price cascades: cdo tranches down, inflation up

[jk]

http://suddendebt.blogspot.com/

Tuesday, October 30, 2007

What Do DAP and CDOs Have In Common?


Before proceeding with the main subject of this post, I see that many people are still surprised by the ongoing tumble in the AAA-AA tranches of the ABX indices. I explained why this is happening a week ago in "Remember The Buckets".


Simply put, their terrible performance is not a matter of market psychology but mathematical fact derived from their cascade structure. As borrowers default on monthly payments, the small, lower tranches absorb the losses and leave the much larger AAA-AA portions intact. But once the process inexorably moves to seizure, eviction and auction, loan losses mount exponentially because the hits now come from far larger principal losses, not just interest and amortization. The lower tranches immediately become overwhelmed and spill over the entire losses onto the AAA-AA tranches, which make up 80-85% of the CDO amounts.

Let's look at the 2006-1 series of ABX, which is the oldest and most "seasoned", meaning the loans in the underlying CDOs had the most time to settle down. Think of the following charts as a series of buckets from top to bottom, successively filling up with losses and spilling over into the bucket below: BBB- spills into BBB, then into A, AA and finally AAA. Notice the time lag as the BBB- and BBB buckets first "fill up" with losses and then the "break" in the higher rated A and AA tranches, as the big principal losses suddenly spill over into them.











The AAA tranche is still holding up, relatively speaking, exactly as we expect. In this most seasoned series, the AA and A tranches are now taking the hits, with the expected time lag. But it won't be long before the AAA is all that is left...
Do the math... including the origination, pooling and underwriting fees that were originally charged to principal and the fees involved in their ongoing maintenance, I won't be at all surprised to see some formerly AAA-AA CDOs going for a panicky 50 cents on the dollar. If that.


Which brings me to today's subject: delayed consumer goods inflation. First some data; price increases from last year, spot month futures.


Soybeans: +76%
Corn: +66%
Wheat: +60%
Oats: +57%
Milk: +50%
Barley (i.e. beer): +50%
Rice: +33%
Coffee:+20%

Crude oil: +53%
DAP (di-ammonium phosphate fertilizer): +69%

Dry bulk cargo shipping rates: +350% (it's not a typo)

What do these prices have to do with CDOs? Nothing, except that raw material price hikes also follow a cascade structure until they reach the consumer, i.e. it takes time for them to be manifested in our local supermarket. At first, wholesalers may work off their cheaper inventories and absorb some price hikes to keep customers happy. We can view that as the equivalent of safety reserves and equity tranches in the CDO structures. Next come the large food processors, who may also abstain from passing the entire price increases to consumers, accepting instead some profit margin erosion to maintain market share. We can view that as the mezzanine tranche. For example, crude oil is at $93/bbl, but gasoline is still retailing as if it were at $70. Refinery margins are horrible, right now.

But once the various inventory, delivery and crop cycles are completed, the merchants and processors will have no choice but to pass the full price increases to the consumer, creating a sudden spike in consumer prices. If the consumer then balks and goes on a consumption freeze (as he will, unless his income rises faster) it will be corporate profit margins that will get squeezed hard. Until recently the consumer could count on easy borrowing to meet extra expenses and sustain price increases to fatten corporate profits; this is obviously no longer the case.

Consumer Food Price Inflation Chart: St. Louis Fed

In my opinion, we are already at the first critical point: price hikes for food commodities are being passed on to the consumer (chart above). We can also observe profit margin squeeze, e.g. WalMart's recent decision to cut prices on thousands of toy and other discretionary items.

The next 2-3 weeks will show if this year the consumer will snub the pre-holiday shopping ballyhoo and simply wait for retailers to panic and slash prices a week before Christmas. I know that's what I will do...

If this happens, you can bet that retailers and wholesalers are going to blow it all back to their suppliers/manufacturers in the form of smaller orders AND demands for lower prices, or at least a freeze. This is when China is going to feel it and given their tremendous overextension in manufacturing capacity and thin profit margins, I strongly believe they are headed for a heap of trouble.

