Bloomberg:

Eager for a chance to run his own portfolio, Pellegrini, then 47, approached Paulson in the summer of 2004, asking for a job. “He said, ‘My analysts are more junior than you,’” Pellegrini recalls. “I said I didn’t care.”

Paulson had founded his firm in 1994 and built up two specialties. First was merger arbitrage, a strategy in which traders typically buy the stock of a possible takeover target and short that of the acquirer. The other was event arbitrage -- wagering on corporate developments such as earnings surprises and stock buybacks. Still, he was also looking for a way to make money from what he saw as a growing credit bubble.

Paulson, who makes all investment decisions at the firm, orchestrated the research and assigned Pellegrini to look into housing -- something he was familiar with from his time at Mariner. The surest bet against the housing market would be to buy credit-default swaps on subprime mortgage-backed securities. CDSs are insurance-like contracts used, in this case, to speculate on the default of a bond.

A Nervous Time

Pellegrini says the critical question was whether adjustable-rate mortgages would default as they reset at higher interest rates. Pellegrini believed they would, so in April 2005 Paulson & Co. began buying CDSs in small amounts for its existing funds.

The first year the trade was in effect was a nervous time. “From early 2005 to early 2006, it wasn’t clear the trade was going to work,” Pellegrini says. “People thought we were throwing money down the drain. We asked, Are we missing something?” Pellegrini says he would wake up in the night pondering the trade.

Before he increased his bet, Paulson wanted proof of a housing bubble, and he thought Pellegrini could produce it. “The mortgage market lends itself to deep quantitative analysis and modeling,” Paulson says. “Paolo excelled in this area.”

Finding the Bubble

Pellegrini and his colleagues zeroed in on numbers from the Office of Federal Housing Enterprise Oversight’s home price index from 1975 to 2000. He drew a regression line through the data points that showed prices would have to fall 30 percent to 35 percent just to get back to the historical trend.

“After hearing a lot of arguments for and against the presence of the bubble, we had a simple and clear insight of our own to go by,” Pellegrini says. He recalls that Paulson broke into a smile when he showed him the proof that houses were overpriced. “John doesn’t smile,” Pellegrini says. “It felt great.”

The next step was to determine the relationship between home prices and defaults. Pellegrini hired a New York firm called 1010Data Inc. to help him integrate two databases: One, compiled by Santa Ana, California-based First American Corp. and called LoanPerformance, tracked 6 million securitized subprime mortgages. The other was based on an S&P/Case-Shiller home price index, sorted by postal code. The combined database showed that even if home prices merely flattened, defaults would surge. “There was a very strong relationship between mortgage losses and home prices,” Pellegrini says.

A Tough Sell

Paulson & Co. began drumming up money for two new funds -- called Paulson Credit Opportunities and Credit Opportunities II -- that would be dedicated to the subprime bet. It was a tough sell. With the housing market still galloping upward, investors wanted details of both Paulson & Co.’s research and how the trade would work.

Whole story

The IMF GFSR has a nice table (p. 10) showing the estimates of global bank writedowns by domicile in billions of U.S. dollars. In bar charts (full bar = estimated holdings, red = estimated writedowns):

Message: Euro area banks are bigger and smarter, no? But they will probably have to raise more capital.

(Foreign exposures of regional banking systems are based on BIS data on foreign claims. The same country proportions are assumed for both bank holdings of loans and securities. For each banking system, the proportion of exposure to domestic credit categories is asumed to apply to the overall stock of foreign exposure.)

IMF: Re-Remics are being used to resecuritize senior private-label mortgage-backed security (MBS) tranches that have been downgraded from their initial AAA levels. In a typical Re-Remic, a downgraded tranche is subdivided into a new AAA-rated senior tranche and a lower-rated mezzanine tranche (see figure). About $25 billion were issued during the first half of 2009, mostly against MBSs backed by prime mortgages. Given that most of the AAA privatelabel MBS tranches issued between 2005 and 2007 have been downgraded, the potential for this market to grow is substantial. However, although these transactions are playing a useful role in dealing with the overhang of legacy assets, they are partly driven by rating/regulatory arbitrage.

Re-Remic issuance is being driven by a number of factors, including the need to maintain the AAA ratings that many investors require to hold these securities. Maintaining AAA status canresult in substantial capital requirement reductions.For example, the new Basel II risk weight on a BB-rated tranche is 350 percent under the standardized approach, whereas it is 40 percent on an AAA-rated resecuritization. Also, for banks and insurers, big rating downgrades can trigger “other-than-temporary-impairments,” which have to be recognized immediately through the income statement. These consequences can be avoided by replacing the downgraded securities with new AAA-rated Re-Remics. In the figure, the new AAA-rated senior tranche comprises 70 percent of the structure, with a mezzanine tranche that absorbs the first 30 percent of losses. Additional credit enhancement is provided by an option for the new senior tranche to be resubdivided into two “exchange classes” should it lose its AAA rating. Also, there is a hedge fund demand for the mezzanine tranches as a means to take a leveraged credit bet. The holder of the senior tranche that was downgraded to BB could then hold the new AAA tranche, and sell the mezzanine tranche to an investor desiring distressed securities. Hence, only 30 percent of the original holding is sold at distress prices, and the risk-weighted par value of the holding goes from 350 to 28 percent (70 percent of 40 percent). Even if the bank were to retain the mezzanine tranche, the riskweighted par value could still be less than the original 350 percent.
For example, for single security-backed Re-Remics, the default probability-based rating methodologies used by DBRS, Fitch, and S&P will typically pass the underlying bond’s rating through to the new mezzanine tranche (emphasis mine). Hence, in the example transaction, the total riskweighted par value would decline from 350 to 223 percent (70 percent of 40 percent on the AAA-rated tranche plus 30 percent of 650 percent on the BB-rated tranche).¹ In this regard, it is notable that Moody’s has been virtually shut out of the Re-Remic rating business, possibly because it rates on the basis of expected loss, which is tougher on mezzanine tranches than the default probability basis (Fender and Kiff, 2005), and thus issuers prefer not to have Moody’s rate their potential securitization.

