What Are They Talking About?

Today's Journal contains an article (Lehman's Demise Triggered Cash Crunch Around Globe). Many in the press and the finance community blame Credit Default Swaps (CDS) for the current travails of capital markets. The article reports that Fed (FRB) has been pushing Wall Street for month to establish a clearinghouse for CDS. This means that unlike the current situation, all such contracts will have to pass through a central body that will record them. This will enable the Fed to, first, have a general picture of what is happening in this field and, second, allow it to regulate it.
Recall: CDS are in essence insurance contracts. Like all insurance types they make sense only when the risk is non-systemic. To understand this, consider home insurance. The insuring company will be able to honor it when the risk is non-systemic. But if a giant hurricane is going to hit the whole U.S. at once (systemic disaster) all insurance companies will fail to honor their obligations. The same holds true for credit insurance. In normal times when a few companies default on their loans in a random manner, credit swaps on such companies will be honored. But what happens if the economy hits a bump and thousands of companies default on their loans? So, I really don't understand how regulation could have prevented the current crisis.
The only way top remove the risk of systemic failure of the CDS market is to ban this type of contract altogether.

Covertible bonds

I recommend you read yesterday's WSJ article "Short-Sale Ban Wallops Convertible-Bond Market" It might serve you in both my forthcoming exam (it falls under the Bond Classification subject) and the derivatives class.
Make sure you understand the claim regarding who issues such bonds and the statement that 75% of convertible bondholders also go short on the stock of the bond-issuing company. Obviously, without knowing what a short sale is, this article will make no sense to you. So if you are a bit hazy about this sale, look it up on the Internet.

Debt Market Distress Spreads

An article in today's Wall Street Journal provides a description of the commercial paper market and its recent upheavals. Read it!!!

Toxic Mortgage Pools

You probably heard a description of the recently proposed $700 billion rescue plan as cash for trash. This plan calls for the Treasury to purchase from financial institution mortgage backed security that are completely illiquid; nobody want to buy them. You may want to ask why is that that these securities are untouchable. The answer lies in the uncertainty surrounding the cash that will ultimately will flow from them. As more borrowers whose mortgages are part of the pool default, the less is the payoff from the securities backing the pool. This is not a problem for conventional (or prime) loan whose cash flows are now guaranteed by the U.S. Treasury. Subprime loans that were securitized by private banks are at risk; they are not protected from borrowers defaulting.
Yesterday's New York Times had an EXCELLENT description of the toxicity of one mortgage pool. Please read this article titled "Plan’s Mystery: What’s All This Stuff Worth?" Make sure to examine carefully the multimedia table in this article.
Once you read this article, you will be able to understand why (in my opinion) the $700 billion rescue plan will reap off the tax payers. Suppose a bank is currently holding securities from two different pools:a high quality Pool I and a low quality Pool II. The bank cannot get rid of either one of them because buyers believe that the bank will try and get rid of the bad pool first. George Akerloff was awarded a noble prize (2001) for this idea (he titled his article "The Market for Lemons"). Enter the cash for trash program: the banks can now sell to the Treasury either the Pool I or the Pool II security. Which one do you think the Treasury is going to end up owning?

Is The Crsis Winding Down?

The DJ Industrials average closed today some 400 points up. Do market believe that the worse is over?
many commentators argue that there is at times a dichotomy between the bond and the stock markets. The bond market "predicted" the current crisis by demanding historically high risk premiums on LIBOR and on junk borrowings. It is my view that the bond market is more "rational" because fewer small investors play this market. I would wait to see if the other shoe (commercial real estate, Credit card ABS) drops before passing judgement.
At any rate, my suggested reading for today is Steven Levitt's blog in the New Your Times titled "Diamond and Kashyap on the Recent Financial Upheavals"

