Thursday, October 30, 2008

20% high-yield defaults? Don't underestimate the power of the autos!

On Monday the yield on the Merrill Lynch High Yield Master index reached a shocking 19.6%. That yield is admittedly enticing, but the real question is, how many of those high-yield bonds might default? In short, if we're getting 20% yield, could we wind up suffering 20% losses in defaults?

According to Moody's, the largest default rate in history was 15% in 1933. In the post Depression era, there have been three years which produced double-digit default rates: 1990 (10.1%), 1991 (10.4%) and 2001 (10.6%). The average recovery rate (i.e., the amount the bond is worth immediately after default) is 32% for the three peak default years. So if a portfolio suffers 10% in defaults with 30% in recovery, it has actually suffered 7% in total credit losses.

That history would seem to favor high-yield, even admits an ugly economic forecast, given the initial yield of 20%. But risks remain. First, the proximate cause of most corporate bankruptcies is either an inability to roll over debts or a demand by creditors for collateral which the company cannot obtain.

Right now roll-over risk in high-yield is higher than any time since at least the early 90's. Junk-rated companies can obtain funding through one of two routes, either bank loans or the public bond market. But neither of those are open to lower-quality borrowers right now. There have not been any new high-yield issues for the entire month of October. And banks remain highly unwilling to lend to anyone, much less to high-credit risk firms.

Should the credit markets thaw somewhat in the near term, new deals may be possible. But even if that happens, how many companies will be able to operate where the cost of debt is 20%? Some companies look for ways to borrow in the secured market, where companies pledge specific assets to lenders, which in effect subordinates existing bond holders.

Then there is the 900-pound gorilla in the junk bond market: the autos. Ford and General Motors alone make up about 7% of the high-yield index. Recent stories in the media suggest that GM will need a loan from the government to complete a merger with Chrysler, and even then there are no assurances that the companies significant problems can be solved.

There are also stories that GM sought help from Toyota. Sounds awful desparate. In fact, I'd argue that a bankruptcy would be better for the American auto industry long-term, as it would allow firms to focus on production rather than dealing with an out-dated union structure. That's the path the airlines followed in 2001-2002.

If high-yield defaults follow the "normal" recessionary pattern of about 10% defaults, but GM and Ford default as well, that would bring total defaults to about 17%, disturbingly close to the 19.6% yield on the index currently.

Given the extremely high rate of interest on high-yield currently, the odds are good that high yield will produce positive returns over next 3-years. Even if defaults spike in the next 12-18 months, investors will likely be well-compensated for the credit losses over a longer period of time. But if one is to take that tact, bear in mind that the near-term could be very painful, and that market-quotes (or NAV values on mutual funds) could still fall from here.

Its probably best to think of high-yield as a low-beta equity investment rather than a bond investment. Go into it with the understanding that equity like gains and/or losses are possible, and size the trade accordingly.

Tuesday, October 28, 2008

We know about the reality...

Don't ruin the fantasy.

Nothing has changed with Agency debt

On Thursday, James Lockhart,head of the Federal Housing Finance Agency (formerly OFHEO), said that the U.S. government is providing a "explicit guarantee to existing and future debt holders." He later retracted the statement. Today, Anthony Ryan, Paulson's right hand man at Treasury, said that Fannie and Freddie are "effectively guaranteed" by the U.S. government.

I get what both are trying to do. Spreads on GSE debt had historically traded 20-30bps over Treasuries. Even just before the Treasury forced the two mortgage giants into conservatorship, Agency spreads were around 80bps over Treasuries. Now 5-year non-call notes are trading at spreads of 155bps.

At those spreads, Fannie and Freddie have effectively stopped issuing term debt, and have instead been funding entirely through discount notes (the GSE equivilant of commercial paper). I admit that the discount notes have been gobbled up by "government" money market funds, and thus there is currently no concerns about funding at the right now. But remember that the government took the GSEs into conservatorship in part to ensure continued debt funding. I'm certain they didn't expect Fannie and Freddie's cost of funding to increase after the take over.

And as long as the GSE's debt costs remain high, its going to be more difficult for them to be active in the secondary mortgage market. The Treasury has an explicit goal of forcing mortgage rates lower to both improve affordability and to facilitate a refinancing wave. No doubt Ryan and Lockhart would like buyers of 2-year Treasury notes, currently at 1.54%, to consider 2-year Freddie Mac paper at nearly double the yield.

