where the mortgage application grossly overstates the buyers income or the appraisal hugely overstates the market price of the house

TO BE NOTED: From Beat The Press:

"Background on the Stress Tests: Anyone Got an Extra $120 Billion?

Most news outlets seem anxious to join the Treasury's PR campaign in pronouncing the banks essentially healthy based on the stress test results. There is of course enormous uncertainty around the course of the economy over the next few years, and the results of these stress tests may well prove to be an accurate assessment of the banks' health, but there are some reasons for believing that the stress tests are likely to prove too lenient.

1) Fraud in mortgage issuance -- we know that many of the loans issued in this period involved fraud, more often on the lenders' side than the borrowers. In these cases, for example where the mortgage application grossly overstates the buyers income or the appraisal hugely overstates the market price of the house, default rates will be far higher than would be expected even in bad economic times. Also, recovery rates will be far lower if the original appraisal price was inflated.

2) Unemployment -- in their negative scenario, the stress tests assumed a year-round average unemployment rate of 8.9 percent for the 2009 and 10.3 percent for 2010. The economy is on track to have a much higher unemployment rate, as it is likely to hit 9.0 percent in April. My best guess for a year-round average would be 9.4 percent for 2009 and probably around 10.5 percent for 2010. (These numbers assume no second stimulus, but of course Congress will not sit back and just let the unemployment rate go through the roof.)

3) House prices -- the negative scenario assumes that house prices, as measured by the Case-Shiller 10-City index fall 22.0 percent in 2009. Prices in this index have been falling at a 24 percent annual rate in recent months. Given the massive inventory of unsold homes, It is reasonable to expect that this rate of price decline could continue at least through 2009.

What difference would harsher assumptions make? The projected loss rate on first mortgages increases by 45 percent between the baseline scenario and the negative scenarios in the stress tests. The baseline scenario assumes an 8.4 percent unemployment rate for 2009 and 8.8 percent for 2010 (some serious stimulus here), compared to the 8.9 and 10.3 rates in the negative scenario. The rate of house price decline in the baseline scenario was 14 percent in 2009 and 4 percent in 2010, compared to 22 percent and 7 percent in the negative scenario.

So, if my somewhat more negative numbers prove accurate let's assume that it increases losses by about 20 percent. That comes to an additional $120 billion in losses. That would mean that instead of having to raise $75 billion, these banks would have to raise $195 billion. That's a qualitatively different picture.

So, are the stress tests worthless? They did provide a much clearer picture of the position of individual banks than we had previously. It is worth noting that this is a 180 degree shift from the original course pursued by Treasury Secretary Henry Paulson last fall. Paulson tried to conceal the situation of individual banks, putting a cloud over all of them. Treasury also should be credited for disclosing many of the specifics of the stress tests so it is possible to do a quick (or more in depth) analysis of its assumptions and explore the implications of alternative assumptions.

Still, it is hard not to conclude that these stress tests and certainly the PR campaign around them, were intended to paint as positive a picture as possible of the banks' financial condition. If this picture proves to be wrong, then it means that we will have unnecessarily delayed the clean-up of the financial system. It will also be bad political news for the administration (Geithner and Summers will presumably be joining the ranks of the unemployed).

Of course, the big second stimulus package that Congress will pass this summer, will save both the banks and the administration.

--Dean Baker"

The forecast for the peak rate has been reduced “in the last couple of months as high-yield bond spreads have declined moderately

TO BE NOTED: From Bloomberg:

"Default Rate Surges to Highest Since Depression, Moody’s Says

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By John Glover

April 7 (Bloomberg) -- Thirty-five companies defaulted in March, the highest number in a single month since the Great Depression, according to Moody’s Investors Service.

The rate at which speculative-grade corporate borrowers worldwide failed to meet their obligations rose to 7 percent from 4.1 percent at the end of last year, Moody’s said in a report today. So far this year, 79 companies rated by Moody’s have defaulted, the New York-based ratings firm said.

Almost $1.3 trillion of losses and writedowns at financial institutions worldwide, combined with the deepest economic slowdown since World War II, have weakened companies’ finances, reducing their ability to pay debt. The global default rate will peak at 14.6 percent in the final quarter of the year, Moody’s predicted, lower than last month’s 15.3 percent forecast.

Defaults “will remain at an elevated rate,” the report said. The forecast for the peak rate has been reduced “in the last couple of months as high-yield bond spreads have declined moderately.”