[Rajiv]

Re: price cascades: cdo tranches down, inflation up

It would seem to me that the answer to the sub prime mess may have been to not reset the interest rates (effectively converting them to a fixed rate) -- so that far fewer loans go into default. Then, there would be no "big" losses, but the losses would string out over time -- thus avoiding the problems you just outlined

[GRG55]

Re: price cascades: cdo tranches down, inflation up

It would seem to me that the answer to the sub prime mess may have been to not reset the interest rates (effectively converting them to a fixed rate) -- so that far fewer loans go into default. Then, there would be no "big" losses, but the losses would string out over time -- thus avoiding the problems you just outlined

The subprime losses aren't that great in aggregate.

It's the fact that the MBS paper (CDO, CDO squared, CDO cubed, etc) are levered. And then levered again (think of a hedge fund-of-funds with 10:1 gearing holding a portfolio of hedge funds themselves averaging 10:1 gearing). The losses can be quite small and still wipe out all the equity. Trying to stop the first domino (sub-prime) from dropping would have been like trying to stop the tide from rising to protect the sand castles.

[GRG55]

Re: price cascades: cdo tranches down, inflation up

http://suddendebt.blogspot.com/

Tuesday, October 30, 2007

What Do DAP and CDOs Have In Common?

...Which brings me to today's subject: delayed consumer goods inflation. First some data; price increases from last year, spot month futures.


Soybeans: +76%
Corn: +66%
Wheat: +60%
Oats: +57%
Milk: +50%
Barley (i.e. beer): +50%
Rice: +33%
Coffee:+20%

Crude oil: +53%
DAP (di-ammonium phosphate fertilizer): +69%

Dry bulk cargo shipping rates: +350% (it's not a typo)

What do these prices have to do with CDOs? Nothing, except that raw material price hikes also follow a cascade structure until they reach the consumer, i.e. it takes time for them to be manifested in our local supermarket. At first, wholesalers may work off their cheaper inventories and absorb some price hikes to keep customers happy. We can view that as the equivalent of safety reserves and equity tranches in the CDO structures. Next come the large food processors, who may also abstain from passing the entire price increases to consumers, accepting instead some profit margin erosion to maintain market share. We can view that as the mezzanine tranche. For example, crude oil is at $93/bbl, but gasoline is still retailing as if it were at $70. Refinery margins are horrible, right now.

But once the various inventory, delivery and crop cycles are completed, the merchants and processors will have no choice but to pass the full price increases to the consumer, creating a sudden spike in consumer prices. If the consumer then balks and goes on a consumption freeze (as he will, unless his income rises faster) it will be corporate profit margins that will get squeezed hard. Until recently the consumer could count on easy borrowing to meet extra expenses and sustain price increases to fatten corporate profits; this is obviously no longer the case.

Consumer Food Price Inflation Chart: St. Louis Fed

In my opinion, we are already at the first critical point: price hikes for food commodities are being passed on to the consumer (chart above)...

Food inflation is becoming the problem for many governments. It's the one kind of inflation that makes people riot when the Central Banks try to deny it or explain it away.

There's a little recognized correlation between crude oil prices and food inflation. As we all know, in the 1970's first energy and then food were removed from CPI. The best description I ever read of modern industrial agriculture is that it's "the use of land to convert petroleum to food". Whether it's the ammonia in DAP, which is made almost exclusively from natural gas, or the diesel in the John Deere, the petroleum inputs are quite substantial when they are tallied.

Although bio-fuel policies have exacerbated the situation, high petroleum prices would by now be contributing to food inflation in any case - just like the 1970's.

(and yes, I know the Bartster twins won't agree with me )

[jk]

Re: price cascades: cdo tranches down, inflation up

grg55,

having just come to this thread after visiting the petroleum discussion, i have a question for you: are we in the midst of a price cascade for petroleum? crude is way up, but gasoline at the pump is the same price as when crude was many, many dollars lower. usually when crude goes up, petrol goes up immediately, while petrol prices tend to be sticky when crude is going down. why is petrol being sticky on the way up this time? are there some unusual dynamics here reminiscent of the cascade phenomena described above?

