This is not a political blog.  That’s not to say that I don’t have opinions on politics, but I try to keep them off my blog for the most part.  But, as Bloomberg notes, why aren’t any of the major candidates talking about the credit crisis?  There’s a simple answer: no one has a solution to an intractable problem, and so they say nothing.

Part of this is the Faustian bargain that politicians of both parties have regarding the economy.  They like to provide the illusion that their policies produce prosperity, and take credit for it, while being quiet when the economy is poor, unless they can blame it on the other party.

Personally, if I were Obama or McCain, I would be concerned about what I would do about the problem if I were elected.  Wait, I would tell people there’s not a lot that can be done aside from increasing immigration on a controlled basis.  But that doesn’t get votes in the US, because we are biased toward action, even if it is useless or harmful.

Things look grim for Fannie and Freddie, if market reaction is the benchmark.  The action in their stocks, preferred stocks, and subordinated debt was ugly on Monday.  Not only did you have the article in Barron’s, which made the case that the equity of the firms wasn’t worth much, but you had selling of their senior debt, and guaranteed MBS by foreign investors.  It may not be that Fannie and Freddie fail, but that they get recapitalized by the government in a way that massively dilutes the equity.  Or, going back to my old idea, they get nationalized and become part of GNMA.  The equity and preferred stock go out worthless, and the subordinated debt gets some sort of haircut (partial conversion to senior, plus an earn-out based off the losses the the government has to bear).  I’m not sure a bailout is inevitable, but the odds are rising.

Now, Fannie and Freddie have been through a lot in the last three weeks.  Freddie has changed servicer guidelines possibly in an effort to forestall current period losses.  They have also both reported huge losses:

Freddie:

• Credit losses are in their early phases.
• The Alt-A loans look horrid.
• Reported a large loss.  This brought them to a negative net worth for GAAP purposes, even counting in the questionable deferred tax asset.  With the negative fair value net worth, aside from the US government, who would pump in capital?  They want to raise 10 billion, but it is hard to raise more than your market cap — the dilution kills.

Fannie:

• Posts a big loss.  Stops buying Alt-A securities.
• Warns that July was worse than June.
• FBR suggests that Fannie needs $5-10 billion in capital, and the market behaves as if it is true.

Then there is the insult added to injury, as S&P downgrades the preferred stock and subordinated debt.

So, after all of this, we should steer clear of the securities of Fannie and Freddie?  Steer clear of the common and preferred stocks, yes.  Subordinated debt, I’m not sure, but when I’m not sure, I don’t take positions.

Now, the senior debt is another matter.  Spreads are very wide, and the possibility of nationalization is significant.  As Accrued Interest says:

The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don’t know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury’s next move is.

I agree, and when I was a bond manager with a good thesis, I would ask which bonds offered me the best advantage.  This article ends with an idea that is practical to some institutional fixed income managers.  Both Fannie and Freddie have a small amount of long non-callable zero coupon bonds.  These bonds will have a significant rally in the case where the US government nationalizes them.  And, if the US government decides to let them slip into default, well, you are buying them at 20-35 cents on par value.  No way in an insolvency you get less than that.

The worst case scenario is that long interest rates rise generally, and the zero coupon bonds get killed.  Sophisticated managers could sell short Treasury zeroes to hedge.

PS — Now, as I wrote this, the estimable Jeff Miller put up a good post on the GSEs.  It is worth a read.

UPDATE — 11 AM 8/19

Manto’s comment below is correct, and I apologize.  Bonds originally issued as discount bonds have bankruptcy claims equal to their accreted value.  Bonds issued at par, that subsequently become discount bonds have a claim value of par.  Why did I make this mistake?  I improperly generalized from my experience trading discount bonds, and other structures (such as zero-to-full bonds created from bonds originally offered at par) where the claim would be par in bankruptcy.

A large-ish number of people have asked me to write this piece.  For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.  For those without access, Barry Ritholtz put a large portion of it at his blog.  (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.  I don’t know, liking the market from 2004-2006 was a pretty good idea in hindsight.

I then wrote another piece applying the framework to residential housing in mid-2005, and I came to a different conclusion  — yes, residential real estate was near its top.  My friends, being bearish, and grizzly housing bears, heartily approved.

