Deus Ex Macchiato

A little while ago I speculated on a possible Ponzi scheme (in fact if not in intention) in pre Crunch CDOs of ABS. The basic idea is that there was a false market in subprime RMBS tranches if there were no real bids, or few real bids, for mezz tranches other than other CDOs.

Bloomberg now leaps into the debate with an article How Wing Chau Helped Neo Default in Merrill CDOs Under SEC View. The key part:

“People on the outside thought the market was going gangbusters because of all the deals getting done,” said Gene Phillips, director of PF2 Securities Evaluations, a New York- based company that helps banks and funds evaluate CDOs. “People on the inside knew this [i.e. the CDO-squared and managed CDO business] was a last-gasp attempt to clear out the warehouses”…

Interactions across the industry among bankers, asset managers, ratings firms and lawyers contributed to what Lang Gibson, head of CDO research at Merrill until early 2008, called a “Ponzi scheme” of CDOs buying other CDOs.

Posted in: ABS, Securitisation and Tranching by David /
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At Jack on tap we find:

Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principle… Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties (if this wasn’t true, we wouldn’t need lawyers). Certainly, if a supplier sold GM a faulty $1 part used in a Chevrolet, we wouldn’t want to shield the supplier from liability simply because there are automotive “professionals” that also work at GM. It eludes me as to why you’re liable if a $15 toaster blows up, but not if a $1 billion collateralized debt obligations of asset-back securities does.

(Hat tip FT alphaville.)

This all seems reasonable (and comes with the usual I-am-not-a-lawyer-indeed-I-don’t-even-know-how-to-cook-one disclaimer). And undoubtedly there are many instances of devious, scheming bankers selling products they knew (or strongly suspected) were toxic to naive investors, including naive professional investors. The industry short hand in some quarters used to be `Belgian pension fund’, meaning any sleepy, ill-informed party who had the authority to enter into transactions they could not price and might well not have understood the risks of. If some people had something they really couldn’t sell to the cognoscenti, they found a Belgian pension fund.

CDOs of ABS, however, are a slightly different story, at least in some cases. These were products that neither buyer nor seller understood. In many cases both parties used the same flawed model to analyse the product; both parties failed to dig deeply into the underlying collateral; both parties did not think through the consequences of the forms of credit enhancement present*. It suits the current mood to blame the industry – or just Goldman Sachs if you prefer – for knowingly blowing investors up. But the truth is rather more complex. I doubt that this will ever come out. The `we didn’t understand it either’ defence might work against a claim of fraud or misrepresentation, but it does rather open the door to a case of failure of due diligence…

* A good example is the use of excess spread accounts. These work as credit enhancement providing defaults happen late enough in the life of the structure. If they happen early, however, as in most of the 2006 and 2007 vintage CDOs of ABS, they are useless.

Posted in: ABS, Reputational Risk, Securitisation and Tranching by David /
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There has been much incendiary and ill-informed comment on the ’shadow banking system’ and Wall Street as ‘a giant Ponzi scheme’. As always in the aftermath of a crisis, hyperbole is not in short supply. Still, there is one sense in which a limited version of this claim might be true: the business of making CDOs of ABS could have been a form of Ponzi scheme. Here’s how.

Note that there are three types of tranche in a CDO: senior, mezz, and junior. One main reason for making a CDO in the pre Crunch period was to create AAA-rated senior securities. Lots of people wanted to buy these, so distributing them was not a problem. (Of course, these securities turned out to much more dangerous than many people thought, but that is not the point: in 2003-07 selling AAA ABS tranches was not a problem.)

The junior was typically retained by the originator; if it wasn’t, there were plenty of (mostly hedge fund) buyers. So that was not a problem either.

In order to have a real transfer, and to convince their risk managers that they really had sold the CDO, the makers of CDOs of ABS had to sell the mezz too. This was a lot more problematic. The ratings were not AAA; the yields were not that attractive (often high tens or low hundreds of bps for risk in the low investment grade or high junk area); and buyers knew that there was risk in these tranches.

So what might some banks have done? One answer could have been to set up (or find) friendly asset managers to buy the mezz. Remember, in managed CDOs the asset manager has considerable discretion about which collateral to buy. If you could find a supposedly independent third party who you could somehow persuade to buy your mezz – perhaps because you had provided them with support somehow – then you could claim that you had sold the whole CDO, and you would be allowed to make another one.

This would be a kind of Ponzi scheme if the originator was covertly financing the mezz purchaser, or otherwise providing sufficient support that the mezz purchase was not a free market transaction. It would mean that CDO tranches prices were not the result of willing buyers interacting with willing sellers, but rather connected buyers taking subsidies for being seen to buy known rubbish. These prices in turn would then support the AAA pricing: after all if the As were seen to be trading at 80 over, it made 15bps for the AAAs seem reasonable.

What do we learn from this hypothetical? Simply that if you want to understand what happened in the CDO of ABS market in the run up to the Crunch, the question ‘who bought the mezz and why?’ is particularly relevant.

Posted in: ABS, Securitisation and Tranching by David /
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MBIA, once one of the most important monoline insurers, is sueing Credit Suisse for pervasive and material misrepresentation of the risk that they insured on RMBS. From Bloomberg via FT alphaville:

A Credit Suisse Group AG unit was accused in a lawsuit by MBIA Insurance Corp. of making fraudulent misrepresentations about mortgage-backed securities… [in a] transaction that was sponsored, marketed and serviced by the Credit Suisse units…

“CS Securities fraudulently induced MBIA to participate in the transaction,” MBIA said in the complaint. MBIA said the bank claimed it had “used certain strict underwriting guidelines to select the loans sold into the transaction when in fact it did not.”

So far, so ordinary. Insurers takes risk, insurer takes hit, insurer claims it did not know what it was doing because the client did not tell them everything, insurer sues is a sadly common story. But this one gets better:

Since the transaction closed, the securitized loans have defaulted “at a remarkable rate,” MBIA said.

“Through Oct. 31, 2009, loans representing more than 51 percent of the original loan balance, or approximately $464 million, have defaulted and been charged-off, requiring MBIA to make over $296 million in claim payments,” MBIA said.

MBIA said that a review of the defects of the loans included in the transaction show they were “systematically originated with virtually no regard for the borrowers’ ability or willingness to repay their obligations.”

One might wonder why MBIA did not notice this before they agreed to take the risk. So (as FT alphaville puts it) in order for MBIA to succeed, it will have to convince a court that its much-vaunted underwriting and due diligence weren’t actually all that great. Mind you, given that MBIA have gone from being AAA-rated to BB-, that might not be too much of a surprise to some people.

Posted in: ABS, Legal Risk and Trade Documentation, Monoline, Mortgages by David /
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In the bad mad days of 2005 and 2006, some people valued ABS by estimating the future cashflows and then discounting them back at Libor flat. In situations with significant prepayment risk, they might well have option adjusted this value to account for interest rate convexity based on some prepayment model.

That process does not produce values that are market consistent these days. The reason is there is compensation in the spread of an ABS for features other than default and interest rate optionality. These other factors include current liquidity risk, potential future liquidity risk, funding cost (remember you cannot necessarily repo an ABS), and the volatility of both the mark to market of the asset and its capital requirements. (The last two can just be thought of as a convexity adjustment for the volatility of EL and UL.)

The market handles this ‘problem’ rather crudely. The convention is to discount tranche cashflows at a rate higher than Libor. Thus for instance one might recover the market price of a AAA tranche by discounting at Libor plus sixty, while a BB tranche might have to be discounted at Libor plus six hundred to get the right price.

These higher rates solve the problem at the expense of introducing an arbitrary step much like the use of implied volatility to recover market prices for options using the Black-Scholes formula. Just as options dealers think in terms of implied vol without for a moment believing that the underlying follows a diffusion, so ABS traders think in terms of these discount factors without believing that they are anything more than an ad hoc market adjustment. Clearly we still have a long way to go in being able to price ABS based on fundamental factors.

Posted in: ABS, Credit, Decision Making, Liquidity and liquidity risk by David /
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From Wells Fargo via Creditflux:

In their latest research report, Wells Fargo (formerly Wachovia) analysts calculate that 360 CDO of ABS have now triggered an event of default – up from 343 last month. At $351.6 billion, the notional value of these deals accounts for just over half of all CDOs of ABS.

Posted in: ABS by David /
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The Atlantic has an interesting if over-simplistic article on the role of securitisation in the crunch. I agree with this last paragraph to some extent:

It’s important for people to realize that the credit crunch was not caused by securitization — it was caused by very poor assumptions used to rate securitizations. In a different world, with smarter rating agencies and investors who did due diligence, things might have turned out better. The future of finance should not exclude securitization. It should continue to be utilized, just with better assumptions.

It is worth noting, though, that securitisation did faciliate the crunch since it allowed the interests of those making loans to diverge dramatically from the interests of those holding the risk of those loans.

Another key issue is that people didn’t – and to some extent still don’t – understand the risks of ABS. An ABS is not like a corporate bond for a number of reasons. First, many of these securities have uncertain duration: if things go well, they can have quite a short weighted average life; whereas if things go less well, you can be on risk for much longer. Second, in a corporate bond, management have real options: they can sell parts of the business, pledge assets to raise liquidity and so on; in an ABS, in contrast, (at least if the collateral pool is not managed), you are stuck with the assets for better or for worse. Third, the credit enhancement in ABS often means that the expected probability of default is low but the loss given default is very high. Corporate bonds may well have a higher recovery. Hence there can be a huge difference between the expected losses on two securities with the same probability of default. None of this means that ABS are necessarily toxic, but it does mean that the buyers of these securities need to understand these risks in detail. More conservative ratings will help, but a single rating alone can never be enough to distinguish the complex risks of ABS.