In the U.S., the default rate at the end of the first quarter was 7.4 percent, up from 4.5 percent at the end of 2008, and in Europe it jumped to 4.8 percent from 2 percent at the end of the final quarter of last year.

European default forecasts remain the highest and are expected to peak at 21 percent in the fourth quarter, down from the 22.5 percent the ratings firm’s model calculated last month."

"But there are lots of other things that credit default swaps are useful for."

Felix Salmon comes to the defense of CDSs. There's something strange about this constant focus on the products, and not on the people:

"John Dizard wants to kill off the entire CDS market. It does no good, he says, and quite a lot of harm, and we'd all be better off without it.

I disagree. Dizard says there are only "three possible defences for treating the CDS market as a going concern"; in fact, there are more than that, and he misses out the big one, which is that the CDS market has allowed investors, for the first time ever, to hedge their credit exposure. Yes, there's a downside to that -- which is that it becomes easier to simply buy credit protection than to do the hard work of fundamental credit analysis. But CDS by their nature are more liquid than bonds, and it will always be easier to buy credit protection than to sell a bond."

I'm not sure why insurance on mortgages and bonds is inherently indefensible. It seems sensible to me. Buying CDSs for other reasons than mimicking bonds bothers me, but only in the sense that I wouldn't personally come near them because they're risky, and more like a bet. All I ask is that buyers be clearly and truthfully explained the risks in buying them. That's it.

"What's more, CDS prices are a much better indication of credit risk than bond spreads are, for many reasons including the tax treatment of bond coupons and the fact that many bonds simply don't trade. In other words, not only are they more liquid, they're also more transparent. These are good things."

This seems true to me in theory, but I'd like to see more information on how these differences work out in practice.

"But Dizard doesn't concentrate on simple things like liquidity and transparency. Instead, he talks about CDS providing "support for capital raising", which was never something it was designed or even really used for. The whole point of credit default swaps is that they're derivatives: they're not cash instruments to be used for raising capital."

This is something I talked about on Derivative Dribble. Some people understand bonds because they're essentially loans for capital, but don't see the sense in investments that look like side bets.

"Dizard does have a good point that as spreads have widened, banks have seen increasing amounts of money tied up in CDS collateral. That's a concern, and it's a good reason to work hard on compression, netting, and rehypothecation. It's not a reason to kill the CDS market outright."

In other words, ways to free capital for other uses. However, I'd worry about this possibly lowering capital on these investments right now.

"Dizard's other big point, however, eludes me:

Price discovery is a useful economic function; that is the rationale for commodities markets. But CDS are derivative instruments, whose price is "discovered" these days as a function of equity volatility, since buying equity puts is one way to dynamically hedge the illiquid legacy books...
At high levels of default risk and equity volatility, if you hedge the one with the other you get frantic, self-defeating activity.

I'm not sure I understand this, but Dizard seems to be saying that there's a lot of capital-structure arbitrage going on: people hedging equity positions in the CDS market, and vice-versa. That's a strategy which has blown up quite consistently since the summer of 2007, and it tends to require quite a lot of leverage, so I'd be surprised if it was a major factor today. But even if it is, I still don't see why it means the CDS market should be abolished."

I actually don't understand the point at all. It sounds like a weird trading strategy, at best.

"I do understand, however, what Dizard is saying here:

If the default rates implied in investment grade CDS spreads were to occur, the only economic activity would be court-supervised reorganisation. The CDS market has been preventing efficient price discovery.

He's wrong. I just had a long conversation with Kai Gilkes of CreditSights, who confirmed for me that it's pretty much impossible, in this market, to back out implied default rates from CDS spreads. There are so many technical factors in the market, so many reasons beyond expected default that people are buying protection on certain credits, that it's impossible to isolate expected default probabilities. So I don't know what implied default rates Dizard is using, but I do know that they're unreliable to the point of uselessness, since right now CDS spreads tell us precisely nothing about expected default rates.

So yes, if you try to use CDS spreads as a guide to default probabilities, you're not going to get very far. But there are lots of other things that credit default swaps are useful for. So let's not abolish the entire market quite yet."

That's correct. Here's my comment:

Posted: Dec 09 2008 3:30pm ET

I too believe that CDSs can be useful. As to spreads on many bonds right now, the question is whether or not they are moved more by panic than clear analysis of a company's fundamentals. Right now, there's so much uncertainty, that it must contribute as well.

The real question is do you believe that these spreads are accurately predicting default rates, or simply overshooting in our current crisis.

James Grant had a good piece in the FT about default rates recently I believe.

