I suppose there is some muni-treasury spread index I should be betting on?
Over the years I've noticed a lot of my super-rich friends in fixed income keep a disproportionate (at least according to naive portfolio theory) fraction of their net worth in munis -- probably because of the tax benefit and because fixed income people always think equities are airy fairy overpriced and can never bear to place a big bet there. I'm going to see if any of them are worried about spillover into their personal portfolios if the bond insurers take a downgrade.
Nov 8th 2007 | From The Economist print edition
With trades scarce and losses mounting, it is going to be a harsh winter.
IT WAS not a good omen. This week Lewis Ranieri, a pioneer of mortgage securitisation in his “Liar's Poker” days at Salomon Brothers, sold his property-financing firm because the subprime crisis had cut it off from fresh debt. If the industry's godfather can't navigate the storm-tossed markets, what hope its greedy children?
Banks that a few months ago were falling over each other to underwrite mortgage-backed securities and the labyrinthine pooling structures, known as collateralised-debt obligations (CDOs), that sit atop them, have admitted to more than $30 billion in losses. That figure is set to rise sharply as mortgage defaults in America climb. Citigroup estimates that big banks may be facing $64 billion in write-downs, excluding its own figures—and it was one of the top two underwriters of CDOs. Banks will be dealing with the pain for a lot longer than anyone imagined only a couple of months ago.
Most CDOs were engineered to provide both yield and safety, with a thick band of each rated AAA or even better, “super-senior”. Lower-rated tranches have been in trouble for months. But the prospect of a collapse in the value of the supposedly safe portions terrifies the banks—not surprisingly, since there is at least $350 billion-worth of such CDOs outstanding.
This looks all too possible now that rating agencies have started to downgrade AAA-rated CDOs, some of them by several notches (14 in the case of one notorious tranche). The agencies have given warning in the past month that they might downgrade another $50 billion-worth of top-rated CDOs, and that looks like the tip of the iceberg. One fear is that this leads to a wave of hurried sales, because many institutional investors are allowed to hold only AAA-rated paper. In addition, default notices have been issued on more than $5 billion-worth of CDOs, as senior investors try to grab what they can.
The uncertainty is compounded by the difficulty of finding a “fair value” for these complex instruments. The fall-back method recommended in a recent paper by the Centre for Audit Quality, an industry research body, is to employ “assumptions that market participants would use”, a technique known as “Level 3”, which becomes subject to strict accounting regulations in America on November 15th. But “Level 3 is not that useful,” confesses a risk controller at a big European bank. Banks have tended to use it as a bucket into which they throw any securities they find hard to value and then make an educated guess at the price. Among Wall Street firms, the soaring amounts of Level 3 securities now exceed their shareholder equity.
Finding a better indicator of market prices is no easy task, however. One measure, though an imperfect one, especially for CDOs, is the ABX family of indices. These relate to derivatives linked to subprime, which are traded even when the underlying bonds are not. The ABX indices are near record lows, having fallen precipitously in October. Even the top tranches are well below par value (see chart). According to Citi, some AAA-rated CDO tranches are faring even worse—at a mere 10 cents on the dollar.
Most banks are probably reluctant to mark down their assets that far. Citi and Merrill Lynch lead the list of shame, with combined write-downs of more than $22 billion. But others may just be slower in coming clean—even the teflon traders at Goldman Sachs. CreditSights, a research firm, estimates Goldman's potential CDO-related charges at $5.1 billion, for instance. On November 7th Morgan Stanley said it would write down its assets linked to subprime by $3.7 billion. For the first time, there is serious talk of banking giants running short of capital.
European banks can expect more grief, too. UBS, a Swiss bank, has reportedly been criticised for booking its mid-quality paper at twice the level implied by the ABX index. Marcel Ospel, its chairman, faces mounting pressure to resign after the bank reported big losses on fixed-income securities in the third quarter.
Banks are not the only ones who need to worry. Hedge funds hold more than 45% of all CDO assets, according to the IMF. Insurers are exposed, too; American International Group, the world's largest insurer, this week fell far short of earnings targets because of mortgage-related problems. In addition, one obscure but important corner of the industry faces a fight for survival over its subprime exposure: the specialist bond insurers.
In return for a premium, bond insurers guarantee repayment of interest on a variety of debt securities in case of default. Their mainstay used to be municipal bonds, but over the past decade they moved aggressively into structured finance. Before October, it was thought that the two biggest, MBIA and Ambac, would get away with losses in the low hundreds of millions. But the rating agencies' assault on high-grade CDOs, the bread and butter of the insurers' structured business, raises the prospect that they could run low on capital. Analysts at Morgan Stanley forecast combined losses for the two firms of up to $18.7 billion. Even the minimum expected loss, a much lower $3.3 billion, would be a huge blow for companies with combined equity capital of just $12 billion.
Some think the rating agencies will eventually have to strip the bond insurers of their cherished AAA ratings. They are loth to do this because it would “wreak havoc”, not only in structured products but across financial markets, says Andre Cappon, a consultant. New issues of municipal bonds could slow dramatically, since many borrowers rely on the insurers' top rating to enhance their own creditworthiness. Over $1 trillion of debt issued by American cities and states—much of it held by retired people through funds—might have to be downgraded. Public-private partnerships in Britain, which are also customers, would also be affected.
For those holding CDOs, things could get worse before they get better. Tim Bond of Barclays Capital points out that defaults on subprime loans are still accelerating in America, particularly on mortgages made since 2006. This will take time to feed through to CDOs, via mortgage-backed bonds, but feed through it will. A consumer-credit slump, which looks increasingly likely, would clobber securities backed by credit-card and car loans, which are also pooled in CDOs. That would be all the beleaguered banks need.