Pair Trade of the Day: Lockheed vs General Dynamic

The costs of CDS protection on Lockheed and General Dynamic are strongly correlated and currently are equal, indicating that credit markets do not consider one firm as more as risk of a major event than the other.



Their stocks are strongly correlated too (R-squared of 0.848, i.e. a correlation of 92%):



However, today's market (shown as a red star on the plot) is an outlier: GD appears way too rich relative to LMT. I would short GD and get long LMT in proportions guided by the slope of the regression line. The upside is about $15 per LMT share (if GD stays around $65, LMT should revert from ~$70 to a regression line level in the mid $80's), or equivalently $15 to $20 per GD share on the short side (if LMT stays around $70, GD should, according to this linear regression, revert from $65 to its trend line in the high $40's).

CSMC 2007-C4

The A1Am note of CSMC 2007-C4 was rated AAA by S&P and Moody's, and still is by the latter:



Almost 9% of its collateral is already delinquent. (BTW, 2600 Michelson is one of Maguire Properties discussed in another post.) An additional 25% is under watch:



If we consider a CDR of 20 (which is in line with the latest remittance reports on ABX collateral of 06 and 07 vintage), Bloomberg's model projects a 49.84% loss on both AM and A1AM notes.

Lehman Mortgage Trust 2008-4

Today, Standard & Poor's Ratings Services downgraded pieces of a 2008 re-REMIC from AAA to just CCC... The deal is Lehman Mortgage Trust 2008-4, and the class is A2. That their ratings can change so dramatically and so suddenly is shocking (Moody's had cut its ratings on the same paper to just C more than 5 months ago). The press release indicates that "although this performance deterioration is severe, the credit enhancement within LMT 2008-4 is sufficient to maintain the rating on class A1." S&P's current projected loss for the pool already stands at 14.74%. Is there enough subordination under class A1 to make any loss on it highly improbable? I don't think so. And in fact, Class A1 was downgraded by Moody's to just B3 five months ago already...

Let's note also that it took only 11 months for the top notes of the re-REMIC to lose its AAA rating from Moody's and S&P: the deal was issued in June 08, and Moody's downgrade took place on May 15 this year.

Follow Up on the Bombardier/Textron Pair Trade

On the graph below, the white dot is where the pair of stocks was standing when I posted the regression. Since then, it moved to the red star. The P&L on the short is 0, but the gain on being long Textron is $2 per share.

For S&P, Gemstone Still Is A Jewel

Moody's announced today it downgraded four notes by Gemstone CDO, an ABS CDO: notes A-1, A-2, A-3 and B. Shares A-1 were initially rated AAA, and now end up below investment grade. In its press release, Moody's notes that "the ratings of approximately 19% of the underlying assets have been downgraded since Moody's last review of the transaction in March 2009. The trustee reports that the WARF of the portfolio is 1,354 as of September 30, 2009 and also reports defaulted assets in the amount of $48.5 million. Securities rated Caa1 or lower make up approximately 32% of the performing portfolio. The trustee reports that the Class C Overcollateralization Test is currently failing."

Now, if we look at the rating history on this paper, we see S&P hasn't touched the rating since 2004! According to S&P, it is still AAA...

Other Possible Pair Trade: XTO and Anadarko

XTO Energy and Anadarko have had almost the same credit-worthiness for the past two years, as shown by their CDS spreads:



Their shares have been strongly correlated (for the past 2.5 years, at least) -- but they've recently been out of whack.

Ideal Pair Trade Candidate: Berkshire A and B

Here's a perfect candidate for stat arb/pair trading: Share classes A and B of Berkshire. Correlation between the two has never been lower than 95%. Still, there's some volatility between the two. On the screen shot, the top pane shows the prices separately (Class A in white, Class B in amber, at the bottom); the bottom pace shows the ratio between the two. Its oscillations show the opportunities offered by the (bounded) volatility between the two share classes.

Interest Rate Swaps Through Clearinghouses

This could be game-changing: LCH.Clearnet, Europe’s largest clearinghouse, said it has processed more than $1 trillion in overnight index swaps 11 weeks after starting the service. Interest-rate swaps are the biggest part of the over-the-counter derivatives market.

Follow-Up on the AUD-USD Trade

Since my post predicting the Australian Dollar would keep rising relative to the USD because of interest rates differential, the AUD gained 5.66%.

