CDS intermediation doesn't die, just gets put on ICE

As the CDS product undergoes changes, the way that the CDS trading participants interact with each other is changing as well. Here is some background.

In recent years some dealers have become what are called "derivatives prime brokers" (or derivatives intermediation providers) for buy-side derivatives users. The idea was the one can execute a derivative transaction (usually a CDS) with any dealer and effectively "give-up" the trade to their derivatives prime broker.






A hedge fund could trade CDS with multiple dealers, but at the end of the day they would face just one counterparty on all their trades (some funds had a couple of derivatives prime brokers). The advantage was that by facing only one dealer, the fund would have a single consolidated margin account that would take into account all the longs and shorts, making the margin process more efficient. Also the derivatives prime broker would provide independent pricing on the whole derivatives portfolio that could be integrated with the fund's portfolio systems.

Some hedge funds would select a large bank rather than a broker dealer to face on their CDS trades, thus reducing counterparty risk. A fund could do a 5-year CDS trade with Lehman a day before it defaulted, give it up to a large bank the same day and have no exposure to Lehman.

But the derivatives intermediation business mostly died with the crisis as Goldman and several others exited the business (some dealers are still providing this service for their top clients). If you look at he diagram above, a give-up simply means that a derivatives intermediary steps in between the fund and the original counterparty. And what made dealers exit the business had more to do with facing another dealer than the hedge fund. The dealers charged funds sufficient margin to avoid major losses. However if the other side (Dealer-A) was Lehman, the intermediary has a problem. The whole model no longer worked when it turned out that it wasn't the hedge funds but the dealers who pose a major risk to each other. The intermediary (Dealer-B) just wasn't getting paid enough by the hedge fund to take other dealers' risk. Plus with the clearinghouse idea looming, it made even less sense to be in this business.

But as ICE North America CDS clearinghouse went online earlier this year, funds and banks started looking for a solution that resembles the give-up process. Recently ICE announced a process that would allow this to happen.

ICE: Credit derivative trades between a buy-side firm and an executing dealer are typically executed and legally confirmed on a bilateral basis. This requires buy-side customers to have ISDA documentation in place with each executing dealer and to take counterparty risk to executing dealers when conducting CDS transactions. Trade date clearing eliminates the need for this documentation between buy-side firms and executing dealers. Instead, a buy-side firm may trade with any executing dealer who is a clearing member, and may clear the trade at ICE through their designated "derivative clearing member" or DCM.

Hedge funds can not be members of the clearinghouse (ICE wanted only the massively capitalized banks to participate). That means that funds would still face banks on CDS trades. But they would be able to trade with multiple dealers and at the end of the day be facing only one, their "designated derivative clearing member". The clearing member would face ICE on the other end instead of another dealer.






Right now ICE only has a couple of index CDS trading, but over time major single name CDS product should start going through the clearinghouse. The hope is this will improve liquidity and make participants less nervous about counterparty risk.

No joy for US commercial real estate

Here is a great picture of the state of the commercial real estate markets in the US. It shows the Moody's commercial real estate price index and the delinquency rates on commercial mortgages.


source: Moody's

In addition, sales of commercial properties have dropped off the cliff as financing disappeared (less than 5% of the volume for the same time in 07). But here comes China to the rescue with the CIC sovereign wealth fund. It's not going to help existing property owners and lenders, but it may create a market for distressed commercial real estate properties.

WSJ: ...in order to achieve any meaningful diversification in its portfolio, the fund would need to set aside between $4 billion and $10 billion to global property investments in the next year and a half, estimates Michael McCormack, an executive director at Z-Ben Advisors, a consulting firm in Shanghai. By 2014, he projects that CIC's U.S. property investments alone could amount to more than $20 billion.

Pushing out the wall of leveraged loan maturities

"Amend and Extend" has been in full swing in the corporate leveraged loan space. Pushing the day of reconing further out in hopes of finding a way to deleverage before maturity has been the theme for many leveraged firms. A total of $38 billion of institutional loans have gone through the amend and extend process.


source: LPC


Lenders have the same dreams and hopes as the borrowers - let's give the company more time and hope earnings will improve enough to blow the loan out. The fact that there is practically no new loans in the pipeline keeps the loan market strong and helps the "amend and extend" process as well. The chart below shows how the bond market has replaced institutional loan issuance, capping the loan market size.


source: LPC

Liquid risk strategies are highly correlated

What does the Australian dollar (AUD) have to do with global equity markets? Fundamentally at first glance not that much. Australian equity market cap is a small fraction of the global markets. But the data shows something else. The chart below shows the regression plot between AUD and the MSCI World Index (global equity index) since Sep-08. The R^2 for the regression is 0.75, pointing to the fact that a large part of AUD/USD movements are explained by the global equity markets. One gets a similar result for the AUD/JPY cross.

AUD/USD vs. the MSCI World Index

source: Bloomberg


In contrast however, Dollar/Yen shows little relationship to the global equity markets (see chart below).

USD/JPY vs. the MSCI World Index

source: Bloomberg


What's going on here? What's so special about our friends down under? It turns out that it has less to do with Australia and more to do with correlated risk taking. We discussed this before in the context of the "carry trade".

Imagine the global markets as continuously jumping in and out of liquid risk trades. A risk trade is anything that produces positive returns when we have an "all is well for now" feel around the world. If no scary things happen a risk trade should do well, but as soon as something spooks the markets, the risk trade gets unwound. That's why it needs to be liquid.

