Friday, September 14, 2007

That bad huh?

Sometimes a picture is worth a 1,000 words. So here is a virtual collage of what a liquidity crunch looks like...

First, the rate on 3-month T-Bills vs. 3-month LIBOR measured in spread. Read this as the amount of extra yield in 3-month LIBOR vs. Treasuries.

Next, Fed Funds target vs. 1-week LIBOR. Both are interbank rates, but one is manipulated and one isn't. I contend that the spike in 1-week LIBOR indicates how banks without access to Fed Funds could borrow. Notice this has normalized a bit.

Finally, the private reverse repo rate with Treasury collateral vs. Government Agency MBS as collateral. Effectively no credit risk in either. Why 60bps more to borrow using the later over the former?

What makes this a liquidity crunch rather than a credit repricing? The fact that there is little/no credit differential in the rates quoted here. And yet the spreads have moved dramatically.


Anonymous said...


What should the Fed do about it if its just a liquidity crunch?

Follow the logic:

-a deep liquidity crunch is harmful to the real economy.

-the Fed should intervene to provide liquidity and prevent spillover.

-the sooner the Fed intervenes, the more effective and less costly the intervention will be.

-therefore the Fed should always intervene the minute liquidity problems arise.

-knowing this, financial firms should use the maximum leverage and duration gap possible.

-the more leverage, the more episodes of illiquidity, the more frequently the Fed must intervene.

-the more interventions, the more trough-to-peak inflation we have.

Interventions are far from costless. The Fed acts like it doesn't know this.

Anonymous said...

I like your blog and am interested in your comment on the following theory:

In my view, inflation was WAY understated by poor government statistics [possibly 2-4 points per year] from 2003-2005, perhaps into '06. Partially as a result, partially because I think Greenspan is politically savvy but a poor economist, the Fed kept rates way too low way too long. That was the main factor in creating the bubbles we are now see bursting.

But I agree with you, that inflation has rolled over and the Fed should and will cut rates. My guess is they will be gradual on the way down as on the way up.

So is the "never counted in the stats" inflation relevant, or just washed away?

Anonymous said...

TDDG -- your charts don't really show a "real economy" credit crunch, they show a leveraged financial market credit crunch. Libor is the rate charged by "top rated" banks to each other. Well regarded S&P companies do not pay Libor flat. Even less so for "Mom and Pop" companies.

Who pays Libor and who pays attention to it? Money managers and money managers.

In June this year, all sorts of portfolios were, directly or indirectly, lending money to mortgage traders, CDO/CLOs, etc. Many were in the great Yen carry trade, borrowing yen at 1% and lending to mortgage accounts at 6%+. Like all carry trades, a huge negative gamma trade.

So along comes August and everyone tries to rush for the exit at the same time. Supply of ABCP and MBS is (materially) unchanged, but demand has plummeted. Economics 101 says price has to fall if supply exceeds demand.

All these carry trades and money managers still have overhead to pay; they MUST invest somewhere. Well, the only "safe" place in town is US Treasuries. Demand for US Treasuries soars -- supply of Treasuries is (materially) unchanged. So ECON101: price skyrockets / yield plummets.

So your graph does not "prove" a credit crunch. It proves that risk tolerance shifted from "risk oblivious" to "risk paranoid".

A few months ago, credit spreads were at all time lows and loans were made that simply had zero economic sense. THAT was the anomaly.

We have reverted to the mean, which is not a credit crunch. No loans for 110% LTV with no documentation would not be viewed as a credit crunch in any historical time frame -- except the last few years.

Its not a credit crunch. Its a return to common sense.

Anonymous said...

While I understand some of what you're saying, having a material gap between agency MBS repo and Treasury repo is an anomaly. And it indicated a liquidity crunch. In fact, none of what you are saying refutes my point that we're in a liquidity crunch. If you want to disagree with my posts, by all means. But your comment doesn't refute anything. We're in a liquidty crunch because of a credit crisis. Doesn't change the fact that 1-week LIBOR deviating from Fed funds makes zero sense.

