MarkIt MCDX (Municipal Bond Credit Derivative) Index has started trading on last Tuesday, May 6th.
MCDX, like its CDX and ABX counter parts, is an index of 50 municipal bond credit default swaps. The blog post here has a good deal of information on MCDX...
A few interesting readings on Credit Derivatives:
Some players I have learnt recently in the course of my work:
Model accuracy in different markets from Paul's latest blog entry.
The dynamic relationship between just two equities can be beautifully complex, and certainly never to be captured by a single number, correlation.
There goes your reason why the CDO business is in deep trouble now...
With Warren Buffett getting into Muni Bond Insurer business, it's time to get a lesson on how municipal bond insurance works.
Asked yesterday if the firm would take the sort of significant write-down facing many of its peers, Mr. Blankfein answered with a succinct "No." Given the continued, challenging conditions in the trading of complex mortgage products, "we continue to be net shorting these markets," he told the crowd.
According to the press release, Morgan Stanley used ABX indices as a reference point for its ABS asset valuations. Looking at the changes in high grade (AAA) ABX-HE index in the last couple days, it seems that there might be more to write down post Oct 31st.
Makes me wonder how other "smarter" banks (read: GS and LEH) are holding up in this climate.
Morgan Stanley reported a $3.7b write down on subprime related exposures. Make no mistake though, Morgan Stanley didn't bet on the wrong side of the market. It started the year with a short position in subprime, a position that earned good profit for the first nine months of 2007. Here is Colm Kelleher, Morgan Stanley CFO's explanation of what happened in the last two months:
We began with a short position in the subprime asset class, which went right through to the first quarter; as the structure of this book had big negative convexity and the markets continued to decline, our risk exposure swung from short to flat to long.
In essence, you can think of Morgan Stanley's trade as a short position in the junior tranche of ABS CDO, with an offsetting long position in the super senior tranche of the same structure.
Initially, as the delinquency ratio in subprime market on the rise, the junior tranche suffers the first loss and declines more in value than the super senior tranche. The overall trade represents a short subprime position.
In the last two months, as the subprime problem continued to worsen, the junior tranche has lost most of its value with losses now bites into the super senior tranche. Since the value of the junior tranche is floored at zero, it now declines in a much slower pace than the value of super senior tranche. As a result, the trade now becomes a long position in subprime, hence the $3.7b paper losses.
BET is a relatively simple technique used by Moody's to price and rate CDOs.
(DS: diversity score. PD: probability of default for each asset)
(Lj: loss for a given tranche with J defaults)
The BET methodology gives a sneak preview of what's deep down in the CDO pricing rabbit hole without getting into the rocket sciences (Monte Carlo, Copula, etc). Here is a good paper that compares the BET with Monte Carlo simulations.
An LCDS works very similar to a CDS, with two major differences:
An introducation on LCDS.
Bear Stearns' letter to investors (PDF) on "their disappeared money".
...Fund managers and account executives have been informing the Funds’ investors of the significant deterioration in performance for May and June. The preliminary estimates show there is effectively no value left for the investors in the Enhanced Leverage Fund and very little value left for the investors in the High-Grade Fund as of June 30, 2007.
In light of these returns, we intend to seek an orderly wind-down of the Funds over time. This is a difficult development for investors in these Funds and it is certainly uncharacteristic of BSAM’s overall strong record of performance.
...
How lovely...
Today's Journal has an article on how hedge funds coming up with all kinds of excuses for the market turmoil in the recent weeks in order to avoid the embarrassing "I'm sorry".
The two (mock) letters below summarized it pretty well. Read the originals here:
How to Say All Their Money is Gone
by Mr JugglesDear Valued Client:
As you may know, the investment process has a normal course. Generally accepted investing practices follows that you, the investor, give us, the manager, money. As manager we take that money and buy something with it. This something generates profits and at the end of the year, we pay ourselves some percentage of what we bought with your money, as well as some percentage of the generated profits. Everyone profits which is a good thing.
Unfortunately, the money you gave us did not follow this normal course. Per usual, we “invested” your money in tranches of CDOs comprised solely of loans to people who specifically would never be able to pay down their mortgage. Their inability to pay was the very thing that made these such great loans and allowed us to demonstrate to you a profitable two year record of performance. This could have continued but your money decided to disappear.
