Thursday, February 07, 2008

A new monoline exposure for banks: CLO negative basis trades

Another day another problem for banks, "pirate equity" and financials...... It feels like more and more pillars of the "alchemy of finance" are crumbling down.....

Ein neuer Tag und mal wieder neue Probleme für Banken, "Pirate Equity" und Finanzwerte im allgemeinen.... Es sieht so aus als wenn immer mehr Pfeiler der "Finanzalchemie" beginnen wegzubrechen....

FT Alphaville Banks’ exposures through bond insurers, or monolines, is far from limited to mortgage-related MBS and muni bonds. There’s a third big exposure - to leveraged buyout loans - that banks will have to deal with if monolines hit the rocks.

Negative basis trades have been around for a while. A bank buys a bond - say it’s AAA - and then it takes out a CDS against that bond with a monoline. Since spreads in the CDS market for such tranches have been typically much lower than in the cash market, the bank pockets the difference.

But as well as banks’ much-dissected CDO exposures, there have been two other big markets for that kind of trade: on infrastructure bonds and - most interestingly - in structured finance, on CLOs (collateralised loan obligations) - CLOs being the vehicle of choice in which to park massive buyout loans.

Monolines, of course, are no longer in a position to be writing new contracts for banks to use as one half of their negative basis trades. The consequence of that has been that banks have stopped buying AAA tranches of CLOs. Unable to sell those, CLOs have faltered and banks in turn, have found themselves with lots of big buyout loans stuck on their books. No new financing is available for private equity deals.

According to Euroweek, 90 per cent of all CLO AAA-tranches have been bought and then wrapped in negative basis trades. Which begs a second question. What of all the AAA CLO and infrastructure paper that banks already have on their books? None of it, of course, shows up as exposures in filings because, net, there is no exposure. Assuming, of course, your CDS counterparty is safe. Err…


> Deutsche Bank was very optimistic in yesterdays call to unload all the € 21 bln loans with no losses. They argue that the quality of the loans is high and that it is and has always been the policy from Deusche to take 10 percent of the structured loans onto their books to signal that they have full confidence in their underwriting standarts. I think they are way too optimistic.....

> Die Deutsche Bank has sich gestern in der Analystenkonferenz extrem optimistisch gezeigt das sie die knapp 21 Mrd € an Unternehmenskrediten die sich in Folge des Private Equity Übernahmewahnsinns angehäuft haben ohne Verluste weiterreichen kann. Argumentiert wird das die Qualität hoch sei und das es seit jeher Politik der Deutcshen Bank ist jeweils 10 % der so strukturierten Verkäufe in die eigenen Bücher zu nehmen. Damit soll unterstrichen werden das man vollstest Vertrauen in die Kreditprüfung hat. Löblich...... Denke trotzdem das hier sicher noch einige gewaltige Abschreibungen kommen werden.

Even if monolines don’t crash and burn, banks will still have to make writedowns on these trades. As the value of the CDS written by the monoline decreases, so, too, will banks exposure to CLOs, and through them LBOs, have to increase. And higher exposures will also, of course, put pressure on capital.

And one final point: having set up one negative basis trade, it hasn’t been uncommon for banks to take out a CDS against the CDS counterparty in that trade. As Paul J Davies points out in today’s FT, through negative basis trades, banks’ monolines exposures have often been hedged with other monolines.

Update: The WSJ has an interesting number crunching piece on the state of the LBO industry - and the amounts banks are finding themselves stuck with.

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8 Comments:

Anonymous eh said...

Hi J-M,

Lack of demand for US debt may make it difficult for the Fed to keep lowering rates:

Prices of Treasury coupon securities plummeted in a tumultuos trading session which was reminiscent of trading in the 1980s.

More of the usual:

Exploding ARMs Roil Bernanke's Drive to Calm Markets

Etwas überraschend:

Dollar Rebound Foreseen by UBS, BNP Gains Momentum

2:35 AM  
Anonymous eh said...

MBIA Share Offering Boosted to $1 Billion

The offering price is about $2, or 14%, below the close yesterday. Which would mean, if this holds (which I somewhat doubt), an instant 16% profit.

Which might explain why the offering was 'oversubscribed'.

3:06 AM  
Anonymous eh said...

The Bush Financial and Economic Bust of 2008 - The Destruction of Capital

3:23 AM  
Blogger jmf said...

Moin Eh,

thanks for the great links!!!!

To be honest i didn´t notice the crash in the bond market so far.....

The rally in the $ will be short lived. In the end all fiat currencies are more or less junk.... What was probably most surprising during the $ rally is that Gold didn´t react at all....

It seems that finally more and more are realising that Gold isn´t just an anti $ play.

Very encouraging!

The MBIA is like an ongoing saga....

What a farce......

3:44 AM  
Blogger jmf said...

Apropos Monolines....

A must read!


Super Friday for monolines? Moody’s cuts rating on XLCA


XCLA has contracts on around $154.2bn of debt, which will be cut by at least the same number of notches - to A3, according to Moody’s. In fact, you can view the massive lists of securities downgraded here (40,151 munis), here (103 structured) and here (137 corporate).

3:47 AM  
Anonymous eh said...

The rally in the $ will be short lived.

You'd think so. Buw who knows? With people piling into US HB stocks recently, as if the builders could recover, much less prosper, while the finance sector -- the source of credit -- and the consumer (buyers) are crashing, I would not be surprised at anything.

The thing about the FX markets is that they are speculative and driven by sentiment. So these Voraussagen tend to be self-realizing: if enough FX traders hear that the dollar is expected to strengthen, and then they see it start to happen, they'll have to join in or risk growing losses.

It's all pretty ridiculous -- völlig absurd.

It's like the fundamentals are the road, but the FX traders are driving, and who knows which direction they'll go. One thing is pretty clear though: in a short time most of them will be going in the same direction.

4:46 AM  
Anonymous eh said...

bezüglich monolines usw:

Could soon be time to take massive short positions, the Fed and other central banks be damned. They are running out of bullets to shoot, and in any case either their aim is bad or this thing can't be killed by low rates.

Good luck in your trading J-M.

4:59 AM  
Blogger jmf said...

"It's all pretty ridiculous -- völlig absurd."

AMEN!!!!

In the short term it is almost impossible to judge the direction of almost every asset class.

But it is good to see that at least in the medium to long term
fundamentals matter ( see homebuilder, banks, gold, $, pound, etc )

5:01 AM  

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