So, a number of people came to me and asked if I would write “The Fundamentals of Market Bottoms.”  Believe me, I have wanted to do so, but some of my pieces at RealMoney were “labor of love” pieces.  They took time to write, and my editor Gretchen would love them to death.  By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.  They really made my writing sing.  I like to think that I can write, but I am much better when I am edited.

Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.  Tops and bottoms are different primarily because of debt and options investors.  At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.  Option investors get greedy on calls near tops, and give up on or short puts.  Implied volatility is low and stays low.  There is a sense of invincibility for the equity market, and the bond and option markets reflect that.

Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.  They spike multiple times before the bottom arrives.  Investors similarly grab for puts multiple times before the bottom arrives.  Implied volatility is high and jumpy.

As a friend of mine once said, “To make a stock go to zero, it has to have a significant slug of debt.”  That is what differentiates tops from bottoms.  At tops, no one cares about debt or balance sheets.  The only insolvencies that happen then are due to fraud.  But at bottoms, the only thing that investors care about is debt or balance sheets.  In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.

I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.  In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.  I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.

Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.

		David Merkel
		Housing Bubblettes, Redux
		10/27/2005 4:43 PM EDT

From my piece, “Real Estate’s Top Looms“:

Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow’s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.

As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.

I’m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.

That’s why I think the hot coastal markets are bubblettes. My position hasn’t changed since I wrote my original piece.

Position: none

I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.  But what of market bottoms?  What is financing like at market bottoms?

The Investor Base Becomes Fundamentally-Driven

1) Now, by fundamentally-driven, I don’t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.

2) Fundamental investors are quiet, and valuation-oriented.  They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.

3) But at the bottom, even long-term fundamental investors are questioning their sanity.  Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.  In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.

4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.

5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.

6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.  M&A volumes are small.

7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven’t morphed into permabears.

8 ) Value managers tend to outperform growth managers at bottoms, though in today’s context, where financials are doing so badly, I would expect growth managers to do better than value managers.

9) On CNBC, and other media outlets, you tend to hear from the “adults” more often.  By adults, I mean those who say “You should have seen this coming.  Our nation has been irresponsible, yada, yada, yada.”  When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.  The “chrome dome count” shows more older investors on the tube is another sign of a bottom.

10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.

11) Value investors find no lack of promising ideas, only a lack of capital.

12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.  They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.

13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot — e.g. money market funds, collectibles, gold, real estate — they chase the next trend in search of easy money.

14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.

Changes in Corporate Behavior

1) Primary IPOs don’t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.

2) Private equity holds onto their deals longer, because the IPO exit door is shut.  Raising new money is hard; returns are low.

3) There are more earnings disappointments, and guidance goes lower for the future.  The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying “So what else is new?”

4) Leverage reduces, and companies begin talking about how strong their balance sheets are.  Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.  The weakest die.  Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.

5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.  As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.

6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.

7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.

8 ) High quality companies keep buying back stock, not aggresssively, but persistently.

Other Indicators

1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.

2)The Fed adds liquidity to the system, and the response is sluggish at best.  By the time the bottom comes, the yield curve has a strong positive slope.

No Bottom Yet

There are some reasons for optimism in the present environment.  Shorts are feared.  Value investors are seeing more and more ideas that are intriguing.  Credit-sensitive names have been hurt.  The yield curve has a positive slope.  Short interest is pretty high.  But a bottom is not with us yet, for the following reasons:

• Implied volatility is low.
• Corporate defaults are not at crisis levels yet.
• Housing prices still have further to fall.
• Bear markets have duration, and this one has been pretty short so far.
• Leverage hasn’t decreased much.  In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
• The Fed is not adding liquidity to the system.
• I don’t sense true panic among investors yet.  Not enough neophytes have left the game.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they’re better than nothing, and kept me in the game in 2001-2002. I hope that I — and you — can achieve the same with them as we near the next bottom.

For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.  Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.  This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).  There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.  In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company — it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.

As for asset allocators, time to begin edging back into equities, but I would still be below target weight.

The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.  That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.  Long only investors must play defense here, and there will be a reward when the bottom comes.

I appreciated Steve Waldman’s article at his excellent blog Interfluidity, which was also posted at Naked Capitalism.  I have a slightly different take on the topic, which I expressed in the comments section of each blog:

Steve, I think we had two, maybe three things go on here. First, the “originate to sell” model failed because basic underwriting was not done well. The incentives against failure were not left with the originator, i.e., having to hold onto a large equity piece.

