February 2007

There are some early indications that some carry trades are unwinding. Too early to tell. Watch Japanese Yen.


I was just watching CNBC where the guy started talking about the new release of Case-Shiller home price index. It seems like it supposed to be a long interview. But once he said that the index posted the biggest decline in history, they quickly wrapped up.

Speak no evil, hear no evil, CNBC.

Don’t believe anyone who claims he can predict when the market peaks. In fact, better just flush this person down the toilet tube. In December 2000 the record number of analysts predicted the market to run even higher in 2001. It did not.

However, this time is different. Oh, I forget to tell – especially avoid anyone who says “this time is different”. That’s what all pundits were telling about Nasdaq in 2000. But the history never repeats itself, it just rhymes. This time is different!

We all know that the market runs on cheap credit. As long as junk bonds yield less than junk stocks it makes sense to borrow to the eyeballs and buy stocks. That’s what the market is doing every day.

So all we need to do is to watch the credit spreads, especially spreads for questionable quality issues. As we watch ABX.HE indexes every day anyway, it’s easy to use the same markit.com site and watch those spreads:CDX.NA.HY

This is CDX.NA.HY, the credit default swap for a pool of junk bonds, including Ford, GM, KB Home, Lucent, Novastar and stuff like that.

I’m not a pro, but I’m 90% sure that this chart will give us a timely and accurate warning on the time when the perceived risk of defaults in the junk bond market will jump. And that will indicate the timing when all those leveraged buyouts will wane in dust.

Looking at this chart, it’s probably not a peak yet, but we shall see…

The main developments last week suggest that the credit problems at the secondary mortgage market turned into panic:

  • The credit default swap ABX-HE-AAA 06-2 of highest credit rating lost 6 years of income in one day last Friday. Forget BBB, we are talking AAA here
  • The more recent credit default swap ABX-HE-AAA 07-1 lost 7 years of income in one week
  • Lehman Brothers, the investment giant with secondary mortgage papers exposure lost 4.3% in two days on big volume
  • Countrywide Financial, the leading mortgage broker, lost 5% in one week and broke the uptrend
  • Some small and crappy lenders are deteriorating, like Novastar Financial, which lost 53% in 3 days

In the coming week we need to determine if panic settles and fundamentals hold:

  • Watch LEH, BSC and CFC, if they find support and stop falling
  • Do not watch crap like NEW or NFI, they are dead already
  • Watch ABX.HE for any sign that panic is settling
  • Watch all rumours about GM and its GMAC, though no news are expected this week
  • Tuesday is existing home sales, I do not expect anything horrible yet
  • Wednesday, new home sales. Could be slightly lower, but nothing serious
  • Wednesday, new mortgage applications. I expect bad surprise there
  • Thursday, initial jobless claims. Should be worse than consensus, construction jobs are already due for correction

To sum all this we should determine if the panic in mortgage lending spreads into general investment and financial public

Marketwatch just published the human-readable explanation of ABX.HE indexes. Let take the example to illustrate:

The very important and actively securitized investment-grade tranche of mortgage-backed securities is protected with CDS paper named ABX-HE-A 07-1. “A” is investment grade, which is in the middle of spectrum offered by ABX. “07-01” means mortgages were sold in H2 of 2006. The graph is here:

ABX-HE-A 07-1

Current price means that protection buyer will need to pay the protection seller 7.5% upfront and then 0.64% per year. This kind of mortgage yield about 6.5%, so upfront charge is more than the paper yield per year.

Do you want to see another scary graph? This one:

ABX-HE-A 06-2

It’s ABX-HE-A 06-2, also investment grade.

Let’s make a conclusion now. The subprime market is stalled. All BBB and BBB- papers from both H1 and H2 of the last year require from 25% to 30% of upfront payments to protect them. This is impossible, nobody’s gonna pay that. The subprime market is dead.

The investment grade “A” papersĀ  require 7.5% payment. It’s horrible, but still possible. The prime market is in major trouble.

After Novastar disaster earlier this week the mortgage market can’t settle on new lows yet:

  • NFI another -9% today after yesterday -40%
  • NEW -5% to punish those who thought it settled
  • AHM, quite a big one, -4% on absolutely no news
  • DFC, HMB, LEND all -4%
  • Only HRB, which is reporting after close, is +1% (pump and dump?)
  • HBC, the world 3-rd largest bank, is 3% below 200-day moving average
  • Some tiny lenders are up a little bit, but its not important

Welcome the brave new world!

Just for reference – mortgage securitization means pools of mortgages are insured with CDS (credit default swaps) and sold on secondary market as CDO (collaterized debt obligations).

After Novastar event the mortgage CDS market collapsed to the point where further securitization of lower grade papers is impossible. Bloomberg says:

Prices for credit-default swaps linked to 20 securities rated BBB-, the lowest investment grade, and created in the second half of 2006 fell 3.9 percent to 78.59 today, and are down 19 percent since being introduced Jan. 18, according to Markit Group Ltd. The drop in the ABX-HE-BBB- 07-1 index means an investor would pay more than $1.1 million a year to protect $10 million of bonds against default, up from $389,000 last month.

Let me translate it. The cost to insure the BBB- grade mortgage papers against the default will cost 11% per year, but it was only 4% last month.

The return of those papers is usually expected to be in the 10% range. When insurance cost was in the 4% area, just few weeks ago, the fully insured CDO paper would yield 6%, which is not bad, assuming it is already well protected with credit default swaps.

When the insurance cost exploded to 11%, the return on new securitization would be -1%. Obviously, it is impossible to bring that kind of expected return to the market for sale. The related chart of ABX-HE-BBB- 07-1 is for reference:

What happened and what should we expect now:

  • The buyers of related CDS papers lost many billion of dollars just in few weeks. We don’t know who they are and on what books this loss will show up, but we know for sure that they will think twice before engaging in that kind of deals again. The proof: the world 3-rd largest bank just fired its senior management
  • The subprime mortgage market with BBB and BBB- grades is dead. Just dead, the last few crazy deals will get through if they are already approved, but the new deals will stall.
  • The subprime market with grade A is still alive, but the expected profit is very low. Any change in the mood about more risk taking, for example after disappointing pending home sales that will be reported the March 6th, will stall this market as well.
  • The 2% or 3% of existing and new home owners will be eliminated, which is enough to make visible adjustments to real estate inventories (up) and prices (down). No RE rebound is expected, sorry guys.
  • The collapse of the subprime mortgage market is the first milestone in my 2007 recession call.

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