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

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

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

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

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

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

CDS could be fair and simple

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The answer is leverage, or a lack of it.

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

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

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

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

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

Managing California's cash ain't like dusting crops

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

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

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

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

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

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

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

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

Credit market indicators that really matter

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

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

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

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

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

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

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

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

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

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

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

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

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

The CMBX is maintained by MarkIt and is updated daily.

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

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

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

Fading fast

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

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

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

I think I got it!

The government is buying shares in banks.

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

Death of capitalism? We'll see.

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

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

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

I continue to like munis and MBS here.

Nevermind...

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

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

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

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

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

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

CDX 11 about 8 tighter.

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

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

We feared the worst

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

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

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

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

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

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

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

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

What is this place?

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


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


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


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

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

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

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

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

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

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

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

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

Why Main Street should support this rescue

You know its bad when my wife, who under normal circumstances immediately dozes off when I start talking economics, is checking finance blogs looking for news on the credit markets. She is getting into heated arguments with friends over the bail out legislation. And to top it off, she's made a request that I explain to non-finance people why they should support a massive bailout of Wall Street. So here is my case. Hopefully regular readers as well as people far removed from finance will find this stimulating if not convincing.

First let's think about how modern lending works. Pick any type of loan: student loan, car loan, credit card, home mortgage, small business loan, etc. Any time a loan is made, whether its to pay for meal with your credit card or to pay for tuition, someone actually has to come up with the cash to lend to you.

Where do lenders come up with this cash? Primarily three places.

1. Deposits.
2. Borrowing from investors or from other banks.
3. Securitization. This means that the loan isn't held by the lender, but sold to investors.

Lenders don't want to use deposits to make loans right now, because there is serious risk of depositors suddenly demanding their cash. Remember that banks don't ever actually have enough cash to give all their depositors their money on any given day. So when depositors are nervous, banks are nervous.

Normally if too many depositors happened to take money out (not in a panic, but just by happenstance) the bank would simply borrow cash from another bank. That's nearly impossible right now. Banks are generally unwilling to lend to each other. Banks can still borrow from the Federal Reserve, but they are so desperate for cash right now that they are accepting any interest rate, and the Fed is finding it nearly impossible to control short-term interest rates. Today banks took overnight loans from the Fed at 7%, 3 1/2 times the target rate set by the Fed. This is historically unprecedented.

Banks also cannot sell loans to investors. Even loans that are backed by governmental guarantees, like certain student loans, are not sellable in the current environment. Forget about automobile loans or business loans.

So if banks and other lenders cannot get cash, they cannot lend it. So what? Isn't our society doing too much borrowing as it is? Maybe, but let's consider the consequences of a world with no lending.

First of all, there would be no housing market. Very few people can buy a house with cash. Housing prices would continue to fall for many years. The result would be that people would almost universally live in rented housing. Wealthy land lords would own all the housing in America, and would reap all the profits from rentals.

Second, there would be no secondary education. Like housing, the vast majority of people need loans to get a college education. Granted, colleges would probably pare back on the quality of the education offered in an attempt to lower their costs. Even so, it would likely be that only wealthy people could afford college. The income gap in our society would increase as a result.

It would also be extremely difficult for average people to start a new business. Most businesses require start-up capital, most of which is normally borrowed. In addition, many small businesses need working capital, which allows the business to make payroll while waiting for accounts receivable to come in. So here again, only the wealthy would be able to start new businesses.

How will this bailout help? Mostly by creating a outlet for banks to sell "troubled" loans. What constitutes "troubled" isn't yet known. But suffice to say the Treasury will mostly be buying mortgage loans that probably shouldn't have been made in the first place. The price paid to the bank will be less than face value, thus the bank will suffer losses. Hopefully enough of these loans will recover their full value that tax payers do not suffer large losses.

But its a mistake to assume that, as tax payers, we aren't already on the hook for this mess. Currently there is about $8.6 trillion in assets that the FDIC insures. The truth is that the FDIC is ultimately funded by tax payers. So as tax payers, we are already on the hook for bank's behavior. And for way more than $700 billion.

In addition, municipal governments are suffering greatly in this crisis. Not only are their facing the prospect of decreased property tax assessments, but the cost of funding municipal projects has skyrocketed recently. Today, 7-day floating rate municipal bonds are carrying interest rates above 8%, breaking all records. Who will ultimately pay for these extremely high interest rates? Tax payers.

