Aftershock Rocks Credit Markets

Heightened concern about credit risk seeps further into segments of financial markets once thought safe

Investment Dealers Digest

March 17, 2008

BYLINE: Aleksandrs Rozens

If last August's credit problems were a high-powered quake, then the latest problems on Wall Street are its aftershocks. And while aftershocks may be expected, their intensity can be surprising. Such was the case in the early days of March.

While a broad range of securities saw a widening in yield premiums, investors were stunned by a rapid widening in spreads of bonds backed by home loans with Fannie Mae and Freddie Mac guarantees, securities seen as so pristine that they are purchased by foreign central banks and routinely used as collateral for loan agreements primary dealers have with the Federal Reserve.

Yield premiums for these housing agency mortgage securities were driven wider by well-publicized problems at a leading mortgage company as well as reports of margin calls faced by several notable hedge funds.

"The number of funds impacted and the securities impacted have grown," says Jeffrey Rosenberg, head of credit research at Bank of America. "As that credit unwind has occurred you are squeezing out leverage from more corners of the financial markets."

The widening of agency mortgage bonds early this month eclipsed what was seen in the wake of the 1998 Long Term Capital Management debacle and served as a reminder that credit woes in the financial markets are by no means over. The concerns about credit showed up in the credit default swaps market where it cost more to insure bank debt and interest rate swaps which are considered a barometer of credit conditions. In early March, the US central bank had to flood liquidity into the financial system through two separate actions.

"The spikes in volatility and price action are unfathomable," says the head of sales at one dealer firm's mortgage backed securities desk. "This is scary. Most people are shell-shocked," says the veteran of Wall Street who for over two decades has traded and sold mortgage bonds.

Jumpy credit markets

To get an idea of just how jumpy Wall Street has gotten when it comes to credit risk, investors ought to look at that gauge of credit conditions and economic well-being, interest rate swaps.

Ten-year interest rate swaps were at 87 basis points last week, having hit 91 in the first week of March. That is just shy of the autumn of 1998, when they were at 96-1/2.

Within the credit default swaps market, where investors purchase insurance against default, yield premiums, too, have widened. For example, Citigroup five-year credit default swaps were at 220 basis points, out from 10 to 20 basis points a year ago, while Bear Stearns five-year credit default swap spreads were at 510 basis points, out from roughly 35 basis points a year ago. JPMorgan spreads were at 150 basis points, out from 12 to 15 basis points a year ago.

Washington Mutual, a well-known participant in the mortgage market, saw its five-year credit default swaps move out to as much as 750 basis points. A year ago, insurance for five-year Wamu debt was at around 45 basis points.

Some of that widening in Wamu, no doubt, was tied to a recent downgrade in the thrift's credit rating by Standard & Poor's which warned of a "more severe residential mortgage credit cycle" and predicted that the severity of losses on all residential mortgages will be higher than initially expected.

Carlyle and Thornburg

When it comes to agency mortgage bonds, much of the widening was spurred by selling related to hedge funds having to meet margin call requirements.

"As mortgages got worse, people got more margin calls," says Art Frank, head of mortgage research at Deutsche Bank. "News of Carlyle and Thornburg prompted people to sell," says Deutsche Bank's Frank.

Among those facing margin calls was Carlyle Capital Corp., an affiliate of The Carlyle Group. Last week, Carlyle Capital was in discussions with lenders that held $16 billion of its securities, but these talks failed and on Wednesday the fund manager said lenders may seize its assets. According to Carlyle Capital's December 2007 annual report, the fund manager held $21.7 billion of residential mortgage-backed bonds, financed through $21 billion of one-month repurchase agreements with commercial and investment banks.

At the same time, financial markets have been surprised by problems encountered at Thornburg Mortgage. The 15-year old Santa Fe, N.M.-based lender specializes in jumbo loans that, by many accounts have performed well amid the nation's housing downturn. Thornburgh restated its financial statements for the year ended December 2007.

The mortgage lender said in filings with regulators that its board "decided that [Thornburg] should restate these financial statements after concluding that there was substantial doubt as to [its] ability to continue as a going concern."

As a result, Thornburgh warned, losses on its available-for-sale securities and securitized adjustable rate mortgage (ARM) loans pledged as collateral for repurchase agreements "were considered to be other-than-temporary impairments as of Dec. 31, 2007 since [Thornburg] may not be able to hold these securities for the foreseeable future because [it] may sell them to satisfy margin calls from [its] lenders or to otherwise manage [its] liquidity position."

In these same documents, the lender explained how last summer until recently the fair value of its ARMs as well as its hedges declined so margin requirements on its financing agreements increased.

In March, Thornburg said, "we have received a significant amount of margin calls ... which significantly exceeded [its] available liquidity ... as a result, [Thornburg has] been unable to meet a portion of our margin calls."

Thornburg also warned that while it has a temporary agreement with lenders halting additional margin calls through March 10, there was no assurance it will be able to get enough liquidity to satisfy its liabilities or that the value of its ARM loans or bonds pooling ARMs do not decline further.

Also, Thornburg said it could not assure lenders won't make additional margin calls or that the Sante Fe, N.M., company will be able to satisfy these margin calls and "continue as a going concern."

Margin Cascade

The latest worries in the US credit markets - to the surprise of many on Wall Street - come from an unusual source: bonds backed by home loans with Freddie Mac and Fannie Mae guarantees.

While these mortgages have seen an increase in the late payments and defaults, they are nowhere as bad as subprime home loans.

In February, many investors - including hedge funds - saw that mortgage bonds guaranteed by the housing agencies had seen their yield premiums widen to levels not seen in 15 years. Viewing the market as oversold, investors sold their US Treasury holdings and dove into the agency mortgage bonds.

