“The proliferation of interest-only loans was symptomatic of the loose underwriting standards of that time,”

TO BE NOTED: From Bloomberg:

"Bondholders Face Losses From Commercial Mortgages (Update3)

By Sarah Mulholland

June 11 (Bloomberg) -- Investors in bonds that packaged $62 billion of debt for U.S. offices, hotels and shopping malls are bracing for more loan defaults through 2010 as Bank of America Merrill Lynch says landlords’ monthly payments may jump 20 percent or more.

Principal is coming due on the so-called partial interest- only loans as an 18-month-old recession saps demand for commercial real estate. About $179 billion of such loans were written between 2005 and 2007 and bundled into bonds, according to data from Bank of America Merrill Lynch.

With soaring vacancies and falling rents, some cash- strapped borrowers will fail to cover the higher costs, said Andy Day, a commercial mortgage-backed securities analyst at Morgan Stanley in New York. About 87 percent of mortgages sold as securities in 2007 allowed owners to put off paying principal for several years or until maturity, compared with 48 percent in 2004, Morgan Stanley data show.

“The worst is yet to come,” MetLife Inc. Chief Investment Officer Steven Kandarian said yesterday in a Bloomberg Television interview. “Typically there’s a lag between when the economy softens and when the defaults actually occur.”

Investors have already seen prices on top-rated senior debt drop below 70 cents on the dollar from 95 cents a year ago, according to Aaron Bryson, a commercial mortgage-backed securities analyst at Barclays Capital in New York.

Just a Stopgap

Interest-only mortgages were designed as a stopgap to allow owners to do renovations and absorb other costs. Owners delay paying principal for the first several years, lowering their initial monthly expenses. Partial interest-only loans allow for postponement of principal payments for a portion of the term. Full-term interest-only deals require the principal at maturity.

Loans that postpone principal payments had become the norm by the time the commercial-mortgage bond market peaked two years ago, said Frank Innaurato, managing director of analytical services at Realpoint LLC, a Horsham, Pennsylvania-based credit- rating service.

“The proliferation of interest-only loans was symptomatic of the loose underwriting standards of that time,” Innaurato said. “Borrowers were taking advantage of the best terms possible.”

Property owners turned to Wall Street to finance office towers, apartment complexes and hotels as banks bundled the debt and sold it to investors. A record $230 billion in commercial mortgage-backed securities were sold in 2007, up from $93.3 billion in 2004, according to Morgan Stanley data. About $750 billion of such debt is outstanding, bank data show.

Subprime Losses

A similar type of loan fueled the U.S. residential housing boom, allowing people to borrow more than they could afford as they assumed home prices would keep going up. The collapse of the subprime mortgage market, which led to almost $1.5 trillion in losses since the start of 2007 at banks and financial companies worldwide, was triggered in part when owners defaulted as their payments rose.

Interest-only loans raised concerns “as an example of excessively aggressive underwriting during 2006 and 2007,” said Kent Born, senior managing director at PPM America, an investment manager in Chicago. “But commercial real estate fundamentals were good, and there was a huge demand for these bonds.”

The jump in monthly payments on commercial property won’t be as severe as in the residential market, though it will still sting, according to a May 1 report from Bank of America Merrill Lynch in New York. The mortgages may be one of the “significant contributors” to delinquencies on loans in commercial mortgage- backed bonds, the analysts said.

Investment Grade

Concern that commercial real estate is poised for a protracted slump comes as credit markets thaw. Borrowers have sold a record $615 billion of investment-grade U.S. corporate bonds this year, according to data compiled by Bloomberg. Junk bonds, which are rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s, have rallied 33 percent since March 9, Merrill Lynch & Co.’s U.S. High-Yield Master II index shows.

The yield gap, or spread, relative to benchmark interest rates on top-rated bonds backed by commercial real estate has fallen 3.8 percentage points to 7.8 percentage points since the Federal Reserve said on March 23 that it would lend to investors to purchase securities sold before Jan. 1, 2009, as part of its $1 trillion program to unlock credit, according to Bank of America Corp. data. Spreads on the debt have widened 1.5 percentage point since before S&P said on May 26 that it may cut ratings on top-ranked commercial mortgage-backed debt, rendering the bonds ineligible for the program.

A year ago, the debt was trading at about 1.6 percentage point more than the benchmark.

Unemployment Effects

While the U.S. services industry contracted at a slower pace in May and the number of Americans collecting jobless benefits shrank for the first time in almost five months, unemployment will continue to depress non-residential real estate, said Mitchell Stapley, chief fixed-income officer for Fifth Third Asset Management.

“The notion that the rate of decline has slowed, and that we are seeing improvement, doesn’t change the fact that the consumer is retrenching,” said Stapley, who oversees $22 billion in Grand Rapids, Michigan. “We need job growth, not just slowing job losses. There are massive fundamental issues.”

Defaults More Likely

Delinquencies on commercial mortgages placed into securities have climbed to the highest levels ever, according to data from RBS Securities Inc., the Royal Bank of Scotland Group unit based in Stamford, Connecticut. The late payment rate on them is 2.77 percent, up from 0.47 percent at the end of 2007.

The U.S. Treasury Department is considering issuing rules to allow lenders to modify commercial real estate loans without triggering tax penalties on investors as the industry braces for more defaults, according to people familiar with the matter.

“Interest-only loans will be a problem for borrowers who can’t reach targets on rent growth, or have been hit by vacancies,” said Morgan Stanley’s Day, who is based in New York. “The added burden increases the likelihood of these properties defaulting, translating to losses on CMBS investments.”

Scaffolding surrounds the ground floor of a 26-story tower at 1775 Broadway in New York. The 1928-vintage building on 57th Street is being refitted with a glass facade and renamed 3 Columbus Circle.

Newsweek, the magazine that’s cutting the circulation rate base of its U.S. edition by 42 percent to 1.5 million by January, vacated 203,000 square feet of the building last month. The unit of Washington Post Co. accounted for 34 percent of the space, according to loan documents. The publication relocated downtown to 395 Hudson St. in Greenwich Village.

Cheaper to Wait?

“Filling that much space will be extremely difficult in this environment,” said John Levy, a principal at John B. Levy & Co., a real estate investment banking firm based in Richmond, Virginia. “That will require several good-sized tenants in a market where most people aren’t making decisions. There is no penalty for indecision. There is no pressure to do anything, and people think it might get cheaper if they wait.”