Finally, most floating rate borrowing, be it small business or mortgage borrowing, is based on LIBOR. So its certainly a relevant rate for any borrower.

Anonymous said...

Most business loans are based off of "prime rate", which is set by banks domestically. Whenever the Fed raises/lowers Fed Funds, Prime rates everywhere "magically" adjust by the same amount (within a few days). I am sure the banks are not oblivious to Libor when they set Prime, but the point still stands that Libor is an interbank offer rate (and even says as much in the name).

Please explain why the inability for borrowers-- who want a 110% zero documentation loan for a property they cannot really afford-- is a credit crunch?

That is what started the snowball rolling. Yes, I grant you that lender losses (or locked up capital) with subprimes is clogging up balance sheets and limiting "regular" loans -- and that is *technically* a credit crunch... but really, its a symptom of banks getting over-leveraged on bad loans.

The solution to over-leverage is not more leverage. Let a few foolish banks fail. It might be a *political* decision to bail out some homeowners (a very unpopular one with those who acted prudently)-- but granting a free ex-post insurance policy to foolish lenders makes zero economic sense (paraphrasing Bank of England's King)

Anonymous said...

Whoops, I forgot a very important point: how can it be an anomaly to have a large difference between Trsy and mbs repo? They are not the same collateral and certainly after this last month I wouldnt expect anyone to argue they are the same credit risk... Obviously, the repo rates are going to be different for different collateral.

Accrued Interest said...

We're talking about agency MBS vs. Treasury bonds. And we're talking about pledging either as collateral for a 1-month loan. The difference in rate should be less than 10bps.

Accrued Interest said...

How about the spread on U.S. Government-backed student loan deals? That's spread out 20-50bps depending on the term.

Or GNMA Project Loans? Those are direct obligations of the U.S. Government. Those are probably 50bps wider.

Or taxable municipals? I'm talking about state and local government obligations. Probably 50-60bps wider in the last 6 months.

I'm not arguing the point that the move in credit spreads is largely a legitimate re-pricing of risk. High Yield, for example, has moved back to fair value, as far as I'm concerned. But its not screaming cheap here. But this is a liquidity crunch.

By definition, a liquidity crunch is where it becomes materially harder to get liquidity. And I'm telling you for a fact that it is more expensive and more difficult to get cash out of any collateral right now.

Anonymous said...

Keep up the good blogging, ttdg.

Just a basic question, pls correct me if I'm wrong.
For a graph showing both a par asset swap and a bond curve (x axis=duration, y=spread, YTM), if the swap curve lies ABOVE the bond curve, can I intepret this as: Swap curve appears Cheaper than bond, therefore, there is a strong demand for longer duration? And vice versa: i.e. if swap lies below bond curve, there's strong demand for short duration (assume all things kept simple as possible).


Anonymous said...


I'd agree with you that High Yield looks OK. Are you surprised at how cheap high quality assets have become?

Anonymous said...

TDDG, why is the fed funds rate at 5.375%? Isn't a rate cut a sure bet?

venkat said...

Ttdg, I guess what you mentioned makes perfect sense. My understanding is that the increased spread between agency collateral vs. the treasury collateral indicates liquidity crunch rather than the risk premium for Agency securities. On the basic level, the increased risk should be reflected in the higher hair cut rather than in increased spreads.

Could it be that the increased LIBOR indicates nothing more than the increased caution among the banks that their counterparts may have a higher than expected exposure in the sub-prime mess?

Anonymous said...

TDDG wrote: By definition, a liquidity crunch is where it becomes materially harder to get liquidity. And I'm telling you for a fact that it is more expensive and more difficult to get cash out of any collateral right now.

OK, so we are in heat wave. Then temperatures moderate. Therefor that proves we are entering an ice age? That logic makes no sense. Of course credit is harder to come by then a couple months ago-- now its back to "normal". For most of the US history, you could really only get a mtge if you put down 20%, had good credit, and documented income. And we are moving back to that.

