While doing further investigation on what has been the root cause of the 30-year swap inversion, Lars Toomre came across an interesting article published by Reuters on Monday November 17th 2008. In that article,

In recent days, another type of hedging emerged, according to UBS analysts.

Whenever the dollar has weakened at or below 97 yen since late October, sellers of Power Reverse Dual Currency Notes (PRDCs) have been keen buyers of 30-year swaps, they said. PRDCs are structured so Japanese investors can obtain a higher yield of the dollar Libor curve but receive the cash flows in yen.

When the dollar breaks below 97 yen, it lengthens the duration of PRDCs and forces sellers to receive 30-year fixed-rate cash flows via 30-year swaps, UBS analysts said.

What the heck are Power Reverse Dual Currency Notes? Just from the name, it reminds Lars of the incredible swap that Bankers Trust sold to Proctor and Gamble and which caused such major losses during the 1994 increase in short-term interest rates.

While Lars Toomre at Toomre Capital Markets LLC was preparing the following post about Lehman Brothers being concerned about its liquidity amidst the Bear Stearns liquidity fallout, the United States Federal Reserve has stepped forward to attempt to settle the Capital Markets ahead of Monday's possible St. Patrick's Day Massacre. Specifically, the Federal Reserve has done the following:

1. Immediately cut the primary lending rate from 3.50% to 3.25%, and
2. Authorized the New York Federal Reserve Bank to create a new lending program for primary dealers to provide funding for those involved in the securitization markets.

This second step clearly is intended to keep the likes of Morgan Stanley, Merrill Lynch, Goldman Sachs and Lehman Brothers liquid in the event that the critical repurchase market seizes up further (like it was starting to do on last Thursday and Friday). This second move likely will somewhat ease the pressure that the major investment banks were going to be feeling on Monday morning. The critical question is Will this be enough in a world where the markets truly go to an all sellers state???

Back on November 8th 2007, Toomre Capital Markets LLC ("TCM") posted a note entitled Incestuous Mix: Structured Credit, Financial Guarantors and Rating Agencies. Over the weeks since, there has been considerable web traffic from people looking for more information on how structured credit (like sub-prime mortgages and CDOs), financial guarantors (like ACA, MBIA, Ambac and FGIC) and the rating agencies (like S&P, Moody's and Fitch) interact. Then, in the last day, traffic about this subject has dramatically spiked with news about ACA's downgrade by S&P and MBIA's very belated disclosure about its "small" CDO^2 insurance portfolio.

As this Marketwatch article explains, MBIA disclosed on Thursday, December 20th 2007 that it has $8.14 billion of exposure to complex credit products known as CDO squareds (also known as CDO^2). Such CDO transactions are generally even more leveraged in their exposure to the credit risk that underlies each of the CDO transactions that since May have been causing such massive losses to many financial institutions. One might think that such a large exposure just might be relevant to investors in its common stock and bonds that include MBIA guarantees!!

For those who are not familiar with the details of structured finance, CDO^2s use as collateral tranches from other CDOs and then the CDO^2 collateral is further tranched into various classes that have differing exposure to credit losses. Generally, the underlying CDO tranches in a CDO^2 deal were those that an underwriter had the most difficulty in selling outright. As a result, many CDO^2 collateral tranches are what are referred to as mezzanine CDO tranches which originally were rated close to the very bottom end of the investment grade spectrum. The assumption behind tranching a CDO and CDO^2 is that the collateral is not highly correlated. In fact, the market has come to understand that almost all sub-prime mortgage collateral is both correlated with other issues from the same year and that the level of both defaults and expected losses are higher than the rating agencies originally projected when rating these structured finance transactions. The net effect of both increasing the expected loss percentages and increasing the correlation between the various collateral tranches is that CDO^2 transactions generally will have higher losses than CDO transactions with similar underlying "raw" collateral.