The U.S. Treasury will have difficulty extending a literal backing to the GSEs, as it would cause them legal problems with the debt ceiling. You can say that by virtue on the conservatorship, which includes a $100 billion credit line, the government has de facto guaranteed the two agencies. I'd agree with that. You can say that the government has no incentive to hurt Fannie and Freddie bond holders, even if mortgage losses accelerate from here. I'd agree with that too.

You could even say that Agency spreads in the +150 area don't make any sense at all given the de facto guarantee position. I agree with all these things.

The danger is that Asia doesn't seem to agree. Selling of both Agency debt and MBS securities have been concentrated in Asia the last several days. We know that that Taiwanese insurance regulators are limiting allowable exposure to U.S. agency mortgage-backed securities, claiming the credit rating cannot be believed. If China or Japan were to come to the same conclusion, there would be real problems real fast.

The good news is that despite heavy selling from Asia, agency spreads (and MBS spreads for that matter) have moved wider slowly. Agency spreads are about 60bps wider this month, whereas corporate spreads have moved 117bps wider. The reason is that there is a much larger universe of natural buyers for agency debt compared with corporate debt. Agencies are one of the easiest sectors for conservative, income oriented investors to simply buy and hold.

I think this is especially true if you have shorter-term money to invest. Agencies at 3% yields look a hell of a lot better than most alternatives. I think if you can be patient, agencies will turn out to be a solid trade.

Friday, October 24, 2008

We'll never get it out now!

Here is something to think about...

"So certain are you. Always with you what cannot be done. Hear you nothing that I say?"

"Master, moving stones around is one thing. This is totally different!"

"No! No different! Only different in your mind. You must unlearn what you have learned."

"Alright. I'll give it a try."

"No! Do... or do not. There is no try."

"I can't. Its too big."

"Size matters not. Look at me. Judge me by my size, do you? And well you should not. For my ally is the Force. And a powerful ally it is. Life creates it, makes it grow. It's energy surrounds us and binds us. Luminous beings are we, not this crude matter. You must feel the Force around you. Here, between you, me, the tree, the rock, everywhere! Even between this land and that ship!"

Now, discuss.

Tuesday, October 21, 2008

30-year Swaps: Look's like we've got a bad transmittor

The 30-year swap spread fell as low as 0.5bps today, closed at 3bps. 3bps! Three. One less than the number of legs on a AT-AT. Equal to the number of good Star Wars movies. If you don't believe me that municipal spreads are stupid, at least believe me that a 3bps spread on 30-year swaps is stupid.

To translate... swap spreads is the yield differential between Treasury bonds and the fixed leg of a fixed-floating interest rate swap. Remember that any interest rate swap has to have a bank or other financial institution standing in the middle. With the world scared out of their minds over counter-party risk, how is this spread at all-time tights!?! By comparison, 2-year swaps have a spread of 104bps, and traded as high as 165bps earlier this month.

This strange anomaly is just another example of what happens when leveraged investors are desperate to unload bad trades into a highly illiquid market. Over the last 2 years, there were many "range notes" sold that referenced the slope of 10-year and 30-year swaps. Now that trade isn't looking so hot and people want to hedge.

Lots of people rushing to leave the building, but a small door of liquidity, and a spread of three is the result.

This just reiterates what I said the other day about leverage. The market can't act "normal" when fresh capital is hard to come by. You should still buy bonds based on fundamentals, but bear in mind that it may take a while for fundamental analysis to pay off.

CDS could be fair and simple

On Friday, Jim Cramer lamented that a fair credit-default swap clearinghouse will be difficult to implement. But I'd argue that a simplified version of CDS could be easily created and listed on existing exchanges. (Click here for the basics of how CDS work...)

The first thing that's needed is homogenization. Currently CDS are liquid so long as there remains 5-years to termination. But as soon as a contract rolls to "off the run" liquidity disappears. That's a major reason why CDS contracts have ballooned to over $60 trillion in notional outstanding. No one actually terminates the contracts, they just buy offsetting contracts.

In addition, CDS are currently struck with various initial spreads. So one person might own Morgan Stanley CDS with a deal spread of 100bps, and someone else with 200bps, and another at 300bps. This also lends itself to illiquidity and poor price transparency.

