The title need not be too clever on this one. In case you have been under a rock for the last week, on vacation, or at the Calgary Stampede taking in some sweet country tunes, this has been an incredible week on the markets. We've seen oil drop from record highs by more than $10 a barrel, only to shoot up again to new records (thanks a bunch Iran and Nigerian rebels). We've seen incredible volatility in both the credit markets (see London on Tuesday for further reference), and astounding drops in equity values across the board in financials, consumer cyclicals, and well, anything with any exposure to the rapidly souring economy. It hasn't been too positive. The sentiment on the street is almost universally bearish.
By far, the biggest story of the week, and potentially one of the bigger stories of the year is the rapid and almost unbelievable fall in the share prices of Fannie Mae and Freddie Mac. The Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) have seen their share prices plunge this week. Fannie closed at $9.96 on Friday, while Freddie closed at $7.75. They opened the week at 19.76 and 15.08 respectively. Their 52 week highs have been $70.57 and $67.20 - an unbelievable erosion of shareholder value. These are the lowest values seen in 16 years.
Fannie and Freddie have been mortgage industry stalwarts since 1968 and 1970 (when the became private corporations - Fannie had been around since 1938 as a government-owned entity). Fannie and Freddie have the unique distinction of having the implicit backing of the U.S. government, and hence, have been thought to be immune to the more wild swings in the market. As a result of this backing, they have been historically able to borrow at very low rates over the benchmark Treasury (about a 1/8th spread over Treasuries). Fannie and Freddie's bonds now yield about .78% over Treasuries - the spread has doubled since last summer. The CDS on Fannie and Freddie has jumped about 20% this week alone. The 5 years now trade at about 78 bp a piece. That is, it costs $78,000 to insure $10m of notional per year.
Fannie and Freddie were created to ensure easy access to home mortgages. The Congressionally-chartered institutions have become critical pegs in the financial system, and currently own or guarantee about $5.2 trillion worth of U.S. home mortgages. That is actually half of all US mortgages currently outstanding. Now, as has been well documented, the subprime and housing crisis that has hit the U.S. in the past year has reduced the much of the value of the assets on Fannie and Freddie's balance sheets. Simply put, many Americans are not keeping up on their mortgage payments, and Fannie and Freddie are starting to see less inflow of cash. To make matters worse, the value of the homes if seized in foreclosure has fallen dramatically from a few years ago. So the two companies are getting hammered at both ends. It's not a pretty picture to say the least.
Thus, with the value of assets on the balance sheet rapidly eroding, it's become clear that FNM and FRE will have to raise more capital. They have already recorded combined losses of about $11 billion this year. That includes losses realized on the sale of foreclosed homes, provisions for future loan losses, as well as the downward revision of the value of mortgages and related securities. These losses will most definitely be added to in the future. Fannie has already issued capital to the tune of $7.4 billion in April, while Freddie is in the process of raising about $5.5 billion. One major problem facing the two companies right now is that they have not been required to hold much capital in the past due to the fact that regulators never fathomed a situation of widespread defaults (like this) occurring. With every massive drop in the value of the common shares, it becomes harder and harder to issue new shares, due to the effect of dilution.
There are a number of possibilities for Fannie and Freddie. One is that the Fed might purchase a bunch of the mortgages from the company, thereby alleviating some of the immediate pain, and shifting the burden to taxpayers. Another, more drastic option, would be to the firms into conservatorship, which would transfer ownership directly to the government. Still another option includes an infusion of private equity capital; however, this is less likely given the huge exposure FRE and FNM have to the housing market, and the tight regulations by which they must abide. Although these options would be explored as a last resort, it's becoming increasingly likely that there will need to be some form of government intervention. The downside risk of these two behemoths failing is stunning, and regulators, politicians, and pundits have all agreed that the government cannot let Fannie and Freddie fail.
One thing that Hank Paulson and the government does not want to do is incentive risk-taking. They do not want to create a moral hazard as they arguably did in the case of Bear Stearns (although Bear shareholders lost so much money, it can be argued that no moral hazard was really created). The implicit guarantee by the government has created an awkward situation, as shareholders have long believed that the companies will be rescued in a crisis, which has allowed the two companies to borrow at very favourable rates. Many would argue that it is these same profit-oriented investors who should feel the brunt of the pain now, as they for years have enjoyed steady dividends and capital appreciation provided by Fannie and Freddie.
