Friday, July 6, 2007

Is The Tide Turning?

The first half of 2007 saw a record $1 trillion in junk bond issuance (up 70% from last year), almost all of it going to finance massive LBO's by private equity firms. As the envelope was stretched, more shaky deals made it through until such old stand-by's like PIK bonds (payment in kind, i.e. interest is paid in more bonds, not cash), zero coupons and toggles had to be used to make the deals possible. And then something snapped - as it always does.

A combination of sharply higher interest rates for long Treasurys, a junk mortgage bond meltdown and a slowdown in the US economy is finally pushing on the breaks from the demand side. And not a moment too soon: almost 27% of all new bonds issued were rated CCC, really malodorous junk. In my experience, such highly risky paper almost always runs into serious trouble - and rather sooner than later.

But where was all this demand for junk coming from, at least until recently? Desperate pension fund managers? Greedy 2/20 hedge fund managers? Colluding foreign central banks? Yes, to an extent... But the real boost has come from CLO's, structured finance's equivalent to CDO's for corporate junk, complete with heroic default assumptions, the usual tranche structure and the ultimate transformation of lead into gold by teams of apprentices sorciers. Oh yes, the usual game of turning CCC junk into AAA bonds... and the rest was easy, as we all know by now.

As I wrote in the previous post on CDS's, the tide now appears to be turning. During the past two weeks buyers are less willing to buy junk, driving risk premiums higher. The CDX index tracking high yield bonds with an average B rating has gone from a spread of 250 b.p. to 325 b.p. - a very large move in such a short time. Several deals were altered, re-priced, postponed or cancelled altogether. I am convinced that we have seen the high water mark for high-yield finance, at least for this economic cycle.

What comes next? The buy-out premiums for stocks should narrow significantly, since takeovers and LBO's are now harder to finance. The significance for equities, worldwide, is obvious.

Have a very nice week-end.


  1. Subprime contagion?

    Ohio's attorney general is investigating the role that credit-rating agencies like Moody's played in rubberstamping dicey bonds, report Fortune's Katie Benner and Adam Lashinsky.
    By Katie Benner and Adam Lashinsky, Fortune
    July 5 2007: 11:16 AM EDT

    (Fortune Magazine) -- While Bear Stearns is the most recent financial institution to find itself caught up in the subprime-mortgage quagmire, the three credit-rating agencies - Standard & Poor's, Moody's (Charts), and Fitch - may be the next ones to see their good names dragged through the mud.

    The reason? Ohio attorney general Marc Dann is building a case against them based on the role he believes their ratings played in the marketing of risky mortgage-related securities.

    "The ratings agencies cashed a check every time one of these subprime pools was created and an offering was made," Dann told Fortune, referring to the way the bond issuers paid to get their asset-backed securities (ABSs) and collateralized debt obligations (CDOs) rated by the agencies. These ratings run from AAA for debt with the lowest risk of default all the way down to noninvestment- grade bonds, which many pension funds are prohibited from purchasing in their charters. "[The agencies] continued to rate these things AAA . [So they are] among the people who aided and abetted this continuing fraud," adds Dann.

    Ohio has the third-largest group of public pensions in the United States, and they've got exposure: The Ohio Police & Fire Pension Fund has nearly 7 percent of its portfolio in mortgage- and asset-backed obligations.

    FUGLY! As I mentioned days ago, the Rating Agencies are about to be beat to a pulp just like a very dirty rug. The lawyers are licking their chops!

  2. This was by Russ Winter in Feb. 2007. Boy, has this come home to roost or what?

    How to turn subprime shit into AAA gold CDOs

    As the subprime market comes unraveled we are hearing more and more about collateralized debt obligations (CDOs). CDOs represent the true dark matter of Ponzi finance. In effect these take the junior tranches of mortgage backed pools, and creates a new security. In turn this daisy chain offers another layer of collateral that backs the bulk of the junior tranches, and viola creates even more AAA ratings.

    As an example, let’s work through this starting with the initial mortgage backed security (MBS), taking Novastar’s subprime 2006-05 issue from last fall, when the subprime blow up was still just a proverbial twinkle in your daddy’s eye.

    Notice that even though all the mortgages in this pool are subprime, all of the senior Class A certificates have a AAA credit rating. That’s $1.054 billion, or 82.3% the total $1.280 billion subprime pool. That’s because the losses from the overall pool are given to the bottom of the daisy chain starting with M-10. The difference between the interest of the pass through rate and the payments collected from the mortgage borrowers is put into a reserve to give some cushion to the junior certificates or tranches. Additionally as lenders churned and refied the mortgages in the pool, the senior certs are paid off first. Now these prepayments are falling off significantly.

    During the 2004-2005 hey days of housing bubble, this reserve cushion was sufficient to cover all the losses from foreclosures and thus preserve the bottom of the structure. Note that the rating agencies have a BBB-BB ratings only on a mere $34.5 million or 2.7% (certs M 8-10) of the entire 2006-05 pool. Also note that the pass through rate on the senior A certificates is barely over a Treasury bill. The Libor rate is currently 5.35% thus A certificates only pay 5.50%, compared to this week’s three month T-bill auction rate of 5.171%. Confidence is so high in the collateral, that even M-6 which is cushioned by a mere $45 million in subordinations gets away with Libor plus 45 bp, or 5.80%. Via the magic of collateralization, subprime mortgages heading into crapper have been transformed into securities with near government borrowing costs.

    Incredibly the game doesn’t stop there. The financial sphere has concocted another method (the CDO) of pulling near government ratings (ponies) out of not just the senior A certs mentioned above, but the junior M certs (out of manure) serving as the collateral for the A certs. They create another security from an assortment of the M certificates. In this example of Novastar’s latest CDO issue from just two weeks ago, they use $375 million of these junior tranches, and created $278.7 million more in AAA securities, with $243.7 million of them paying only 5.67% returns.

    The main line of defense for this CDO is the $43.5 million in class D and subordinated notes, which are retained by Novastar, who will absorb the first losses. Looking at the performance of 2006-05, we see 1.97% million of the remaining $1,250 billion pool is already in foreclosure and REO status after only four months. No wonder the subprime market has finally had a wake up call. Incidentally, of the 2006 vintages where NFI has kept the retained notes, they have so far only reserved losses of $10.254 million against just one issue, 2006-01 ($1.030 billion remaining balance), which is showing 5.25% foreclosure and REOs at month 9.

    Lastly is Novastar’s year end balance sheet (and a lot has happened since) just to give readers some context about judging their financial ability to collaterialize these retained issues, and thus stay in the origination biz. Their assets largely consist of mortgages to the tune of $4.187 billion of which only $3.659 million were marked down to market in the fourth quarter. Apparently NFI is asking investors (and skeptics) to believe their large portfolio of securities has sailed through the subprime rout unscathed? If their number were to be accepted in good faith, then NFI shows net assets after subtracting liabilities of $514 million, including $150.6 million in cash. Yes, call me a skeptic on that one: the whole basis for this MBS, CDO arrangement is based on a fantasy pony trail of slippery collateral assumptions. Also and perhaps a sign of the post-Pony times are the $21.5 million real estate owned assets on NFI’s balance sheet, up from $1.2 million last year. If outfits like Countrywide Financial are any indication, this is growing at a fast clip, 14% higher in just the last three weeks for CFC.