what's happening in credit/CDO etc

[rowdyroddypiper]

"Which begs the question which perhaps rrp can answer: How closely do rental rates track the published inflation indices? There is a subtlety in debt service relative to inflation - an interesting macro trade is buried in here somewhere, that can be carried off through the ABS markets."



I can answer it but I don't guarantee that it's correct.  Rents do incorporate inflation pretty well.  The issue becomes that commercial leases tend to be long term (5-10) years and the escalators put in at the inception are generally a pretty poor estimate of inflation.  In fact they are really just nice round numbers that leasing agents can calculate.  So asking rents will increase with inflation but in-place rents generally don't that well and you earn your money from in-place rents.  This brings up the interesting issue that while in place rents are stuck (or more apropriately deterministic) expenses are really subject to the forces of inflation and track it very well.  So if your structured rent escalations are higher than realized inflation, you may have a little pick-up, if they are lower then you will have a little drop-off.  This will of course impact your ability to cover debt service. 



Just as an aside, about 4 years ago I was working with a group that was putting together a model that was meant to simulate rents and vacancies and a bunch of other economic factors and then create an income statement for the property.  This would then feed into a structural model for default at the property level.  They kept showing me default probabilities that were much higher than my intuition would have suggested.  After peeling back the layers there were a substantial number of scenarios where default was triggered due to ridiculous inflation and static (or nearly static) rents on an in place basis.  Imagine a case where you have a building that has signed leases for 5 years in even increments so you get 20% roll every year.  An extended period of high inflation hits so you entire expense amount increases by that inflationary number but only 20% of your rent does.  It can pretty quickly throw you out of whack and put you underwater.



It's weird but it can happen.

[kr]

cool... this was not my immediate intuition. I was thinking in a more drastic scenario where the tenant's business fails, when you find a new tenant then you 'mark to market' that part of the lease portfolio - i.e. recovery hedge.

[granchio]

this is good, thank you all

[math_trading_coding]

What are some trades people have on in response to the CDO news? 

(Short BSC, buy puts, sell calls, etc?)



Short term vs. Longer term plays?

Any "cockroach theory" plays?   (ie: There's more to come)

[Bachelier]

I typically don't post whole reports, but RBSs Bob Janjuah wrote what I think is the best round-up of good thinking on the bear side of credit.



This is his "Bob's World" piece for today.
My piece for the CSI Fortnightly is below - plse read. Clearly markets lurched badly on Friday and this weakness has carried on into today (so far). The focus has been the BSAM issue, not just in the context of BSAM, but in the context of the wide and then even wider implications of the fallout. It is important to remember however that the market panic now relates directly to > heavily leveraged US consumer, the US Housing bubble, and the fact that consumers are defaulting at an increasing rate, bought abt by the shift in real yields from ZERO to abt 2.75%, ARM resets, bad lending, and Wall St greed (via the ABS and CDO product).Interest rates are key - and we think they are going higher GLOBALLY, due to GLOBAL inflation. And as a result, the ability of the Fed to cut rates to bail out housing - which is going to get worse for sure IMHO - is heavily tempered by global inflation, global diversification out of USTs, and continuing strong growth in Asia/the BRICs. In essence, the fact that the Fed lost control of the long end of the UST curve over the last 4/5yrs was GOOD  for consumption and asset prices (same thing?) because bond yields remained low and VOLA remained low due to globalisation (which for G7 was deflationary) and global flows (into USTs/Bunds etc). HOWEVR, now that globalisation is hitting inflationary headwinds, and as global reserves flows shift away from the USD and USD fixed income, this is BAD. I really do think we will see bond yields high and higher than US growth would otherwise have us assume, because of GLOBAL inflation. So we could be setting up for an environment of weak US consumption/growth and weakness in US/G7 asset prices due to too high bond yields and rising volatility.The fabled wall of money can disappear...Ask yourself this - if you can, going fwd, make more than adequate returns in high quality shrt dd govvies, and/or if banks/leveraged investors can make easy 'risk' free money out of domestic/G7 govvie yield curves, why would you take on unnecessary credit risk. You Won't. Especially if your end buyer of credit risk - the CDO/CLO market, is getting squeezed by housing defaults, investor redemptions, rising volatility leading to PB margin calls, etc etc etc .....Leverage is Good on the Way Up. But is destroys lives/families and even nations on the way down. You may not see that risk NOW, and it may not be a high probability, but the Credit Bubble, IF the Ponzi blows globally, will be very very very BAD.NOW, having said all that, I am not yet convinced that the End Game is underway - I still think that is a mth or 2 away, and requires more evidence of weakness in the US housing and consumer space (incl the knock on onto the ABS/MBS/CDO/CLO space) AND more evidence of strong global (ex-US) growth and strong global inflation. In other words we need to see bond yields HIGHER (5.5% 10yr USTs next, after any shrt term rally back toward 5%) and a handcuffed Fed, with the market assuming we are in a period of stagflation. I think this is late July/August's business. And very shrt term, watch out/be warned abt being too bearish NOW, because I can surely see the Fed (this Thursday) being dovish (remember, end of this week is a key mth, qtr and half yr end). Soft (but of course 'fake') PCE will also help.Longer term however,, this is clearly now a market where one SELLS RISK on RALLIES, which is fundamentally different from the last 3/4/5yrs, where you have been paid to buy on dips. UNLESS you are very very nimble or unless you disagree with my views, NOW is NOT the time to be getting Long/Longer. Now is the time to be selling down. I know credit and stk markets will possibly be slightly stronger at some point over the next few weeks - in fact, they PROBABLY will be stronger - but I think we are only weeks/a mth or 2 away from a serious puke (XO from 200/225 to 300, S&P from 1500/1550 to 1250). CAUTION WARRANTED. USE ANY RALLIES TO SELL LONGS/TO SET NEW SHORTS. IF YOU ARE A TRADER, TRADE FROM A SHRT BOOK AND LOOK TO DOUBLE UP ON ANY XO SHORTS OVER THE NEXT ONE TO THREE WEEKS ON ANY MOVE TOWARDS 200.Aside from the expectation of a very shrt term, very 'soft' credit/stk/yield rally over the next week or 3, my overall call is firmly BEARISH and I will only turn if 10yr USTs close below 5% for more than 4 consecutive days, if the S&P closes above 1545 for 4 consecutive days, and if iTraxx S7 XO closes BELOW 187 for 4 consecutive days. OTHERWISE, any lesser bullish moves are just oppos to get SHORT/FLAT.Higher Yields and Credit markets


