Bad liquidity cuts both ways in municipals

Municipal bonds have posed an impressive rally in the last few days: the Barclays Municipal Index is up 3.78% since 12/15. That is better than either the Treasury market (+1.55%) or the S&P 500 (+0.57%) over the same period. As much as I think munis are a great value here, this rally has more to do with illiquidity than anything else, and it is a stark lesson for anyone looking to trade fixed income over the next year.

First, consider why municipals have performed so poorly recently. The Municipal Index had fallen over 9% from September 11 through December 15 before rallying this past week. During the same period, the Treasury market rose over 7%. Its easy to point to credit worries about municipal issuers, after all, state budget woes are a constant headline. But this can't explain poor muni performance in its entirety, after all, even munis backed directly by Treasury bonds in escrow haven't been immune from the sell-off.

A better explanation is that many of the biggest holders of munis have become forced to raise cash in recent months, particularly mutual funds and insurance companies. In the old days, the broker-dealer community would have bought up these bonds, held them on the balance sheet, and eventually sell the bonds to another customer for a profit. In essence, dealers used to serve a sort of wholesaler function, holding bonds in inventory while looking for an end-buyer.

Today, dealers are no longer willing to hold bonds on balance sheet. This means that if customers want to sell municipal bonds an end buyer must be found first. If the seller needs immediate liquidity, s/he is at the mercy of whatever end-buyer happens to have available capital at any given moment. Not surprisingly, this results in lower prices on bonds.

But that same illiquidity cuts both ways.

Recently, buyers have emerged in the municipal market, spurred in part by the Fed's aggressive rate stance as well as a desire to add duration before year-end. But whatever the reason, buyers are finding that dealers have no bonds to sell. Buyers want to buy at "forced sale" prices, but are finding a dearth of forced sellers.

Now those that want to buy are having to pay prices high enough to entice current municipal bond holders to sell, thus pushing the trading price of municipal bonds dramatically higher in a short period of time.

You can imagine brokerage firms having once acted like a buffer between buyers and sellers. They were willing to buy when the market wanted to sell, and then sell when the market wanted to buy. Now they are acting like true brokers, matching buyers and sellers, but not putting the firm's capital at risk either way.

What does this bode for municipals going forward? Difficult to say. Munis offer very strong long-term value, but the technical picture is cloudy. But this whipsaw trading should serve as a warning to anyone involved in the fixed income markets. The lack of market making activity isn't unique to municipal bonds. The situation is similar in almost all bond types other than Treasuries and large issue government Agencies. And we should expect the same kind of whippy price action in other sectors as well.

It thus represents both an opportunity and a danger. If you are willing to buy when others are selling, you can buy good bonds cheap. This is true in various sectors, from hybrid-ARM MBS, to municipals, to commercial MBS, to corporate bonds.

But one also needs to be careful assuming that fixed-income sectors are moving for fundamental reasons. Right now, to assume that the current muni rally is some sort of all-clear sign is a mistake. The muni market didn't suddenly forget all of the problems facing municipal bonds, both fundamental and technical. Rather certain buyers came into the market, found the primary calendar empty and secondary supply sparse. The result? Higher prices. There really isn't anything more to it.

Mark-to-Market: Discussion minus the Zealotry

Mark-to-market accounting has got to be one of the most controversial topics of the year. Unfortunately, its also rife with bias and downright zealotry. You have on one side apologists for financial companies and/or people looking for a one-trick excuse for the whole financial meltdown. On the other hand, you have people who believe all of Wall Street is just lying and everything they own is worthless.


But somewhere in there is a legitimate, rational debate.


First let's consider what accounting is supposed to achieve. Broadly speaking, accounting should have a few simple goals:


1) Accurately reflect the current economic situation of a firm.

2) Allow for comparison of a firm's results and position over time.

3) Allow for comparison of one firm to another.

4) Be as objective as possible.


Now let's consider how mark-to-market as a concept fits in with these goals. I call mark-to-market a "Liquidation Theory of Accounting." In other words, by marking all assets to where they could be sold, one is valuing a firm based on what it might be worth in liquidation.


This is clearly appropriate with any pool of assets intended to be traded in the open market. But in other assets, it isn't obvious that mark-to-market serves the 4 basic goals above. Take a life insurance company which bought the longest available Treasury Strip (5/15/2038) on August 8, when it was first trading. The position is an offset to their long-term liabilities, say the life insurance policy of a young person. For the sake of argument (and brevity) let's assume that the actuarial life of the policy holder is exactly 30-years, and the accrued interest on the strip will exactly cover the life policy with a small profit.


The strip was trading at $25.6 on 8/8, but is now about $42.5, an handsome 66% return.


But has the life company's economic situation changed? Is that firm 66% better off? We'd all agree that no, it isn't. The basic economics of the firm haven't changed at all. They have the same liabilities and same cash flow stream. If we followed strict mark-to-market theory, we'd mark both the asset and the liability higher, leaving the firm's balance sheet unchanged.


Or would we? Under current market conditions, "selling" the life insurance policy liability to another firm might be possible, but it would be highly unlikely to have the same gain as the Treasury position.


That example is very black and white, and of course, the real world is much more grey. Its easy to use a Treasury bond as an example, where we know the change in market value isn't reflective of a change in asset quality. But where there has been a real change in asset quality, the situation becomes more grey.