The two most liquid risk trades are global equities and currency carry trades (long a currency with high interest rate and short a currency with low interest rate). We all know why equities represent a risky trade. The carry trade is also risky because it tends to be highly leveraged. Some may argue that commodities are in that camp as well, although liquidity there is not as high (relative to currencies and equities). That means that when traders put on risk, some go long equities, others put on the carry trade. When they jump out, the reverse happens. The key is that they do it simultaneously (usually it's different sets of people who trade these). That's why the correlation works for AUD/USD and AUD/JPY - both of these are a high rate currency against a low rate currency, i.e. carry trades. USD/JPY is not a carry trade, thus the correlation to equities is insignificant.

The lesson here is simple: if you have liquid risk strategies, expect them to be correlated, no matter what the asset class is. That is why those who think diversification will significantly cut their risk are surprised every time when seemingly unrelated markets/strategies become correlated.

Buying a home - revisited

We received a great comment on the recent post dealing with mortgage rates from someone named OptimizedPrime on Seeking Alpha. Here is the full re-print of the comment and some responses:

Yep, great time to buy. You know what happens when interest rates inevitably go back up? Your newly purchased house's value drops like a rock!

Put that in your spreadsheet and smoke it.

Here in the US house prices are virtually indexed on interest rates (people pay the PAYMENT not the purchase price), so the minute they go up you can expect price drops FAR BEYOND THE CURRENT MARKET CORRECTION.

So let's take an example, shall we?

A working couple buys a house for $330k with 10% down at 5% interest. Their payments are $1600/month give or take.

With that, you can surmise that the price of their house is not "$330k", but actually "$1600/month +30k down".

Now imagine interest rates pop up to a more sustainable 10%. This is not AT ALL out of the question when the government stops forcing taxpayers to keep your mortgage low by subsidizing the market (if there's any hint of inflation on the horizon, then 20% is more like it but let's just use 10% to make it easy).

But let's just see what rates going to 10% does here.

Now the same 1600 will get you a loan for $185k. Add your 30k down and you can afford a house for $215k.

In other words, the change in interest rates have made the EFFECTIVE "price" of your house DROP from $330k to $215k. This is a 34% drop in price, or a loss of $115k, which is to say about 3x your down payment. (You are way underwater now btw).

In this scenario you are much, much better off renting and paying the higher interest rates when purchase prices come down because:

1. You'll pay less property taxes (esp. in prop-13 limited CA).

2. You down payment will be a much bigger percentage of the purchase price meaning you will purchasing less of other people's money.

3. You will actually have equity in the house vs. being deep underwater.

4. When interest rates come BACK down, you can refi and get the best of both worlds.

Is this all to say that the latter scenario is "better" somehow? Inflation certainly muddles the picture, but assuming your down payment is carefully invested you will be much better off putting it in some other asset (even WITH the leverage).

What this really means is that interest rates are essentially a "wash". There's nothing inherently good or bad about interest rates being low. Low interest rates in many scenarios can be much, much worse than high interest rates.

You should therefore not take interest rates into consideration when you decided whether to or not to buy a house. Low interest rates (like these) that have no direction to go but UP are for suckers.

OP

OP makes some excellent points. In some areas real estate definitely moves (or at least used to move) with mortgage rates. As mortgage rates go higher, "affordability" drops and so does the price. However that tends to be driven by "stretch" buyers. When real estate is overpriced beyond most people's means, every basis point in rates makes a difference in whether a stretched buyer can afford it (particularly in California). That's not so much the case these days, particularly outside the overpriced areas.

Here are some common sense thoughts on buying a home:
1. Make sure you can comfortably afford the mortgage, and would have been able to afford it even if the rates were higher. Check those taxes.
2. Make sure the house has utility value to you. That means you really want to live there for many years and are not buying purely as an investment. If you are buying a house to flip it, you are asking for trouble.
3. Make sure the house does not require significant additional initial investment.

Assuming you stick with the guidelines above (and there are plenty of better qualified professionals out there who can give useful guidelines), here is why buying a home should be just fine.

1. High rates probably means we've got inflation. At least that was the situation in the 70s. Financial assets don't do well during high inflation - just look at some charts form the 70s of stocks and bonds. Commodities do well, but most people need a home, and you can't live in your gold bars. Your house price should at least be stable.

2. With a weaker dollar, foreigners are going to like your home. Have you seen the crap you get for your sterling around London lately? That's why the Brits love those homes in NJ.

3. If you currently already own a home and need a bigger one because your family needs a bigger home, you don't have much choice. If the new house works for your family now, in years to come this house will work for someone else's family. Remember, the US population gains one person every 10 seconds. With new construction significantly down, the demographics will take care of the rest:

From VOX, William C. Wheaton:

During the last decade, net new household formation averaged approximately 1.4 million per year. Last year, the Census reported that the US added only 544,000 new households – during severe contractions the young stay at home, singles “double up”, and household formation (normally) slows. Even with declining demographics, however, most analysts foresee new household growth resuming to a level of at least 1 million by 2010 and beyond. If we conservatively add 200,000 demolitions per year, the US economy will “need” at least 1.25 million new units yearly in the near future. With today’s currently depressed construction, this generates a yearly deficit of 750,000 units.

4. If you rent, just remember that OP's logic above applies to rents far more than it does to home prices. Rates go up, so do rents. That's because as rental properties become more expensive to finance, they need to charge more to make any profit. If you are in a rent-control place, it's a different story. If not, you run the risk to have your rent raised to painful levels. At least with a 30-year mortgage, your housing expenses are fairly stable.

5. Even with the financial hell we've been through, mortgage lending is a great business for banks. Decent credit, proper paperwork, 30-year fixed mortgage, and a 30% downpayment, all make for a quality loan. Remember that you probably are a better credit than that restaurant around the corner or the strip mall down the road, and banks know it. Mortgage lending isn't going anywhere and neither is the tax deduction.