Overall occupancy has decreased to about 30 percent, according to loan documents. The building was 98 percent occupied in January 2006, when the Moinian Group took out a $250 million interest-only mortgage, according to loan-service documents reviewed by Bloomberg. When principal starts coming due early next year, the monthly bill will climb by $225,000, or 18.4 percent, to $1.45 million, the documents show.

‘In Good Standing’

“The loan for 3 Columbus Circle is and will remain in good standing,” said Roxanne Donovan, president of Great Ink in New York, which represents the Moinian Group. The firm “is currently executing a comprehensive $65 million renovation” and “is confident it will lease the property to a credit tenant that will appreciate the exciting design, quality construction, new systems and excellent location at Central Park.”

Joseph Moinian, 55, the chief executive officer of New York-based Moinian Group, declined to be interviewed, Donovan said.

Moinian Group owns more than 20 million square feet of space in office, residential, retail and hotel properties, 13 million of which is in Manhattan, according to the company’s Web site.

$3.9 Billion Bond

The 1775 Broadway mortgage was wrapped into a $3.9 billion bond with 304 other commercial property loans across the U.S. and marketed in February 2006 by Wachovia Corp., now part of Wells Fargo & Co., according to the prospectus. More than half of those contained in the bond delayed paying principal for part of the term, the documents show.

Across the U.S., office vacancies climbed to 15.5 percent in the first quarter from 13.3 percent a year earlier, according to CB Richard Ellis.

The U.S. government has made reviving the market for commercial mortgage-backed bonds a cornerstone of the program to get credit flowing and end the recession. Sales of the bonds plummeted as investors shunned the debt and the cost to sell them became too high for investment banks to profit, choking off funding to borrowers that need to refinance.

There have been no sales of the bonds so far this year, and only $12.1 billion were sold last year, according to Morgan Stanley.

The mortgage bonds due this year and next “are coming up against capital markets not active enough to deal with those maturities,” Federal Reserve Bank of Atlanta President Dennis Lockhart said today in a speech.

“Even with government support, the commercial real estate fundamental picture will continue to get worse before it gets better,” said PPM America’s Born, who holds about $7 billion in commercial mortgage-backed bonds as part of a fixed-income portfolio. “Interest-only loans that start to amortize in this environment are one more piece of that picture.”

To contact the reporter on this story: Sarah Mulholland in New York at smulholland3@bloomberg.net"

Under the TALF, the Fed provides low-cost loans to investors, such as hedge funds, to buy AAA-rated asset-backed securities.

TO BE NOTED: From Bloomberg:

"Fed Says TALF Loan Requests Increase to $11.5 Billion (Update2)

By Scott Lanman and Sarah Mulholland

June 2 (Bloomberg) -- The Federal Reserve said investor requests for loans to buy asset-backed securities increased to $11.5 billion from May, the program’s highest monthly total and a sign of sustained interest after a slow start.

Investors sought funds from the Term Asset-Backed Securities Loan Facility to purchase bonds backed by auto, credit card, equipment, education and other kinds of loans, the New York Fed said today on its Web site. About $15 billion of securities were eligible for TALF loans in the fourth monthly round of requests, compared with $13.5 billion in May.

“The momentum is positive,” said Ron D’Vari, co-founder and chief executive officer of NewOak Capital LLC, an advisory and asset-management firm in New York. “There’s a lot of pent- up demand. We have been in a dysfunctional mode of the market, with very low issuance for close to a year and a half now.”

The Obama administration and Fed Chairman Ben S. Bernanke are counting on the TALF as a cornerstone of plans to revive credit and end the recession. While the program is on pace to fall short of its $1 trillion official ceiling, Bernanke said in a letter to a lawmaker last month that the TALF has helped create “improved conditions” in the ABS market.

This month’s requests follow totals of $4.7 billion in March, $1.7 billion in April and $10.9 billion in May. Bernanke said May 12 that “early indications” showed demand for TALF loans in June would exceed May’s amount.

Missed Payments

Today’s loan requests include $528.6 million to buy securities backed by loans designed to help small businesses buy insurance and $494.5 million for debt backed by loans extended by residential-mortgage servicers to cover missed payments by homeowners. They are the first such TALF loans for the two classes of securities.

The housing-related loans are notable because “there’s a crying need for financing in the mortgage area,” said Ed Gainor, a law partner at McKee Nelson LLP in Washington, who is working with TALF issuers and underwriters. “You’ll see a lot more of those deals.”

The Fed is expanding the TALF over the next two months to aid the commercial real estate market, seeking to avert defaults in an industry with “severely strained” lending conditions, Bernanke said last month.

The central bank will begin taking loan requests sometime later in June to buy commercial mortgage-backed securities issued this year. In late July, the Fed will start accepting investor requests for loans to purchase older CMBS.

Fed officials are discussing how and whether to add private residential mortgage-backed securities to the TALF.

Eligible Debt

Bayerische Motoren Werke AG, Ford Motor Co. and Nissan Motor Co. were among companies selling asset-backed debt eligible for the fourth round of the TALF. Some deals were increased in size, as Germany’s BMW and Ford each sold $2 billion of securities backed by automobile debt, according to people familiar with the sales who declined to be identified because terms aren’t public. BMW had planned to sell $1.5 billion of the debt, and Ford was to offer $1 billion.

Dearborn, Michigan-based Ford also sold $834 million in bonds backed by auto leases, the people said. Other companies that sold the TALF-eligible debt include American Express Co., CIT Group Inc., Citigroup Inc. and Deere & Co., they said.

Under the TALF, the Fed provides low-cost loans to investors, such as hedge funds, to buy AAA-rated asset-backed securities.

Next Phases

The Treasury Department is using capital from the $700 billion Troubled Asset Relief Program to protect the Fed from losses. Under the initial phase of the TALF, directed at consumer and business credit, the Fed has committed to extend as much as $200 billion of loans this year, aided by $20 billion of TARP funds. The Treasury and Fed have said the next phases of the TALF may increase total loans to as high as $1 trillion.

Elizabeth Warren, the Harvard University law professor who heads a panel overseeing the U.S. financial bailout, said in March that the committee was “concerned that the TALF appears to involve substantial downside risk and high costs for the American taxpayer, while offering substantial rewards to a small number of private parties.”