But still, mark-to-market still doesn't fully satisfy. Let's say that we have two firms, both have made loans to XYZ Retailer. But one is a bank which has made a traditional loan, and the other is a brokerage which holds a private placement bond. The broker almost certainly has to mark that loan to market, but the bank may not.


And in both cases, the rapid changing liquidity premium in the market place alters the "mark" for this asset. By this I mean, say the retailer is performing reasonably well, and thus the risk of non-payment remains remote. Given the weak economy, its obvious that the risk has increased by some degree, but given the extremely weak liquidity across fixed income products, the larger portion of the assets price decline would reflect liquidity. If the firms don't intend to trade the loan, is the changing liquidity premium relevant?


There are other problems. Say you are a bank that has a private loan to a company with traded CDS contracts. Your best mark-to-market estimate would be to price the loan based on the cost of hedging out the credit risk. But in many cases, the CDS and cash bond markets have decoupled. Many bonds are trading a drastically wider levels than the CDS market, owing in part to easier funding of CDS. Take Amgen, where cash bonds are trading at a LIBOR spread of nearly 300bps, but the CDS are around 90bps. On a 10-year loan, that implies a valuation differential of about 15 points!

So here again, we have a situation where two firms can use "market" prices to price non-marketable assets, and come up with wildly different valuations. We hear mark-to-market and assume that the "market" is some kind of observable thing. But that is just not the case.

I argue that when the current fair value accounting standards were cooked up, a rapid change in liquidity premia was never envisioned. It was assumed that the market would deliver an efficient price which was primarily reflective of the real economic risks of a security. Thus a change in price would reflect a change in risks. It makes perfect sense in theory, but clearly does not reflect economic reality for some firms, nor does is it creating balance sheets which are comparable across firms.


But what's the alternative? Those that are calling for an end to mark-to-market are out of their mind. First of all, there is no clear alternative. Second, we have enough trouble trusting firms' balance sheets as it is. Imagine if mark-to-market were suddenly suspended!

And it doesn't help that so many critics of mark-to-market in the recent past have been managers of firms who were, in fact, fudging the real economic position of their firm.

So I don't know what the answer is. And I don't blame accounting for the financial crisis that we're going through. But I'd like to see some better ideas.

TALF: Quicker, easier, more seductive

The Fed has expanded the Term Asset-Backed Loan Facility (TALF), which AI first discussed here. Here is the quick recap of the facility.

1) Fed will loan funds for purchase of recently issued ABS. This was clarified to mean ABS issued after January 1, 2009 made up of loans no older than October 2007. The ABS must be rated AAA, and be made up of student loans, auto loans, small business loans, or credit cards.

2) Loans will be non-recourse and not marked-to-market. The borrower will not have to deal with margin calls due to price declines.

3) The loan term will be up to 3-years, originally was only 1 year. That is extremely positive for the potential success of this program. See below.

4) The loan rate will be set at "yield spreads higher than in more normal market conditions but lower than in the highly illiquid market conditions that have prevailed during the recent credit market turmoil." In other words, lower than the rate paid on the asset.

So what has the Fed done here? Created an easy arbitrage. All investors have to do is do accurate credit work, and this is a guaranteed profit. Note that the 3-year term seals this thing. 3-years is basically the entire life span of most eligible collateral, so it eliminates the last thing an investor needed to worry about. Given a 1-year term, investors would have worried that the end of 1-year, new financing might not be available. But by the end of 3-years, the asset will be all but gone.

Also through this facility, the Fed can really control consumer lending rates. The rate on newly issued AAA ABS will be stuck at a level slightly higher than the Fed's lending rate. Banks which are currently hoarding cash will fall over themselves to buy ABS and pledge them into this facility.

Now don't read this as especially bullish for the overall economy. I still see this as a facility intended to aide in quantitative easing, and not a "fix" for the recession. Or put another way, a means of preventing the economy from getting still worse. But as far as ABS go? Should get that market rolling again.

Is the Treasury market a bubble?

Yields on U.S. Treasuries have fallen to levels once thought impossible, and we are now hearing the "B" word (bubble) used to describe these formerly staid securities. Just a few days ago I was resisting the bubble label, but with the 10-year dropping below 2.10%, its getting very hard to argue. But more important than assigning labels like "bubble" is to discern what could cause the Treasury market to move in the other direction. In other words, if its a bubble, when can you short it?

First, consider who is driving the Treasury market to these levels. It isn't relative value investors, like money managers and mutual funds. Sure they might hold some amount in Treasury bonds for liquidity and duration management. But these kinds of managers are generally assuming that Fannie Mae and Freddie Mac debt has equivalent credit quality as Treasuries with substantially better yield. So investors who are willing to consider relative value have already reduced Treasury holdings as much as they are likely to any time soon. So selling pressure isn't likely to come from relative value buyers.

Foreign buyers have dominated the demand side of things, buying up just over half of net Treasury issuance in October. Why are they willing to buy at historic low levels? Classically foreign buying of U.S. bonds has been due to recycling of trade dollars. In other words, foreign money will keep flowing into the U.S. so long as U.S. consumers are buying foreign goods. Foreign buying of Treasuries has been especially robust among private accounts (not central banks), which suggests that foreign financial institutions are driving demand.