Why this exposure was not disclosed earlier is almost criminal. As Ken Zerbe, an analyst at Morgan Stanley, wrote in a note to clients, "We are shocked that management withheld this information for as long as it did. MBIA simply did not disclose arguably the riskiest parts of its CDO portfolio to investors." The MBIA stock promptly tanked more than 26% to close at $19.95 for the day. Clearly investors have expressed what they thought of this very belated disclosure and it clearly had a dramatic impact on MBIA's valuation.

Toomre Capital Markets LLC would strongly urge the financial regulators to investigate why this key information was not disclosed earlier and hopefully charge those responsible for this omission. Some reader may recall that MBIA also was at the center of another financial scandal when it entered into what was deemed an improper reinsurance transaction to hide losses from the default of the debt that it insured for a large health care system. TCM has previously written about this MBIA transgression in the post MBIA Nears Settlement. Politely, it is becoming more and more apparent that MBIA has a corporate culture that seems to stretch judgment calls to the border of illegal. Is it not time for the senior management of MBIA to be replaced?

In recent days, what Toomre Capital Markets LLC ("TCM") considers to be two of the most challenging Chief Risk Officer ("CRO") roles in the financial services sector have been filled. Both JP Morgan Chase with its considerable Credit Default Swap ("CDS"), leveraged loan and other large derivative exposures and Citigroup with its kitchen-sink collection of issues have named new CROs.

On Monday November 26th 2007, JPMorgan Chase announced that former Goldman Sachs managing director and chief administrative officer, Mr. Barry Zubrow, had been hired as its Chief Risk Officer. Starting December 1st, Mr. Zubrow will be reporting directly to CEO Jamie Dimon and will be a member of JP Morgan's Operating Committee. Earlier in his career, Mr. Zubrow was Chief Credit Officer and co-head of the Goldman Sachs risk committee that oversaw that investment bank's strong risk culture which is credited with helping Goldman Sachs steer clear of much of the losses associated with this year's subprime meltdown.

Apparently, CEO JPMorgan Jamie Dimon had been fulfilling this role for the bank since former CRO Don Wilson retired at the end of 2006. JPMorgan's recent performance during the credit market turmoil suggests that, unlike former Merrill Lynch CEO Stan O'Neal who apparently was off playing golf on many business days during the summer seizures, Jamie DImon was very much hands on (like Goldman Sachs CEO Lloyd Blankfein and Lehman Brothers CEO Dick Fuld were widely reported to be). Is it any wonder then that JPMorgan, Goldman Sachs and Lehman Brothers have fared relatively well during the mortgage credit crunch, especially when compared to Citigroup, Merrill Lynch, and Bear Stearns?

On Thursday November 8th 2007 at 12:40 EST, Bloomberg News ran this little story by Cecile Gutscher: Insured CDOs May Have AAA Ratings Cut Four Levels, Fitch Says. Toomre Capital Markets LLC just three hours earlier posted a note entitled Incestuous Mix: Structured Credit, Financial Guarantors and Rating Agencies that was focusing on what might happen if the financial guarantors were downgraded.

Apparently, if you were an investor in collateralized debt obligations that were rated AAA because of guarantees issued by bond insurers including MBIA Inc. and Ambac Financial Group, Fitch Ratings has now decided that the credit ratings may be cut in one swell swoop by as much as four rating levels. According to this Bloomberg article, Fitch rating analyst Thomas Abruzzo said in an interview today that "We expect there could be situations that could lead to downgrades of three to four notches on insured structured-finance CDO transactions."

New York-based Fitch said Nov. 5 it may lower the top ratings of bond insurers after a review that takes into account the CDOs they guarantee. Any bond insurer that fails the new test may be downgraded within a month unless the company is able to raise more capital. ``The bond insurers themselves remain AAA but there is the potential that companies could fall short of capital and also be downgraded, but we don't expect below the AA category,'' Abruzzo said. AA is the third-highest investment grade.

Oh well… There goes another linchpin under the high-grade bond market. No longer can one buy an insured bond and assume that the bond will remain in its original rating category throughout its life cycle. Perhaps someone can now suggest what credit enhanced bonds are really worth??? Does a AAA credit rating really mean anything??? Shouldn't AAA-rated structured finance transactions trade more cheaply than AA-rated corporate debt, or maybe even A-rated corporate debt? Or maybe it really is worth JUNK???

