If the Agencies, each of which spent billions of dollars a year on risk-management systems and hired thousands of people, supposedly to manage their investments, couldn’t keep the accounting straight for their mortgage securities, what hope did anyone else have? The subprime meltdown was caused, at its root, by the fact that neither borrowers nor lenders fully appreciated the risks they were assuming. If the Agencies couldn’t account for ever-more-complex structures like the hybrid ARMs described in Chapter 1, what hope did individual borrowers have? What hope did institutional investors in mortgage-backed securities have? As it turned out, neither group appreciated the risks they were running. This is relevant to valuing credit derivatives because a parallel situation is developing.

A subsidiary of the insurance company MBIA had created a venture, which ultimately failed, to purchase the delinquent tax receipts of properties throughout the city. Many of the delinquent taxes were owed on properties where the occupants were deceased and the properties themselves had little value. Many of the homes had partially collapsed or had become crack houses inhabited by addicts.

The reinsurance company packaged the tax receivables into bonds. Even though each property owed just a few thousands dollars in back taxes, the bonds’ asset-backed note structure prevented MBIA from negotiating to resolve the tax problems of individual properties with potential buyers, including the city. Approximately 8 percent of Pittsburgh’s real estate was part of this failed business venture.

The workout entity was named, appropriately, Caulis Negris, a flawed Latin translation for “black hole.” The idea behind the venture was to buy cheap land and houses and package the pool into a collateralized note. Caulis Negris purchased properties that had once sold for hundreds of thousands of dollars for just a few thousand. How could the venture have gone wrong? Apparently not enough on-site inspections were done, or else the company would have seen that they were essentially buying raccoons’ nests with siding. The city eventually applied pressure and repurchased the properties for a grand total of $6.5 million so that they could be demolished. Imagine owning 8 percent of a major U.S. city for just $6.5 million! While one of the great cities in America was struggling with urban decay and lacked the funds to repurchase and revitalize nearly a tenth of its area, the Agencies were spending billions of dollars on lawyers and accountants to restate their earnings.

The Caulis Negris venture was a small-scale example of what eventually sank the subprime market (and its derivatives) on a national scale: securitization can create value from thin air and assumptions.

On December 18, 2006, the Office of Federal Housing Enterprise Oversight (OFHEO) brought civil charges against CEO Franklin Raines, CFO Timothy Howard, and controller Leanne Spencer, seeking more than $100 million in monetary penalties and restitution for their alleged misdeeds at Fannie Mae. The charges brought against these three surprised some, because they were all politically connected, influential people within Washington. Raines, for example, had been White House budget director under President Bill Clinton prior to taking the helm as CEO of Fannie Mae. According to a January 2005 Business Week article by Mick McNamee, when Fannie Mae first revealed its accounting problems, Raines’s “arrogant insistence that Fannie was above reproach spurred OFHEO to do a white-glove examination.” OFHEO director James Lockhart stated in the complaint: “The 101 charges reveal how the individuals improperly manipulated earnings to maximize their bonuses, while knowingly neglecting accounting systems and internal controls ... [and growing] Fannie Mae in an unsafe and unsound manner. The misconduct cost the Enterprise and shareholders many billions of dollars and damaged the public trust.” The OFHEO charges made it clear, in no uncertain terms, that the old way of doing business at the Agencies was over, and so was their heyday of influence in Washington and on Wall Street.

Changes in the political fortunes and leadership of Freddie Mac and Fannie Mae corresponded to a change in the pattern of debenture issuance of the two firms. In 2005, just prior to the adoption of the portfolio limits, both companies abandoned the issuance calendars they had worked so hard to establish. Rather than issue many large noncallable deals (and some standardized callable structures) at regular intervals, the Agencies began relying more on their medium-term-note (MTN) programs. Although the name implies a specific tenor or expiration for the securities issued, perhaps one with a “medium” maturity, there is nothing standardized about the program, and MTN is the label given to all issuance outside of the regular calendar. MTNs always have some structure, and they are typically quite small, in the tens of millions. How do the Agencies help to fund more than a trillion dollars in retained portfolios with $10 million issues? They do lots of them. As of the beginning of 2007 there were approximately 10,000 individual MTN issues outstanding from both Freddie Mac and Fannie Mae, which speaks to the relatively small size of each individual issue.

