6 December 2008

CDO market "no longer exists"

Massive redemptions at the largest hedge funds, mutual fund redemptions, high borrowing costs for insurance companies, and capital constraints at banks combine to vaporize the credit market. Shown below is the Moody’s seasoned Baa bond spread as a percentage of the constant maturity 20-year Treasury yield:

Baa Spread as a Percentage of Treasury Yield:

That is, with Baa-rated bonds yielding 8.8% and the 20-year Treasury yielding 3.36%, the excess yield is about one and a half times the Treasury yield. This means that if you purchase a portfolio of long Baa’s and all the bonds default instantly and recover 40%, you more or less break even. Implied default rates are impossible to calculate from spreads because the timing of defaults is everything. Nonetheless, it is very difficult to work out scenarios in which Treasuries held to maturity outperform corporate bonds.
Live by liquidity, die by liquidity. The explosion of structured product issuance in 2005-2007 suppressed credit spreads to ridiculously tight levels, and the collapse of leverage during the past year has widened credit spreads to ridiculously wide levels.
Back in 2006, credit was crazy tight. As I wrote in a Jan. 5, 2006 report for Cantor Fitzgerald:
In C.S. Lewis’s Screwtape Letters, an old devil gives practical advice to a novice demon. Diabolical amounts of leverage compressed credit spreads during 2005. Wrong as the market may be about inherent risk, it is likely to stay wrong, as the Fed backs off from aggressive tightening, the threatened curve inversion fails to materialize, absolute yield levels remain low, and investors enhance returns through leverage. LBO’s may batter individual names, but not the aggregate market. The same hunger for returns that prompts investors to lever up equities drives them towards leverage in the form of structured credit product. My advice is: don’t fight the tape.
Investors are not piling into levered synthetic BBB structures because they are complacent about credit risk. On the contrary, all the investors I know are scared to death. But as long as the average U.S. pension fund requires returns of 8.75% to meet its long-term obligations, and the aggregate corporate bond index yields just over 5%, institutional investors will continue to pick up nickels on the slope of the volcano. Investment banks are selling AAA-rated synthetic CDO principal with coup on indexed to the performance of the equity tranche, like the old range accrual notes that brought down Orange County in 1996. Trust Preferreds, REITs, Chinese loans, home equity and a wide variety of other assets have entered the lists of CDO collateral. Sponsorship of ever-more-esoteric structures is a failsafe symptom of yield dearth.

The market for synthetic collateralized debt obligations no longer exists. None were issued during the third quarter, trading has shut down, skeleton crews at dealers manage what is in effect a run-off business, and the hedge funds are in slow-motion liquidation. There are opportunities out there, to be sure. Don’t hold your breath, though. They will be there for a while.

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