What would ya like?

Does the TARP mark the death of capitalism? To some commentators, apparently it does. To be sure, this kind of massive government intervention is the last thing any real capitalist wants to see. But is what we have now any better? Let's think about why we like capitalism as a concept, then consider whether this market even remotely resembles capitalism.


Free markets are supposed to efficiently allocate resources. If there are too many pizza places in your town, but not enough auto mechanics, the free market is supposed to drive one of the pizza places under and encourage entry by an auto mechanic. While we may feel for the proprietor of the pizza joint, we know that in the long run, we're all better off when the market is allowed to move resources away from the pizza business.


But we don't want to see the pizza guy forced to close shop because of some external dictate. We want to see a vote held to decide whether we have too many pizza shops in town. We want all the pizza places to compete for business, with the better competitors enjoying strong profits. In fact, we don't even want to see the weaker competitors driven under. Ideally, the weaker competitors will improve their operations and become stronger competitors. But if not, then indeed one or more of the pizza restaurants will undoubtedly go under.


So what kind of world are we living in now?


Let's take a hypothetical investment bank. We'll call it Merrill Brothers (MB). MB became involved in underwriting a series of commercial real estate loans during 2006 and 2007. MB retained some subordinate interests in these loans, as management believed these projects were attractive investments.


Some of these were for condo deals, which is obviously not the best place to be now. Perhaps given the benefit of hindsight, MB wouldn't have entered into the condo deals at all. But it is what it is. MB's management needs to decide what to do about the loans now.


I think in a real capitalist economy, MB would be given the chance to live or die based on the actual performance of these loans. Why? When any bank makes a loan, their credit analysis is based on the perceived odds of the loan remaining current. The capitalist system should reward the banks that make good underwriting decisions based on this criteria.


But in today's market, MB would not be given that chance at all. In terms of mark to market, all credit-oriented securities have declined in value from 2007 to today. Obviously a loan for a condo project would have declined significantly in market value. Forget, for a moment, why these loans have declined in market price and/or whether that decline is reasonable. Let's just stick with the fact that the market price is lower than the original price.


Let's assume that MB's management absolutely loves their loan portfolio, but the market believes their loans are only worth $0.60/dollar. And many will question whether $60 is a good price. But if MB plans to simply hold the loan, what does the market price matter anyway? It really shouldn't. MB should have the chance to live and die by the economic reality of their lending decisions. Not the market's perceptions of those decisions.

Now perception becomes reality as the continuous negative headlines cause trading partners and lenders to back away from MB. In the end, MB either fails or runs to some better capitalized partner. But ultimately it isn't a capitalist ending at all.

Think of it like a poker hand. There are two queens and a 10 on the board, and you have a 10 in your hand. Your opponent is betting the hell out of it. Sure seems like he's got a third queen, and maybe the best play is to fold. But should the other players at the table step in and force you to fold? In a free market, you can bet, raise, or fold, no matter what other people say.

So now we're faced with to non-capitalist paths. On one hand, the current situation. On the other hand, a government bailout.

The bailout will create some semblance of confidence in financial institutions and their balance sheets. There will be some increase in lending capacity. There will be some end in sight for declining home prices.

If there is no bailout, then what? When do things improve? Does the commercial paper market shut down? Is it possible to leverage trading books? Can anything be securitized?

So as much as we all hate the idea of a government bailout, we really need to consider what kind of capitalism we think we're defending. I'd love to hear more about long-term solutions to our problems. But in the short-term, we have to stem the relentless waves of fear. Before its too late.

Stock shorting isn't the problem. CDS are.

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

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

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

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

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

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

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

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

Resolution? Trust? A Jedi seeks not these things!

I hate to say it. But we need this. There needs to be massive government intervention to create some degree of confidence. It would be one thing if Lehman and Merrill and WaMu and AIG all went under (or were taken out under duress). But now they are coming for Morgan Stanley and Goldman Sachs.


That just can't happen.


Look, the financial world is a confidence game. Even simple trades involves confidence. You put your money into a Merrill Lynch account and buy a stock, you assume they're holding that stock. Hell, you assume the money market fund they use is safe. You assume your bank will be able to cash your checks. Etc. Etc.

Once that confidence is lost, the system can't continue. Everything will break down, and I mean everything. Our whole economic system would collapse.

Spare me the moral hazard arguement. What about the reverse? Should Goldman Sachs pay for the sins of Bear Stearns? Should Morgan Stanley pay for the sins of Lehman Brothers? Look maybe no one is completely innocent here, but it seems to me that Morgan Stanley is petty theft whereas Bear Stearns was a serial killer. Should we execute both?

Its sad that its come to this. But I don't know what else we were supposed to do. I want to live in a Libertarian/Capitalist paradise as much as anyone. But if we waited for the market to figure all this out, we'd be left with no capacity to finance anything. Our economy just won't work like that. No capitalist economy could. Its called capitalist for a reason. We need capital to make it work.

Bonds are highly illiquid right now. Even Treasuries are showing unusual bid/ask spreads. There are many many many players who are going to be caught on the wrong side of this thing. On top of that, there are many players who are going to (quite reasonably) want to flatten their positions and wait to see how this plays out.