Posted in: ABS, Securitisation and Tranching by David /
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Sorry, I couldn’t resist the bastard cross of chess and bond ratings. Let me explain. Once upon a time there was a leveraged loan CDO arranged by Goldman called Greywolf. Greywolf, which sounds like a monster who wants to gobble up your money, was in fact a monster who wanted to gobble up your money. In the fullness of time, the AAA tranche was downgraded to A-, or A3 in Moody’s speak. Now, according to Bloomberg, Morgan Stanley is doing the Re-REMIC (aka CDO-squared) trick on the Greywolf AAAs. That is, they are buying the AAAs into a SPV and issuing two tranches of notes on the other side, a CDO-squared structure. Bloomberg suggests the tranching is roughly two of AAA to one of Baa2.

My only question, really, is if these new bonds are downgraded too, will someone else step in and ReRe-Remic them?

Posted in: ABS, Securitisation and Tranching by David /
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No, not my standard broker’s commission, but the average level of credit enhancement in CMBS before 2003. FT alphaville, commenting on the forthcoming tsunami of CMBS downgrades, reprints this enlightening table from S&P:

This very clearly shows how investors let their standards slip in the hurt for yield during the Boom years. Not everyone was convinced though: from 2004 the practice of splitting the AAA into two or more tranches became commonplace. The top tranche, amusingly, is called super duper AAA.

S&P want at least 19% credit enhancement for AAA going forward. At least this is generating a nice repack business as banks take junior AAAs and resecuritise to keep most of the notional at AAA. The Americans call this a Re-Remic* — which isn’t nearly as cool sounding as super duper AAA.

* Real estate mortgage investment conduit, or CDO-squared to its friends.

Posted in: ABS, Ratings by David /
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This is a geeky post about the CDS market.

The newswires have been buzzing recently with news of a ‘daring’ CDS trade by Amherst Holdings. I didn’t comment on it at first as I didn’t understand the trade from the initial news items, but I now think it is possible to work out what’s going on.

Let’s start with the bonds this trade refers to. They are subprime MBS. Like most MBS, these are amortising, prepayable bonds. The fact that these are amortising bonds means that the face value of the security is irrelevant: what counts is the principal balance at the time the trade was done. [Quite a lot of the stories were confused about this point, so it is worth pointing out.]

So, let’s say we have some bonds with $100M left to repay.

The next bit that is tricky is the nature of the CDS protection sold. Everyone agrees Amherst sold protection and some banks bought it. But what protection exactly? It is most common for CDS on MBS to be pay as you go, meaning that the protection sellers compensates the protection buyer for principal deficiencies as and when they occur. There is no event of default as such, unlike corporate CDS. [To be strictly honest, there may be an event of default as well, such as bankruptcy of the issuing SPV, but that is irrelevant for our purposes.]

Let’s suppose then that Amherst sold pay as you go protection on $100M of bonds.

Since the bonds were thought likely to repay little to nothing of the outstanding principal balance, the banks paid Amherst, say, $80M up front for their protection. [There may have been an ongoing coupon as well, but we'll ignore that.]

Amherst then paid the servicer to buy out the underlying mortgages and pay off the bonds. Thus the bond holders got their $100M. The servicer could do this because the bonds had a 10% clean up call, meaning that if more than 90% of the face had amortised, they could repay the remaining principal balance at any time. [So to keep with the example, the face amount was more than $1B.] 10% cleanup calls are common in ABS, and they are what makes Amherst’s trade work*.

Now, here’s the confusing part. Who won and who lost?

First the banks. If they had held the bonds, then they would be about flat. $80M for CDS protection paid out, but $100M paid back is a $20M profit, from which subtract the (few cents) cost of the bonds. So the only way the banks could have lost massively on the trade, as reported, would have been if they had been net short the bonds. That is, they did not own the bonds, and bought protection, betting that total losses would be more than $80M. The losers, then, were parties who did not own the bonds and who did not realise the significance of the cleanup call to their short.

[The WSJ story suggests that JP Morgan lost money but that RBS and BofA didn't. This would be consistent with JP being net short, while RBS and BofA had a negative basis trade on, i.e. owned the bonds and bought CDS on them. The presence of net shorts is also consistent with the WSJ's suggestion that more protection had been traded than the notional of bonds outstanding.]

Next Amherst. They had the $80M of CDS premium. But how much did they have to pay to get the bonds repaid? Clearly a logical answer would be about $80M. Therefore the only way that Amherst could have made money would have been if they had sold more protection than there were bonds – $200M say rather than $100M. Say they sold $50M to JPM, $50M to RBS and $50M to BofA. Then they would have had to pay $80M, roughly, to buy back the mortgages behind the RBS and BofA CDS, but the JPM CDS was not backed by any bonds and so the $40M premium from JPM would be straight profit.

In other words, the only way Amherst could have made a lot of money on this trade would have been if it sold more protection than there were bonds. The only way that the banks could have lost money would have been if they bought more protection than there were bonds. In a situation like this someone was always going to be squeezed. It’s just that this time, that party wasn’t an investment bank.

The lesson of this amusing little situation? Nothing more than read the small print. The buyers of protection — and in particular naked shorts — should have understood that arbitrary action by servicers is possible, and that in particular the 10% clean up call could be exercised. This is a much bigger risk late in the amortisation profile of a bond than early, but it is there for most ABS. Caveat emptor.

* Contrary to what Willem Buiter writes in his blog, if you own 100% of a bond, you cannot necessarily control whether it defaults or not. A default on a public security is a default, regardless of who is affected.

Another mistake Buiter makes is assuming that centralising CDS trading would not have helped in this situation. It would certainly have helped the banks to avoid their losses, in that the size of Amherst’s long vs. the cash would have been obvious thanks to trade reporting. Personally I don’t particularly feel the need to help the CDS trading desks of investment banks, mind you.

Posted in: ABS, CDS and Negative Basis, Legal Risk and Trade Documentation by David /
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I have been surprised at the slow takeup of the TALF. It looked to me like a license to print money. As Zero Hedge points out, less than $30B has been allocated to a program with a trillion dollar capacity.

Part of my surprise is that to be eligible for the TALF (at the moment at least – this will probably change) a security needs to be AAA rated. And S&P are on the downgrade war path. As Calculated Risk reports, quoting S&P, approximately 25%, 60%, and 90% of the most senior tranches (by count) within the 2005, 2006, and 2007 vintages [of CMBS}, respectively, may be downgraded. So you would have thought that people would have rushed to throw things into the TALF before they became ineligible.

Bloomberg suggests that the TALF, and its brother the PPIP, is stalling. They seem to have a point.

Posted in: ABS, Mother of all Bailouts by David /
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…as the FT says, will be felt mostly by the banksWhat is interesting about this is how vintage insensitive it is. In the US, there is a world of difference between the 2005s and the 2007s: in Spain, not so much.

Update. Downgrades loom for the Spanish banks as an interest diversion test is tripped on a Caja Madrid RMBS.

Posted in: ABS, Mortgages by David /
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Bruce Krasting has an interesting story on sub-prime related litigation in Massachusetts:

Goldman has agreed to pay the state of Massachusetts $60 million to settle a dispute regarding Goldman’s “predatory lending” practices in and around Boston. $50 million will be made available to reduce the loan principle on 714 individual mortgages… In the critical years 2005-2007 Goldman was ranked 15th in the League Tables for sub prime and Alt-A origination/securitization. Goldman’s management must be pleased as punch with that poor showing today.

As Bruce says, this is not a big deal for Goldman — but it might set a nasty precedent for those higher up the subprime ABS underwriting tables, notably BoA (labouring under both Countrywide and Merrill) and Citi. You can expect this story, like Enron-related litigation, to run and run.

Update. A different account of the case from Jonathan Weil at Bloomberg is here. His take is that Goldman paid greenmail to Mass, perhaps to avoid the disclosure associated with a full hearing. His article certainly makes interesting reading.

Posted in: ABS, Legal Risk and Trade Documentation, Photography, Securitisation and Tranching by David /
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According to the FT, 47.6 per cent of all CDOs of ABS by volume issued since the market substantively began in 2002 have now hit an event of default. Wow.

Posted in: ABS, Securitisation and Tranching by David /
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No, not the closing down sale at one of Britain’s many bankrupt retailers, although it could be. Rather it is the fall in property prices from the peak in one of the exurbs of Fort Myers, Florida. The NYT story is here. But mull on that number for a second. 80%. Then consider putting -0.8 in the HPI vector, and think what that will do for the price of even prime RMBS.

Posted in: ABS, Fair Value, Mortgages by David /
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Accrued Interest has a great post on the newly expanded TALF. An edited version follows:

Fed will loan funds for purchase of recently issued ABS. This [means] ABS issued after January 1, 2009 made up of loans no older than October 2007. The ABS must be rated AAA, and be made up of student loans, auto loans, small business loans, or credit cards.

