moral hazard.

Rumor of the day

Apparently today's sudden sell-off (rally in bonds) has something to do with Fannie Mae and Freddie Mac. Both stocks are down ~25%, MBS are getting crushed (FNCL 6% underperforming the 5-year by close to 3/4 of a point) and even agency debentures are 5-ish wider. Pretty big single-day move. The 2-year Treasury went from 2.55% to 2.36% in about 10 seconds. Now that's a flight to safety!

Its also obvious rumor mongering. Haven't heard any specific rumor of earnings pre-announcement or anything like that. Both companies don't report until August. I'll post what I hear.

Update:
Hearing that one of Freddie Mac's top 3 shareholders either has or wants to dump his shares. FRE/FNM CDS are 80bps senior and 200bps subordinate, the former is 13bps wider on the day and the later about 23.

Update #2:
The main-stream media has been citing a Lehman research report discussion the adoption of FAS 140, which according to the report would require $46 and $29 billion of capital for Fannie Mae and Freddie Mac respectively. Say what you want about FAS 140, but the Lehman report is absolutely positively not why the market is moving today. First of all, the report want issued early this morning. The sell-off really got going in the early afternoon. Second, the Lehman report is bullish on the GSE's stocks! From the report...

"One issue we want to focus on in this report is a pending FASB rule change, the outcome of which could be so contrary to all other current capital ratios and policy initiatives that we cannot imagine such an outcome occurring."

and...

"But at these prices we are sticking by our view that the NPV of the GSEs' profit growth and intrinsic franchise value should produce returns that make today's price look compelling."

Looks like bank and broker CDS can't catch a bid despite the FRE/FNM story. Also 2-year swaps, which initially pushed 3bps wider just as the GSE's were cratering is now about 1/2 of a bp tighter. Don't read that as indifference about the GSE's, read that as what can happen when a trade becomes uni-directional.

MBS spreads were as much as 20bps wider on the day, now only 7. Straight agency debt still about 5-8 wider. FRE/FNM CDS in the same context, maybe 2-3 better than the wides.

If you care, here is my view on a GSE bailout, basically that it would most likely take the form of direct government-backed debt, as opposed to some huge outlay of cash. It will happen if it comes to that.

Housing Legislation: Short help

The Frank/Dodd housing proposal, while not law yet, looks to be headed there. While it seems the proposal will have some non-zero impact on the housing market, I'd vote against it. Quickly, here are my problems with the proposal:

• The key element is that the government will trade a GNMA security for a troubled loan as long as the bank holding the loan agrees to write down the principal to 85% of the assessed value of the home. This could be a very large write down in many cases. Say I bought a $300,000 home at the peak and put 5% down. Let's say the appraised value has fallen by 15%, so the house is worth $255,000. Now the bank has to write the loan down to 85% of that ($216,750) in order to participate in the Frank/Dodd program. What started out as a $285,000 loan must be written down by $68,250, or 24% of the original loan amount. Banks are going to be very reluctant to participate in this program. Why not roll the dice and hope that the borrower keeps paying?
• Given the above, any loan the bank does decide to put into the GNMA program will be of the truly toxic waste variety. So tax payer costs will be significant.
• Even if the proposal were to be signed into law today, most analysts agree that the book on 2008 foreclosures is already written. The foreclosure process is always a lengthy one, and currently servicers are swamped, so its taking longer than usual. So the proposal won't start having an impact until 2009.
• By that time, we'll be nearing a "burn out" on bad mortgage foreclosures. By this I mean, at some point, all the really bad loans from the 2005-2007 period that are going to default will have defaulted. By mid-2009, it will have been two full years since the sub-prime blowups started. That should be enough time for the overwhelming majority of the loans to borrowers who really can't afford the loan to be ferreted out. From that point on, loan foreclosures will probably be above average for a while because of the lack of equity, but the pace should decline.
• By early 2009, homes in the most bubblicious areas will be down 25-40%. So the amount banks have to write down to stick these loans to the government will be very large indeed. The risk/reward may be to retain the loans and hope that most of your borrowers keep paying, or to work out a separate modification rather than participate in the Frank/Dodd program.
• Put the last three points together, and most banks will figure they've already foreclosed on the properties they might have originally put into the Frank/Dodd program, and what remains is worth keeping.
• I'm not even mentioning the obvious moral hazard, which is another issue entirely.

So this housing proposal, at least as far as helping home owners, is a lot of political posturing without much eventual impact. So I'd vote against it.

What kind of government intervention might actually work? What the housing market needs is a reduction in supply. We're slowly getting to a place where new construction isn't so much a problem, but as I've alluded to above, I think we're about a year to 18-months away from the peak in foreclosures. So that's going to remain a problem.

Normal household formation won't soak up the supply for a while. A recent report from Lehman Brothers indicated that there will be 4 million units which need to be absorbed by the end of 2009, both foreclosures and new home construction. About 1 million can be taken down by normal household formation. That leaves 3 million homes to sell, a pretty big nut to crack.

Demand could come from either current renters becoming home owners or investors. In both cases, prices need to drop a large degree to stimulate demand for 3 million marginal homes. For what its worth, the Frank/Dodd proposal is estimated to help 500,000 home owners. That still leaves a pretty big nut to crack!

There is actually a relatively simple way for the government to help soak up this demand quickly. Make investing in a home more attractive. In other words, make buying a foreclosed property for the purpose of renting it out a more attractive investment. It could work any number of ways: there could be a large tax rebate to the investor, FHA could offer cheap loans, etc.

It could even be structured such that the financial system was strengthened in the process. Say the government allowed anyone who bought a foreclosed property to write off 20% of the purchase price on their taxes, but in order to qualify, the buyer has to have at least 20% equity in the home. The result would be a deleveraged housing sector. Most alternative proposals involve the government helping to provide down payments. But that doesn't deleverage anything, only shifts the leverage to the government.

Anyway, my idea is politically untenable, since it would help wealthy investors make money on the back of a displaced homeowner. So it isn't likely to happen. There have been similar programs enacted in urban areas, under the auspices of reducing urban blight. So it might be that some local municipal housing agencies attempt such a thing.

By the way, while I doubt the Frank/Dodd proposal helps much in terms of housing prices, it probably will help in terms of certain sub-prime securities. As I said above, banks will most likely transfer the worst of their loans to FHA under the proposal, i.e., the ones they securitized. Most of the A and BBB-rated sub-prime bonds from 2005-2007 are toast anyway, but the senior stuff trading at 50% of par could see some significant benefit. Too bad it'll be too late for Ambac and MBIA...

Oh the uniform!

By the way, I've turned off anonymous commenting. Its annoying when the thread gets long to keep referring to Anon #1 or Anon @ 3:45. Just invent some handle and be defacto anonymous if you must.