In other the-world-might-or-might-not-be-ending news, the government on Friday announced that it was seizing IndyMac Bank. It is the 3rd largest bank failure in U.S. history. The collapse is expected to result about $4 to $8 billion in costs for the FDIC (Federal Deposit Insurance Corp). This could constitute about 10% of the fund's $53 billion deposit-insurance fun. Funny/sad story on this one. A few days ago, Democrat Chuck Schumer sent a letter to the Office of Thrift Supervision (the regulator) questioning the solvency of the bank. Of course, that's not the wisest thing to do in a situation like this, and investors promptly withdrew $1.3 billion in deposits from the bank. Schumer's comments, though, were only the large straw that broke the camel's back. IndyMac has been in trouble for months. The bank specialized in Alt-A mortgages, which are given to people who don't need to fully document their incomes or assets. Surprise, surprise, this didn't turn out so well for them. The bank will be reopen on Monday. The FDIC will provide about $100,000 per depositor. About $1 billion of the deposits were uninsured, so about 10,000 investors will get the shaft. Long story short, add IndyMac to the list of institutions to get absolutely smoked as a result of the subprime crisis. There will be more to come.
Friday, July 11, 2008
Sunday, July 6, 2008
Credit Default Swaps
To this point, this blog has focused largely on the stock market and on stock-related things. However, the stock market pales in comparison to the fixed-income market. As of 2006, the fixed income market's size was an estimated $45 trillion. The vast majority of this market trades OTC (over the counter). That is, bonds and fixed income securities are not generally traded on an exchange as stocks are. They are instead carried out by market makers, using inter-dealer trading programs. Thus, the fixed income market doesn't often get much recognition in the financial press (except for when the assets underlying a structured product - like a subprime asset-backed security - blowup), as it is not as visible to the average Joe Public.
So this market is not as visible to you or me, unless you are working on the credit trading floor of an investment bank (in which case, you can probably skip the rest of this blog, and go wait for the rain delay in the Wimbledon finals to end). So, if it's not as visible, what is it all about? Well, basically, banks create a market for these securities by matching buyers and sellers. They make their cut on the bid-offer spread. Think of this as the commission the dealers make in return for providing liquidity. What are they trading you ask? Well, they are trading everything. Some desks trade corporate bonds, while others government bonds, or municipal bonds, etc. Often times though, a company will issue many bonds. Each of these bonds is subject to a variety of risks: credit risk, interest rate risk, and foreign exchange risk.
So with all these different types of debt floating around, how do we isolate the credit risk (the risk of default) for a certain company? Well, in 1994, in London, a JP Morgan employee formulated an answer in the credit default swap (CDS). The CDS is essentially a form of insurance on a company's credit (read: debt). It is an OTC contract between two parties, and it allows you to go long or short on the risk that the company has a credit event (bankruptcy, default, restructuring). The basic structure of a CDS is as follows. Party A buys protection from Party B on a reference entity (call this reference entity a bond issued by Company TML). Party A pays party B a periodic payments (say every year) in return for the guarantee that if there is a credit event on TML Co's debt, Party B will return the full face/par value to Party A. In other words, Party A is selling risk, and Party B is buying it. If no credit event occurs during the life of the contract (typically 5 years), then Party B will have to do nothing, and will have received a nice yield. If TML Co's defaults on its debt (because it can't sell enough tickets now that Mats Sundin is gone, and it can't pay the interest on its debt), then Party A delivers the defaulted company's debt and gets 100 cents on the dollar from Party B (i.e., par value). One of the beautiful aspects of the CDS is that neither company needs to actually own TML's debt. That is, you don't need to own the underlying in order to buy or sell credit risk on said entity.