Keep in mind, the US government, particularly the Fed is trying to re-inflate home prices. It's not clear how successful they will be, but if you just want price stability and you buy a home now, over a period of time you should be fine. Mortgage rates are definitely going up, but that doesn't mean home prices are going significantly down in the long run.

Statutory debt limit about to be raised - again

The chart below shows the increases in the US statutory debt limit since 1974. The limit applies to the amount of federal debt outstanding that only applies to publicly held debt. Debt held by the Social Security Trust Fund is not included.

The Treasury is projecting that we are going to hit the current limit of $12.1 trillion shortly. That means going back to Congress for a vote, which is going to get noisy. Nobody is going to want to vote for it, yet unless we plan on shutting down the government (which nearly happened in 1996), this increase will pass. But other than setting these artificial limits, there is no real strategy in place to keep this from escalating out of control.


source: Moody's

Affiliated Computer Services options volume

As predicted, M&A activity is picking up. This morning it was Abbott Labs planning to buy Solvay as well as Xerox grabbing Affiliated Computer Systems.

But as with Perot Systems, once could ask questions about how "clean" these transactions are.

The chart below shows Affiliated Computer Services option volume for $50 strike call options maturing 17-OCT-2009.


source: Bloomberg

We are not going to make any statements about this, and would like to invite the readers to draw their own conclusions.

Grab that cheap mortgage before the pary ends

The stars have aligned to bring down mortgage rates to levels (even for jumbo mortgages) that may not be here for long.


source: Bloomberg (Bankrate.com mortgage rate and jumbo rate (orange) national average)

The US consumers who are able to refinance will find money in their pocket. Those who want to buy a new home, go for it - prices are down and you can't beat a 30-year mortgage rate at around 5%. That's a 3-4% 30-year loan on an after-tax basis, courtesy of the US government. Some may argue that house prices are going lower, and in some areas they will be. But by trying to time the exact bottom in the housing market, you may miss the great American 30-year mortgage party. Here are some reasons for this "generosity" from your local bank and why the party may not last:

1. The Fed has purchased $689 billion of mortgage backed securities plus $127 billion of agency paper. The supposed target for the program is $1.25 trillion, but it is possible they will slow down the purchases. The Fed is getting nervous about the quantitative easing, which has recently moved into full swing.

Demand for mortgage securities from the Fed lowers the financing rate for mortgages, making bankers set a lower rate and still have the ability to make their fees. The chart below shows the narrowing spread between a 5% mortgage bond from Fannie Mae and the 10-year treasury note (part of the reason for the drop is also the reduced volatility in interest rates - discussed below). Going forward, that spread may not keep on tightening the way it has.


Source: Bloomberg


2. Related to the point above, the government has been providing unprecedented support for Fannie and Freddie. Once the agencies stop bleeding profusely, there isn't going to be much political will to help them other than to keep them from collapsing. Chase for example keeps a large slug of mortgages they originate, where as Wells Fargo tends to sell more to the agencies (to deal with Wachovia's portfolio). If the agencies start controlling their balance sheet growth, the mortgage rates may be impacted.

3. Interest rate volatility has dropped significantly. Because interest rates impact the prepayment option embedded in long-term mortgages, high volatility in rates makes that option more valuable. When a bank gives you a mortgage, it in fact sells you the option to prepay your mortgage early. That option impacts the pricing of mortgage backed securities, therefore impacting mortgage rates. The chart below shows historical 30-day volatility in 10-year note futures.



As the chart below shows, that lower volatility reduces the value of the prepayment option, making the mortgage cheaper. If you believe low volatility is here to stay, than there is plenty of time to grab that mortgage. But not many professionals would bet on that.


source: Kalotay's paper (attached)


30-year mortgages at close to 5% are an excellent (and a safe) choice, but before you refinance or select your mortgage however, please read Kalotay's paper blow (Financial Analysis of Consumer Mortgage Decisions primer). He does a superb job in analyzing under what circumstances refinancing makes sense and what types of mortgages work best. When it comes to mortgage analytics, Andrew is one of the best in the business.


Enjoy!

Financial media gets the hype award for reports on "derivatives revenue"

Financial media is at it again hyping up derivatives revenue at banks. CNBC: "Banks Made $5.2 Billion From Derivatives in 2nd Quarter". WSJ: "Banks Made $5.2 Billion in Derivatives Trading". (Interestingly enough, this time Bloomberg didn't carry the story.) Yes these "banksters" are back doing their derivatives thing again. Great headline grabber. Of course they all picked it up the Associated Press article (here is a copy reprinted in the WSJ):

AP: U.S. commercial banks earned $5.2 billion trading derivatives in the second quarter, as the level of risk eased in the global market for the complex financial instruments, according to a government report released Friday.

The financial media of course doesn't have much understanding of how trading desks report revenues (shown here in the OCC report).


source: OCC report below

A "rates desk" (or division) for example may be trading everything that involves interest rates. It's a combination of cash instruments (bonds), OTC derivatives (swaps, caps, floors, swaptions), secured loans (repo contracts), and financial futures (eurodollar futures, etc.) These instruments constitute books and portfolios, both market making and proprietary. Separating the P&L by instrument for reporting purposes does not work because many of these individual positions act as offsets for one another. Nor does the OCC ask for that information - it reports results by broad business lines, not by instrument type. Here is what the OCC actually said (see attached report below):

U.S. commercial banks reported revenues of $5.2 billion trading cash and derivative instruments in the second quarter of 2009

Again, "cash instruments" means stocks, bonds, loans, physical assets, etc. Trading "contracts" does not necessarily mean derivatives either - it includes repo, spot FX, etc. Derivatives are simply an integral part of market making and prop activities.