Follow-Up on CHK vs FST

The pair trade suggested the other day has paid off: CHK is slightly lower, giving a small profit on the short side, and FST is up, giving a nicer gain on the long side.

"Credit’s Divorce From Stocks Signals End of Rally"??

Interesting "chart of the day" today on Bloomberg: it overlays the S&P500 index with the iTraxx Europe 5Y index (inverted, so that a upward curve also indicates positive performance). The resulting graph shows two curves that look very similar -- until very recently:



The conclusion reached by the strategists who published that graph is that the S&P500 went ahead of itself, as judged by the relative under-performance of the credit index. To quote the press release, "Credit’s Divorce From Stocks Signals End of Rally."

Although I do believe the equity index went ahead of itself, I have issues with the reasoning.

First, we have to be mindful of units: one time series is expressed in S&P points, the other in the inverse of bp; so a more meaningful comparison would be to compare time series of returns (for instance, day-to-day returns).

Second, the time scale is short: their time series begins in early August. If we look at a longer period, we get the graph below. The time frame is still relatively short (we pulled data starting on March 02, 09) but long enough to show that there's been other "credit's divorce from stocks" in recent past:



And third and foremost, how can we tell: Is it S&P500 that's too high, or iTraxx that's too low?? The two indices do have a (relatively short) history of moving in tandem, but there have already been times when the two plots diverged before merging again -- i.e., there have been other "divorces of credit from equity," and they were temporary: None of these instances was followed by an end of the equity rally! On the contrary, the trend has steadily been upward! So I find the technical chartists a bit short on convincing arguments here.

Dollar Flows at Banks

On Bloomberg news, Oct. 12:

"Central banks flush with record reserves are increasingly snubbing dollars in favor of euros and yen, further pressuring the greenback after its biggest two-quarter rout in almost two decades. Policy makers boosted foreign currency holdings by $413 billion last quarter, the most since at least 2003, to $7.3 trillion, according to data compiled by Bloomberg. Nations reporting currency breakdowns put 63 percent of the new cash into euros and yen in April, May and June, the latest Barclays Capital data show. That’s the highest percentage in any quarter, with more than an $80 billion increase."

Rate on Non-Financial CP: Lowest in 9 Years

Commercial Paper issued by non-financial companies pays the lowest rate in 9 years. However, the rate is just tracking LIBOR, and the spread between the two is simply coming back to normal levels.


(Click to enlarge.)

In the top pane, the CP rate is plotted in white and 3-month LIBOR in amber. The spread is shown in yellow in the bottom pane.

Too High Too Fast

The CS HY index is up 56% from its trough at the end of last year. Of course it's too high too fast... Default rates are not yet as high as feared earlier this year, but HY bonds are in what looks and feels like a bubble. (Sorry, this is as of Wednesday -- didn't have time to upload the chart earlier.)

Merrill Lynch Posts $250 Million of Mortgage-Issue Trading Losses

The article below was published in 1985! All the financial fiascos of the last 2 years had already happened then, including huge bank losses (by 1985’s standards…); process failures; rogue traders (or presented as such by their employers); untested financial engineering & lack of proper modeling of newly created securities; sudden markets illiquidity and investment banks stuck with their inventory (think of CDO warehouses); and the question of whether risky investments are appropriate for all investors.... I highlighted a few juicy sentences and added a couple of comments. Enjoy.

Merrill Lynch Posts $250 Million of Mortgage-Issue Trading Losses
by Steve Swartz
The Wall Street Journal, April 30, 1985

NEW YORK Merrill Lynch & Co. said it sustained an estimated $250 million pretax loss, largely because of unauthorized mortgage-securities dealing by a senior trader. The rest of the loss came from “subsequent market volatility" in the securities, the company added. The trader, Merrill executives said, had far exceeded his limits in acquiring mortgages that were packaged into a particularly risky form of securities. The value of some of those securities plunged recently when interest rates went up. Market experts said the trading setback was by far the biggest in recent memory, and was likely the largest in securities industry history. “This is a new world record," said the head of mortgage trading at a rival firm.
[..]

Merrill Lynch said the senior trader, whom it didn't identify, had been fired. However, executives at Merrill Lynch privately identified the trader as Howard A. Rubin.
[..]