The payment that Party A (the buyer of protection a.k.a the seller of risk) makes to Party B (the seller of protection a.k.a. the buyer of risk) is measured in basis points. This premium is often referred to as the spread. The spread is, as mentioned, paid in basis points per annum and is usually paid quarterly. For instance, if 5-year protection for AT&T bonds are trading at 200 basis points, in order to protect a $10 million notional exposure to AT&T bonds, you'd have to pay 50 bps every quarter, or $50,000 each quarter on the $10 million notional.
If you're a keen observer, you'll have said, "hey, wait a minute here chief, why the hell are you calling this a spread, it's not at all like the yield spread of a corporate bond over a government bond". To which I would respond, "yes, that is correct, thank you for your concern." CDS spreads, as you can see from the example above, are not based on any risk-free bonds or benchmark interest rates. They are simply the annual price of protection on a reference entity, quoted in basis points (bps).
If it helps, try to think of a CDS as a put option written on a corporate bond. The protection buyer is protected from losses resulting from a decrease in value of the bond resulting from a credit event. Therefore, you can look at the CDS spread as the premium on the put option. This premium is spread out over the life of the contract.
As I mentioned earlier, the CDS allows for the isolation of credit risk. The CDS also provides liquidity to the markets, as the contracts are standardized, and concentrated around certain maturities (5-year being the most common). These two factors have helped make the CDS market worth about $45 trillion in 2007. The explosion of CDS-related instruments in the past few years has been helped by the creation of CDS-indices around the world. In Europe, the main index is iTraxx. The iTraxx Europe CDS index is used as a benchmark, and is composed of 125 equally weighted names as selected by a poll of financial dealers (the dealers select the CDSs based on volume traded over the last 6 months). Each 6 months, a new series is issued.
There are 1, 3, 5, 7, and 10 year maturities. Put them all together, and you get a nice little curve. If the curve flattens (that is, the premium paid on 1-year CDSs is roughly similar to that paid on 7 or 10 year CDSs), it is a bearish scenario, as investors believe that there will be more defaults in the short term. This is quite bizarre if you think about it, as it means that investors are worried about credit events in the immediate term. Naturally, you'd think that given a long time frame, there'd be more probability of a negative credit event. So when the curve flattens, or even inverts, it's not a great sign.
One of the other interesting aspects of credit default swaps alluded to earlier is that leverage can very easily be utilized. This is because a CDS does not require funding initially. In other words, you have to only commit a portion of the capital of the notional. As all good finance students know, leverage can be both good and bad, so it's important to be careful with credit default swaps. In order to reduce your risk, you can hedge by buying protection at a certain level on a reference entity, and sell protection on the same reference entity, at either a different spread, or a different maturity.
So basically, you now know how credit default swaps work. If tomorrow Ford comes out with an announcement about how bad U.S. auto sales are, you can be darn sure that the CDS spread on its debt will increase, as there is a greater chance of default. That is, it will cost you more to buy protection on it, as the risk of default is higher.
CDSs are incredibly useful tools for hedging risk, and a great deal of money can be made using these derivatives. With the market in its current state, the volatility of CDS contracts is extremely high, which makes for an incredibly fascinating time. Keep a close eye on credit default swaps, as I guarantee you'll be hearing more of them.
So this market is not as visible to you or me, unless you are working on the credit trading floor of an investment bank (in which case, you can probably skip the rest of this blog, and go wait for the rain delay in the Wimbledon finals to end). So, if it's not as visible, what is it all about? Well, basically, banks create a market for these securities by matching buyers and sellers. They make their cut on the bid-offer spread. Think of this as the commission the dealers make in return for providing liquidity. What are they trading you ask? Well, they are trading everything. Some desks trade corporate bonds, while others government bonds, or municipal bonds, etc. Often times though, a company will issue many bonds. Each of these bonds is subject to a variety of risks: credit risk, interest rate risk, and foreign exchange risk.