In corporates, especially Goldman and Morgan, potential sellers have disapeared so as far as I can tell, little is trading currently. CDS are gapping tighter of course. There will be a serious short-squeeze in CDS before things stabilize.

Some hedge funds are going to get crushed. I mean, anyone who was leveraged short financials may wind up getting busted out. That will result in some weird trading in seemingly unrelated instruments. Hence, I think you would be wise to not chase this move too aggressively. If you can find stuff that's lagging merely because it isn't getting any attention, fine. But don't over play it.

Personally (not professionally) I'm looking to reset a dollar short I've had. While this may be the right move for the economy, it isn't good for our currency.

Lehman Brothers: Bounce too close to a supernova

I have nothing to say about Lehman itself, except to say that I really and truly believe they could have remained solvent in a more normal market. I'll also say I'm surprised no deal emerged as it seemed to me like there were enough parts worth buying. But deep down, I think Barclays in particular was scared that if they bought "Lehman" assets, the market would have seen it as nothing more than "Lehman" assets. In other words, Barclays might have gotten away with buying the same assets from someone else, but the very fact that they were Lehman's would create a special stain. What would then stop them from coming for Barclays? Ultimately, it was too risky.

On the market overall, it should be lower. Goldman and Morgan Stanley are going to have to merge with a bank. Period. Even if its a bank that's smaller (say a U.S. Bank), it will have to be done to diversify their funding sources.

This also pushes back any kind of recovery for the economy for a long time. I was thinking 3Q 2009, but now I'm thinking at least a year beyond that. I could be convinced to move off that either way by incoming delinquency figures, but for now I'm thinking year-end 2010 before any improvement in the economy.

So I've further reduced my credit underweight and increased Treasury exposure. The risk on Treasuries is the dollar. Most of the Treasury rally in September was dollar related up to today. For the moment we're getting a big rally on fear, which makes sense. But if the dollar starts to get pushed around, the Treasury market won't hold up.

Right now I'm willing to bet on Treasuries because I don't think Europe is any better off, and in fact I'd expect interest rate differentials to favor the U.S. on the margins (i.e., Europe will cut rates). But the situation is fluid enough to where I'm watching everything very closely.

This is truly uncharted territory.

Fannie Mae's new Debt: Look at the size of that thing!

Fannie Mae sold $7 billion 2-year notes this morning at Treasuries +70. The deal was oversubscribed. Here are the distribution stats.

US: 63%
Asia: 12%
Europe: 8%
Other: 17%

By type...

54% Money managers
27% Central banks (!!)
19% Other

The 27% Central Bank number is really helping Agency spreads tighten. We're 5-6 tighter, with MBS mildly tighter as well.

Dunno what to say about Lehman. Seems obvious that Fuld has given up the quest to remain independent and is looking for a buyer. That's why they are doing this spin-off of commercial real estate. Once they do the spin-off, then they are basically just a bunch of investment bankers without all the balance sheet ugliness.

Some are skeptical that finding a buyer is possible, but all Lehman needs is someone who has a stronger balance sheet and can take reasonable risks, and the firm can be plenty profitable. It will probably be someone who wants to rapidly increase their presence in the U.S. HSBC has been mentioned, but denied interest. Or Nomura. Either way, someone like that should have interest in Lehman at some price. Remember, it will only take about $4 billion to buy Lehman at current market prices once you take out the commercial real estate holdings.

I'd rather buy Lehman than WaMu. There was a time when several banks were interested in WaMu, but bear in mind that WaMu's whole business is West Coast banking. Maybe J.P. Morgan would still be interested at some price, but you have to wonder JPM wouldn't rather hunt for another West Coast bank with fewer problems. There are accounting issues, which the media has been talking about all day, but forget all that. Do you really think buyers are saying "I'd love to own WaMu, but the accounting is tough." No, I think they are thinking, "I'm not really interested in WaMu, and I'll tell the media its because of accounting."

MBS: Marching into the detention area

While many expected the Treasury to eventually act on the GSEs, few (including myself) expected it to happen over the weekend. So what's the trade in fixed income? There have been four major ideas bandied about Wall Street over the weekend. They are: buy agency debentures, buy agency MBS (mortgage-backed securities), buy credit, and sell Treasuries.

The one I like the most is buy MBS. Yesterday MBS spreads moved dramatically tighter, 55bps in OAS (option-adjusted spread) according to the Lehman index, from +147 to +94. But you haven't missed it yet. For most of the last 10-years, the index OAS has been between 30 and 60bps, so there is plenty of room to tighter further in OAS. I've always felt as though OAS was an over-rated value metric, but today its especially questionable. The Treasury has announced their intentions to buy MBS in the open market, with the clear goal of pushing mortgage borrowing rates lower. Ideally the Treasury would like to set off a refi wave, which would help banks "naturally" delever as well as help separate good loans from bad. In order to get most 2006-2007 borrowers "in the money", mortgage rates probably have to fall to around 5.25%. I think this implies another 50bps of MBS tightening.

