Vikram Saxena

Lehman's Preferred Offering: Bullish for Stocks

www.reuters.com/articl...

The spread tightening today was 'the most extreme narrowing of yield spreads ever' according to UBS.

And I continue to believe that a default on the GSE default is at least a 4 sigma event (April 3 comment) with the pendulum shifting towards 5 as a United States battered by a weak economy, high oil prices and a general crisis of confidence, has to step in to stabilize the boat in the short term.

Lehman's Preferred Offering: Bullish for Stocks

:)

The Fed Window rumor turned out to be false, but it is clear that GSE bonds are almost as good as Treasuries now. The spreads tightened today as the implicit backing of the GSE bonds is becoming more explicit. Treasuries fell as there is concern that the debt of the US Treasury will no longer be 'AAA+' once the GSEs bonds get formally get the blessing and the treasuries debt burden increases by a huge amount.

From a big picture perspective, I think fear is what is completely in control. The GSE have about 1.5% in loss reserves. For all the equity to be wiped out, we need a 7.5% default rate with a 20% severity rate on the entire portfolio. With a bulk being confirming 80-20 loans, where the replacement value of the home (the unofficial floor) not very far from the home price, the severity rates might be lower except for the loans in 2005-2007. But equity holders have to be *very* concerned.

It is time for the Resolution Trust Corportation Part II, to end the uncertainty; the fear of the future loss is going to harm a lot more people than the actual losses which the Resolution Trust might take.

Lehman's Preferred Offering: Bullish for Stocks

stochval:

Thanks for your comments.

Again my point is that the Fed has significantly increased the profitability for IBs when the take risks so LEH is raising cash at a time when they can really profit from it. The market reaction on the day after I wrote this article seems to have vindicated my post.

GSE spreads had really widened (when Carlyle failed) and the spreads are tightening, and much more likely to be tighter an year from now simply because the Fed backstop is now in place.

A bulk of GSE backed paper continues to be prime/confirming/20% down. GSEs have been issuing bonds for a long time and the Alt-A/Subprime/neg-amo... boom is very recent. You have to look at it as a total percentage of GSE's outstanding debt. And even if the GSEs fail, it is the equity holders will be wiped out. The bond-holders are likely to be made whole by Uncle Sam simply because the fallout is going to be catostrophic. I continue to believe that GSE bond's defaulting is at least a 4 sigma event (I will give that to you ;) ).

Lehman's Preferred Offering: Bullish for Stocks

TallIndian:

0. I am not sure why the time I take to clarify an opinion or respond to a question is seen as an attack. Have I said something offensive?

1. Your point about the original post not mentioning GSE's backed AAA is correct. I wish I could correct it.

2. More important: do not miss the forest while looking at the trees. IBs are in the business of taking measured risk. They take it everytime they underwrite a deal, make a market in a particular security or take a prop position. Right now the Fed has made the profits from taking the risk significantly more than what it traditionally is. As a result an IB which has capital can profit from the environment. This is what makes the timing great.

I gave an example of how leverage works using AAA MBS; IBs typically have a LOT more leverage than the 10x example I used. The Fed allows them use a 2% haircut for GSE backed bonds which can be used for 50x leverage.

3. Modeling RMBS performance is a complex task with a LOT of assumptions about prepayments, and of late default rates for non-GSE backed bonds. However, even you agree that there is very little chance of principal loss on GSE backed bonds. Not to digress too much but let me address your questions about prepayment risk in the context of an IB:

-> Prepayment happens is small steps; it is highly unlikely that an entire pool will be prepaid in a single month or quarter.

-> Prepayment implies a return of principal. For example, as you pay off your mortgage, the note holder does not lose principal even if the value of the note goes down. Note that the market already prices its current expectations of prepayment/interest rate risk and its effect on the PV of the bonds cash flow; LEH is pretty good at it being the provider of a huge variety of tools used by buy side firms to model them.

-> The IB can use that cash returned by prepayments to pursue what it deems is as the most profitable investment. The IB can reinvest it and buy more bonds or lend it at out at LIBOR which is still significantly higher than the borrowing cost from the Fed (look at TED spreads) or do whatever it wants with the new capital.