The AIG Crisis

9/17/08
These are momentous times. Current events in the fixed income area may paralyze the world’s economy and push it eventually into a deep recession. This is not a forecast but rather one of several potential scenarios.
I could elaborate in person on current events. Fortunately, because of the centrality of fixed income securities in the current crisis, better persons than me comment on the situation and it is my pleasure to refer you to several excellent sources:
1. In today’s New York Time read “Fed Agrees to Lend A.I.G. $85 Billion to Head Off Crisis” In particular, examine the Multimedia chart in this article titled “AIG Troubles and Why They matter”. You should review the concept of Credit-Default Swaps that I discussed in an earlier posting.
2. The front page from today’s WSJ (print!). The article titled “U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up” mentions the fact that even money market funds are no longer safe. This means that for the first time in two decades, investors who park their cash in a MM funds can actually collect less than 100% of what they deposited. In short: their buck may break.
3. You should also listen to an excellent interview conducted today with Professor Michael Greenberg, (a U. of Maryland law professor) on Fresh Air – an NPR podcast. It takes 38 minutes to listen but it’s worth it.

To me the most worrisome development is that banks stopped lending to each other. This may have happened either because banks don’t have excess reserves or because they don’t trust each other.

Last: it is easy to forget but the FNMA-Freddie Mac dominated the news only a week ago. Are you sure you can describe the nature of the business conducted by those two institutions?

The Financial Markets Crisis

In my most recent posting, I elaborated on the murkiness of the default-credit swap market and pointed out the risks involved. In page 8 of today's Section C (The WSJ)there is an excellent article making the same point: "Credit-Swap Players Puzzle Over Fan-Fred Fallout" I suggest you read all parts of the newspaper today. In a way this crisis can be a positive development. Lehman Brothers is sunk because it revealed that its mortgage security holdings are worth only 39% of their face value. Many other institutions will have to take a similar bath now (marking their investments to market). This will encourage investors to step in knowing that 39.000 is probably a fair price. Reality may however refute this optimistic view.
Life has never been so interesting in the fixed income securities area.

Credit Default Swaps

1. What is a Credit-Default Swap?
I am going to make my life easy today. I have found a WSJ blog explaining exactly what I had planned to write about: bond insurance. The blog posting is titled “The Vicious Circle” . I would like to emphasize the paragraph to the left of the graph:
“The credit-default swaps, a measure of protection against default, have exploded. Today it costs $1.2 million, along with $500,000 annually, to protect $10 million in bonds against default, compared with $680,000 on Thursday, according to Phoenix Partners Group.”
A credit swap is a put on a bond. The trigger is a default event. Let me give you an example using the numbers in the above paragraph: Suppose I hold $10 million AIG bonds and wish to protect myself against this bond defaulting. I can buy such insurance by: paying $1.2 million upfront plus an annual premium of $500,000.
The question is why is that contract called a swap? The answer is that if default occurs, the insured can swap the bond with the insurer for its face value of $10 million.
Note: this swap has very little in common with interest rate or currency or equity swaps.

2. Why Are Credit-Default Swaps So Important?
When two counterparties enter a credit default agreement, they do not have to report this agreement to anybody. According to some estimates, credit-default swaps have been written on bonds with more that $60 trillion. This amount is a multiple of the amount of actual bonds outstanding in the U.S. (Government and private). It is reasonable to assume that many of these swaps have been entered for speculative purposes (if you bought such swap on AIG last week you could sell it this year at a huge profit).
Now, several financial institutions hold bonds that lost a lot of their market value but have not, as yet, defaulted. These bonds appear on their books at 100% of face value because, on the face of it, they are insured, or rather, “insured”. Nobody knows if the insurer (who can be AIG or a hedge funs or a bank) will be capable of making its commitment whole in case of default.

Credit market column-more on LBO

The previous posting described the general structure of an LBO transaction. Today's Credit Markets (http://online.wsj.com/article/SB122113907477223393.html) column in the Journal touches upon the effects of the current credit crunch on LBO transactions. You might recall that private equity firms secure a bridge loan from banks prior to actually "LBOing" a target firm. The article discusses what happened when two private equity firms (Thomas Lee Partners and Bain Capital- not mentioned in this article) took over Clear Channel Communications (CCC - http://www.clearchannel.com/). Part of the bridge loan agreement (also known as the credit agreement) written at that time, required CCC to issue $1,400 million ($14 billion) in junk bond aimed at retiring the bridge loan. Unfortunately, the market refuses to buy these bonds at the current situation and the bonds have to be issued in chunks. The current intended chunk is $980 million. Even when these new bonds were discounted to 70% of face value, the underwriters who market these bonds for CCC were able to find buyers for only $228 million.