The securities said to have caused the problems are created by splitting of the interest payments on the mortgages from the principal and selling each separately. They are known as “interest-only/principal-only" securities, or IOPOs.
[..]

People at Merrill Lynch said Mr. Rubin had accumulated for the firm's account an unusually large portion of the principal-only securities without notifying his superiors. When interest rates went up earlier this month, principal-only securities lost as much as 15% of their value over two weeks, traders said. “He just put them in his drawer," said one senior Merrill Lynch executive. “We didn't know we owned them." Mr. Rubin eventually told his superiors about the unauthorized trades, according to people at Merrill Lynch. Securities firms and banks usually allocate a specific amount of capital that can be risked in each area of trading.

Merrill Lynch's announcement also raised questions about the firm's controls. “This would suggest to me that Merrill's international controls are far less than they should be," said Perrin Long, an analyst at Lipper Analytical Securities Corp. and a frequent critic of Merrill Lynch management. Although Merrill Lynch said that the greater part of the loss stemmed from unauthorized trading, it declined to say how much. However, rival mortgage traders said that Merrill Lynch came to market early this month with more than $900 million in IOPOs at a time when the market was becoming unreceptive to IOPOs. The competitors say Merrill Lynch was largely stuck with the principal portion of the securities in its inventory when the price plummeted.

Merrill Lynch officials say they sold most of the $900 million to customers, except for a portion that was kept in the belief that the price would go up. [my comment: does that imply the other portion was dumped on customers knowing its price would go down??]
[..]

Principal-only mortgage securities are attractive in a market where interest rates are low and mortgage holders have an incentive to pay off early. That produces a quick profit for the security holder, who buys at a discount to principal. When interest rates rise, however, early payments on fixed-rate mortgages become less attractive and the profitability schedule of these mortgage securities is stretched out.

Merrill Lynch officials said Mr. Rubin was suspended a couple of days ago after disclosing his unauthorized trading to his superiors. The officials said Mr. Rubin kept the trades secret for 10 days. They said they were unable to independently monitor Mr. Rubin's trades because he never wrote out tickets for them, a violation of standard procedure.
[..]

The risk of stripped mortgage-backed securities has been a hotly debated topic on Wall Street since the technique was developed last summer. Many investment bankers believed the extraordinary volatility of the security wasn't well understood, and have been predicting that holders could get badly hurt if interest rates moved sharply. However, nobody was expecting a hit as large as the one Merrill took. Although the price of the securities the firm held has dropped dramatically in the last couple of weeks, it didn't fall more than about three points in any one day. Even if Merrill had known it had all the securities, however, selling them when the market began to drop might not have been as easy as it looked. An official at one major firm called the market for stripped securities, of which IOPOs are by far the most popular form, “the most illiquid $11 billion market in the financial world." Merrill Lynch has been selling its position gradually over the last 48 hours, and made its announcement after most of it was sold, market sources said. The firm was extraordinarily active in the Treasury market Tuesday, they added, leading to speculation it was trying to hedge what it hadn't yet sold.

Merrill Lynch officials won't say where they sold the securities, but the firm is rumored to have disposed of at least part through its retail system. Merrill Lynch has sold portions of other stripped offerings retail, but the question of whether retail investors understand a product that complex is a much-debated one.

The Curious Case of Lincoln Avenue -- A Structured Credit Medley

If you find this post complicated: it's the whole point. Thanks to the Lincoln Avenue deal, we are about to encounter in this post almost every contraption created in the gogo years of credit. In fact, it is so complicated that I doubt any rating agency or investment bank has the models and the infrastructure to properly analyze such deals. Of course, we could also say that confusing structured credit investors is the whole point as well!

So judge by yourself. And BTW, everything here is public data, you just need to google for "Lincoln Avenue CDO" and do some research on the Bloomberg terminal.

The Lincoln Avenue ABS CDO, issued in July 2006, has a rather eclectic collection of paper as collateral: other collateralized debt obligations (CDOs), some U.S. commercial mortgage-backed securities, and U.S. residential mortgage-backed securities. So it is in part a CDO-squared, a CDO of CDO.