I completely understand the visceral anger that many Americans feel about the situation we're in. I'm sick over the fact that its come to this. But this is what it's come to. We would be foolish, as Americans, to destroy our long-term economic prosperity just to satisfy our righteous anger with Wall Street.

If we don't do this bailout, Main Street will pay anyway, and pay much more dearly. So I would encourage you to write your Representative and tell him or her exactly that. You are angry at Wall Street, but you also want to see some justice for Main Street.

Fell free to e-mail this or send links as you'd like. I don't really care about getting credit.

What would ya like?

Does the TARP mark the death of capitalism? To some commentators, apparently it does. To be sure, this kind of massive government intervention is the last thing any real capitalist wants to see. But is what we have now any better? Let's think about why we like capitalism as a concept, then consider whether this market even remotely resembles capitalism.


Free markets are supposed to efficiently allocate resources. If there are too many pizza places in your town, but not enough auto mechanics, the free market is supposed to drive one of the pizza places under and encourage entry by an auto mechanic. While we may feel for the proprietor of the pizza joint, we know that in the long run, we're all better off when the market is allowed to move resources away from the pizza business.


But we don't want to see the pizza guy forced to close shop because of some external dictate. We want to see a vote held to decide whether we have too many pizza shops in town. We want all the pizza places to compete for business, with the better competitors enjoying strong profits. In fact, we don't even want to see the weaker competitors driven under. Ideally, the weaker competitors will improve their operations and become stronger competitors. But if not, then indeed one or more of the pizza restaurants will undoubtedly go under.


So what kind of world are we living in now?


Let's take a hypothetical investment bank. We'll call it Merrill Brothers (MB). MB became involved in underwriting a series of commercial real estate loans during 2006 and 2007. MB retained some subordinate interests in these loans, as management believed these projects were attractive investments.


Some of these were for condo deals, which is obviously not the best place to be now. Perhaps given the benefit of hindsight, MB wouldn't have entered into the condo deals at all. But it is what it is. MB's management needs to decide what to do about the loans now.


I think in a real capitalist economy, MB would be given the chance to live or die based on the actual performance of these loans. Why? When any bank makes a loan, their credit analysis is based on the perceived odds of the loan remaining current. The capitalist system should reward the banks that make good underwriting decisions based on this criteria.


But in today's market, MB would not be given that chance at all. In terms of mark to market, all credit-oriented securities have declined in value from 2007 to today. Obviously a loan for a condo project would have declined significantly in market value. Forget, for a moment, why these loans have declined in market price and/or whether that decline is reasonable. Let's just stick with the fact that the market price is lower than the original price.


Let's assume that MB's management absolutely loves their loan portfolio, but the market believes their loans are only worth $0.60/dollar. And many will question whether $60 is a good price. But if MB plans to simply hold the loan, what does the market price matter anyway? It really shouldn't. MB should have the chance to live and die by the economic reality of their lending decisions. Not the market's perceptions of those decisions.

Now perception becomes reality as the continuous negative headlines cause trading partners and lenders to back away from MB. In the end, MB either fails or runs to some better capitalized partner. But ultimately it isn't a capitalist ending at all.

Think of it like a poker hand. There are two queens and a 10 on the board, and you have a 10 in your hand. Your opponent is betting the hell out of it. Sure seems like he's got a third queen, and maybe the best play is to fold. But should the other players at the table step in and force you to fold? In a free market, you can bet, raise, or fold, no matter what other people say.

So now we're faced with to non-capitalist paths. On one hand, the current situation. On the other hand, a government bailout.

The bailout will create some semblance of confidence in financial institutions and their balance sheets. There will be some increase in lending capacity. There will be some end in sight for declining home prices.

If there is no bailout, then what? When do things improve? Does the commercial paper market shut down? Is it possible to leverage trading books? Can anything be securitized?

So as much as we all hate the idea of a government bailout, we really need to consider what kind of capitalism we think we're defending. I'd love to hear more about long-term solutions to our problems. But in the short-term, we have to stem the relentless waves of fear. Before its too late.

Stock shorting isn't the problem. CDS are.

There has been much hubbub over the SEC's new naked short-selling rules. Now, I've got no problem with enforcing some basic short-selling rules, but it won't make a difference until something changes in the credit-default swap (CDS) market.