After all, one has to use one of those modern computers to calculate the value of the structured finance security? There is no absolutely transparency like there is in whether a company might be able to pay back its debts! The structured finance market used to have some degree of trust. With these dramatic ratings downgrades in portfolios that traditionally have seen small changes in principal value, is there any question about why there is a complete breakdown in reputation and trust? Widows and orphans bought high-grade bonds because of their high quality and predictable cash flows. What is a rating worth if it can go from AAA to BB on one Friday afternoon? What the heck good is bond insurance if a rating agency can suddenly bring down the rating of the insurer and all of the insured bonds that it backs? In short, What good is a credit rating?

While listening to the November 8th 2007 testimony of Federal Reserve Chairman Ben Bernanke and the follow-on questions from members of the United States Senate and House of Representatives, Toomre Capital Markets LLC ("TCM") was very struck by a looming and incredibly important effect of the on-going sub-prime mortgage credit crisis. From the remarks of the Senators and Representatives, it is clear that the financial services industry is about to undergo one of its periodic periods of unpredictable political change driven by populist outrage.

It is virtually impossible to predict what might result from the messiness of the political process. However, with potentially millions (yes, millions!!!) of constituents losing their homes to the foreclosure process so that the eventual sale proceeds can be passed through to structured finance security interests, there will be changes. Perhaps the personal bankruptcy code might be changed again? Perhaps Congress might change after-the-fact some significant terms of the securitization process which depends either on timely payment of principal and interest or some cure of the underlying delinquency/default to make the security holders near whole? Perhaps the populist outcry may lead the political process to get into another of the Have's vis-à-vis Have not's battles?

Toomre Capital Markets LLC has no idea of where the populist outrage will lead. However, one thing is very clear: major change is afoot. The key implication for investors in the coming months is that liquidity and being able to be nimble will be key. Also, no doubt there will be sharp and dramatic moves as investors react to one or another political proposal, both in America and from overseas, particularly in the Far East. Hence, another key theme will be a pick-up in volatility and a need to perform enterprise risk management on a real time basis. The value of embedded options in securities and derivative contracts are going to take on increased importance and no doubt another generation of portfolio managers and investors are going to be surprised by how quickly things can change.

Toomre Capital Markets LLC would suggest that a period of greater uncertainty lies ahead. How one manages money in such an environment or produce absolute return will change from how return has been created in the recent past. Just what those changes will be remains to be seen. However, there will be significant change. Reader thoughts and comments are welcome.

Toomre Capital Markets LLC ("TCM") has been extremely concerned about the Structured Investment Vehicle ("SIVs") and their large holdings in supposedly safe collateral such as Super Senior, AAA-rated and AA-rated Collateralized Debt Obligations ("CDOs"). On Wednesday November 7th 2007, Moody's started the final crash of the SIV market with ratings action on $33 billion in SIVs, including several SIVs affiliated with Citigroup.

According to this news article, "'SIV senior note ratings continue to be vulnerable to the unprecedented large and sustained declines in portfolio value combined with a prolonged inability to refinance maturing debt,' Moody's said. … SIVs would be hurt by 'further deterioration in the market value of the portfolio,' resulting in losses on capital and senior notes if they have to sell holdings in an unfavorable market."

Specifically, Moody's downgraded the SIV called Victoria Finance Ltd. Further, Moody's placed on review for possible downgrade several other SIVs including:

• Harrier Finance Funding Ltd.
• Orion Finance Corp.
• Carrera Capital Finance Ltd.
• Beta Finance Corp.
• Centauri Corp.
• Dorada Corp.
• Tango Finance Ltd.
• Asscher Finance Ltd.
• Cullinan Finance Ltd.
• White Pine Corp.
• Hudson-Thames Capital Ltd.
• Nightingale Finance Ltd.
• Links Finance Corp. and
• Premier Asset Collateralized Entity Ltd.