The maturity of Lincoln Ave is nothing less than 40 years. Its senior tranche, the Class A-1 notes, was originally rated AAA by S&P and Aaa by Moody's; it had $1.094bn of notional. The next notes in subordination order is the A-2, with $77mm of face value; then $26mm of Class B notes, $21mm of Class C, and $19mm of Class D, "equity" or "first-loss" notes.

According to totalsecuritization.com, Lincoln Avenue ABS CDO had an "event of default" (EOD) as early as Sept 12, 2008. In fact, a majority of Lincoln Avenue's collateral has today a rating of just C (i.e., junk) by DBRS.

So not surprisingly, everyone seems to be trying to get rid of this stuff.

First, in December 2007, Barclay's repackaged $7.5mm of face value of Class C notes (ISIN: USG5490EAD07) of Lincoln Avenue, together with 9 other CDO securities, into $70MM "Principal Protected CDO Portfolio-Linked Notes" and into a $20MM so-called "Credit Linked Note Programme." Looking at the OM, it seems that these securities had ISIN XS0336216634, and were marketed mostly in Europe.

Then, recently, even the holder of the top of the capital structure of the Lincoln Avenue CDO, the holders of Class A-1 Notes, seems to try to swap the toxic asset away: DBRS announced today that it "has assigned a rating of BBB (low) to the total return swap (TRS) referencing Lincoln Avenue ABS CDO, Ltd.'s Class A-1 Notes, pursuant to the transaction documents dated April 28, 2009, with a current notional amount of $82,860,028." As an aside, DBRS indicates that "this rating is being provided at the request of the majority Class A-1 Noteholder." I.e., their client is not the CDO, but indeed an investor in the CDO's top tranche -- the holder trying to swap its position away.

Now, listen to this: "The TRS benefits from approximately 92.2% subordination" from the Class A-1 Notes and from a "commitment letter" (a credit enhancement). So, even with 92.2% of subordination and the credit enhancement, the TRS could barely get an investment-grade rating? Personally, I consider ratings in structured finance have lost all and any credibility. (In fact, I find suspicious the sheer fact that the TRS barely passed IG.) But the low rating given the subordination and the commitment letter shows how toxic the collateral and the structure is. In other words, if the TRS on the A-1 notes are BBBL-quality, the Barclay's note probably couldn't receive a rating at all.

Possible Stat Arb on Bombardier and Textron

Bombardier and Textron are in the same industry, and have almost identical creditworthiness according to the CDS market:



Their shares, too, have moved in tandem. The linear regression of their share prices shows a correlation of 89%:



Still, today's point if far from the regression line, suggesting that the shares of Bombardier are rich relative to those of Textron. Specifically, it suggests being long 0.129 shares of Textron for each share of Bombardier shorted. According to this model, if Textron's shares don't move, Bombardier's should retrace from about $4.5 to about $4; if Bombardier's shares are unchanged, Textron's may revert to its trend line, from about $18 to about $22. Any other scenario reverting to the red regression line is of course possible as well, and would also generate a profit.

Commercial Real Estate: Delinquencies by Property Type

The percentage of commercial real estate loans that are 60 days or more delinquent in the hospitality industry shot up in September:

(Source: Bloomberg, dataforthoughts. Click to enlarge.)

In absolute $ of loans delinquent, however, the hospitality industry is on par with multi-family and retail commercial real estate loans:

(Source: Bloomberg, dataforthoughts. Click to enlarge.)

Note that the total amount of loans late 60 days or more has reached a staggering $25bn.

What Is Wrong With Re-Securitized MBSs

To see what is wrong with re-securitized MBS, we need look no further than Credit Suisse Mortgage Capital's recent CSMC 2009-10R deal.

Its collateral is 2242 loans, all ARM. 29.7% are in California, 5.8% were taken for investment. 99.6% of them were originated in H2'06 and Q1'07, at the trough of mortgage origination's standards. The performance of its collateral is catastrophic:

• Loans delinquent for 60 days or more represent 57.34% of collateral
• Loans with a loan-to-value between 80% and 139% are 57.96% -- not surprisingly, almost the same number as the fraction of households who stopped making payments! (Remember, an LTV above 100% means that you owe the bank more than what your place is worth.)
• 91.8% had FICO score at or below 700, 68% below 651.
  
• 11.1% of these loans currently pay usury interest rates of 10% or more! (Their ARM rates probably reset.)