Ford paid 250 basis points more than the benchmark interest rate when it sold auto-loan bonds maturing in two years for the first round of TALF on March 19, compared with just 140 basis points more than the benchmark today. That means it’s cheaper for Ford to borrow, and more expensive for investors buying the bonds.

“Returns are still attractive, but they are not as attractive as they were in April, when the bonds were ridiculously cheap,” said Dan Castro, chief risk officer at Huxley Capital Management, an investment and advisory firm in New York. “Not as many of the TALF bonds are going to work for a 15 percent rate of return as did at the beginning of the program.”

The lower potential return may drive away some hedge funds from the program and bring in other investors who “can accept a lower yield,” Castro said.

To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net; Sarah Mulholland in New York at smulholland3@bloomberg.net."

saying its members “strongly believe” that TALF loans should be at least five years.

TO BE NOTED: From Bloomberg:

"Fed Said to Weigh Charging Higher Rates for Longer TALF Loans

Share | Email | Print | A A A

By Scott Lanman

April 7 (Bloomberg) -- The Federal Reserve may offer investors longer-term loans at higher interest rates to buy commercial mortgage-backed securities, aiming to protect the central bank’s balance sheet while acceding to an industry plea.

Lobbyists in the commercial mortgage-backed securities industry say the Fed needs to provide loans of at least five years, rather than the current three-year limit, to avert a meltdown in the market. Fed officials, wary of granting the request outright, are considering a compromise in altering terms of its $1 trillion emergency-lending program.

Fed policy makers are wary of loosening limits on the Term Asset-Backed Securities Loan Facility because longer loans would make it more difficult to tighten credit when inflation picks up. At the same time, rejecting the industry’s request may further stymie the TALF after a slow start that’s hindering Chairman Ben S. Bernanke’s efforts to revive the economy.

Charging higher rates for longer terms, “as a compromise, seems like it meets the needs of both sides,” said Louis Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. “It’s the certainty of the funding, and providing certainty goes a long way to address those concerns.”

Today, the Fed received applications to borrow $1.7 billion in the TALF’s second monthly round, down 64 percent from $4.7 billion in March. Hedge funds and other investors are balking because of visa limits on workers and possible efforts to tax earnings, undermining Bernanke’s attempt to further drive down borrowing costs.

TALF Expansion

The Fed started the TALF last month, lending to investors purchasing securities backed by auto, credit-card, education and small-business loans. In coming months, the program will expand to include securities backed by commercial real-estate loans.

“We have been advocating strongly for a term of at least five years,” said Christopher Hoeffel, president of the Commercial Mortgage Securities Association, a trade group. “The most important thing is the term of the loan. If the cost of the financing and the equity requirement increased with the length of the loan, that would be a workable solution.”

Investor participation would be curtailed by a loan term of less than five years, said Hoeffel, who is also a managing director at Investcorp.

Fed officials are still devising terms for the expanded facility, which may reach $1 trillion. No decisions have been reached yet on the loan length. Sales of CMBS plummeted to $12.2 billion last year from a record $237 billion in 2007, according to estimates by JPMorgan Chase & Co.

Risk of Default

That raises the risk of increasing defaults on commercial mortgages, making it tougher for borrowers to refinance maturing debt and avoid delinquency or foreclosure, industry officials say.

Charging higher fees after three years would be a compromise aimed at giving more incentive for investors to borrow from the Fed and helping restart markets for commercial mortgage-backed securities, while protecting the Fed’s flexibility to raise interest rates in the broader economy once consumer demand recovers.

The Fed normally raises the benchmark federal funds rate by selling Treasuries on its balance sheet, draining reserves from the banking system. That task is tougher with the Fed’s commitment last month to buy more than $1 trillion in mortgage- backed securities, which are harder to sell quickly without roiling markets or potentially attracting political scrutiny. TALF loans in particular would be difficult for the Fed to move.

Loan Rates

Investors can take out a fixed-rate TALF loan to buy newly issued auto-loan securities at the one-month London interbank offered rate, or Libor, plus 1 percentage point. For today’s loan applications, that comes to 2.87 percent, the Fed said.

One potential solution under consideration would be to increase the spread over Libor to, for example, 200 basis points after three years and 300 basis points after the fourth year. The thinking is that rates for private-market financing would decline enough in the next three years to make Fed loans too pricey for investors to keep.

Commercial Mortgage Securities Association officials said last month that the government’s effort to boost bids for the commercial-mortgage bonds may fail unless the length of TALF financing is increased.

The group posted on its Web site a summary of recommendations dated March 25, saying its members “strongly believe” that TALF loans should be at least five years."

hiding behind claims the assets are too complex to value and anyway their market prices don’t capture their true long term worth

TO BE NOTED: More or less my view: from HousingWire:

"If you read the headlines (and most people don’t bother to go much farther beyond the headline than the lead paragraph –- to our collective disgrace), you already think FASB eased the rules for measuring fair value on Thursday. You might believe that it has at last caved in to pressure from banks and Congress, and decided to allow “preparers” and their auditors to use judgment when valuing illiquid assets.

Not so. They are reiterating for the third time that “fair value is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date.”

And for the second time it is “highlighting and expanding on the relevant principles in FAS 157 that should be considered in estimating fair value when there has been a significant decrease in market activity for the asset.”

The first time, of course, was when they issued FAS 157. The second is the SEC/FASB staff clarifications on fair value accounting issued September 30, 2008. This is the third statement, second clarification and expansion.

Despite press reports on the Board meeting, the March 16 exposure guidance was toughened to reflect comment letters. In particular, staff recommended removing the “presumption that all transactions [in an inactive market] are distressed unless proven otherwise.” The handout and Board discussion acknowledged this proposed language confused people and might serve as a pretext to exclude relevant transaction information or preclude the use of pricing services or brokers in fair value measurement. The requirement to use all factors and information still stands.

Press reports on of FASB’s vote are also somewhat overreaching. The discussion centered on questions the staff had about possible changes to the proposed guidance and the kinds of language that might be added. In other words, precise sections of the next draft of the guidance were not read and voted on. Instead staff –- who do the writing of these things –- were given more guidance on what should be in the final guidance. I might be alone in this, but I’m hedging a bit on what was decided until I see FASB’s summary of decisions taken at the meeting (usually posted the evening of the meeting) and read the final FSP when it is issued, not before the end of next week.