What are the implications of this inability to sell these junk bonds? CCC cannot repay the bridge loan. Most bridge loan agreements prevent the lending bank (or syndicate) from suing the private equity firm so the banks are stuck with a huge loan that was meant to be short-term in nature. The numbers are staggering: as you can learn from this article, banks are stuck with $48 billion of bridge loans that carry relatively low interest rates.

The Saga of CCC is long. You can go for example to a previous June 14 Journal article (http://online.wsj.com/article/SB121336291248771553.html). I am quoting from article so that you can familiarize yourself with the concept of PIK or toggle bond.

“The $2.31 billion of Clear Channel bonds are split between a pay-in-kind toggle note, which allows a company to make interest payments in debt rather than cash. Such a bond is risky for investors because, should the company run into trouble and go bankrupt, it has the potential to leave them with more debt and lower recoveries.”

Private Equity Firms

9/10/08

To All Fixed Income/ Interest Rates Students:

I would like today to discuss the activities of private equity firms.

A pretty good summary of the activities in which these firms engage may be found in Wikipedia (http://en.wikipedia.org/wiki/Private_equity), namely: Leveraged buyout (LBO-remember this acronym!!!), venture capital and growth capital. I would like to briefly concentrate on the LBO issue that is not illustrated very well by the Wikipedia page (http://en.wikipedia.org/wiki/Leveraged_buyout). The following description of the LBO process is a general scheme and may have other variations. In essence the process entails finding other people to pay for the deal while keeping all the upside potential from equity ownership of the Company.

Step 1: The private equity firm (“the Firm”), identifies a target with (preferably) the characteristics described by Wikipedia. The Firm thinks that it is a good idea to take over the Firm because of the following potential advantages:

a. The Firm judges the Company's management lacking.

b. The Firm owns other companies with potential synergies with the Company under consideration

c. The Firm judges the Company as underleveraged. The more the leverage the more the tax advantage (Modigliani-Miller)

d. The Firm hopes it can find a lot of suckers that will help it take all the risk while accepting low returns.

Step 2: The Firm identifies a bank (or a syndicate) that will be willing to provide it a bridge loan. This loan is intended to help the Firm to pay for the purchase of ALL the Company shares until new suckers are found.

Step 3: Approach the Company’s management (and board) and convince them to approve of the takeover at a premium over current market price.

Step 4: Once agreement is reached, the Firm purchases all shares in the Company with money provided by the banks in Step 2.

Step 5: Once the Company is fully owned by the Firm, it issues a large amount of new debt. Because this debt comes on top of older, pre-LBO, debt it usually offer high interest and fall into the junk bond (=high yield bond = below-investment-grade bond) category.

Step 5: The Firm makes the Company pay most of the proceeds from the new bond issue in dividends to itself (the Firm)

Step 6: The Firm repays the bridge loan from the dividend money. In many cases the dividend amount exceeds the bridge loan amount. After paying the bridge loan, the private equity Firm already has some “free” money in its coffers.

Step 7: If the Company does well, the Firm can re-sell it (to another private buyer or even back to the public (reverse LBO!) and pocket the selling price (it doesn’t owe anything to the bondholder, the Company does).

If the Company does not do well, it can go bankrupt and taken over by the bondholders or even be liquidated. Although this may deprive the Firm from additional profits, it doesn’t suffer any out of pocket cash losses if this happens.

A few asides:

1. When the Company is made by the Firm issue additional debt, the situation of the original bondholders is worsened (say the interest coverage ratio of the firm goes down from 2 to 1). These original bonds lose value. Since this is all a zero-sum game, who is gaining this value? Answer: the Firm.

2. Issuing additional bonds is not the only way in which the deal can be financed. In recent years, leveraged loans (high-interest loans granted by banks) became popular. Not surprisingly, more than a few such loans became virtually worthless in recent months. The lending banks had to take a bath on this account as well.

Read the following article from yesterday’s WSJ (http://online.wsj.com/article/SB122091910239912651-email.html)

Think about the following: At what Step did this deal go wrong?