Buying agency debentures is less intriguing. Right now non-callable agencies are trading between 50 and 60bps more than comparable Treasury bonds. This spread might fall into the 20's for short-term bonds, but it won't collapse to zero. We don't currently know what the GSEs will look like after 2009, and therefore bonds maturing beyond 2-years shouldn't (and won't) be viewed as truly government-guaranteed.

Credit is highly questionable here. The large-cap financials should benefit significantly from a mortgage refi-wave. This would get the "good" loans off bank's balance sheets, freeing up capital, and clarifying how much each bank truly has in good versus bad loans. But the real catalyst for finance credit will be bank earnings which isn't until next month. Obviously the Lehman situation isn't helping either. Buying new issue bank credits isn't a bad idea as a trade but I'm staying underweight for now.

Non-finance credit makes even less sense. The GSE bailout may have been necessary, but it isn't a panacea for the real economy problems we're facing. I'd stay very high quality within credit.

The direction of Treasury rates is also questionable. There remains significant dollar-related buying, as evidenced by the strong bid for the 10 and 30-year bonds in recent sessions. That is a classic sign of foreign bank buyers, especially given the fact that economically, the yield curve should probably be steeper not flatter. There is also no particular reason to believe the GSE bailout results in dramatically more Treasury supply. Not to mention the simple fact that the economy remains weak which should be a natural support for interest rates. I'm staying close to home on duration.

Nevermind...

Remeber like 4 hours ago when I said it didn't look like anything was going to happen with Fannie and Freddie? Yeah... what I meant to say is that something could happen this weekend! At least that's what the Wall Street Journal is reporting.

Anyway, we'll see what it looks like. I still think that its most likely that the companies have agreed to whatever the Treasury is about to do, so it can't wipe out shareholders. Some capitalist president this dude turned out to be...

Unfortunately, the effect is going to be Treasury rates selling off and MBS rising, which isn't how I'm set up.

Did you catch Bill Gross on CNBC just now? They asked if he had been approached by the Treasury about any government-led solution, presumably asking if PIMCO would participate. Gross said he couldn't comment, which means the answer is yes. Hmm... wonder why no one asked Accrued Interest!?!

Anyway, its possible that this turns out to be a rotation moment, because a bailout of Fannie and Freddie doesn't solve our real economy. It does help prevent it from getting worse, but it doesn't solve anything. But it should help bring mortgage rates down, creating liquidity for financial firms. Could also improve risk aversion, which would help financial firms raise capital or at least sell debt. So we could see a period where financials outperform industrials.

GSE Bailout: Episode III

In recent weeks, a GSE bailout has seemed less imminent. Not because anything is getting better, but because it appears that the Treasury lacks the will to make a move. To be fair, the way the authorizing legislation is written, the Treasury cannot make a move without either the GSEs falling below their capital minimums or compliance by the companies. Based solely on how the company's are valuing their assets and liabilities, their capital position is well above regulatory minimums (especially Fannie Mae).

Now many believe that F&F's asset values are inflated, and perhaps that's true. But what do we expect? Will the government come in and audit the companies, write down their assets and then nationalize? It seems far fetched.

So if there is going to be some near-term action on strengthening the GSEs, it will have to come in a form to which the companies would consent. Ergo, it can't be something that would punish common shareholders.

I think that leaves three options. First would be to do nothing and see how things develop. Let's get back to that one later. Second would be for the Treasury to start buying loans and/or securities from the GSEs to reduce their liabilities. I talked about how this could work here.

Third would be for the Treasury to help the GSEs raise private capital. What if the Treasury agreed to guaranty the principal (not the interest) on a preferred stock offering. The size would be whatever is determined to be needed. In reality it might not be a single preferred offering, but a series of offerings with some pre-determined limit as to the total size.

The preferreds would be callable after 5 years, with the call becoming automatic if the GSEs share price reaches some milestone. The idea would be that if the GSEs are able to issue common equity, then they would be forced to call the tax-payer backed preferred and issue their own securities of some variety.

The Treasury could charge some fee in exchange for the guaranty. Say its an interest rate equal to the 30-year Treasury bond rate, currently about 4.25%. What interest rate the preferred would carry to investors would be determined in the market, but I'd bet somewhere in the 6-7% area.

Here are the advantages of such a plan. First, it could be implemented right away, allowing for stability in the mortgage market and likely a decline in mortgage lending rates. Second, its probably a cheaper plan for tax payers when compared with other options. We know that F&F's new business will be profitable, so if they can be stabilized with a capital injection, the odds that tax payers actually have to shell out any cash is low.

Unfortunately, this kind of solution has a number of problems. First, it creates all kinds of moral hazard, as common equity holders wind up benefiting from the tax payers risk. Currently Fannie Mae and Freddie Mac preferreds are trading with 15% yields, and a new issue, if possible at all, would certainly come at a discount to current levels. So under this plan, the GSEs would be able to issue preferred equity about 500bps cheaper than would otherwise be.

Second, this plan doesn't move us any closer to a more permanent solution to the problem of macro risk and the GSEs. Its a plan that, while easy, doesn't really get us anywhere in the long-term. I suppose such a plan could be an interim step on the path toward full privatization, the idea being to stabilize the market now, buying time for a long-term solution.