What happened next, shocked even old hands in the US housing finance world. Agency mortgage bond spreads hit levels not seen since 1986 when the nascent mortgage bond market was buffeted by its first wave of home loan refinancings.

As the spreads widened and hit that 1986 level, lenders asked investors to make up for the difference in the value of securities used as collateral for the loans. This forced some investors to sell their most liquid securities, in this case the agency mortgage bonds. In some cases, lenders seized the collateral and put it out in the market.

For those who relied on leverage to amplify returns, the rapid widening in agency mortgage bonds came as a shock and brought about a cascade of margin calls.

"As you move to execute on your right to claim collateral you can exacerbate losses," says Bank of America's Rosenberg, adding that "you are reducing liquidity in the market."

"As more mortgages performed worse, people were more likely to get margin calls," says Deutsche Bank's Frank.

The selling also spurred sales by money managers and banks who wanted to get ahead of any further widening in agency mortgage bond spreads. At the same time, there were no notable buyers of agency mortgage securities even though they were broadly seen as oversold and even inexpensive.

"There was someone selling every minute every day," says Chris Low, chief economist at FTN Financial.

In 1998, a widening in mortgage bonds guaranteed by Freddie Mac and Fannie Mae in the wake of Long Term Capital Management's problems brought about buying by the two housing agencies. This time around, Fannie Mae and Freddie Mac have limits as to how much they can buy for their portfolio and they themselves face a jump in losses related to late payments as well as defaults for loans they have guaranteed. Also, agency borrowing costs have risen because investors are demanding more of a yield premium to buy their debt. For example, five-year credit default swaps insuring senior agency debt are at 91 to 92 basis points and 200 to 210 basis points for subordinate agency debt.

"There is no risk appetite," is how the veteran bond salesman with the Wall Street dealer firm characterized the current market. "People are worried about career risk. They can't be long" mortgages, he adds.

Just how much wider are US agency mortgage security yield premiums?

The interpolated current coupon agency mortgage bond in early March was at 190 basis points to seven-year swaps and it was 293 basis points over interpolated US Treasuries. "This is the widest mortgages have been since the summer of 1986," says Deutsche Bank's Frank.

Back then, the mortgage market was smaller. Today, the mortgage bond market is the largest credit market in the word. In 1986 the widening came after large influx of mortgage securities on the heels of a massive refinancing wave of home loans. The wider spreads prompted Wall Street to expand the structured mortgage bond market by repackaging simple agency mortgage pass throughs into bonds known as planned amortization class securities or PACs.

These days, the mortgage bond mart has seen little of this structured mortgage debt created.

In February, $19.5 billion of collateralized mortgage obligations were created. While that is up from January's $6.6 billion and December's $5.9 billion, it is off from $34.7 billion worth of CMOs created last June.

Although the widening was surely tied to massive sales by hedge funds and other investors, there is another reason behind the wariness about mortgage debt. What was once merely a problem within subprime debt is now a problem within Alt-A home loans and has crept into the prime market. Recent data from an industry trade group showed that fourth-quarter foreclosures for a wide range of home loans were at historic highs and delinquencies were at a pace not seen since the mid 1980s.

What next?

Early last week, the Fed came in again to support liquidity in financial market. Specifically, the US central bank expanded its securities lending program to include agency debt, agency mortgage bonds and AAA-rated residential mortgage bonds with loans that did not have the agency guarantee.

Also, the Fed increased temporary reciprocal currency arrangements with the European Central Bank and the Swiss National Bank. Financial markets saw prices of stocks soar higher with approval.

That said, credit on Wall Street remains tight. Lenders are asking for larger haircuts in repo agreements, meaning borrowers will have to post more collateral for less money.

"The cost of borrowing has risen and availability has gone down," says Bank of America's Rosenberg. "The increase in required margins have gone up significantly. The reason why is the perceived volatility of all assets used for collateral has gone up."

Meanwhile, spreads for many securities ranging from high yield corporate debt to commercial mortgage bonds have seen their yield premiums widen. Within the leverage loan market, paper that changed hands in January at 95 cents now trades at 88 cents. Last August when the subprime turmoil was first felt, these leverage loans could command a price of 95 cents.

An index of tracking home equity debt underwritten in 2006, the HEL ABX 06-2AA tranche, that is widely used on Wall Street to value securities is trading at 30 cents to the dollar. A year ago, these issues were at or close to par.

Just how much more does it cost for hedge funds to borrow? That depends on the securities being posted as collateral. But in the case of adjustable rate mortgage debt or collateralized mortgage obligations with loans guaranteed by Freddie and Fannie the cost has risen by 30 to 40 basis points.

"Usually you could borrow at Libor. Now it is at Libor plus 40 [basis points]," according to Andreas Pericli, chief executive officer of Wash., DC-based hedge fund Euclid Financial Group. "They need more collateral and they lend less."

Soon after the Fed action early last week, FTN's Low predicted that the central bank's move "should put a floor under prices."

Pericli agreed: "The Fed action will help significantly over time."

Deutsche Bank's Frank noted that last Tuesday's Fed action helped improve the tone to the US mortgage market. He said that the most actively traded mortgage bonds were nearly 20 basis points tighter at 171 basis points to swaps.

Rosenberg meanwhile was more reserved with his optimism. "The issues are not immediately solvable by the Fed. The can alleviate the credit crunch, but it takes time for policy levers to work through."

Joyce Delucca, managing principal at Kingsland Capital, was also circumspect.

"It is great to see that the stock market traded up (on news of the Fed move), but I don't think it fixes the problem. It does improve liquidity for banks and broker-dealers, but whether or not that liquidity reaches the broader system remains to be seen."