As far as we can tell, there is no current record that points to existence of your money. It’s no longer part of our assets under management. Look, it’s up to you how you raise your money and I don’t want to get into a nature vs nurture sidebar with you, our valued client. But don’t you think that maybe you should have imbued your money with more of a sense of sticktuitiveness? I mean, it literally seems to have vanished at the worst possible time, what with the depressed prices and attractive yields which now litter our market. This is when we could be printing profits for you (if only your money hadn’t disappeared).
I guess, for us, we’re disappointed in you. Your role is to let us take your money, assume none of the risk and allow us to give you some of the return. Don’t you see how this relationship breaks down if you allow your money to disappear? We’re not angry with you, just disappointed. It’s your loss, as we still earned our management fee, it just seems like a waste for you.
I have enormous confidence in Long or Short Capital management and the ability of our talented professionals to bring you the highest quality products and services now and in the future as they have in the past. You can count on us to deliver…if you don’t let your money vanish.
Sincerely,
Mister Juggles
How to Say All Their Money is Gone - Part II
by Johnny Debacle
Dear Valued Client:
Last week you received a letter from the head of Long or Short Capital Management, Mr Juggles. In this letter Mr. Juggles told you that although your money was invested wisely according to the prospectus, that money has subsequently disappeared. We wanted to write you to let you know that after further diligence this is 100% accurate. Your money is definitely, definitely gone, for sure.
The feedback we received on the previous letter has revealed that you are unhappy that your money is gone but you were especially upset with our refusal to accept responsibility for your money being gone. Well first we would like to remind all of our valued clients that you shouldn’t point fingers. This is not just your fault, it’s everyone’s fault. Even ours, just to a much lesser degree than it is yours( especially important point for you to take away). We have completed a detailed and rigorous analysis of whose fault it is and thought it was important to share the results:
The chart depicts graphically the small size of our fault. After further study it was determined that all of our market share of the fault stems from one person: Mr. Juggles. As of this morning we have resigned him. Kaiser Edamame, our Germo-Japo restructuring expert and portfolio manager of our anti-union humor portfolio, will take-over for Mr. Juggles effective immediately.
We have also implemented several restructuring measures to ensure that when your money disappears in the future, it is less our fault than it was this time. Starting on August 30th, before we invest in low-yield, illiquid securities with high default risk we promise to “think-twice”. This represents a 100% increase in the amount of thinking we have done in the past. Also, in the case of our most risky investments, before we increase our exposure to them we will now “sleep on it,” something we have not done previously. We feel confident that these measures will significantly increase your returns and hence our fees over time.
Please contact me with any questions.
Subprimely,
Johnny Debacle
EVP Long or Short Capital Managment
As the housing market keeps turning for the worse, the subprime sector of asset backed market has been deteriorating since the beginning of the year.
In the last couple weeks, amid the fallout of the Bear Stearns hedge funds, there have been signs that this weakness is spreading to other sectors of asset back securities and even the broad credit market.
Here are some of the relevant indices tracked by MarkIt:
A good introduction on how to price CDS indices (a basket of single name CDSes). And here is the link to the spread sheet.
Of course, you can always use the average of single name CDS spreads as a first order approximation, which ignores the spread convexity. The proper method, as presented in the spread sheet, is risky annuity/DV01 weighted average of these spreads.
Correlation
People (at least myself) have loosely interpreted Correlation as the strength of predictability between two random variables. I.E. A correlation coeffecient of 0 indicates the value of Y is independent of the value of X. Turns out that's not really the case. In the following example:| X | Y |
| 1 | 1 |
| -1 | 1 |
| 0 | 0 |
The same kind of simple yet common mistake as the misconception of volatility.
Copula
Dr. David Li's original paper on using Copulas to model default correlations.
CME is tapping into the $30 trillion credit market with its single name and index credit default swap future contracts. Eurex is also set to launch future contract on Itraxx CDS indices. This is hardly surprising given the hyper growth in OTC credit derivative market in the last couple years (also in the news today, the overall size of credit derivative market has been growing at 100% three years in a row). It would be interesting to see the impact of exchange involvements on the overall credit market (I.E. on counter-party credit risk, liquidity, etc).