Moreover, the discussion on Thursday clearly indicated that more tweaks and adjustments could occur as Board and staff continue to digest comment letters and each others’ opinions. And the door is not closed on comments, especially because normal due-process was foreshortened by the political pressure brought to bear on this traditionally independent standard setter.

Whatever the fine points of expansion and clarification provided in the final FSP might be, one can hope the third time is a charm and that there will be no further protest that FASB doesn’t allow preparers and auditors to use “significant professional judgment” in arriving at a fair value in a market where there has been a significant reduction in trading activity.

Inactive markets not the real issue

I didn’t come here to praise FASB, however, but to bury the notion that the devalued and disgraced RMBS securities on banks balance sheets are illiquid. Nor should the observable market prices be described as “fire sale” or “distressed sales.” ( NB DON )

Not that there have not been fire sales. There were some very large and visible fire sales last year as the biggest “sinners” in structured products (a blanket term that includes fairly vanilla non-agency RMBS and CMBS as well as CDO, CDO’s backed by CDS, CDS and so on) shed assets on their way to bankruptcy or acquisition (Merrill’s infamous 22-cents-on-the-dollar sale will come instantly to mind for many).

That those fire sales took place has provided a smoke screen, as it were, for banks and their enablers in Congress, free-enterprise, free-market “think tanks” and industry groups, and the media, to claim these markets are inactive.

The other mythos this crew hides behind is the notion that these riskier-than-first-thought assets are too complex to easily value( THANK THE LORD DON ) (please notice that I am not going to say “troubled,” “toxic” or, no not never, “legacy” with regard to this batch of soiled laundry).

First, there is plenty of pricing information on triple-A private RMBS and CMBS. They may not trade where banks holding lots of this paper at a loss wish they traded, but they do trade. Let’s get something clear, too — they NEVER traded with the kind of depth or frequency that Treasury, agency debt or Ginnie, Fannie and Freddie MBS do. Each bond is unique enough that it has to be manually evaluated — anything from a simple cash flow calculator that uses market conventions for prepayments and defaults – or elaborate option pricing models that take into account hundreds of different interest rate, credit performance and prepayment scenarios. The cash flow calculators are ubiquitous — the sophisticated tools are available at a market price.

They trade less frequently because significant sources of demand have been eliminated. Except for the big trading books at the big banks, banks have eliminated themselves as potential buyers on the re-trade. They also cannot sell held-to-maturity triple-As unless they are downgraded, they can’t realize much in the way of losses on available-for-sale triple-As. Ditto for insurance companies, though the rising tide may let them wriggle out of some clunkers.

What’s left is the subset of investors who are marked-to-market. Ergo they have experienced their losses. This would include money managers of various kinds of funds (mutual to pension) using what we call “real money” and leveraged investors — the hedge funds and private equity managers. This segment of the market can and does trade this paper. It has been slow, but their activity has been significant enough for trading desks on both sides of the trade to track market levels, make offers and attempt to buy paper from known holders. ( YES DON )

Most pertinently, sources on trading desks tell me they make “on the market” bids to banks for their paper and banks won’t sell. These same sources will explain that hedge funds are still the buyer on the margin, and prices have adjusted to reflect the hedge funds’ required yield –- typically 25 percent.

However, hedge funds used to achieve that yield by leveraging securities that traded at much higher prices, back when triple-A was assumed to mean risk-free (not a waiting game or playing chicken with a falling housing market). Now hedge funds’ traditional sources of leverage are gone. Security pricing has adjusted to reflect this loss of leverage.

To summarize: there are lots of tools for assessing the cash flow value, even for adjusting for credit, prepayment and interest rate risk. So market pricing would incorporate those factors, transactions will incorporate a “market view” of those risks. Those prices are further adjusted to satisfy the risk appetites of hedge funds that no longer can easily leverage to their required returns. There is necessarily a liquidity premium as well, but it is not sized on the assumption that only a fire sale will entice a buyer. It is sized given the fact that the securities must be manually examined and the field of buyers has shrunk.

The PPIP/TALF-expansion announced last week caused spreads to tighten and speculative buyers to build positions. It also triggered research from every major bond house left standing that (1) provided current market levels for the affected sectors –- either generically or for specific bond examples –- and (2) modeled expectations of price improvements when TALF and PPIP reintroduce leverage for secondary RMBS (originally rated triple-A) and triple-A CMBS.

For one thing, an illiquid market would not be graced with so much professional research. Nor would an illiquid market adapt so rapidly to the hope of new buyers (rather than the fact). In fact, if PPIP/TALF do nothing else, they should at last stop institutions that made bad investments (and, in the case of SIV, ABCP assets come home to roost, bad funding decisions) from hiding behind claims the assets are too complex to value and anyway their market prices don’t capture their true long term worth. ( GREAT JOB DON )

Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.

---

Unless the Legacy Loan Program winds up buying assets at $90 or more, banks won't sell.

TO BE NOTED: From Accrued Interest:

"PPIP: Maybe you'd like it back in your cell?

The big question surrounding the toxic asset plan is will banks sell? I've put a little pencil to paper here and come up with some actual numbers.

First of all, I expect the Legacy Securities Program will work wonderfully. Sellers will flock to it like Jawas to a stray astromech droid. This program is aimed at securities which have been severely impaired from both a credit and liquidity perspective. CLOs, RMBS, ABS, CMBS, etc. The program should succeed in turning these programs into just liquidity impaired. In effect, it will separate the red ones with the bad motivators from the blue ones in prime condition. That will be key to an eventual economic recovery. It should foster a healthy new issue market for RMBS, ABS and CMBS (don't know that CLOs can come back), which will help get the velocity of money back to a more normal level.

Obviously having ready buyers able to earn impressive ROEs should improve the value of the underlying assets. Financial institutions have already marked these securities to market, an improvement in the actual value of the instruments ought to result in an improvement of balance sheets. This will particularly benefit financials who invested primarily at the top of the asset-backed capital structure. It will also benefit those that hold more risk in securities (such as brokerages Goldman Sachs and Morgan Stanley and possibly some P&C insurers) and less those that hold risk in loans (such as almost all banks). Even there, much of Goldman and Morgan's risks are tied to the equity markets, not to debt markets. Same goes for life insurance, generally speaking.

