Monday, August 06, 2007

Large leak, very dangerous

The severe illiquidity in corporate bonds of the last several days is no doubt concerning the Federal Reserve. After all, the Fed is the ultimate provider of liquidity, and Bernanke himself has publicly professed his belief that it was a liquidity crunch that perpetuated the Great Depression. Today, there is considerable debate over what the Fed will (or should) say about recent turmoil in the bond market tomorrow.

I think the Fed has been concerned with how tight spreads (and how loose credit standards) had become recently. Not only in the residential mortgage market, but in the corporate loan/bond market as well. Over investment and the subsequent need for a repositioning of capital is a common reason for recessions. So on one hand, many Fed economists are likely relieved to see credit conditions moving toward more normal conditions.

However, the severity of the credit crunch is concerning, and I'm certain Bernanke and Co. are watching carefully. Remember in the fall of 1998, when Long-Term Capital Management collapsed, Greenspan cut rates aggressively to stave off a liquidity crisis. By June of 1999, the Fed was hiking again. That was an obvious case of the Fed cutting to prevent a even wider contagion. This also is a classic example of the so-called Greenspan Put, which was the widely held belief that Greenspan was willing to bail out financial markets with easy money. Didn't happen in 2000-2002, but I digress.

Will there be a Bernanke Put? Tomorrow will tell us a lot. If Bernanke and his economist minions are sufficiently worried about the recent credit crunch, then they mention it in their statement. This would set up the possibility of a cut if things get worse. In turn, this would create considerable comfort in the credit markets. The shorts would get worried that a Fed cut will restore liquidity. The value buyers would see Fed cuts as limiting their downside. I really think a little nod in the credit market's direction by the Fed would go a long way. We don't need credit spreads to tighten, but we need stability. If the credit market can't stabilize, it really threatens to create a serious recession.

I will note, however, that there are a lot of traders expecting some mention of credit conditions in Tuesday's statement. So it may be that some degree of "nodding" is priced in. If so, then it will take more than one Fed statement to actually have any effect. In fact, I'm bearish on Treasuries tomorrow regardless. A dovish Fed statement would ease the flight to quality, while a hawkish statement takes away some of the cuts currently priced in.


Anonymous said...

What is "illiquidity" in the case of corps? lack of trading? price being that done a few days ago? a buyers strike a sellers strike? I do not see that pricing embodying information uncertainty qualifies as illiquidity. There appears to be a good deal of liquidity in stocks and other bonds and forex for example. A rate cut would be using a household hammer in an operating theatre.

Accrued Interest said...

Illiquidity means no trading. Banks pulling credit facilities. That sort of thing.

I didn't say the Fed would cut, just that they'll express an open mind to the idea.

Anonymous said...

Your blog is very informative so maybe you can tell me what I'm missing.
The credit markets are a mess. I guess because of mortgage defaults, as a result of rate adjustments, recasts, and inability to refinance.

I saw a chart of the monthly amount of ARM's that will readjust monthly(in billions)
JAN 07 22 FEB 25
MAR 35 APR 37
MAY 36 JUN 42
JLY 43 AUG 52
SEP 58 OCT 55
NOV 52 DEC 58
JAN 08 80 FEB 88
MAR 110 APR 92
MAY 76 JUN 75

It seems to me absent a huge increase in housing prices, much lower interest rates, and an increase in loan making capacity for subprime loans, we haven't seen anything yet as far as foreclosures go. Maybe you can tell me what I'm missing.
Also I don't see how a 25 basis point reduction tomorrow will change what seems baked in the cake so to speak.
Thank you.

Accrued Interest said...

I don't think you are missing anything. Foreclosures are going to continue to be high. I don't know the source of your data, so I don't know if that's all ARMs or just sub-prime ARMs, but remember that 5/1 and 7/1 ARMs were very popular among prime borrowers as well, and many of those would have actually been qualified at the fully indexed rate. So it isn't like everyone is going to default as soon as they reset.

For a long time, I had been more concerned with borrowers simply spending less once their reset hit. I figured most would refi into a fixed rate loan, but a greater percentage of their monthly budget would bo for housing. That would cause a consumer slowdown and hurt the economy.

I did not understand until more recently how prevelant no-doc loans had become. I really think fraudulent loans is driving the foreclosure rates, and will continue to drive foreclosure rates.

The Fed WILL NOT CUT TODAY!!!!!!! I've seen several sites where people are speculating about this. There is no way the Fed cuts today. I would bet my life savings on it. Bernanke is not in the surprise business.

Anonymous said...

Just like the prospect of a fed tightening last summer would have done very little to stave off globally led inflationary concerns, a fed cut now, or even a hint of it in the statement, would do little to change the credit markets today.

As my discussions have yielded, the fed would have to make a serious loosening effort to have an immediate impact on credit liquidity. Simply 25-50 bps would not get the job done. Given the global growth fueled inflationary interests, there is no way the fed can afford a serious rate cut sequence and not threaten price stability.

For those who side with a cut, to which there are arguments that could be made, to what extent would you expect the cutting to reach.

Accrued Interest said...


I don't think the Fed wants to get credit spreads back to where they were in January. I think they want to create some stability. I think they have the tools to do that.

venkat said...

I have a feeling that Fed would want to maintain the current rates. I think that their focus would still be on inflation. USD has weakened considerably in the recent weeks and for a country which has huge trade gap, it is not an ideal scenario. It costs more dollars now to buy the same imports, which directly contributes to an increase in core inflation. If the Fed cuts the interest rates without worrying about inflation, USD will weaken further as the real rates suffer, which results in a reduction of foreign credit. This will have a disastrous effect on US credit markets. I think that Fed would hate this scenario than the current turmoil in the sub prime sector.