Then there is the problem of defaults. When an issue defaults, the buyer of protection may deliver a bond to the seller of protection in exchange for par. Except when there are large-scale defaults, like in the case of Lehman or the GSEs, actual delivery of bonds is impractical. So they hold an auction to determine a theoretical value for all outstanding bonds, and that amount of cash is exchanged between sellers and buyers of CDS protection. The problem is that whole process creates a huge degree of uncertainty, and only lends to the feeling that CDS are too easily gamed.

But CDS wouldn't be hard to boil down to a very basic tradable contract. First you set all contracts with a 5% coupon paid quarterly. Second, the contracts have 5-year maturities, with new contracts created each year. Third, in the event of default, the seller of the contract pays the buyer 60 cents on the dollar. No actual bonds change hands. That's it.

The contract would trade based on the present value of the 5% coupons vs. the expected default probability of the referenced company. This may result in either the buyer or seller of protection making an initial cash payment to the other party. For those familiar with the vulgarities of CDS, it would be similar to how up-front contracts work now, except that it could cut both ways.

For example, take a relatively low risk company, say Johnson & Johnson. Let's say that you estimate the proper default spread given J&J's default risk is 0.6%. Since the contract stipulates a 5% annualized payment, the recipient of the 5% coupon (seller of protection)must make an initial payment to the buyer of protection. The opposite would be true for higher-risk companies, like General Motors or MBIA.

Perhaps the best part of this is that a simplier product could be more widely adopted. Sellers of protection would have a defined set of gain/loss scenarios if held to maturity. Currently CDS trade only among large institutions, but wider distribution would certainly improve liquidity and price transparency.

And contracts of this sort could be implemented by exchanges tomorrow. And we wouldn't need some massive new regulatory scheme for CDS. Just simplify the contracts and put it all on an exchange, and all kinds of problems just float away.

Now yes, we want to start winding down the massive number of CDS contracts outstanding, if for no other reason than to eliminate the systemic risk. That's easy enough. Tell banks that any non-exchange traded CDS contract has an additional risk weighting to account for counter-party risk. Banks will immediately start pairing off their CDS exposure and looking to replace it in the exchange-traded market. That would go a very long way to reducing current CDS notional outstanding in a very short period of time.

It can be done. Let's see if anyone actually wants to solve this problem or not.

Thursday, October 16, 2008

The Empire doesn't seen leverage as any threat...

Yield spreads in various areas of the bond market are at non-sensical levels. I'm not talking about financial corporates or junk bonds, which may look cheap, but do have significant risk. I'm talking about state-backed municipal bonds, government-guaranteed student loans, agency MBS, Fannie Mae and Freddie Mac senior debt, among others. These have little or no credit risk, the chance of investors recouping their principal over time has not materially changed, and yet spreads on all these bond types is at or very near all-time wides.

There are specific reasons why each of these sectors has widened. But the real question is, what is going to drive the trading levels on these sectors toward economic reality? Or maybe a better question is, if its an arbitrage, what's stopping the market from taking advantage of the arbitrage?

The answer is leverage, or a lack of it.

Capital is supposed to flow to the area where it can generate the best returns. In the past, arbitragers would constantly comb the bond market, looking for bonds that could be purchased with yields higher than the arbitrager's cost of borrowing. Hedge funds would pledge the bond to a bank or a broker-dealer along with a certain amount of cash, and in exchange was able to borrow at a relatively low rate. Banks would buy bonds that would out-yield their deposit yields. Dealers would buy bonds and put them into arbitrage accounts.

This system worked well until it was taken one step too far and we got SIVs and CDO-squareds, and we all know how the story ends.

Now of course, leverage is extremely difficult to come by, and this makes it difficult for hedge funds and other fast money to get involved. Say you are looking at 5-year Fannie Mae senior debt. The spread on that paper is currently 1.3% over the 5-year Treasury. We know that Fannie Mae has been put into conservatorship by the Treasury, so that spread should be close to zero. So let's say a hedge fund predicts the spread will drop to 0.3%. That would imply a price return of about 4%. But hedge funds can't charge 2 and 20 to make 4% for clients. That 4% return either has to happen quickly or they need to leverage it.

