Coming Ka Event: Real or Nominal?

[c1ue]

Re: Coming Ka Event: Real or Nominal?

c1ue, I'm not savvy enough to follow your rationale here. If institutions/individuals lose money in the "MBS/CDO Ponzi scheme," how does the loss of money translate into a higher stock market?

If I lose 10% on something, how can I use that to reinvest in order to try to make more money?

Surely I am missing your point. Please help me.

Jim,

It is not so much that they reinvest in order to make more money - although that is a consideration.

It is that they will move money out of MBS/CDO's, the money must then go somewhere.

Unlike individual investors, pensions and hedge funds really REALLY don't like to sit on tons of cash.

Bonds are a bad bet now as the winds are clearing blowing the wrong way.

Thus I would see a 'flight to quality' in stocks for this money.

Think in terms of portfolio balance: the MBS/CDO's were probably supposed to be on the 'safer' but still 'quality' part of the equation.

With normal bonds that catastrophically decrease in value (10% decrease in capital on a AAA rated bond is extremely catastrophic!) you can just sit on it and collect the bond's interest payments in 10, 12 years or more. The exception is when a company/government defaults on the bond.

The MBS' and CDOs clearly have a severe percentage risk of defaults significantly more than the very low single digits which AAA bonds have been having in the past decade, and very possibly well over the 10% which 'junk' bonds have historically had.

Thus the equation changes completely. Gain of alpha vs. standard benchmarks - the reason for the previous investment in these MBS/CDOs - is now changed to avoidance of loss of capital, a powerful reason to divest.

I'd bet that the only reason it hasn't happened completely is that a number of these institutions haven't yet decided to just bite the bullet.

But that will come once actual evidence of A, AA, or AAA defaults on an MBS or CDO occurs - thus far it is primarily a pricing and liquidity issue.

My thinking is that the correct model would be that of bonds in a company like Enron.

Once Enron showed evidence that they were a house of cards and had neither the cash generation nor growth potential they had been spoofing for years, their bonds went into freefall. I'm talking 10 cents on the dollar of capital returned.

While this was an over-reaction - many including Buffet made money on certain parts of the Enron bond portfolio - were something like this to happen to the MBS/CDO world it would be much uglier.

I doubt even Buffet would do the detailed research necessary to distinguish a 'good' MBS/CDO vs. a 'bad' one. It would require a statistically significant review of all the properties+loans in the MBS/CDO, and that is both a mind-boggling large amount of work and something which is improbable given the lack of transparency.

Even a 50% coverage would not give me much confidence since a mere 10% overall non-payment (foreclosures) would hit capital investment.

[jk]

Re: Coming Ka Event: Real or Nominal?

... they will move money out of MBS/CDO's, the money must then go somewhere.

Unlike individual investors, pensions and hedge funds really REALLY don't like to sit on tons of cash.

Bonds are a bad bet now as the winds are clearing blowing the wrong way.

Thus I would see a 'flight to quality' in stocks for this money.

Think in terms of portfolio balance: the MBS/CDO's were probably supposed to be on the 'safer' but still 'quality' part of the equation.

With normal bonds that catastrophically decrease in value (10% decrease in capital on a AAA rated bond is extremely catastrophic!) you can just sit on it and collect the bond's interest payments in 10, 12 years or more. The exception is when a company/government defaults on the bond.

The MBS' and CDOs clearly have a severe percentage risk of defaults significantly more than the very low single digits which AAA bonds have been having in the past decade, and very possibly well over the 10% which 'junk' bonds have historically had.

Thus the equation changes completely. Gain of alpha vs. standard benchmarks - the reason for the previous investment in these MBS/CDOs - is now changed to avoidance of loss of capital, a powerful reason to divest.

I'd bet that the only reason it hasn't happened completely is that a number of these institutions haven't yet decided to just bite the bullet.

But that will come once actual evidence of A, AA, or AAA defaults on an MBS or CDO occurs - thus far it is primarily a pricing and liquidity issue.

My thinking is that the correct model would be that of bonds in a company like Enron.

Once Enron showed evidence that they were a house of cards and had neither the cash generation nor growth potential they had been spoofing for years, their bonds went into freefall. I'm talking 10 cents on the dollar of capital returned.