But obviously truth doesn't always grab headlines, and financial media doesn't always do it's homework. For their misleading reporting as a means to grab headlines, the mass media and in particular the Associated Press gets the Sober Look Hype Award:

Political double standard in bank failures

In a recent post we discussed the fact that regional and small banks are overexposed to real estate, which has been the primary reason for their rapid failures. The latest failures in Georgia represent a good example of this exposure.

As the FDIC shuts these Georgia banks down, the state politicians are getting increasingly annoyed, as if the failures are the FDIC's fault. What happened to tough new regulation? Or does it only apply to those banks in New York?

WSJ: Just two days after Reps. David Scott (D., Ga.) and Tom Price (R., Ga.) chastised Federal Deposit Insurance Corp. Chairman Sheila Bair about the rapid number of banks failing in Georgia, a Georgian bank failed. Fittingly, its name was Georgian Bank.

It’s the 19th bank in the state to close so far this year. That means of the 95 banks that have failed in 2009, 1 in 5 have been in Georgia. Regulators have cracked down on banks in the state, in part because real estate losses are extraordinary. Georgia lawmakers are furious and blaming the FDIC in part for overreacting.

Many politicians in Georgia have received political contributions from banks and real estate developers, therefore this reaction should not be a surprise.

WSJ: Georgian Bank was the second-biggest bank headquartered in Atlanta. It had $2 billion in assets, five branches, and roughly 185 employees. It also had major problems tied to real estate. Its chief executive was pushed out in July. In the second quarter, problem loans accounted for 7.6% of its total portfolio.

In fact by the time Georgian failed, it's non-performing loans represented 17% of it's total loan assets. But what got them to that point to begin with was that 77% of it's total assets were for property.

This exposes the broader political issue with bank regulation. When the FDIC wants to be proactive in closing these institutions to limit taxpayer losses, the politicians jump in:

“...the people of Georgia would appreciate very much if the FDIC could review how they’re dealing with the banks in Georgia to work with a plan to see if we can’t stop this very terrible pattern. Because it’s — it’s — it’s just not fair nor right.” David Scott (D., Ga.)

"not fair"? It's easy to bash Citi for it's mess, but when banks in the politicians' back yard need to be dealt with because they put on speculative exposures using taxpayer insured deposits, the FDIC should be using white gloves?

These banks should be shut down quickly, because letting them linger not only puts the taxpayer at additional risk, but makes any economic recovery that much slower. The only way to deal with the bad real estate loan problem is to by auctioning off (repricing) the assets. Otherwise the "head in the sand" syndrome will continue.

“We felt along with most people that the real estate situation in Atlanta would have begun to correct itself by the summer of 2009,” Poelker, who replaced [Georgian Bank] founder Gordon Teel at the closely held bank last month, said in an interview today. “Nobody expected this downturn in real estate to be as widespread and deep as it turned out.” (Bloomberg)

Really Mr. Poelker? You expected real estate in Atlanta to recover by this summer? What planet are you from? And you were actually put in charge of a bank with $2 billion dollars in assets? And according to Georgia's politicians the FDIC should leave your bank alone? Incredible.



Yes you do.

How to run your economy into the ground: a lesson from Venezuela

What happens when you mix irresponsible borrowing and spending policies with a socialist government that is hostile to private enterprise? Then you impose exchange controls to keep the currency from collapsing. Throw on top of that a nasty dictator who disregards the constitution and you get a real mess. The answer is, you get Venezuela (although you may have been thinking of something else).

With nearly half of the country's revenues coming from oil sales (and oil being significantly down from last year), Venezuela's government is desperate for cash:

Bloomberg: Venezuelan President Hugo Chavez will likely sell dollar bonds for the first time in more than a year after unveiling a $5.7 billion local debt offering yesterday, said Goldman Sachs Group Inc. and RBS Securities Inc. The dollar bond sale may total about $4 billion, according to RBS analyst Siobhan Morden. The government announced yesterday in the Official Gazette plans to sell as much as 12.15 billion bolivars ($5.7 billion) of bonds by year-end, an offering that could swell the supply of debt in the local- currency market by more than 25 percent.

Venezuelan currency, the bolivar actually has two markets: the official exchange rate, where one needs government permission to buy a foreign currency, and the black market (offshore) where the currency trades at a 62% discount. Of course if you are a friend of some government officials in Venezuela, you too can purchase dollars at the official government rate and make a 62% profit in the black market. The chart below shows the price of a dollar in bolivars in the "official" market. The best way to create a black market of course is to impose price controls (a note for those who want to impose price controls on commodities for example).


Source: Bloomberg


All the money printing and currency controls actually do have some consequences. And they are not pretty. The chart below shows Venezuela's inflation rate compared with Colombia, Peru, and even Argentina.



Source: Bloomberg


Imagine inflation rate of close to 30% as cash dwindles by nearly a third every year. May make buying dollars at a 62% discount potentially attractive. Of course to compensate for that, Venezuelan banks must pay a pretty hefty interest rate. But only when they need the cash. At other times they pay very little, making for "jumpy" interest rates.


Source: Bloomberg


So how do you solve such dire domestic problems? It's simple, you blame your neighbors and go on a weapons purchasing spree.

Reuters: In recent years, Venezuela has bought over $4 billion in weapons from Russia including 24 Sukhoi fighter jets. Critics say Chavez is gearing up for an arms race in Latin America, but he says he is modernizing the military for defensive purposes.

CDS curves are moving to pre-crisis "normal"

As the corporate bond market opened for business this year, it slowly became clear that many corporations, even ones with poor business models, may be able to refinance their debt. The market just has that much appetite for paper. The number of expected defaults in the near-term has dropped off significantly (thanks in large part to all the liquidity chasing yield).