Its going to be a while before we find a happy median between the excessive leverage of the past and the unavailable leverage of the present. Until that happens, yield spreads are going to remain very wide on a variety of fixed-income sectors. Meanwhile, investors in beaten up sectors are going to have to be patient. I've gotten many e-mails from readers about municipal and agency bonds lately. Generally speaking, there is nothing fundamentally wrong with either sector, but its not easy to say when it might start to improve back.

Perhaps the period of excessive leverage programmed investors to expect any arbitrage to disappear quickly. Today its going to take real money buyers coming in to restore fundamental value. And that just takes time.

Managing California's cash ain't like dusting crops

On October 3, California Governor Arnold Schwarzenegger warned that his state might need a Federal loan of $7 billion. This week we find out if that scenario has been averted as California is marketing $4-5 billion in "Revenue Anticipation Notes" or RANs. These will be tax-exempt securities. A RAN is used by municipalities to manage cash flows while waiting for tax and other revenue to be collected.

Originally the deal was to be $4 billion, with $1 billion maturing in May and the other $3 billion in June 2009. Retail orders were taken Wednesday, with dealers getting $3.8 billion in orders. The deal has been increased to $5 billion, with dealers taking institutional orders Thursday.

The yield on the bonds is not yet set. The original sales literature indicated a range between 4 and 4.75%. But with orders coming in so strong from retail, the May maturity will probably yield 3.75% and June piece 4.25%.

At 4.25%, the rate on the California bonds would be about equal to 6-month LIBOR on an absolute basis, and is similar to current reset levels on 7-day variable rate municipals. The 4.25% is also about 6.5% on a taxable equivalent basis, more like 7% if you are a California resident. Any way you slice it, its a lot of yield.

The challenge in placing these notes is the combination of California's economy and the sheer size of the note. A note of this kind would normally be attractive for money market funds and other short-term buyers, especially at that rate. But currently money markets are strapped for liquidity themselves, and have been focused on buying bonds with overnight maturities (or put options) to ensure the fund can meet redemptions. So buying a longer-term bond is probably out of the question.

Vulture buyers entering the municipal market are probably looking elsewhere. If you want to buy munis cheap, you should buy longer-term securities, where a recovery will result in a price pop. Currently 15-year munis can be had for at yields over 5.5%. If that rate were to fall to 4.5%, the owner would enjoy a 8-9% price return. With the short-term California bond, investors best return is going to be the yield.

And of course, California is at the epicenter of the housing crunch, which is likely to weigh on property tax revenues for some time. Offsetting this somewhat is the diversity of their economy and the benefits of Proposition 13. Bear in mind also that local governments are the primary beneficiaries of property taxes, whereas the state revenues are primarily sales and income taxes.

So are these California bonds worth the risk? Perhaps California will have more budget difficulties than other states, but ultimately the state's budget will come down to tough political decisions rather than an inability to finance their debts. Put another way, I'd rather own 9-month state of California paper at 6.5% taxable equivalent levels than most corporate bonds. And its investors thinking along those lines that will wind up buying up these bonds.

Wednesday, October 15, 2008

Credit market indicators that really matter

With the credit crisis accelerating and governments attempting a number of "solutions," investors are being introduced to a wide variety of credit metrics. Here is a quick list of the credit market indicators that really matter, and where you can find up-to-date data on each.

LIBOR has gotten plenty of press, but many have been focused on the TED spread, which is the yield differential between 90-day T-Bills and 90-Day LIBOR. TED is interesting in terms of historic comparison, but its the absolute level of LIBOR that is a better credit indicator right now. With T-Bill rates extremely low (0.19% as of 10/10), and intra-day T-Bill moves highly volatile, it would be entirely possible to see T-Bill rates rise by some degree without any significant improvement in conditions. Thus the TED spread would technically be tighter, but to no import.

Instead, watch 1-month and 3-month LIBOR rates. Both should be around 1.5-2%, based on where the Fed Funds target is. Watch Euro-denominated rates as well. A governmental guarantee of inter-bank loans would certainly drive LIBOR lower, as LIBOR is supposed to measure inter-bank lending rates. Otherwise I'd expect LIBOR to remain elevated until at least year-end.

Get various LIBOR rates, including international levels at the British Bankers' Association website.

