Is Credit On The Verge Of An Oversaturation "Perfect Storm" Implosion

Tyler Durden's picture

Something quite disturbing happened during today's latest attempt by the Fed to sell $3.8 billion in face amount of Maiden Lane 2 assets: it had a busted dutch auction. In fact, the auction was so massively busted, the New York Fed managed to sell only half of the bonds for sale, or $1.898 billion in 36 Cusips of the total 73 Cusips offered for sale. Suddenly, the Fed's attempts to sale piecemeal portions of the $31 billion Maiden Lane II portfolio that was offered to be repurchased by AIG, and subsequently was offered for open auction as Zero Hedge first suggested, is starting to backfire, after a month ago several traders complained that instead of "dribbling" out small piece of the portfolio (the previous average auction block notional for sale was under $1 billion). As per Housing Wire from May 17, which cited a complaint by an MBS trader: "if you charge ahead and bleed out one or two lists a week for the next
10 to 12 weeks, prices will continue to go lower, and in the interest of
maximizing value for the taxpayer, I think it is time to re-engage the
large portfolio bid you had or make available to other counterparties
the ability to bid large chunks of what you have left to sell." Well, the trader got what he wanted... And in the process may have blown up the credit market. As Bloomberg reports, "Federal Reserve auctions of mortgage securities that the central bank assumed in the rescue of American International Group Inc. are fueling a selloff in credit markets as Wall Street rushes to hedge against losses on stockpiled debt." Sure enough, someone focusing on the equity market may be completely oblivious to the devastation that has been unleashed on HY and IG traders: "Declines in credit-default swaps indexes used to protect against losses on subprime housing debt and commercial mortgages accelerated this month, reaching almost 20 percent in the past five weeks as the cost of the insurance climbs, according to Markit Group Ltd. The plunge this week started infecting everything from junk bonds to the debt of financial companies." And while as Bloomberg points out that there is a confluence of technical and fundamental factors affecting credit sentiment,  "You almost have a perfect storm of events,” said Shah of AllianceBernstein. “You have both the fundamental justifications for the market going lower and you have the technicals being created by Maiden Lane” there is a far scarier implication. If dealers and funds are unable to handle a mere $31 billion MBS portfolio disposition, and its weekly sale (think of its as a reverse repo) is starting to cause massive ripples in the bond market, just what will happen when dealers are forced to hold back the tens of billions in weekly bond auctions they freely flip back to the Fed now. In other words, is the credit market on the verge of a oversaturation implosion (hence the title)?

A quick glance at the performance of the 5 CMBX AAA vintages over the past year demonstrates that unlike equities, credit, especially of the resi-backstopped variety, already is plumbing year lows:

More from Bloomberg on this very precarious position in the credit market:

The central bank, which this month plans to conclude its purchases of $600 billion of Treasuries in a program meant to bolster markets, had typically been offering about $1 billion from its Maiden Lane II portfolio once or twice a week until early May. In its ninth auction yesterday, the first since May 19, the New York Fed offered $3.8 billion of debt. Investors presented accepted bids for $1.9 billion, the smallest share yet.

“The manner in which the sale of the Maiden Lane II portfolio has been conducted put the market in a vulnerable state,” said Bryan Whalen, the co-head of mortgage-backed bonds at Los Angeles-based TCW Group Inc., which oversees $120 billion in assets. Falling mortgage swap indexes and bond prices are “reflective of levered money, dealers especially, taking risk off the table, which is feeding on itself,” he said.

Jack Gutt, a spokesman for the New York Fed, declined to comment.

One Markit ABX index tied to subprime mortgage bonds that were rated AAA when issued in 2006 has dropped to 47.2 from 58.8 on April 1, declining from a more than two-year high of 62.7 on Feb. 15. A similar index tied to junior AAA ranked commercial- mortgage bonds created in 2007, known as the Markit CMBX, has plunged to 68.7 from 80.4 at the start of April and more than two-year high of 85 on Feb. 15.

“I imagine the original $15.7 billion bid from AIG would be looking pretty good right now,” said Clayton DeGiacinto, who manages about $200 million as chief investment officer of New York-based hedge fund Axonic Capital LLC.

Don't worry Clayton, AIG is now focusing on buying up Europe's toxic sludge... Somehow we think you are happier it is AIG who is forced to bid it up and not you. Oh wait:

Investors are also bracing for more sales from non-U.S. banks after Dexia SA on May 27 said that it would take a charge to accelerate its sales of toxic holdings, including $8.5 billion of home-loan securities, DeGiacinto said. “Europe has never gone through the disgorging process that we’ve gone through here,” he said.

As for why we believe there is massive oversaturation with credit holdings, and why the end of QE2 is about to expose everyone who has been swimming without a bathing suit:

Primary dealers’ holdings of fixed-income assets including corporate debt, commercial-mortgage bonds and home-loan securities without government-backed guarantees swelled to $94.9 billion in the week ended May 25, according to Fed data. That total, which includes only notes maturing in more than one year, was up from $85.7 billion at the end of 2010 and a six-year low of $59.8 billion in April 2009.

The drop in the mortgage-bond markets began spilling over to corporate credit, which already had started to weaken from the deteriorating economic picture and disagreement among European leaders over who should bear the burden of rescuing deficit-plagued governments including Greece.

“Somebody who trades these indexes sees that kind of movement in CMBX and reacts,” Angelo & Gordon’s Solomon said. “That is the mechanism that leads these indexes lower.”

Default swaps on the six largest U.S. banks have gained an average of 19.4 basis points to 137.2 basis points since May 31, according to data provider CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

Apparently the topic is so disturbing to the PD and hedgie community they even got the WSJ to promptly post an identical article to Bloomberg's minutes after.

Bottom line, unless someone opens up a release valve, we are about to see a massive regurgitation and even more massive repricing of credit risk, first in IG, then in HY and ABX/CMBX, and lastly, and most massively, in equities, which continue to exist in their own world and which are now totally disconnected with HY, which they used to track so very closely.

And lastly, in perhaps the most ominous news, the rates legend, the former head of Merrill's RatesLab, Harley Bassman, who recently moved to the prop side, has decided to call it a day.

Farewell Merrill Lynch…..

Today marks my twenty sixth year at Merrill Lynch; so it is with strong feelings that I inform you that I am retiring from the firm.
I will always bleed Merrill blue and I thank the firm for allowing me the freedom and support to build out new ideas. 
Mostly, I will miss all of you.  How lucky I have been to be able to engage daily with such clever and brilliant people.  Every success I have achieved stood upon your shoulders.

As per some final trading advise:
1) It is never different this time, and
2) The Greeks had it right 2500 years ago, it is all about character. 

 
As this chapter closes, so another will open - I can only hope it will be as great. 
 
Harley Bassman
The Convexity Maven

Good luck Harley... And yet we can't help but wonder - just what spooked one of the oldest veterans in the rates space to pull the plug, in the middle of the year, a time when traders are more focused on the Hamptons than on transitions...