That means that the high front-loaded default probabilities of corporate debt in the CDS markets are shifting further out in time and falling overall. The CDS curves that have been highly inverted for some vulnerable names are starting to flatten or even become normalized (spreads increasing with term).

As an example consider what happened to Ford CDS in just a month:

Nobody thinks Ford is out of the woods on a long-term basis, but it took mostly just a reduction in the front-end default risk to change the shape that much. To get a feel of how a drop in near-term default probability drives the shape of the CDS curve, here is a simple illustration. The chart below shows a hypothetical default probability curve (probabilities for each year).

With only the front-end probability of default dropping, the resulting change in the shape of the CDS curve is as follows:

This effect is now seen across the corporate credit markets, with CDS curves changing shape this way. A spectacular example of that is seen in the financials. Consider the Goldman 1-year CDS spread. It is now at pre-crisis levels. According to the market, the government has succeeded in taking out the risk of a major financial institution failure.



And here is what the Goldman CDS curve looks like now, a month ago, and a quarter ago.



These moves in CDS curves are unprecedented. The markets are saying that in the corporate sector we are close to being back to the pre-crisis "normal". The question of course remains as to whether this is justified by the fundamentals or sustainable.

A signal from the Fed?

At first glance, there wasn't anything unexpected in the FOMC statement today. But reading more into the wording, the following difference in the language between this statement and the one from last month may have significance:

From the FOMC statement August 12:

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.

From the FOMC statement September 23:

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.

Many Fed watchers have interpreted this as a signal that the Fed is planning to do something different. Some beleive it is related to the beginning of an end to the liquidity buildup. Yes, the rate will stay at zero, but it is likely that the remaining securities purchases will be "sterelized", meaning some won't be outright buys, but instead may be repo transactions . The Fed may not want significant additional quantitative easing.

Hedge funds remain defensive

Hedge funds remain defensive on the market. Leverage and directionality are significantly below recent highs. Here is a quote from a recent JPMorgan report on alternative investments:

"… our in-house estimates of leverage also point towards low leverage and directionality. Leverage and directionality have increased in the past few months. We currently estimate that Equity funds have a gross leverage around 1.75x. Our estimate earlier this year was 1.6x, while leverage was about 2.0x in its peak in 2008."

A quick analysis of the CS/Tremont index beta confirms the JPMorgan statement. The chart below shows the index beta to the S&P500 by year, a good indicator of hedge funds' market directional exposure. Hedge fund beta this year is the lowest since 2003.

“This was the first time in 20 years that we have played defense,” Griffin, president and chief executive officer, said in an interview at Citadel’s Chicago headquarters, after recently returning from Europe, his first vacation since the bankruptcy of Lehman Brothers Holdings Inc. a year ago. (Bloomberg )

Harvard's 5-year return below treasuries

As predicted back in July, Harvard's Management's performance, which they have recently released, shows the endowment significantly down.


source: HMC

For the 08-09 academic year (which is how endowments tend to measure performance) they are down 27.3%, bringing their 5-year annualized return to 6.2%. iShares 7-10-year US treasury ETF's (IEF) annualized return was 6.4% over the same period. Except one doesn't need a highly overpaid staff to manage a portfolio of medium-term maturity bonds.

Here is the latest asset allocation of Harvard's portfolio. It surely will do well given the current market euphoria, until the next time.


source: HMC

The US quantitative easing has just begun

With the FOMC meeting currently under way, it's worth reflecting on the Fed's implementation of the monetary policy this year. Surprisingly, according to the latest Credit Suisse research, there hasn't been much quantitative easing in 2009. But how could that be possible, given the way the Fed has been growing its balance sheet? The chart below shows securities held outright by the Fed. How can this NOT be a form of quantitative easing?



Credit Suisse argues is that the monetary base has not really grown much in 2009, as the following chart shows.


Source: Bloomberg

So where is all the cash going from the Fed's purchases? It has to end up in the banking system and show up in the monetary base. The argument Credit Suisse makes is that all the short-term lending the Fed had put in place last year as an emergency measure has been shrinking in size, effectively offsetting the securities purchases.



Banks are de-leveraging, trying to reduce their borrowing from the Fed. Effectively securities purchases put Fed’s money with the banks, while the banks in turn pay back the Fed on their loans, thus neutralizing the impact. As we discussed before, this has slowed down the pace of the Fed's balance sheet growth significantly.



In addition some of the cash for the Fed's recent lending had come from the SFP program in which the US Treasury has issued treasury bills with the proceeds to be used by the Fed for its emergency lending. That type of program does not add any new cash to the system, because while the Fed injects cash (by lending to banks, etc.), the Treasury takes the liquidity out by selling bills. That in fact was the original purpose for SFP.

But SFP is expected to be wound down shortly. The impact of the reduction in short-term funding facilities will end as the programs come to a close. Therefore there will be nothing more to offset securities purchases going forward. That means that if the Fed continues purchasing paper at it's recent pace, quantitative easing finally will kick in with force.



This will end up ballooning bank reserves and truly “flooding” the system with dollars. The chart below from Credit Suisse shows their projection for reserves (translating into a rapidly rising monetary base):



The Fed is keenly aware of this problem going forward, particularly with the dollar weakness. Once SFP as well as the short-term facilities wind down, every dollar of purchased securities will be a new dollar “printed”. That is why the Fed is now supposedly putting together a new securities reverse repo program with the dealers. The idea is that going forward the Fed will be buying new securities by borrowing money from the dealers rather than “printing” new dollars. The Fed will place its securities with the dealers as collateral when it borrows. In fact the central bank may choose to borrow against the existing securities as well. New security purchases will be putting liquidity into the system, but by borrowing from the dealers, the Fed will be temporarily taking liquidity out.