Commercial Paper Term Spread
Many have been watching commercial paper outstanding as a credit market indicator. The problem there is that CP issuance is bound to decline as the system delevers, so total CP outstanding may see year-over-year declines, even as credit conditions are improving. A much better indicator is the yield spread between over-night CP and 60-day CP. Currently over night AA-Finance CP costs firms 1.23%, according to the Federal Reserve, whereas 60-day CP costs 3.51%. Under normal conditions, those rates would be within 25bps of each other.

The Fed also reports on asset-backed CP rates in the same report. These should converge with AA-Finance rates as conditions improve.

Municipal Bond Swap Index
This index measures the average reset rate on tax-exempt, weekly Variable Rate Demand Notes (VRDN) issued by municipalities. Basically, it is the cost of short-term funding for municipal issuers. It is calculated by the Securities Industry and Financial Markets Association (SIFMA) and hence is often just called the SIFMA index.

VRDN's are a mainstay of municipal money-market funds. Investors in a VRDN can put their bond back to the issuer at any reset date, which in this case is weekly. This liquidity is usually guaranteed by a highly-rated bank. With banks under such pressure recently (Wachovia and Dexia were major players in this business), and with municipal money-market funds seeing massive redemptions, VRDN rates have risen dramatically.

Typically the SIFMA rate is between 60 and 80% of the 1-week LIBOR rate. So if LIBOR were 4%, SIFMA would usually come in around 3%. But the SIFMA rate spiked to 7.96% on September 24, and although it has fallen to 4.82% as of last week, the level is far above normal levels.

If there rates remain elevated, municipalities will be under pressure to refinance their variable rate debt with long-term debt. And any kind of debt issuance is extremely expensive in this market. However, falling SIFMA rates would indicate investor confidence in municipal issuers.

SIFMA updates its index each Wednesday. Note that VRDNs are not the same as Auction Rate Securities, which remain highly illiquid.

The CMBX is a basket of credit default swaps on commercial mortgage-backed securities (CMBS). It goes without saying that commercial mortgages are likely to suffer significant losses in the near future, likely larger than other recent recessions. At the same time, commercial mortgage securities are structured with significant levels of subordination. This means that junior securities take losses before more senior securities suffer. A typical CMBS deal would have 30% or so subordination beneath the AAA-rated tranche.

So while losses may be high, not too many deals will suffer much more than 30% in losses (which implies a much greater default rate). In addition, principal payments go to retire higher-rated tranches first, therefore the subordination actually increases over time. Thus the spread on AAA-rated CMBS should remain relatively tight. Right now, the recent vintage AAA CMBX is trading in the 220bps area.

The CMBX is maintained by MarkIt and is updated daily.

There are a few other indicators which are commonly cited but I don't think are very useful. One is swap spreads. This is the spread between the fixed-leg of a fixed-to-floating swap and a corresponding Treasury. Classically this was seen as a generalized measure of counter-party risk, since normally a highly-rated bank would stand in the middle of any interest rate swap. However right now the swaps market is being driven by some unusual technicals. Note that the 2-year swap spread is at all-time wides, where as the 10-year swap spread is only a couple basis points wider than its 10-year average. The 30-year swap spread is at all-time tight levels. So as a day-to-day indicator, swap spreads aren't very informative.

Another is Agency debt spreads. With Fannie Mae and Freddie Mac now fully backed by the Treasury, one would expect those spreads to collapse to near zero. Yet currently 2-5 year Agency debt is trading at 100bps or more above comparably Treasury rates. While this is indicative of how bad liquidity currently is in the market, this is as much a function of swap spreads as anything else. As long as swap levels remain elevated, so will Agency debt spreads.

Finally, the various measures of borrowing at the Fed. This includes the discount window, the TAF, the TSLF, etc. Investors should realize that the mere existence of these facilities has an influence over how much institutions use them. Put another way, the fact that we need these programs is the real indicator. The most recent TAF auction on 10/6 produced the lowest stop-out rate since the program's inception. Yet I have a very hard time saying liquidity is improving.

Tuesday, October 14, 2008

Fading fast

Stock rally is fading fast here, but credit rally is still in full swing. This makes total sense to me, as the government's maneuvers mean more in terms of survival than thriving profit growth.

CDS and swap spreads on most names remain at their tights for the day. LQD, the corporate bond ETF is up 1% today after gaining 5% yesterday. Note that the actual bond market was closed on Monday.

For what it's worth, the euro-dollar futures market, which essentially is a traded market on LIBOR predicts the 3-month rate will fall from 4.63 to 3.99% tomorrow.