Although Re-Remics and similar repackaging transactions are playing useful roles in dealing with the legacy asset overhang, they also serve to illustrate the vulnerability of ratings-based regulations to gaming and shopping. Also, these new securities remain exposed to further downgrades if economic and housing market conditions worsen. However, the information underpinning these securitizations and the methodologies applied to their ratings are likely more robust than before and thus pricing is likely to reflect risks more appropriately.

Source: Restarting Securitization Markets: Policy Proposals and Pitfalls, IMF

¹ The new risk weights would be even lower if they were calculated with the securitization exposure weights (20 and 350 percent, respectively, on the AAA and BB tranches), rather than the resecuritization exposure weights (40 and 650 percent). The Basel Committee has defined a resecuritization as a securitization where “at least one of the underlying exposures is a securitization exposure” (BCBS, 2009), but some market participants are hopeful that single-security repacks may not be considered resecuritizations (Mayer Brown, 2009).

Martin Wolf on Narrow Banking, FT

Addendum: Does anybody dare to come up with an estimate of how many man hours it took to create and implement Basel II? What's your take on the opportunity cost of implementing Basel II? Would have banks come up with a more appropriate risk management or did Basel II actually force banks to think more about the risks they took?

Wealth Manager writes:

The Options Industry Council (OIC) released a study, “Loosening Your Collar: Alternative Implementations of QQQ Collars,” citing the advantages of using options collars to boost performance and reduce risk in investment portfolios.

Options-based strategies to reduce risk and boost relative performance in a down market are not new. This study, though, covers a 10-year period from March 1999 to May 2009, including the current crisis and the technology boom [sic] and bust.

Take a look at the chart. During my time as a hedge fund analyst I saw such charts every second day. Stellar outperformance when looking at backtests (i.e. hypothetical performance after the fact) and flat since inception (in this case probably Feb. 2004). Yawn. And keep in mind that this study is 100% backtest. So with a different collar strategy you might have performed worse.

Get used to it. You can't invest in something with a risk premium, hedge the risk and expect... a risk premium! Due to transaction costs you will earn less then the risk free rate. Sorry, markets are more efficient than you might think.

I'm sure Mark Faber likes this chart:


You could also plot the SPX in EUR since 2000 and then refer to the Arcsine Distribution. Even more scarry!

Reuters: U.S. regulators say that the level of losses from syndicated loans facing banks and other financial institutions tripled to $53 billion in 2009. <>

The Shared National Credit Program which was set up in 1977 to review large syndicated loans now reviews and classifies all institutional loans of at least $20 million that are shared by three or more supervised institutions.

The volume of SNCs rated 'doubtful' and 'loss' in 2009 rose almost 14-fold to $110 billion, while non-accrual loans touched $172 billion, up from $22 billion in 2008.

The report also said foreign banks held about 38 percent of the $2.9 trillion in loans, while hedge funds, pension funds, insurance companies and other entities held about 21 percent. [Source]

Credit Quality Declines in Annual Shared National Credits Review, FDIC

FT: The wall between banking and commercial enterprise in the US is crumbling in the high-stakes world of commodities.

A number of big international banks have in recent years won Federal Reserve approval to buy, sell and store much more than bars of gold in vaults. Banks have chartered tankers to park oil at sea, hoping to profit from future price gains. They have entered “tolling agreements” with power plants, selling them coal or gas and buying their electricity. Some own power plants outright. Click here to read the whole story.

Anthony Rinaldi, left, of LaBranche & Co. and James Kay of J.P. Morgan Securities trade shares in Cemex, which was raising $1.55 billion to pay down debt, on the floor of the New York Stock Exchange, Wednesday, Sept. 23, 2009, in New York.

(AP Photo/Henny Ray Abrams)

The FT writes: "After a year of painful investor redemptions, sharply reduced leverage available from banks and economic uncertainty, hedge funds now exert a far smaller pressure on prices than they once did. They currently account for just 12 per cent of average volume in the $33,500bn US fixed income market, compared with nearly a third in 2007, according to research by US consultancy Greenwich Associates. <>Whereas leverage of about five times was not uncommon for the average fixed income strategy in 2007, hedge funds are now investing with a maximum of two times leverage, or more often, none at all, according to prime brokers."

Greenwich Associates says: The results of Greenwich Associates' 2009 U.S. Fixed-Income Investors study reveal that hedge funds have acted more forcefully than other types of institutions to manage counterparty risk and otherwise adjust their trading practices in response to the credit market crisis. Hedge funds are more likely than other types of institutions to say they have cutback on the total number of dealers they use for fixed-income trading, shifted trading volume to dealers with the least counterparty risk and reduced the concentration of their trading business held by any single dealer [Source.]

related items:
Negative 30-year rate swap spread linger, FT