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Securitisation's second death!

|Includes: S&P 500 Covered Call Fund (BEP), TLT
Longstanding Thaler's Corner readers know that I rarely dissect the same topic in two consecutive notes, but I feel that the "Fraudclosure Mess" (fraud + foreclosures) merits further scrutiny, because we are clearly just at the beginning of a long legal process in the United States whose repercussion for the American banking system are quite simply terrifying. 
I have used the highly emotive as opposed to rational term, terrifying, because the consequences of this mess will not stop with the potential loss estimates of JP Morgan at between $55bn and $120bn.
 
This story needs to be understood because the implications for the "real" estate market are aggravating the turbulence on this crucial economic sector in the United States, with all that that implies for economic growth and fresh bank balance sheet problems.
 
This topic also deserves our urgent attention because the revelations of the questionable methods used to structure MBS, CDOs and other debt-backed securities are now raising questions about the very principle of securitisation, at least in its current form! Securitisation is a credit accelerator we have been following closely since 2005, with the famous equation, MV= PQ always at the ready. This sector really did not need this new scandal at this time.
 
 
All this could thus throw into question our asset allocation biases of recent weeks (bull Eurostoxx, bear flattener eurozone, narrowing of spreads with peripheral nation debt).
Indeed, a new wave of deterioration on the US financial sector (as if that were the only sector to be hit) in the midst of a credit crunch will be another factor of macroeconomic weakness (bear equities) and an incentive justifying a new flight to safety (bull Schatz).
 
The debate will thus be reduced to an evaluation of present forces:
 
Ø     Fall-out from the "Fraudclosure Mess" on bank balance sheets à RISK OFF. Negative equities, bull flattener US.
 
Ø      The disappearance, at least in its current form, of the securitisation process  à RISK OFF. Continued contraction of the V in MV=PQ. Deflationist, negative equities, bull flattener US.
 
Ø      The Fed's stimulus via QE2 à RISK ON. Enormous liquidity, bull equities, bull steepener 10/30 US.
 
Ø      The ECB current monetary normalisation  à Bear Flattener eurozone.
 
 
 
Let's begin with this updated graph, often seen here, tracking the ABCP market in the US (Asset Backed Commercial Papers).
 
Securitisation in agony: ABCPs
Outstanding ABCP funds have plunged 67% since 2007 to their lowest levels since these data have been tracked!
 
 
 
Devastated by the implosion of the Bear Stearns hedge funds, the paralysis of dynamic money market funds, the cholera of SIVs and other conduits, followed by the Lehman bankruptcy, today's MBS investigation may just finish off the securitisation sector, which have revealed misconduct committed as these securities were being constructed.
 
The Procedures
 
We learned last night that PIMCO, Blackrock and the Fed were asking Bank Of America to buy back $47bn in decaying MBS securitised by Countrywide Financial, the firm bought by BoA in January 2008 (ouch!).
Since the contracts governing these MBS effectively require the issuer to buy them back, if the mortgages in them do not fit the description (liar loans), and initial revelations indicate that the fraud was widespread, the banks involved in this practice could find themselves in deep trouble.
Especially since the Fed's involvement in this move against BoA gives it enormous credibility in that the US central bank hardly has the reputation as an ambulance chaser.
 
Another group of investors set up a legal entity, RMBS Investor Clearing House, including BlackRock, Pimco, Fortress Investment Group LLC, Fannie Mae and the Federal Home Loan Banks, which represents $600bn of this type of debt! The number of participants in this entity has grown from 65 to 100 in the past two weeks.
 
 
The Securitisation contagion
 
Furthermore, the methods used to structure these securities, which, even if the original components do not point to fraud, are hardly up to investor expectations, could cause these problems to spread to all securitisation products, beginning with ABS (Asset Backed Securities).
An ABS is composed of many different securities, some of which are used to back consumer loans, auto loans or for commercial real estate mortgages; in short, just about anything investors were willing to accept at the time.
Credit rating agencies relied on specialist firms to verify that the proportion of risky loans in an ABS, ranked by credit scoring tranches, for example, matched the description provided to investors.
In order to avoid the fastidious task of verifying one-by-one the securities composing an ABS, these specialist firms used sampling methods, which seems fairly logical for statisticians fascinated by the Random Walk and EMH.
 