Let's stipulate that speculation and manipulation is part of the problem here. Let's stipulate that John Mack is right and that if Morgan Stanley were to go down, it would be solely because of short-selling.

To make that claim, you have to assume that pressure from short-sellers is feeding upon itself. That Morgan's falling stock price is creating panic, bringing out more sellers and causing more panic. But if you really want to create panic, the CDS market is a better choice. In stocks, you can always offer a stock below the current price, and that may spook people. But the CDS market is traded over the counter. The trading volumes are unknown. Bid and offer sizes are unknown. In such an environment, anyone can throw any bid or offer out there and move the market.

In addition, buyers and sellers need to be matched in this market. In a time when there are few sellers of protection (the seller is effectively long a credit), eager buyers of protection can move the CDS market wider extremely rapidly. The general lack of knowledge about the CDS market doesn't help either. Media reports suggesting that a particular "expected" default rate is predicted by a certain CDS trading level shows a complete misunderstanding of the CDS market.

What could be done? The first step would be to move CDS trading to an exchange. This would allow for more disclosure and less mystery. It would also reduce all the country-party confusion that has surrounded AIG and Lehman and eliminate the need for novation.

Second, make the CDS contracts more standardized. Currently many CDS players don't actually close out their contracts, but rather buy off setting contracts. As a result, any given contract becomes less liquid than it really should be, which makes price discovery all the more difficult.

Another step would be for market makers in CDS to increase the margin requirements on CDS trades. Margin requirements on CDS are set by individual investment banks, but there is no reason why there couldn't be a coordinated effort on this. Increasing collateral requirements would force protection buyers to be more judicious about which names they short. By the way, having an exchange would make monitoring collateral requirements much easier.

There may be other solutions to the CDS problem, some of which will take time. But the steps I've outlined could get done quickly. And they need to be.

Resolution? Trust? A Jedi seeks not these things!

I hate to say it. But we need this. There needs to be massive government intervention to create some degree of confidence. It would be one thing if Lehman and Merrill and WaMu and AIG all went under (or were taken out under duress). But now they are coming for Morgan Stanley and Goldman Sachs.


That just can't happen.


Look, the financial world is a confidence game. Even simple trades involves confidence. You put your money into a Merrill Lynch account and buy a stock, you assume they're holding that stock. Hell, you assume the money market fund they use is safe. You assume your bank will be able to cash your checks. Etc. Etc.

Once that confidence is lost, the system can't continue. Everything will break down, and I mean everything. Our whole economic system would collapse.

Spare me the moral hazard arguement. What about the reverse? Should Goldman Sachs pay for the sins of Bear Stearns? Should Morgan Stanley pay for the sins of Lehman Brothers? Look maybe no one is completely innocent here, but it seems to me that Morgan Stanley is petty theft whereas Bear Stearns was a serial killer. Should we execute both?

Its sad that its come to this. But I don't know what else we were supposed to do. I want to live in a Libertarian/Capitalist paradise as much as anyone. But if we waited for the market to figure all this out, we'd be left with no capacity to finance anything. Our economy just won't work like that. No capitalist economy could. Its called capitalist for a reason. We need capital to make it work.

Bonds are highly illiquid right now. Even Treasuries are showing unusual bid/ask spreads. There are many many many players who are going to be caught on the wrong side of this thing. On top of that, there are many players who are going to (quite reasonably) want to flatten their positions and wait to see how this plays out.

In corporates, especially Goldman and Morgan, potential sellers have disapeared so as far as I can tell, little is trading currently. CDS are gapping tighter of course. There will be a serious short-squeeze in CDS before things stabilize.

Some hedge funds are going to get crushed. I mean, anyone who was leveraged short financials may wind up getting busted out. That will result in some weird trading in seemingly unrelated instruments. Hence, I think you would be wise to not chase this move too aggressively. If you can find stuff that's lagging merely because it isn't getting any attention, fine. But don't over play it.

Personally (not professionally) I'm looking to reset a dollar short I've had. While this may be the right move for the economy, it isn't good for our currency.

