State of the Crisis

Frankly, I don’t buy the Fed’s latest hawkish talk – rates aren’t going anywhere. I think the Fed had little choice regarding which stance they took, if they continued to ignore inflationary pressures the market could lose (or has it already?) confidence in their ability to reign it in.

ARM resets are firing on all cylinders right now and remember this is just a chart of the first reset, they will continue to reset until default or payment.

So, subprime mortgage holders need to refi or they’ll be defaulting in droves (rather than just for the most part being delinquent for now). Unfortunately, refinancing these things will be next to impossible for now since many have or will have negative equity AND until house prices bottom and start climbing the securitization market will be dead. Sure, there are some ongoing efforts to get these people into something that at least won’t reset for another few years (see: WAMU). We can expect housing to bottom no earlier than 2010, so until then rates will either have to stay low (and TED spread will have to remain tight), or lenders will have to warm up to short-refis (short sales), or gov’t will have to step in and let these guys out of their shitty loans. For the Fed to start raising rates, the second two will have to take up the slack.

This is certainly a plausible situation but gov’t policy tends to take time, and due to the securitization chain widespread short sales may be tough to get authorized. Moral of the story, Fed will have to keep libor and ff low, in my opinion, at least through 2008 and probably well into 2009 if not further. The market has been pricing in gruesome levels for the BAD subprime (some are worse than others):

As liquidity has begun to return (see TED spread below), we should be expecting CDS to tighten so this can’t be attributed to worsening liquidity I think. These pieces went mostly down the chain, so there are some hedge funds and probably foreign entities (not sure who was buying it there) still getting killed on subprime. Add to this all the bottom fishers that tried to come in over the past few months and I’m really surprised we haven’t seen more blowups in the news.

On the brighter side, things have improved drastically for the big banks. TED has come in sharply, perhaps too sharply: While I think the worst is behind us, I’d be long credit spreads here, I think we’re due for another hiccup.

A lot of the Fed’s rhetoric is relying on TED’s to stay tight, if they widen again you can absolutely forget about hikes until they come back in. Taking a look at that mid-May Morgan Stanley report which included some estimates at what banks are still holding on to and where it’s marked:

As far as commercial real estate, I think we dodged a real bullet. If this stuff continued to widen we could have experienced some REAL trouble. The CMBX has tightened quite a bit since Bear Stearns and I think the banks are breathing a huge collective sigh of relief that they didn’t have to mark to those nose bleed levels. I’m kind of surprised big financials haven’t rallied that much from where they were when this stuff was at it’s wides. I don’t have the data in front of me, but I think LBO debt has tightened up similarly, why aren’t the banks rallying yet?

A decent proxy for the high quality subprime RMBS would look something like ABX AAA 07-1. The super senior exposure should be tracking this as well, albeit at lower levels due to a crappier liquidity situation. Alea mentioned the on-going AAA situation, in my eyes this is a fat liquidity premium that will tighten up over time, quite likely when the lower tranches start rallying and the panic over super senior subsides. I think banks will be able to hold on to most of this and start writing it back up within a year. In the medium term, this would represent something like $15-20 bil in writeups. The odds of them realizing big (or pretty much any) losses on this stuff by holding to maturity are slim to none.

The big wild card is still counterparty risk and CDS. The key here is that this only becomes an issue when spreads blow out and there is a possibility of default. There are two major facets to the CDS counterparty thing. First is mark to market, people wrote a lot of protection at low levels and as spreads blow out their counterparties may/will demand payments (margin) or may try to close out contracts with dubious counterparties demanding that they pay them based on current levels. In addition, there is the much more serious risk that there will be a large underlying default and the protection sellers won’t be able to pay. Now that spreads have tightened sharply, both problems have pretty much gone away. There will be no counterparty issues with CDS going forward unless we have a major default or spreads widen again, protection sellers aren’t doing that bad anymore even from early 2007 levels.