Its looking to me like this administration won't do anything about Fannie Mae and Freddie Mac unless they are truly forced to do so. The closer we get to a new administration, the more likely that Paulson waits and lets the next Treasury secretary make the call on the GSEs. So I think we're in for another 6-months of the same with the GSEs. Its always possible that something happens in the interim that diminishes risk aversion and subsequently allows the GSEs to raise capital privately, but I'm not optimistic.

Would I buy agency securities given this outlook? Yes. Senior debt and MBS, but I remain underweight both. I'm probably negatively exposed should a full-on bailout occur. But that's a risk I'm willing to take.

MCDX: We had better start the evacuation

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

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

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

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

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

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

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

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

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

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

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

Accrued Interest Job Posting

I know times are tough in the finance business so I figured I'd pass along a job opening I know of. Its a chief compliance position for a trading firm. I don't know that much about what they are looking for, but I'd assume some compliance experience is required. E-mail your resume to "accruedint *AT* gmail.com"

GSE Bailout: Alternative forms of persuasion

The other day I wrote about a possible form of a GSE bailout. In the spirit of stimulating creative ideas, here is another possibility. Bear in mind that its looking more and more like a bailout isn't imminent (meaning its a matter of weeks or months, not days). I expect an interim step, probably some kind of purchase of MBS, to come before any actual injection of cash.

Despite what all the talking heads are saying, no one really knows, maybe not even Henry Paulson, what a bailout will actually look like. But there are ways that a bailout could be structured to both protect senior bond holders and help prevent the need for another bailout in the future. Now is a good time for people with good ideas to come forward.

First we have to consider what the goal of a bailout should be. In this case, its very simple: ensure liquidity to the mortgage market. This protects banks which have committed to home loans assuming one of the GSEs would buy them. This also keeps mortgage borrowing rates stable.

Beyond that though, there needs to also be some long-term solution to the GSE situation. Fannie Mae and Freddie Mac cannot return to business as usual. Another structure needs to be devised that reduces the systemic risk surrounding the mortgage GSEs. On the other hand, a simple "demonstrable privatization" is not a near-term solution either. Currently Fannie Mae, Freddie Mac, and Ginnie Mae are the only thing standing between here and absolutely zero market for home loans.

Many solutions being bandied about presume the long-term model for mortgage securitization remains in tact. But why? A big part of the inherent problem in the GSEs' current business model is that it requires substantial leverage to generate a reasonable return on equity. Think about it. They collect a relatively small fee in exchange for guaranteeing MBS. The de facto leverage created is huge, evidenced by the fact that foreclosure rates in Fannie and Freddie's guarantee portfolio remain fairly low, and yet both GSEs are facing capital problems. There is just no way around the leverage issue if the current business model remains in tact.

Covered bonds have been advanced as a long-term solution for the mortgage market. But covered bonds, as currently conceived, would not be a good replacement for agency MBS. This is because covered bonds would not trade generically, meaning that a covered bond from smaller banks would trade as well as those from larger banks. We'd wind up with large banks dominating the mortgage market, which has its own systemic risk problems.

So what if in the future the GSEs provided some limited guarantee on covered bonds? Remember that a covered bond is backed both by the credit of the issuing bank as well as a pledged pool of mortgages. So in order for anyone to take a loss on a covered bond, the bank would have to be bankrupt and mortgages would have to be defaulting.

Let's say the newly recapitalized GSEs are restructured more like an insurance company, where the GSEs would guarantee to investors some percentage of par, say 95%. Banks would remain on the hook for losses within the pledged pool as long as the bank itself remained solvent. But in the event that the bank goes under, covered bond investors would have a known limit on their losses. The GSE would also have contained costs, since in most cases the pool of mortgages which had originally secured the covered bond would have some residual value.

This a plan combines the best parts of both the covered bond idea (alignment of incentives) and the original mission of the GSEs (lowering mortgage rates). It would also kick-start the emergence of a covered bond market, because it would give investors a known set of outcomes when buying the new bond sector.

That leaves what to do with the old GSE guarantee portfolio. Assuming the Treasury has infused Fannie Mae and Freddie Mac with new capital, those portfolios could simply be allowed to run off. Alternatively, the Treasury could require the new GSE to buy preferred shares of the old Fannie and Freddie, helping to offset tax payers costs. Eventually this new GSE could be "demonstrably privatized" as market confidence is regained.

GSEs: No takeover this weekend

Merrill Lynch is telling clients that a source within Treasury says they want to keep the GSEs in their current form, as in shareholder owned. That implies no "takeover" any time soon. It also implies that some alternative to a full blown takeover would be the first step.

I'd say that tells me that Treasury buying MBS is very likely in the near term.

What Treasury needs to do is simply give the market a plan. What if they came out and said "If either or both of Fannie Mae or Freddie Mac's capital ratios fall below the regulatory minimums, the Treasury will [insert plan here]" The plan would spell out where the Treasury's investment would be, which would give some picture to all investors in any part of the capital structure.

The market doesn't care what happens to GSE common holders. The market needs some visibility about the possible outcomes.