So with all these different types of debt floating around, how do we isolate the credit risk (the risk of default) for a certain company? Well, in 1994, in London, a JP Morgan employee formulated an answer in the credit default swap (CDS). The CDS is essentially a form of insurance on a company's credit (read: debt). It is an OTC contract between two parties, and it allows you to go long or short on the risk that the company has a credit event (bankruptcy, default, restructuring). The basic structure of a CDS is as follows. Party A buys protection from Party B on a reference entity (call this reference entity a bond issued by Company TML). Party A pays party B a periodic payments (say every year) in return for the guarantee that if there is a credit event on TML Co's debt, Party B will return the full face/par value to Party A. In other words, Party A is selling risk, and Party B is buying it. If no credit event occurs during the life of the contract (typically 5 years), then Party B will have to do nothing, and will have received a nice yield. If TML Co's defaults on its debt (because it can't sell enough tickets now that Mats Sundin is gone, and it can't pay the interest on its debt), then Party A delivers the defaulted company's debt and gets 100 cents on the dollar from Party B (i.e., par value). One of the beautiful aspects of the CDS is that neither company needs to actually own TML's debt. That is, you don't need to own the underlying in order to buy or sell credit risk on said entity.
The payment that Party A (the buyer of protection a.k.a the seller of risk) makes to Party B (the seller of protection a.k.a. the buyer of risk) is measured in basis points. This premium is often referred to as the spread. The spread is, as mentioned, paid in basis points per annum and is usually paid quarterly. For instance, if 5-year protection for AT&T bonds are trading at 200 basis points, in order to protect a $10 million notional exposure to AT&T bonds, you'd have to pay 50 bps every quarter, or $50,000 each quarter on the $10 million notional.
If you're a keen observer, you'll have said, "hey, wait a minute here chief, why the hell are you calling this a spread, it's not at all like the yield spread of a corporate bond over a government bond". To which I would respond, "yes, that is correct, thank you for your concern." CDS spreads, as you can see from the example above, are not based on any risk-free bonds or benchmark interest rates. They are simply the annual price of protection on a reference entity, quoted in basis points (bps).
If it helps, try to think of a CDS as a put option written on a corporate bond. The protection buyer is protected from losses resulting from a decrease in value of the bond resulting from a credit event. Therefore, you can look at the CDS spread as the premium on the put option. This premium is spread out over the life of the contract.
As I mentioned earlier, the CDS allows for the isolation of credit risk. The CDS also provides liquidity to the markets, as the contracts are standardized, and concentrated around certain maturities (5-year being the most common). These two factors have helped make the CDS market worth about $45 trillion in 2007. The explosion of CDS-related instruments in the past few years has been helped by the creation of CDS-indices around the world. In Europe, the main index is iTraxx. The iTraxx Europe CDS index is used as a benchmark, and is composed of 125 equally weighted names as selected by a poll of financial dealers (the dealers select the CDSs based on volume traded over the last 6 months). Each 6 months, a new series is issued.
There are 1, 3, 5, 7, and 10 year maturities. Put them all together, and you get a nice little curve. If the curve flattens (that is, the premium paid on 1-year CDSs is roughly similar to that paid on 7 or 10 year CDSs), it is a bearish scenario, as investors believe that there will be more defaults in the short term. This is quite bizarre if you think about it, as it means that investors are worried about credit events in the immediate term. Naturally, you'd think that given a long time frame, there'd be more probability of a negative credit event. So when the curve flattens, or even inverts, it's not a great sign.
One of the other interesting aspects of credit default swaps alluded to earlier is that leverage can very easily be utilized. This is because a CDS does not require funding initially. In other words, you have to only commit a portion of the capital of the notional. As all good finance students know, leverage can be both good and bad, so it's important to be careful with credit default swaps. In order to reduce your risk, you can hedge by buying protection at a certain level on a reference entity, and sell protection on the same reference entity, at either a different spread, or a different maturity.
So basically, you now know how credit default swaps work. If tomorrow Ford comes out with an announcement about how bad U.S. auto sales are, you can be darn sure that the CDS spread on its debt will increase, as there is a greater chance of default. That is, it will cost you more to buy protection on it, as the risk of default is higher.
CDSs are incredibly useful tools for hedging risk, and a great deal of money can be made using these derivatives. With the market in its current state, the volatility of CDS contracts is extremely high, which makes for an incredibly fascinating time. Keep a close eye on credit default swaps, as I guarantee you'll be hearing more of them.
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