By DonthelibertarianDemocrat

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Felix also posted a couple replies:

"Posted: Dec 09 2008 3:20pm ET

My point is that you need to combine default probabilities with an opaque risk-aversion function to get credit risk prices. We can use CDS prices as a great way of pricing risk. But how much of that is default probabilities and how much is something else, we don't know.

By Felix"

"Posted: Dec 10 2008 09:39am ET

Let me try one more time: the *price* of credit risk is a *very* important number in financial markets, and the CDS market is the best way of discovering it. The implied probability of default, on the other hand, is basically bullshit, and neither the CDS market nor anything else is going to help you very much on that front.

As for Whalen, his numbers make zero sense to me, sorry, and I think the reason that he's unable to explain them in English is that they just make zero sense, period. I do like the way though that when he stuns an audience into silence, he takes their lack of questions as assent.

By Felix"

"Credit-recovery swaps are trading on the debt of about 70 companies"

I don't know why this strikes me as funny, except that the ingenuity of investors astonishes someone like me who has no such skills. From Bloomberg:

"Nov. 25 (Bloomberg) -- Goldman Sachs Group Inc., Citigroup Inc. and JPMorgan Chase & Co., which helped turn bets on company defaults into a $47 trillion market, are among banks offering wagers on the amount investors may recover from bonds after borrowers go bankrupt. "

First of all, notice the use of the word "wager". Yep, Derivative Dribble isn't going to like that. It sounds a bit like me. Anyway, we now have, are you ready, DRSs, i.e., Default-Recovery Swaps.

Now, given the wonderful explanations on Derivative Dribble, and so knowing that anything on earth that can go up or down and be measured can become a Derivative, I should have expected this.

So, we now have a Derivative on CDSs. Hello.

"Credit-recovery swaps are trading on the debt of about 70 companies, including automaker General Motors Corp. and bond- insurer MBIA Inc. That’s up from 40 during the summer, according to Mikhail Foux, a strategist at Citigroup in New York.

The contracts, barely traded in 2006, are now worth about $10 billion as more companies fail to repay debts, Foux said. Also known as recovery locks, the agreements are bought as insurance by sellers of credit-default swaps, such as banks, hedge funds and insurers."

So, DRSs=Recovery Locks. They are an insurance policy on CDSs, which are an insurance policy on mortgage defaults. So, I assume, if your CDS doesn't pay, or defaults, then you get paid. I'm getting dizzy.

How long will it take to have insurance on DRSs?

“The market definitely has potential to grow,” Foux said. “As we see more defaults -- and there’s no doubt we’re going to see more defaults -- you’re going to see more recovery swaps trading.”

Try and control your glee, for God's sake. Hey, how can they figure odds on defaults of CDSs, when no one else can? Wouldn't they need to know that to write insurance on them? And how can they trade? That means they're priced. How can you price them without some idea of how many CDSs are going to default?

"Goldman Sachs and JPMorgan officials declined to discuss their role in the market. '

Yeh, some people earlier lost money on these derivatives you're writing derivatives on. It's in the news. Give it a read. And, no, we don't want to be seen profiting on this distress. Can you say "Bad publicity"?

"Securities and Exchange Commission Chairman Christopher Cox blames speculation in credit-default swaps for contributing to almost $1 trillion in global financial losses. Some sellers of the contracts buy recovery locks to protect what they may get back on bonds when companies default. "

How do they know what they might get back?

"Holders of recovery swaps agree to exchange a preset fixed rate for the actual amount received by bondholders after a default. The investor getting the fixed amount will benefit if the payment they get is lower than the rate agreed. "

How are they figuring these things?

"The Oct. 10 derivative industry auction on bankrupt Lehman Brothers Holdings Inc.’s credit-default swaps set a value of 8.625 cents on the dollar for the New York investment bank’s debt, according to Creditfixings.com. '

Okay. You got nine cents on the dollar. Yikes.

"A credit-default derivative seller could have bought a recovery lock to ensure a 20 percent recovery rate on Lehman debt three days before the firm’s Sept. 15 bankruptcy, Foux said. The seller would thus have received 11.375 cents on the dollar from the recovery contract."

That sounds like a better deal, less the premiums and fees. Yep, an extra 11 cents. Good work, if you did that.

"MBIA, of Armonk, New York, trades at a recovery value of about 26.5 cents on the dollar, down from 40 cents at the beginning of the year, Foux said. Detroit-based GM, the largest U.S. automaker, is valued for a recovery of about 15 cents, about half what it was on Jan. 1. "

I'm shocked that they had these things at the beginning of the year. And they were betting on getting back only 40%? At the beginning of this year? And it's only declined 15 cents?