Student Loan ABS: Do or do not!

The world of asset-backed bonds (ABS) is in disarray. While home-equity securities have grabbed the headlines, other types of ABS have suffered as well. Student loan ABS are one example of the baby being thrown out with the bath water.

There are two basic types of student loan ABS. Some are constructed with private student loans, and these carry risk of those borrowers failing to make payments. Others are made up of Federal Family Education Loan Program (FFELP) loans. FFELP loans are at least 97% guaranteed by the Department of Education (loans made before July 2006 have a greater guaranty).

Despite the guaranty, the yield spread on FFELP student loan bonds has widened substantially, creating an opportunity for investors looking for income securities which are not significantly exposed to credit risk.

A typical FFELP student loan securitization will include approximate 5 tranches. The first four will usually be labeled something like A1, A2, A3, and A4. These are all senior securities. The last tranch is a junior security, commonly called the B tranche. In the most recent Sallie Mae student loan securitization, the B tranche represented 3% of the entire deal structure, exactly the amount uninsured by the Federal government. This effectively eliminates credit risk for the senior securities.

The four senior tranches pays floating interest quarterly based on a spread to 3-month LIBOR. The spread is set at issuance. In the secondary market, the bonds will trade at a premium or a discount to par based on the relative attractiveness of the original issue spread. Principal on these issues is paid sequentially, with all principal flowing to the A1 tranche until that tranche is completely repaid. Then all principal flows to A2 and so on. As a result, the tranches have very different average lives. Usually the A1 tranche has an average life of around 1 year. The average lives of the other tranches varies from deal to deal, but typically there is a 3-year and 5-year tranche as well.

According to Merrill Lynch, 1-year FFELP student loan ABS currently yields 65bps over 3-month LIBOR. 3-year paper has a spread of 100bps, and 5-year 125bps. These spreads had been relatively constant in the 0-15bps area for several years before widening rapidly last fall. So far in 2008, student loan ABS spreads have moved higher or lower with the tide of liquidity. Spreads peaked in March, tightened in April and May, and have recently widened to near March levels again.

In a fixed income market where many securities are offering historically wide spreads, student loan ABS offer some unique advantages over other short-term alternatives. The structure is most similar to a corporate floating rate note (FRN), but of course the student loan paper has no substantial credit risk. Consider that John Deere Capital (rated A2) just sold $350 million of a new 2-year FRN at LIBOR+50bps. Investors could buy a 1-year average life student loan bond and get more yield with less credit risk. Other alternatives, like agency discount notes, collateralized mortgage obligations (CMOs), or other ABS, either yield less or exhibit more credit risk.

Of course, student loan ABS has widened for a reason. General market liquidity is the primary reason. In consort with the lack of liquidity is the fact that funding of leveraged positions has become more difficult. So buyers who might have arbitraged away the wide spreads in student loans are just not able to do so. Indeed, there is no obvious catalyst for student loan ABS to tighten from current levels.

But these securities allow investors a place to hide from credit risk while still earning attractive interest rates. Eventually the fundamental value of these bonds will bring in buyers weary of losses in other sectors.

GSE Bailout: It's not impossible

I had previously argued that the GSEs should be broken up into 10 or so separate private companies. On Monday, Alan Greenspan spoke favorably of the same idea. Yesterday, Richmond Fed President Jeffery Lacker argued that the GSEs needed to be nationalized, then "demonstrably privatized" by selling off the remains, likely into more than just 2 pieces.


Such a plan is probably the least risky to tax payers. It also would result in a cleaner and more permanent solution than some kind of Treasury-backed equity investment.


How might this work?


First we'd need to make the GSEs sellable, which they currently are not, as evidenced by their share price. To do this, there would need to be meaningful deleveraging, which has to come at tax-payer risk, I'm afraid. I think the solution is to use GNMA program. Treasury announces they are tendering some amount of Fannie/Freddie MBS. The bonds tendered would be exchanged for GNMA bonds of the same coupon. This would ultimately be similar to the MEGA program. It could be stipulated that all tendered loans would have to meet standard FHA guidelines, so like most hybrid-ARM securities wouldn't qualify. But so what? We'd get the leverage of the GSEs down by a certain degree.


Note that the tender would be initially profitable for the Treasury, because of the spread between GNMA securities and FNMA/FHLMC MBS, currently just under 1 point on 6% MBS, and 2 points on 5.5% MBS. Say GNMA offered to tender any eligible FNMA/FHLMC MBS for 1.5% of the principal balance. GNMA could tender say 10% of the total FNMA/FHLMC balance (about $4.3 trillion) and collect $6.5 billion up front.


The Treasury then fully guarantees the principal of all outstanding Fannie Mae and Freddie Mac senior securities. More on this in a moment. The Fed also extends access to the discount window for some extended period of time, like 3-years or so, to the new owners of the former GSE businesses.

Finally, all current mortgage guarantees would be owned pro-rata by the new companies. So if we created 10 new "GSEs" they would each be responsible for 1/10th of any losses that arose. In this way, the old agency MBS securities would still trade generically, as opposed to being passed off to a new guarantor.