Lehman Brothers: Bounce too close to a supernova

I have nothing to say about Lehman itself, except to say that I really and truly believe they could have remained solvent in a more normal market. I'll also say I'm surprised no deal emerged as it seemed to me like there were enough parts worth buying. But deep down, I think Barclays in particular was scared that if they bought "Lehman" assets, the market would have seen it as nothing more than "Lehman" assets. In other words, Barclays might have gotten away with buying the same assets from someone else, but the very fact that they were Lehman's would create a special stain. What would then stop them from coming for Barclays? Ultimately, it was too risky.

On the market overall, it should be lower. Goldman and Morgan Stanley are going to have to merge with a bank. Period. Even if its a bank that's smaller (say a U.S. Bank), it will have to be done to diversify their funding sources.

This also pushes back any kind of recovery for the economy for a long time. I was thinking 3Q 2009, but now I'm thinking at least a year beyond that. I could be convinced to move off that either way by incoming delinquency figures, but for now I'm thinking year-end 2010 before any improvement in the economy.

So I've further reduced my credit underweight and increased Treasury exposure. The risk on Treasuries is the dollar. Most of the Treasury rally in September was dollar related up to today. For the moment we're getting a big rally on fear, which makes sense. But if the dollar starts to get pushed around, the Treasury market won't hold up.

Right now I'm willing to bet on Treasuries because I don't think Europe is any better off, and in fact I'd expect interest rate differentials to favor the U.S. on the margins (i.e., Europe will cut rates). But the situation is fluid enough to where I'm watching everything very closely.

This is truly uncharted territory.

Fannie Mae's new Debt: Look at the size of that thing!

Fannie Mae sold $7 billion 2-year notes this morning at Treasuries +70. The deal was oversubscribed. Here are the distribution stats.

US: 63%
Asia: 12%
Europe: 8%
Other: 17%

By type...

54% Money managers
27% Central banks (!!)
19% Other

The 27% Central Bank number is really helping Agency spreads tighten. We're 5-6 tighter, with MBS mildly tighter as well.

Dunno what to say about Lehman. Seems obvious that Fuld has given up the quest to remain independent and is looking for a buyer. That's why they are doing this spin-off of commercial real estate. Once they do the spin-off, then they are basically just a bunch of investment bankers without all the balance sheet ugliness.

Some are skeptical that finding a buyer is possible, but all Lehman needs is someone who has a stronger balance sheet and can take reasonable risks, and the firm can be plenty profitable. It will probably be someone who wants to rapidly increase their presence in the U.S. HSBC has been mentioned, but denied interest. Or Nomura. Either way, someone like that should have interest in Lehman at some price. Remember, it will only take about $4 billion to buy Lehman at current market prices once you take out the commercial real estate holdings.

I'd rather buy Lehman than WaMu. There was a time when several banks were interested in WaMu, but bear in mind that WaMu's whole business is West Coast banking. Maybe J.P. Morgan would still be interested at some price, but you have to wonder JPM wouldn't rather hunt for another West Coast bank with fewer problems. There are accounting issues, which the media has been talking about all day, but forget all that. Do you really think buyers are saying "I'd love to own WaMu, but the accounting is tough." No, I think they are thinking, "I'm not really interested in WaMu, and I'll tell the media its because of accounting."

MBS: Marching into the detention area

While many expected the Treasury to eventually act on the GSEs, few (including myself) expected it to happen over the weekend. So what's the trade in fixed income? There have been four major ideas bandied about Wall Street over the weekend. They are: buy agency debentures, buy agency MBS (mortgage-backed securities), buy credit, and sell Treasuries.

The one I like the most is buy MBS. Yesterday MBS spreads moved dramatically tighter, 55bps in OAS (option-adjusted spread) according to the Lehman index, from +147 to +94. But you haven't missed it yet. For most of the last 10-years, the index OAS has been between 30 and 60bps, so there is plenty of room to tighter further in OAS. I've always felt as though OAS was an over-rated value metric, but today its especially questionable. The Treasury has announced their intentions to buy MBS in the open market, with the clear goal of pushing mortgage borrowing rates lower. Ideally the Treasury would like to set off a refi wave, which would help banks "naturally" delever as well as help separate good loans from bad. In order to get most 2006-2007 borrowers "in the money", mortgage rates probably have to fall to around 5.25%. I think this implies another 50bps of MBS tightening.

Buying agency debentures is less intriguing. Right now non-callable agencies are trading between 50 and 60bps more than comparable Treasury bonds. This spread might fall into the 20's for short-term bonds, but it won't collapse to zero. We don't currently know what the GSEs will look like after 2009, and therefore bonds maturing beyond 2-years shouldn't (and won't) be viewed as truly government-guaranteed.

