March 19, 2012

Rate Spike, Phase 2

March 19, 2012

Rate Spike, Phase 2

Mortgage bonds sold sharply all day today, pushing rates higher.

The Fannie Mae 3.5 coupon that lenders use as a benchmark to price consumer rates closed the day down 66 basis points.

Rates rise when bond prices drop like this, and rates will rise about .25% if this selloff holds.

Today’s selloff was driven mainly by two factors:

(1) Investors were focused on stocks, pushing the S&P 500 to its highest level since May 2008 on positive sentiment following Apple announcing it’s first dividend in 17 years and a $10b stock buyback.

(2) Losses by those who sold Greek credit default swaps (CDS) were slightly less than previously reported at $2.5b. CDS are used as a form of insurance for bondholders, and when Greece’s debt restructuring was deemed to be a default, the CDS contracts had to be paid. Below is a CDS BASICS piece written by Dick Lepre last year, and FTAlphaville is all over the day-to-day CDS news on Greece—and see bottom of this FT page for more good links.

This rate spike began mid-week last week, then leveled of late-week before resuming today.

More positive U.S. economic news could add fuel to this bond selloff.

Tomorrow continues this week’s U.S. housing data flow with February’s New Construction (aka Housing Starts). As of last month’s January Housing Starts report, the three-month moving average was 697k for Starts, the highest since November 2008.


Credit Default Swaps 101 (by Dick Lepre)

The news about Greece triggering credit default swaps (CDS) has returned CDS to the news. The following is a piece I wrote last year on CDS.

In all of the post-bubble analysis of what went wrong a share of the blame is often placed on credit default swaps.

Credit default swaps (CDS) are fairly new having not existed before 1994. Inauspiciously enough, CDS stemmed from a disaster. On March 24, 1989 the Exxon Valdez, an oil tanker headed to Long Beach, CA hit a reef in Prince William Sound, Alaska and spilled somewhere between 260,000 and 750,000 barrels of crude oil. In 1994 a jury awarded the plaintiffs (there were 38,000 litigants) $287 million in compensatory damages and $5 billion in punitive damages. The defendant was Exxon. Exxon appealed the case (this was not settled until 2009) but did not want to tie up $5 billion in capital. Exxon went to J.P. Morgan and got a $4.8 billion credit line in case it lost the appeal. J. P. Morgan was (and still is) a bit of an “old school” company. Exxon was a big client and an old client of J. P Morgan so they said “yes” to the loan.

The Basel capital accords call for such a commercial loan (the one JP Morgan made to Chase) to be a 100% risk loan. That means that this loan tied up a minimum of $4.8 billion x 0.08 or $384 million of J. P. Morgan’s capital. Blythe Masters who was then a member of J. P. Morgan’s swaps team (I have added a piece at the end on swaps) and is now the head of commodities for J. P. Morgan Chase had the idea of selling off the risk associated in the event that Exxon defaulted on that $4.8 billion credit line. The deal was made in 1994 and CDS (which did not even have a name at the time) were born. J. P. Morgan had its capital freed, the insurer got a premium, Exxon had its credit line, the plaintiffs had a guarantee of payment, and Exxon and J. P, Morgan preserved their relationship.

Subsequently CDS became the way that holders of debt purchased insurance in the case that the party owing the money defaulted. They were a form of credit insurance.

CDS started as insurance for corporate debt but what may have happened is that with the economy being healthy and very few corporations defaulting on debt, folks started to think of CDS as a cash cow and aggressively expanded the concept to include other debt including home loans. With the help of HUD mandated subprime and other subprime non-GSE home loan debt the prescription for a firestorm was created: 1) bad loans 2) expanded money supply and low Fed rates and 3) CDS Since then credit default swaps have grown gigantically. There is a web site which has outstanding CDS. By the end of 2007 the outstanding notional amount of CDS was $62.2 trillion. One year later it was $38.6 trillion. The web site above show it currently at $27.1 trillion.

There is nothing inherently wrong with CDS What should be considered for regulation is 1) should CDS be traded on a open market and 2) should naked CDS be allowed. Naked CDS are those wherein the buyer of the CDS has no underlying stake. Think of this as buying fire insurance on someone else’s house because you notice that he does not take good care of it. While this could be a motivation for arson it could also serve as a red-flag to an insurance company that the market is telling them that one of their policy holders is not taking adequate care of the insured property.

The home loan mess/Great Recession has provided a very large dose of reality to those who gambled with CDS After the Lehman BK there was a total of $400 billion (notional) in CDS Most of the $400 billion involved entities that had money both coming and going on Lehman CDS so that the total net amount after balancing funds coming and going was about $7.2 billion. The big loser from CDS was AIG which had unwisely held an unbalanced portfolio.

Before there were credit swaps the common swap of concern to the home loan industry was the interest rate swap. An interest rate swap is the exchange of a fixed rate loan for an adjustable rate loan. If I hold assets such as fixed rate home loans but my liabilities are of much shorter duration than the weighted average maturity of those home loans then I may want to buy a swap to protect against a rising cost of funds.