That brings us to the with the Treasury's Legacy Loan Program. I expect this to go over like the exotic twi'lek dancer's routine in Jabba's palace. The plan will indeed increase the theoretical price at which banks could sell loans. That's fine, but its short help. Loans haven't been marked to market. Instead, they are held at book value less an allowance for expected loss.

I've done some deep dives on bank residential loan portfolios. Getting detailed data is a challenge, but basically I tried to figure out what percentage of the bank's current portfolio is "challenged." High CLTV, bad geographics, low FICO, etc. You can make a relatively safe assumption that most of the loss reserve is pledged to those kinds of loans. Anyway, I can't find any big banks that are holding, say home equity loans at less than 90% of face. Unless the Legacy Loan Program winds up buying assets at $90 or more, banks won't sell.

So will the PPIF's pay $90? I doubt it. Take home equity loans as an example. Start with the following assumptions:

• PPIFs get loans at 1mo-LIBOR +50bps. Its hard to say exactly what the cost of funds might be, but worth noting that FDIC paper trades around L+20.
• 6-1 leverage, which is the max allowed under the program. I think its reasonable that non-delinquent, prime loans would get the max leverage.
• Assume the loans float at Prime-flat.
• Assume the loans are 1-2 years old, and will repay over the course of 6 years. To make it easy I'm going to assume equal payments per month.
• The pool of loans will suffer 10% cumulative losses, all of which occur in the first two years. I won't write down the losses as they occur, simply take away the interest. That's consistent with a hold-to-maturity IRR calculation.
• Finally, and perhaps most importantly, I'm assuming that the PPIF equity investors are targeting an IRR of 20%.

The result? $82.5.

That price will render it impossible for most banks to sell. For example, based on Bank of America's recent earnings presentation, it has something like $250 billion of prime, non-delinquent home equity loans with 90%+ LTV. I'd call this the kind of stuff that isn't exactly toxic, but selling could improve BAC's risk exposure significantly. Say they effectively have a $90 mark on these. If they sell at $82, they'd suffer an 8% loss versus their capital, or $20 billion. BAC has core equity capital of $48 billion. You do the math.

I don't expect commercial loans to be much better. Now a lot of commercial stuff has large loan loss reserves, and therefore sales would more easily be accretive to capital. But commercial loans are also present an information asymmetry problem. You can put a zillion residential loans into a pool and get some semblance of diversification. You can then look at average stats and get some idea of the make-up of the loans: geo diversification, average FICO, etc. A bank that is selling a commercial loan is telling you they don't want that commercial loan anymore.

This isn't to say the toxic asset plan will have no positive impact, but it is likely to be more indirect than investors are currently hoping. The best chance banks have for decreasing their residential loan portfolios is a revived securitization market, which is the primary aim of the TALF. Banks may be more willing to sell a portion of their home equity loans as a senior security, with the bank retaining a subordinate position. In that case, the bank might retain the upside while still freeing up some capital. In addition, a revived securitization market would give the market confidence that banks have enough liquidity to hold their loan portfolios to maturity.

It will also help banks who have made larger writedowns, especially those that made acquisitions. At the time of acquisition, the bank has to write down the loan to fair market value. In the case of J.P. Morgan's acquisition of WaMu, or Wells Fargo's acquisition of Wachovia, there would be no motivation to under-estimate the FMV decline. Those banks could therefore enjoy improved capital positions from certain sales. "

But this has some chance of success in my opinion, and so is worth a try

TO BE NOTED: From The Aleph Blog:

"Liquidity and the Current Proposal by the US Treasury

One of the earliest pieces at this blog was What is Liquidity?, followed by What is Liquidity? (Part II). I’ve written a bunch of pieces on liquidity (after doing a Google search and being surprised at the result), largely because people, even sophisticated investors and unsophisticated politicians and regulators misunderstand it. Let’s start with one very simple premise:

Many markets are not supposed to be liquid.

Why?

• Small markets are illiquid because they are small. Big sophisticated players can’t play there without overwhelming the market, making volatility high.
• Securitization takes illiquid small loans and transforms them into a bigger security(if it were left as a passthrough), which then gets tranched into smaller illiquid securities which are more difficult to analyze. Any analysis begins with analyzing the underlying loan collateral, and then the risks of cashflow timing and default. There is an investment of time and effort that must go into each analysis of each unique security, and is it worth it when the available amount to invest in is small?
• Buy-and-hold investors dominate some markets, so the amount available for sale is a small portion of the total outstanding.
• Some assets are opaque, where the entity is private, and does not publish regular financial statements. An example would be lending to a subsidiary of a corporation without a guarantee from the parent company. They would never let and important subsidiary go under, right?
• The value of other assets can be contingent on lawsuits or other exogenous events such as natural disasters and credit defaults. As the degree of uncertainty about the present value of free cash flows rises, the liquidity of the security falls.

When is a securitization most liquid? On day one. Big firms do their due diligence, and put in orders for the various tranches, and then they receive their security allocations. For most of the small tranches, that’s the last time they trade. They are buy-and-hold securities by design, meant to be held by institutions that have the balance sheet capacity to buy-and-hold.

When are most securitizations issued? During the boom phase of the market. During that time, liquidity is ample, and many financial firms believe that the ability to buy-and-hold is large. Thus thin slices of a securitization get gobbled down during boom times.

As an aside, I remember talking to a lady at a CMBS conference in 2000 who was the CMBS manager for Principal Financial. She commented that they always bought as much of the AA, single-A and BBB tranches that they could when they liked the deals, because the yield over the AAA tranches was “free yield.” Losses would never be that great. Privately, I asked her how the securitizations would fare if we had another era like 1989-92 in the commercial property markets. She said that the market was too rational to have that happen again. I kept buying AAA securities; I could not see the reason for giving up liquidity and safety for 10, 20, or 40 basis points, respectively.

Typically, only the big AAA tranches have any liquidity. Small slices of securitizations (whether credit-sensitive or not) trade by appointment even in the boom times. In the bust times, they are not only not liquid, they are permafrost. In boom times, who wants to waste analytical time on an old deal when there are a lot of new deals coming to market with a lot more information and transparency?