Loans will be non-recourse and not marked-to-market.

The loan term will be up to 3-years.

The loan rate will be set at “yield spreads higher than in more normal market conditions but lower than in the highly illiquid market conditions that have prevailed during the recent credit market turmoil.”

So, buy some ABS, repo it to term with the FED. Sit back and enjoy positive carry, no margin calls, and, err, that’s it. Gentlemen, start your engines.

Posted in: ABS, Liquidity and liquidity risk by David /
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From FT alphaville:

Posted in: ABS, Ratings by David /
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Just like these council workers taking down fly posters only for them to reappear in a few days, so banks are getting ABS off balance sheet by offering to finance them. The FT reports one such set of tricks here and Naked Capitalism has a discussion of Lehman’s deleverage using related shenanigans here. The bottom line is obvious: if you can’t sell something but you need to look as if it is gone, find somewhere to park it, pay the parking fee and transfer any risk you can get rid of, and hope that when or if the asset comes back, it is worth more.

Posted in: ABS, Accounting by David /
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I have been reading a fascinating (if long) article Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions by Joseph Mason and Joshua Rosner. There is an awful lot in the document, but here I want to concentrate on one issue they raise which I had not thought about before, namely the shape and trajectory of the loss distribution through time.

Consider a corporate bond. For a holder of the bond, the (hold to maturity) loss distribution has a big lump of probability in the 95%-100% return bucket corresponding to the likelihood that they will get their money back. Then there is a gentle bell curve lower down corresponding to the distribution of recovery values. Two observations:

• As the credit quality of the corporate declines, this shape moves but typically those moves are slow. The big lump gets a little smaller and default gets a bit more likely, fattening out the curve around the expected average recovery.
• One of the reasons that moves are slow is that the company has management. Default is bad for these folks so they try to avoid it by altering their strategy or the capital structure and/or by asset sales. They have strategic options which they exploit, often saving the company.

Now consider a typical tranched ABS backed by a pool of collateral. Here tranching and other credit enhancement means that default is unlikely for the rated tranches. However:

• The shape of the distribution is different. In particular, the average loss given default can be much higher.
• The time evolution of the distribution is different: most static ABS pools evolve so that for a given tranche, default becomes either certain or vastly improbably.
• Thus if the pool behaves a bit better than expected, most or all of the rated tranches will be money good. Mason and Rosner say this `wastes’ credit enhancement, which I don’t really see, but certainly even lower tranches can become risk free in some deals fairly fast.
• On the other hand, if the pool behaves even a little worse than expected, the impact on the lower tranches can be severe. Therefore ABS downgrades, when they come, are often multiple notch downgrades.
• Note that this is partly because most ABS has no asset diversification and no time diversification: unlike a corporate, there are no strategic options for the issuer to do something that doesn’t lose as much money as their current approach.

None of this means that ABS ratings are wrong, necessarily, but it does mean that the users of ratings need to understand the key differences in the time evolution of credit risk between corporates and ABS.

Posted in: ABS, Ratings by David /
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The Economist points out an issue:

The European Central Bank (ECB), widely praised for providing banks with ample liquidity during the credit crunch, now has a problem: how to encourage banks to place freshly created asset-backed securities (ABS) with investors, rather than dumping them, like so much radioactive waste, in its vaults…

On the face of it there is no immediate problem. Only around 16% of the ECB’s collateral so far is ABS. Banks are drinking from the liquidity fountain and keeping the cost of high-street mortgages contained at the same time, which they might not be able to do otherwise.

But it is not helping the revival of a publicly traded ABS market, and may be fostering the creation of even murkier securities. Many of today’s ABS are even less transparent than those sold before the crisis—the ECB requires a rating by only one agency, not the usual two, and pre-sale reports are often sloppily prepared.

What’s the answer? Well one obvious one is slowly, and with considerable vigilance over the market impact, to raise the haircuts. Countercyclical central bank window haircuts make sense. As matters improve, the ECB can tone down its roll as financer of first (and only) choice.

Another is to permit the assignment of the financing as I mentioned earlier. The ECB could allow banks to sell the securities and transfer the obligation to repay to a third party. Obviously that means the ECB would have to be willing to offer liquidity for a short period to firms who were not necessarily member banks. But if that helps restart the ABS market, it might be a small price to pay.

Posted in: ABS, Liquidity and liquidity risk by David /
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Whither the CMBX? Specifically, where are the 08-01s going to come from, given that CMBS issuance has plunged along with prices. According to the FT:

The amount [of CMBS] issued in the first five months of this year fell 89 per cent to $10.8bn, the lowest level since the late 1990s, according to Commercial Mortgage Alert. Overall issuance last year was $253bn.

That does not just mean hard times for securitisation desks and commercial property investors looking for leverage. It means that it is hard to build a representative index of recent deals. Spreads have come in a little from the wide levels earlier in the year, but it will take months for the market to recover. Could it be a good time to buy what little there is out there?

Posted in: ABS, Markets by David /
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On Wednesday HBOS closed the first UK RMBS deal since August 2007 (that we know about, anyway). Libor + 85 for AAA bonds with a 160% OC. Yep, the deal is £500M and there is £800M of collateral. 800. Just pause a moment and think about that OC. The deal can suffer 35% delinquencies with zero recovery and still be money good. That is truly an astonishing level of safety for the market to demand in return for something as rich as 85bps. Remember AAA prime UK RMBS used to trade at low teens of bps: 85 was BBB territory. Verily the Crunch is a harsh mistress.

For the curious, there are more details here and here.

Posted in: ABS, Mortgages by David /
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The UBS shareholder report on the firm’s subprime losses makes fascinating reading and I will try to return to it later in the week. Meanwhile however it is worth noting that a major cause of the UBS losses were AMPs. Let the report take up the story:

[AMPs] were Super Senior positions where the risk of loss was initially hedged through the purchase of protection on a proportion of the nominal position (typically between 2% and 4% though sometimes more). This level of hedging was based on statistical analyses of historical price movements that indicated that such protection was sufficient to protect UBS from any losses on the position.

Let’s try and tease this apart. The bank is long the supersenior tranche in a CMO. They ‘hedged’ this position by buying credit protection on the underlying mortgage portfolio in an amount calculated to minimise short term P/L volatility. I think.

Isn’t this pure gaming of the VAR model? This ‘hedge’ dramatically reduce the VAR. But losses build up in the junior and rise through the mezz, the bank will need to short a larger and larger percentage of the underlying mortgages to remain hedged. In other words this position is massively short credit convexity even if it is credit delta neutral. And even that is assuming that you can short more of the underlying pool into a falling market, an assumption that is highly questionable.

Anyway, even if the AMPs position was not designed to game the VAR model, it certainly achieved that effect:

Once hedged, either through NegBasis or AMPS trades, the Super Senior positions were VaR and Stress Testing neutral (i.e., because they were treated as fully hedged, the Super Senior positions were netted to zero and therefore did not utilize VaR and Stress limits). The CDO desk considered a Super Senior hedged with 2% or more of AMPS protection to be fully hedged. In several MRC reports, the long and short positions were netted, and the inventory of Super Seniors was not shown, or was unclear.

(See here for a discussion of negative basis trading.) For something like this there is real danger that the system’s view is seen as the only reality. If the VAR model says there is no risk, the firm might actually think that’s true.

Next we come to model risk:

The AMPS model was certified by IB [UBS investment bank] Quantitative Risk Control…but with the benefit of hindsight appears not to have been subject to sufficiently robust stress testing. [...] The cost of hedging through a Negative Basis trade was approximately 11 bp, whereas the cost of hedging through an AMPS trade was approximately 5 – 6 bp.

So, a positive carry asset hedged very cheaply but leaving a large short gamma position which was not captured by the firm’s risk model. They really were asking to be creamed by a big market move. And then one came along.

Posted in: ABS, Derivatives, Hedging and Convexity, Model risk, Mortgages, VAR by David /
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Gillian Tett comments on the large supersenior ABS holdings at Merrill and UBS in the FT backed by mortgages on properties like the fine abode above:

Most notably, as these banks have pumped out CDOs, they have been selling the other tranches of debt to outside investors – while retaining the super-senior piece on their books. Sometimes they did this simply to keep the CDO machine running

Absolutely. And also as a funding arbitrage: for a bank that funds at Libor flat and views supersenior as risk free supersenior paying Libor plus ten is a good investment. Tett continues:

[Since] super-senior debt carried the AAA tag, banks were only required to post a wafer-thin sliver of capital against these assets

Again true, but I doubt that the advantageous reg. cap. position of these assets was that important. Any low volatility bond would do in a VAR setting, or any internally highly rated one under Basel 2 in the banking book. And there are plenty of AAAs that yield more than Libor plus ten. The real issue is the risk assessment: some banks managed to persuade themselves this paper was risk free. And that brings us nicely to an article in the WSJ on how exactly the firm got to that assessment. Enjoy.

Posted in: ABS, Basel, Photography, Regulation, VAR by David /
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Should the Bank reduce its collateral quality requirements and/or buy ABS outright? It is certainly thinking about it. The FT reports:

Mervyn King indicated on Wednesday that the Bank of England was poised to take a revolutionary step and buy or swap illiquid assets on banks’ books for cash or liquid assets as way to find a “longer-term resolution” to the problems faced by British banks.