So here is what the buyers of the GSE's broken pieces would get:

1. Relatively certain liquidity from the discount window
2. Reduced balance sheet due to the GNMA tender
3. Pro-rata ownership of the GSE's tax loss carry forwards
4. Freedom from the GSE's old "public" mission of providing affordable housing
5. Freedom to price their guarantee however they wish
6. Freedom to participate in any segment of the mortgage market, not just "conforming" mortgages

In exchange, the buyer has to put enough capital into the new company to realize bank-type leverage levels. Exactly what those leverage levels should be is up for debate, but it should be enough to engender some degree of market confidence.

The market as a whole would get...

1. More capital put into the GSEs (viewed in aggregate) provided by private investors, which is all but impossible now.
2. A limit on tax payer's costs. GNMA would collect a profit on the initial tender of MBS, which would offset losses taken in those pools. Plus the government would get cash from the buyers of the GSE pieces. All this would serve to mitigate losses significantly.
3. A long-term solution to the GSE problem. If there are 10 new entities, none would be too big to fail. All would have to maintain bank-like capital levels, rendering the system safer.
4. Certainty as to the end game with Fannie and Freddie.

As for common shareholders, they become victims of the GSEs declining capital base. Preferred shareholders and sub debt holders would see their interests split among the new firms. But that would surely result in an increase in the valuation from current levels.

Today both Fannie Mae and Freddie Mac management are meeting with Treasury officials. My take is that Treasury is setting a deadline for them to raise new capital before the Treasury acts. I hope they at least consider something along the lines of what I've proposed here.

GSE Preferreds: I don't believe it!

Fannie Mae and Freddie Mac preferred stocks rose ~$3 in the last hour of trading. Yes you read that right. Something like 25% off the lows of the day to finish some 10-15% higher for the session.

I couldn't find anyone who knew why, but all the traders I talked to suggested it had a certain "The Dukes know something!" feel to it. Who knows. Shit like that happens all the time. Sometimes someone actually knows something. Sometimes its just a very thin market and someone just thinks they know something. Anyway, theories are welcomed.

That bad huh?

CDS trading is looking real panicky this morning. Lehman is 40ish bps wider, other brokers 20 wider. Zero liquidity. Swaps wider again, although mildly. Fannie and Freddie senior spreads unchanged. MBS look slightly wider after finishing basically unchanged yesterday.

Dow currently down less than 100 points. Financials down ~2%. That ain't gonna be enough. I wouldn't be surprised if we suffer through another 200 point day.

The market continues to obsess about housing starts, which is a completely worthless statistic here. I'm looking at housing sales and delinquencies as the key stats.

UPDATE
FRE and FNM preferreds are down another 20% or so today, threatening the $10 area on FRE Z. One trader told me he's started to see bottom fishing here, which seems incredibly stupid to me. Bottom fishing can work as a strategy, but no one can put odds on whether the impending GSE nationalization will make preferred shareholders whole or not. This isn't about financial analysis anymore. I'd rather bottom fish in WaMu or Lehman or National City any day. At least those are actual businesses where management will be making every effort to survive. Fannie and Freddie are going to get taken out regardless of how the housing crisis plays out from here.

GSEs: Fear leads to suffering

GSE securities of all types getting hit hard today. Interestingly, both the common and preferred shares are down ~20%. Sub debt some 200bps wider with poor liquidity. Even senior paper is 7-8bps wider on the day. MBS look to be only about 4bps wider.

I've heard there has been panicky selling by retail investors in Freddie Mac and Fannie Mae senior notes. One trader told me he's been up to his eyeballs in 100 bond lots today. Haven't heard of aggressive Asian selling, but with zero buying there are clearly net outflows from overseas.

The catalyst was Barron's (followed by Barclays and Merrill Lynch) saying that a Treasury-backed infusion was only a matter of time, and that common shareholders would be wiped out. Barron's also suggested that preferred shareholders would lose their dividends. I doubt that very much, but more on that later.

The ultimate problem here is best described by Merrill Lynch's Ken Bruce. You can dive into Freddie Mac or Fannie Mae's balance sheet and make a good case that they don't need new capital, at least under current forecasts for housing. You'd therefore conclude that if they were a truly private company, they'd best serve shareholders by trying to stick it out. But they aren't a truly private company. As the perception of their capital strength wanes, policy makers are going to conclude that we are better off nationalizing the GSEs. The case will be made that the collective needs lower mortgage rates, and only a strong, liquid and publicly minded GSE can help bring that about.

And indeed, tax payers take the least risk the sooner action is taken. The more unsettled markets become, the harder it will be the stabilize. And the more unsettled things become, the more losses will be alread baked into the GSEs book. If the tax payer's position in FRE/FNM's capital structure is ahead of preferred shareholders and behind senior debt holders, the risk of the government actually losing money should be low. Where sub-note holders fall remains to be seen.