Eventually the Fed will have to outright sell the trillion plus of securities it holds, taking liquidity out permanently (the reversal of quantitative easing) – a dangerous thing to do in this economy. And the more purchases it makes going forward, the harder on the economy it will be to reverse it. For now however, the reverse repo effort will have to do, by (at least in part) compensating for the wind down of SFP and the short-term emergency lending programs.

Retranching a credit index after defaults

We received several requests to explain how some major synthetic tranches of credit indices such as CDX and LCDX get adjusted when defaults take place. The best way to go over this is to look at an example. Consider the loan index LCDX-12 (if you want to brush up on credit indices, please see the primer in this post). Here are the original tranches of LCDX-12:

0-8% (equity)
8-15% (junior mezz)
15-30% (senior mezz)
30-100% (senior)

That means that on $100 worth of the index, the tranche notionals are:

$8
$7
$15
$30

Each tranche can be traded on its own, allowing someone to go long or short a specific part of the capital structure of this loan index of 100 credits. But since the index was launched, 7 names have defaulted. One key parameter needed here is the average recovery rate, which in this case was 80%. Note that such high recovery is a fluke for leveraged loans this year, but it just happened to be the recovery for these specific names.

Note that as names drop out of the index due to defaults, the equity takes the full loss, while the most senior tranche is reduced in notional. This is equivalent to a static cash CLO deal, where recoveries from defaulted collateral go to pay down the most senior tranche.

With 7 defaults (each name representing 1% of the index) and an 80% recovery rate on $100 index notional, we would expect $7 of defaults, $1.4 in losses, and $5.6 of recoveries. The easiest way to think about this is that losses reduce the most junior tranche, while recoveries reduce the most senior tranche notional. The tranches in the middle stay intact. So here are the new amounts:

$6.6 (8 - 1.4)
$7
$15
$64.4 (70 - 5.6)

But the total notional is no longer $100; it is now $93 (7 names defaulted). Thus the tranche percentages of the lower notional become as follows:

0 - 7.1%
7.1 - 14.6%
14.6% - 30.7%
30.7% - 100%

This index capital structure has changed due to defaults as well as names taken out of the index, and can be significantly different from the original structure.

Insider trading in M&A is alive and well

In an earlier post we discussed the fact that M&A about to pick up steam. That is in fact happening and will be accelerating as companies look for growth avenues in this economy and are feeling more confident about their own share price. Here is an example:

"CNN: Computer maker Dell will acquire information-technology company Perot Systems for $3.9 billion in cash, the companies said Monday. Once the purchase is complete, Perot (PER) will become Dell's services unit, a press release said. Dell plans to buy Perot for $30 per share, 67% higher than the IT firm's Friday closing price of $17.91."

But with M&A comes the dirty little feature of the US equity markets: insider trading. As the SEC spends their resources on implementing misguided registration and oversight of thousands of small hedge funds and venture capital firms, insider trading in public securities is alive and well. The proof is right there in plain sight. The chart below shows the PER Jan $20 call option price action and volume. As expected, the price spiked this morning with the acquisition announcement, but the volume spiked a few days earlier. And this is not some small random volume jump, it's a serious spike for a stock with a fairly sleepy options market.


Source: Bloomberg

Obviously not only was the information about this acquisition leaked out a couple of weeks earlier, but someone acted on it and made a bunch of money. In the boom days of M&A this sort of activity went on all the time and obviously things haven't changed much. It's a sad statement about the US equity markets and their regulator who is unable to halt this illegal practice.

The GGP case changed the rules of engagement for securitization

A recent ruling in the case of the defaulted General Growth Properties (GGP) has sent shock waves through the securitization markets. The ruling placed into question the strength of what's called "bankruptcy remote" entities. These entities are set up to ring fence the assets that represent the collateral pool for structured debt. One key reason for this requirement is to protect the debt holders' collateral from being dragged into bankruptcy if the equity holder defaults.

For example, consider a hedge fund that wants to leverage some assets. It would create a Special Purpose Entity (SPE) to purchase assets (loans, bonds, etc.) The hedge fund then contributes equity to the SPE. The leverage would come from senior lenders who are comfortable with the pool of assets in the SPE as collateral, but want nothing to do with the hedge fund. Their concern obviously is that if the hedge fund blows up, the fund's creditors will go after the assets in the SPE, even if the SPE itself has not defaulted and has plenty of asset coverage.

Using Delaware law allowed structured finance gurus to ring fence the SPE. A bank structuring the deal would work with the equity holders (in this case the hedge fund) to appoint independent directors and a trustee. If the hedge fund defaults, the structured senior debt holders and the trustee would make sure nobody can touch the collateral (including cash) in the SPE.

The GGP case seems to have changed the rules of engagement with respect to Delaware SPEs. In this particular case, the SPEs in question were GGP's property holdings that used CMBS financing. First let's take a quick look at a typical CMBS structure with respect to the equity holders and the SPEs:




Usually each property is held in an SPE which gets a mortgage on the property from the CMBS pool. These SPEs have independent directors and have been viewed as "bankruptcy remote". The mortgage provider is the CMBS SPE (a separete entity), which holds a pool of such mortgages on multiple properties (usually geographically diversified). To finance these mortgages, it issues structured notes that are tranched based on seniority. Cash flows (mortgage payments) generally follow a "waterfall" prescribed by the CMBS indenture, with senior notes getting priority to these cash flows.

In many cases a credit worthy equity owner will provide some form of a limited non-recourse guarantee to the mortgage lender. That creates additional credit support to the CMBS structure, reducing the financing cost to the property owner. This credit support however was a negative when the judge was considering the issue of "bankruptcy remoteness". The ruling allowed the bankrupt GGP to go after the properties and cash held in these SPEs, exposing the weakness in the Delaware SPE structure. The paper below discusses the weaknesses of the Delaware SPEs, particularly as it relates to CMBS.