"Many credit-default contracts written early this year assumed a 40 percent recovery rate in pricing deals, Foux said.

MBIA spokesman Jim McCarthy and GM spokeswoman Julie Gibson each declined comment."

No ever comments on these things from the company being "wagered on". I guess if you figure something's going to default, you're not going to bet on getting a lot back.

"Recovery locks for Tribune, the newspaper publisher and broadcaster taken private by billionaire Sam Zell, are trading at about 7 cents on the dollar, down from about 14 cents in September, Foux said. Contracts for MGM Mirage, the biggest casino operator in Las Vegas, are trading at about 27 cents, compared with about 37 cents in September. "

No TARP money, maybe, explains this drop. Or just the general downturn? Can we write Derivatives on government bailouts? Calling Derivative Dribble.

"Tribune spokesman Gary Weitman declined to comment. MGM Mirage spokesman Alan Feldman didn’t immediately return a call seeking comment. "

Do any of these people ever answer their phones?

"Seventy U.S. companies have defaulted through Nov. 11, more than four times as many as in all of last year, according to a Nov. 17 Standard & Poor’s report. "

No Frank Sinatra songs for this year.

“One would expect much lower recovery rates as default rates soar,” Diane Vazza, head of S&P’s global fixed income research group, said in an e-mail. '

Hey, somebody answered an e-mail. I guess the likelihood of default helps determine the recovery rate. Less money to go around when these things settle.

"S&P cited an “inverse correlation” between defaults and investor recoveries in a February 2007 report. "

That's interesting.

"When default rates are less than 2 percent, more than half of defaulted debt recovers more than 70 percent of face value, according to the rating company.

When defaults are greater than 8 percent, more than half such debt recovers less than 40 percent, S&P estimated."

I can only figure that the pool of money to settle is smaller if there are more defaults. Any other explanation?

"Investors use credit-default swaps to protect themselves or speculate on the value of company debt. The market grew 100-fold to more than $62 trillion between 2001 and the end of 2007."

In other words, CDSs can be:
1) Actual insurance
2) A bet on the likelihood of default

It's 2 that troubles the average person. It certainly can be used to determine risk, since that's what 2 is based upon, but most people, I'll wager, see it as a side bet.

"In case of a default, swap sellers must pay buyers the difference between the amount being protected and the value of the defaulted bond, as determined by an industry auction."

In that sense, it's like insurance.

"Specifics about recovery-lock contracts aren’t generally available because they are made privately and don’t trade on an exchange. The contracts date back to 2005, when a Fitch Ratings report said investors were starting to use them to lock in returns after defaults. "

So, this all was beginning in 2005. I wonder if they'll have to be on an exchange going forward?

"The International Swaps and Derivatives Association established standard documents for deals in 2006. The New York- based trade group doesn’t keep records on the size of the market.

“There has not yet been member demand for us to track recovery swaps,” said spokeswoman Cesaltine Gregorio.

“Nobody thought about hedging the recovery rate” when default rates were low and recoveries stable, said Philip Gisdakis, a Munich-based credit strategist at UniCredit SpA."

Wouldn't the demand be to see how they're doing, so that I could invest in them? No average investors need apply. How about just doing it because it interests me?

“Typically, investors thought recovery rates for financial companies should be in the range of 80 to 85 percent,” Gisdakis said. “With Lehman below 10 percent and with other financials at very low recovery rates, that’s something that is completely new.”

Well, yeh, which is why I thought those 40% rates at the beginning of the year were scary.

"Recovery swaps aren’t traded heavily because bid-offer spreads “remain wide,” Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California said in an e-mail. That means it’s hard to find a price that satisfies traders on both sides of a deal. "

I'm surprised that they can be priced at all, with so little information to go on, unless you can correlate these things with other, more definable, numbers.

“It is definitely more of a buy-and-hold security than a traded security in this environment,” Backshall said. "

In other words, it's more insurance than speculation.

"The bid-ask spread for MBIA and GM debt is about 6 percentage points, according to Foux. By comparison, the companies’ credit-default swap bid-ask spreads are about 2 percentage points, according to CMA Datavision prices. "

Now, that interests me. You have an idea about one number, which you base the second on, but the second is iffier. It makes sense, but the spread seems too wide. Oh well.

Have I convinced anyone to buy DRSs?