I am not an expert but I feel that the discussion till now is focused more at the market level. My feeling is that Fed would consider both focus more on the macro economic factors and would choose the path which would cause the least damage to the credit markets overall. We have to accept that there have been problems in the sub prime market and somebody has to bear the consequences. I think it would be wishful thinking to expect the Fed to cut the rates to bail out a group of investors who were not diligent enough when issuing credit. Please feel free to correct me.

Accrued Interest said...

My thought is less about bailing out subprime and more about reassuring the banking community that the Fed was willing to act as liquidity provider. Sub-prime is dead. Period. The Fed would never cut enough to rescue sub-prime, if for no other reason that the huge moral hazard problem they'd create. But they can help bring stability to the rest of the credit market. Stability, not improved prices. Just stability.

Anonymous said...

It has been interesting to me to see the fixed income people clamoring lately for a rate cut (or such seems to be the clamoring, punctuated last Friday when I was home sick watching Jim Cramer have a total meltdown about the fed in his 3ept bit he does).

My mind goes back to an economist I saw give a talk last spring when it was the equity people clamoring for a rate cut. He called himself an Inflation Hawk, and referred to that as alternately a dying breed or an endangered species. At that time, people were still calling for rate cuts starting in like June, and his point was there was no way there would be cuts this year given the level of both headline and core inflation.

With both still relatively high, I simply do not see how the fed can even signal easing.

Of course, if the afore mentioned economist is endangered, I must be a dinosaur since I also call for substantial reduction in the national debt following a properly cyclically balanced budget and if I had the power so to do I would engrain "All Hail King Dollar" as the mantra for anyone in Washington or New York with power over fiscal or monetary policy. :->

Accrued Interest said...

I don't know why your economist friend said inflation hawks are a dying breed. I believe the current Fed is full of 'em. Maybe he had a different definition.

Anyway, there is a difference between a sell-off and a collapse in liquidity. I don't know how many commenters here are active traders in the corporate bond market, but I'm telling you, liquidity was extremely bad last week. **IF** this persists, the Fed will get involved. In other instances where liquidity has become as bad as it was last week, (and stayed that bad) the Fed cut. 1998 and 2001 are the most recent examples.

Anonymous said...

Hi Tom,

As a long time professional equities trader, I feel way out of my comfort zone reading your blog. However, I am trying to educate myself on fixed income. Would you be so kind as to give some pointers as to books or resources for a lowly stock trader?

Accrued Interest said...

Besides reading my blog you mean? And my name isn't Tom. Or maybe it is. Whatever.

Anyway, The Handbook of Fixed Income Securities by Fabozzi is the standard. I'd start there. If you have access to institutional fixed income research, Citigroup has a great series of what they call "classic" research. These are primers on various fixed income sectors and/or strategies.

Anonymous said...

thanks for the pointer. Sorry about the name mixup....thats what is listed at the top of the profile.

Accrued Interest said...

I thought my profile was private. Where did you see that? My name is Tom I'm just trying to stay anonymous. Not doing such a hot job so far.

Vivek Vish said...

On the right column of your blog, there's a link that says "View my profile."

Anonymous said...

In an earlier post you commented how bank loan CDO's were less risky than others. With the noise in the market, do you think these "safer" CDOs take a hit? Ultimately I guess it's down to what the economy does and if defaults creep out of the mortgage arena...can these simply be priced down along with other CDO's?

Accrued Interest said...

Damn you technorati!!
Thanks for pointing that out.


CLO's (bank loan CDO's) are, in my opinion, better structures than ABS CDOs. They are less levered and were marketed with more realistic default levels (in general). They also don't have the same correlation problem that the ABS CDOs had, as I posted in an earlier piece.

Anyway, CLOs have been hit, but I'd say its been more in subordinated pieces, and in line with high-yield spreads generally. People I talk to are worried about CLOs more because of contagion than problems with the structure. I'm sure there are people dumping CLOs right now because they're afraid of the structure, but I don't know of any.

venkat said...

Hi tddg,
I was wondering if you can throw some light on why the rating agencies did such a poor job in providing the ratings to the CDOs backed by subprime. It is very evident now that these agencies have given considerably higher ratings for some CDOs backed by in my opinion- junk collateral.
What surprises me even more is that the ratings of some of the most illiquid CDOs have not been changed in spite of this whole turmoil. I would appreciate if you can throw some light on this aspect. Btw, I see that your profile is disabled but enterprising folks can still figure out that your last name is ‘Graff’. :)

Anonymous said...

tddg, technorati is still messing with you at your other (nomenclature) blog, it isn't even necessary to follow the profile link -- your full name is identified as author at the top.

When it comes to CDO's backed in whole or in part by residential mortgages, subprime or otherwise, I've never been convinced that ratings agencies and investment banks modeling these products really dealt with the legal and social complexities inherent in the underlying to say nothing of the structure itself when under stress.

I'm certainly no bond maven but I do know something about systems and it sure looks to me as if adding these structural layers, presumably in an attempt to distribute and/or reduce risk, actually had the (presumably unintended) effect of concentrating and/or increasing uncertainty.

In the world of financial modeling, increasing uncertainty is absolutely the wrong direction to go, at least as I understand it.

Accrued Interest said...

Here is my thought on sub-prime CDO problems:

Anonymous said...

You want illiquidity, try trading financial electricity in the southeast (or even physical a good bit of the time). I can't believe there is any fixed income product whose illiquidity even now even comes close to approximating even normal liquidity there. A good bit of the time there it boils down to if Southern Company does not feel like making a market, there is no market. Period. And then there are a myriad of other wrinkles.

Looking from the outside from that perspective, it looks to me like bids have dried up somewhat for a few weeks and now the fixed income traders are calling for the fed to hold their hands.

After only a few weeks????