The SIVs Beta, Centauri and Dorada are three of the seven SIVs that Citigroup manages and were placed on credit watch for possible (and likely probable) downgrade. The reader should remember that Citigroup had pledged that it would provide up to $10 billion in credit support to its SIVs. According to this Bloomberg article, Citigroup already has drawn down $7.6 billion of this credit support facility as of month-end October.

Toomre Capital Markets LLC is a specialist in structured finance and risk management. Any potential clients or service providers (like fiduciaries, accountants and/or legal advisors) are welcome to contact TCM at the information below for how Lars Toomre or Aldon Hynes can help your organization in these times of extreme stress. Please feel free to contact us or leave any thoughts or comments.

Reuters is reporting the obvious on Monday, November 5th, 2007: Cantor CEO says big CDO market has shut down. Apparently Cantor Fitzgerald LP Chairman and Chief Executive Howard Lutnick publicly has stated what Toomre Capital Markets LLC ("TCM") and many others have been saying for several weeks now: There are effectively no buyers and what people and organizations own on their books in CDO format, sub-prime mortgage format or just as general collateral has one place to go: DOWN.

The complete CDO market seizure means that there still are tremendous losses to come for those financial intermediaries that retained CDO bond classes, those investment portfolios that invested in them and, perhaps most importantly, all of those organizations that put on CDO "arbitrage" strategies. Perhaps people have not fully appreciated the full impact of this credit crisis? Maybe $25 Billion of the originally estimated $100 Billion dollars in losses have been reported by investment banks and global banking institutions. Where is that $75 Billion in other losses lurking? And assumes that the original $100 Billion number was even conservative enough… Some are already speculating that the total losses from CDO investments may total more than $250 Billion.

"The big CDO market is gone," Lutnick told the Reuters Finance Summit. "You'll see all the banks step out of it because they just can't do (the deals anymore) because they won't be able to churn them out to the buyers because the buyers are gone." Lutnick, whose firm controls one of the world's largest bond brokerages, said the easy buyers of CDOs have left the market. That leaves what he described as sophisticated buyers, who are willing to do their own math and find their own value for distressed CDOs. That will spawn a market for packaging the securities in a way that appeals to those investors, Lutnick said.

"The (CDO) repackaging business will be there, and it will grow enormously," Lutnick said. "No one is going to believe anybody anymore (about CDOs)," Lutnick said. "It's not just about the rating. You have to run your own math and come to your own view."

Lehman Brothers and its Chairman and CEO, Dick Fuld, are the focus of an article entitled The Survivor written by Jenny Anderson in the Sunday October 28th 2007 edition of The New York Times. Toomre Capital Markets LLC ("TCM") got its professional start on the fixed-income trading floors of Lehman Brothers where first Lew Glucksman, and then Dick Fuld, Joe Gregory and Christopher Pettit roamed among the traders and sales personnel. The sale of Lehman Brothers Kuhn Loeb to Shearson American Express in 1984 led to the integration of the Lehman Brothers' scrappy fixed-income trading personnel with the more relaxed fixed-income specialists from Shearson. To put it politely, there was a revolt at the thought of the Lehman Brothers traders reporting into Shearson American Express fixed-income management, and hence for several years, the Shearson Lehman Brothers fixed-income division was in essence divided into two parts. An entity run by Dick Fuld called Lehman Commercial Paper Inc. ("LCPI") controlled the repo desk portion of central funding, the entire and very significant commercial paper operations, the government bond trading and sales operation and the relatively small group that was called the mortgage department. The rest of fixed-income reported into management from the former Shearson entity.

The mantra of the old Lehman Commercial Paper Inc. ("LCPI") division was "Every day is a battle: think about the firm, do the right thing, protect your client, protect the firm, be a good team member and most importantly, Be in the Game, BE IN IT." Lars Toomre is smiling this morning as he reads very much those same thoughts being shared some twenty plus years later. The old LCPI culture was incredibly strong and now apparently permeates much of the other segments of the firm, both in the New York City headquarters and in the branch offices around the world. Congratulations to Dick Fuld, Joe Gregory (Lars' former direct boss and now Lehman's President) and the rest of the Lehman Brothers management team on transforming a very successful bond operation into a truly global firm.

