The AAA Trap

Things are snowballing in the (nominally) AAA residential mortgage-backed securities land. As I pointed out two weeks ago and then again just a week ago, the weakness in those tranches is more a matter of structure and time delay, than anything else.

Lo and behold, the AAAs are now getting some serious selling attention, as investors and speculators alike wake up to the ultimate effects of cascaded tranches. (I should point out that ABX indeces are NOT direct bond prices, as some think. They follow credit default swap prices for CDOs; the lower the index, the more expensive the CDS and thus the higher the presumed risk of default.)

Here is the set of all AAA ABX tranches...

Real money investors (e.g. pension funds) who bought into this AAA sub-prime trap are now in a bind. They thought they were buying gold-plated bonds but are now stuck with securities whose value is melting away with no bid underneath. Turns out, you can't make silk purses out of sows' ears, after all.

Where does this leave the Fed? After yesterday's plunge in stocks the air is full once more with calls for them to cut, cut, cut. Two decades of regular pilgrimages to the temple of Fed The Saviour has resulted in financial invalids, rogues, mountebacks, conjurers and snake oil merchants expecting that their Lourdes is located at 33 Liberty Street in Manhattan.

But what if the Fed's own juju majik, even if supplied in copious quantity, fails to miraculously grow new limbs for the credit amputees? Will they pitifully gather outside the massive faux Renaissance palazzo, begging for miracles and alms? Some have already been unceremoniously defenestrated (e.g. Merrill and Citi CEOs), though their golden parachutes made the decent rather comfy.

The trip down will not be as painless for plain shareholders and creditors.

P.S. The ABX/CMBX situation is now quite well understood - if not by the populace at large, at least by the more informed. But the CDX, iTraxx and LCDX indeces tracking corporate bonds and high-yield loans are not yet discussed as much. I believe the market is still underestimating the extent of the trouble in the corporate sector.