But the worst may be yet to come for this security: 10% of the loans faced resets on their mortgages last month (September); almost 8% will be reset in December, then 19.7% more in Jan, and 23% in February! While again already 57.34% of the loans are late on their payments! I have no idea what this paper can be traded at, but probably not much.

The Rates Banks Charge vs. Their Funding Cost -- Continued

We already noticed examples where banks are charging their customers much more than their funding costs. Here's another example: the spread between the national average of rates charged for a home equity line of credit (HELOC) and 3-month LIBOR.


(Click to enlarge)

The screen shot is a bit busy, but the top pane shows the average HELOC rate, in amber, and LIBOR, in white. The spread between the two has been about constant until 2008, when it started to gap out. This can equivalently be seen in the bottom pane, which plots the difference between the two: that difference has risen steadily since late 2007, except for a brief period in 2008 due not to the generosity of banks but to a sudden spike in LIBOR.

Mini Panic Today, and "Riskless" Assets Rallied

The yield on the 30-year Treasury bond fell 11bp to 3.94%, the lowest level since April 29. The 10-year note yield dropped 3.18 percent, its lowest level since May 21. Yields on Fannie Mae’s current-coupon 30-year fixed-rate mortgage bonds tumbled 14bp to 4.09%, the lowest since May
21 as well.

NY Fed Buying More 5.5s MBS

The NY Fed established its Agency Mortgage-Backed Securities Purchase Program to prop up mortgages and their liquidity. The NY Fed seems to be shifting its purchases in the coupon stacks, from 5s to 5.5s -- a few months after another purchase shift, from MBS with 4.5% coupons to MBS with 5%-coupons. Given the amounts, the Program could move the markets in these different segments.


(Source: NY Fed, dataforthoughts. Click to enlarge.)

TSLF's Loans of Agency Debt

Another NY Fed program is the Term Securities Lending Facility (TSLF). Effective July 9, 2009, the Federal Reserve Bank of New York’s Open Market Trading Desk began to offer for loans direct obligations of housing-related government-sponsored enterprises (GSEs) Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Note that such Agency debt are securities lent by the NY Fed (in addition to Treasuries and TIPS already available in previous auctions), not collateral pledged by borrowers. Since then, demand for Agency paper has been a success, and is trending higher:

(Source: NY Fed, dataforthoughts. Click to enlarge.)

Follow Up on the CHK / FST Stat Arb

As of 1:30 pm today, CHK has dropped 1.92% to $28.55 since the post, and FST has gained 5.39% to $19.93...

Future U.S. Rates -- And the Aussie Dollar

The future rates implied by markets always offer food for thought. First, let's look at the Fed's target rates expected by the markets, according to Bloomberg:



As most of us would expect intuitively, the Fed is believed to stay on hold his year. Where opinions differ is as to when in 2010 it will begin to increase its rate target by 25bp increments: at its January meeting, or the one in March? In any case, the target rate would be at, or close to, 1% in the middle of next year.

This is consistent with future 90-day Eurodollar rates implied by the markets:



As the graph nicely shows, the rate should approach 1% by the middle of 2010, and be around 2% by the middle of 2011 -- with confidence intervals color-coded with different shades of blue.

Now, comparing futures dollar rates with that of the Australian dollar makes me pause:



By the middle of next year, their interest rates will hover around 4.5%; by the middle of 2011, around 5.5%! The carry trade between the two currencies is not finished; if nothing changes, the AUD will certainly strengthen against the dollar.

To that topic, as an aside: Deutsche Bank has the Euro at USD 1.25 in a year and the USD at 100 Yen.

Citi's Savings

On Sept. 17, Bloomberg indicated that Citigroup plans to sell $2 billion of five-year notes that aren’t guaranteed by the Federal Deposit Insurance Corp. This senior debt may price to yield about 325 basis points more than similar-maturity Treasuries. Looking at today's levels, the YTM on 5-yr Tsy is about 2.372%, so adding 3.25 implies the yield on Citi's debt would be 5.622%.