While this was an over-reaction - many including Buffet made money on certain parts of the Enron bond portfolio - were something like this to happen to the MBS/CDO world it would be much uglier.

I doubt even Buffet would do the detailed research necessary to distinguish a 'good' MBS/CDO vs. a 'bad' one. It would require a statistically significant review of all the properties+loans in the MBS/CDO, and that is both a mind-boggling large amount of work and something which is improbable given the lack of transparency.

Even a 50% coverage would not give me much confidence since a mere 10% overall non-payment (foreclosures) would hit capital investment.

if you want to argue that current holders of cdo's will sell them, you need to tell me who'll buy them. i don't see buyers until prices are [very few] pennies on the dollar, when you'll get vulture investors. my impression is that cdo's aren't bought and sold much, they're PLACED, i.e. sold by the underwriter to, say, a pension plan which is expected to sit on the investment. is there a secondary market? so i'm skeptical of the theory that money will flow from cdo's to some other investment. i think cdo's have become the black holes of finance - money goes in, but it can never come back out. that's why merrill called off the sale of bear stearn's collateral - no bidders.

[metalman]

Re: Coming Ka Event: Real or Nominal?

that's why merrill called off the sale of bear stearn's collateral - no bidders.

interesting. what's your source?

[c1ue]

Re: Coming Ka Event: Real or Nominal?

JK,

Your thoughts are probably correct, but my feeling is that even should CDO's go into a black hole, the slot they occupied will still need to be filled.

An example: If you are balancing your portfolio as follows:

10% (bulletproof treasuries )
10% (slightly higher risk corporate bonds)
20% (MBS/CDO AAA)
10% (MBS/CDO A-AA)
5% (MBS/CDO B and lower)
25% (stocks, various)
10% (Hedge fund)
10% (Private equity)

Even should the (5% MBS/CDO B and lower) disappear, that slot would be replaced with some other type of security as new money comes in to invest, if not actual rebalancing. In of course, a new slot.

However, I was referring to the MBS/CDO AAA, A-AA slots. These won't disappear completely as they are not valueless, but the money in them definitely can come out (at least some of it) and the slots themselves will be replaced somehow. Given that the PE's are full of money and are starting to have problems finding places to invest, and bonds are looking like a bear market, that leaves stocks and possibly commodities as default.

However, I just don't see a pension fund putting significant assets into commodities - they are too volatile historically.

[jk]

Re: Coming Ka Event: Real or Nominal?

interesting. what's your source?

i can't remember. what i read [somewhere] was that they got bids of about 85 [!] on the AAA tranches, and about 10 cents on the dollar or no bid at all on the rest, so they yanked the auction.

[jk]

Re: Coming Ka Event: Real or Nominal?

JK,

Your thoughts are probably correct, but my feeling is that even should CDO's go into a black hole, the slot they occupied will still need to be filled.

An example: If you are balancing your portfolio as follows:

10% (bulletproof treasuries )
10% (slightly higher risk corporate bonds)
20% (MBS/CDO AAA)
10% (MBS/CDO A-AA)
5% (MBS/CDO B and lower)
25% (stocks, various)
10% (Hedge fund)
10% (Private equity)

Even should the (5% MBS/CDO B and lower) disappear, that slot would be replaced with some other type of security as new money comes in to invest, if not actual rebalancing. In of course, a new slot.

However, I was referring to the MBS/CDO AAA, A-AA slots. These won't disappear completely as they are not valueless, but the money in them definitely can come out (at least some of it) and the slots themselves will be replaced somehow. Given that the PE's are full of money and are starting to have problems finding places to invest, and bonds are looking like a bear market, that leaves stocks and possibly commodities as default.

However, I just don't see a pension fund putting significant assets into commodities - they are too volatile historically.

c1ue, you still haven't addressed the other sides of the transactions. who do you suppose will buy these things, and what will those purchasers be selling to generate the funds? money doesn't go in or out of the market, it passes through from buyer to seller.

[jk]

Re: Coming Ka Event: Real or Nominal?

AAA and AA, in the ABX markets, got hit today. AAA can contain up to 8% subprime. AA can contain up to 12%.

