Mortgage Market Turmoil Pushes Swaps To Record Wides

[Ash4781]

http://www.reuters.com/article/companyNews...626062320080306

By Richard Leong

NEW YORK, March 6 (Reuters) - U.S. interest rate swap

spreads blew out to their widest ever on Thursday as investors

unwound hedges no longer needed following a massive liquidation

of mortgage bond investments.

The turmoil in U.S. credit markets this week has spread to

what had been viewed as the least-risky part of the mortgage

market as investors unloaded bonds backed by Fannie Mae (FNM.N: Quote, Profile, Research)

and Freddie Mac (FRE.N: Quote, Profile, Research) to raise cash to meet margin calls.

Compounding the situation was news that a mortgage lender

and an investment fund were in trouble after banks that lent

them cash to finance their investments demanded their money

back.

Moreover, news of a Moody's downgrade of bond insurer CIFG

Guaranty and Citigroup Inc's (C.N: Quote, Profile, Research) plan to shrink its mortgage

business added to investor jitters.

"It's a flight to quality into Treasuries, which makes swap

spreads wider," said James Caron, co-head of global rates

research with Morgan Stanley in New York.

In a swap transaction, there is an exchange of fixed-rate

and floating-rate payments between two parties. The party that

receives fixed-rate cash flows is vulnerable to a spike in

long-term rates, which happened this week.

Interest rate swaps are used to hedge or bet on interest

rate moves. The spread on the swap rate and comparable Treasury

yields reflects the cost to exchange fixed-rate for floating

interest-rate payments.

The two-year swap spread widened to 112.50 basis points in

late trading, compared with 105.75 basis points late Wednesday.

It eclipsed the record of 106.50 basis points in December.

Swap spreads ranging from two years to nine years broke 100

basis points collectively for the first time ever, analysts

said.

Short-dated and intermediate spreads have expanded as much

as 25 basis points so far this week with the sharp steepening

of the Treasury yield curve, which reflects the difference

between short-term and long-term interest rates.

Swap spreads are considered gauges of risk aversion among

investors. They have expanded in recent days on credit worries

stemming from ongoing problems in the financial sector due to

their subprime exposure.

Risk aversion, together with the unwinding of hedges by

mortgage investors, intensified on Thursday following news that

an affiliate of private equity firm Carlyle Group [CYL.UL]

failed to meet some margin calls and has received a notice of

default.

Speculation that Thornburg Mortgage Inc. (TMA.N: Quote, Profile, Research), a lender

that specializes in expensive homes, might file for bankruptcy

caused the credit market to unravel further.

MORTGAGE UNWIND

This week's exodus from mortgage investments did not come

from the battered subprime segment, but rather from the

higher-quality agency and "Alt-A" sector.

Some funds that had invested in these less-risky mortgage

securities did so by borrowing heavily. A sharp price decline

on mortgage securities has triggered demands from the lenders

for the loans to be repaid.

"In times of stress this can exacerbate losses, create

forced liquidations and increase hedging needs, which can drive

swap spreads wider," Morgan Stanley's Caron said.

These forced sales have kicked off a vicious cycle that has

led to more losses on mortgage securities and further selling

to meet margin requirements on leveraged portfolios, analysts

said.

Investors have been closing out their mortgage-related

hedges in the swaps market by paying in fixed-rate cash flows.

This boosts swap yields and their spreads over Treasuries.

Among longer-dated swaps, the five-year spread was last

quoted at 115.75 basis points, beating the record 113.25 basis

points set earlier.

The spread on 10-year swaps was last quoted 92.75 basis

points, the widest since April 2001.

(Reporting by Richard Leong; Editing by Dan Grebler)

Grim

[BandWagon]

http://www.reuters.com/article/companyNews...626062320080306

Grim

Yes, the news is Grim, but on the bright side it's nice to see a little reality starting to sink in.

I think people are now starting to understand that this isn't some little blip, this is a major global financial crisis.

[Ash4781]

Yes, the news is Grim, but on the bright side it's nice to see a little reality starting to sink in.

I think people are now starting to understand that this isn't some little blip, this is a major global financial crisis.

http://www.bloomberg.com/apps/news?pid=206...&refer=home

Alabama County Won't Pledge $184 Million for Swaps (Update2)

By Martin Z. Braun

March 6 (Bloomberg) -- Jefferson County, Alabama, in a move that may cost it $184 million, said it wouldn't pledge reserves against $5.4 billion of interest-rate swaps tied to sewer debt that its bankers may demand.

The reluctance to commit funds prompted Standard & Poor's to cut the county's $3.2 billion of sewer debt deeper into junk status. S&P cut the debt three levels to CCC from B and said the rating could move up or down in the short-term.

Jefferson County, where Birmingham is located, faced a March 7 deadline to put up the $184 million in collateral or buy insurance to meet its obligations to JPMorgan Chase & Co. and three other banks on 13 swaps after its sewer debt was downgraded by S&P and Moody's Investors Service.