Now, just a few days earlier, again according to Bloomberg, Citigroup issued $1.5 billion of two-year fixed-rate bonds guaranteed by FDIC. (The FDIC program guarantees debt maturing in 3 years or less, so Citi had to do without to issue 5-year bonds.) Thanks to the Government guarantee, the issue priced to yield 3 basis points less than the benchmark mid swaps rate; with the 2yr swap rate at 1.306%, that’s 1.276%. So if Citi had to pay 2-yr Tsy rate + 325bp, its cost would have been 0.992 + 3.25 = 4.242%. Its savings are thus 2.966%, or $44.5mm per year.

On the same day, Citi also issued two more notes guaranteed by FDIC: First, $2.5 billion of three-year fixed-rate notes at the mid swaps rate. The 3-yr swap rate, mid, stands at 1.9%, but if Citi had to pay at the non-guaranteed (3-yr Tsy rate plus the same spread debt, 325bp), the firm would have to pay 1.478 + 3.25 = 4.728%. So its rates savings is 2.828%. Second, it issued $1 billion of three-year floating-rate debt at the three-month London interbank offered rate, where 3-mo LIBOR today is at 0.2825%. Now, assume the funding cost are the same as for fixed-rate (at origination, that should be true): that's another saving of 2.828%, or $99mm par year for both 3-yr notes!

To sum up, this back-of-the-envelope calculation tells us that the Gov't guarantee will save Citigroup $143.5mm per year over the next 2 years, and $99mm in 3 years -- and that, just on the bonds the bank issued in September!

CMBS Issuance and Issuers

CMBS issuance is still anemic at $8bn YTD, compared to $16bn in 08 and $203bn in 07. Not a single floating-rate deal this year, compared to 40.7% ($11bn) of 08 issuance and 20% ($50bn) in 07. The secondary market for floating-rate CMBS is also weak.

Looking at the issuers' ranking tables, Jefferies is coming strong, out of nowhere: #2 in Q3'09, was #6 in Q2, and virtually inexistent in past years. Loop Capital has been in the top 10 since Q3'08, but also coming out of nowhere -- they star started to rise even before they were selected by the NY Fed, on Sep 1, 09, as one of the four "non-primary dealer broker-dealers" (a mouthfull) for TALF. Morgan Stanley, which was at the top of the league table in 07 and 08, seems to be losing most.

Personal Bankruptcy Filings

Mary Kane at Citi “calls for roughly 24-34% growth in personal bankruptcy filings for the year ending June 30, 2010 – i.e., roughly 1.5-1.7 million personal bankruptcy filings.” Given her credentials (she and her team placed second in Institutional Investor's Sept 09 ranking of the best analysts of the year, category ABS/Consumer), the prognosis is worth keeping in mind.

CMBS Remittance Reports

Interesting data aggregated over the latest remittance reports on about 45 CMBS deals, about evenly split among 06-1, 06-2, 07-1 and 07-2.

• Serious delinquency for the aggregate deals alarmingly increased again, by 1%, to 47%.
  
• Severity in aggregate stands at a staggering 71.6%, but is down 140 bp from August.
• CDR in aggregate declined by 50bp to 18.8%.
• Cumulative loss is up by 55bp and now reaches a severe 12.2 %.
  

Reallocation Out Of Cash

From Barclays Capital's Asset Allocation report dated Sept 24: "The environment of near zero interest rates means that savings are being slowly forced out of cash and into riskier asset classes. Around $350bn has left US money market funds this year, while $185bn has moved into equity, bond and hybrid mutual funds. Roughly 2/3 of the reallocation out of cash has headed into bond and credit funds. This move out of cash into riskier assets represents just 23% of the $1.5trn flight into cash that occurred over the 2007-Q1 09 period. As such, the remaining volume of savings that remain in near-zero yielding cash offer a considerable potential fuel for a continued rally in riskier asset classes."

Fly on Swaptions on 2y/5y/10y Rates

As discussed in previous posts, 1:2:1 flies on short-expiry options on 2y, 5y and 10y rates reached historical peaks recently. They retraced nicely, offering profit opportunities. Below, the fly on 6-month expiries:

Number of U.S. Banks Has Been Dropping... For 20 Years

Amazing stats from the St Louis Fed: there were more than 12,000 banks in the U.S. in 1990, more than 8,000 in 2,000, and about 7,000 at their latest count.



The original data can be found here, and match the numbers reported in this FDIC paper.