One of Mervyn’s motivations is to try to reopen the market for these assets, or at least allow them to be financed until such a time as the market reopens.

Commenting on the “fragility” that exists in the financial system, Mr King said there was an “overhang on banks’ balance sheets of assets in which markets have closed”

“These assets cannot now be sold or used to secure funding in the market – they are difficult to finance. That has created uncertainty about the strength of banks’ financial positions”.

This is, if late, at least right. Many ABS assets have no market at the moment. Hence they cannot be marked to market. That in turn means that they are not good collateral and hence they cannot be used in secured funding. Having to use unsecured funds to finance these assets is gumming up banks’ balance sheets and making them reluctant to lend. A short term answer to this problem is a key step in regularising the markets. However, this intervention needs to be strictly limited. The FT reports:

In the short-term, [King] said the Bank would continue to lend against mortgage-backed securities and other asset-backed securities where markets are closed, but he added that such lending, while “a useful bridge to a longer-term solution” can “be only a temporary measure”.

Weaning the banks off cheap financing of illiquid assets will be difficult and there is very little experience to draw on. But still King’s proposed action is the right one, even if he does not know how the story ends.

He was not specific about the longer-term resolution, since he said “it is too soon to say where these discussions will lead”, but he indicated more radical moves were necessary because “it is unrealistic to assume that markets for many asset-backed securities are likely to re-open speedily or, when they do, to their previous levels of activity”.

It is important to ensure that this does not introduce too much moral hazard, nor does it act as a guarantor for new issues.

“First,” [King] said, “the risk of losses on their lending should remain with banks’ shareholders”. This implies the Bank would only accept assets at well below face value, or would insist on banks’ indemnifying taxpayers for the credit risk they would adopt if they took hold of the assets.

“Second,” he added, “a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets”. Mr King is keen not to allow another frenzy of lending and it implies the Bank would not be willing to take any new mortgage-backed securities on its books.

The devil is in the details, of course, but all-in-all the Bank’s strategy is encouraging.

Posted in: ABS, Liquidity and liquidity risk by David /
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Even though this article appeared on the Sunday before a Bank Holiday Monday, I don’t really think it was deliberately buried. It is just that it might be troubling to some. From the FT:

The first public price estimates for specific structured credit securities to have emerged since the start of the credit crisis show that values have fallen sharply.

Some securities have lost almost a third of their value – even though many were considered to be so safe that they carried top-notch ratings from the credit ratings agencies.

Meanwhile, some subprime mortgage-linked securities issued by groups such as UBS have lost almost 95 per cent of their value.

The price estimates were made in a legal filing following a decision by JPMorgan Chase to ­publish detailed securities valuations in a Canadian court. The securities are linked to commercial loans and medium-grade mortgages.

The estimates are likely to be scrutinised by auditors and regulators since they come at a time when the issue of security pricing has become controversial.

Banks are under pressure from regulators to book losses they have incurred on such instruments. However, trading has virtually dried up in many corners of the credit markets, and it is hard to compare prices for these instruments between banks.

Many regulators and investors fear that banks are still varying in the degree to which they have booked losses on their credit instruments in recent months – not least because it is hard for auditors to compare internal estimates with external benchmarks.

The figures have emerged because the US bank is leading an effort to restructure a group of 20 Canadian structured investment vehicles that issued $32bn of asset-backed commercial paper.

JPMorgan and Ernst & Young lodged a report with an Ontario court gives estimates for the securities held by the Canadian SIVs based on implied values.

This is undoubtedly a data point but it is not definitive. Remember these are estimates, and liquidity has largely or completely disappeared in these instruments. It may be that the idea that the value of these instruments is impossible to determine precisely in the current market is lost on the court, but that particular fallacy should not trouble market participants.

Posted in: ABS, Fair Value, Markets by David /
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I have long argued that the split between solvency and liquidity is a false dichotomy in the current market. Decreasing liquidity can of itself and without changes in expectations of default depress the price of an asset and hence create a solvency problem. Similarly institutions that whose insolvency is rumoured find their liabilities illiquid. The FED’s actions recently would, I suggest, support this view. They have been creating liquidity – as Alea notes by selling treasuries and repoing in illiquid assets, primarily ABS – in order to support asset prices. This explicit management of liquidity premiums is as important a factor as interest rate cuts. The early signs are that the two effects are working, especially now the primary dealers can assess the FED too. We’ll see.

Update. The argument above broadly motivates my concerns with the positions of those, like Willem Buiter, argue that central banks should repo in ABS collateral, but should do so at aggressive haircuts. (See here for Buiter on Radio 4’s today programme – be warned that that link might not persist for long however.) In purely financial terms Buiter is correct: this is the prudent approach. However it is seriously unhelpful in meeting the broader policy objective of reducing soaring liquidity premiums. If the Bank takes risk on the collateral it is much more likely to be effective in ensuring that it does not take as much risk on its counterparties.

Posted in: ABS, Liquidity and liquidity risk by David /
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What does AAA mean? Almost nothing it seems. Hot on the heals of the agencies’ failure to downgrade MBIA and Ambac there is a lovely interactive graph from Bloomberg showing the collateral support for the AAA bonds in the ABX: Bloomberg concludes only 6 of the 80 deserve the rating.

Barney Frank has noticed that the disconnection of ratings from default probability is an issue for municipalities, who have been given a rating far below their PD, then charged for insuring their debt on that basis. And he wants to see some changes. According to Bloomberg:

Barney Frank gave ratings companies a month to fix “ridiculous” standards that they apply to local government debt, as his House committee opened a hearing today on how the firms evaluate municipal bonds.

“I am going to say to the rating agencies and to the insurers: they have about a month to fix this,” Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, told reporters in Washington yesterday. “We’re going to tell them they have to straighten it out.”

I think I like this guy…

Let’s look at the prospects for the monolines then. Barney is going to ensure the good quality states and other munis are rated AAA. A lot of muni insurance business goes away because of that. Buffett will eat much of the rest. And the structured finance market has disappeared too. Hmmm, business model, what business model?

Posted in: ABS, Monoline, Ratings by David /
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Following yesterday’s announcement that a Carlyle fund is in default over its repo arrangements on Agency RMBS, Bloomberg comments on the agency/treasury spread:

Yields on agency mortgage-backed securities rose to their highest relative to U.S. Treasuries in 22 years as banks stepped up margin calls and concerns grew that the Federal Reserve may be unable to curb the credit slump.

The difference in yields, or spread, on the Bloomberg index for Fannie Mae’s current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened about 7 basis points, to 223 basis points, the highest since 1986 and 89 basis points higher than Jan. 15.

Why? There are a number of reasonable explanations. Firstly and most obviously there are more buyers than sellers of treasuries and more sellers than buyers of agency MBS. Why does no one step in to arbitrage the spread? Because there is little risk capital in this market that is not deployed, and/or anyone with money is waiting for things to get worse.

Next, even if we do accept that an arbitrage relationship holds between treasuries and agencies, (1) the liquidity premium on agencies is high; (2) the credit spread on agencies is increasing [since as the agencies lose money and become more highly leveraged, the likelihood of government support must decline somewhat]; and (3) regulatory risk in the mortgage market makes it unclear what the cashflows of the underlying assets will be anyway. (Remember even if the agency guarantee holds good, a reduction of principal on the asset pool causes prepayment, thus regulatory risk effects the optionality of the pass through.)

Posted in: ABS, Bonds and CBs, Federal Agency, Mortgages by David /
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The mot de jour for the last few days was ‘tsunami’. Now it seems we need something more potent. Bloomberg quotes Ed Steffelin: “People are calling it financial Ebola,”. Certainly the moves in ABS spreads are impressive:

Yields on three-year, AAA rated credit-card bonds with floating rates rose to 75 basis points over the London interbank offered rate, up from 40 basis points at the start of the year [...] Spreads over three-year swap rates for three-year, AAA rated fixed-rate auto-loan securities rose to 140 basis points, up from 75 basis points. The average spread over U.S. Treasuries on AAA rated commercial-mortgage securities climbed to 364 basis points, from 167 basis points on Dec. 31

Meanwhile, a sticking plaster is in sight. Henry (when did he become Henry? I thought it was always Hank – perhaps that’s the best sign of how serious things are) Paulson is to release new proposals within weeks:

“We’re looking at the mortgage-origination process, we’re looking at the securitization process, we’re looking at rating agencies, we’re looking at disclosure issues, we’re looking at capital issues and regulatory issues,” he said in an interview today with Bloomberg Television. More specifics will come “in the weeks ahead,” he said.

Now clearly action is needed. But speedy action has its dangers too, and Paulson has a big list of maladies there. Treat at haste, autopsy at leisure perhaps?

Posted in: ABS, Bonds and CBs, Markets, Regulation by David /
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The enormous $51B advance the FHLBs made to Countrywide has received a lot of press: see here for Bloomberg and here for comment from Naked Capitalism. What I had not realised, though, is the extent to which this goes beyond Countrywide. Sizing the issue is difficult as the various sources use different dates: CNN reports that in Q3 2007 FHLB loans to member banks were $822B, while Bloomberg says that institutions borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September 2007 alone.

Basically the 12 FHLBs are standing in for ABCP and securitisation buyers. Compare this with the FT’s assertion that the FHLB’s never used to lend more than $150B in a year and we can see that the FHLB system is basically acting as another FED window, and perhaps a wider one than the central bank has itself.

