March 04, 2007

Given the sheer size and significance of the unregulated credit derivative markets, this is the kind of stuff that capital market crashes are made of

From Doug Kass at comes this article on what's going on in the credit markets. Yes, 99% of people in America don't know, don't care and don't want to be bothered with all this financial mumbo jumbo CDO credit risk subprime blather...

But oh, how they will be bothered. How they wish they had paid attention.

The credit spigot is being turned off. No more cash-out refis. No more cash-back-at-close flips. No more Hummer H2s. No more trips to Greece. No more no-money-down-do-doc-interest-only loans. No more bidding wars on condos. And no more price appreciation on homes.

Damn this has all been prewritten, so there should be no surprises for HP'ers. It's like we have the playbook. And actually, we do.

The Next Shoe to Drop?

With the contagion that started in subprime mortgage lending now spreading to other mortgage tranches, as reported here, the next shoe to drop might well be in the broader securitization market.

Not only will older, less-protected packaged securitizations and other derivatives decline in price in a readjustment, but the entire credit securitization chain will become less profitable to industrial companies, mortgage lenders, banks and brokerages.

Consider what has occurred and is now occurring in subprime. The prices of mortgages are rising as the originations become less profitable for the financial intermediaries that serve the market. In turn, housing affordability worsens, delinquencies and foreclosures rise, housing inventories build further, and home prices drop in the second leg down for residential real estate.

This is the vicious cycle and contagion in credit markets.

Now I am hearing stories of plunging demand for CDO tranches and sponsors taking large fee-haircuts before deals can be sold. It is in the mixed asset class of CDOs where the contagion of subprime might soon spread as buyers recoil from sharper-than-anticipated losses in the mortgage market.

Credit spreads are flying open and the vicious cycle of credit has begun as the evaluation of risk is reassessed.

Given the sheer size and significance of the unregulated credit derivative markets, this is the kind of stuff that capital market crashes are made of.


E said...

This is exactly why I left Canada for India last Sept - and cashed out into precious metals. I was gonna go back home for the summer, during the upcoming monsoon here, but now I'm not so sure - I see a worse monsoon approaching! While a collapse isn't likely tomorrow, at this juncture the probability increases on a weekly basis.

Butch said...

This is the "elephant in the living room" that the regulators are trying to ignore.

The problem is much, much worse than we are being told.

Here's why:

At this point, there are roughly $26 trillion in CDS in place. Now, unlike interest-rate swaps--which the regulators will coo that the $300 trillion of these bets are "only" notion amounts, not the actual amount--CDS bets are ZERO SUM. This means that when a "credit event" happens (such as default, downgrade, or other covenenat not being met), the CDS writer must pay up their counterparty.

Now, let's explore this relationship a little further. The CDS "writer" is typically a hedge fund that is acting as an insurance company. They collect "premiums" in the form of payments to "insure" a certain amount of debt. The premiums can run from $100k up to $1 million or more per year to insure $10 million in debt, typically.

As long as nothing goes wrong and no defaults happen, the hedge funds make huge "profits", all the while skimming off their 2/20% fees per year.

However, when, not if, a default happens, then the hedge funs must pay the counterparty (who made all those "premium" payments) the entire amount (the $10 million).

Now, the punch line here is that the hedgies are not squirreling away enough reserves to make these payments, which will leave a bunch of counterparties (typically MBS holders) with nothing.

By the way, it's been this CDS "insurance" that has allowed the whole housing bubble to reach biblical proportions because the buyers of the MBs believed that they were covered in the event that the sub-prime, Alt-A, deadbeat homedebtors can't make their McMansion mortgage payments.

Now that it appears that this is exactly what is happening, you are seeing the cost of "insurance" skyrocket.

This will, indeed, lead to a complete shut down of the CDS market, which will also lead to a shut down in the MBS market, which will also lead to a complete, utter collapse of the sub-prime market first, then ALL mortgage lending second--if the loan isn't 20% down, fully documented, and at probably an interest rate of 15%.

Can you say "dominoes falling"?

Anonymous said...