Every day, dozens of MTNs are issued of all different maturities and option structures. The most common structure is an embedded call, which allows the issuer to redeem the issue if interest rates fall. The Agencies favor callable structures because they simplify their accounting, since the embedded option in a MTN is not marked to market like a naked option. Second, callable notes match the risk profile of the mortgages held in the retained portfolios, since they too are callable.

Normally, MTNs are sold by reverse inquiry, which means that investors approach dealers and ask for pricing of individual structures. For example, a bank might have a few million dollars to invest and want a 5 -year final maturity note with a yield that is slightly higher than a 5-year bullet (noncallable) issue. In such a case it might ask for the yield of a “5 noncall 2”—bond market slang for a note that isn’t callable until two years from today. The bank could choose the kind of call option: Is the note callable only on a single date two years into the future (a European option), or is it callable on a series of dates starting in two years (a Bermudian option), or is it callable at any time after the two-year mark (a continuous call or American option)? The greater the risk of a note being called, the higher the reward. A note with a continuous call offers a higher yield than a one-time or a Bermudian structure. If the bank in this example wants a little more yield, it might shorten the noncall period from two years to one. The note would then be callable for four out of a total of five years. This would offer higher yields on the note and add more potential variability in the average life of the note. The note might be called in just one year if interest rates fall and the short-call option goes in the money. Or, if interest rates rise and the option stays out of the money, it might never get called.

There is a lesson to be learned from this cursory description of the MTN market: investors do not want the embedded option to go in the money. Many individuals mistakenly believe that they want the notes they own to get called. This makes no sense. If you were to sell an option outright, and not embed it in a note, would you want the option to go in the money or to expire worthless? If you had sold the option, you would want its price to go down and for it to remain out of the money to expire worthless. The same is true when the option is embedded in a note; you still want its price to go down. Since most MTNs are callable, rather than putable, the option remains out of the money when interest rates rise.

Why would someone who expected interest rates to rise buy a fixed-income investment? Such an investor could potentially wait months or even years for the rise in rates to happen. In that case, it makes sense to invest the cash in order to earn some sort of return on the money in the interim. As it turns out, there is a range of interest rate increases with any callable note where the investor is better off having sold the call option to buy a longer-term note than not having sold a call option to buy a short-term note. For example, the bank in the example above had the choice of buying a 5-year note callable in two years or a 2-year note. The 2-year note has a shorter duration than the 5-year note, but likely offers less yield. There is a certain range of interest rate increases in which the investor is better off with the callable note than the bullet. There will, however, be a point where the higher duration note begins to lose so much in price that it overwhelms the additional interest earned by selling the call option. Investors in callable notes want interest rates to rise, but only slightly, in order for the option that they’ve sold to remain out of the money.

The psychology at work in the MTN market is as interesting as the structure of the issues. The fact that so many people emphatically believe that they want their callable notes to be called, something that is not in their best interest, may be evidence that the MTN market is dominated by less sophisticated investors. However, there have also been times when the Agencies have wanted to promote a certain structure, perhaps because it matched some short-term asset/liability mix, and have therefore cheapened the structure to make it quite attractive to an institutional audience. In these instances, a handful of interested major institutional investors dutifully slog through the calculation to determine if the security is fairly priced. The psychology comes into play when the Agencies cheapen a structure so that it appeals to an institutional audience of sophisticated investors who have lots of money to invest, but can’t overcome the general perception that the Agencies are rich. This perception refers to the Agencies’ tradition of opportunistic issuance that at one time pitted them against their investors: the Agencies only wanted to only sell debt when it was rich compared to historical levels. The market tension is interesting to see, and every knee-jerk reaction of “Agencies are rich” is evidence of how difficult it is to change perceptions in the market once they have become part of the popular lore. While opportunistic issuance from the Agencies may have helped them scrimp out a few extra basis points from time to time, the practice cost them an institutional audience.