Posted in: ABS, Liquidity and liquidity risk, Securitisation and Tranching by David /
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The conventional explanation for the decline in the ABCP market is that structured finance is on the slide, perhaps for good. There is another reading, though. It could be that the structured finance isn’t dead – after all Morgan Stanley got a CMBS deal done recently – it could be that maturity transformation is dead. Northern Crock didn’t fail because of structured finance, it failed because of funding. Of course the reality is not so clear-cut, but if there is even a grain of truth in this musing, securitisations with little or no liquidity risk and well understood collateral will continue to be executed even as other parts of the structured finance market fail.

Posted in: ABS, Commercial Paper, Liquidity and liquidity risk, Securitisation and Tranching by David /
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Courtesy of Markit.

The ABX AAAs (scale in cents on the dollar so falling is bad).

The CMBX AAAs (scale in bps spread so rising is bad).

And the CDX North America Investment grade corporate credit index (both):

In the words of the Klaxons, It’s Not Over Yet. In fact, it looks as if it is only just getting going.

Posted in: ABS, Markets by David /
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The recent spread widening on Markit’s CMBX indices indicates that contagion from RMBS is no longer a concern: the infection has happened. Here are the AAAs

170 over (Update: 200 over) is quite a chunky spread for paper with this degree of subordination. Note that in CMBS there are many fewer pieces of collateral – since each deal is individually so much bigger – so it really is possible to understand each asset backing the deal. I suspect that those people willing to go and measure the footfall in Alabama shopping centres and talk to office realtors in downtown Seattle will find that some of the underlying AAA bonds still look pretty good.

Meanwhile in the UK not only is the IPD showing sharp falls – 8.7% in Q4 2007 – but also investors are withdrawing money fast from commercial property funds. Or at least as fast as the funds will let them.

Posted in: ABS, Markets, Securitisation and Tranching by David /
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Lots of CDO sales people and traders do… Here is the latest CDO issuance data.

Source SIFMA via Alea.

Posted in: ABS, Markets by David /
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Before 1990 defaults on Hong Kong credit cards were very rare. It seems that then the holders viewed paying back their debt as a matter of face, and they would borrow from family or friends rather than default on an obligation to a bank. Between 1990 and 2000 the default frequency slowly rose, and now there is very little difference between U.S. and HK cards. It appears as if a more western attitude now prevails, with consequences for the holders of card deals.

A similar cultural change seems to be taking place in the U.S. Let’s pick up the story with Bank of America CEO Ken Lewis:

There’s been a change in social attitudes toward default [...] We’re seeing people who are current on their credit cards but are defaulting on their mortgages, [...] I’m astonished that people would walk away from their homes.

Tanta takes up the story, quoting the recent Wachovia earnings call:

Part of one of the challenges is, and we’ve mentioned this before, a lot of this current losses have been coming out of California and it’s — they’ve been from people that have otherwise had the capacity to pay, but have basically just decided not to.

This could be huge for the CDRs on RMBS. And no one is coming to the rescue.

Posted in: ABS, Mortgages by David /
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The headline is Merrill Posts Record Loss on $16.7 Billion Writedown. Let’s take the Merrill earnings release and pull it apart a bit. Specifically, consider the CDO positions.

A first glance, the position seems fairly benign.

But now consider the footnotes:

(2) Primarily consists of principal amortization for U.S. super senior ABS CDO net exposures, as well as changes in hedges and increases due to ineffective hedges.

Now, amortisation reduces exposure. But the high grade number is up. So the increase must be due to ineffective hedges. This emphasises that these are net numbers.

(3) For total U.S. super senior ABS CDOs, long exposures (including associated gains and losses reported in income and other net changes in net exposures) were $46.1 billion and $30.4 billion at September 28, 2007 and December 28, 2007, respectively. Short exposures (including associated gains and losses reported in income and other net changes in net exposures) were $31.3 billion and $23.6 billion at September 28, 2007 and December 28, 2007. Short exposures primarily consist of purchases of credit default swap protection from various third parties, including monoline financial guarantors, insurers and other market participants.

Ah. Those would be the monolines that are doing so well at the moment. I don’t want to rain on Merrill’s parade, but if I were an investor, I might want to know a bit more about those hedge counterparties other than their ratings. The weighted average spread they trade at in the CDS market perhaps. That would give some idea of where between a net $4.8B and a gross $30.4B the exposure really lies.

Posted in: ABS, Broker/dealers, Credit, Monoline, Writedown by David /
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Do you remember when prime card backed ABS was the best kind of ABS money could buy? I do… but it isn’t any longer.

Posted in: ABS by David /
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Bloomberg reports that MBIA is falling again:

MBIA Inc., the giant bond insurer hobbled by the collapse of the subprime market, will cut its dividend 62 percent and raise $1 billion in a sale of notes to boost capital and preserve its AAA credit rating.

The Armonk, New York-based company has declined 81 percent on the New York Stock Exchange in the past 12 months and fell 4.2 percent today after it reported fourth-quarter writedowns and expenses of about $4 billion related to mortgage securities.

Bizarrely Buffett may be willing to help, despite his interest in setting up a competitor:

“We’re looking at multiple ways to participate in the industry,” Ajit Jain, head of Berkshire’s new bond insurer, said today in an interview. Berkshire, based in Omaha, Nebraska, is “looking at ways to support the existing insurers in terms of reinsurance and capital,” he said.

Part of the reason the monolines are in focus is, as Naked Capitalism reports, that Countrywide is rumoured to be close to bankruptcy. If it were to go down, it would trigger a wave of claims on the wraps the monolines have written that they likely could not pay. In this context, why doesn’t Buffett just let his competitors go down? Or has it been gently suggested to him that it would be in the U.S. national interest if he used that spare cash to support the industry? Certainly the NYT’s account of the support Buffett got for setting up his new monoline is bizarre. To pick some of the juicier bits:

Shortly before Thanksgiving, Eric R. Dinallo, the insurance regulator for New York State, did something unusual. He called Warren E. Buffett’s right-hand man on insurance, Ajit Jain, and suggested that he start a new company to insure municipal bonds in New York….

To be a New York company, Berkshire, with its main insurance offices in Stamford, Conn., would technically need to run its new business from offices in New York. But Mr. Dinallo agreed that Berkshire could set up a token office in New York and do most of its work in Connecticut…

For its part, Berkshire agreed to put up $105 million in capital to start, $30 million more than the minimum required by New York. But “to minimize the amount of capital trapped in the entity,” Mr. Jain said, Mr. Dinallo worked out a way for Berkshire to increase its leverage by permitting it to exceed the usual limits on reinsurance, or insurance on the risk the new company acquired.

Posted in: ABS, Insurance and Actuarial Practice, Monoline, Mortgages by David /
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In the financial markets there is nothing really new. Some vaguely good news:

• The ABCP market has expanded a little, for the first time since August 2007;
• The 3m swap spread has come in a little; and
• Despite all the talk, a major monoline has not yet defaulted or even lost its AAA.

Meanwhile the realignment is continuing:

• The VIX is up;
• Shares are broadly down although they are still bizarrely high compared with bond spreads;
• Corporate defaults are expected to rise according to Citi and JPM and the iTraxx is a little wider;
• The rerating and downgrading of CDO tranches continues; and
• The tightening of the ABX over Christmas was temporary.

Posted in: ABS, Commercial Paper, Economic Theory, Markets by David /
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Anyone who is even thinking about owning U.S. RMBS, or ABS backed in part by RMBS, needs to understand in detail how the underlying mortgages can not pay. In particular, in some U.S. states, mortgagees can simply mail the keys back to the mortgage lender – a practice sometimes known as jingle mail – and walk away without personal bankruptcy. In times of failing house prices, like, err, now, that gives rise to perverse incentives. Consider the following post on brokeroutpost (a site for american mortgage brokers) picked up by Calculated Risk (with the punctuation and spelling mildly edited):

I got an agreement of sale today from a realtor looking for a prequal on a shortsale, the buyer lives next door, he has a current mortgage for $800,000 on a home he purchased in 2005 with no money down, the home he has under contact is right across the street from his present home, the offer is for $500,000 and it looks like the bank will accept it.

The borrower plans to buy it as a primary, once he moves in, they will stop making payments on the $800,000 loan that they have with CW. He qualifies full doc and has a 770 FICO, he figures letting his credit tank is not a big deal when he is lowering his mortgage debt by $300,000 .

I told him the new bank may deny the deal based on occupancy, tried to convince him to go NOO but he does not want the higher rate.

Let’s pick this apart. Someone has a house with a 100% mortgage of $800K. The house is worth less. He can move over the road into a $500K (current price) house, and he has a good credit score so he will get a mortgage for the new house. Then he will agree a sale of his current property to the mortgage lender for much less than the loan amount and accept the impact it has on his credit rating.

(A short sale is an arrangement between the current owner of a home and the bank that lent them the money to buy their home to accept an offer for less than the total amount owed to pay off the home. Presumably here the bank would rather get a certain recovery than have the keys in the post and have the uncertainty of what they might be able to realise for the property in due course.)

The comments on this post are fascinating. Firstly it seems that no one, yet, has managed to show that this is actually illegal.

As far as breaking a law, I wish someone would say how, because everyone I have quizzed, replies with a blank stare.