If the underwriting had been done well, the next problem would be weak financing structures on the part of the certificate buyers. Many were leveraged higher than prudent, even on “super seniors.”

Finally, the servicing models are often flawed. There has to be adequate pay for servicing and special servicing, or else loss mitigation efforts will be poor.

Risks were taken and avoided, but many of the seemingly avoided risks come back when the one guaranteeing the avoid risk cannot perform.

It is true that there was a lot of demand for AAA assets, but there was also a lot of demand for mezzanine and subordinated assets out of complex debt structures.  Within all investor classes, there was a hunger for excess yield, whether it was a little extra at the AAA level, or a lot extra for subordinated and equity levels.

The demand for AAA assets, whether senior or super-senior, was often driven by leveraged investors, seeking to profit from being able to arbitrage the AAA securities versus their funding rate.  Safe assets were turned into unsafe assets by the added leverage.

And in this sense, the rating agencies are culpable, because they let the concept of a AAA, which means capable of surviving a depression, drift to a lesser standard.  They trusted simple mathematical models, and did not spend enough time on the quality of underwriting.  Of course, that takes time, and profits for the rating agencies comes from cramming as many deals out the door as they can.  That is, if you don’t care about your franchise.

When I was a mortgage bond manager, I spent time on any deal, even at the AAA level by asking, “Who has skin in the game?”  If they were credible underwriters, I had greater comfort, but if the originator was selling and retaining little exposure to the outcome, I did not tend to buy.

Deal structure cannot make up for bad underwriting, usually.  Lousy assets lead to lousy returns for everyone in the capital structure.  I have owned AAA assets that have gone into default.  In every case, lousy underwriting of the original debts, not a bad economy, was the cause of the problem.

The entire period 2004-2007 was characterized by low spreads, as a hunger for yield depressed yields on newly issued corporate and structured debts.  Now we are facing the true value of those debt promises.

Of course after too much risk is taken, the regulators come along and say, “We must tame this!  No more excessive risk taking by investment banks because that leads to systemic risk.”  jck at Alea pokes at the recent efforts to do so, and if you look at the comments, I agree.

It is impossible to separate the desire for high returns from high risk-taking.  Having been a risk manager inside insurance companies, I read with some sympathy this article from The Economist.  Substitute actuary for risk manager, and marketer for trader, and the same situation plays out in insurance companies every day.

The only place that I have worked in that solved the problem bonused both marketers and actuaries on the same formula, offering slightly more reward from sales to marketers, and risk-adjusted profits to actuaries.  It got both sides on the same page, because they were compensated similarly.  I told the head of that division that he was fortunate to have business-minded actuaries.  He choked on his drink when I suggested that we were cheap for what he was getting.

My view is that investors did take too much risk 2004-2007.  They did it in many ways, by not underwriting properly, by levering up too much, by not servicing properly.  We are paying for that now.

This post is not meant to be a fair rendering of the recent housing bill.  It is meant to be a rendering of its faults.  Part of the difficulty here is the effort that would go into reading page-by-page the whole document.  My guess is relatively few legislators read the full document, and even staffers would have had a hard time making their way through it.

Now for “unbiased” renderings, I offer you:

• NPR
• MarketWatch
• Associated Press

The basic rendering of the bill revolves around the following:

• Help to Fannie Mae and Freddie Mac from the Treasury if they need it.  (Together with a supposedly stronger regulator)
• Refinancing help for homeowners under stress from the FHA.
• Grants for municipalities to buy abandoned properties.
• Housing tax breaks, including a credit to first time buyers.
• Money for pre-foreclosure counseling and legal services.
• Some profits from Fannie and Freddie will build affordable rental housing.  (They already do this…)

Unfortunately, our dear government has a tendency to give with the right hand, and take with the left.

• The bill eliminates down payment assistance programs, which is a good thing because those that get the assistance default more.  They don’t have the requisite maturity to own homes, with help, or without it.  (Also here.)  But it cuts down on housing demand in the short run.
• The effective mortgage rate from the FHA for refinancing will be high, around 8%.  That won’t help many people.
• The tax credits are no interest loans which have to be paid back over the earlier of 15 years, and when the house is sold.  That’s worth 10-20% of the nominal value.
• The GSEs get crisis funding, but also get their wings clipped.