I think I got it!

The government is buying shares in banks.

The FDIC is going to insure "most" new bank debt. (Not sure exactly what that means yet.)

Death of capitalism? We'll see.

As for the bond market, CDS are obviously crashing tighter. The CDX is 50bps tighter to 170. Goldman about 250 tigher to +200, Merrill 190 tighter to +180, Citi 230 tighter to 110, Bank of America, Wells and J.P. Morgan each about 80 tighter. Morgan Stanley goes from 20-something points up front to about +370.

Swaps spreads 20 tighter on the front end, about unchanged in the 10-year area. Treasuries lower by a 1.25 points in the 5-10 year area, long bond down 3 points.

I'd look for a violent short-covering in financial CDS. The big names have been de facto guaranteed by the government, like it or not. They've got a bigger balance sheet than you, and they are now using it in full force. Don't fight it. If you don't like it, just stay out of the way.

I continue to like munis and MBS here.

Wednesday, October 08, 2008


Wow, practically as soon as I wrote the last piece, everything reversed. Swap spreads are still modestly tigher, but stocks, CDS, Treasuries all back to recent patterns. Good times... good times...

We'll eventually see a bounce in risk product, but I'm not positioning for it. I'm selling all rallies.

World cuts 1/2 point, or "Its just a dead animal..."

The world's major central banks (well, except Japan obviously) have all cuts their target rate by 1/2 point. Truthfully, I have no idea what this is supposed to accomplish in the U.S. I have long thought rates in the U.K. and the Eurozone were too high given their economic situation. Admittedly, deflation is an increasing risk, so I suppose there is no harm in making this a global rate cut.

You can see the dollar is weaker and stocks are much higher just by watching CNBC. Here's the bond market's immediate reaction is interesting. Treasury market is modestly weaker in the intermediate part of the curve. About flat on both the 2-year and 30-year. Its a little counter-intuitive that bonds would be weaker on a Fed cut, but I think that just shows how strong the panic bid for Treasuries is. I wouldn't be surprised to see this sell-off fade in the short-term, but longer-term there isn't much upside (price wise) in the 7-10 year area of the Treasury curve.

CDS on major financials are a good bit tighter. Bank of America, Citigroup, and Wells Fargo 10-20 tighter. Goldman 30 tighter. GECC 20 tighter. American Express 25 tighter. Morgan Stanley confused (I'm getting quotes indicating both tighter and wider, welcome to the Financial Panic of 2008.)

CDX 11 about 8 tighter.

I don't think the Fed is "out of bullets." But in my mind, they've done enough. Now we just need time. Everyone wants stocks to soar and credit to return overnight. They want one of these Treasury/Fed measures to "solve" the crisis. But the crisis isn't about any one thing, its about confidence and trust. Financials broke that trust when they made a slew of bad loans. Now they need to rebuild trust. Like a philanderer trying to reform, it just takes time.

Now, remember that I'm not a stock guy, but I think retail investors keep withdrawing from their mutual funds for a while here. Of course, historically when retail sells its usually a great time to buy. Regardless, I see stocks remaining under pressure until retail is done selling.

Friday, October 03, 2008

We feared the worst

The question is, of course, now what? First, what’s happening in the bond market.

Treasury bonds, which were down around ½ point all day are now flat. I am very surprised, as it seems like the most obvious impact of the TARP is that Treasury issuance will rise significantly. I do not like the Treasury market here at all. I am also surprised the dollar remained stronger. For what its worth, I'm not shocked the stock market sold off.

Credit spreads, at least in CDS, were mixed. Goldman, GE Capital, American Express, all about 40bps tighter. Interestingly Merrill Lynch is about 30bps tighter while Bank of America is unchanged, indicating an increasing odds on the merger being completed. Currently BofA is around +165 and Merrill is around +400, so there is plenty of room there. The CDX was 2bps wider.

Citi and Wells Fargo both a little wider. I would bet on Citigroup prevailing in the Wachovia thing. Citigroup has apparently been the only thing standing between here and a run on Wachovia since Monday. I think the FDIC wants to reward banks who are “first responders” on failed banks. Allowing Wells Fargo to step in now would create a bad precedent. The FDIC does not want to see other banks hesitate to step in to buy deposits in future bank failures.