Some people even think it is part of the game:

In my opinion, a mortgage is a contract which allows both parties to walk away from their deal if they don’t like what is going on. If the borrower doesn’t like the agreement they are in, it is their right walk away. When they do however, the bank has the right to get their collateral. It’s just how it is.

It gets better: even knowing the story, some people like the risk.

I will do this loan for .25% less than his best quote.

[...]

I see no reason to walk away from the deal, his present mortgage is not my concern.

And it appears that you can even minimise the impact on your credit rating:

He would not damage his credit if he does it right. He could move into the house across the street and then short sale the house that he owes the larger amount.

Now I don’t know how much of this to believe, and I should point out these people are if not estate agents, then pretty close, so I would take a couple of kilos of salt along for the meeting. But still. From the perspective of a security holder supported by the original loan, we appear to see:

• The collateral value is less than the amount we have lent;
• There may well be people willing to finance an alternative loan to someone they know is about to default on their previous obligation;
• Worst of all, the original lender is going to agree to a loss of principal, perhaps because a bird in the hand is worth two in the bush, but more likely because their foreclosure group is so busy any recovery is worth something given the number of houses they are trying to sell. Which is all very well if it is their loss – but it might well be the ABS holders.

Did ABS holders really understand this kind of thing could happen when they bought the securities?

Posted in: ABS, Mortgages by David /
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The FT in the dog end of the year has an insightful article on the Federal Home Loan system. Continuing one of this year’s themes – that the hardest core free marketeers are among the most interventionist when it comes to their own business – it points out how the FHLBs are providing state aid to the mortgage banks.

What the FHLB essentially does is raise money cheaply, by virtue of having an implicit state guarantee. It then uses this to provide loans to other financial institutions, against their mortgage collateral.

The important point to grasp is that these loans have quietly ballooned in recent months: as my colleague Krishna Guha recently noted, the Fed’s Flow of Fund data shows that the FHLB system issued new loans to mortgage lenders at an unprecedented annualised rate of $746bn in the third quarter of this year. That was up from practically nothing in the second quarter. And while the FHLB does not name the lucky recipients of this largesse, the cash almost certainly went to institutions no longer able to fund themselves in the normal way – ie through the capital markets.

[...]

The real moral is that investors in Europe’s securitisation market have, in a sense, been sold a pup. In the past decade, the US has often been hailed as the cradle of modern financial capitalism, partly because it has been so wildly innovative in areas such as mortgage securitisation.

But now it is clear that this market innovation was partly built on the presence of an obscure state safety net. Europe’s problem is that in the past decade it has copied US financial innovation – such as mortgage securitisation – without adopting the other safety valves that the US had too.

I’m not sure the US market innovation was ‘built’ on the existence of the FHLB system: without it, the same securities might well have been issued. But it certainly is proving useful at the moment, just as the (perhaps accidentally) superior design of the FDIC insurance system in the US has thus far prevented a Northern Rock type event.

Posted in: ABS, Markets, Mortgages by David /
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An update on two deaths foretold (neither of which you need an instrument as sophisticated as the Lowell refractor here to see):

• As suggested earlier, the MLEC is dead.

Confirmation from the WSJ is, here.

• And also as predicted, the ABX 08-01s aren’t coming any time soon.

Finally, in the bleedingly obvious category, Bloomberg tells us that monoline wraps are less valued than they used to be.

Posted in: ABS by David /
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It’s not much, but the ABX BBB- has bounced since the lows of late November:

As you would expect, the effect is more noticeable on the AAAs:

Now of course things can go down again from here, but this is at least that rare commodity, positive news on the ABX.

Posted in: ABS, Mortgages by David /
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The WSJ reports an amusing scrap over Sagittarius, a $985M CDO sold to investors in March by Wachovia and structured, it appears, by Deutsche (who is the trustee). Several UBS funds are investors, and an MBIA affiliate, LaCrosse, is a swap counterparty to Sagittarius. Sagittarius has MBS assets so apparently there was a default event. What happened next is the interesting part:

The day after the event of default, LaCrosse sent Deutsche Bank a letter saying that no interest or principal should be paid to other junior noteholders.

Other investors, unnamed in the legal filing, disagreed, telling Deutsche that MBIA’s position “is neither reasonable nor correct,” according to court papers filed by Deutsche Dec. 3. These other bondholders also might disagree about how they would share continuing payments, assuming they got any money. The disputed payments total several million dollars and will pile up until the dispute is settled, according to a person familiar with the matter.

With its legal filing, Deutsche is essentially asking the court to guide it on whom exactly should be paid.

It appears MBIA’s view is that it is supersenior via the swap, and hence no one should get any cash until they are whole. The others, unsurprisingly, disagree. In any event this highlights the importance of understanding where any derivatives sit in seniority vis a vis the note investors. Default contingent market risk can be ugly, and it’s quite hard to hedge.

JP has the right take here I think. Analyst Chris Flanagan wrote in a report recently:

“If there’s one safe prediction for 2008, it is that legal teams will be busy”.

May all your reindeer in 2008 be made of pecans, or not, as you desire. Unless you are a lawyer, of course. They can find their own nuts.

Posted in: ABS, Legal Risk and Trade Documentation, SIVs and Conduits by David /
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Over at Calculated Risk, Tanta makes a very good point about the dramatic decrease of subprime capacity:

The main impact of subprime lending on the overall mortgage business was the take-out function. As subprime lending grew, you saw better “performance” of prime or near-prime mortgage portfolios. This was not because subprime lending did away with the traditional default drivers of job loss, illness, divorce, or disorderly conduct; it was because loans in that kind of trouble had a place to go besides foreclosure. Prime lenders could and did congratulate themselves on their low foreclosure rates as if it were a matter of their superior underwriting skills, but that involves a high degree of naiveté. It’s really important to understand this issue, because it gets to the heart of the “contagion” thing. It is not that subprime delinquencies are “spreading” to prime loans as if some infectious agent were in play. It’s that the drain got backed up: when subprime lenders go out of business, or investors won’t buy subprime loans, there is no place for the inevitable prime delinquencies to go except foreclosure. Prime delinquencies become “visible” because they don’t move out of the prime portfolio via refinance into the subprime portfolio, where we “expect” to see them.

In other words, because there is less subprime capacity to take out troubled loans that were made as prime, some of these loans will now default because they have nowhere to go. Subprime provided a valuable rescue function to the prime market, and now it is mostly gone, the consequences for both lenders and borrowers of a loan falling out of the prime performing bucket are much more severe.

This implies of course that there is a lot of money to be made by stepping up to the subprime plate now, with rigourous underwriting criteria, very prudent liquidity risk management and a whole shedload of capital. Just as we saw a lot of fresh capacity in non-life insurance after Katrina, so it would make sense for new players (those private equity players with a lot of money and nothing to spend it on, for instance) to come to support the mortgage market while the established players are licking their wounds and sulking in their dens.

Posted in: ABS, Mortgages by David /
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Short of green men landing in the City and eating everything within a mile of Bank station, how serious could the credit crunch get, given what we know? The following is not a prediction, more of an exercise in generating plausible worst case scenarios.
Firstly the possibility of the failure of a systemically important institution cannot be ignored. The rumours surrounding further write-downs are too pervasive for that. Undoubtedly a rescue would be organised, but confidence would be very severely shaken and massive injections of liquidity would be necessary to stabilise the markets.

In this context we could expect a series of hedge fund failures too, and a widespread deleverage and flight to quality across the system. Significant falls in equity markets, moves in low yielding currencies vs. the dollar (as carry trades are unwound) and spikes in implied volatility are also to be expected. The securitisation markets would remain shut for an extended period of time, ABCP would be very difficult or impossible to roll, and the swap spread would go out significantly.

Another possibility is the failure of a monoline (such as MBIA, Ambac, FGIC, FSA or Radian) or a large insurance company involved in the credit markets such as Ace or XL. This is more problematic in that the parties who would be involved in a rescue are less clear and the majority of the systemic risk related to such a failure would be confined to the wholesale market. On balance though in the circumstances I think a rescue would be more likely than not. We have not seen a failure like this before so the consequences are harder to predict, but certainly the impact on the muni and structured credit markets would be considerable.

We can reasonably assume that the largest firms have the resources to attempt to mark their books. For smaller banks or fund managers that may not be the case, so there could well be medium sized institutions that are sitting on losses that are significant given their capital base without knowing it. This won’t be as bad as a big player going down, but on the other hand a struggling tiddler might actually be allowed to fail, depending on the country. That would cause further spread widening and deleverage across the industry.

Just as Sarbannes Oxley was a (-n over) reaction to Enron, so we can expect to see revisions to Basel 2 and to the accounting framework for conduits and SIVs. These will be a slow burn rather than sudden changes, in all likelihood, but depending on how far they go, they have the potential to reduce the intermediation of risk and decrease bank profitability, at least until the industry figures out how to arb the new rules.
Meanwhile we can expect the U.S. housing market to trend down for an extended period, until mid 2009 at the earliest, and contagion into other bubbly markets such as the UK and Spain is entirely possible. Specialist mortgage lenders, REITs, builders, and the holders of 2006 and 2007 vintage MBS paper are likely to suffer most. The impact on the economies concerned will be considerable, and full blown consumer-lead recessions are entirely possible in the U.S. and the UK.