[GRG55]

Re: price cascades: cdo tranches down, inflation up

grg55,

having just come to this thread after visiting the petroleum discussion, i have a question for you: are we in the midst of a price cascade for petroleum? crude is way up, but gasoline at the pump is the same price as when crude was many, many dollars lower. usually when crude goes up, petrol goes up immediately, while petrol prices tend to be sticky when crude is going down. why is petrol being sticky on the way up this time? are there some unusual dynamics here reminiscent of the cascade phenomena described above?

Good question, and at this point I can only speculate on the answer based on past observations, until the lagging data comes out. But I would lay heavy odds that the economic slow down is finally reducing motor fuel consumption, and this is creating inventory clearing problems at the local level throughout the refined fuel distribution system. When wholesale jobbers can't turn their inventory as fast as they used to it backs up the system about as fast as the traffic jam behind a stalled car on a freeway. This is the reason it usually comes as a "surprise" when the lagging official inventory figures finally confirm for the market what has already happened.

Housing contractors with idle fleets of trucks, reports of reduced trucking and rail movements, laid off workers and those concerned about being laid off...perhaps all this is finally adding up. You will recall earlier this year when there were numerous refinery problems and WTI backed up at Cushing (still remember the pic zoog!) and was trading at a wide discount to Brent, instead of the usual slight premium.

Two short term US scenarios could play out here. WTI prices start falling very shortly as the system backs-up upstream of the refineries. Alternatively, having learned their lesson from the earlier discounting, crude and refined fuel importers are better prepared to rebalance deliveries internationally to avoid a large build up in the USA. This latter case will work only to the degree that the rest of the world economies keep going. I suspect that the actual outcome will be in between these two with an adjustment downward fairly soon in global crude, not just WTI.

There is now such a heightened expectation of tight supplies, fueled in part by the increasingly hysterical IEA releases, that it wouldn't surprise me that they are once again completely wrong, at least in the short (12-18 mo) term. The first indication that real North American demand was softening was when Pemex shut in most of its production for more than a week this summer during a hurricane, and it didn't even ripple the price in the USA.

However, if I am wrong and crude prices continue at these lofty levels much longer there will be price increases at the pump.

[touchring]

Re: price cascades: cdo tranches down, inflation up

This is when China is going to feel it and given their tremendous overextension in manufacturing capacity and thin profit margins, I strongly believe they are headed for a heap of trouble.

It will take a little more time than that. China now exports more to the EU than the US (the US now takes less than 20% of chinese exports - if you add in china's domestic demand, exports to US is less than 15% of total factory output). Even a 10% drop in US demand, a drastic reduction, will barely affect Chinese manufacturers.

So, the whole thing must cascade down to the EU before China is affected.

Also, stuff that the Chinese make are usually low end and cheap goods. Japan, OTOH, makes high end branded goods, and these will more seriously affected in a recession.

[jk]

Re: price cascades: cdo tranches down, inflation up

Good question, and at this point I can only speculate on the answer based on past observations, until the lagging data comes out. But I would lay heavy odds that the economic slow down is finally reducing motor fuel consumption, and this is creating inventory clearing problems at the local level throughout the refined fuel distribution system. When wholesale jobbers can't turn their inventory as fast as they used to it backs up the system about as fast as the traffic jam behind a stalled car on a freeway. This is the reason it usually comes as a "surprise" when the lagging official inventory figures finally confirm for the market what has already happened.

Housing contractors with idle fleets of trucks, reports of reduced trucking and rail movements, laid off workers and those concerned about being laid off...perhaps all this is finally adding up. You will recall earlier this year when there were numerous refinery problems and WTI backed up at Cushing (still remember the pic zoog!) and was trading at a wide discount to Brent, instead of the usual slight premium.

Two short term US scenarios could play out here. WTI prices start falling very shortly as the system backs-up upstream of the refineries. Alternatively, having learned their lesson from the earlier discounting, crude and refined fuel importers are better prepared to rebalance deliveries internationally to avoid a large build up in the USA. This latter case will work only to the degree that the rest of the world economies keep going. I suspect that the actual outcome will be in between these two with an adjustment downward fairly soon in global crude, not just WTI.