``The county commission faces difficult decisions on the sewer system debt. However, these decisions will not be made at the expense of the county's employees,'' Jefferson County Commission President Bettye Fine Collins wrote in a memo to the workers.

While Collins said filing for bankruptcy was an option, ``its not something that they're considering,'' said Leigh Butler, a Collins aide. The county will not cut jobs, dip into its pension fund or curb health and other benefits to generate cash to bail out the sewer system, Collins wrote to employees.

Jefferson County, its interest expense on $3 billion in floating-rate obligations skyrocketing, is caught in a faltering credit market that has more than doubled costs for many borrowers in the municipal-bond market. Investors are no longer willing to trust much of the insurance backing the bonds, as the guarantors face subprime mortgage losses, leaving the county paying interest rates as high as 10 percent.

Backfiring Swaps

Compounding the problem, interest-rate swaps the county bought from JPMorgan, Bear Stearns Cos., Bank of America Corp. and Lehman Brothers Holdings Inc. to shield it against rising borrowing costs have backfired. The floating rates it pays on its bonds have climbed while the variable rate banks pay the county under the agreements has declined, pushing interest costs higher.

In a disclosure to investors late yesterday, the county said the counterparties to its swaps could terminate them ``upon notice to the county, in which event the county would be obliged to pay the resulting termination payment.''

JPMorgan spokesman Brian Marchiony and Lehman spokeswoman Kerrie Cohen declined to comment on whether they would terminate the swap contracts. Spokespeople from Bear Stearns and Bank of America couldn't be reached immediately. The firms are all based in New York except Bank of America, which is located in Charlotte, North Carolina.

Cash on Hand

The county's sewer fund had $193 million as of Jan. 31, according to Moody's. In a Feb. 20 disclosure, the county said its sewer construction fund contained $105 million, after it withdrew $59.8 million from the account to pay debt service on the sewer bonds.

Financial advisers and lawyers for the county met with bankers in New York earlier this week to discuss a possible debt restructuring, Collins said in an interview March 4. She didn't immediately return a call seeking comment on the latest disclosures.

The county, on the advice of JPMorgan Chase & Co., refinanced about $3 billion of sewer debt in 2002 and 2003 using floating-rate debt, mostly insured by FGIC Corp. and XL Capital Assurance, whose coverage is rated A and A-, respectively, by S&P.

$6 Million Additional

After the insurers' ratings were cut from AAA in January, rates on the county's floating-rate bonds soared when dealers failed to find buyers for the securities or use their own capital to purchase them. The county said it paid $6 million more in interest on its sewer debt in the four months ended Jan. 31.

The surging debt costs initially led credit-rating companies to cut the county's sewer bonds to near junk status. That, in turn, triggered clauses in bond and derivative contracts that gave banks the right to force the county to post collateral on the swaps and buy back as much as $847 million of floating-rate debt.

Officials in a Feb. 28 notice said they were unable to assure investors that revenue generated by the sewer system would be sufficient to pay the obligations, which are payable from customer bills. That led S&P to cut the county's sewer debt rating to B and Moody's to lower the ranking to B3, both below investment grade.

CCC Rating

The latest S&P bond rating of CCC means that county's sewer debt ``is currently vulnerable to nonpayment,'' according to S&P's ratings definitions. ``In the event of adverse business, financial, or economic conditions, however, the obligor is not likely to have the capacity to meet its financial commitment on the obligation.''

County fixed-rate sewer debt insured by FGIC and maturing in 2027 traded as high has 92.6 cents on the dollar today and as low as 82 cents on the dollar for a 7.126 percent yield.

Municipal bond lawyers who specialize in distressed issuers say that the county would declare bankruptcy as a ``last resort'' because it would effectively freeze the county's ability to borrow and create a stigma that may last for years.

About $2.2 billion of the sewer debt consists of auction- rate securities, long-term securities whose interest rates are set every 7, 28 or 35 days. The county has experienced failed auctions on $869.45 million of the obligation, causing rates to rise to as high as 6.25 percent on Feb. 25, up from 4.7 percent on Jan. 22.

Auction-Rate Conversion

The county is likely working to convert its auction-rate securities to floating-rate debt and will purchase a bank letter of credit to guarantee the debt, generating a higher rating.

``In one form or another, they want to eliminate FGIC and XL,'' said Scott Fairclough, a New York City-based investment banker with Birmingham-based Sterne, Agee & Leach Inc., which has proposed a restructuring plan to the county.

Lastly, the county could sell or lease the sewer system to a private buyer to pay off bondholders.

As of Dec. 31, the county had $2.4 billion of interest-rate swaps on its sewer debt with JPMorgan, $1.6 billion with Bear Stearns, $643 million with Bank of America and $190 million with Lehman Brothers.

It also has additional swaps with JPMorgan on other bonds.