A slowdown of foreign buying would clearly push rates higher, but in the near term, what would be the catalyst? Note that foreigners have been paying for their Treasury bonds by selling government Agency debt, $50 billion worth in October. This is reflective of a lack of confidence in any security not directly backed by the U.S. Government. The Treasury could make the backing of Fannie Mae and Freddie Mac explicit, but even this won't instantly reverse selling of Agency securities. Foreign trading is notoriously slow-moving, often waiting for bond maturities to reinvest rather than trading their portfolios.

Many of those calling the Treasury market a bubble are ignoring the threat of deflation. Under deflation, normal perceptions of interest rates as well as relationships among interest-bearing instruments break down.

Of course, we don't need investors to sell to create selling pressure. The Treasury is doing plenty of selling of its own. If investors, both foreign and domestic, gained more confidence in financial institution generally, they would move out of Treasuries and into better yielding, high quality bonds. But that will be a slow process. But until this happens, demand for ultra-safe investments will continue unabated, keeping a lid on Treasury rates.

Mortgage Backed Securities: Its a trap!

The agency-backed mortgage sure is tempting. Fannie Mae 30-year 6% mortgage-backed securities are currently yielding in the 4.40% area with just a 2-year average life, based on Bloomberg figures. That looks pretty good compared with 2-year Treasuries at around 0.66% and 2-year Fannie Mae bullet debt at around 1.50%. Now that Fannie Mae and Freddie Mac are owned by the government, one should view these credits as all the same. Why not take that extra yield?


But beware, there is likely to be a massive difference in MBS performance over the next year, as the government works hard to push mortgage borrowing rates lower. When a borrower repays his/her mortgage in part or in full, that repayment is passed through to the investor at $100. With almost all agency-backed MBS priced at $102 or above, investors will be taking a loss on every loan refinanced. Thus gauging the potential refinancibility of your mortgage-backed security as well as predicting the direction of government policy will be the key. This is especially true of those holding agency CMOs, which remains a popular product among individual and bank investors.


First question is, how low can mortgage rates go? According to Bankrate.com, the national average mortgage rate is now 5.57%, with GSE conforming mortgages probably available in the 5.25% area this week based on forward commitment rates. Rates could easily fall much further. The long-term average spread between the 10-year Treasury and mortgage rates is 152bps, the current spread is 300bps. Given that the Fed has pledged to buy $500 billion in agency MBS in 2009 (equal to half of 2008's total issuance), there is every reason to believe the spread between Treasury and mortgage borrowing rates will fall, at least for GSE conforming borrowers.


Currently about 80% of the fixed-rate agency MBS universe has a rate of 6% or above. Under normal circumstances, we'd expect most of those borrowers to refinance. However, conventional wisdom says the combination of declining borrower equity and strict lending standards are likely to mute refinancings.


Yet despite the national average home price declines, most borrowers within the agency universe probably still have strong equity. The FHFA's Home Price Index (formerly OFHEO) has only declined by 4% year-over-year. In terms of general economics, the Case-Shiller index probably better represents the housing picture. But remember that the FHFA index is calculated by looking at homes with GSE mortgages, so its exactly the relevant index for agency MBS investors.


All this leads to a highly divergent degree of refinancability among agency MBS pools. If you have a pool originated in 2007 with 90% loan-to-value (i.e., 10% equity) those borrowers will struggle to refinance in today's tight credit environment. A pool where the original loan-to-value was 75% and which was originated in 2005 might be highly refinancable should rates continue to fall.


Geographics will also be crucial. Only 21 states have actually experienced price declines according to FHFA, with some very large states suffering outsized declines. A pool with mostly Midwest or Southeastern exposure would not have many underwater mortgages, whereas a pool concentrated in the Southwest would. The former will repay much quicker than the later.

Mortgage prepayment speeds are especially dangerous for investors in collateralized mortgage obligations (CMOs). A CMO structure is dependent on prepayment speeds occurring within some range. But what we are likely to see is some pools pay extremely fast while others pay extremely slow. This kind of bifurcation could easily bust CMO structures and leave investors with cashflows wildly different from what was expected.


The big wild card is government policy. There is talk that Treasury might allow for no-appraisal refinancing, basically lending based on original loan-to-value as opposed to current loan-to-value. Debate the wisdom of this policy as you might, it would case a massive refinancing wave that would make 2003 look like a a splash in the kiddie pool.


Are mortgages worth owning? Sure, but beware of the risks. Investors who need more certain cash flows should look elsewhere. Investors focused on income and who are willing to dig into the specifics of a mortgage pool can find great rewards.

Negative T-Bills?

I'm on record as saying that I think Treasury bonds have no logical lower limit in yield. While its conceptually hard to be bullish on the 10-year at 2.60%, the threat of deflation completely changes the game.

However, there should be one logical limit on any bond, and that's zero. You can't possibly be willing to lend money to anyone and lock in a loss on the trade. It doesn't make sense.

So when I heard that there were T-Bill trades occurring above par, I was more stunned that Princess Leia aboard the Tantive IV. Who bought T-bills above par? Why would you enter into that trade with a certain loss when you can simply hold currency at no loss?

And don't tell me the dollar is worthless bullshit, because you aren't better off buying dollar denominated T-Bills if the dollar is worthless. Hell, if the dollar was a problem, Treasuries would be cheap, not insanely rich.

