Structured Products and Derivatives – Page 45

Deerfield: A Difficult Rebalancing Trade

Posted on 2 August 2007 by David Merkel

The following things that I write are more risky than normal, and may be wrong.? If you decide to imitate what I have done, you are doing so at your own risk.? Please do your own due diligence.

I have bought more Deerfield Triarc [DFR] today @ $9.76.? A sharp-eyed reader noted (see the first comment) that DFR must have been past my rebalance point, and wondered why I hadn’t bought more.?? Truth is, I had been working on the issue for two weeks.? Whenever a security falls dramatically (it was close to a second rebalancing sell for me at one point), I do a review.? I don’t automatically do rebalancing buys when a company is under stress.

Okay, what gave me confidence to buy? DFR is levered; the main risk here is that they cannot continue to finance the positions that they hold.? Point one that gives me comfort is that the financing is likely secure.

Most of it is repo funding on prime mortgage collateral, most of which is floating rate.? Though there is a high degree of leverage there, the hedging inherent in managing such funding is a common skill.? You could contrast Deerfield and Annaly.? The collateral and leverage are similar; the main difference is that Deerfield uses swaps and floors to manage interest rate risk, and Annaly uses longer repo terms (1-3 years) than Deerfield (0-3 months).

The trust preferreds are not putable, and they lever up their alternative assets through CDO structures, which are not callable.? The risk there is that the equity and subordinate bonds that they hold could be worthless.? Unlikely, but a possible loss somewhere north of $50 million.? They also have warehouse lines, where assets are held prior to securitization.? I don’t know what might be in their warehouse lines now, but they did recently complete a securitization which freed up $230 million of those lines.? (Note: they couldn’t sell the BBB securities.)? The lines are capable of financing $375 million, and extend to April of 2008 at minimum.

Point two is that very little of the assets inside DFR’s CDOs are subprime.? The total risk to DFR is from the Pinetree CDO, which if they end up writing off the CDO equity, will reduce net worth by $12 million.? Not huge.

Point three is that they might not be able to consummate the merger with Deerfield? Capital Management [DCM], since DFR has to pony up $145 million.? I find it unlikely that they could not get the financing for what is a profitable asset where Debt/Operating Income is around 6.? But even if they can’t do the deal, that does not affect DFR, except that they don’t get to purchase an asset manager at a bargain price, which is even more of? bargain now, given that the stock price has fallen, and the deal terms (half stock, half cash) don’t adjust.

Point four is might the deal terms adjust?? Couldn’t DCM allege a material adverse change, and try to get the terms changed?? It’s a little late for that.? The DFR shareholders meeting is one week from today.? Besides, many of the same problems facing DFR are facing DCM.

Point five is that much of what DCM manages are ABS CDOs.? Much of the ABS collateral is subprime residential mortgages.? (For more details, here is an S&P report from last year.) Now, aside from about $20 million of investments in the CDOs that they manage, they don’t have any more risk exposure.? There is the outside possibility that they could be removed as manager on some of the deals that they manage, but that doesn’t happen often.? The current market environment could have a negative impact on their ability to issue more ABS CDOs and other CDOs, but once things clear up, those that? are still in the game of issuing CDOs will make much better interest spreads than they made in the last two years.

In summary, why did I buy more?

The losses look limited, if they occur at all
The financing seems secure
Exposure to subprime losses are small, and
I think the deal goes through.

Could I be wrong on some of these points and lose badly?? Yes.

Full disclosure: Long DFR

Speculation Away From Subprime, Part 3

Posted on 30 July 2007 by David Merkel

More on speculation, while avoiding subprime which is still over-reported.