In a swap, two parties agree to exchange payments over a period of time that can last as long as 30 years. Typically, one agrees to pay a fixed rate and the other to pay a variable rate that changes with a benchmark index or formula defined in the contract.

The contracts generally have provisions requiring the parties to pledge assets in the event their credit rating is lowered to a certain level.

What's going on here ?

Edited March 6, 2008 by Ash4781

[R K]

Excellent find.

[_w_]

I expect the banks to pounce on Carlyle.

IIRC Carlyle (a fine example of the superior 'homo private equiticus') was recently whining upon experiencing margin calls that "It's not fair, Alt-A bonds always go up, and they're guaranteed by the treasury".

They forced the treasury to flately deny it hence the plunge in Alt-A and Agency bonds.

Well done Carlyle, by being so brash they signed their own death warrant.

Edited March 6, 2008 by williamdb

[Ash4781]

I expect the banks to pounce on Carlyle.

IIRC Carlyle (a fine example of the superior 'homo private equiticus') was recently whining upon experiencing margin calls that "It's not fair, Alt-A bonds always go up, and they're guaranteed by the treasury".

They forced the treasury to flately deny it hence the plunge in Alt-A and Agency bonds.

Well done Carlyle, by being so brash they signed their own death warrant.

Carlyle unit says could see liquidity depleted

http://www.reuters.com/article/ousiv/idUSL0667685020080307

Do ALt-A bonds go through Fannie and Freddie ?

[Extradry Martini]

What is going on here is that banks are using swap spreads as a proxy credit hedge. The reason they are doing this is because credit index futures are very illiquid and they can't even get a fraction of their size done in them. Swaps spreads (being interest rate swaps and government bonds), on the other hand, are highly liquid, and also have no balance sheet implications as swaps are off-balance sheet (being derivatives) and government bonds are 0% risk-weighted under the basle rules.

However, and this is important, swap spreads are not true credit risk. There is a credit risk element (the counterparty on the swap) but they move with changes in overall risk premium and also as the shape of the rate curve moves. It is very likely that banks taking large positions in swap spreads right now will lose money on them without making any back on their credit positions. This is pretty much what happened in the second half of August when they were hedging with stock index futures (stocks went up and credit kept falling).

[_w_]

http://www.reuters.com/article/ousiv/idUSL0667685020080307

Do ALt-A bonds go through Fannie and Freddie ?

Not as far as I know. They're Alt-A because they are 'prime' (or so they say) but don't meet the criteria for Agency (Fannie and Freddie) purchase. So Alt-A and Agency are two distinct markets.

Edited March 7, 2008 by williamdb

[Fishfinger]

What is going on here is that banks are using swap spreads as a proxy credit hedge. The reason they are doing this is because credit index futures are very illiquid and they can't even get a fraction of their size done in them. Swaps spreads (being interest rate swaps and government bonds), on the other hand, are highly liquid, and also have no balance sheet implications as swaps are off-balance sheet (being derivatives) and government bonds are 0% risk-weighted under the basle rules.

However, and this is important, swap spreads are not true credit risk. There is a credit risk element (the counterparty on the swap) but they move with changes in overall risk premium and also as the shape of the rate curve moves. It is very likely that banks taking large positions in swap spreads right now will lose money on them without making any back on their credit positions. This is pretty much what happened in the second half of August when they were hedging with stock index futures (stocks went up and credit kept falling).

EDM for Chancellor.

I may not always understand what's going on but you give a very impression of doing so especially in comparison with the current clown..

[Methodius]

What is going on here is that banks are using swap spreads as a proxy credit hedge. The reason they are doing this is because credit index futures are very illiquid and they can't even get a fraction of their size done in them. Swaps spreads (being interest rate swaps and government bonds), on the other hand, are highly liquid, and also have no balance sheet implications as swaps are off-balance sheet (being derivatives) and government bonds are 0% risk-weighted under the basle rules.

However, and this is important, swap spreads are not true credit risk. There is a credit risk element (the counterparty on the swap) but they move with changes in overall risk premium and also as the shape of the rate curve moves. It is very likely that banks taking large positions in swap spreads right now will lose money on them without making any back on their credit positions. This is pretty much what happened in the second half of August when they were hedging with stock index futures (stocks went up and credit kept falling).

A good summary but please let me correct one minor point if I may: interest rate swaps are, in common with most other types of swap, collateralized on a daily basis. At least, in theory, if the collateral management department of the banks in question are doing their jobs, there is no direct credit risk other than some residual amount if a new counterparty for the swap in question cannot be found in the event of an unwind after insolvency.

However, I predict that this will make no difference, the sums involved elsewhere are so enormous that, in the thunder clap noise of the implosion to come, the sound of the IRS sub-implosion will barely register. The tensions now being felt in all areas of the global financial system are merely the pre-shocks emanating from epicenter of the asset back cataclysm currently building.