Now normally I'd assume that someone got trapped in a short, but who is shorting T-Bills? Seems like an odd trade.

Anyway, if you know how the hell this could have happened, post a comment.

Lower interest rates and home prices

Calculated Risk is one of the best financial blogs going. Accrued Interest should only hope to get 1/10th of their hits. And the blogging world will certainly miss Tanta. She and I had several e-mail conversations over the years and I learned a lot of very useful info about real-life mortgage servicing from her.

However, I really think CR is lawyering in this post from 12/3. In it, CR claims that lower mortgage rates will not improve home prices, only improve home demand. The crux of the argument is...

But the current buyer wouldn't pay much more, because the rational buyer would realize interest rates will probably not be artificially low when they try to sell, and their future buyer would have a higher interest rate and a lower price.

To me, this argument has a few holes. First, an increase in demand, ceteris paribus, will always increase the price of a good. I suppose one could make some kind of non-linear demand curve argument, claiming that demand is higher at the current price point but does not support higher price points. CR doesn't say that, but it sounds like that's what is being advanced.

To follow his logic, however, is to say that buyers are indifferent to interest rates. If rates are high now, they are likely to fall in the future and vice versa. The data doesn't support this at all. Housing prices tend to rise when rates are low and lending standards are easy. That's exactly why we had the boom we just had!

Now maybe CR is saying that the 4.5% would be obviously artificial since its the product of Fed manipulation. Perhaps. But I will say that within the fixed income community, its is widely thought that mortgage rates are fundamentally too high. With the 10-year Treasury at 2.55%, mortgage rates shouldn't be 6%. At least not for conforming (i.e., GSE) loans. Based on more typical ratios, the rate should be 4.5-5%. If they Fed were to manipulate the loan rate back to its long-term norms, why would we expect the rate to rise precipitously in the future? Maybe because Treasury rates would rise if the economy returned to normal, but then we're back to claiming that buyers ignore rates, which they don't.

Put another way, when the Fed pushed short-term rates to 1% in 2003, did buyers abstain from those low-low-low teaser rates loans? Did they rationally assume rates would soon rise in the future? You and I both know the answer.

Another way to think about it is if a home buyer plans on living in the home for an extended period, why not take advantage of the combination of low fixed rate mortgages and low prices currently available? Even if you assume rates may be higher in the future, wouldn't we also assume that over an extended period, say 5-7 years, housing would also recover?

Now remember that new housing construction is well below normal household creation. So ignoring foreclosures, net supply of housing is negative. Thus, even if 4.5% mortgages can't stimulate enough demand to cause home prices to rise, could it create enough demand to soak up foreclosures? If so, that would certainly be a major step in the right direction, no?

The $10 trillion question is whether the Fed can succeed in pushing mortgage rates much lower. The Fed has plenty of money to do it. Remember that although the entire mortgage market is very large, the Fed only needs to manipulate new loans to change the clearing rate. Comparing the Fed's balance sheet to the entire mortgage market is the wrong comparison. Its like saying they can't manipulate Fed Funds by measuring the entire intra-bank lending market.

All they need to do is announce a target and pledge their full resources toward that target. Mortgage rates will drop down to 4.5% very quickly.

Perhaps CR is thinking in terms of 4.5% mortgages "working" in that it "solves" the housing crisis. As I wrote here, there are no magic solutions that will immediately reverse the home price decline or avoid a deep recession. But there are appropriate measures which can help either diminish the downturn or shorten its length. This is one of them.

That isn't what I had in mind

Lost 500,000 jobs? Almost 200,000 worse than expected? And yet bonds sell off?

This isn't a case of whisper numbers being worse or any such thing. Its a matter of bonds being massively overbought at the same time we're looking at a 3 and 10-year auction next week. Below is the intra-day chart, the green line is the announcement of NFP.

Notice that about 10AM, with stocks off sharply, the 10-year was about 1/2 point lower. It manages to rally to near flat a couple times but basically is down all day. So despite a horrible NFP, every time 10's rally a little, someone is there to short it. I think that's classic pre-auction behavior. I expect a significant sell-off, maybe into the 2.90% area on 10's before the auction, then a rally after that.

And what of the job losses? We are getting a series of extremely bad economic data points from a tumultuous October. The question is whether this is the first salvo of a self-feeding downward spiral, or is it a matter of taking the big pain now so that we see less pain later. In the later scenario, the economy contracts rapidly at the beginning of the recession, then levels out for a while before rebounding.

I don't think its a self-feeding downward spiral, but it could become one. The best policy now is for the Fed to target mortgage rates through open market purchases. Note that just a few days ago, 30-year fixed-rate mortgages were 6%. If they could get down to 4.5%, which isn't out of the question given how low Treasury rates are, that would make a massive difference in affordability. 1.5% interest savings is $625 per month on a $500,000 mortgage. That could start to make a real difference in the housing market.

Until housing turns, the economy keeps getting worse.

Port Authority: You overconfidence is your weakness

The headline is that the Port Authority of New York/New Jersey got no bids on a $300 million municipal bond offering. Its distressing, yes. Its a clear sign of how dislocated the muni market is, yes. But the mainstream media is badly missing the most important aspect of this story. This was a problem entirely of the Port Authority's creation.