ABX After Remittance Reports

ABX tranches took a beating after the latest remittance reports: for example, ABX.HE.07-2 lost one point, closing Wednesday at a bid of 30 and change and an ask a tad higher than 33. It closed yesterday at a bid-ask of about 29-32.

Follow-up on Swaptions on 1-Year Rates

We had noticed that the vol surface on options on 1-year swaps was humped for 6-month expiries, indicating these options were relatively rich. The volatility surface regained a smooth look over short expiries:

How U.S. Banks Help Fund the Deficit -- And Prop Up the Price of Treasuries

U.S. banks have been piling on U.S. Government securities since the beginning of the crisis:


(Source: Board of Governors of the Federal Reserve System; St Louis Fed. Click to enlarge.)

This can be explained by the need for banks to reduce risk on their balance sheet, and by their inability to find borrowers at the rates they suddenly began to charge. This renewed demand certainly helped push the Treasury prices higher despite the massive supply of the last couple of years.

Looking at absolute numbers is also informative:


(Source: Board of Governors of the Federal Reserve System; St Louis Fed. Click to enlarge.)

We learn that about $300bn of Govt securities were absorbed by US banks alone, thus helping fund the stimulus and the deficit. (Which in turn may explain the relatively lenient attitude of the Government toward banks, capital requirements, compensation, etc.)

Real Rates on (Inflation-Protected) TIPS

According to Bloomberg, real yields to maturity are negative, mostly, for inflation-protected U.S. Government bonds (also known as TIPS) maturing over the next 6 years. To look at their inflation assumptions and corresponding real yield calculations, you just need to go to their DES screen for a given bond. The few exceptions may even offer arbitrage opportunities: The TIPS with CUSIP 912828HW, maturing on April 15, 2013, has a positive real YTM; but the two TIPS with closest maturities, 912828AF and 912828BD maturing on 7/15/2012 and 7/15/2013 respectively, have inflation-included YTMs of -1.093% and -0.814%, respectively...


(Source: Bloomberg, dataforthoughts. Click on chart to enlarge.)

Swaption Fly on 3m Expiries on 2y/5y/10y Rates

The 1:2:1 butterfly on 3m-expiry swaptions on 2y/5y/10y rates reached levels not seen in years and several standard deviations away from its historical average.

The Rates Banks Charge Vs. Their Funding Cost

In an article in the Washington Post today, Steven Pearlstein wrote that "the Fed was [..] lowering the interest rate at which banks borrow from the Fed and each other, to pretty close to zero. What didn't change was the interest rate banks charged everyone else. As a result, "spreads" between what banks pay for money and what they charge are near record highs."

We can relatively easily find hard data to back up that claim. For example, we can look at the average 24-month finance rate for a personal loan by a commercial bank. If you want to try this at home, I'm using the CCOI24MO Index on Bloomberg. (FYI, the Bloomberg description adds that "the index is taken from the G.19 report disseminated by the Federal Reserve, and is not seasonally adjusted.") The value of that index dropped to a rate of 11.25%, much lower than in recent past. But to echo Pearlstein's point, we want to compare it to the cost of funding that banks themselves face, i.e., to LIBOR. The graph of the spread makes the point clear:



The spread hasn't been that high since the early 2000's and the early 1990's.

Stat Arb on Chesapeake and Forest Oil?

For those stat-arb minded: The stocks of Chesapeake and Forest Oil are correlated at 95.9% (R squared at 92%), but Chesapeake is historically high. Both CDS spreads tightened recently and widened out a bit yesterday. We'd need to do more homework on both companies of course, but selling CHK against a long position in FST may be a good idea for a pair trade.

Jumbo ARM Deliquencies At 10.5% in August

Worrisome news in Moody's ResiLandscape report published Friday 9/17: "Jumbo delinquencies continue to rise rapidly, increasing to 10.5% in August 2009 from 2.7% a year ago for jumbo ARM pools issued in 2007." Also, "average loss severity has climbed to 45% as of August 2009 from 39% a year ago for 2007 vintage securitizations."

Following Up On the 3m1y/6m1y/1y1y Swaption Fly

A few days ago, we observed that the 1:-2:1 butterfly of 3mx1y, 6mx1y and 1y1y swaption vols was a historically low level, breaking -25bp. (i.e., confirming the observation made earlier than the 6m1y swaption was rich.) The fly nicely retraced above -17bp.