Let's assume we are correct and bond yields continue to rise into and in Q3 and Q4. We are looking at the possibility of 10 year yields in the US hitting 6%, 5% in Europe and near 6% in the UK. Global (Asian?) inflation and shifts in buying patterns by Asian CBs will drive this move - largely irrespective, I feel, of what goes on with respect to domestic US GDP growth and the US consumer/US housing. The New Conundrum. Does this matter? Unequivocally I say YES. In fact, I feel that bond yields are the most important single item in financial markets (slightly simplistic, but everything IS de facto priced off of the US/Euro etc yield curve - including Volatility). So what are the implications for credit markets? Below are some thoughts - not definitive answers, but thoughts. I look forward to discussing the below with as many of you as possible over the next few weeks and months:



n   Rising yields will discourage (but not stop) corporates from adding leverage to buy back stock and will discourage (but not stop) Private Equity. But rising yields will also bring forward issuance, as corporate treasurers look to term out funding ahead of a higher yield environment. Heavy issuance is expected in Q3, at precisely the time risk version and volatility will be rising. This is not positive.



n   Rising yields will hurt investors who rely on leverage to generate returns at the simplest level because costs and volatility will rise. Cash and shorter dated high quality risk on an unlevered basis will be seen as a genuine alternative asset.



n   Rising yields hurt real money managers with existing fixed income portfolios. There will be a move to cut duration risk and also, I think, a move to become much more selective about adding credit risk. All this is likely to be happening precisely when big supply hits the markets.



n   Of course rising yields will hurt overly indebted consumers (and corporates) - further consumer/housing weakness will feed through to consumer/mortgage backed debt, including CDOs.



n   In this context a rising yield world is going to make the ratings agencies very nervous about their rating of, and role in, the whole CDO 'bubble', particularly with respect to anything that touches on US housing/the US consumer. This would unnerve CDO issuers, structurers and investors.



n   Prolonged consumer weakness will hurt earnings and eventually credit metrics. This will lead to fears of higher defaults and will feed straight back into the structured credit markets. The potential for a clearly 'vicious' spiral can be seen here.



n   Rising yields will make risk free debt much more attractive and a much more viable alternative to 'risk' assets. This will impact the flow AND structured world, as investors will no longer have to 'stretch' to earn good returns.



n   The 'wall of money' is not going to vanish but in a rising yield environment, this wall will look more like a little fence as far as credit markets are concerned. Just consider this: if, as we think is possible we get some genuine steepness between front end rates and 5/10 year yields in (say) the US, banks can make money just investing in USTs funded overnight. The pressure on banks to lend/take credit risk to earn income will fall away, it will NOT disappear, but will fall.