Alright, raise your hand if you've heard that liquidity is bad. Oh and raise your hand if you've heard that broker/dealers are capital constrained. Also raise your hand if you've heard that the municipal market is dislocated. Is that everyone? Every person who reads Accrued Interest is well aware of the problems in this market, I'm sure. Keep that in mind as you read the following.

The Port Authority was attempting to sell taxable municipal bonds, which is to the municipal market what the Gungans were to the Naboo. Taxable municipals, while potentially great investments, don't have the natural buyers that tax-exempts (e.g., mutual funds) that tax-exempt bonds do. Taxable munis should trade like high-quality corporate bonds, but tend to be much less liquid, even in good times. $300 million is a lot for any municipal deal, but its a humongous size for a taxable municipal deal.

Next, the Authority tried to do this sale competitively. Basically there are two ways municipalities come to market. One is a negotiated deal, where the issuer hires an investment bank ahead of time. The bank agrees to buy the debt from the issuer and resell it to the public. In a competitive deal, investment banks are invited to bid on the issue. The highest bidder then buys the bonds from the issuer and resells them to the public.

In a negotiated deal, the investment bank has time to work the bonds. The salesforce knows its their deal to sell, so they are more motivated to sell it. In a competitive deal, the salesforce usually only has a hour or two, and if their firm's bid isn't the winning bid, the salesforce has wasted their time. In addition, a competitive deal requires the winning investment bank to immediately and unconditionally buy the deal from the issuer. In other words, commit capital.

So when a competitive deal comes along, what's Wall Street going to do? They are completely unwilling to commit capital to something as low-margin as municipal bonds. So they are going to only bid if they have the deal pre-sold. This has been the case for several months, but has never been more true than right now.

Now if you and I know all this, then surely a big municipal authority like the Port Authority must know all this. And even if they don't, then clearly their financial advisor must know all this, after all, that's what the FA gets paid for. And yet, knowing all of the above, they decide to go forward with a $300 million competitive deal. They decide that Wall Street should cow to their every bond issuing whim. Perhaps they figure that Wall Street takes the PATH trains into Manhattan in the morning, they must be dying to buy Port Authority bonds!

The fact is that the investment community isn't dying to buy anything! Even the TGLP bonds are being sold over a period of multiple days. And those are 100% full faith and credit! The Port Authority apparently scoffed at this fact. Surely investors would scarf up their bonds in mere hours! Right?

I know at least two large Wall Street firms had over $100 million in orders, but couldn't get to the $300 million number before the bids were due. So guess what? They didn't bid. It wasn't that there was anything wrong with the Authority's credit. It was that the Authority decided to pursue a perfectly stupid means of raising cash.

Why did the Authority need $300 million right now? If they had done a $75 million competitive deal, they would have had no problems. They could have done another in 3-4 months. And another a couple months after that. Or they could have done the deal negotiated. Given their bankers time to convince the big whales that 3-year Port Authority bonds at +375 was a great deal. I'm telling you, it would have worked.

But instead, the Authority assumed they were endowed by their maker with the right to foist bonds onto Wall Street. Instead of paying attention to market conditions, the Authority pretended like it was business as usual. Instead of following a sensible strategy for raising cash in a liquidity-challenged environment, the Authority displayed a foolhardy level of arrogance.

And what did they get in return? A lot of egg on their face.

Accrued Interest Job Posting

I know times are really tough in the finance business, so when I hear about a job opening I'm going to pass it on. I have one now that is for a pure number cruncher in the Baltimore area. Hearing they are looking for a couple years experience, and the salary is commensurate. Very small firm.

E-mail me (accruedint AT gmail.com) with your resume if you have interest.

Treasury Rates: Less than your bargained for

T-bills at zero? 2-year notes less than 1%? 5-year notes less than 2%? Locking up your money for 30-years at 3.30%?

If these yields make it sound more like you are donating your money to the Treasury rather than lending it to them, you aren't alone. People are going to struggle to buy anything at such low yields.

But your normal precepts about interest rates are not going to hold in a ultra-low inflation (or possibly deflationary) environment. Be careful reflexively assuming that one should short rates at these levels.

Be especially careful taking your bond allocation into cash at this point. Money market rates are much more likely to fall than to rise. Currently fed funds futures predict an 64% chance that the Fed will cut to 0.5% on December 16, and a 36% chance they will cut to 0.25%. Recently, J.P. Morgan joined UBS and others expecting the Fed to cut all the way to zero eventually. At that point, 2% on 5-year notes won't seem so ridiculous. And the odds are good that short-term rates will stay low for a long time. So holding cash waiting for better yield opportunities isn't likely to be a winning strategy.

In addition, consider the diversification effect. For most investors, bonds are meant to be an offset to riskier allocations. When stock prices fall, Treasury prices tend to rise, helping to at least stabilize one's portfolio to some degree. If stocks continue to fall, cash rates are all the more likely to got to zero. If stocks rise, you won't be complaining about money lost on intermediate bonds!

Of course, ultra low rates hurt income oriented investors the most, such as someone already retired. Those investors really should be looking away from Treasury bonds at this point anyway. 5-year Treasury rates might only be 2% but five-year non-call Agency bonds are still north of 2.75%. For that matter, 5-year municipal bonds are still available at 3% tax free. Agency-backed mortgage bonds carry yields over 5%. These are all sectors where buy-and-hold investors should be able to find bonds with minimal credit risk, and can therefore ignore periodic marks and just collect the income.

