Thursday, January 24, 2008

Market Flash Commentary

Perspective on the Last Few Trading Days

The nation's stock market did an amazing 600 point about-face, rising from its morning low to finish deep in positive territory yesterday. The rally, which followed two days in which anxious investors drove stocks sharply lower around the globe, culminated in a 30-minute buying frenzy that left the Dow Jones Industrial Average at 12,270.17, up 298.98 points. The Dow's 631.86 point intraday swing was its biggest since July 2002, one of the low points of the last bear market. There have been just nine days with 500-plus point swings since 1995, many of which occurred at major market turning points.

Yesterday’s trading was important not just because of the point gains but because of the reason for these gains. The rally was supercharged late in the day by news that insurance regulators met with major Wall Street firms to discuss ways to stabilize and potentially bail out big bond insurers. These insurers have taken a hit because of their exposure to securities tied to subprime mortgages, and their instability threatens the wider financial system because they insure tens of billions of dollars in bonds, many of them held by Wall Street firms. Together, this insurer bailout, talk in Washington of creating a fund to buy troubled mortgages, and the hope for continuing Federal Reserve interest-rate cuts was the perfect combination to address the largest concerns in the market.

Understanding Credit Default Swaps

Credit default swaps (CDS) have become an increasingly popular way for financial institutions to insure potential default losses in their portfolios. Speculators such as hedge funds use CDS’s to potentially profit from the changing credit outlook in the economy. The technical definition of a CDS is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).

The popularity of CDS’s has leaded them to become the most widely traded credit derivative in the international financial marketplace. Outstanding CDS’s totaled $28.8 trillion in December 2006, up 107% from the year before. The market for credit derivatives is now so large that in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company was to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. In addition to spreading risk, credit derivatives in this case also amplify it considerably. This is a huge and meaningful market. As such, more and more entities are becoming involved in trading these securities.

With any CDS there are two parties. The buyer wishes to reduce his exposure to risk and the seller who is willing to increase his exposure to risk for a fee. The buyers are typically banks, pension funds, insurance companies and the like. The sellers have traditionally been speculators such as hedge funds. However, bond insurers like Ambac and MBIA have become increasingly active in this market place over the last few years. This is at the heart of the credit crisis today.
Because mortgage backed bonds comprise approximately 60% of the bond markets, it is easy to see how the CDS market has been impacted by the massive default rate of sub-prime loans, and thus sellers of these derivatives have experienced loss rates that had never been imagined.
One of the biggest criticisms of the CDS market is that these contracts are not collateralized. Their ultimate value depends on the creditworthiness of the counterparty. This counterparty risk is at the core of the latest round of fear that has struck the financial markets and was partially addressed yesterday.

A recent survey found that 26% of investors were worried about counterparty risk. These fears are not unfounded. Two days ago ACA Financial Guaranty Corp. asked its trading partners for more time as it scrambles to unwind more than $60 billion of swaps it sold but can’t fully pay off. The contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own. As a result, Merrill Lynch had to write down $3.1 billion on debt securities it hedged through ACA. Citigroup has set aside $935 million to cover the likelihood that trading partners won't make good on trades in this market. These write-downs are in addition to the actual un-hedged losses that these banks have already taken. This has been taking place all over Wall Street.

Wider Implications

What happens when your insurance company goes broke? That’s what many have been asking themselves about Ambac and MBIA. These two monoline insurers are by far the largest insurers of municipal bonds. Most municipal bonds that trade today carry the highest credit rating of AAA. In a great many cases, that rating has been granted based on the bond insurance issued by one of these two firms. In fact, most small municipal governments have no credit rating at all. They find it cheaper to buy the insurance than pay to have a full audit performed and rating assigned.

Thanks to the huge losses incurred at Ambac and MBIA on their CDS business, their capital base has dwindled dangerously low. Forced to raise capital, MBIA issued $1 billion in bonds to shore up its balance sheet. To attract buyers, these bonds had to carry a 14% coupon. Even so, a week later these bonds were trading down 10-15%. Keep in mind that a typical investment grade bond (BBB or higher) would trade in the mid-5%. Not only was the 14% coupon indicative of a junk bond rate, but the fact that they traded so much lower immediately after issuance says that the marketplace feels bankruptcy is extremely likely. The next week, Ambac followed up with attempting to float its own issue. With the MBIA issuance fresh in investor’s minds, they had no takers. That day, credit agencies cut Ambac’s rating to AA (still very generous in our opinion) and stocks in both companies tanked.

The obvious question to ask is how can all of these bond issues trade with AAA ratings if the underlying insurance is perceived as no good? Shouldn’t the value of these bonds be marked down as well to reflect the riskier nature of their credit? How does this impact the cost of borrowing for municipalities that depend on those ratings? The cascading effect of this becomes obvious. Further write-downs lead to a further reduction in portfolio values which in turn puts more pressure on required capital levels which then limits banks’ ability to lend.

Pending Recession

Financial institutions, especially in the U.S. but also globally, have lost a tremendous amount of capital in the last few months. Faced with the prospects of another wave of write-downs that could be larger than the first, it’s apparent how economic growth is threatened. Modern economies run on credit. Whether it be consumer credit or business liquidity needs, access to capital is essential. The current situation is that most banks are either limited or unwilling to make major loan commitments at this time. All of the current data clearly points to a slowing economy and stock prices have come down to reflect this. There are only two events that will bring us out of this downturn, which are a stabilization of asset values and a massive injection of liquidity into the economy.

The Fed’s Role

Tuesday morning we were greeted by a surprise announcement that the Fed was cutting a key interest rate by 75 basis points. The size and timing of this announcement was a complete surprise that helped stem massive losses in stocks. The Fed’s move helped pair the opening declines on the Dow by roughly 350 points. The next day we were told that a bailout of the bond insurers was being orchestrated, which fueled a 600 point rally. It’s clear what the financial markets perceive as important. This is beginning to resemble the Fed’s orchestrated bailout of Long Term Capital Management in 1998. That too was centered on counterparty risk that threatened capital liquidity. We’re hopeful that all the cards are on the table now and it’s just a matter of accounting for all the losses.

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