Unfortunately, as you will see in this paper, Whistleblower Speaks On Fraudclosure, business ethics were not exactly front and centre.
Check out the quote, below, and decide for yourself the credibility of these difficult to verify assertions:
 
"I put together a large subprime deal where we said that the percentage of Stated income assets was 10%.  Out of a pool of over 500 assets, we ran our due diligence and pulled a sample of 50 assets, we had over 25% of the assets come back as stated income.  Well, we got another 50 assets and still came back with 22% stated.  It was obvious to me and the underwriter that the stated income levels were higher than originally reported.  
How did we handle this issue?  We threw all the stated income assets out of the deal.  In this case we threw out 22 assets and packaged the deal as 10%.  In fact that is how we would typically handle issues where we had discrepancies.  I told my boss on several occasions that it was a real fishy way of doing things, but as everyone was also doing it, my coworkers, the guys from Goldman, the agencies, I just kind of went along with it.   
We securitized that deal and put 10% stated on the dealbook.  S&P put their name on the package.  Goldman underwrote that deal and sent it out to hedge funds and pension funds.  
What the hell?"
 
 
After all that, what investor would dare buy securitised instruments and what bank would take the risk of structuring them?
Beyond the real amount of the eventual damages and penalties to be paid, I am more worried about the future of securitisation itself and thus of the V in  MV=PQ.
 
 
Contagion to real economy
 
At the same time, there is this notion of risk paralysing and spreading to the real economy via the Fraudclosure Mess.
 
The incredible scenes of recent months of people being expelled from their homes, followed by their reinstallation, and other dramatic incidents relating to property titles in the United States can only further weaken the US real estate market once the legal primacy of private property is laid open to question!
 
Some friends regularly talk to me regularly about taking advantage of low prices to buy property assets in the United States, like, for example, in Miami. But who would take the risk today of buying a previously foreclosed property only to receive a letter months later that the purchase was invalid because the foreclosure was itself illegal? This could be a real nightmare, especially, for a country in which property rights are guaranteed by the constitution!
 
Given the sorry state of the US real estate market, with nearly 4 million homes still for sale, and a banking sector that will logically becoming increasingly shy of anything even slightly resembling a real estate transaction (Credit Crunch + legal uncertainties), we can legitimately look forward to a few more tough years ahead.
 
 
Conclusion
 
My goal in highlighting this topic today was not to scare people, despite the text's alarming tone, but to explain why the uncertainties stemming from this situation are so important and why I prefer to put our core asset allocation biases on hold for the time being in favour of our well calibrated option strategies.
 
I am taking this stance, despite my conviction that a QE2 is just around the corner. I am even willing to estimate the Fed's programme at around $200bn per quarter between each of the FOMC's Quarterly Forecasts. These forecasts will be used to guide the terms of  the continuation of the QE2 in a transparent way in the eyes of the public to better orient inflation expectations so that they do not spin out of control, in either direction.
 
 
Have a good evening.
 
 
Asset allocation biases and advised option strategies 
 
Ø      Bund, Bobl, Shatz: See below…Bear Steepening, Schatz  vs 10-year Bund.  On options basis!
Long December Schatz puts vs Bund puts, premium received and net delta short.
 
Ø      2800/2900 on the Eurostoxx 50.    On options basis!
The Eurostoxx call ladders are working perfectly, given the hike in the spot price and the passage of time.
Call spreads and outright call purchases on the Eurostoxx on October and December, hoping for a little velocity and affordable implied volatility.



 
Feel free to contact me for details on strikes and maturities.


Disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds, Long Eurostoxx50 ETF