So when you see interest rates hitting all-time lows, remember that the U.S. hasn't faced this confluence of deflationary forces since the Depression. Investors are going to need to adjust their expectations about interest rates accordingly.

We need? What about you need?

The Fed's new Term ABS Loan Facility (TALF) announced this week could be a significant step in improving credit availability. While many of the details of the program are not yet known, there is already several take aways.

First, this looks and smells a lot like a back-door way of reviving some of the TARP's original concept. Consider what we already know about the program. Eligible collateral for the TALF will basically include AAA-rated bonds within the major non-housing ABS sectors: auto loans, student loans, credit cards, and SBA loans. TALF loans will have a one-year term and will be non-recourse to the borrower. The facility appears to be oriented toward banks and insurance companies, but may actually be available to anyone. TALF loans "will no be subject to mark-to-market or re-margining" which is a critical part of the program.

Now put these criteria together and consider the effect. A bank may originate loans of the above types, then get funding from the Fed at an attractive rate. There is no need to worry about the funding being taken away suddenly because of changing haircuts, nor is there any worry about interim marks impacting economic results. The originator does have an incentive to make a good loan, since the Fed is going to require some haircut. But as long as the originator can make good loans, the eventual profit will be the differential between the lending rate and the Fed borrowing rate.

Let's look at a real life example. COMET 2008-A6 A6 is a credit card ABS issued in May. The original deal spread was +110bps over 1-month LIBOR with a 2.4 year average life. Currently bonds of this type are trading with a spread of around 600bps, which makes the dollar price of this bond around $89.

Analyzing asset-backed bonds gets complicated because bond holders get monthly principal and interest payments. But in simple terms, the bond is yielding LIBOR +600bps. If the Fed is willing to lend at LIBOR +50 or 100bps, banks will quickly gobble up high quality ABS paper. As a result, the yield spread on this kind of ABS will contract until its closer to the Fed's lending rate. If the COMET bond were to go from LIBOR +600 to LIBOR +300, the bond's price would appreciate by 5.5 points.

There would be two important knock-on effects. First, it would create a price floor for similar ABS which isn't pledged into a Fed facility, alleviating mark-to-market problems banks are currently facing. Second, it will allow for new origination in ABS, which will help rejuvenate consumer credit.

The primary beneficiary will be the ABS securities itself. Next would probably be the bigger holders of ABS paper, which include banks and P&C insurers. Companies involved in securitization will also benefit: credit card issuers like Capital One and student lenders like Sallie Mae. There is already talk that this program could be extended to Commercial MBS, which would benefit REITs tremendously.

Disclosure: Long certain ABS as well as Sallie Mae

Accrued Interest Holiday Edition

Its time for a new tagline for the blog. So in proper geek fashion, I've created a poll. The options are...

Republic credits? Credits are no good out here. I need something more real.

More wealth than you can imagine

That was before the dark times... before deleveraging

Or suggest something else in the comments.

And NOW young monoline... you will die

Moody's has downgraded FSA and Assured Guaranty on Friday, claiming that with the future of municipal monoline insurance uncertain, it is unlikely that any stand-alone insurer could ever get a Aaa rating. I predicted the death of these insurers back in July when Moody's first put both on negative watch. For several months it appeared I was wrong, as either FSA or Assured wrapped approximately 22% of all new municipal issuance from August 1 to today. Assured's stock price rose from $11 to $17. They worked out a deal to re-insure CIFG's muni book. They agreed to purchase FSA. All in all it seemed like there were plenty of believers in municipal insurance.

But Moody's was the only doubter that mattered. Now municipal bond insurance is all but extinct.

Now I've outlined a good case for why municipal insurance should continue to live on. But forget about that. One can also make a case that FSA and/or Assured Guaranty shouldn't get a Aaa rating because of issues related to those companies specifically. But that's not what I want to talk about either.

What bothers me is Moody's assertion that demand for municipal bond insurance might decline and therefore no firm can get a Aaa rating.

Here is the problem with Moody's stance. It has nothing to do with their actual view of municipal insurance. Its painfully obvious that this is nothing more than CYA. Its like a referee doing a make-up call. They completely screwed up structured finance ratings from 2002-2007 or there abouts. And thus they have a lot of egg on their face in regards to FGIC, Ambac, MBIA, etc.

So now they want to act all tough and refuse to give Aaa ratings to monolines under any circumstances. Does this make any more sense than when they were giving out Aaa like business cards? Aren't they essentially making Assured Guaranty pay for the sins of FGIC?

Consider this. Let's say that a new municipal insurer is created and that insurer acquires all the municipal policies from Ambac. Now let's say that the new insurer has enough capital such that if it immediately went into run off, it could pay all realistic potential premiums with a significant cushion. What is "realistic" and "significant" in the previous sentence would need to be defined, but there is no reason why Moody's can't come up with those numbers.

Why can't such a firm be rated Aaa?

Notice how in the above scenario, the firm's ability to generate new revenue isn't relevant. The firm's ability to raise new capital isn't relevant. Its simply does the firm right now have adequate capital to pay its liabilities. Why is that concept so unreasonable?