n   In terms of geography, in a rising global yield environment, I most want to avoid US/USD markets and favour European/EURO markets, where speculative asset bubbles are far less of a factor. The UK/GBP credit market sits somewhere in the middle, perhaps closer to Europe than the US, largely because the Bank of England has been honourably hawkish.



n   In terms of credit market sectors, in a rising/high yield environment, we want to move OUT of High Yield and into AA/high A paper where credit risk is minimal - hedged with swaps. In other words, I think being long the BARBELL in credit is now OVER. Sovereign Emerging market debt will outperform High Yield, and is something we (still) like going forwards.



n   The outlook for credit curves and basis is more difficult, and will likely be choppy (in terms of flows and price action). At this juncture, I think curves will steepen more further down the credit curve, and tighten further up (A/A+ and higher) the credit curve. As for basis, I suspect that cash will underperform CDS.



n   At the risk of repeating a point, the reaction of the structured credit market to a period of higher yields, higher volatility, higher (consumer) defaults and headline making unwinds of leveraged long credit portfolios, is going to be critical. I cannot see how the broad credit market is not going to be influenced negatively. I think the only question is HOW negatively. Here I worry about the unwind of global leverage as the era of 'no risk, no volatility', lever up and get long' is consigned to the bin. The mark to market ramifications of this unwind could be significant.



It is important to state that our bearish outlook for Q3 and in fact the next 2/3 quarters is going to be driven by data on inflation, not by fears of actual corporate defaults. Corporate defaults are NOT going to be a major factor in our lives for at least the next 2 quarters. Our fears are centred on the consumer and housing markets in the US and the unwind of leverage in the investor community, all driven by higher yields (higher volatility goes hand in hand with rising yields). And central to this is the belief that inflation is a global (Asian) factor which the West will have to pay for, irrespective of what our domestic growth rates may be. As such, and assuming we get a decent flushing out of excess asset valuations over the next 2/3 quarters, we feel that there will (potentially) then be significant value to be had in corporate credit markets. But this discussion is for another day.      



trading outlook:



Read Bob's World for timely/detailed updates. In summary, I am looking at 'range bound to slightly bullish' markets  for the next few weeks. In iTraxx S7 Crossover terms this means a 190/215 range. In S&P this means 1540/1490. And on 10 year USTs this means 5.05%/5.20%. If you are very nimble and like trading, I think the next 2/3 weeks can be rewarding if you use the range indications given here as a trading guide. However, the more important view is the view for H2 July and August/September. We see the next yield spike, taking 10 year US yields out to 5.5%/5.6%, as most likely to occur in this period. This will lead volatility higher, spreads wider and stocks lower. My targets for the H2 July/August sell off are for Crossover to hit 245 (+/- 5bps), and for S&P to hit mid-to-low 1400s. Beyond which we are likely to see another attempt at a rally (driven by the UST market), which in reality will just set up the next 'shorting' opportunity. We'll discuss this in future weeks as the market develops. And in this context, it goes without saying that data will be key.

[Bachelier]

You just have to laugh when something is titled



"The Bear Stearns Structured Credit Enhanced Leverage Fund"



and it ends up being in trouble.



I am fast extracting an algorythm that goes something like:



"when the title of the fund has a coeeficient of buzzwords >3 it is a "short""



Long Term Capital Management (>3)



others?

[nsande]

Which are the buzzwords in LTCM? Possibly "Long term" if you treat it as one word.



For the BS fund your case is better. "Structured", "Enhanced" and "Leverage" would probably fall into that category but I think your theory needs some more evidence.



Big Smile  



However, I do like the idea. It like the old truth that any country which has "democratic" or "people" in it's name is certain to be anything but democratic.

[IAmEric]

I'm also a fan of the magazine cover as contra indicator



From February 19, 2007, just before ABX blewd up reel gewd



[img]/User%20Files/257/LowLowLowLowRates.gif[/img]

[rowdyroddypiper]

We have a fund called the "Enhanced High Yield Debt Fund", I don't think you can short it though.



 



As an aside, I wish that I had a camera phone, because I saw a guy wearing a T-Shirt that said "Dr. James Ward" with the number 11 beneath.  James/Bachelier, are you in NYC now??

[Bachelier]

"Dr. James Ward" is an Australian statistician, or an LSE Math Prof, or (this is the one I love) a Beverly Hills plastic surgeon Smiley



I don't have a doctorate (yet.....)