This was a very "interesting" day for them. This is their 2nd trip below $20 within two months. Tommorrow should be interesting...
Posted on 09/18/2002 4:13:54 PM PDT by AdamSelene235
NEW YORK -(Dow Jones)- Growing concerns over the operational performance of two financial heavyweights has manifested in modestly wider credit spreads in some key derivative markets Wednesday. Interest rate swap spreads are one to two basis points wider against comparable Treasury yields across the entire swaps curve in moderate trading Wednesday, following moves by Standard & Poor's and Fitch Ratings to strip J.P. Morgan Chase & Co. of its double-A ratings late Tuesday.
The ratings downgrades, which followed the bank's announcement of a sharply lowered third quarter earnings forecast, coincided with some increased scrutiny of mortgage giant Fannie Mae in the wake of recent news about a wide mismatch between its liabilities and assets.
Credit protection spreads for both names was wider amid active two-way trading in the credit derivatives market Wednesday, said traders. Five-year default swaps on J.P. Morgan were quoted 10 basis points wider at around 95 basis points or $90,000 per annum for $10 million of protection for J.P. Morgan bonds. Quotes for Fannie Mae were around 31 basis points, out from Tuesday's close of 27 basis points for five-year protection.
Taken together the problems at these two institutions, whose counterparty positions are among the most widespread on Wall Street, have refocused attention in swaps and other fixed income markets on the specter of systemic risk.
"These two events raise the question as to what other exposure risk and credit concerns exist within financial markets," said Brad Stone, derivatives strategist at Barclays Capital in New York. "There is more upside risk in swap spreads given the current environment."
Both J.P. Morgan and Fannie Mae are huge counterparties to other financial institutions trading interest rate swaps. Fannie regularly uses swaps to hedge prepayment risk on its mammoth mortgage portfolio, while J.P. Morgan is the largest player in terms of notional holdings in the derivatives market.
Of the $50.1 trillion in notional derivatives outstanding at insured commercial banks, the bank accounted for just over half of the total at the end of June, according to the latest OCC Bank Derivatives Report compiled by the Office of the Comptroller of the Currency. That amount includes both foreign exchange, commodity and interest rate derivatives.
The ratings downgrade is expected to force J.P. Morgan' counterparties to tighten their credit standards. Noting that the "severity of the problems is somewhat surprising," Morgan Stanley analysts said in a research note Wednesday that they "would expect increased scrutiny of JPM's derivatives franchise in the near-term."
Very few market participants say a tightening in credit standards by J.P. Morgan's swaps counterparties could create settlement problems in the interbank swaps market because swaps are regularly marked to market and are usually fully collateralized between counterparties.
But many nonetheless recognize that credit concerns among the banking counterparties that participate in the swaps market do create some pressure for wider swap spreads, especially given the recent weakness in equities markets.
With the 10-year swap spread - quoted at 54.25 basis points Wednesday versus Tuesday's late close of 53.25 basis points - "swap spreads are too narrow given the current (credit) risk environment," said Michael Cheah, portfolio manager at SunAmerica Asset Management in New York. "I would be surprised if other financial institutions do not disclose poor credit exposures given how widespread credit problems in the past year have been."
The degree of spread widening Wednesday was muted when compared with the previous episode of credit concerns regarding J.P. Morgan and Citigroup seen in late July. During a period of four days then, the 10-year swap spread widened twelve basis points. The volatile conditions abated after J.P. Morgan issued a statement denying a market rumor that it was experiencing liquidity problems.
The relatively cautious reaction of the swaps market Wednesday was underlined by the three month London Interbank Offered Rate for J.P. Morgan being quoted at 1.82%. This was in line with the 11:00 a.m. London setting and indicated that other participants in the cash market were not charging the bank a premium to borrow cash following its downgrade.
"Spread widening has been very muted," said Robert Podoresfsky, chief derivatives strategist at Fleet Global Markets in Boston. With J.P. Morgan well capitalized and swap trades underpinned by collateral agreements, the issue of counterparty risk is well contained within the interbank market, he said.
Another diluting effect is the current surge in corporate bond issuance. Around $12 billion in new issuance has been announced or priced so far this week and swap dealers expect around half of that to be swapped. Corporate bond issuers often swap their fixed rate exposures into floating rate payments, narrowing the swaps spread.
The swelling "pipeline of corporate issuance supports tighter swap spreads," said George Ooman, derivative strategist at Credit Suisse First Boston in New York. If the pipeline remains healthy until the end of the month, CSFB expects the 10-year swap spread to trade in a 50 to 60 basis point range with higher levels of issuance tending to push the spread below 55 basis points. However, " credit concerns are a key influence upon the swap market," said Ooman.
Indeed, the fact that spreads have widened in the face of such issuance suggests the J.P. Morgan concerns are weighing to some extent on the market.
