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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

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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:

"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.

An 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

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Sources:

Bear Stearns Fund Collapse Sends Shock Through CDOs
Mark Pittman
Bloomberg, June 21 2007
http://www.bloomberg.com/apps/news?pid=20601087&sid=ahWfhEJ7dra4&

A 'Subprime' Fund Is on the Brink
KATE KELLY
June 16, 2007; Page B1
http://online.wsj.com/article/SB118195157416137321.html

Bond Risk Rises on Concern Over Bear Stearns Hedge-Fund Losses
Hamish Risk
Bloomberg, June 21 2007
http://www.bloomberg.com/apps/news?pid=20601087&sid=azSulI_FQDkk&

Index With Odd Name Has Wall Street Glued; Morning ABX.HE Dose
CARRICK MOLLENKAMP
WSJ, June 21, 2007; Page C1
http://online.wsj.com/article/SB118239055039342915.html

Thursday, June 21, 2007 | 11:15 AM | Permalink | Comments (38) | TrackBack (1)
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Comments

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

Is this actually the price at which the CDO's trade? My understanding of the Markit system was that their charts reflect the relative cost of insurance on the asset being graphed. No?

Posted by: winjr | Jun 21, 2007 11:22:03 AM