Friday, February 13, 2009

The bubble in TBT

Just a few weeks ago, a number of commentators were calling the Treasury bond market a bubble. The 10-year Treasury had fallen to nearly 2.00%, and the 30-year bond had fallen to 2.50%. But since that time, the 30-year Treasury has risen by 100bps, representing a 19% decline in price.

Now if you really want to find a bubble, try TBT, the ProShares UltraShort 20+ Treasury ETF. This fund is designed to delivery -200% of the return of the 20-year and longer segment of the U.S. Treasury market.

First take a look at the shares outstanding in TBT. This is an excellent proxy for how popular a short US Treasury trade has become.

What's one of the conditions for a bubble? Parabolic increases in demand? The outstanding shares in this ETF has gone from about 7 million shares on 10/31 to nearly 63 million shares now.

Treasury bonds should be hitting new lows in yield. Economic and liquidity conditions are as bad as its been since the Depression. Deflation is a more serious threat than its been since that same time. Why shouldn't interest rates fall to record lows? Why shouldn't they stay there?

Yet its fashionable to scoff at Treasury rates, even now that yields have backed up. Some fear inflation, due to the massive stimuli currently being thrown at the economy. But with financial institutions as well as households rapidly deleveraging, there simply isn't enough spending to create inflation right now. Some day I hope inflation becomes a problem, but we're a good ways off from that. Consider that, according to Merrill Lynch economist David Rosenberg, that the balance sheet of U.S. households has declined by $13 trillion. The expansion of the Fed and the Treasury's balance sheet has been only 1/5 that amount.

Others fear supply of Treasury bonds. But the reality is that savings rates world wide are set to increase, creating more demand for safe assets, not less. We don't need to worry about Treasury borrowing crowding out private sector lending. Not now at least.

Finally, the Fed has a strong interest in keeping Treasury rates low. There won't be any economic recovery if mortgage rates start rising. The Fed won't be able to maintain a mortgage rate south of 4.5% if the 10-year Treasury rises above 3%.

And here is a little secret: The securitized mortgage market is about double the size of the Treasury market. It will be much easier for the Fed to manipulate Treasury rates lower than to manipulate mortgage rates!

Income-conscious investors may be loathe to buy up long-term Treasuries at current yields. Those investors should consider any very high-quality non-callable bonds: government agencies, municipals, and some corporate bonds would all make sense.

Tuesday, February 10, 2009

Clumsy and Random Thoughts

Just as Geithner is about to speak...

  • They want to call the Bad Bank an "Aggregator" bank. Does that mean we can call it "Aggie Mae?" I think back to Rod Stewart... "Oh Aggie I wish I'd never seen your face..."
  • The TALF remains an under-rated part of the effort to jump-start consumer lending. The Fed will have a conference call on the TALF on Thursday 2/12 at 3PM. The number is 1-866-216-6835, Access Code 296081

Monday, February 09, 2009

TARP II: Find a way into the detention block!

Details are emerging about the new financial rescue package. Some of the items the Wall Street Journal has reported sound far more market-friendly than what I had feared.

The centerpiece is the bad bank. While not exactly what I talked about last week, this bad bank will be funded with private sector money. Its daring, but if it can work, then I think it will achieve some of the goals I laid out in that post. A privately funded bad bank should involve less government intervention than would otherwise be.

Another key element will be a FDIC-insured covered bond program. I talked about creating a government-backed covered bond program backed by some limited government guarantee. Now it looks like it will be a reality. Basically banks will be able to issue FDIC-insured debt with maturities as long as 10-years as long as that debt is backed by loans. I'd expect this to be restricted to new loans, because the idea is to get credit flowing again.

Remember that covered bonds differ from securitizations in that the debt is an obligation of the issuing bank no matter what. So even if the loans which "cover" the bond go into default, the bank still has to pay. With a securitization, the bank sells all its risk to investors in the securitization. From a moral hazard perspective, the beauty of the covered bond program is that the risk stays with the bank who originated the loans. The FDIC (i.e. tax payers) are only on the hook in the event that the bank goes under. And we're already on the hook for that!

From a "fix" the economy perspective, the covered bond program gives banks a guaranteed profit as long as it can underwrite good loans. The bank's cost of funds for 10-year FDIC insured covered bonds would be about 4.5% (my own estimate, maybe lower). How easy is it to make loans well north of 4.5%? By implementing this program, the government is telling banks not to worry about their funding sources, just worry about lending the money to worthy borrowers.

The last piece of this bailout that I think will really matter is the TALF. Similar to the covered bond program, the TALF will guarantee profits to banks and other financial institutions as long as they can make good loans. Combined with the covered bond program, this should eliminate the hoarding of cash at banks.

The real trick is how the government is going to incent private investors into the bad bank. I think that if the government guaranteed some percentage of the initial purchase value, private investors would come in. I'm not sure how high this number has to be, but there is a number.

TIPS: What know you of ready?

I recommended TIPs vs. nominal bonds in an earlier article. Since that time, the 10-year Treasury is down 4%, while the 10-year TIP is slightly higher. I think TIPs are probably overbought here, and its time to take profits.

First a chart of the breakevens. The blue line is 5-year, the green 10-year and the red 20-years. Breakevens measure the expected future inflation rate as implied by the TIP trading level versus Treasury bonds.

All three have bounced nicely off the lows, with the 10-year breakeven rising from zero to about 1.1%. For a buy and hold investor, that might still seem too low. I still think the Fed's massive expansion of its balance sheet will eventually cause above average inflation reads. But that's probably 1-2 years down the road. Measured CPI inflation could easily be negative, perhaps sharply so, in coming quarters. Will CPI average 1.1% over the next 10-years? Probably not, but it could.