The key issue was that the independent directors of the SPEs as well as the management (which now were the direct creditors of GGP) were allowed to consider not just the interests of the creditors, but of the equity holders when deciding about the fate of the SPEs. GGP creditors wanted to drag the SPEs into bankruptcy and they got the directors to vote their way. Interestingly enough GGP fired existing SPE directors and appointed new ones (that would be more cooperative) shortly before they filed for Chapter 11. The explanation was that the new directors knew more about commercial real estate.

But how can you force an entity into bankruptcy if it is current on its debt and doesn’t have to refinance for up to three years, as was the case with these SPEs? GGP argued that these entities will be bankrupt anyway when they have to refinance their balloon mortgages. This argument is in fact valid because of the wall of commercial real estate debt maturing in a few years (see looming balloon risk).

In addition, the argument was that the current state of GGP (as the SPEs’ affiliate), should be considered. In order to preserve value, the SPEs need to file now, rather than wait until their debt matures. The judge accepted this argument and allowed to have the SPEs file for Chapter 11.

That of course was a shocker to the CMBS debt holders, because their collateral was now compromised. Some legal scholars have argued that GGP is an isolated case and new cases (which are definitely coming) will prove that Delaware law works for bankruptcy remote SPEs. But given the sad state of the securitization markets, nobody wants to take a chance, and structurers are quickly moving away from Delaware. The jurisdiction of choice is now the Cayman Islands, where directors (when they get back from the beach) will side with the debt holders. And hedge funds that want to obtain non-recourse leverage (to the extent it's available) even for their onshore funds, will be setting up Cayman SPEs.

Fuel substitution: power plants switching to natural gas

A number of Sober Look readers have questioned the thesis of the earlier post that suggests that natural gas oversupply creates an overhang in distillates, thus pressuring crack spreads and ultimately capping oil prices. In particular some question the ability to switch between the two fuels.

Fuel switching is actually quite common at power plants, the biggest users of natural gas. Many modern power plants can switch between gas and fuel oil, and many can switch to coal as well.

EIA: A generating unit capable of burning more than one fossil fuel is referred to as a dual-fired unit. Some dual-fired units can only burn one fuel at a time (that is, the fuels are fired sequentially), while others can burn more than one fuel simultaneously (concurrent firing of different fuels). A sequentially fired unit generally uses one fossil fuel as its primary energy source, but can switch to a second fossil fuel as an alternate energy source.

In fact cheap natural gas has created an oversupply of coal as well.


source: EIA

Similarly distillates (fuel oil) inventories are building up, pressuring crack spreads:


source: EIA

Power plants and others are storing the more expensive fuel to be used in the event natural gas prices spike (because natural gas is difficult to store and not much storage is available). But for as long as gas prices remain depressed, buying gas in the spot market makes a great deal of sense for power producers, reducing the demand for other fuels.

During some periods in the past, natural gas was more expensive to burn, with coal and distillates being the preferred fuel. Natural gas at some plants was used to provide power during peak demand because gas generation could be brought online very quickly. But with the push toward a more environmentally friendly power generation, the switching capacity has increased significantly. The paper below provides an overview of both the switching capability and its use in practice. Since the paper was published, fuel switching technology has improved even more, allowing plants to respond to market prices and switch relatively quickly.

As LIBOR declines, banks hoard more cash at the Fed

US Banks continue to hoard over $850 billion in cash at the Federal Reserve. They are required to hold some reserves there, but since the Fed started paying interest on deposits last year, that amount spiked and stayed at these elevated levels.




In fact that deposit amount has been rising recently. The reason has to do with the collapse in interbank deposit rates (LIBOR). The chart below shows just how flat the LIBOR curve has become:




Out to 3 months the rate is almost the same as the overnight rate. It's an indication of the spectacular rise in confidence banks have in each other and their own ability to fund themselves short-term. If you are a bank treasurer however, and you have a choice of depositing your excess cash with other banks or with the Fed at almost the same rate, your preference would be to park the money with the Fed. And that is exactly what is taking place with the decline in LIBOR rates.

Part of the problem with Western banks these days is that much of the liquidity is trapped within the banking system. One way some central banks have been dealing with this is to lower the deposit rate on reserves to zero, and even below zero. This forces banks to look for a better place to put the money and possibly do some lending. But it continues to be a challenge to encourage banks to lend outside the banking system; they either lend to each other or to the central bank (via reserve deposits).

So far in the US there is no evidence that much of this cash is making it's way to the consumer. Consumer loans outstanding at commercial banks have actually been declining.


source: the Fed


That is why the expectation is for the Fed to stay put for a while with respect to rates. Until some of the liquidity the banks are hoarding in reserve deposits is unlocked, consumer credit will continue to stay constrained.

The market's expectation of a rate hike keeps getting delayed

The Fed is now officially expressing optimism about the economic turnround that is supposedly taking place.

WSJ: Federal Reserve Chairman Ben Bernanke said Tuesday that the recession was "very likely over," as consumers showed some of the first tangible signs of spending again.

Mr. Bernanke, who had become cautiously more upbeat in recent weeks amid signs of third-quarter growth, said for the first time that forecasters agree "at this point that we are in a recovery."

If the Fed is really confident we've turned the corner, they should be getting ready to raise rates. Fed Funds were at 18 basis points today - that is banks are lending to each other at 0.18% annualized. It's basically interest free money. So if what Mr. Bernanke said this week is true, the Fed is preparing to be (or at least thinking about) raising rates.

But the market doesn't believe the Fed is going to raise rates any time soon. The Fed Funds futures, the market's bet on where overnight rates will be in the future, are forecasting a rate increase that's increasingly further away. The following chart shows the futures curve changes from June-09.