I work in the CDO area of a large bank. While I don't think the coming subprime meltdown is going to spread massively to other parts of the financial world, it will not be limited to a just a few participants. A few thoughts:

1. The rough path of subprime mortgage risk in the past 8 years has gone from home buyer -> mortgage originator -> investment bank securitization group -> ABS bond -> CDO -> CDO investor.
2. Thus, the bulk of the pain as foreclosures happen will be investors who are long structured finance CDOs, followed by investors who are long the ABS bonds directly.
3. There's never been a study showing exactly where most CDO end investors are. A large number of them are in Europe and Asia, sleeply little banks looking for extra yield with AAA, AA, A ratings.
4. however, a large portion of all CDOs are bought by other CDO managers as collateral for their CDo. That's why subprime falling could blow apart 'all' CDOs--the contagion factor will be high.
5. incidentally, the real untold story here is why Moody's / S&P decided that, when rating CDOs, the correlation between subprime ABS bonds is as low as 30%. Without that assumption, there's no way CDOs backed by BBB/BBB- subprime ABS could get AAA ratings themselves. Funny how that worked out so well for both the CDO managers, and Moody's/S&P (who are payed by the CDO Mnagers to rate their CDOs)...
6. What investment banks will feel the pain most? First, banks that have large mortgage origination businesses (bear, cs...) will feel a little pain (they are huge banks, so subprime origination just won't be that big an effect). Second, banks that have large abs securitization businesses will lose fees from that. Third, banks that have large CDO banking busiesses will lose that fee stream.
7. But perhaps more painful is going to be the banks that have large cdo warehouses, ie that have been buying a ton of subprime ABS to put into new CDOs. if those CDOs fail to get issued, those warehouses suddenly hold Billions of subprime RMBS that were purchased at a price of $98 and are now worth $78, $68,...who knows.
8. Some banks could lose nine figure amounts on warehouse blowups.
9. Lastly, any banks that were taking on prop positions (ie betting) on subprimes moving one way or another.

So, industry-wide on Wall Street there might be some pain (a loss of 1%~3% of revenues), but there's potential for one or two banks to get hit in the 4%~5% range, by my guess.

As CDOs fall, subprime ABS falls, so subprime lending falls, so stressed subprime borrowers default, so housing prices go down furthre, so subprime borrowers default, so subprime lending falls, so subprime ABS falls, so CDOs fall,.......

Anonymous said...

Nothing like throwing the baby out with the bath water.

Anonymous said...

I just saw Maria Bartiromo on the Today Show. Let me pull some choice quotes (thank you Tivo)

Lester Holt: Is this the early signs of a recession or is this what Wall Streeters call a correction?

Maria Bartiromo: Well I don't think it's the early signs of a recession...Alan Greenspans's comments were taken out of cotext and by the end of last week he actually backed away from those comments. Yes we are seeing a slowdown in the seems the utterance of Recession, people were calling in the "R" word, just unnerved people.

LH: What's a correction?

MB: Well a correction is 10% to the downside, could be over a month, could be a couple of weeks, we've only gone down 532 points.

LH: what should we be looking for tomorrow to know whether this is a correction or not?

MB: Well I don't think this is a correction, it doesn't feel that way, certainly we will see choppy markets. But at the end of the day you have to remember fundamentals. Hank Paulson the treasury secretary came out on Friday, tried to calm investors down and what he said was number one, we have a vibrant economy, even though we are seeing a slowdon. We've got an unemployment rate of 4.6% that's virtually full employment. Employment is looking good, you've got the corporate sector, very vibrant, earnings right now you're talking about profit growth year over year of about 12%. It's very strong.

LH: So that person right now getting ready to dial the phone to their broker, your advice would be take a deep breath?

MB: Take a deep breath, I don't think you're gonna want to have a knee jerk reaction here...because we're looking at a strong fundamental backdrop to the stock market and I think you just want to wait this out. We're still seeing interest rates relatively low, in terms of housing even if we are seeing a slowdown, it doesn't look like a collapse by anyone's standards in the housing market.

LH: There's a silver lining, Thanks Maria.

Next time put on a cheerleader outfit Maria.

Shakster said...

Let's not get ahead of reality here.The Spigot is still on.The advertising on radio,and TV for crap loans is at a higher level than in 2005 IMO.Remember that the numbers don't cause the crash,huge imbalances don't cause recessions even if they are at record levels on record percentage basis.Psychology of the largest market players is what causes severe downturns.The largest players IMO are,Banks,Governments,Hedge Funds(and equities),then the largest,The Consumer(general population).If any one of these falters we have a downturn,but if it happens to be the Consumer that gets tired,weary,and changes sentiment to one of savings,protecting his money,or generally sick,then we have a crash.Average Joe is the Biggest plyer,and the Banks are throwing everything they have at him to keep him awake,upbeat,and spending.

Anonymous said...

People are much easier to be herded during bad times, than good. (e.g. 1930's Germany)

The best way to steer the herd is to create a problem and then provide YOUR solution.

If you think for a minute that the financial elite did not see this coming just think back to fall of 2005 when bankruptcy laws were anticipation of...

Machivelli would be proud....the only question is where this is all leading...and why???