AAA


AA

[zoog]

Re: Coming Ka Event: Real or Nominal?

Wow, that had to get someone's heart pumping today.

AAA can contain up to 8% subprime. AA can contain up to 12%.

Is there anything to suggest that these percentages might be higher, given the apparent black box just-trust-us nature of these packaged roulettes?

Or if 8/12% is indeed the maximum, then I suppose the rhetorical question is: what percentage of AA and AAA actually is subprime.

[grapejelly]

Re: Where Are the Retail Investors ?

Brian Pretti of contraryinvestor.com has said the dumb money public isn't in this market. They are investing in foreign funds. He has shown this with some charts of mutual fund inflows and so forth. I think he makes a convincing case. He believes the present US market is invested by funds of different types, rather than individuals. He has shown how, in the past, individuals (what used to be called "odd lotters") used to pile in about, say, 8 or 9 months into a bull market. But now they are not piling in for some reason.

I think it's because individuals don't have much money. They are tapped out.

[c1ue]

Re: Coming Ka Event: Real or Nominal?

c1ue, you still haven't addressed the other sides of the transactions. who do you suppose will buy these things, and what will those purchasers be selling to generate the funds? money doesn't go in or out of the market, it passes through from buyer to seller.

Sorry, had some other stuff on my plate.

As for who would buy - there are definitely those who make a living on distressed debt.

As in my Warren Buffet example of Enron bonds, there are plenty of funds and people who are professionals at buying mispriced securities.

I would put Warren in that list, as well as the Saudi prince. Others would include PimCO (general bond dudes), Cerberus, Oaktree, Shoreline, Longacre, Eagle Rock, even Fortress. I'm sure there are innumerable smaller funds.

I myself would consider AAA and AA MBS and CDOs if I had enough resources to look into specific ones to determine the extent of any possible mispricing. Its painful work but then again the rewards could be significant.

I think even us iTulip doomers don't believe that the truly high level MBS/CDOs are worthless? Just not worth as much as was paid for them originally...

Feel like teaming up to start a fund?

[jk]

Re: Coming Ka Event: Real or Nominal?

those charts i posted of the abx markets look like they're pricing the subprime components at approx zero. i.e. AA can contain 12% subprime, AA dropped to 88.

c1ue, if it's vultures buying the cdo's at pennies on the dollar, it's not generating a lot of dough for the cdo sellers to put somewhere else. as for becoming such a vulture, i don't have the expertise to find the value amidst the rubble, do you?

[grapejelly]

Re: Coming Ka Event: Real or Nominal?

those charts i posted of the abx markets look like they're pricing the subprime components at approx zero. i.e. AA can contain 12% subprime, AA dropped to 88.

So let's just be simplistic. Let's say you are buying mortgages for a moment. Are subprime mortgages worth zero?

If I loan Smith $100,000 and Smith buys a house that is now worth $90,000, what is the value of my loan?

I have to foreclose on Smith, and then I have bought myself a Big Problem. I will pay $20,000 in foreclosure fees, legal fees, brokerage and fix-up fees, so I have spent $120,000 and maybe, just maybe, I'll recover $90,000.

If I got the mortgage handed to me free, then I could foreclose on the property and pay $20,000 and maybe sell the property for $90,000. That would be a great deal of course.

I recognize that my example addresses mortgages and not CDOs. Point being there are a lot of costs and much investment required even after one has acquired a portfolio of these things. Someone will make a lot of money arbitraging the market and turning these things around, or wholesaling them. But it is a big challenge, one that will last many years and affect likely millions of homeowners. Ouch.

[jk]

Re: Coming Ka Event: Real or Nominal?

So let's just be simplistic. Let's say you are buying mortgages for a moment. Are subprime mortgages worth zero?

If I loan Smith $100,000 and Smith buys a house that is now worth $90,000, what is the value of my loan?

I have to foreclose on Smith, and then I have bought myself a Big Problem. I will pay $20,000 in foreclosure fees, legal fees, brokerage and fix-up fees, so I have spent $120,000 and maybe, just maybe, I'll recover $90,000.

If I got the mortgage handed to me free, then I could foreclose on the property and pay $20,000 and maybe sell the property for $90,000. That would be a great deal of course.