How much risk do hedge funds pose to the financial system?? My view is that the most severe risks of the financial system are being taken on by hedge funds.? If these hedge funds are fully capitalized by equity (not borrowing money or other assets), then there is little risk to the financial system.? The problem is that many do finance their positions, as has been seen in the Bear Stearns hedge funds, magnifying the loss, and wiping out most if not all of the equity.
There is a tendency with hedge funds to hedge away “vanilla risks” (my phrase), while retaining the concentrated risks that have a greater tendency to be mispriced.? I want to get a copy of Richard Bookstaber’s new book that makes this point.? Let’s face it.? Most hedging is done through liquid instruments to hedge less liquid instruments with greater return potential.? Most hedge funds are fundamentally short liquidity, and are subject to trouble when liquidity gets scarce (which ususally means, credit spreads rise dramatically).
Every investment strategy has a limit as to how much cash it can employ, no matter how smart the people are running the strategy.? Inefficiencies are finite.? Now Renaissance Institutional is feeling the pain.? My greater question here is whether they have pushed up the prices of assets that they own to levels not generally supportable in their absence, simply due to their growth in assets?? Big firms often create their own mini-bubbles when they pass the limit of how much money they can run in a strategy.? Asset growth is self-reinforcing to performance, until you pass the limit.
I have seen the statistic criticized, but it is still true that we are at a high for short interest.? When short interest gets too high, it is difficult but not impossible for prices to fall a great deal.? The degree of short interest can affect the short-term price path of a security, but cannot affect the long term business outcome.? Shorts are “side bets” that do not affect the ultimate outcome (leaving aside toxic converts, etc.).
I’ve said it before, and I’ll say it again, there are too many vulture investors in the present environment.? It is difficult for distressed assets to fall too far in such an environment, barring overleveraged assets like the Bear Funds.? That said, Sowood benefits from the liquidity of Citadel.
Doug Kass takes a swipe at easy credit conditions that facilitated the aggressive nature of many hedge funds.? This is one to lay at the feet of foreign banks and US banks interested in keeping their earnings growing, without care for risk.
Should you be worried if you have an interest in the equity of CDOs?? (Your defined benefit pension plan, should you have one, may own some of those…)? At present the key factors are these… does the CDO have exposure to subprime or Alt-A lending, home equity lending, or Single-B or lower high yield debt?? If so, you have reason to worry.? Those with investment grade debt, or non-housing related Asset-backed securities have less reason to worry.
There have been a lot of bits and bytes spilled over mark-to-model.? I want to raise a slightly different issue: mark-to-models.? There isn’t just one model, and human nature being what it is, there is a tendency for economic actors to choose models that are more favorable to themselves.? This raises the problem that one long an illiquid asset, and one short an illiquid asset might choose different values for the asset, leading to a deadweight loss in aggregate, because when the position matures, on net, a loss will be taken between the two parties.? For a one-sided example of this you can review Berky’s attempts to close out Gen Re’s swap book; they lost a lot more than they anticipated, because their model marks were too favorable.
If you need more proof of that point, review this article on how hedge funds are smoothing their returns through marks on illiquid securities.? Though the article doesn’t state that thereis any aggregate mis-marking, I personally would find that difficult to believe.
If you need still more proof, consider this article.? The problem for hedge fund managers gets worse when illiquid assets are financed by debt.? At that point, variations in the marked prices become severe in their impacts, particularly if debt covenants are threatened.

That’s all in this series.? I’ll take up other issues tomorrow, DV.? Until then, be aware of the games people play when there are illiquid assets and leverage… definitely a toxic mix.? In this cycle, might simplicity will come into vogue again?? Could balanced funds become the new orthodoxy?? I’m not holding my breath.

Speculation Away From Subprime, Part 2

Posted on 28 July 200729 July 2007 by David Merkel

What a week, huh? Even with all of my cash on hand, I did a little worse than the S&P 500. One house keeping note before I get started, the file problem from my last insurance post is fixed. On to speculation:

When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.
We lost our NYSE feed on Bloomberg for the last 25 minutes of the trading day. Anyone else have a similar outage? I know Cramer is outraged over the break in the tape around 3PM, and how the lack of specialists exacerbated the move. Can’t say that I disagree; it may cost a little more to have an intermediated market, but if the specialist does his job (and many don’t), volatility is reduced, and panics are more slow to occur.
Perhaps Babak at Trader’s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
The bond market on the whole responded rationally last week. There was a flight to quality. High yield spreads continued to move wider, and the more junky, the more widening. Less noticed: the yields on safe debt, high quality governments, agencies, mortgages, industrials and utilities fell, as the flight to quality benefitted high quality borrowers. Here’s another summary of the action on Thursday, though it should be noted that Treasury yields fell more than investment grade debt spreads rose.
Shhhhh. I’m not sure I should say this, but maybe the investment banks are cheap here. I’ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.
Comparisons to October 1987? My friend Aaron Pressman makes a bold effort, but I have to give the most serious difference between then and now. At the beginning of October 1987, BBB bonds yielded 7.05% more than the S&P 500 earnings yield. Today, that figure is closer to 0.40%. In October 1987, bonds were cheap to stocks; today it is the reverse.
Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
Now, a trailing indicator is mutual fund flows. Selling equities and high yield? No surprise. Most retail investors shut the barn door after the cow has run off.
Deals get scrapped, at least for now, and the overall risk tenor of the market shifts because player come to their senses, realizing that the risk is higher than the reward. El-Erian of Harvard may suggest that we have hit upon a regime change, but I would argue that such a judgment is premature. We have too many bright people looking for turning points, which may make a turning point less likely.
Are we really going to have credit difficulties with prime loans? I have suggested as much at RealMoney over the past two years, to much disbelief. Falling house prices will have negative impacts everywhere in housing. Still, it more likely that Alt-A loans get negative results, given the lower underwriting standards involved.

We’re going to have to end it here. Part 3 will come Monday evening.

Speculation Away From Subprime, Part 1

Posted on 26 July 2007 by David Merkel

Subprime lending is grabbing a lot of attention, but it is only a tiny portion of what goes on in our capital markets.? Tonight I want to talk about speculation in our markets, while largely ignoring subprime.

I have grown to like the blog Accrued Interest.? There aren’t many blogs dealing with fixed income issues; it fills a real void.? This article deals with bridge loans; increasingly, as investors have grown more skittish over LBO debt, investment banks have had to retain the bridge loans, rather than selling off the loans to other investors.? Google “Ohio Mattress,” and you can see the danger here.? Deals where the debt interests don’t get sold off can become toxic to the investment banks extending the bridge loans.? (And being a Milwaukee native, I can appreciate the concept of a “bridge to nowhere.”? Maybe the investment bankers should visit Milwaukee, because the “bridge to nowhere” eventually completed, and made it to South Milwaukee.? Quite an improvement over nowhere, right? Right?!? Sigh.)
Also from Accrued Interest, the credit markets have some sand in the gears.? I remember fondly the pit in my stomach when my brokers called me on July 27th and October 9th, 2002, and said, “The markets are offered without bid.? We’ve never seen it this bad.? What do you want to do?”? I had cash on hand for bargains both times, but when the credit markets are dislocated, nothing much happens for a little while.? This was true after LTCM and 9/11 as well.
I’ve seen a number of reviews of Dr. Bookstaber’s new book.? It looks like a good one. As in the last point, when the markets get spooked, spreads widen dramatically,and trading slows until confidence returns.? More bad things are feared to happen than actually do happen.
I’m not a fan of shorting, particularly in this environment.? Too many players are short without a real edge.? High valuations are not enough, you need to have an uncommon edge.? When I short, that typically means an accounting anomaly.? That said, there is more demand for short ideas with the advent of 130/30 and 120/20 funds.? Personally, I think they are asking for more than the system can deliver.? Obvious shorts are full up, and inobvious shorts are inobvious for a reason; they aren’t easy money.
From the “Too Many Vultures” file, Goldman announces a $12.5 billion mezzanine fund.? With so much money chasing failures, the prices paid to failures will rise in the short run, until the vultures get scared.
Finally, and investment bank that understands the risk behind CPDOs.? I have been a bear on these for some time; perhaps the rapidly rising spread environment might cause a CPDO to unwind?
Passive futures as a diversifier made a lot of sense before so many pension plans and endowments invested in it.? Recent returns have been disappointing, leading some passive investors to leave their investments in crude oil (and other commodities).? With less pressure on the roll in crude oil, the contango has lessened, which makes a passive investment in commodities, particularly crude oil, more attractive.
Becoming more proactive on ratings?? I’m not holding my breath but Fitch may be heading that way on CMBS.? Don’t hold your breath, though.

Part 2 tomorrow.