Swap spreads were also tighter. 2-year swaps were 13bps tighter, while 10-year swaps were 5 tighter. I do not know exactly what to make of it, but the 13bps move in 2-year swaps is consistent with recent volatility, but the 10-year is an outsized move.

Agency spreads moved in context of swaps. MBS spreads were unchanged after being significantly tighter through most of the day. Still like MBS and agencies over corporates here.

Fed funds futures have now priced 100% chance of either a 50bps or 75bps cut at the October meeting. I think other liquidity measures, like extending liquidity to ABCP or some such, would be more effective. But I’m not going to fight the Fed if they want to cut. The play is to bet on the curve steepening and dollar weakening.

I am remaining defensive in credit. I would say I am closer to buying finance paper than industrial paper, though not buying either at the moment. The bailout and all the Fed’s liquidity measures are much more likely to help large financials to survive, but nothing is going to stop the coming recession. But I need to see some better trading volume before even considering any corporate bond trade here.

What is this place?

The stock market is getting crushed today, but that hardly tells the story. The Dow falling 350 points is rare, but its happened many times. What's happening right now in the credit markets is unprecedented.

I'd like to focus on an under-reported corner of the credit markets: municipals. We have a variety of factors converging to cause municipal bonds to perform extremely poorly.

First of all, market makers are hoarding cash. Remember that the Wall Street titans were never dominant municipal players. The better muni shops among big Wall Street firms were the ones with large retail operations, like Merrill Lynch. Regional brokerages were always major players (as a group) because they had the local customers who wanted to buy local bonds. A firm like Morgan Keegan or Stephens knew the market in Mississippi or Arkansas or Tennessee better than anyone from New York.

Regional brokers face a more uncertain funding than larger Wall Street firms, especially if they are not tied to a bank. Typically dealers fund their inventory either through repo or through bank credit lines, with the later probably more common among regionals. The bank credit lines function very much like repo in that there is usually some basket of acceptable collateral and that the line must be over collateralized by some amount.

The reality is that those bank credit lines are usually not contractually committed for an extended period. In other words, the lending bank usually has the right to pull or reduce the line at any time, or at least with relatively short notice.

In that kind of environment, dealer firms cannot hold inventory. If they were to see their credit lines taken away, or even reduced, the firms would see significant odds of sudden bankruptcy. Forced sale of anything right now, even municipals and government agencies, would entail significant losses.

So municipal trading must occur with no market makers whatsoever. Obviously that makes the cost of immediate liquidity much higher.

Add to that the fact that municipal funds, particularly money market funds, are seeing large outflows. Currently tax-exempt money market fund balances are about 10% below August levels. While there have been some inflows the last couple days, there is still tepid demand for money market securities. And investors are not being unreasonable in selling their tax-exempt money market funds. Most muni money market securities rely on bank letters-of-credit for liquidity. And various U.S. regional and European banks are major muni LOC providers. In fact, Wachovia was a very big player in that market. While Wachovia-backed bonds are to be backed by Wells Fargo or Citigroup, certainly there is good reason to be worried about other banks.

Meanwhile other municipal buyers are pulling back as well. While I have not seen stats on long-term muni funds for September yet, anecdotal evidence is that there have been outflows. Plus there is the spectre of closed-end funds deleveraging. Closed-end funds have been using auction-rate securities to create leverage for many years, but have recently been trying to refinance those securities. The current market has made that all but impossible. So there is a good chance that closed-end funds will have to sell a percentage of their current holdings to deleverage.

On top of everything, things aren't exactly rosy for municipal governments. There is no doubt that states and local governments are going to face their most difficult budget periods in a generation, and it might not get much better next year either.

Still, I think intermediate-term munis are a relatively good trade. You've got pre-refunded bonds, which are backed by Treasuries, trading at a higher yield than Treasuries. You've also got hospitals, public universities, transportation authorities, etc., that are less sensitive to housing prices and general economic activity. I think if you focus in that area, and can stomach the lack of liquidity, those will turn out to be good long-term trades.

In terms of muni weekly and daily reset VRDNs, if you are going to play in those, make sure you have a ultra-safe LOC provider. There are bonds out there with Fannie Mae and Freddie Mac LOCs which would seem the strongest. But again, be sure you understand exactly what the LOC means. If you can't understand it, don't buy it.