Foreign central bank purchases, from Asian countries in particular, have long been singled out as the easy explanation for whatever ails the market. Yields too low? Asian central bank purchases. Yields too high? Pause in Asian central bank purchases.

While it’s true that foreign central banks own an increasing proportion of Agency debt (roughly half of all new issues go overseas), it’s unclear what effect these purchases have had on prices, since many traditional buyers left the market at the same time that the foreign central banks entered. There is one clear difference between the old and new buyers: central bank purchases and sales are not made for purely economic reasons, at least not in the same way that a domestic bank would think about them. China and Japan are purchasing dollar-denominated debt in such vast quantities because they have a large and growing trade surplus with the United States. At the same time, both countries have what amounts to a crawling peg for their currencies, which are fixed in the short run to the dollar. However, every Toyota purchase puts pressure on the yen to appreciate. Both Japan and China, despite very different political structures, arrived at the same conclusion: development and social policy will be fostered by a favorable balance of trade with the United States. To break the exchange-rate peg against the dollar would be to strike at the very fabric of their political agendas.

Agency traders may not realize it, but they are part of the very core of global economic development. To understand why, it is necessary to look at how other governments invest in U.S. Agency debt.

Economic systems are linked, in ways that are often referred to but often misunderstood. Every country that wants to open its borders to the benefits and perils of trade desires three things: capital mobility, effective monetary policy, fixed exchange rates. Even people who wouldn’t be able to create this list would recognize the benefit of each item on it in their daily lives.

When countries chose currency restriction over currency mobility, people face the following predicament: A person works for a foreign firm and is paid in local currency. As long as this person wants to spend the money in his or her adopted land there is no problem. However, this person’s labor is being held captive: the benefit of his or her efforts can’t ever be enjoyed elsewhere. China is a prominent example of a country that has made this choice. At every airport and port, inspectors attempt to control the amount of foreign currency coming into the country and domestic currency moving out of the country. Why would a country ever make this choice?

Effective monetary policy may seem an abstract goal, but it touches the lives of everyone who finances a home or borrows on a credit card. Countries with fixed exchange rates and capital mobility are forced to use monetary policy in order to maintain the value of their currency on the world market. If there were no counterweight to currency transactions, capital would flow into or out of the country based on differences between the local and world interest rates. Everyone would like to earn the double-digit interest rates of many developing countries with high inflation. The problem is those interest rates are paid in the local currency, and in order to translate those gains back into the foreign currency a second exchange must take place. Interest-rate parity holds that in perfect equilibrium, the value of the currency will fall over the time period in which local interest rates are higher than world rates, so that by the end of the period investors are no better off than if they had stayed in their original currency. At least, this is how it works in theory. The reality is quite a bit messier, with surprises and shocks to the market that no one can foresee, so that sometimes arbitrage is possible. In general there is no free lunch across currencies. Everyone would love elevated foreign interest rates and a fixed exchange rate, because that would mean you could pile into a currency, earn a rate higher than the global rate, and then put those earnings back into the original currency at no risk.

As an aside, there is another, less popular method of maintaining an exchange rate: allowing an “official” black market, as China did before recent market-based reforms. Officially, no one in China was allowed to trade currencies at any rate; punishments for transgressions were severe, as befits a totalitarian regime. There was, however, a widely tolerated black market for small transactions in foreign currency. While this market was not large enough for corporations, there are anecdotes of individuals changing money for personal use and officials looking the other way, as long as the deal wasn’t business-related. Communist countries lean toward prohibiting capital mobility since they have the infrastructure necessary to enforce the ban. This method brings to mind the old economics joke that says that murder could be eliminated if only everyone in the whole country could be put in jail. Making currency trading illegal, and then actually maintaining the infrastructure to police the law, may in fact be more costly than the other exchange rate systems mentioned.

