How Might Subprime Issues Unravel?

Is there anything more expensive than reaching for yield?

Its been touch-and-go lately in the subprime sector lately, brought on by the combination of higher interest rates and a blow up in a Bear Stearn’s Hedge Fund. Here’s the latest from Bloomberg:

"Merrill Lynch & Co.’s threat to sell
$800 million of mortgage securities seized from Bear Stearns Cos.
hedge funds is sending shudders across Wall Street.

A sale would give banks, brokerages and investors the one
thing they want to avoid: a real price on the bonds in the fund
that could serve as a benchmark. The securities are known as
collateralized debt obligations, which exceed $1 trillion and
comprise the fastest-growing part of the bond market.

Because there is little trading in the securities, prices
may not reflect the highest rate of mortgage delinquencies in 13
years. An auction that confirms concerns that CDOs are overvalued
may spark a chain reaction of writedowns that causes billions of
dollars in losses for everyone from hedge funds to pension funds
to foreign banks. Bear Stearns, the second-biggest mortgage bond
underwriter, also is the biggest broker to hedge funds."

Let’s have a look at those prices that are schmeiessing Bear Stearn’s fund:

CDO Subprime-backed, sold at 3.6% over Prime 
BBB, BBB minus

chart courtesy of Markit

Ouch! That’s a new low on the ABX BBB minus CDOs, down 40%. This validates the old expression there is "nothing more expensive than reaching for yield."

The weekend edition of the WSJ detailed exactly how Bear ran into trouble:

Bbb"The fund bet a popular index that tracks subprime
mortgages, the ABX, would fall. Late last year and early this year,
those moves bore good returns, says a person familiar with the matter.
Then the tide began to turn. After reaching a low of 62 late in
February, amid
rising numbers of defaults and delinquencies in the
subprime market, the ABX unexpectedly recovered in the months that
followed, reaching 72 in mid-May. It has since gone back down to 61.
This led to losses for Mr. Cioffi.

Mr. Cioffi’s team also bet collateralized debt
obligations, or pools of mortgage-backed bonds, would keep their value.
But some of them fell in value, leading to further losses."

As the above chart showed, the ABX CDOs now trade even lower, at 60.

So much for the theory that pools of risky assets wouldn’t fall. Indeed, it is slowly starting to dawn on people that the Subprime-Loan Risk has increased significantly. Yet another Bloomberg article today:

"The perceived risk of owning low-rated subprime-mortgage bonds created in the second half of 2006 rose to a record as loan delinquencies and mortgage rates climb, according to an index of credit derivatives.

Bbb_minusAn index of credit-default swaps linked to 20 bonds rated BBB- fell 2.9 percent to 62.12, according to Markit Group Ltd. The ABX-HE-BBB- 07-1 index’s previous low of 62.25 came on Feb. 27. An ABX index linked to 20 similar securities from the first half of 2006 remains about 10 percent off a low hit in February.

About $515 billion of securities backed by subprime mortgages were sold last year, according to Arlington, Virginia- based Friedman Billings Ramsey Group. U.S. foreclosure filings surged 90 percent in May from a year earlier, to 176,137, Irvine, California-based RealtyTrac Inc. said today.

Subprime mortgages are made to borrowers with poor or limited credit histories or high debt. Interest rates on the loans are usually fixed for two years, usually at least two percentage points higher than the safest mortgages, and then typically rise 3 percentage points or more unless benchmarks that the rates are tied to decline.

Late payments of at least 60 days, foreclosures and seized property among loans tied to the latest ABX index rose 1.63 percentage points to 8.75 percent in April, after climbing more slowly in the previous two months, Barclays Plc analysts say, based on “remittance reports” bond trustees released May 25. The index had rebounded 18 percent between Feb. 27 and May 14."

Will the liquidity rich markets be able to shake this off? if the Bear fund is the only blow up, I would imagine yes.

However, if there are other funds out there with lurking sub-prime issues like this one, then the deadly derivatives crowd — of which I have not been an active participant — may actually have something ugly to worry about. The Bear Stearns fund was highly leveraged — it was $21 billion long, $9 billion short ($13B net?). On equity of $660 million, that works out to be  about 20 to 1 . . .

UPDATE: June 21. 2007 12:29 pm

There’s an interesting article on the history of the ABX sub-prime indices:

"Founded and run by a former bank credit-trading executive, 45-year-old Lance Uggla, the Markit firm — with the backing of 13 of the world’s biggest banks — is helping turn the opaque world of credit trading into a high-volume and more transparent business. The ABX.HE indexes that it runs are acting as a barometer of the subprime market and also allow investors to trade credit protection against that market.

Markit’s Mr. Uggla came up with the idea to found Markit five
years ago while overseeing credit-trading operations at TD Bank Financial
Group’s TD Securities’ London operations. He noticed how little available
pricing information there was.