110% LTV, or even 90% LTV is weird, and leaves absolutely no margin of safety. That is the difference between traders / portfolio magagers of 10-15 years ago versus today; they were risk managers first, leveraged high wire acts second. The last 5-7 years, traders forgot all about risk.

Not sure on what basis you decided that mtge collateral should be no more than 10bp over Trsy. You are not the same credit risk as a money center bank, and TED spreads usually run 30-35bp. Your mtge pool is made up of 1001+ people like you (with the same credit risk). It makes zero sense that your spread would be under 30bp, and in times of dislocation, could easily be many times that.

Your analysis completely overlooks the cost of a rate cut-- bailing out irresponsible traders is not "free" by any stretch. Just for openers, pension funds and insurance companies will need to defease liabilities at much lower rates-- ie at much higher costs.

To see what your "Cut Rates Now!" policy will do to solve uneconomic loans being in default, look at Japan. Fifteen plus years of near zero rates and their economy is still nowhere. Bad loans are bad loans, no matter when the Fed Funds rate is.

As you yourself have pointed out, the effective FF rate has already been defacto cut. It has had limited if any effect, as one would expect.

Accrued Interest said...


By "bond curve" do you mean Treasury bonds? Think of the swap curve as a AA-rated Bank credit curve. If that's not what you mean, post a follow up.

Accrued Interest said...

Anon #?: I'm very surprised at how cheap high quality assets have become. But I never expected a liquidity crunch. I would have expected a credit crunch.

In the bond market, there are some bonds which are just more liquid than others. Often its nothing more than high velocity traders are involved in the issue. For example, MER 6.05 '16 is a pretty liquid issue. I know MER has a 2015 issue too (don't know the coupon), which is far less liquid. It doesn't mean anything other than people pay more attention to the '16's. Right now, the bid ask differential between the highly liquid bonds and the kinda liquid ones has ballooned to crazy levels. That's a liquidity crunch.

Accrued Interest said...

I'm not in my office so I can't look at my flashy screens and tell you anything about the 5.375. Just know that sometimes the Fed allows higher risk banks to borrow from other banks well above the target rate. So you'll see prints 100bps over target, and that's why.

Accrued Interest said...

Anon (who wrote a long piece): I think you are missing an important element of this discussion, so please listen carefully:

1) The fact that its harder to get a mortgage is a credit repricing. The fact that is materially more expensive for the State of Virginia to borrow is non-sensical.

2) Agency MBS used as collateral for repo have always been at similar levels as Treasury collateral for as long as I've been following it. That's many years. I cannot remember seeing a spike like we just saw.

3) Please please please please please understand that I'm not talking about credit-risky MBS, I'm talking about Fannie Mae and Freddie Mac mortgage pools. So my credit or your credit or Brittany Spears' credit doesn't matter one fig.

4) I don't want to get back into this "bail out" argument, because I've posted about it many times and frankly the argument doesn't hold up to scrutiny. Please read the archives and think through your case carefully. Comment again if you can explain who is being bailed out and why its a problem.

Accrued Interest said...


I know a private mortgage REIT who owns only agency MBS. In fact, almost all GNMA, which means that there is literally no credit risk. Banks are taking away credit lines left and right. He says that he can't convince them that he doesn't have sub-prime exposure. That no amount of remittance reporting or what not will convince people right now. Fear rules the day.

NA said...


Dear AI-

I was wondering whether now would be a good time to keep an eye out on Senior Secured Loans which have no exposure to sub-prime related issuances, maintain a diversified source of loans and have low default rates/history of cutting distributions?

Going forward, the market’s decreased appetite for risk, new senior secured bank loans will be issued with more conservative structures, wider spreads, higher collateral coverage and stricter financial covenants.

Anonymous said...