This New York Times article includes significant information that explains why Lehman Brothers escaped relatively unscathed from this summer's credit crunch. Lehman Brothers truly has strong risk management and survived this round of stress so that it can play in the game of fixed-income another day. Whereas many associated with Merrill Lynch, the old Salomon Brothers division within Citigroup, and Bear Stearns are questioning just how badly are their firms wounded, will there be jobs there for them in the future, and if so, just what type of risk appetite will there be in those future days?

At present, it appears that the true kings of the fixed-income world are Lehman Brothers and Goldman Sachs. The interesting challenge will be if they remain in the game as the mortgage market meltdown continues to evolve and the challenges of globalization, electronic trading, increased compliance, and illiquidity put further stresses on the global fixed-income (and FICC) divisions.

The Wall Street Journal reported on October 26th 2007 in a story entitled Bond Raters Get Subpoenas that Connecticut's Attorney General Richard Blumenthal issued subpoenas to the three largest debt-rating firms as part of an anti-trust investigation. Apparently Standard & Poor's Ratings Service, Moody's Investors Service and Fitch Ratings Service were served with the subpoenas on October 10th. "Standard & Poor's ("S&P"), a unit of McGraw-Hill Cos., and Moody's, part of Moody's Corp., control about 80% of the debt-rating market, which assesses the ability of corporations, banks, mortgage firms, governments and other borrowers to pay back a loan. Fitch is a unit of Fimalac SA of Paris."

This WSJ article continues with the following key information: "My investigation seeks to determine whether credit-rating agencies may be exploiting their dominant positions to unfairly raise prices or exclude competitors. Assuring debt ratings are honest and untainted is vital to investors, companies and government," Mr. Blumenthal said. The focus of the investigation includes three key areas: so-called unsolicited ratings, so-called notching and the concept of exclusive contracts. "There are allegations that some raters conduct an unsolicited rating and then demand the issuer pay for it or face a possible poor rating," the attorney general said. Notching is when raters allegedly threaten to downgrade an issuer's debt unless they get a contract to rate the issuer's entire debt pool, even if parts already have been assessed by another agency. Exclusive contracts give issuers discounts for having all their debt rated by a single agency. "Such agreements may hinder competition by locking out other debt raters," the attorney general said.

Toomre Capital Markets LLC ("TCM") cannot testify whether unsolicited ratings, notching or exclusive contracts are applicable to recent structured finance transactions in areas such as Asset-Backed Securities ("ABS"), non-agency Collateralized Mortgage Obligations ("CMOs"), Commercial Mortgage-Backed Securities ("CMBS"), adjustable-rate mortgage ("ARM") pass-throughs, Collateralized Debt Obligations ("CDOs"), or Asset-Backed Commercial Paper ("ABCP"). However, Lars Toomre can directly testify to how Moody's used unsolicited ratings and notching to establish some supposed credibility in rating residential mortgage-backed securities ("RMBS") in the first place.

On Tuesday October 23rd 2007, The Telegraph newspaper out of the United Kingdom states in an article written by Ambrose Evans-Pritchard that a New Credit Crunch Looms. The article suggests that fresh turmoil in the global debt markets has set off sharp falls in commodity prices and higher-risk assets as investors scrambled for the safety of relative safer investments.

In one of the most dramatic currency moves of the year, the dollar soared as US investors liquidated foreign holdings, ending at $1.4129 against the euro and £2.0276 against the pound. Libor spreads in Europe's interbank market jumped to 64 basis points, roughly the level that set off the credit crisis last summer and prompted a liquidity rescue by the European Central Bank. The iTraxx Crossover index that measures spreads on corporate bonds has jumped 100 basis points since last week to 364 bp yesterday.