CDS Spreads on Local Governments

The cost of CDS protection on local governments is at its tightest since the beginning of the year. Interestingly, they all seem to have moved in a very correlated manner.


(Click to enlarge)

Term Structure of CDX IG 12, Continued

In a previous post, we noticed that the term structure of the CDX IG Series 12 was surprising. It reverted to normal, with the cost of protection increasing with maturity. The graph below shows the cost of protection for 1-, 3-, 5-, 7- and 10-year contracts.


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Another Way To Play The Richness of the 6m1y

Another way to play the richness of the 6m1y swaption is through a 1:-2:1 fly with the 3m1y and 1y1y at the wings. It broke its record last week but was still incredibly dislocated this morning.

Humped Vol Surface of Swaptions on 1-Year Rate

In a previous post, we noticed that the ratio of implied vols of 6m1y and 6m2y swaption was 4.4 standard deviations from its historical mean. The ratio retraced but still 3.3 std devs away.

It is also worth noting the current hump on the vol surface on the 1-year rate. Typically, the implied vol of a swaption on a given tenor decreases monotonically with expiries. Today however, volatility peaked at 6-month expiries -- i.e., the vol of 6m x 1y swaptions of all strikes is high relative to same-strike options of shorter or longer expiries.


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International Demand for Long-Term U.S. Assets is NOT Much Weaker

Bloomberg News published today, on its terminals and on the web, an alarming article entitled "International Demand for Long-Term U.S. Assets Weakened in July" decrying that "foreigners sold a net $97.5 billion [of US securities] in July, compared with net selling of $56.8 billion the previous month." It also lamented that "foreign demand for U.S. agency debt from companies such as Fannie Mae and Freddie Mac weakened, with net sales of $4.6 billion in July after buying of $5.1 billion in June, according to the Treasury." Supposedly, that is due to "record amounts of debt sales to fund a $787 billion stimulus spending package" and to "the U.S. budget deficits [being] off the charts."

Well, the stimulus and the deficits don't help, but let's first look at facts.

Using data from the same company, let's first look at total net foreign purchases of US assets: that time series can be found on the Bloomberg terminal by typing FRNTTNET . The plot for the last few years is as follows:


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We can see that the July number is far from being as bad as that of Jan 09, or that of August 2007!

Let's now look at net foreign purchases of US Agency debt, using the FRNTUSGV index on the Bloomberg terminal. We see that the July number is in fact more than 10 times better than the October 08 number, when net foreign sales were $50.2bn, and much better than the July 08 or December 08 numbers!


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So, the numbers are not good, but nothing new, and nothing worse...

The US High-Yield Bond Market Is Dependent On Foreign Inflows

That may not be a surprise, but here are some facts to back up the claim that the domestic high-yield bond market depends on foreign purchases.

Comparing the Credit Suisse HY index to the volume of US Corporate bond purchases from foreign funds (Ticker FORPUSCB on Bloomberg) shows that both peaked at the end of April 07, and that the CS HY index plummeted after foreign investments dropped. A revival of foreign investments this year was later followed by a nice performance of the index.



How statistically significant is the relationship? Correlation, over almost 15 years, is 93%:

Swaptions: 6m1y / 6m2y Vol Ratio At 4 Standard Deviations

The ratio of vols (6m1y over 6m2y) stands at more than 4 standard deviations from its mean over the entire period covered by Bloomberg's data, which is more than 12 years. In that respect, the 6m1y clearly is expensive relative to the 6m2y.


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AMR: The Equity Market Was In Fact Right!

In a previous post, we noticed that the cost of CDS protection on American Airlines was increasing while the stock was going up, i.e., that the two markets were contradicting each other. I suspected the credit market knew something equities didn't know; well, it looks like the opposite was true: AMR's stock rose even further while the CDS spread (5yr protection on bonds) tightened violently.

1y x 2y ATM Swaption Straddle Rich Relative to 1y x 5y

The ratio of implied vols of the 1y x 2y and 1y x 5y ATM straddles just reached historical highs. It slightly retraced already but is still 2.34 standard deviations away from its historical average. (As for any option, the value of a swaption increases with vol, so a high implied vol on the 1y x 2y option relative to another swaption indicates relative richness.)