In June the market was expecting that by Feb-2010, the overnight rate will be near 75 bp - indicating a couple of increases by early next year. But now the first increase is not priced in until May - June, and it will be July - August before we reach 75 bp. The market is expecting the Fed to keep a near zero rate policy for another 8-9 months. That is obviously contributing to market strength, particularly in fixed income, but keeping rates at zero in a growing economy is a dangerous game. There are two possible outcomes here. Either the Fed doesn't really believe the recovery they announced is real and will keep rates near zero for a long time, or the markets are in for a big rate hike surprise.

Rating agencies under fire

The rating agencies are now taking hits from every direction. The Big Three are becoming increasingly focused on trying to defend themselves against law suits, investigations, and pending regulation. The most critical blow recently came from the highly publicized case involving Cheyne Finance. This was an SIV that issued medium term notes which were rated "investment grade" by the agencies. The notes defaulted recently and the holders took the agencies (as well as Morgan Stanley) to court.

Dow Jones: Two credit-rating agencies must defend a lawsuit over the collapse of a $5.86 billion structured investment vehicle in 2007, a federal judge has ruled, rejecting an argument that their ratings are protected free speech.

In an order Wednesday, U.S. District Judge Shira Scheindlin in Manhattan rejected an argument by rating firms Moody's Investors Service and Standard & Poor's that their ratings of SIV Portfolio PLC were protected by the First Amendment.

The rating agencies' traditional defense had always been the "freedom of speech" concept. The argument is that the ratings they issue are simply their opinion and therefore should be protected under the US constitution. This case however shook things up because the judge ruled otherwise (at least in a couple of specific instances). With evidence like this IM exchange between two S&P employees, it's a bit difficult to argue freedom of speech.

source: CNBC

The agencies are confident they will be able to overturn this ruling, but nevertheless this may set a precedent and open a floodgate of litigation.

But the Big Three's problems are not limited to investor lawsuits. As people begin to fully appreciate their role in the financial crisis, more players are coming out of the woodwork to start investigations, file complaints, or propose regulation. Now the California Attorney General is jumping on the bandwagon.

Reuters: California Attorney General Jerry Brown issued subpoenas on Thursday to Standard & Poor's, Moody's Investors Service, and Fitch Ratings as he launched an investigation of whether they broke state law with the ratings they provided mortgage-backed securities.
…
The investigation focuses on whether the agencies broke consumer protection and unfair business practice laws, in the most populous U.S. state, which give the state broad authority to bring suit in cases of false advertising and unfair competition.

The insurance industry is also getting ready to pound on the rating agencies.

NAIC: The National Association of Insurance Commissioners (NAIC) will hold a public hearing on September 24 to discuss the past and future roles of Nationally Recognized Statistical Ratings Organizations (NRSRO). The hearing will examine the role of these credit rating agencies in the insurance regulatory system and what changes may be needed in light of the financial crisis.

Insurance companies hold nearly $3 trillion in rated bonds and the insurance industry constitutes the largest sector of the financial services industry to rely on credit ratings to supervise capital asset adequacy. Insurance regulators currently mandate the use of credit ratings to determine capital reserves and other regulatory requirements for insurance companies.

And here comes the SEC with what seems to be a fairly constructive disclosure rule that may cause the agencies and banks some pain:

Reuters: The SEC may require banks and other issuers to disclose preliminary ratings, to prevent them from shopping around for the better ratings, the people familiar said. They requested anonymity because the discussions are private.

The SEC may also require all credit agencies to reveal more information about past ratings so investors could compare their relative performance, with perhaps a one- or two-year time lag, the people said.

The structural problem with the rating agencies and their role in the crisis is finally getting the much needed attention. Here is a simple fact: if the rating agencies' subordination requirement for AAA subprime paper was higher when the deals were rated, the subprime market would never have grown the way it did. A typical subprime deal had 21% of collateral below AAA, while Alt-A subordination was about 7%. If the rating agencies were just a bit more conservative, requiring a higher cushion, the mortgage rates for these loans would have been much higher to make the securitization work. And that simply means most such mortgages would not have been possible.

The question is where do we go from here. Securities ratings process is so entrenched in the financial services industry, it's hard to imagine the system functioning without some form of ratings. It's part of the lexicon: when we discuss "investment grade" market or the "high yield" market, there is an implied rating assumption - whether people use it or not. The lesson of 2008 was of course to rely less on the agencies, but the system depends on them being there. And the government is doing a great deal to increase (rather than reduce) reliance on the ratings process: from new money market regulation to TALF - all depend on some form of agency ratings.

That means that the rating agencies are here to stay, and when the dust settles, the surviving agencies (and it's not clear if all of the Big Three will survive) will have a great deal of work to do. It's critical that we fix the ratings system: from agencies' internal structure to the ratings process to models and transparency to fees/conflicts - all must be revamped in order for the system to function properly. Because not getting this right will set us up for another fiasco down the road.

A look at the US consumer leverage

There has been a great deal of talk lately about consumer deleveraging, particularly with the focus on consumer credit. The Fed tracks consumer credit separately and releases the number fairly frequently. Based on the chart below, some deleveraging has in fact taken place.


source: Bloomberg


However, the Fed number for consumer credit excludes any real estate loans. This next chart shows consumer credit and mortgages as percentage of household disposable income (also from the Fed).



In 2003 consumer mortgages (including home equity) were 82% of household income. That number shot up to over 100% in 2007, dropping to over 95% by the end of the last quarter. There is still tremendous amount of debt reduction to go before we get to 2003 levels. Unless household disposable income suddenly improves, the deleveraging of the consumer will take some time.