The equity markets seem particularly vulnerable at the moment: perhaps we are seeing the start of an inevitable repricing of risk, but with many established equity markets close to their all-time highs, large falls from here are possible. Bank debt must also be vulnerable: while spreads have blown out, they are still rather tight compared with the potential downside in some of the scenarios I have outlined. This will have a knock-on effect in credit markets generally as risk capital is withdrawn and investors become much more risk averse.

None of this is inevitable, or even — so far at least — likely. But looking at what the future might bring is always a useful exercise, particularly in the heat of a crisis. Look on my stress tests, ye Mighty, and despair:

• Failure of your largest (by notional or PFCE) bank counterparty.
• One day equity market fall of 25%, followed by a further 40% over six months. Private equity cannot be sold.
• Short rates go to 2%, long rates to 6%, and the swap spread is 100 bps.
• Interbank borrowing is impossible for three months. Securitisation is impossible for ever.
• One day dollar fall of 5% followed by a further 20% over six months.
• All asset-backed securities except RMBS become completely illiquid and halve in value. (Remember this has an effect on collateral from clients and on SIVs and conduits too.)
• Default rates on prime retail mortgages are the worst ever experienced historically plus 10%. Subprime assets are worthless.
• AA- or better credit spreads for financials go out 100 bps. 150 bps for A to BBB. 300 bps below that. Corporate spreads go out by half those amounts, as do emerging market spreads. (Or if you want a riff on this, BRICS spreads tighten.)
• All monoline or credit insurer protection is worthless. Monoline spreads are 500 bps.
• All hedge funds concentrating in ABS default. Default probabilities triple for the rest.

Posted in: ABS, Basel, Markets, Worst case scenarios, Writedown by David /
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Watch it. The ABX index of a given vintage is supposed to have 20 bonds in it. At the moment, issuance is so light, only 3 qualify according to Wachovia via CreditFlux. That will make it extremely difficult for the ABX to continue in its current role of barometer of the crash, assuming it goes into 2008.

Alea further points out the bid/offer spreads are so wide that even now the veracity of ABX-derived marks is somewhat questionable. Certainly trying infer the possible losses of a player – Merrill, UBS or Citi for example – from the ABX is a very approximate business. This is particularly so for the AAAs since the ABX index member may have significantly different subordination from the position held. In some securitisations, for instance, there are as many as 5 AAA bonds, with the real supersenior much safer than the lowest AAA.

Posted in: ABS by David /
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First, many subprime mortgages are simply unaffordable for the mortgagee. As Naked Capitalism points out, the true interest cost for many buyers is more than 50% of their income:

Right now the full force of this has not been felt yet as many of these mortgages are in their teaser period where the rate is artificially low: the yellow shows the distribution of actual payments including the teaser rate, the blue what it would have been without the teaser. The current low rates change soon, however, as this picture of the notionals resetting by mortgage type shows:

As Stan might say, oops.

Posted in: ABS, Mortgages by David /
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Naked Capitalism makes a very good point about the (relative) lack of a catastrophe in the ABCP market recently:

Many mortgage-related ABCP issuers have gone to a lender of last resort, namely the Federal Home Loan Banks, which have extended $163 billion of loans to them.

(The FHLBs are commonly thought of as equivalent to U.S. government risk, although they do not have an explicit government guarantee.) NC then references a Bloomberg article, quoting

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

To meet the sudden demand, the institutions sold $143 billion of short-term debt in August and September, according to the FHLBs’ Office of Finance. The sales pushed outstanding debt up 21 percent to a record $1.15 trillion, an amount that may become a burden to U.S. taxpayers because almost half comes due before 2009.

[...]

The home loan banks “were the only game in town for a lot of borrowers,” said Jim Vogel, head of agency debt research at FTN Financial a securities firm in Memphis, Tennessee. They are “like an old watch your grandfather left you years ago, and you pull it out of the drawer and find it’s the only timepiece you have.”

This is really scary. The FHLBs are lightly regulated (laws tightening the regulatory framework around them are currently stalled in the Senate), were one of them to fail or come close to failure, there would be enormous pressure for a government bail-out, yet their risk management practices are hardly likely to be in the same category as a Goldman Sachs. Avoiding a market crisis this way may just be storing up trouble for the future. Gangway, gangway, I want to get off this particular boat.

Posted in: ABS, Commercial Paper by David /
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One of the many threats to the ABS market at the moment is the perceived decline in the credit worthiness of the large bond insurers, aka the monolines. There are a small number of these firms, and most of them carry either a AAA or AA credit rating. They are vital to the functioning of the ABS market in that they wrap bonds, providing a guarantee that if the underlying collateral does not pay timely interest and ultimate principal, then the monoline will. This solves the information problem on less well understood ABS collateral, and lowers funding costs for pools with non-standard characteristics.

Unfortunately the monolines have wrapped a significant amount of subprime collateral. This is causing a drag on earnings with both AMBAC and MBIA reporting losses last week. Investors are concerned that this is only the beginning and have bid up default protection on the monolines. Five year CDS spreads have gone from a few tens of basis points to 300 for AMBAC and 200 for MBIA.

The monolines typically have very diverse pools of risk that they have wrapped, considerable claims paying ability, and fairly large capital bases. However they are also highly leveraged and, since much of their protection is legally insurance, they do not mark all of it to market, and even where they do have MTM instruments, these are often sufficiently illiquid that they are marked to model. They also engage in transactions other than public bond insurance, wrapping risk in private transactions and, in MBIA’s case, managing a SIV. Given rising default and rising default correlations across ABS, then, investors are concerned that the monolines’ capital models might not be robust and hence that their AAA status is questionable. Certainly were a monoline to fail the impact on the market would be very considerable. MBIA alone, for instance, from 2005 to mid 2007 insured $35B of bonds, their RMBS portfolio is over $45B, and their CDO book over $100B. The muni market would also suffer a massive case of illiquidity as investors scramble to understand bonds that previously had traded on the strength of their wraps.

Note finally that since the monolines are insurers, they are not regulated by the FED or the SEC. Any bail out would have to be coordinated between the insurance commissioners and the capital markets regulators. The threshold for ‘default’ is also higher, since a monoline cannot operate unless rated at least AA: a downgrade below that level would probably be taken by the market as more or less equivalent to failure. Meanwhile 300 over isn’t a typical AA credit spread: the market evidently views a monoline failure as a real possibility.

Update. As at the 1st of November, according to the FT, the (AAA-rated) debt of Ambac and MBIA costs 345 bps and 310bps respectively to protect in the CDS market. XL Capital is trading at 445bp.

Posted in: ABS, Monoline, Ratings, Regulation by David /
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John Snow – Hank Paulson’s predecessor as Treasury secretary – isn’t that keen on the MLEC either. According to Reuters:

We’ve got all this paper out in the system, and my inclination is to say, let’s accelerate the price discovery process on this paper [...]

We know that when you prop things up artificially — Japan — we know when you prop things up artificially — the (savings and loans) in the United States — you get bigger adverse consequences

He has a good point. Warren Buffett is not keen either:

I think there should be a requirement that before the securities are put into the new super-SIV, 10 per cent of the holdings should be sold into the market to people who are not associated [with the subprime problem]

Certainly the history of intervention to prop up prices in the markets is not encouraging, and suspicions remain that the MLEC will not use the right mark. Perhaps it falls foul of the Market Abuse Directive? Oh, and the ABX is on the way down again. Here are the 07-02 BBBs:

Posted in: ABS, Fair Value, SIVs and Conduits by David /
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The news that Countrywide is modifying a huge swathe of mortgages brings out the issue of servicer related convexity again.

Countrywide is going to modify two types of borrower according to Naked Capitalism:

Borrowers who are current now but look unable to cope with an upcoming reset. That is budgeted for $4 billion of loans

Delinquent borrowers. These will be targeted with a “predetermined, preapproved” reduction. This program is targeted to $2.2 billion of mortgages.

For Countrywide the aim of this programme appears to be to keep as many borrowers current as possible and so earn their servicing fee. But remember a mod will typically decrease cashflow. If these mortgages have been securitised (as is highly likely) that cashflow reduction flows through the waterfall and hits the tranches. In other words, the servicer’s proactive attempt to protect their fees is modifying the cashflows on securities they likely do not own. Which tranches are effected depends on the precise securitisation structure and the history of the security (losses and prepays so far). Nonetheless it is not obvious that Countrywide have the interests of all security holders at heart in implementing this mod programme.

Posted in: ABS, Mortgages, Securitisation and Tranching by David /
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In sharp contrast to some mild improvements in other parts of the credit markets, FT alpahville presents this enlightening chart, courtesy of Fitch. It shows how the average NAV of the SIV’s assets has continued to slide.

The better players have been doing fine, but the worse ones are catching a severe cold, and the average is still declining. At this rate more triggers start to be hit, and forced liquidations are putting further pressure on prices. And that of course leads to more write downs. The rumor is that that $5B at Merrill is only the start for instance. We’ll see…

Update. It’s another $2.5B at Merrill, apparently. And that’s not the end of it, obviously, as the markets have been so illiquid that it is likely that all the big players still have a significant part of their position. Unless the recent ABX kickup is the start of a trend, there will be more writedowns like this.