"It's the summer that won't end," said Peter Berezin, a strategist at Goldman Sachs. He said investors were shaken by last week's drop in US home-builder sentiment to an all-time low and by fresh falls in the ABX index for sub-prime debt. "We continue to learn that it pays to respect the sell-offs in ABX and housing-related credit. This has elements of the February and August sell-offs, where credit markets signaled problems," he said. The lowest tier of ABX debt has fallen to a record low of 20.72 – from par of 100 – pointing to huge losses that have yet to surface.

Toomre Capital Markets LLC ("TCM") has been very concerned about the evolution of this credit crunch and has privately argued that it is very much like a slow motion train wreck. Unlike some of the market sectors like United States equities where the markets seemingly quickly react to market moving news, the credit markets, and particularly the primary mortgage market which is composed of many, many local markets, react much more slowly. It takes considerable time for the delinquencies to first appear and then the stress of missed payments to turn into actual foreclosure actions. It also takes some time for individual homeowners to realize that the prices of their homes may not longer be appreciating, and seemingly often most recently, the value of the homes has in fact declined. It is psychologically hard to sell an asset at a loss and TCM suspects that many homeowners will hold off on selling homes in which they have a loss. Hence, the true state of both the magnitudes of the delinquencies/foreclosures as well as the losses given default are not likely to be known for some weeks and even months to come.

Maybe Toomre Capital Markets LLC ("TCM") is a bit naïve. After all, who really will miss a fifty or two? Fifty Billion or Hundred Billion in losses, that is? Maybe the reader can pay this structured finance bill due to sub-prime and Collateralized Debt Obligations ("CDOs") valuation mark-downs from his or her wallet, but the Toomre Capital Market's wallet is likely to be more than a few dollars short on this monsterous tab!!

On Monday, March 12th 2007, the woes of the sub-prime mortgage market continued. This morning in a filing with the Securities and Exchange Commission, New Century Finance indicated that substantially all of its short-term creditors are cutting off credit. The filing indicates lenders under its short-term repurchase agreements and aggregation credit facilities had either discontinued their financing or notified the company they plan to do so. These firms are said to include Morgan Stanley, Goldman Sachs, Citigroup, Bank of America, Barclays and IXIS Real Estate Capital.

According to Bloomberg News on Monday March 5th 2007, the evolving carnage in the United States sub-prime mortgage market continues. Late on Friday March 2nd, one of the four largest sub-prime lenders, New Century Financial Corp., announced that it was the subject of civil and criminal investigations by the Securities and Exchange Commission and the U.S. Attorney for the Central California district. Also late on Friday, another of the four largest sub-prime lenders, Fremont General announced that it was exiting the sub-prime mortgage business after signing a cease and desist order with the FDIC about inadequate lending standards and the origination of many poor sub-prime mortgage loans.

Of course, it also does not help when the federal financial regulators step in to tighten lending standards as the did on March 2nd. Nonetheless, the brutal sell-off on March 5th has been most impressive.

On March 5th 2007, Regulation National Market System ("Reg NMS") will go into effect for the United States stock markets. Designed to even the playing field between U.S. stock exchanges and rival electronic trading platforms, these regulations require one exchange to route customer orders to other trading venues that display a superior price execution. The goal is to ensure that customers get 'best execution' on each and every one of their stock and equity option transactions, while eliminating the current practice of 'trade-throughs' (ie executing an order at an inferior price than that currently available nationally) and encouraging the greater use of limit orders.

Late on Friday March 2nd 2007, the New York Stock Exchange ("NYSE") asked the Securities and Exchange Commission for a partial delay in adopting the new Reg NMS rules with certain alternative display facilities such as Direct Edge, LavaFlow Inc., and Track Data Securities Corp. The NYSE also apparently needs more time to connect with the International Securities Holdings Inc., which is in the midst of rolling out its equities trading. None of those trading platforms are plugged into the broadly used Intermarket Trading System, which is what the NYSE and other major exchanges use to route orders. There is no indication yet of how the S.E.C. will react to yet another request for a delay.