As for wiping out preferred shareholders... Remember that the big preferred shareholders are smaller banks. I don't think it would make sense for the Administration to bolster one part of the banking system (Fannie and Freddie) at the expense of another part of the banking system (regional banks). And besides, I don't think its necessary to protect tax-payers interests. With Treasury backing, the GSEs will have a luxury they don't currently have: time. Within 3-years or so, I'd expect FNM and FRE to both be profitable on a cash-flow basis. At that time the government can spin it off for a profit or fold it all into FHA.

The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don't know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury's next move is.

Citigroup: Do you think I had a choice?

Citigroup issued $3 billion of a new 5-year senior bond issue on Tuesday. This was Citi's first offering since May, and the first billion dollar sized new issue from a major financial since Berkshire Hathaway came with a 5-year deal on July 30.

Access to the bond market is critical for all large financial institutions. Citigroup's issue proved that access is very expensive. The new issue was sold at a yield spread of 337.5bps over the 5-year Treasury. Prior to the announcement of the new issue, Citigroup's 5.5% bond due in April 2013 was bid at +275. Since the 5.5% bonds have approximately the same maturity and seniority of the new debt, its yield spread is directly comparable to the new issue. Hence the difference in spread levels means that Citigroup had to pay more than 60bps in extra yield in order to find enough investors to buy their debt. Not good.

This highlights some very telling facts about today's market. First, this is an extreme concession for a plain vanilla debt sale of a Aa3 rated bank. In 2006, the concession might have been 5 or 10bps at the most for a new issue. Alternatively, Baa-rated Deutsche Telecom recently brought a new 10-year issue, and the concession was around 15bps. This tells you that while there are buyers of Citigroup debt, they pretty much have to give it away.

Second, at a spread to Treasuries of +337.5, the deal has a very large negative basis to credit default swaps. This means that buyers of Citi bonds could also buy CDS and realize an arbitrage. Citi CDS closed Tuesday at 160bps and 5-year swap spreads closed at +98.5. You own the bond at +337.5bps, swap out the interest rate risk for 98.5bps, and the credit risk for 160bps. You are left with 79bps for free. This arbitrage won't last long, at least not at that level, so expect Citi cash bonds to tighten and CDS to widen in the near term.

Finally, this highlights an important risk of owning bank and brokerage bonds, and the opportunity that new issues offer. Under normal conditions, banks and brokers are routine issuers of new debt. The fact that accessing the bond market is currently so expensive is keeping issuers on the sidelines, but in fact, that's pent up demand for debt financing. As soon as conditions improve, expect a flood of new bond issues, all of which will come at a substantial concession to secondary trading levels.

But its common for the initial trading of the new debt issue to be tighter than the initial offer spread. The idea is that while Citigroup needed to pay a significant yield premium to clear $3 billion in bonds, once that initial supply has cleared, trading in the issue should resume at close to pre-supply levels. Indeed, the new Citi bond is traded initially about 10bps tighter than its original spread, although it now only slightly tighter.

So even if you believe we're already past the bottom for financials, tread carefully into financial bonds, and wait for new issues to make your allocation.

Auction-Rate Securities: You are now mine!

Several banks/brokers, lead by Citigroup, have either reached a settlement regarding auction-rate securities (ARS) or are offering to repurchase the securities from customers. As of this writing, Merrill Lynch, Morgan Stanley, and UBS are among those ready to buy back at least some ARS from customers. Several others are either in negotiations with the New York AG or remain part of the inquiry.

Citigroup's settlement states the bank will purchase approximately $7 billion in ARS which are currently not clearing from individuals, small institutions and charities. The announcement on Thursday immediately sent Citi's stock down 4%, and pushed the shares of other major municipal bond dealers sharply lower as well.

There is a key element of this that hasn't been well reported. A very large percentage, something like 80%, of the true "municipal" auction-rate securities have either been refinanced or are actually succeeding at auction. Most of what's left are related to student loan financings. In a typical student loan securitization, a trust is formed which holds the actual loans. The trust then sells securities to the public. This trust is bankruptcy remote from the originator of the student loans. So if Citigroup arranged your student loan, they probably put it into a trust labled Student Loan Corporation. The loan is then considered off Citi's balance sheet.

Very few student loan auction rate securities (SLARS) have been refinanced. This is because the trust which issued the SLARS has no incentive to refinance. Or more precisely, there is no real decision maker for the trust, at least in terms of their outstanding debt. In addition, SLARS typically have relatively low maximum coupon rates in the event of an auction failure. Without a tight limit on the rate, it would be possible for the SLARS to carry a higher rate than the underlying student loans.

So now Citi (and others) are going to need to find a way to create liquidity in these securities. Unfortunately with many SLARS, a simple refinancing, even if Citi were willing to somehow subsidize the transaction, may not be possible. Its also not realistic for Citi to just starting making a market in the ARS and assume liquidity will follow. In other words, Citi cannot just go back to their market-making role of years past. Investors will be once bitten, twice shy this time around.

So this is going to take some creativity. You can bet that Citi already has legions of investment bankers working on structuring something to create an out. Perhaps some sort of resecuritization where Citi puts a series of these SLARS into yet another trust and then sells bonds with a legal put to fund the trust.

