Tuesday, April 21, 2009

Back To CDS

Yep, back to these graphs again. The bank rally on the back of yesterday's slide was accompanied by MORE NEW LOWS in bank asset pricing. Please note: the CMBX tranches are now priced using the same convention as the ABX tranches. The data provider made the switch yesterday.

So, once again, bank stocks moved higher and the perceived quality of their assets dropped. To review, these credit default swaps are based on indices of asset backed securities. The ABX indices track residential mortgage assets and the CMBX tracks commercial mortgage assets.

Although similar to bonds and other fixed income products in some respects, these mortgage assets are not guaranteed (nor even expected) to pay off the full face amount. This is true for even Fannie, Freddie and Ginnie mortgage backed securities. The cash flows from the loans themselves are used to make the principal and interest payments on the securities. The main reason why, even in normal conditions, $100 in principal would not be expected to be paid back is prepayments. Of course, there is also some baseline default activity as well.

Therefore, I would not expect to see the lower rated tranches move off their lows. There is no "pull to par." The problem is the higher rated indices, particularly the residential side. This is important to note, especially since Fannie & Freddie reported today that prime mortgages were defaulting a substantial rate. There is no safe haven. Those 600,000 jobs a month that the economy is losing devastating all types of borrowers.

I urge you to use extreme caution on either side of the bank stock trade. Fundamentally, I see no reason to establish a long position in any bank. Shorting can be hazardous because the SEC can change short selling rules whenever they want to. Stay true to your targets.

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