For Moody's to claim they cannot rate on this basis is a total cop out, because this is exactly how all securitized deals are rated. A securitization is always a closed loop. The ratings have to be based on available capital versus expected losses. Obviously mistakes were made in rating securitized deals in recent years. But for Moody's to claim they cannot rate on such a basis is complete bullshit. Do we need to alter our models? Absolutely. But Moody's cannot on one hand claim to be a competent ratings agency and on the other hand claim they can't estimate muni losses versus available capital.

Municipal insurance benefited both investors and municipalities. Now it will die, all because Moody's doesn't have the courage to rate insurers based on dollars and cents. Instead they are rating based on public relations.

And by the way, why the hell has AGO's stock price risen since this news? They are toast, and I'm short.

My God, they aren't kidding!

The Fed will be buying up to $600 billion in debt and MBS backed by Fannie Mae and Freddie Mac. Yeah, that'll move the market. Today we had Agency debt 30-40bps tighter, swaps about 15bps tighter, and MBS about 35bps tighter.

Here is the quick take from that. I love agency and MBS debt for long-term holders, but I'd probably wait for this to settle out before buying anything. This week is classically a poor liquidity week, and we're living in a poor liquidity market. So every event is going to result in outsized moves. You are smarter to buy on the second round, not the first.

Also this should be effective in lowering mortgage rates. Already I'm hearing borrowing rates should be down around 5.5% after today's move. But given where the 10-year Treasury is, mortgage borrowing rates should be able to drop down below 5%. That would help a lot in creating a refi-wave as well as improving housing affordability.

Meanwhile, Goldman priced their FDIC insured deal today at 3-year +220. Immediately traded down to +200. Morgan Stanley, J.P. Morgan, Citigroup, and Bank of America should all be coming with similar deals either this week or next. As I predicted, this came cheap to Agencies by about 20bps.

Will the liquidity be decent in these FDIC deals? I don't see why not. Will it be as good as Agencies? Not at first. Various funds that have "government" mandates may not be able to buy this paper without some sort of approval from council or a board. That may take a few months, but eventually I think actual "full faith" paper (FDIC) will trade tighter than "implicitly" backed (Fannie/Freddie) paper.

It is entirely possible that the Treasury eventually puts a full faith backing on the GSEs, which would negate the above statement. So I'd say at even spread, I like the FDIC paper. If GSE paper is wider, I prefer the GSE.

Goldman Sachs: General, count me in

The FDIC announced their final rules on the so-called Temporary Liquidity Guarantee Program, or TLGP (Pronounced "Teelgup"). This is the program that was designed to allow banks to issue FDIC insured debt, ensuring that they'd be able to roll over any debt coming due in the coming months.

The key change in the final rules is that the guarantee will now be timely principal and interest. Under the original rules it would be possible for an investment in a failed bank to get tied up in bankruptcy court, and while the FDIC would eventually pay you, there was no assurance as to exactly when.

Already Goldman Sachs says they will be bringing FDIC insured debt as early as Monday, and I'd expect an avalanche of banks to come with new issues in the next few weeks.

This debt will now carry a full faith and credit guarantee for as long as three years (6/30/12 to be exact). Note that similar debt has been issued in Europe, most notably Barclays who did the first deal in the U.K. That deal was priced at swaps +25. I expect U.S. debt to come wider. To me, its got to trade in context of Agency bonds, which are more like swaps +50, Treasuries +165.

There are three interesting wrinkles here. First, the FDIC bank debt will be explicitly guaranteed, while Fannie and Freddie are not. However, I'm hearing the FDIC stuff will have a 20% risk weighting for banks. That's equal to Agencies currently, but there has been talk that the Agencies will be reduced to 10%.

Finally, there will be extensive supply of the FDIC stuff over the next month or so, whereas the Agencies have done very little term issuance. So given the market's poor liquidity, I'd expect the new FDIC issues to have a new issue concession, and therefore price wider than Agencies.

Update on 30-year Swaps

On October 21, I wrote that 30-year swap spreads, which were hovering around zero at the time, was a another sign that lack of liquidity was creating some non-sensical prices.

Now that same spread is -59. Yes, if you want to receive fixed and pay floating for the next 30-years, your fixed payment will be... drum roll... 2.85%.

Initially this was all about hedging of range notes. But there is more to it now. Many long-duration managers, particularly hedge funds and insurance companies, are holding highly illiquid corporate bonds, but they need to maintain that long duration. So say you own a 7-year Comcast bond, but you really want 30-year duration. Its easy enough. You pay fixed on a 7-year swap and receive fixed on a 30-year swap.

More likely a lot of managers are just receiving fixed on the 30-year as an overall portfolio extension trade. This doesn't require any cash commitment assuming the swap has a zero PV at origination. For a manager with a highly illiquid portfolio, that's probably real attractive right now.

3.44% for 30-years? Where do I sign up!?!?

Okay, someone is obviously short the long-bond and can't find a buyer, because not only did it rise 5 points during the regular session, it rose another 4 points after 4PM. Up 9+ points on the day. The yield is a paltry 3.44%

As a tax payer, I demand the Treasury immediately offer to sell as many bonds as the market will bear at this level. I also demand that the Treasury sell any maturity of T-Bills at 0.01% in unlimited quantities. If the public wants to just donate their money to the Treasury, I insist the Treasury take it.

