Vikram Saxena

Browsing Through Lehman Emails

I saw a graphic after that fateful weekend:
DIck Fuld: Long Term Investor
John Thain: Trader

I wish Lehman had injected some fresh blood into its Board or Senior Management so that they could see how bad things were becoming. At times of extreme stress, long term insiders can not detach themselves from the past, and internalize the implication of the present.

Fuld never understood how the game had changed with hedge funds, no uptick rule, blatant naked-shorting, and trend following computerized trading severely exaggerating any directional move in a nervous market.

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.

Lehman's Preferred Offering: What Does It Indicate?

Another person confusing liquidity with equity. The Fed window gives liquidity by allowing LEH to borrow against assets. The preferred offering gives LEH the capital (equity) to buy those assets or deleverage their books. And with the current state of the markets, and the Feds backstoping, the IBs can make a huge amount of money just buying high quality bonds at distress prices and parking them with the Fed. But to do that they need capital and LEH has just raised some at pretty decent terms.

Next Up: Lehman Brothers?

LEH can park their MBS with Uncle Ben for six months now. There will be no liquidity crisis in LEH. The spreads on MBS are also narrowing so the chance of a margin run on LEH are low. Plus unlike BSC they have been working on getting other sources of funding.

It took BSC's fall for Uncle Ben to act though.

Subprime Write-Downs More Than 50% Done? Write-Ups Coming Next?

www.aleablog.com/dont-.../\
Dont Mark to Markit


seekingalpha.com/artic...

10) Be careful using the ABX indices. They are too easy to short, and do not represent the values that are likely to be realized in the cash markets. The same is true of the CMBX indices. This would lead me to be a bull, selectively, in AAA CMBS, after careful analysis of the underlying collateral. (CMBS was a specialty of mine when I was a mortgage bond manager.)

Subprime Write-Downs More Than 50% Done? Write-Ups Coming Next?

mtclm:

I think what he meant was that all the short positions which MS has will expire worthless; i.e. the loss and severity will not be as bad and MS will not earn anything on these after accounting for the maintenance cost. The write-downs, as noted by the Lehman analyst and specificially probed by the City analyst factor in the worst case scenario on BOTH sides of the trade!



www.risk.net/public/sh...

"Chief financial officer Colm Kelleher said that the the mortgage desk had decided to short the subprime market by taking a $2 billion short position in low-rated subprime mortgage-backed securities (MBS). In order to meet the cost of the negative carry of the short position, the desk also went long $14 billion of AAA-rated super-senior [tranches] of BBB subprime securities, which we refer to as mezzanine," he said. The investment in the top tranches of collateralised debt obligations (CDOs) of MBS was assumed to be safe enough to provide a reliable source of funding to meet the cost of the short position, even if the underlying market declined"

As it is clear, their short positions are in much worse tranches since they needed $14B of long mezannine debt to balance out the negative carry spread on $2B of the short sub-prime.

Their long positions are going to be worth a lot more before the short positions start losing money. And the principal of the short positions which earns interest will detoriate much faster than the long position, decreasing the cost of carry.

Again, do the math.

Subprime Write-Downs More Than 50% Done? Write-Ups Coming Next?

Thanks for all the messages folks. Some observations.

The bond market has already priced most sub-prime based bonds at very low valuations. Mark to Market rules ensure that the banks have to take the write-downs as they occur. Bonds originally rated as AAA are trading in the 50s, reflecting extreme risk even though there is real tangible collateral backing them.

1. ABX sub-prime indices
markit.com/information...

Index Series Version Coupon RED ID Price High Low

ABX-HE-AAA 06-1 6 1 18 0A08AHAA1 86.19 100.38 84.17
ABX-HE-AAA 06-2 6 2 11 0A08AHAB8 70.06 100.12 66.1
ABX-HE-AAA 07-1 7 1 9 0A08AHAC6 55.94 100.09 53.46
ABX-HE-AAA 07-2 7 2 76 0A08AHAD4 52.92 99.33 52.47


2. The TABX index tracking the BBB sub-prime mezannine debt which fund many CDOs is trading as almost worthless; even the 40-100 tranche which start taking losses after 40% of the principal is exhausted are trading in the teens

markit.com/information...

3. Salvage Value: The salvage value for loans on homes in foreclosure varies between 50-80% of the home's market value depending on the size of the loan and the market condition. And not all these loans were no-down payment loans; in many cases they homeowners had some kind of equity in the deal (downpayment).

Homes have a tangible value and use; in nominal dollar terms there are unlikely to fall significantly below the replacement costs.

4. Creative solutions for Tough Times:
The Fed has shown that they are willing to reveal weapons most people do not even know exist.

Similarly it is also likely that the stakeholders affected by the high amount of foreclosures will band together to find a solution.

For example, subprime related foreclosures are concentrated in specific pockets of the country. The geographical concentration means that it is easy to form entities to manage them as rentals. If the homes are transferred at 60-70cents to the dollar to new entities, a bulk of these homes are going to be cash flow positive rentals from day #1; Californa, Nevada and Florida continue to be very attractive places to live in. The original note-holders can continue to have an equity stake in the entities.

Time, inflation, and the devalued USD will fix things. The wash-out is occuring as we speak.

Subprime Write-Downs More Than 50% Done? Write-Ups Coming Next?

As I wrote in the article, MS took the $9B write-down assuming 100% default and 100% severity. Houses are tangible assets and not going to be worthless in nominal dollar terms. You do the math.

AAA Bonds That Fail the Investment Grade Test

The market is already pricing the risk.
Here is what the different AAA ABX indices are trading at:
Index Series Version Coupon RED ID Price High Low

ABX-HE-AAA 06-1 6 1 18 0A08AHAA1 86.19 100.38 84.17
ABX-HE-AAA 06-2 6 2 11 0A08AHAB8 70.06 100.12 66.1
ABX-HE-AAA 07-1 7 1 9 0A08AHAC6 55.94 100.09 53.46
ABX-HE-AAA 07-2 7 2 76 0A08AHAD4 52.92 99.33 52.47

Another thing to keep in mind: The salvage value for loans on homes in foreclosure varies between 50-80% of the home's equityng depending on the size of the loan and the market condition. Assuming an average recovery of 65%, the number of loans defaulting has to be 3 times the credit support before the bonds get hit. And not all these loans were no-down payment loans; in many cases they homeowners had some equity in the deal.