Anonymous said...

Real money move into credit has fuelled turmoil, comments Financial Times

Writing in today’s Financial Times, Gillian Tett comments on an investor survey by Citigroup’s European credit research team, which found that hedge funds have recently reduced their positions in riskier areas of the credit market such as high yield, while real money investors have raised their exposure.

She argues that this ‘style slippage’ among real money investors may explain the collapse in spreads over the course of last year. But, she comments, a swathe of inexperienced investors have been holding assets and were likely to sell them if turmoil hits. She concludes that this may explain this week’s roller-coaster ride in credit spreads.

Anonymous said...

Credit derivative volumes soar

Today’s Financial Times reports that trading volumes in credit derivatives hit almost unprecedented levels this week as the market turmoil that continued to infect stocks yesterday led to wild gyrations in corporate credit default swap spreads.

The article says between €125 billion and €150 billion of trades on European indices alone have been executed in the past three days, citing estimates from banks.

Analysts and traders said losses from the blow-out in spreads - or risk premiums - particularly on junk-rated derivatives indices of the past few days would have been widely shared between investment bank traders and asset managers involved in the market.

This is in part because almost everyone in the market has been making the same "long" bets - adding exposure to credit risk with the idea that the outlook was not going to worsen any time soon. "Both [Wall] Street and clients have been caught long," said one trader. "With the moves on Tuesday, some peoples' year would have been wiped out."

The most violent movements in recent days have focused on the iTraxx Crossover Index, which measures the danger of default on risky corporate bonds. Last week this traded at about 169 basis points, implying that it costs €169,000 to insure against default on €10m of debt. In the past few days the price rose over 235bp and yesterday moved 204bp and 230bp.

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Anonymous said...

Remember "it's all about the derivatives markets"? Wait til those screwed grease palms for a Fed bailout. Then the dollar is toast in a massive devaluation. You'll be tellin' your grandkids about this. And your Honda full of silver ain't too bright because Ivy League grads are gonna carjack it.

Anonymous said...

"The advertising on radio,and TV for crap loans is at a higher level than in 2005 IMO"

Yes, but have you read the fine print terms & are sure that those haven't changed to provide an even bigger potential return for the party on the otherside of the loan? Why else would someone back that transaction if it wasn't in their favor?

Anonymous said...

BTW: gold is public enemy #1. Banks and governments are firmly into fiat currencies and can't afford to let folks lose confidence & run to gold. If you think Paris Hilton, Britney Spears, and Anna Nicole are overexposed, just wait until the showdown comes between fiat currency backers and gold.

Anonymous said...

MBS = Mortgage Bull Shit

cool hand luke said...

The thing that is sticking in my craw here lately is the fact that the notional amount of financial derivatives actually exceeds the entire total global output of goods and services by (and I gulp even to type it) ten times over! And yet (you had better sit down for this, as I did not, and now I have a big, nasty bump on my head when I collapsed to the floor in shock, and I also have a lot of new bruises where everybody kept kicking me to see if I was dead because they wouldn't believe me when I kept telling them I was not), I keep reading how this is all okay with everybody because nobody understands derivatives! Hahahaha! This is the level of genius at work here! We're freaking doomed, I tells ya!

Richard Daughty
...the angriest guy in economics
The Mogambo Guru

Anonymous said...

The FED may bail out the big boys, but they are going to let plenty of small fry hang out to dry. The BEST case scenario for them is to keep the whole ball of wax from unravelling, but there is no way in hell they will be able to keep a lot of pain from flowing down hill.

That pain is going to translate into the dollar diving and credit (in all it's forms) drying up. Credit disappearing means that the stock market tanks and jobs disappear. The dollar diving means that anything not produced totally here in the USA (which means basically everything except for housing) is going to inflate in price.

The first round of hell is going to be an inflationary crash just like the 1970's - don't forget that as the dollar tanks, oil skyrockets too.

The second round of hell is way worse.

Anonymous said...

Buffett attacks hedge fund feesWarren Buffett, the world’s second-richest person, on Thursday stepped up his criticism of hedge funds, calling their fee arrangements “grotesque” and cautioning shareholders against unrealistic return expectations.

In the legendary investor’s much-anticipated annual letter to Berkshire Hathaway shareholders, he slammed “Wall Street’s pied pipers of performance” and said it was “folly” for investors to pay ever-greater commissions and fees in an attempt to increase returns.

In a nod to his advancing age Mr Buffett, 76, and his board have already chosen, but not publicly identified, a successor as chief executive.

He planned to hire one or more understudies with the potential to succeed him as the company’s investment mastermind, he said.