Tail Wags Dog – Again

Today is the launch of the Primex index of credit default swaps on prime “jumbo” mortgage-backed securities.  This index was ready to go in late 2007, but got delayed after the damage its junkier cousin, the ABX, did to the dealers, and to the MBS issuers.

Reading the commentary on the launch, I found myself muttering “What kind of economic theory would say that existence of a liquid, visible hedge instrument should make the value of the underlying market sector decline?”

Lets open it up to the free-market true believers in the crowd, because no microecomic theory I know of can explain.  It must be in the magical power of markets in some way I can’t fathom, just the way I didn’t understand how their policies helped anyone other than a select few speculators over the past decade.

If an asset class is difficult/expensive/impossible to hedge, introducing a liquid, transparent hedge instrument should make the assets

A) More valuable, because holders now have a way to manage their risk and enjoy more liquidity


B) Less valuable, because…. Well, just because.

In this Bloomberg article one of Wall Street’s leading mortgage research analysts doesn’t mince his words:

When a plan to create the indexes linked to older prime loans larger than the limits for government-supported Fannie Mae and Freddie Mac was announced in December, Wells Fargo & Co. analyst Glenn Schultz suggested investors consider selling jumbo-mortgage securities because PrimeX trading could drive down their prices, as happened with subprime bonds and the ABX indexes he had called “Frankenstein’s monster.”

Chris Flanagan, of BankAmerica née Merrill is a little more circumspect, but the advice is the same — that the price of the mortgage bonds are about to suffer, due to the introduction of the new hedging index.

He suggests that the new index will be attractive in comparison to the older ABX index, or the cash bond market.


If I were a mortgage lender or investor, I might be tempted to say “Thanks for nothing,” or “Don’t do me any favors.

I guess the logic is “They’re dead already, so now they can’t complain.”

At least for the stand-alone issuers of private label MBS, whether the Primex is traded or not can’t change the fact that they’re dead, and most mortgage bond investors are still clinging to trees after the tsunami, if they survived at all.

There is good evidence to show that existence of the hedge instrument ABX to speculate on the future performance of subprime bonds was used to affect the outcome, and, unfortunately, make the collapse of housing prices and the wave of foreclosures quite a bit worse than they would have been without it.

Part of that was due to the exploitation of naive reporters by the big short sellers, an exploitation those reporters were only too happy to be part of (hoping to get their equivalent of the Oscar for breaking the story).

How they were exploited is a little technical, but not terribly so.  When the ABX AAA index was defined, it was defined using the last-pay bond in a series of AAA bonds carved off the collateral.

As any bond investor knows, if rates go up, the value of a two year bond falls far less than the value of a 20-year bond. When even AAA subprime bonds traded to higher yields, naturally the decline in value was most extreme in the 4th bonds in those 30-year series…. precisely the bonds in the ABX index.

From there, it was easy to get everyone into the mantra of saying ALL subprime bonds were worth what the index price was quoted.  It wasn’t even true about the last-pay bonds (as shown in this study), and the damage done by convincing the market that it was true for all bonds is hard to understate.

In the case of the ABX, far too many reporters (or more precisely, housing bears that gave them the “scoop” and the stock market bears who piled on by saying all the banks were insolvent or lying, or both) just equated the price they saw on the MarkIt.com website with the value of the banks’ holdings.

What those reporters couldn’t see, and the bearish hedge fund traders talking to the reporters weren’t about to tell them, is that bonds were still trading at much higher prices while they were pushing their stories.

It was the breath-taking audacity of the shorts that fooled most of the long-time investors.  They were actually willing to destroy the entire system of home financing in order to make their trade profitable.  With the CDS, they had what they needed to make that destruction possible, and hidden from sight.

Those of us in the bond market “knew” from experience that declines in house prices like that seen in Southern California when the military cut back, or the collapse of housing in the Oil Patch that followed the precipitous decline in oil prices would only affect those few home owners who had to sell.

Other home-owners would hold on.  Basically, other than foreclosures, house prices tended to be very “sticky” on the way down.  A market that had gotten unaffordable was more likely to sit without increases until buyers’ incomes caught up with the prices.

The only way to be sure house prices would decline massively and nationally was to make sure there were lots of foreclosures.  They did this by seeing that half the potential buyers had no place to get financing.  Then even prime, 20% down, fixed-rate, fully-documented loans were in trouble.

So here we are.  After reading and listening for a day to former colleagues and finance insiders make fun of Congress for not knowing the difference between a CDO and an ABS, I’m amazed that people from the Street don’t get the simple reality that Senator Claire McCaskell summarized:

“It’s not investment in a business that has a good idea. It’s not assisting local governments in building infrastructure. It’s gambling. Pure and simple, raw gambling.”

Maybe those people questioning the Goldmanites weren’t all so dumb, after all.

Think about it the next time you’re in a casino.

Would you think maybe “no limits” tables were a bad idea if you had to pay part of the winnings (cover the losses) if one or more of the players went bust?  Welcome to the world of unregulated CDS.


PS.  When “Cornhusker Kickback” Ben Nelson voted yesterday to prevent Wall Street reform from even being debated, he did so because his constituent Warren Buffet likes playing at the high-stakes derivatives table without putting up any cash for his chips.  I’d like it too, if I could hold $60 billion in positions and put up no capital.

For crying out loud, Warren, they aren’t even asking you to buy all the chips, just make a deposit of five cents on the dollar or so. You gave all the rubes a solid misdirection when you called these “WMD,” all the while loading up for your own speculation.

Stop whining about how you got into the game when it was so easy and cheap.  Either pay up or get out now that those of us poisoned by the fallout want to see you and the other players put up a containment chamber around your dangerous poker game.


2 Responses to Tail Wags Dog – Again

  1. Fred says:

    Howard, RWT was able to sell a tranche of high grade bonds to institutional investors yesterday. Got an opinion about RWT?


    • hhill51 says:

      Decent company. Not enough yield to get me revved up. If all the Agency mREITs were trading at a premium of 25% or more and/or levered 10-1 or more, I’d be a buyer. It trades at a premium to book, and the meltdown showed me that its private label portfolio has far more risk than I used to think, so I’m not a buyer at a premium without current yield in the 20% neighborhood. Same applies to CIM and IVR (yield bogey).

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