Beyond that, the hybrid nature of the GSEs is retained, which is a source of some of the troubles.  Mixed economic motives tend to lead to irrational decisionmaking, which implies credit losses.

Finally, I will close with the idea that condemnation and destruction of buildings is a lousy strategy.  It is lousy, because it would be better to allow for bidding on the part of private entities to use the building and space.  Why drop the value to zero, when you can take the valuable property, and put it to its best alternative use?

In summary, this bill will cost a lot less than its sticker price advertised to the American people.  There is lots of show, and less go.  Personally, that makes me thankful, because the budget can’t bear with aggressive programs that cost a lot.  It really looks like the Republicans won on this one, and that leaves me puzzled, because the Democrats should have had the upper hand.

Today’s FOMC meeting is largely a done deal.  No moves, but sound hawkish.  Personally, if I were in their shoes, I would move the Fed Funds target to 2.05%, just enough to weird the markets out, but not enough to do any real damage to those who rely on Fed Funds.  Creating uncertainty through breaking the convention on quarter percent moves would be good for the market, because market players have gained a false confidence over what the Fed can and can’t do.

The thing is, the Fed is boxed in, like many other central banks.  A combination of rising consumer prices, rising unemployment, and a weak financial sector will compel them to stay on the sidelines for now.

Now, as for Saturday’s post, I received a number of responses asking me to explain my views.  Here goes:

1) I’m not a gold bug; I have no investments in gold, or metals generally at present.  Any liking that I have for a gold standard is that it gets the government out of the business of manipulating the economy through manipulating the money supply.  Currency boards, pushed by my old professor, Dr. Steven Hanke, are another good idea.

2) Where am I on inflation/deflation?  We are experiencing goods and services price inflation, asset deflation, and a monetary system where the Fed is not increasing the monetary base, but the banks are expanding their liability structures over the last year, but that may have finally peaked.  Consider this graph:

There is a limit to how large the liabilities of the banking system can get relative to the Fed’s stock of high-powered money.  We reached that limit in the first four months of 2008, and now banks seem to be focusing on survival.

It is very hard to reflate bubbles — you can’t build an economy on sectors that are credit impaired, which makes me think that the housing stimulus ideas will likely fail.

3) The Fed is in a box.  They have no good policy options now.  They are stuck between rising (or at least high) inflation, rising unemployment, and the banks are not strong.  Fortunately the US Dollar has been showing a little more strength, but that’s probably anticipating the hawkish tone of today’s announcement.  If the statement is insufficiently hawkish, I would expect the US Dollar to weaken.

4) I expect goods inflation to persist in a moderate way over the intermediate-term, unless the main US Dollar pegs are broken (Gulf States, China).  Presently, we import a little of the inflation that the rest of the world is experiencing mainly through energy, and energy related commodities, like fertilizer.

5) Globalization does restrain wage growth on the low end.  On the high end, it is likely a benefit, and in the middle, probably neutral.  Those who benefit the most are those who are able to use relatively cheap labor for unskilled tasks.  But technological change also affects job prospects in different industries.  My view on steel is that the industry shrank mainly due to technological improvements at the lower cost mini-mills.

6) As for the GSEs, banks, and the investment banks, the Fed would be challenged to raise rates much.  At present, the positively sloped yield curve is allowing some banks to repair by borrowing short and lending long.  That is a good trade for now, but will be prone to trouble if the Fed ever concludes that it has to shift to fighting inflation, and not just put on a rhetorical show.

7) Finally, we have some degree of restiveness among the hawks on the FOMC.  I would expect two (or so) dissents favoring tightening today, but now with the current cast of ten (counting Elizabeth Duke, a banker), but if we get four, which is not impossible, I think it would unnerve the markets.  Mishkin is leaving at the end of August, and the custom is that he attends but does not vote at his last meeting.  (For more on FOMC dissents, I have this article.)

Well, let’s see what the FOMC has to say.  After all, at present, they are all talk.

In the midst of a loosening cycle, the Fed keeps the monetary base flat.  This is not normal.  Instead, they use their high-quality balance sheet to bail out the liquidity problems of banks, broker-dealers, and maybe others, all while not expanding high powered money.  This is not normal, either.  After all, the Fed wants to heal the providers of badly underwritten credit (and increased their efforts last week, also here, here, and here), but they don’t want any liquidity to spill over into the general economy, because it might spark a wage-price spiral.