There is now such a heightened expectation of tight supplies, fueled in part by the increasingly hysterical IEA releases, that it wouldn't surprise me that they are once again completely wrong, at least in the short (12-18 mo) term. The first indication that real North American demand was softening was when Pemex shut in most of its production for more than a week this summer during a hurricane, and it didn't even ripple the price in the USA.

i recalled that there was a recent release on inventories, so i googled "oil inventories" and came up with this, dated nov 1:

The price of oil rose to a record above $96 a barrel Thursday after a surprise drop in U.S. crude stockpiles raised concerns about supplies for coming winter demand. Other energy futures also gained.

It was the second week in a row the U.S. Energy Information Administration reported a sharp and unexpected drop in oil inventories.


"The decline in U.S. crude oil inventories has been a key driver of oil prices," said David Moore, commodity strategist at the Commonwealth Bank of Australia in Sydney.

http://www.businessweek.com/ap/finan.../D8SKT14O7.htm


this doesn't seem to fit with your scenario. are there stores not counted in these reports?

[bill]

Re: price cascades: cdo tranches down, inflation up

It will take a little more time than that. China now exports more to the EU than the US (the US now takes less than 20% of chinese exports - if you add in china's domestic demand, exports to US is less than 15% of total factory output). Even a 10% drop in US demand, a drastic reduction, will barely affect Chinese manufacturers.

So, the whole thing must cascade down to the EU before China is affected.

Also, stuff that the Chinese make are usually low end and cheap goods. Japan, OTOH, makes high end branded goods, and these will more seriously affected in a recession.

China’s most defiantly concerned and on the move to promote economic conditions with EU and Asia nations.
http://en.ndrc.gov.cn/newsrelease/t2...9800.htm#_edn1

The First ASEM SMEs Ministerial Meeting was held in Beijing on 30-31 October 2007. SMEs Ministers and their representatives from 45 ASEM members[1] gathered under the theme ¡°Drive the Future with Innovation, Promote Development through Cooperation¡± and conducted extensive and in-depth discussions on issues of common interest regarding SMEs such as technological innovation, business development services, and cooperation and development, and achieved the following outcomes.

Asian SMEs and European SMEs are highly complementary to each other in terms of product, technology, labor and market with huge potential of cooperation. It is of great necessity to further improve trade and investment climate, enhance exchanges among ASEM members, establish effective cooperation mechanisms for SMEs, and promote cooperation in multiple fields, notably trade facilitation, services, transfer of technology, intellectual property rights (IPRs), corporate social responsibility and accountability, with a view to narrowing the gap of development among members and promoting common economic prosperity in Asia and Europe.

[jk]

Re: price cascades: cdo tranches down, inflation up

grg55,

just found this current release covering the week to 10/26, to supplement my question above:


U.S. commercial crude oil inventories (excluding those in the Strategic
Petroleum Reserve) fell by 3.9 million barrels compared to the previous week. At
312.7 million barrels, U.S. crude oil inventories are in the upper half of the
average range for this time of year. Total motor gasoline inventories increased
by 1.3 million barrels last week, and are in the lower half of the average
range. Both finished gasoline inventories and gasoline blending components rose
last week. Distillate fuel inventories increased by 0.8 million barrels, and are
at the upper limit of the average range for this time of year. Propane/propylene
inventories increased 0.9 million barrels last week. Total commercial petroleum
inventories decreased by 1.1million barrels last week, but are in the upper half
of the average range for this time of year.

http://www.eia.doe.gov/pub/oil_gas/p...t/txt/wpsr.txt

[GRG55]

Re: price cascades: cdo tranches down, inflation up

i recalled that there was a recent release on inventories, so i googled "oil inventories" and came up with this, dated nov 1:
http://www.businessweek.com/ap/finan.../D8SKT14O7.htm


this doesn't seem to fit with your scenario. are there stores not counted in these reports?

The official inventory reports are based on a small sample of the system at the major nodes and stock holders only. I don't view any one week's numbers as any more useful than the monthly jobless stats, quite frankly, because there's a fair bit of "birth/death style" extrapolation going on (but the trend over time is important). If my scenario is correct the product inventory backlog is now happening all over the country at the local (micro) level, and won't show in any of the "macro" stats right away. But when it does show up it usually happens with "a bang", and if I am correct it won't take very long to see it first as a wholesale gasoline/diesel inventory build, and eventually in the crude feedstock build (subject to how well the importers of both anticipate and manage their volumes - the USA imports about 40% of its finished product consumption so there is a lot of swing room there).