Posted in: ABS, SIVs and Conduits by David /
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From the FT:

Investors scrambled to buy a multimillion-dollar catastrophe bond on Wednesday as the market for natural disaster debt continued to boom.

“Investors like these bonds because of the high premiums and the fact there are very few pay-outs. It is also a great diversification play. These investments are not linked in any way to subprime. That also explains why the market has continued to boom despite the credit problems over the summer.”

This is a BB+ cat bond paying Libor plus 275, and people are waving it in because it is not a credit instrument and specifically because it is not a mortgage backed security. Gosh, that let’s avoid the place the lightening struck last week and go and stand under a different tall tree during a storm strategy always works, doesn’t it? The bond may or may not be a good deal but it has to be a cause for concern if it is being bought by people who are more interested in what it isn’t than in what it is.

The illustration shows some underwriters’ desks at Lloyds of London. Perhaps they have left the building thanks to the willingness of the capital markets to take their risk?

Posted in: ABS by David /
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The importance of my earlier question about how the MLEC will price the assets it is going to purchase is highlighted by an article in the FT today:

[It has emerged that] Axon Financial, a SIV linked with the US hedge fund TPG-Axon, had taken losses of $110m on sales of $3bn of its investments.

Very crudely scaling from $110m on $3b to Citi’s $100b in conduit assets gives us a loss of $3b. So we know a real mark to liquidation would really really hurt. The market is so illiquid at the moment that it’s hard to be sure until you try to sell of course. So it should be no surprise to learn that many banks have not yet marked their conduit assets down:

One banker said last week: “The banks have varied enormously in terms of how much they have marked down their books – of course there are some that want to avoid the big write-downs.”

The MLEC then looks like an attempt at creating a new vehicle the banks can claim is arms length and which they can use to justify valuations which might not really be liquidation levels. That helps in turn helps the banks other conduits and the value of their on-balance sheet ABS. If you tell people it’s worth par often enough, loudly enough, maybe it will be…

Posted in: ABS, Commercial Paper, Fair Value, SIVs and Conduits, Writedown by David /
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Another sign we are on the upswing: the market for commercial paper in US is expanding again. Buy illiquid structured securities. And LBO loans.

Posted in: ABS by David /
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Obvious really.

Posted in: ABS, Mortgages by David /
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From Bloomberg:

“Moody’s does not structure, create, design or market securitization products,” Kanef [group managing director, asset finance group, Moody's Financial Services] said. “We do not have the expertise to recommend one proposed structure over another, and we do not do so.”

Update. After that confidence building statement, we have the FT reporting that a senior U.S. official is considering splitting up the advisory and ratings functions of the agencies to reduce their conflicts of interest. It will be interesting to see if there is a knock-on effect to Basel 2 here: after all, ratings are at the heart of the new Accord, and now it is clear how untrustworthy they were in some cases, the supervisors might have a change of heart.

Posted in: ABS, Basel by David /
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Today the Bank of England said it will lend £10B to commercial banks in an emergency three-month auction and widen the range of securities it accepts as collateral to include mortgage backed securities. That should bring the 3 month swap spread in. The question is, why have they caved in to the banks after holding the line admirably until now? Some possibilities, the first three none too savoury:

• The political clamour over Northern Rock could not be ignored and the Bank was worried that someone like Alliance and Leicester or HBOS might be next.
• The Bank knows that another player is in serious trouble.
• The knock-on effects of the high cost of Libor-referenced funds in the real economy are becoming too large.
• The rate the Bank is charging for this extra liquidity is sufficiently high that it provides appropriate liquidity yet makes anybody imprudent enough to need it pay through the nose. This wouldn’t be too bad but one wonders why at least some of this £10B was not provided earlier.

I agree with Nils Pratley that this is not a resigning matter for Mervyn King – the Bank has played a reasonable hand. But we do need understand what their thinking is. The performance today will be interesting.

Update. King is blaming the Market Abuse Directive for preventing him lending to Northern Rock covertly, and the takeover code for stopping him organising a quick-but-effective sale. This is fascinating if it’s true.

Posted in: ABS, Commercial Paper, Credit, Liquidity and liquidity risk by David /
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For a CDS on a corporate loan or bond, restructuring is often a credit event so in a CDO of corporate debt, adverse modification of the loan causes a loss which flows up the waterfall (albeit sometimes a minor one if the restructuring is purely a technical one).

This is not true for a CMO of retail mortgages. If a retail mortgagee is in trouble, the CMO docs often permit a modification of the loan at the discretion of the servicer. That’s huge. The servicer might well have no economic interest in the cashflows of the mortgage yet they often have the discretion to modify them to the probable detriment of the CMO tranche holders.

And the FED wants them to. This is from Interagency Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages via Calculated Risk:

Servicers of securitized mortgages should review the governing documents for the securitization trusts to determine the full extent of their authority to restructure loans that are delinquent or in default or are in imminent risk of default. The governing documents may allow servicers to proactively contact borrowers at risk of default, assess whether default is reasonably foreseeable, and, if so, apply loss mitigation strategies designed to achieve sustainable mortgage obligations. The Securities and Exchange Commission (SEC) has provided clarification that entering into loan restructurings or modifications when default is reasonably foreseeable does not preclude an institution from continuing to treat serviced mortgages as off-balance sheet exposures. Also, the federal financial agencies and CSBS understand that the Department of Treasury has indicated that servicers of loans in qualifying securitization vehicles may modify the terms of the loans before an actual delinquency or default when default is reasonably foreseeable, consistent with Real Estate Mortgage Investment Conduit tax rules.

The last sentence is particularly telling:

Servicers are encouraged to use the authority that they have under the governing securitization documents to take appropriate steps when an increased risk of default is identified

Now this is presumably in the interests of the home owners. I can see why the FED is doing it. But did the tranche buyers know this could happen? Caveat emptor.

Posted in: ABS, Mortgages, Securitisation and Tranching by David /
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Caroline Baum writing for Bloomberg points out that Bernanke of the FED is an expert on the Great Depression:

Bernanke [...] wrote in a 1983 paper for the National Bureau of Economic Research (“Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”): [...] “the financial crisis of 1930-33 affected the macroeconomy by reducing the quality of certain financial services, primarily credit intermediation.”

Translation: Many commercial banks, considered efficient at allocating credit (they have a knack for differentiating “good” from “bad” credits), failed. The ones that remained solvent wanted to hold liquid assets or, if they were willing to make loans, charged a higher rate of interest.

Then and Now

“It was reported that the extraordinary rate of default on residential mortgages forced banks and life insurance companies to ‘practically stop making mortgage loans, except for renewals,”’ Bernanke said, citing the work of the late economist A.G. Hart.

Sound familiar? The rate of default isn’t extraordinary just yet, but the mortgage market is contracting in leaps and bounds, starting with originations and ending with securitizations. The tentacles of the home-loan market are starting to strangle portions of the debt, equity and even the normally staid money market.

Bernanke is fully sensitized to the collateral damage damaged collateral can cause. Over and over in speeches during his stint as Fed governor from 2002 to 2005, he returned to the subject of the Great Depression, detailing where the Fed went wrong and what the Fed could have done to ameliorate the problems of the banks (provide liquidity or lower interest rates).

This is interesting as we are now in a true market for liquidity. Cash is a rare commodity at the moment and those people who have it are charging through the nose for it. The reason it’s rare is that the market has woken up to their lack of knowledge of default probabilities both for securities and for their counterparties. A triple A rating doesn’t mean much for ABS, and nor does a AA- give much comfort when attached to a broker/dealer in current conditions. Faced with this ignorance and in many cases plummeting or highly uncertain or both collateral values, the market is making people who want cash pay up for it. One ABCP conduit, for instance, with a (nearly full) guarantee from a very good credit quality sponsor and good quality assets was paying Libor plus 40 for one month CP this week. That’s extraordinary if you think you can estimate the joint default probability of the assets and the sponsor and you are charging for that risk. It isn’t if you have cash, they don’t, they need it badly, and there is no one else they can go to. Then you can charge what you like…

Posted in: ABS, Financial Models, Liquidity and liquidity risk, Markets by admin /
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An aban- doned shoe and a banana skin on Old Street to begin a post on the willingness of ABS servicers to abandon their trades if things go badly. Specifically, Tanta on Calculated Risk makes a good point about rising defaults in RMBS:

Foreclosure waves create additional losses just by being foreclosure waves. You can try to rush for the exits all you want; it takes too long to get out of this door if there are too many people in line [...] when declining home values [...] get to a certain point, the foreclosure volume gets to a point such that the operational risk explodes, which drives those loss severities even deeper.

So when house prices go down not only do you have rising losses in RMBS, these losses increase costs dramatically at the servicer. Therefore you also have massive pressure on servicing fees because if you don’t agree to let the servicer raise them to cover these costs, they default, and the back up servicer will demand higher fees anyway. There is not sufficient liquidity for all holders to be able to get out at anything like the marked price once this starts happening. As Tanta puts it:

“Look, bondholders, you’ll either approve some modifications or your servicer will fold beneath you and any substitute servicer will be able to name its price because you need them waaay more than they need you,”

In most ABS the holder is short a (real) option for the servicer to demand a change in fees, and this option is really worth something. Moreover its moneyness is highly correlated with default levels. If you hold, say, non Agency AAA, are you getting paid for being short this option?

Posted in: ABS, Mortgages by David /
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