Consider the efforts of the Treasury toward Fannie, Freddie, the banks, and the housing market generally.  Yes, they are trying to avoid systemic risk, and that’s important.  But where is the support from the Fed and Treasury over unemployment, which is beginning to grow currently.  I’m not just talking about more unemployment, but about less compensation growth for labor in total.  Their focus is away from that, and looking at stabilizing a financial structure.  That’s good for all of us, but a disproportionate amount of the benefits goes to enterprises that made bad loans.  My rules of bailouts say that you must make bailouts painful to management teams and shareholders, while protecting senior debt, and thus preventing systemics risk.  That is not what is going on here.

I’m no great fan of central banking; I believe it makes our economy more stable in the short run, but intensifies crises when they take place (In my opinion, we never would have had the Great Depression if we had not created the Federal Reserve).  Life under a true gold standard has real panics, but they are sharp and short.

At present, we are setting the stage for an increase in unionization.  I am no fan of unions, but who can blame workers from seeking more bargaining power when they have had it rough for a long while?

My summary is that the policies of the Bernanke Fed are too clever.  Restrain wage/price inflation while bailing out banks and broker-dealers, Fannie, Freddie, etc.  But goods inflation keeps running ahead, and the oversupply of houses keeps forcing prices lower.  The actions of the Fed and Treasury protect the financial system for now, but at what eventual cost?  It might have been better for the Bernanke Fed to have been more traditional, and have stimulated the general economy, while letting the Treasury protect individual financial institutions in trouble.

I don’t think this will end well, but perhaps a recession like 1973-74  will clear the decks.  The Fed has to see that its main roles are price inflation and unemployment, with systemic risk third.  Any other way of prioritizing Fed action will lead to greater controversy in the long run.

Here’s a not-so-quick note on covered bonds.  What is a covered bond?  It is a form of secured lending, where a bank borrows money and offers a security as collateral.  That security remains on the bank’s books, but in a default the covered bondholder could claim the security in lieu of payment from the bank’s receiver.

It is not a passthrough, it is a bond.  The covered bond buyers do not receive the principal and interest from the security held by the bank, the bank receives it.  The covered bondholder (in absence of default) receives timely payment of interest at the stated rate, and principal at maturity.  Only in default does the value of the security for collateral matter.  If the collateral is insufficient to pay off principal and interest, the covered bondholders are general creditors for the difference.

Okay, so we’re talking about a type of secured lending, or secondary guarantee.  That exists in many places in different forms:

• Credit Tenant Leases, which are secured first by the lease payments, and secondarily by the building.
• Commercial and Residential Real estate loans are secured by property, and the ability of the debtor to service the loan.  Same for auto loans.
• Utilities do a certain amount of first mortgage bonds where they pledge valuable plant and equipment, and receive attractive financing terms.
• Enhanced Equipment Trust Certificates are how airlines and railroads do secured borrowing, pledging airplanes and rolling stock as collateral if they don’t pay.
• Insurance companies in certain large states can set up guaranteed separate accounts.  If the insurance company’s General Account is insolvent, the separate account policyholders are secured by the assets of the separate account.  The separate account is tested quarterly for sufficiency of assets over liabilities.  If there isn’t enough of a positive margin, more securities must be added.  If those assets prove insufficient in an insolvency, they stand in line for the difference with the general account claimants.

That last example, obscure as it is, is the closest to the way a covered bond functions under the current Treasury Department’s statement on best practices for covered bonds.

Here is what collateral is eligible for the as the pool of assets securing the bonds (stuff from the Treasury document in italics):

Under the current SPV Structure, the issuer’s primary assets must be a mortgage bond purchased from a depository institution. The mortgage bond must be secured at the depository institution by a dynamic pool of residential mortgages.

Under the Direct Issuance Structure, the issuing institution must designate a Cover Pool of residential mortgages as the collateral for the Covered Bond, which remains on the balance sheet of the depository institution.

In both structures, the Cover Pool must be owned by the depository institution. Issuers of Covered Bonds must provide a first priority claim on the assets in the Cover Pool to bond holders, and the assets in the Cover Pool must not be encumbered by any other lien. The issuer must clearly identify the Cover Pool’s assets, liabilities, and security pledge on its books and records.