Investors’ Markets versus Gamblers’ Markets

Posted on 25 July 2007 by David Merkel

Before I get started on tonight’s piece, I thought I might apologize for a wrong prediction, lest I be confused with a famous guy that I sometimes get associated with.? I was wrong that ABX.HE 07-2 would not get created.? A number of the tranches priced significantly above a 500 bp yield, and so those lower rated tranches got sold at a dsicount to the par value of the securities.? In the unlikely event that those securities get paid off at par, the buyers will be most happy indeed.

But onto tonight’s topic.? Regarding credit default swaps, and their new cousins, ABX, CDX, LCDX, CMBX, etc… there are often more swaps trading than there are underlying cash obligations.? What this implies is that most of the activity going on is not hedging and speculation facilitating hedging, but merely speculation/betting.

What this means is that in the short run, until the cash obligations underlying the default swap mature, there is little to keep the cash and derivative markets together.? The swap spread could be a lot higher than the cash market spread, indicating fear, and a lot of players being willing to bet on partial or total default occurring.? That’s where we are now.? So, when I hear new lows on ABX.HE indexes, and some authoritative voice says that means many defaults are occurring in subprime mortgages, I take a breath and remind myself that it means that more players are betting on increased defaults and loss severity on subprime mortgages.

The opposite can happen too.? Back in 2002, when I was a corporate bond manager, and default swaps were pretty new, I would not buy bonds where the cash spread was smaller then the swap spread, because that indicated a lot of players betting against the bonds in question. If someone holding a bond would sell and replace it with offering protection on a default swap, they would improve their yield, so when the swap spread was wider, it would often lead the bond spread wider as well.? I would wait until the swap spread fell beneath the cash bond spread, and then I would pile in.? Worked really well, and my brokers at the time thought I had this great sense of timing.? Well, maybe I did, but it was analytical, not intuitive.

My main point for my readers: take the prices and yields from swap markets with a grain of salt, particularly on anything they imply to the real economy.? For that, look at the spreads in the cash bond markets.? Limited arbitrage aside, those spreads are more free from raw speculative frenzy.

One last note: almost all users of the bundled credit default swaps are speculators.? They never hold the exact exposure as the swaps, and so the best of them cross-hedges his positions.? So why did these get created?? Wall Street saw a need to allow speculators to express bets that correspond to larger liquid composites in the cash bond markets.? Individual tranches in structured bond deals below AAA are all very thin, and the ability to put a lot of money to work rapidly is limited as a result.? But what if you could pair up additional shorts and longs to take on opposing risks, without them directly investing in the cash bonds?? You would then have a swap market, and the spreads there would differ from the cash market depending on which side of the trade was more motivated: the side needing yield, or the side betting on default.? It’s a big side bet, and hopefully both sides are well-capitalized, but who can really tell?

Survival of the ABX.HE Indexes

Posted on 24 March 200722 June 2017 by David Merkel

When Wall Street comes up with a good idea, they overdo it until the system chokes on the product they created. After the market failure, the system becomes more sophisticated and risks are priced better.

The ABX.HE indexes were created to have a uniform way of trading tranched subprime mortgage credit on a consistent basis. This would allow parties to go long or short, and in greater volume than the underlying cash market would support. They started with the 06-1 deal, which reflected subprime mortgage deals from 20 different originators from the second half of 2005.? They have gotten as far as the 07-1 deal,which reflected subprime mortgage deals from the same 20 originators from the second half of 2006.

Well, now what?? Many of those originators are gone, and most of the rest have scaled back massively. Will there be an 07-2 deal?? In some ways, I wonder if the existence of the ABX.HE deals didn’t help to create part of the problem, in that the 20 originators had to come out with at least one deal of a certain size every six months.? Being in the index would mean cheaper funding, so an originator would want to do that if possible.

I don’t see how the ABX.HE 07-2 gets done, and honestly, the system might be better off if it doesn’t get done.? The existence of subprime mortgages encourages some people to take on onerous debt that they would be better off not incurring.? Anything that encourages more subprime lending (and other high interest forms of debt) is in my opinion, a bad thing.? Let people learn to defer their gratification, put more money down, and on the whole, they and the whole nation will be better off.