On a global macro level, crude oil inventories in the developed economies started building about mid-2004 when the crude curve went into contango (because of an expectation of potential future supply constraints) and, for the first time in decades, it actually paid to hold inventory. The curve is now again in backwardation (mostly because there is a widespread short term view of an impending supply constraint driving up spot) and quite naturally inventories are being gradually drawn down to some lower level as it now costs money to store crude.

(I edited this last paragraph, but I still don't think it's written very clearly, sorry). Lukester and others discussing peak oil are dealing with the secular trend. The forward curve driven inventory and price movements over the past few years are cyclical overprints on that. And the short term stuff like the refinery outage induced WTI discount is "noise". Maybe too important to be called noise, but I can't come up with a better analogy, sorry. The overprint at the cyclical level can mask or obscure, for a while, what is happening at the secular and local levels.

[touchring]

Re: price cascades: cdo tranches down, inflation up

China’s most defiantly concerned and on the move to promote economic conditions with EU and Asia nations.
http://en.ndrc.gov.cn/newsrelease/t2...9800.htm#_edn1

The EU and Asia nations are providing strong support for world demand. The US experienced 3.9% 3Q economic growth, but few people actually noticed that the growth was "due to exports".

The domestic situation in the US has to get "a lot worst", or an extraordinary non-economic event like an Iran war that hits oil supplies, before the contagion effect will hit Asia.

[GRG55]

Re: price cascades: cdo tranches down, inflation up

The EU and Asia nations are providing strong support for world demand. The US experienced 3.9% 3Q economic growth, but few people actually noticed that the growth was "due to exports".

The domestic situation in the US has to get "a lot worst", or an extraordinary non-economic event like an Iran war that hits oil supplies, before the contagion effect will hit Asia.

I would expect that, unlike the "strong dollar" in the USA, the truly strong European currencies (against the yuan and yen) would support your view. The only competition for these markets will come from the depreciating currency US dollar block. And that is playing out in the Middle East, with their dollar-peg currencies, as we are seeing some signs of displacement of European and Austral-Asian products, particularly agricultural, by the USA.

[touchring]

Re: price cascades: cdo tranches down, inflation up

I would expect that, unlike the "strong dollar" in the USA, the truly strong European currencies (against the yuan and yen) would support your view. The only competition for these markets will come from the depreciating currency US dollar block. And that is playing out in the Middle East, with their dollar-peg currencies, as we are seeing some signs of displacement of European and Austral-Asian products, particularly agricultural, by the USA.

Possible, the weaker dollar does help American exports. But at the same time, the demand from Asia, Eastern Europe, Russia and South America is strong to begin with.

These regions are starting from a low base and it is natural that they will grow in areas of travel (more orders for Boeings), infrastructure (more orders for Cisco equipment), and transport (GM does better in China than the US).

Also, the inflationary and weak dollar policy of the US Feds is causing capital and funds to flee to the developing world, which helps stimulate growth and investment.

Thus, you can say that the last 3 months was the best possible kind of condition for the developing world.

But the situation will change if a new war starts in the middle east, or if the US Feds raises interest rates.

[GRG55]

Re: price cascades: cdo tranches down, inflation up

Possible, the weaker dollar does help American exports. But at the same time, the demand from Asia, Eastern Europe, Russia and South America is strong to begin with.

These regions are starting from a low base and it is natural that they will grow in areas of travel (more orders for Boeings), infrastructure (more orders for Cisco equipment), and transport (GM does better in China than the US).

Also, the inflationary and weak dollar policy of the US Feds is causing capital and funds to flee to the developing world, which helps stimulate growth.

Agree completely. Even in the dollar-peg Middle East the displacements will be at the margin, as nobody here is about to wholesale give up buying Toyotas & Lexus', or Chinese made construction equipment and wide screen TVs. In fact this is probably one of the biggest export markets for Chinese made light vehicles - higher disposable income than Africa, and without the safety and emissions barriers of Europe or the US. I see a lot of Chinese made (Chery, Great Wall) delivery vans and pick-up trucks. They look like a one generation old Toyota or Nissan, and I understand the local business owners love them because they are incredibly cheap.