So, how do managers keep track of these securities as they age? Typically, they don’t track them individually. There are pricing grids or formulas constructed by the investment banks, and other third-party pricing services. During the boom phase, tight spread relationships show good prices, and an illusion of liquidity. Liquidity follows quality in the long run, but in the short run, the willingness of investors to take additional credit risk supports the prices calculated by the formulas. The formulas price the market as a whole.

But what of the bust phase, where time horizons are trimmed, balance sheets are mismatched, and there is considerable uncertainty over the timing and likelihood of cash flows? All of a sudden those pricing grids and formulas seem wrong. They have to be based on transactional data. There are few new deals, and few trades in the secondary market. Those trades dominate pricing, and are they too high, too low, or just right? Most people think the trades are too low, because they are driven by parties needing liquidity or tax losses.

Then the assets get marked too low? Well, not necessarily. SFAS 157 is more flexible than most give it credit for, if the auditors don’t become “last trade” Nazis, or if managements don’t give into them. More often than not, financial firms with a bunch of illiquid level 3 assets act as if they eating elephants. How do you eat an elephant? One bite at a time. They write it down to 80, because that’s what they can afford to do. The model provides the backing and filling. Next year they plan on writing it down to 60, and hopefully it doesn’t become an obvious default before then. Of course, this is all subject to limits on income, and needed writedowns on other assets. I have seen this firsthand with a number of banks.

So, relative to where the banks or other financials have them marked, the market clearing price may be significantly below where they are currently marked, even though that market clearing price might be above what the pricing formulas suggest.

The US Treasury Proposal

The basics of the recent US Treasury proposal is this:

• Banks and other financial institutions gather up loans and bonds that they want to sell.
• Qualified bidders receive information on and bid for these assets.
• High bid wins, subject to the price being high enough for the seller.
• The government lends anywhere from 50-84% of the purchase price, depending on the quality and class of assets purchased. (I am assuming that 1:1 leverage is the minimum. 6:1 leverage is definitely the maximum.) The assets collateralize the debt.
• The FDIC backs the debt issued to acquire the assets, there is a maximum 10 year term, extendable at the option of the Treasury.
• The US Treasury and the winning private investor put in equal amounts, 7-25% each, to complete the funding through equity.
• The assets are managed by the buyers, who can sell as they wish.
• If the deal goes well, the winning private investors receive cash flows in excess of their financing costs, and/or sell the asset for a higher price. The government wins along with the private investor, and maybe a bit more, if the warrants (ill-defined at present) kick in.
• If the deal goes badly, the winning private investors receive cash flows in lower than their financing costs, and/or sell the asset for a lower price. The government may lose more than the private investor if the assets are not adequate to pay off the debt.

I suspect that once we get a TLGP [Treasury Liquidity Guaranty Program] yield curve extending past 3 years, that spreads on the TLGP debt will exceed 1% over Treasuries on the long end. Why? The spreads are in the 50-150 basis point region now for TLGP borrowers at 3 years, and if it were regarded to be as solid as the US Treasury, the spread would just be a small one for illiquidity. (Note: the guarantee is “full faith and credit” of the US Government, but it is not widely trusted. Personally, I would hold TLGP debt in lieu of short Treasuries and Agencies — if one doesn’t trust the TLGP guarantee, one shouldn’t trust a Treasury note — the guarantees are the same.)

One thing I am unclear on with respect to the financing on asset disposition: does the TLGP bondholder get his money back then and there when an asset is sold? If so, the cashflow uncertainty will push the TLGP spread over Treasuries higher.

Thinking About it as an Asset Manager

There are a number of things to consider:

• Sweet financing rates — 1-2% over Treasuries. Maybe a little higher with the TLGP fees to pay. Not bad.
• Auction? Does the winner suffer the winner’s curse? Some might not play if there are too many bidders — the odds of being wrong go up with the number of bidders.
• What sorts of assets will be auctioned? [Originally rated AAA Residential and Commercial MBS] How good are the models there versus competitors? Where have the models failed in the past?
• There will certainly be positive carry (interest margins) on these transactions initially, but what will eventual losses be?

The asset managers would have to consider that they are a new buyer in what is a thin market. The leverage that the FDIC will provide will have a tendency to make some of the bidders overpay, because they will factor some of the positive carry into the bid price.

I personally have seen this in other thin market situations. Thin markets take patience and delicate handling; I stick to my levels and wait for the market to see it my way. I give one broker the trade, and let him beat the bushes. If nothing comes, nothing comes.

But when a new buyer comes into a thin market waving money, pricing terms change dramatically after a few trades get done. He can only pick off a few ignorant owners initially, and then the rest raise their prices, because the new buyer is there. He then becomes a part of the market ecosystem, with a position that is hard to liquidate in any short order.

Thinking About it as a Bank

More to consider:

• What to sell?
• What is marked lower than what the bank thinks the market is, or at least not much higher?
• Where does the bank know more about a given set of assets than any bidder, but looks innocuous enough to be presumed to be a generic risk?
• Loss tolerances — where to set reservation prices?
• Does participating in the program amount to an admission of weakness? What happens to the stock price?

Management might conclude that they are better off holding on, and just keep eating tasty elephant. Price discovery from the auctions might force them to write up or down securities, subject to the defense that prices from the auctions are one-off, and not realistic relative to the long term value. Also, there is option value in holding on to the assets; the bank management might as well play for time, realizing that the worst they can be is insolvent. Better to delay and keep the paychecks coming in.

Thinking about it as the Government and as Taxpayers

Still more to consider:

• Will the action process lead to overpriced assets, and we take losses? Still, the banks will be better off.
• Will any significant amount of assets be offered, or will this be another dud program? Quite possibly a dud.
• Will the program expand to take down rasty crud like CDOs, or lower rated RMBSand CMBS? Possibly, and the banks might look more kindly on that idea.
• Will the taxpayers be happy if some asset managers make a lot of money? Probably, because then the government and taxpayers win.

Summary

This program is not a magic bullet. There is no guarantee that assets will be offered, or that bids for illiquid assets will be good guides to price discovery. There is no guarantee that investors and the government might not get hosed. Personally, I don’t think the banks will offer many assets, so the program could be a dud. But this has some chance of success in my opinion, and so is worth a try. If they follow my advice from my article Conducting Reverse Auctions for the US Treasury, I think the odds of success would go up, but this is one murky situation where anything could happen. Just don’t the markets to magically reliquefy because a new well-heeled buyer shows up."