-> For an IB, it is all about spreads. A buy and hold investor in RMBS has to consider the reinvestment risk since the prepayments increase at a time of low interest rates and change the traditional notion of a bond rising in value when interest rates fall. This affects the secondary market pricing of the bonds. However an IB primarily cares about is the:
a) The spread between their borrowing costs and the coupon on the bond (which is heavily in the IB's favor). And the spread is so high that the IB can easily weather any UNEXPECTED prepayment related risk. The market will already price the expected prepayment risk in the current bond price.

b) The spread at which the bond trades with respect to an index (say LIBOR or the treasury). Currently GSEs spreads have widened compared to historic norms so it is a great time to buy and park at the Fed, assuming that the spreads will eventually regress to the mean.

There are several notes out there saying that it is a great time to invest in funds/ETF who buy GSE backed paper. Clearly these market observers do see something similar to what I have been saying.

Lehman's Preferred Offering: Bullish for Stocks

stochval:

1. My example was to illustrate how the Fed's inexpensive lending makes this the perfect time for IBs to raise new capital to work with.

2. The link you posted is talking about private label Alt-A mortgages. These are neither prime nor are they backed by the GSEs; the market is treaging them like that. Private label Alt-A mortgages are trading at a huge discount; UBS sold them at 70c/dollar to PIMCO; subsequently Thornburg Mortgage's equity holders have been diluted by 20x after TMA was forced to raise capital to meet margin calls on Alt-A bonds they had purchased.

To be eligible for GSEs the mortgage has to be to a prime lender, have a minimum of 20% down payment, and be conforming. GSEs backed mortgages used to trade at a very narrow spread to treasuries. The Fed is essentially backstopping them now with the TAF/TSLF; they could buy them in the open market as some observers have suggested but by using the TAF/TSLF they are letting the IBs take the spread. This is helping rebuild the IBs balance sheets and enhance their ability to lend again.

Note that Caryle Capital's failure happened because GSE paper lost a few points last month. It was the widening of the GSE paper spread which prompted the Fed to act. The GSE spread is already tighening we speak and the IBs can also benefit from principal appreciation as the market unfreezes and spreads tightens further. The Fed will continue the lendng facility as long as the market is dysfunctional

3. The GSE are government sponsored agancies with an implicit backing of the US Government. For the GSE AAA bonds to default, these GSEs will have to become insolvent and unable to fulfil their debt obigations. The US will not allow the debt obligations to fail that unless the Treasury itself is insolvent (the equity might be wiped out). With the Treasury's ability to raise money by increasing taxes and issuing treasury bonds, I feel that this scenario is truly a 5 or 6 sigma event. Given that the Roman Empire fell just 2000 years ago, I think it is highly unlikely that the United States too will fail ;).

Lehman's Preferred Offering: Bullish for Stocks

tallIndian:

What I have outlined is an example of how an IB can put the cash they have to use thanks to the low cost borrowing they get from the Feds. The reason the Fed is offering this facility is to encourage the IBs to take some risks and unfreeze the credit markets. That is why it was a great move for LEH to raise money right now.

IBs are in the business of taking measured risks. They do well most of the time but mess up sometime. Right now we are in an environment where the Fed and Treasury has clearly announced their intention not to allow a meltdow. BSC was the sacrificial lamb; after that they will backstop the financial system.

In this environment to expect GSEs to default on their bonds is like a 5-6 sigma event and banks will take their chances on that. If the GSEs default the entire global financial system is in touble, so there are greater things to worry about than LEH. The Fed has made it clear that they will continue the lending facility as long as the market is dysfunctional. This also means that LEH could buy the AAA GSE backed bonds at a much wider spread than the norm and profit from the eventual spread tightening. They will take comfort in the knowledge that the Fed will hold the bonds till the markets become fluid (and the spreads tighten).

Lehman's Preferred Offering: Bullish for Stocks

TallIndian:

The Fed has declared that they will continue to lend to the banks as long as the market is dysfunctional. The AAA bonds themselves are backed by the GSEs so unless they go under, the principal is safe. The only risk is interest rate movement which can be hedged.

stochvol:
You borrow from Peter (Fed) to lend to Pan (the bond seller). Suppose the IB buys $10M bonds and puts $1M down. It needs to borrow $9M. It goes to Peter and deposits the AAA bonds and in exchange gets treasuries (with some haircut say 10%) worth $9M at a spread of 33bps. These treasuries are as good as cash and the bank pays Pan with the $9M in treasuries (or by selling them and generating cash) and $1M in their on equity. If there is a spread of 300 bps (5.6% AAA yield, 2.6% borrowing cost), the ROE on the 10% equity is 32.6%. The haircuts for AAA bonds are smaller than 10% so in principal the bank can leverage even more than 10x.