I recognize that my example addresses mortgages and not CDOs. Point being there are a lot of costs and much investment required even after one has acquired a portfolio of these things. Someone will make a lot of money arbitraging the market and turning these things around, or wholesaling them. But it is a big challenge, one that will last many years and affect likely millions of homeowners. Ouch.

i agree that someone is going to make a lot of money on these things, but it's going to be an unholy mess. i've read a few articles about subprime borrowers being able to prevent foreclosure because no one could figure out who really owned the mortgage or had the right to foreclose. one story mentioned that the borrower remained in his house and had made no payments for years, but a judge threw out the foreclosure efforts because the paperwork was so bad that there was no one with the power to foreclose. it's a real question- if your mortgage has been sliced and diced into various tranches of a variety of cdo's sold to a multitude of pension plans and hedge funds, who has the right to foreclose if you stop paying? apparently, in at least some cases the lawyers drawing up the cdo documents didn't focus adequately on that issue.

[c1ue]

Re: Coming Ka Event: Real or Nominal?

c1ue, if it's vultures buying the cdo's at pennies on the dollar, it's not generating a lot of dough for the cdo sellers to put somewhere else.

Jk,

I don't think the issue really is sub-prime or not sub-prime, the issue is going to be the overall repayment. This is going to play out for everything MBS/CDO including Alt-A.

While the maximum case is to take a sample (5%) and do an exhaustive study for each individual MBS, I suspect that there might be value is studying the time and source of the loans.

There is likely some pattern to each individual MBS/CDO based on the sources of the mortgages - for example, did New Century have a profile for mortgages? What about Accredited?

Obviously this profile would have changed over time, but if there were any consistency to the loans then the home location combined with the profile and LTV (based on loan amount, past sale history, and leavened with some Case-Schiller) could give you some value.

I think it is actually early to have any bargains be available - the pricing of AA and AAA MBS/CDOs is only digesting the sub-prime component, not the Alt-A or even the general 'true prime' deterioration that will occur.

Possibly a better rule of thumb is to assume the worst case public foreclosure scenario: 2M homes.

According to http://www.infoplease.com/us/census/data/housing.html
there are about 55M owner occupied homes in the US.

Using the above profiles (sub-prime vs. Alt-A vs. 'true prime') vs. the foreclosure worst case, it would give you a scenario as to how far the non-payment in MBS/CDOs would run - possibly enough granularity to extend into specific tranches within AAA/AA/A.

Then you prime your financial guns and see if the blood boils down to your price level.

This is probably too much work for one person, but it won't be for a mid-size hedge fund or P.E. group.

[c1ue]

Re: Coming Ka Event: Real or Nominal?

So let's just be simplistic. Let's say you are buying mortgages for a moment. Are subprime mortgages worth zero?

If I loan Smith $100,000 and Smith buys a house that is now worth $90,000, what is the value of my loan?

I have to foreclose on Smith, and then I have bought myself a Big Problem. I will pay $20,000 in foreclosure fees, legal fees, brokerage and fix-up fees, so I have spent $120,000 and maybe, just maybe, I'll recover $90,000.

If I got the mortgage handed to me free, then I could foreclose on the property and pay $20,000 and maybe sell the property for $90,000. That would be a great deal of course.

Grape,

The issue funds and banks will have with foreclosed properties is liquidity and market value, plus maintenance.

I don't think almost any financial institution is going to even try to make money on foreclosed homes as an asset class - there is too much specialist labor required to make it financially worthwhile. Maintaining, upgrading, repairing, and selling houses is a non-trivial exercise - multiplied by scale and scattered across the entire US.

What I was referring to was the portions of the MBS/CDOs which do not default. There is still a significant income stream from these non-defaulted properties - this is what will determine the worth of the MBS/CDO.

As in my Buffet/Enron case, certain of the Enron bonds were guaranteed by Enron hard assets - i.e. pipeline revenues and thus were worth much more than the 15%-25% or so Buffet got them for. Looking at the 2006 annual report, BK said that out of the initial $82M payment, BK has received $179M in distributions with $173M remaining value.

I'm sure there will be similar values embedded in the MBS/CDO saga!