1. David Merkel Says:
   March 25th, 20091:19 pm at

   RB — since writing, I have had more time to think.

   Because of the auction process, subsidized funding, and the free put option, this will tend to get the buyers to overpay, which might induce the banks to part with more dud assets. Then the pricing grids will reflect those overstated prices, making the banks look better than they should. The banks get time, but the underlying problems in the eventual cash flows don’t disappear.

   Losses will get taken later by the asset managers, but mostly, by the government. Maybe things will be better then — some suggest that the economics team for Obama is merely playing for time and hoping.

Me:

1. Don the libertarian Democrat Says:
   March 27th, 20098:04 am at

   An excellent post. One of the few commentaries on this plan that I can understand, and relates well to what I actually read in the government White Paper and further comments.

   The holding company post was very good as well.

"But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed"

David Merkel on The Aleph Blog with a list:

"1) There are firsts for everything. Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952. America has always been a pro-debt and pro-debtor nation( SPENDER NATION ). It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period. But, the Pilgrims did extinguish the debt. Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity. With the decline in housing values, the fall in the ratio was inevitable. The low ratio puts downward pressure on home prices, because it means that more homes are underwater ( IT STILL HAS A GOOD SIDE ). Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector. Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more( TRUE ).

5) Now these same low yields whack Treasury money funds. How many will close? How many will cut fees? How many will break the buck, and credit negative interest? An unintended consequence of monetary policy. Another unintended consequence reduces liquidity in the repo markets. Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates( WHO KNOWS? ).

6) Brave Ben Bernanke is fighting the Depression. If his theories are right( I AGREE WITH BERNANKE ) (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy ( TRUE ). But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle( TRUE ).

7) Inflation is the lesser evil at this point.( I AGREE ) It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go( TOO MUCH ), and Elizabeth Warren now confirms it for the Treasury. My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.” So it is for the TARP bailout( A HYBRID ). Policy made hastily rarely works. Spend more time, get it right. The market won’t die as you work it out.

9) But will AIG die, or the automakers?

• Sales are slow for assets at AIG. ( THEY WILL BE. BUYERS CAN TAKE THEIR TIME ) (no surprise valuations are crushed, and all likely buyers face lower P/Es and higher debt costs.)
• And who knows where the writeoffs end? As I said long before the failure of AIG, don’t trust the financial statements ( TRUE ). The palce was too complex, and the culture of fear inhibited objective financial reporting.
• GM’s suppliers are seeking cash. Just one of the costs of financial stress.( WOULDN'T YOU )
  
• Suppliers worry over a lack of demand if the automakers fail. They should retool for Japanese and European automakers. ( MAYBE )
  
• From Credit Slips, the important idea is that without a good business plan the automakers are toast anyway. I predict they will be back hat in hand in half a year even with a bailout( THEN WE CAN LET THEM FAIL ).
• A GM bankruptcy would take a long time, and a prepack would not get done before the cash runs out. Maybe, but I would still take it through bankruptcy, with the US Government as the DIP lender. ( THE BAILOUT NEEDS TO BE SEEN AS JUST THAT, BOTH FOR SOCIAL REASONS DEALING WITH PERCEPTIONS OF FINANCIAL TYPES BEING THE ONLY ONES SAVED, AND THE GOVERNMENT GUARANTEES ARE ESSENTIAL TO GETTING OUT OF THIS . THAT'S WHY INVESTORS ARE FLEEING AGENCIES FOR TRASURIES )
  

10) Even VCs are looking at the survivability of their portfolio holdings. Who can survive and become cash-flow positive in a tough environment. Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers. Watch the loan covenants, so that you can get good recoveries in a default. If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults. For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices. Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss. This is a tough time for anyone taking credit risk. That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics. I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers. He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes. ( I'VE BLOGGED ABOUT THIS POST )

16) You can give the banks funds, but you can’t make them lend. Would you lend if you didn’t have a lot of creditworthy borrowers? ( YOU CAN MAKE THEM LEND )

17) The export boom is dead, for now. Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed. Sorry, but the secret to changing the residential real estate market is not lowering interest rates( IT'S A WAY THAT THEY CAN BE SEEN AS HELPING HOME OWNERS ), but writing-off portions of loan balances. Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater. Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?( THAT'S A POSSIBLE SOLUTION )

19) On commercial property, when do you extend on a loan vs foreclosing? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan. More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position. With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now. (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever. Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming ( TRUE ). As the interest rate differentials narrow in real terms, the US Dollar should improve.( TRUE )

But, there are complicating factors. Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates. Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply ( TRUE ).

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies ( TRUE ). For now, put your macroeconomics books on the shelf, because they won’t be useful for some time ( TRUE ).

A good post.

"Basically, the Fed is targeting a lower interest rate on GSE debt. Sound familiar? Yup, that’s monetizing government debt."

Rebecca Wilder at News N Economics with an interesting post:

"At some point the Fed may choose to monetize new debt issued by the Treasury (let’s say in order to raise $700 billion to finance TARP), but I doubt it. There is already a new $1 trillion of new liquidity sloshing around in the banking system, posing huge inflationary risks.
Well, circumstances have changed. Twenty-four days later, and in a rather nontraditional manner, the Fed is now monetizing government debt.
The time has come to officially monetize government debt. Yesterday the Fed announced that it would purchase $100 billion in debt obligations from Fannie Mae, Freddie Mac and the Federal Home Loan Bank next week. And furthermore, it will purchase $500 billion in mortgage-backed securities (MBS) – I like to call this FARP (Fed Asset Relief Program).

The purchase of GSE debt is a direct attempt to reduce the spread on government agency (GSE) debt over comparable Treasury debt, the relative borrowing costs. Basically, the Fed is targeting a lower interest rate on GSE debt. Sound familiar? Yup, that’s monetizing government debt.

The chart illustrates the difference between newly issued Fannie Mae debt and a comparable U.S. Treasury through 11/24/08. This spread has widened from an average of 29 bps (0.29%) spanning 2006-2007 to 90 bps spanning 2007-2008. Fannie Mae must pay more in order to finance its mortgage obligations, which limits its ability to roll over current obligations, and tightens the terms on new mortgage loans.