Further collateral requirements:

• Performing mortgages on one-to-four family residential properties
• Mortgages shall be underwritten at the fully-indexed rate
• Mortgages shall be underwritten with documented income
• Mortgages must comply with existing supervisory guidance governing the underwriting of residential mortgages, including the Interagency Guidance on Non-Traditional Mortgage Products, October 5, 2006, and the Interagency Statement on Subprime Mortgage Lending, July 10, 2007, and such additional guidance applicable at the time of loan origination
• Substitution collateral may include cash and Treasury and agency securities as necessary to prudently manage the Cover Pool
• Mortgages must be current when they are added to the pool and any mortgages that become more than 60-days past due must be replaced
• Mortgages must be first lien only
• Mortgages must have a maximum loan-to-value (“LTV”) of 80% at the time of inclusion in the Cover Pool
• A single Metro Statistical Area cannot make up more than 20% of the Cover Pool
• Negative amortization mortgages are not eligible for the Cover Pool
• Bondholders must have a perfected security interest in these mortgage loans.

Other major requirements (not exhaustive — stuff copied from the report in italics):

• Overcollateralization of 5% must be maintained.  It must be measured each month.  If the test fails, there is one month to get the overcollateralization over 5%, else the trustee can terminate the covered bond program and return proincipal and accrued interest to bondholders.
• For the purposes of calculating the minimum required overcollateralization in the Covered Bond, only the 80% portion of the updated LTV will be credited. If a mortgage in the Cover Pool has a LTV of 80% or less, the full outstanding principal value of the mortgage will be credited.  If a mortgage has a LTV over 80%, only the 80% LTV portion of each loan will be credited.
• Currency mismatches between the collateral and the currency that the bond pays must be hedged.  Interest rate mismatches may be hedged.
• Monthly reporting with a 30 day delay
• If more than 10% of the Cover Pool is substituted within any month or if 20% of the Cover Pool is substituted within any one quarter, the issuer must provide updated Cover Pool
  information to investors.
• The depository institution and the SPV (if applicable) must disclose information regarding its financial profile and other relevant information that an investor would find material.
• The results of this Asset Coverage Test and the results of any reviews by the Asset Monitor must be made available to investors.  The issuer must designate an independent Asset Monitor to periodically determine compliance with the Asset Coverage Test of the issuer.
• The issuer must designate an independent Trustee for the Covered Bonds. Among other responsibilities, this Trustee must represent the interest of investors and must enforce the investors’ rights in the collateral in the event of an issuer’s insolvency.
• Issuers must receive consent to issue Covered Bonds from their primary federal regulator. Upon an issuer’s request, their primary federal regulator will make a determination based on that agencies policies and procedures whether to give consent to the issuer to establish a Covered Bond program. Only well-capitalized institutions should issue Covered Bonds.  As part of their ongoing supervisory efforts, primary federal regulators monitor an issuer’s controls and risk management processes.
• Covered Bonds may account for no more than four percent of an issuers’ liabilities after issuance.
• Issuers must enter into a deposit agreement, e.g., guaranteed investment contract, or other arrangement whereby the proceeds of Cover Pool assets are invested (any such arrangement, a “Specified Investment”) at the time of issuance with or by one or more financially sound counterparties. Following a payment default by the issuer or repudiation by the FDIC as conservator or receiver, the Specified Investment should pay ongoing scheduled interest and principal payments so long as the Specified Investment provider receives proceeds of the Cover Pool assets at least equal to the par value of the Covered Bonds.  The purpose of the Specified Investment is to prevent an
  acceleration of the Covered Bond due to the insolvency of the issuer.
• Not more than 10% of the collateral may be composed of AAA-rated mortgage bonds.

My Stab at Analysis

The four percent limitation takes a lot of wind out of the sails of this for now.  The regulators are taking this slow.  They want to see how this works before they let it become a large part of the financing structure of the banks.

So long as this remains small, there shouldn’t be any large effects on the yields for unsecured bank bonds, both of which are structurally subordinated by the new covered bonds.  In other words, if some more assets are off limits in an insolvency, particularly more of the better-quality assets, that means that much less is there to recover.  Now, discount window borrowing and FHLB advances are secured already, so this just makes the issue of what is left in an insolvency to the unsecured lenders tougher.  That doesn’t affect depositors under the FDIC limits, but if you have deposits or CDs exceeding the limits, you might want to watch this issue.