CMBS: This is no cave...

If you are like many of our readers, you are a bond guy and are well aware that CMBS (commercial mortgage-backed securities) are in an absolute free-fall. If you aren't a bond guy, let me be the first to tell you that the CMBS market is in an absolute free-fall. Here is the chart on the Barclays INVESTMENT GRADE CMBS index month-to-date.

Yes... that -19.61 number? That's a percentage return vs. Treasuries. The whole index down 20% month-to-date. Ugh.

The story is no better for AAA-only bonds. Check out the AAA CMBX spread (higher spread = bad).

Readers may remember that I said AAA CMBX should tighten based on fundamental risk if the credit crisis was improving. That's way back when this index was around 220. Now 550. So I'll go ahead and say the credit crisis isn't improving.

Anyway, this sparked an interesting debate among two colleagues of mine. I argued that if I had to blindly buy a CMBS deal full of hotel projects or retail projects, knowing nothing else about the deal, I'd buy the hotels. Its purely academic, because I actually wouldn't buy either. But its an interesting debate, and I think its one that would extend to REIT stocks as well.

Here's my thinking. I believe that the liquidity crisis is passing, but that we're entering into a severe recession. Economic activity of all types are going to contract, so the question is who is better prepared for such a contraction?

Classically hotels have been viewed as more economically sensitive compared with retail. In a recession, business cut back on travel and consumers cut vacations. But they still keep shopping, even if at a reduced rate. Add in the fact that during the most recent recession, hotels were hit particularly hard, as 9/11 curtailed travel even more than a normal recession.

My conclusion is that the hotel sector might actually outperform the retail sector.

Post your thoughts, and remember death is not an option. You have to go to bed with one of these uglies, which one do you choose? I'm also posting a new poll on the same subject.

The New Order

Much has been made of the November 15 deadline for many hedge fund clients to submit redemption requests. While we wait to see what the eventual impact of this will be, let's consider how the changing nature of leverage has altered the the bond market. Bear in mind that fixed income arbitrage was among the most popular hedge fund strategies. In addition, it was a core strategy for many dealer prop desks as well as the foundation of the CDO market. The decline of leverage may permanently alter the nature of fixed income spreads.

Fixed income arbitrage is, at its core, fairly simple. Start with a bond that yields x% (over and above some hedge in some cases), assume one can borrow y% of the par amount at a cost of z%. If the math of all that works out to a reasonable IRR on the residual, the arbitrage works.

These arbitrage accounts were the marginal buyers in the fixed income markets. As long as the arbitrage remained attractive, yields (or yield spreads) would remain within a narrow band. When an investor wanted to sell a bond, even if there was no long-term buyer at the ready, arbitragers would step in and provide liquidity. In this way, leveraged buyers were ensuring that the market remained efficient. Spreads would only meaningfully widen when credit risk increased.

We know it went too far. CDO^2 and SIVs were the most obscene examples. But even reasonable arbitrage strategies, like TOBs and CLOs became too large as a group. They stopped just being the marginal buyer and became the whole market.

That marginal buyer is gone, and isn't likely to come back any time in the foreseeable future. Admittedly, it isn't as though leverage is being pushed to zero in the fixed income markets, but haircuts (i.e., the amount of margin that must be posted) are now such that levered buyers cannot force efficiency. Take something simple like Fannie Mae 5-year bullet bonds. Should have a very small spread versus Treasuries given the government backing of the GSEs, but instead the spread is currently around 1.45%. It seems like an arbitrage.

But in order for an actual arbitrager to realize a decent IRR on the trade, it probably needs to be leveraged 20x or so. Now maybe one can actually get that amount of leverage versus Agency collateral, but what happens if the trade initially goes against you? The potential margin calls would kill you. Its a difficult arbitrage to actually realize.

The consequences for investors are far reaching. First, bonds will be permanently less liquid. Dealers will be going away from making money via bond arbitrage and go back to making money on transaction flow. In order for that to be viable, the bid/ask spread is going to have to stay much wider than in 2006. Odds are good that trading volumes will also remain much lower than was the case in 2006.

Second, yield spreads will probably remain more volatile than in years past. This is because real money buyers, like mutual funds and banks, will become the marginal buyer of bonds. The technicals of real money demand will suddenly become much more important in determining short-term spread movements.

Third, new debt issues will need to have a greater concession to secondary trading in order to get sold. Take a look at Thursday's 30-year Treasury auction to see what I mean. Primary dealers aren't able to keep Treasury auctions orderly in a world where Treasuries in general are in hot demand. The result? The 30-year Treasury priced about 2.5% lower in price than where it was trading the previous day. By Friday morning, it had regained all that it had lost. The same thing will happen to new issue corporate, municipal, and even agency bonds of large size.

In the short term, what should investors consider in bonds? If banks, mutual funds, and other long-term investors are going to be the new marginal buyers, buy what they are going to want. That is high quality, high yielding bonds. This means longer-term or bonds with option risk, such as callable agencies, municipals, and agency mortgage-backed securities.

Finally, if liquidity is going to remain challenging, buy bonds you are comfortable owning for the long-term. If you do buy a corporate bond, assume that it will cost you 3-5% of the bond's value to sell at short notice.