TDDG - To adddress the issue of moral hazard, here's my case of why the Fed's should NOT cut rates at all

1) Inflation is still a threat, especially with rising energy prices. Cutting rates would only add fuel to the fire to what is economically destructive
2) In general, stocks go down when rates go up and vice versa. The economic rationale is, when rates are higher, it implies inflation is a concern, therefore, rational investors discount cashflows at a higher rate because they know the present value of their investment is less. Also, rate cuts will reduce cost of borrowing, which may lead funds to borrow more aggressively to fully capitalize on the subsequent bull market from the rate cuts - we'll eventually be in the same position we are today, but magnified
3) No rate cuts - stocks go down, equity hedge funds (most of whom do not even hedge, but are rather levered long) will be forced to reduce their leverage and/or meet margin, hence no bail-out. Their survival as well as year-end bonus is dependent on rate cuts to further inflate the stock market. On a side note, I really really HATE what these guys on Wall Street have done, by pushing down future interest to imply a rate cut, which is really tieing Bernanke's hands and MAGNIFYING the consequences if he does not cut
4) Fixed-income hedge funds will also be forced to liquidate their levered portfolio because fear of massive default from subprime and alt-a reset,with little refinancing option to bail them out, will lead to major credit sell-off, repricing and higher repo levels
5) But wont' that push us into recession? Possibly. Between slower growth to rein in on inflation and extending this bullish bubble, I'm going to have to go with the former. No rate cuts -> lower stock price -> firms will be forced to cut head-counts to maintain/grow EPS -> higher unemployerment -> greater defaults, even in non-agency prime and credit cards -> recession. This is legimate, but when growth in the last few years has been fueled by unusually low interest rates, a correction is what an efficient market needs, albeit a very painful one

Anonymous said...

Also note, when I say hedge funds, I am also including investment banks (which in recent years, act like hedge funds) who hold onto crappy subprime/alt-a securities on their balance sheet and seriously need a refi wave to help make their terrible investemtns whole again - investment banks would be beneficiaries of a rate cut

Anonymous said...

This Federal Reserve has no integrity - I'm going to find a job at a hedge fund and just take on stupid risk and get my fat bonus at the end of the year

Accrued Interest said...

Yaser: I think that 2H 2007-2008 vintage bank loans will be of far higher quality than 2004-2006 vintage. And you'll get paid more. I think that new CLO's assuming all new loans will turn out to be great investments.

Sigma: I think you make a reasoned argument. I disagree, but I think you are thinking rationally. I think people who claim the Fed is bailing out subprime borrowers are not thinking through the problem.

I will say that in reality, hedge funds are being forced to cut back on leverage right now. I don't think that will change with FF at 4.75%. We'll have to see.

Anonymous said...

"state and local government obligations. Probably 50-60bps wider in the last 6 months."

"The fact that [it] is materially more expensive for the State of Virginia to borrow is non-sensical."

I support your characterization of widening spreads as unusual and am grateful to you for mentioning them in several of your posts.

Just wanted you to see this Florida Municipals article in case you thought the Fed's 50bps cut would ameliorate things.

I think the assault on certain securities (agencies, municipals, etc.) has only started.

Accrued Interest said...

Whether these high quality assets keep getting wider depends on the technicals. We need more liquidity to allow things to normalize. Getting just enough might be tricky, but its not impossible.

Accrued Interest said...

The Florida problem is a legal one and I'm not sure how it plays out. Unfortunately, if the media doesn't understand the bond market generally, it sure as hell doesn't understand the municipal market at all. TFA bonds are basically a legal end-around Florida's consitutional requirement that voters approve any bond issue where taxing power is pledged. Muni guys use the term "general obligation" to mean a situation where a municipality pledges all their taxing power, including the ability to raise property taxes, to pay off the bonds.

The legal theory is as follows: tax payers are ultimately on the hook for any general obligation bond, because the government would be forced to raise taxes if they couldn't make the debt payments. Therefore the voters should approve of the project being funded.

TFA's are backed by a portion of the property tax collection, as opposed to the muni's taxing power. The Flordia court essentially ruled that there was no effective difference.

For what its worth, many (most?) states require voter approval for GO issues. And most states have concocted ways around the voter approval. So we'll see if this legal case has legs.

Anonymous said...

tddg, any thoughts on the reported liquidity crunch in Russia's o/n rates? thanks.