Either way, its good news for investors stuck in ARS. It should free up some cash which will most likely flow into short-term municipal bonds. Ultimately it should be something with which Citi (and other dealers) can handle liquidity wise. Remember that student loan ABS are eligible collateral at the discount window and the TSLF, and most of the underlying loans are government-backed. But it will be a distraction.

Big day for the monolines

Wednesday was a big day for municipal bond insurers Ambac and FSA. Muni investors may be seeing some light at the end of the monoline tunnel. Stock investors in Ambac should be careful.

FSA announced a net loss of $330 million in the second quarter after increasing its estimated claims on residential transactions by $603 million. But the bigger news was that parent Dexia has contributed $300 million in fresh capital to FSA, and in addition has assumed all risk in FSA's guaranteed investment contracts (GICs). In response, S&P affirmed FSA's AAA rating, although the outlook was revised to negative. Fitch affirmed FSA's rating at AAA with a stable outlook.

There is no word yet from Moody's, who had put FSA's Aaa rating on negative watch in July. However, Moody's did release a very telling FAQ on their ratings methodology for the monoline insurers. Moody's claims that their ratings methodology has not changed, but a simple read of ratings reports from late 2007 indicated a focus on excess capital beyond "stress case" losses. In putting FSA on negative watch in July, Moody's emphasis has clearly shifted to financial flexibility. One might conclude that Moody's now views losses on structured finance products as too uncertain to estimate, and therefore has shifted their focus on an insurer's ability to raise new capital no matter the loss level. Nothing in the Moody's FAQ says this in so many words, but there are statements that hint at this sort of thinking: "Moody's believes that both FSA and Assured [Guaranty] will be able to meet claim payments with a very high degree of reliability. However, the compositions of their insured portfolios... may leave them vulnerable to a higher degree of volatility than their existing business models can sustain at the current Aaa ratings."

Meanwhile, Ambac reported first quarter profit of $823 million. Unfortunately, that figure reflects a $976 million gain due to deterioration in Ambac's own CDS spread. Its a frustrating quirk of the mark-to-market accounting rules and it really renders Ambac's as reported income statement irrelevant. But the rationale is quite simple. If a CDS contract with Ambac as the counter-party were traded on the open market, there would certainly be a discount for Ambac's credit worthiness. Since Ambac is effectively short all these CDS contracts, if the value goes down for any reason that's a gain for Ambac! Worth mentioning that Ambac's CDS have improved significantly since June 30, (quoted at 18 points up front, down from 36). On the conference call Ambac indicated that the $976 million gain would have swung to a $1.3 billion loss had they used 7/31 CDS figures.

Media reports are going to focus on the CDS loss/gain shell game, but that's is all besides the point. What really matters to Ambac investors is:

• Clairty on their expected losses in structured finance
• Efforts to terminate CDS contracts, thus lending clarity to the their expected losses
• Progress on recapitalizing Connie Lee

On that front, Ambac reported mostly good news. Real clarity on structured finance losses isn't coming any time soon. The housing and economic picture is just too uncertain. But Ambac is now all but fully reserved on their remaining CDO squared transactions with large RMBS exposure. Therefore any recovery in these assets will be accretive to capital.

Ambac management suggested that they remained in serious talks to commute additional CDS contracts. Ambac had announced a deal with Citigroup on August 1 to terminate $1.3 billion of protection on a CDO-squared transaction in exchange for a cash payment from Ambac. When asked why Citigroup (or anyone else) would agree to terminate if Ambac is indeed a strong counter-party, company management suggested that some of their counter-parties may have bought CDS protection on Ambac and now have a large gain on that hedge. The way it was said leads one to wonder if Ambac in fact knew this to be the case. Either way, the company was positive on the prospects of future termination deals.

In addition, Ambac has been working to eliminate or reduce RMBS exposure by searching for violations of representations and warranties in their insured transactions. Finding such violations would allow Ambac to void some or all of an insurance policy. During the quarter, Ambac recorded $339 million in reduced loss reserves related to such violations. The company indicated that a survey of some of their higher delinquency transactions showed a 80%+ "hit rate" on representation and warranty violations.

Finally, Ambac indicated that progress on capitalizing Connie Lee, a dormant insurance subsidiary, is on schedule. The plan is for Connie Lee to capitalized with $1 billion in cash, be insulated from Ambac's existing insurance exposures, and therefore get a stable AAA rating. In theory Connie Lee could then begin municipal insurance underwriting. Ambac indicated they had completed the "second step" of what would be a 3-4 step process. Ambac believed Connie Lee can be up and running by October 1.

All this is making Ambac more likely to remain solvent, especially if more progress can be made on terminating CDS on structured finance. But the idea that Connie Lee can become a force in the municipal insurance business is still a long shot. And absent that, there is limited profit potential for Ambac. The most likely scenario seems to be that the company survives the next couple years and then eventually sells their remaining portfolio to some third party. That would likely leave some non-zero amount left over for common shareholders, but not much. So you really have to wonder about Ambac's meteoric rise over the last two weeks: from a low of $1.74 on July 28 to $5.85 today.

But any outcome where Ambac remains solvent is good for municipal investors. If Ambac can stabilize at any investment-grade credit rating, Ambac insured municipals will appreciate quite a bit.