Notice that there hasn't been any confirmation of an impending inflation problem in other markets. Since the 10-year breakeven hit bottom on 11/20 (green line on the chart below), the dollar is basically unchanged (yellow line) while commodity prices have fallen (white line).

If there is really increasing concern about inflation, then the dollar should be weakening and commodity prices should be rising. The fact that these indicators aren't confirming the rise in TIPs breakevens suggests that investors have either become enamored with TIPs, or have abandoned Treasury bonds. If there really were an inflation spike around the corner, we'd have confirming data from other markets.

And it isn't like there has been any encouraging economic news in recent weeks to stoke inflation fears. The key drivers of our current deflation problems is wealth destruction from housing and deleveraging in the financial system. Both these problems continue unabated. We won't get realized inflation until consumers start spending money again. Just look at today's jobs report! Spending will eventually pick-up, but not in the near term.

One can argue that the rise in breakevens has more to do with a sell-off in traditional Treasury bonds than anything else. I think the sell-off in Treasuries is also over done, as investors have become paranoid that increasing Treasury issuance won't be easily absorbed by the market. In a world that is rapidly deleveraging and desperate for safe stores of cash, the U.S. Treasury market will be well-bid. Volitile, due to a lack of market-making,

The bottom line. Eventually inflation will return to the 3% area, and maybe even a good deal higher. But 10-year TIPs are probably fairly valued with breakevens around 1-1.5%, given the fact that the eventual acceleration in prices is a long way off. Given how quickly breakevens have risen, its bound to pull back. Re-establish closer to 0.50%.

Friday, February 06, 2009

I'm back

AI returns after a nearly 2-week hiatus. Well, semi-hiatus as I was traveling and not able to write much. If you've e-mailed me and I haven't gotten back, I'm sorry.

While every one is talking about Monday's big TARP Episode II release, there's been some other goings on. Big news today is the potential for Fannie Mae and Freddie Mac to be taken on balance sheet by the Federal government. This isn't such huge news from a practical perspective, but could radically change debt trading. Imagine if there is no more agency issuance!

More on this on Monday.

Tuesday, February 03, 2009

Bad Bank/Worse Bank

So what do we think of Geithner's Bad Bank idea? Is this the solution that will finally fix the economy? Will this mark a Bottom (tm)?

First of all, the universal bad bank idea is much better than how the TARP is currently being utilized, namely equity injections into private banks. When you have the government actually owning private companies, it opens up any number of Pandora's boxes. Already the government is trying to influence how banks operate by forcing them to lend out TARP injections. That's a terrible precedent.

On the other hand, if the government simply buys certain assets from banks, that could be the end of it. Congress could attach certain rules and regulations surrounding the asset purchases, for example, forcing banks to agree to executive pay restrictions. But once the purchases have happened, that could be the end of it.

If you want to some day return to real capitalism, then we need to figure a way to get through the current crisis. But we also need to do it in such a way that government interference in private business is minimized. As long as government owns banks, that isn't happening.

How should the purchases of bad assets be handled?

I'd like to see it done something like this. We form a new company, call it LoanCo. The Federal Government capitalizes LoanCo with some amount of money, say $500 billion. LoanCo agrees to hold weekly reverse auctions. Each auction is held with specific types of mortgages or mortgage securities. For example, one week might be OptionARMs with a certain FICO range, original loan size range, vintage year and interest rate. The next week would be a different set of characteristics.

Each bank would offer to sell their block of loans at some price, expressed as a percentage of original loan amount. LoanCo would have a pre-determined total amount they will be buying. The purchases would occur at the lowest price that "cleared" the market. Essentially, banks would be giving LoanCo limit sell orders. Bank of America might say they'd sell some set of loans at 60% of par or better. If LoanCo gets all the loans they want by paying 30%, then B of A is left out in the cold. If LoanCo winds up paying 70%, then B of A simply gets better execution.

But rather than get cash for the bad assets, the selling bank gets stock in LoanCo. All interest received by LoanCo is initially retained, but all principal is immediately returned to shareholders. The government guarantees half of the principal in these loans. In exchange, the government keeps all interest payments until LoanCo starts winding down and keeps any principal payments over the initial purchase price. So for example, if a loan was sold to the government at $60 but they eventually recover $80, taxpayers keep the $20.

(Note there is a somewhat similar plan being proffered in today's WSJ. Robert Pozen's idea is similar to mine in many ways, but I like mine better).

The advantage of my system is that banks would get capital relief, as LoanCo stock has a guaranteed value of at least $0.50 cents on the dollar. It would also make investors in banks feel more confident, knowing that the value of distressed mortgage assets can't be any worse than half of its current value.

This would also create a somewhat market-based price for the "bad" assets, at least more so than creating some model to determine a price. There is a good chance that LoanCo would suffer from selection bias. Banks would have to submit loans with certain criteria, but they would clearly pick the "worst" loans that fit that criteria. But in the scheme of things, this shouldn't be a deal breaker.

The downside of this plan is that banks get very little in fresh cash, only certainty as to the downside on their assets. But I argue that's not all bad. If we just give banks cash, they are essentially allowed to grow earnings on the backs of taxpayers. By issuing stock, the banks get the capital certainty they need, but have to figure out how to grow earnings on their own.

And I argue that banks will start lending once the fear of another round of bank runs diminishes. The margins on new loans should be excellent. I don't think we need to dole out free cash in order to incent banks to lend.

And the best part about LoanCo is that its clearly a one-time deal. The moral hazard and long-term government intervention problem is limited.