Floating exchange rates seem to solve all of the aforementioned problems, since there is no cost to administering the system. However, they make international transactions more difficult, because the exchange rate may have changed by the time the funds are repatriated to the original currency. Uncertainty is a cost just as real as any other, and currency risk keeps some projects unfunded, usually projects that are only marginally profitable and cannot face the additional risk of currency fluctuations.

One way to judge the cost of this system is to look at the prices for hedging instruments. It is convenient that those Western countries that have adopted fixed exchange rates also have the most developed financial markets. Therefore, the prices of hedging currency risk are readily available. All of this is relevant to holders of dollar-denominated debt. A country with a fixed exchange rate, like China, must intervene in the market to maintain its peg to the rest of the world. When that country also happens to run a current account surplus with the rest of the world, it ends up constantly selling its currency to buy dollars. The billion-dollar question is, what happens to these dollars? Most often they are used to purchase U.S. Treasury and Agency notes (Figure 3.1).

The net effect of Asian central bank purchases and diminished domestic buying is not clear, but it is clear that central bank decisions are tied to politics. Other market participants usually decide what to do based on the relative value of the various options. It is also clear that central bank decisions affect the whole market. For one thing, traders expect that the notes, which are sold overseas, won’t make it back into the secondary market any time soon. Also, notes sold to a central bank are seldom lent back out again as collateral for financing trades. These are two reasons why the increase in purchases of the Agency debt by central banks is nailing the lid even tighter onto the coffin of Agency repo trading.

Liquidity is a difficult animal to tame, and another problem with growing foreign central bank purchases is that they dampen the possibility that notes sold to domestic buyers will enjoy much of a secondary market. In the short run, shortages of supply lead to higher bond prices, but over the long run people get tired of never being able to find bonds and simply exit the business. If there’s one thing for sure, it is that there are alternatives to everything. The irony is that just a few years ago the Agencies were touting foreign central bank ownership of their debt as an indication of its high credit quality, another brick in the wall of building the perception that their debt was at the same level of credit quality as the U.S. Treasury’s. Their dream came true. Unfortunately, foreign central bank demand was kindled at a time when the purchases drained liquidity from the market rather than adding to it. The net result was an increase in China’s appetite to diversify its dollar bond holdings away from Treasuries and into Agencies. Without new Agency supply, their purchases ended up creating orphan issues—issues in which the major portion is owned by foreign central banks who are unlikely to trade them on the secondary market.

Remember that this book began by describing an emergency move by the European Central Bank to forestall a liquidity crisis in the European financial system caused by declines in the value of U.S. subprime mortgage bonds. The reality is that a crisis in a single area of the fixed-income market will not long stay contained in that sector. The functioning of credit derivatives markets is a primary concern to all participants in the fixed-income market, whether or not they are directly involved in trading the securities. Figure 3.2 vividly illustrates why everyone in the market, even traders of risk-free Treasury notes, has to be concerned with gyrations in credit derivatives. Figure 3.2 illustrates how 2-year Treasury note yields dropped on concern over the meltdown in the lower-rated sectors of the ABX index, a credit derivatives index linked to subprime mortgage bonds. Ordinarily, one would never consider the two markets linked, since one has to do with risk-free rates, and the other is a structured mortgage product. However, in June 2007, when the ABX became volatile in response to uncertainties in the subprime market, many traders sought the safe haven of 2-year notes, which are normally the beneficiaries of global meltdowns of all sorts. (This reaction in times of uncertainty is referred to as a flight to quality.) Traders would prefer to hold an increasingly rich 2-year note, whose yield is almost 75 basis points below the fed funds rate, than to hold a credit-risky product.

Of primary concern in this book is what happens when things go wrong. Credit derivatives, for example, replicate corporate bonds quite well until there is a default, at which time an embedded option often requires physical delivery of an underlying note, which is very different from what happens in the cash corporate market. While credit derivatives are the fastest-growing segment of the fixed-income market, their behavior during times of crisis is only now beginning to be understood. Undoubtedly, our understanding of these products will evolve along with the market itself, but if the impact of the subprime meltdown is any indication of what is to come, it’s clear that derivative traders are in for a very steep and painful learning curve.