What Do DAP and CDOs Have In Common?

Before proceeding with the main subject of this post, I see that many people are still surprised by the ongoing tumble in the AAA-AA tranches of the ABX indices. I explained why this is happening a week ago in "Remember The Buckets".

Simply put, their terrible performance is not a matter of market psychology but mathematical fact derived from their cascade structure. As borrowers default on monthly payments, the small, lower tranches absorb the losses and leave the much larger AAA-AA portions intact. But once the process inexorably moves to seizure, eviction and auction, loan losses mount exponentially because the hits now come from far larger principal losses, not just interest and amortization. The lower tranches immediately become overwhelmed and spill over the entire losses onto the AAA-AA tranches, which make up 80-85% of the CDO amounts.

Let's look at the 2006-1 series of ABX, which is the oldest and most "seasoned", meaning the loans in the underlying CDOs had the most time to settle down. Think of the following charts as a series of buckets from top to bottom, successively filling up with losses and spilling over into the bucket below: BBB- spills into BBB, then into A, AA and finally AAA. Notice the time lag as the BBB- and BBB buckets first "fill up" with losses and then the "break" in the higher rated A and AA tranches, as the big principal losses suddenly spill over into them.



















































The AAA tranche is still holding up, relatively speaking, exactly as we expect. In this most seasoned series, the AA and A tranches are now taking the hits, with the expected time lag. But it won't be long before the AAA is all that is left...
Do the math... including the origination, pooling and underwriting fees that were originally charged to principal and the fees involved in their ongoing maintenance, I won't be at all surprised to see some formerly AAA-AA CDOs going for a panicky 50 cents on the dollar. If that.

Which brings me to today's subject: delayed consumer goods inflation. First some data; price increases from last year, spot month futures.

Soybeans: +76%
Corn: +66%
Wheat: +60%
Oats: +57%
Milk: +50%
Barley (i.e. beer): +50%
Rice: +33%
Coffee:+20%

Crude oil: +53%
DAP (di-ammonium phosphate fertilizer): +69%

Dry bulk cargo shipping rates: +350% (it's not a typo)

What do these prices have to do with CDOs? Nothing, except that raw material price hikes also follow a cascade structure until they reach the consumer, i.e. it takes time for them to be manifested in our local supermarket. At first, wholesalers may work off their cheaper inventories and absorb some price hikes to keep customers happy. We can view that as the equivalent of safety reserves and equity tranches in the CDO structures. Next come the large food processors, who may also abstain from passing the entire price increases to consumers, accepting instead some profit margin erosion to maintain market share. We can view that as the mezzanine tranche. For example, crude oil is at $93/bbl, but gasoline is still retailing as if it were at $70. Refinery margins are horrible, right now.

But once the various inventory, delivery and crop cycles are completed, the merchants and processors will have no choice but to pass the full price increases to the consumer, creating a sudden spike in consumer prices. If the consumer then balks and goes on a consumption freeze (as he will, unless his income rises faster) it will be corporate profit margins that will get squeezed hard. Until recently the consumer could count on easy borrowing to meet extra expenses and sustain price increases to fatten corporate profits; this is obviously no longer the case.

Consumer Food Price Inflation Chart: St. Louis Fed

In my opinion, we are already at the first critical point: price hikes for food commodities are being passed on to the consumer (chart above). We can also observe profit margin squeeze, e.g. WalMart's recent decision to cut prices on thousands of toy and other discretionary items.

The next 2-3 weeks will show if this year the consumer will snub the pre-holiday shopping ballyhoo and simply wait for retailers to panic and slash prices a week before Christmas. I know that's what I will do...

If this happens, you can bet that retailers and wholesalers are going to blow it all back to their suppliers/manufacturers in the form of smaller orders AND demands for lower prices, or at least a freeze. This is when China is going to feel it and given their tremendous overextension in manufacturing capacity and thin profit margins, I strongly believe they are headed for a heap of trouble.