At TD Securities, "we were running a global credit-trading group
that had some $20 billion-plus in assets," Mr. Uggla says. "We built the Markit
database to gain insight into credit pricing across the major markets."

He approached the bank with the idea of spinning off his trading
group’s database and the technology behind it as its own company. The
Toronto-based bank signed off on the plan with the caveat that Mr. Uggla had to
find other banks to become investors as well as to send their credit-derivative
pricing to Markit.

A spokesman confirms that the bank supported Mr. Uggla but says
specifics of the deal are confidential.

By 2003, Mr. Uggla had a dozen banks signed up. He sold stakes in
Markit to each founding bank, including Bank of America Corp., Morgan Stanley, Toronto-Dominion Bank and
Goldman. Like other customers, they also must pay fees for Markit’s data. Mr.
Uggla made a critical acquisition in 2003: a database operated by J.P. Morgan
Chase & Co., Deutsche Bank and Goldman. That database keeps a record of
companies, their legal entities and their debt obligations.

- Index With Odd Name Has Wall Street Glued; Morning ABX.HE Dose



Bear Stearns Fund Collapse Sends Shock Through CDOs
Mark Pittman
Bloomberg, June 21 2007

A ‘Subprime’ Fund Is on the Brink
June 16, 2007; Page B1

Bond Risk Rises on Concern Over Bear Stearns Hedge-Fund Losses
Hamish Risk
Bloomberg, June 21 2007

Index With Odd Name Has Wall Street Glued; Morning ABX.HE Dose
WSJ, June 21, 2007; Page C1

Category: Derivatives, Hedge Funds, Psychology, Real Estate

Agflation !

Category: Commodities, Economy, Federal Reserve, Inflation

Crude Remains Strong Despite Inventory Build

Category: Commodities, Energy, Index/ETFs, Psychology, War/Defense

Home Depot has Money for Buybacks, but not Service?

Category: Corporate Management, Retail

Inflation Consensus?

Category: Commodities, Federal Reserve, Fixed Income/Interest Rates, Inflation, Psychology

Rocco DeLuca & The Burden

Rocco DeLuca & The Burden
have put out the most interesting new rock album I’ve heard in some time: I Trust You To Kill Me.

Their sound is original — jangly roots-rock romp laced with bluegrass
and countrified leanings.

I agree with the reviewer who wrote that their bluesy debut album "fairly vibrates on DeLuca’s Dobro steel guitar and throaty wail."

DeLuca careens from influence to influence, paying homage to his predecessors and then going a step further.

The music is flavored with dollops of Jeff Buckley, Coldplay and
most of all, Bron Y-Aur Stomp Led Zeppelin.

I Trust You To Kill Me is one of those rare discs where there in not a single weak cut on the CD.

The band’s Myspace page has four songs to stream.

The band has been opening for the likes of Ben Folds and John Mayer.  The next area show I could find is
Tue Jul 31st 2007, Bowery Ballroom, NY


Videos below

Read More

Category: Digital Media, Music

Media Appearance: Kudlow & Company (6/19/07)

Category: Media

Yahoo! Gone in 12 Months?

Category: Corporate Management, Finance, Financial Press, M&A

Most Over/UnderValued U.S. Housing Markets

Yesterday, we learned that the NAHB Housing Market Index, a gauge of home-builder confidence, declined to its lowest reading since the 1991 recession:


Source: NAHB, Wells Fargo

Given the high inventory still around, its no surprise that all three components of index dropped: Single-family Home Sales fell to 29 (from 31); Traffic of Prospective Buyers droped to 21 from 22; Expected Sales for the next Six Months declined to 39 from 41.

The last time the HMI was this low was in the throes of the 1990-91 recession.

Rather than spend much time on this well-covered report, I want to draw your attention to a little followed report on Home Valuation. I stumbled across this extremely informative analysis, filled with great
info-porn maps (below) from Global Insight and National City

It looks at the regions of the country which have had the greatest home price appreciation and, by their measures, are the most overvalued.

First the good news: less homes are overvalued today than in 2005, when the study found 45% of all homes 23% of homes were overvalued by 45%.

Today, 14% of homes for sale are still overvalued — but by only 25%:


The following shows where the overvalued/undervalued homes are located:


That decrease in overvaluation comes as no surprise: The huge overhang of inventory = price decreases (see  below).

Thus, many of the over-valued regions are becoming a little less overvalued.

But, depsite the hopes of the bottom-callers, there is still a ways to go.


Full Study: House Prices in America – Q1 2007
A Global Insight / National City Corporation, June 2007

2006 Q1 PDF:


additional graphs, and a summary of the report, after the jump

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Category: Data Analysis, Economy, Real Estate

Media Praise for The Big Picture

Category: Uncategorized