Acceptable collateral is generally high quality, which means the bank has to pledge some of its better mortgages, and accept a 5% minimum haircut on the amount received back.  This should provide some support to the jumbo loan market; I didn’t see any size limits.  It looks like it would be impossible to issue subprime loans because of the 80% LTV, income verification, no neg am, first lien, underwriting must be done at the fully indexed rate.  Maybe some Alt-A could be done, but I’m not sure.  With the requirement that you have to replace collateral if a loan goes 60-days delinquent, I’m not sure a bank would want to put in collateral with a high probability of replacement.

For underwriting, an LTV of 80% or better is acceptable.  Other underwriting guidelines are left implicit to guidance given in the past on lending practices.  It’s possible that appraised values could be stretched to meet the 80% hurdle.  It’s happened before.

AAA-rated mortgage bonds are an interesting twist here as well.  I assume that it has to be AAA at every agency rating the bonds, first lien collateral, Prime or Jumbo collateral in order to be consistent with the intent of the document, but that is not explicitly defined.  Could a bank contribute a AAA home equity loan to the pool?  I doubt it, but…

Securitization is still getting done through Fannie and Freddie, but so long as the private mortgage securitization market is closed, this could be an attractive option for some banks to finance their mortgage loans.  When the securitization market comes back, covered bonds should reduce considerably as a financing source.  Overcollaterization for a securitization is less than the 5%+ that is necessary here, and it gets the loans off of your books, reducing capital requirements.  If I were a bank entering into a covered bond program, I would only borrow for the amount of time that I would expect the securitization market to be closed.  That could be years, but at some point, it will likely be cheaper to securitize, and the bank won’t want the mortgages trapped in the covered bond program then.

Beyond that, the bank would analyze whether it has better terms in securitized borrowing from the FHLB, or the newly non-stigmatized discount window of the Fed.  Even funding the loans through an ordinary deposit/MMMF/CD base would be most attractive under normal conditions, if the bank has the capital to support the loans.

Other collateral was proposed for use in covered bonds, but the regulators are taking it slow there as well.  They are starting with higher quality collateral; it might get expanded later.  The banks would probably like that.

Two final notes, and a tentative conclusion: this is a relatively complex solution for giving a new financing method to banks.  Only medium-to-large banks could be able to use it.  I’m not sure who a logical buyer of small transactions might be…. Hmm… maybe it could be a substitute for CD investors.

Second, the inclusion of of a Specified Investment is interesting.  It further constrains what can be done with the proceeds of the bonds, which could be a big negative.  Are banks going to buy GICs from insurers?  BICs from other banks?  I don’t know.  Maybe I am misundstanding that part.

My conclusion, after all that, is that I don’t think this is going to be that big of a help to banks in the short run.  Why?

• Small size of the program.
• High overcollateralization.
• Mostly (90%+) high quality mortgages can be pledged.
• Capital requirements don’t change because the loans stay on the books.
• Need for the Specified Investment.
• Marginally increases the yields on unsecured debt.

But the benefit they get is a cheap-ish borrowing rate.  Would this get a AAA yield and rating?  Probably.  Is that enough to overcome the negatives?  Well, let’s watch and see, but I would expect it to have less impact than many expect.

PS — One other note: I read this elsewhere today, but Yves Smith points out that covered bond markets can have panics too.  Good to know; nothing is a panacea.

With trends, I often try to answer the question, “Has the goat reached the end of the snake yet?”  (I got that phrase from a Canadian Investment Actuary with a quirky sense of humor.)  Another more common metaphor would be “What inning of the baseball game are we in?”  I’ll stick with the goat for now — but what I am considering is how far are we into the negative phase of the credit cycle, where:

1. bad debts develop
2. are realized
3. written off
4. new capital raised
5. capital calls fail at a few financial entities, leading to bankruptcies
6. contagion/ systemic risk worries multiply
7. moderate-to-weak capital structures come into question, perhaps a few fail…
8. increasingly, as failures happen, and marginal entities dilute the equity and raise capital, the number of zombie debts starts to decline
9. when the amount of zombie debts drop below a threshold, the credit markets realize that the rest is solvable, and the bull phase starts, usually with a roar.