By driving down the spreads on GSE debt now, and later on mortgage-backed securities, the Fed gives the GSEs more flexibility in the mortgage market, and they can offer lower rates and better terms for potential homebuyers. That’s the theory.

I am interested to hear why the Fed is supporting the GSE debt and securitized assets that derive their value from the mortgages (MBS) rather than the mortgages themselves. The Fed could allocate a similar stock of resources to mortgages directly, where the effect would be immediate (mitigating foreclosures or offering better terms directly). However, I assume that the Federal Reserve Act prevents the Fed from doing such a thing – that sort of action probably lies in the hands of Congress. Although the immediate effects do appear to be quite positive.

Expect the Fed’s balance sheet to rise by another $100 billion (at least) in two weeks. It is official: the Fed is monetizing government debt."

So, the Fed is monetizing government debt.

Here's my comment:

Don said...

From Bloomberg: Rebecca, Can you tell me why they won't say so publicly, if you agree that this is what they're doing:

"The U.S. officials, speaking on condition of anonymity, said they don’t see the Fed purchases of mortgage bonds as a way of “quantitative easing,” or using central bank policy to add reserves to the banking system when interest rates are very low, even though the purchases will have that effect. "

Why didn't they just ask Poole? He's not shy.

"Quantitative easing was a tool of monetary policy that the Bank of Japan used to fight deflation in the early 2000s.

The BOJ had been maintaining short-term interest rates at close to their minimum attainable zero values since 1999. More recently, the BOJ has also been flooding commercial banks with excess liquidity to promote private lending, leaving commercial banks with large stocks of excess reserves, and therefore little risk of a liquidity shortage.[1]
The BOJ accomplished this by buying much more government bonds than would be required to set the interest rate to zero. It also bought asset-backed securities, equities and extended the terms of its commercial paper purchasing operation."

I'm not sure why, if it's going to have that effect, it wouldn't be considered a positive side effect.

Don the libertarian Democrat

November 26, 2008 2:20 PM

Here's Rebecca's reply:

"Rebecca Wilder said...

Hi Don,

Good to hear from you?

Honestly, I don’t know what else you could call it – government purchasing MBS and credit directly? That sounds like quantitative easing to me – and Kohn said that the easing has already started. http://blogs.wsj.com/economics/2008/11/19/feds-kohn-deflation-risk-bigger-but-still-small/

In my book, the Fed can call it whatever it likes – monetization, easing, whatever - it’s not like they are going to tell us anyway. To me, the Fed purchasing MBS is better than an outright purchase of Treasuries because the yields on those bonds are already so low. Why not target an market that is actually going to do some macro-economic good, like the MBS market. I wonder if they will purchase CMBS, too? Probably not, but those spreads are very, very wide.

Thanks for reading and Happy Thanksgiving!

Rebecca"

Across The Fear

The Fear and Aversion to Risk is staggering. From Across The Curve:

"Anyway, the cash AAA bonds which I note above are super senior and are packaged for the bondholders’ enjoyment with 30 percent credit enhancement. They are designed to absorb enormous stress. I am not sure how much the landscape would need to mimic 1929 before these things are wounded but they are wounded, but they are designed to withstand a lot of pain.

My belabored point is that at currents levels they are Libor + 1200 which is somewhere north of 14 percent.

One participant citing that yield level noted that sales at these levels can only be motivated by fear and panic.

There are some other factors involved in the panic. I mentioned the failure of the TARP to purchase assets. Anticipation of the TARP led some shorts to keep their powder dry. Those shorts are now happily establishing positions.

Additionally, two loans which comprise a large portion of a deal in the index soured yesterday and that struck fear into the hearts of participants.

And one participant noted the overall dismal state of the economy and noted that it was likely to lead to a glut of office space."

And:

"The corporate bond market had experienced a renaissance or revival of sorts over the last several weeks. The implosion in the CMBS market as well as the persistent weakness in the equity market has drained that sanguine attitude and substituted the melancholic mindset which had prevailed previously.Participants report that there is very little trading. Bid to offer spreads have widened and the little which does trade trades into the bid side."

And:

"By Gabrielle Coppola and Caroline Salas
Nov. 19 (Bloomberg) — Yields on speculative-grade
corporate bonds surpassed 20 percent for the first time in at
least two decades as a declining economy increased the risk of
default.
“Prices are in a virtual freefall,” Fridson said.
“Either the market is right and expecting a default rate
considerably higher than it was in the Great Depression, or we
have such profound dislocations and selling pressures going on
that it really is creating extraordinary fundamental value.”
“The risk premiums are just at a staggering level; the
number is not something any of us expected to see,” he said,
referring to the 20 percent yields. "

And:

"I had not watched the agency market today but it is undergoing an historic meltdown of its own. (I should sponsor a contest in which the winner supplies me with a synonym for meltdown which I am overusing. First prize is a free subscription to Acrossthecurve.com.) The 2 year benchmark widened 22 basis points today to finish at 180. Less than two weeks ago on November 7 it closed at 113. The five year benchmark sector widened 11 basis points today to finish at 155 basis points. The five year benchmark was 109 on November 7th. Ten year benchmarks are 9 basis points wider at 162 basis points. They closed at 115 on November 7,

I use the November 7th date as that was about the low point following an episode of spread tightening following the previous widening. That date is also just prior to the announcement by Secretary Paulson that he was not unrolling the TARP and chose to spend his money by purchasing bank equities rather than illiquid and damaged assets.

It was also just prior to the time in which the Secretary and several of his acolytes engaged in linguistic acrobatics in which they would not ever say that agencies are full faith and credit instruments. Lack of that explicit guarantee has led some large buyers to shun the sector."

Now, from my view as a novelist and philosopher, there's something irrational at work here. The Human Agency type of explanation would recommend combating the irrational fear and aversion to risk. How to do that?

For Corporate Bonds, I would think tax breaks down the line will help, but now? How about Agencies? Fully back them, or not? Into this mix the auto maker's bailout fits, which is why it is such a hard call in this crisis. But not to understand the effects of human agency in this crisis, is to resort to the kind of mechanistic explanation that got us into this mess in the first place, although not by itself, by any means.