As for concerns over Fannie Mae's mortgage portfolio, which experienced a record wide 14-month gap between assets and liabilities in August, Fleet Boston's Podoresfsky said, "the swap market is well versed in the mechanics of mortgage accounts frequently rebalancing their portfolios."
Fannie Mae needs to buy exposure to low-risk fixed interest flows, which can be achieved by receiving fixed in swaps. Yet there is a question of just how much hedging activity Fannie will undertake in swaps to close the gap, especially given the concurrent J.P. Morgan concerns and the fact that the Office of Federal Housing Enterprise Oversight - Fannie's regulator - is requiring weekly reports from OFHEO examiners on the company's exposure to interest-rate risk. Also, given that Fannie knew of the duration gap two weeks before publicizing the fact, many traders believe it may have already completed the bulk of its hedging.
Whatever hedging activity that Fannie and other mortgage investors do undertake is more likely to involve purchases of Treasurys rather than receiving fixed rates of interest in swap contracts, some analysts say. The current low level of swaps over underlying Treasury yields means that "mortgage hedgers will likely choose Treasurys if rates keep declining," said Barclay's Stone.
-Michael Mackenzie; Dow Jones Newswires; 201-938-5451; michael.mackenzie@dowjones.com
If you do a freerepublic search on the keyword Fannie, you will find dozens of my posts on this subject and spirited debate between myself and my Fannie Mae foil, Southack.
JPM and FNM stockholders OTOH are getting hosed.
JPM and FNM will both be less aggressive for the next year or so, and that is the way it's supposed to be.
This was a very "interesting" day for them. This is their 2nd trip below $20 within two months. Tommorrow should be interesting...
GSE debt is now larger than the publicly held Treasury debt. They are "too large to fail" which means the taxpayers would be on the hook for a multi-trillion dollar bailout.
The value of Fannie's real estate portfolio is distorted by their lending activities. Easy money for homes drives up their value. This is a feedback loop with positive gain. Eventually the system will saturate and the cycle will reverse to destroy wealth much faster than it created it.
That's true in continuously quoted liquid markets like financials, but less likely to be true in real estate.
That said, I wouldn't touch FNM or JPM with the proverbial barge pole.
Home values no longer reflect the cost of labor,materials and local supply & demand. Rather they are instruments of speculation. The GSE are acting as banks without multiplier restrictions. How much money can the bond and MBS market funnel into real estate before they encounter or far exceed the systems natural limits?
If I knew, you'd be my *2nd* phone call. :)
Nonsense.
Home prices ABSOLUTELY reflect the balance of supply and demand. The cost to build a home has NOTHING to do with the price of a home. NOTHING. Many a builder has gone broke learning that lesson the hard way. Build a $90 million home in rural Alabama and then try to sell it. Poof. You're broke. Idiot builder. Likewise, a home in Beverly Hills that cost $35,000 to build in 1950 may very well be worth $6 million today, and again that has NOTHING to do with the original cost to construct said house. What matters is supply and demand.
Now, is "speculation" driving up demand? I don't see it. Perhaps some isolated regions (e.g. San Francisco and Denver) are seeing a little of that, but for the most part what I see are people buying homes for their own use, not buying 3rd homes in an effort to gamble that home prices will keep rising.
What you have to look at are the demographics. Are more people (i.e. demand) moving into a given region? Are more people being born in a given region? Is more land being made in that region? Are more homes being built there (i.e. supply)?
Other factors to consider that impact demand are interest rates. Are interest rates getting lower or higher?
Still other factors impact supply. Are building permits getting issued faster or slower in a given region?
But if you think that the price of homes should be related to the cost to build homes, you'll NEVER understand why the market moves the way that it does.
The construction cost is ONE factor in the total cost, and in many situations it is BUT one factor. There are areas where construction cost is important, because land and permits are readily available, and the demand for new homes is more or less balanced by the available supply. However, as you've pointed out, hidden costs which limit supply can influence the price at which supply and demand meet--as in Beverly Hills, or, on the other side where there is oversupply, as in a ghost town in the Rockies.
I know some of this material was included in prior posts. However, can you provide a quick summary of:
Asset $
Liability $
Net Worth $
An essentially plain vanilla business that buys retail mortgages, keeps some and repackages some, is not likely to be at risk for more than 5-10% of assets under the worst of scenarios. If capital is less than 5%-10%, the shortfall only is at risk. That might amount to multi billions, cetainly not multi- trillion.
Also, "too big to fail" usually means "too big AND too well connected to fail" That probably does apply to Fannie because of its GSE nature. Other big entities, however,(e.g. Knickerbocker Trust (1907), Drexel Burnham (1990), Bank of the United States (1932)) are allowed to fail. Some are even pushed.
Sorry, I have provided this stuff in previous posts. Just keyword search Fannie.
I'm too busy making the world safe for technocracy.
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