Nine points?  Maybe I should get rid of the goat, and bring back the baseball analogy.  The nine points aren’t perfectly linear, though, and portfolio managers, both equity and debt, operate in a fog.  In 2002, when I was a corporate bond manager, I would sometimes take my head in my hands at the end of the day, and say to the more-experienced high yield manager who sat next to me, “This can’t go on much longer.”  When I would get that feeling, we were usually near a turning point.  The high yield manager would usually encourage me and tell me it was the nature of the market, and things change.

Part of the challenge is identifying the drivers of the credit bear market.  Is it the technology/CDO bubble (2000)?  LTCM (1998)?  Commercial real estate (1989)?  Here are two posts from the RealMoney CC:

		David Merkel
		Analogies for the Current Market Environment
		3/9/2007 10:13 AM EST

When I think of the current market environment, I don’t think analogies to Autumn 1987, Autumn 1998, or 2000-2002 are proper yet.

What do I think are reasonable analogies? Mexico/bonds in 1994, Cash flow Collateralized Debt Obligations [CDOs] 1999-2001, Manufactured Housing Asset-backed securities [ABS] 2002-2004, and the GM/Ford downgrade to junk crisis in May 2005 when the correlation trade went wrong.

All of these were large enough in their own right to be minor crises, and they sent measures of systemic risk up for a while, but ultimately, they were self contained, because market players with strong balance sheets picked up the pieces from failed players, and earned a reasonable return off them after buying up the “toxic waste” at fire sale prices. What was a horrible idea buying at par ($100), can be an excellent idea buying at $30.

In general, my systemic risk proxies are falling. There is still systemic risk out there, a lot of it, but it will take a bigger crisis than Shanghai/subprime to unleash that. Just be careful; watch your balance sheets and your valuations — for long-term investors, that will reduce your losses in a crisis.

Position: none

		David Merkel
		Gradualism
		1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

Add in the housing bubble, lousy credit quality in high yield issuance 2004-2008, mismarking of derivative books at investment banks, the troubles with CDOs, and growing problems in commercial real estate, and you have the main elements of the current financial crisis.  This crisis is broader than the previous crises.  Many players played it to the wire in a wide number of areas.

In this environment, the continuing fall of residential housing prices another 10-15% will lead to more bank failures, and failure of a few related institutions.  Commercial real estate has far to fall, and there is no telling what it might do to financial institutions.

So, we’re still in the middle innings.  The goat has only eaten one-third to one-half of the snake.  What this means to investors is to be careful of credit risk.  Avoid entities that need credit risk to improve for now.  And pray that we don’t get a negative self-reinforcing scenario where financial failures lead to more failures.

Be wary of credit risk particularly among financial stocks.

A large-ish number of people have asked me to write this piece.  For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.  For those without access, Barry Ritholtz put a large portion of it at his blog.  (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.  I don’t know, liking the market from 2004-2006 was a pretty good idea in hindsight.

I then wrote another piece applying the framework to residential housing in mid-2005, and I came to a different conclusion  — yes, residential real estate was near its top.  My friends, being bearish, and grizzly housing bears, heartily approved.

So, a number of people came to me and asked if I would write “The Fundamentals of Market Bottoms.”  Believe me, I have wanted to do so, but some of my pieces at RealMoney were “labor of love” pieces.  They took time to write, and my editor Gretchen would love them to death.  By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.  They really made my writing sing.  I like to think that I can write, but I am much better when I am edited.

Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.  Tops and bottoms are different primarily because of debt and options investors.  At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.  Option investors get greedy on calls near tops, and give up on or short puts.  Implied volatility is low and stays low.  There is a sense of invincibility for the equity market, and the bond and option markets reflect that.

Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.  They spike multiple times before the bottom arrives.  Investors similarly grab for puts multiple times before the bottom arrives.  Implied volatility is high and jumpy.

As a friend of mine once said, “To make a stock go to zero, it has to have a significant slug of debt.”  That is what differentiates tops from bottoms.  At tops, no one cares about debt or balance sheets.  The only insolvencies that happen then are due to fraud.  But at bottoms, the only thing that investors care about is debt or balance sheets.  In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.

I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.  In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.  I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.

Whew!  For an introduction to an article, that’s a long introduction.  Tomorrow, I will pick up on the topic and explain how one sees market bottoms from a fundamental perspective.