Credit is highly questionable here. The large-cap financials should benefit significantly from a mortgage refi-wave. This would get the "good" loans off bank's balance sheets, freeing up capital, and clarifying how much each bank truly has in good versus bad loans. But the real catalyst for finance credit will be bank earnings which isn't until next month. Obviously the Lehman situation isn't helping either. Buying new issue bank credits isn't a bad idea as a trade but I'm staying underweight for now.

Non-finance credit makes even less sense. The GSE bailout may have been necessary, but it isn't a panacea for the real economy problems we're facing. I'd stay very high quality within credit.

The direction of Treasury rates is also questionable. There remains significant dollar-related buying, as evidenced by the strong bid for the 10 and 30-year bonds in recent sessions. That is a classic sign of foreign bank buyers, especially given the fact that economically, the yield curve should probably be steeper not flatter. There is also no particular reason to believe the GSE bailout results in dramatically more Treasury supply. Not to mention the simple fact that the economy remains weak which should be a natural support for interest rates. I'm staying close to home on duration.

Nevermind...

Remeber like 4 hours ago when I said it didn't look like anything was going to happen with Fannie and Freddie? Yeah... what I meant to say is that something could happen this weekend! At least that's what the Wall Street Journal is reporting.

Anyway, we'll see what it looks like. I still think that its most likely that the companies have agreed to whatever the Treasury is about to do, so it can't wipe out shareholders. Some capitalist president this dude turned out to be...

Unfortunately, the effect is going to be Treasury rates selling off and MBS rising, which isn't how I'm set up.

Did you catch Bill Gross on CNBC just now? They asked if he had been approached by the Treasury about any government-led solution, presumably asking if PIMCO would participate. Gross said he couldn't comment, which means the answer is yes. Hmm... wonder why no one asked Accrued Interest!?!

Anyway, its possible that this turns out to be a rotation moment, because a bailout of Fannie and Freddie doesn't solve our real economy. It does help prevent it from getting worse, but it doesn't solve anything. But it should help bring mortgage rates down, creating liquidity for financial firms. Could also improve risk aversion, which would help financial firms raise capital or at least sell debt. So we could see a period where financials outperform industrials.

GSE Bailout: Episode III

In recent weeks, a GSE bailout has seemed less imminent. Not because anything is getting better, but because it appears that the Treasury lacks the will to make a move. To be fair, the way the authorizing legislation is written, the Treasury cannot make a move without either the GSEs falling below their capital minimums or compliance by the companies. Based solely on how the company's are valuing their assets and liabilities, their capital position is well above regulatory minimums (especially Fannie Mae).

Now many believe that F&F's asset values are inflated, and perhaps that's true. But what do we expect? Will the government come in and audit the companies, write down their assets and then nationalize? It seems far fetched.

So if there is going to be some near-term action on strengthening the GSEs, it will have to come in a form to which the companies would consent. Ergo, it can't be something that would punish common shareholders.

I think that leaves three options. First would be to do nothing and see how things develop. Let's get back to that one later. Second would be for the Treasury to start buying loans and/or securities from the GSEs to reduce their liabilities. I talked about how this could work here.

Third would be for the Treasury to help the GSEs raise private capital. What if the Treasury agreed to guaranty the principal (not the interest) on a preferred stock offering. The size would be whatever is determined to be needed. In reality it might not be a single preferred offering, but a series of offerings with some pre-determined limit as to the total size.

The preferreds would be callable after 5 years, with the call becoming automatic if the GSEs share price reaches some milestone. The idea would be that if the GSEs are able to issue common equity, then they would be forced to call the tax-payer backed preferred and issue their own securities of some variety.

The Treasury could charge some fee in exchange for the guaranty. Say its an interest rate equal to the 30-year Treasury bond rate, currently about 4.25%. What interest rate the preferred would carry to investors would be determined in the market, but I'd bet somewhere in the 6-7% area.

Here are the advantages of such a plan. First, it could be implemented right away, allowing for stability in the mortgage market and likely a decline in mortgage lending rates. Second, its probably a cheaper plan for tax payers when compared with other options. We know that F&F's new business will be profitable, so if they can be stabilized with a capital injection, the odds that tax payers actually have to shell out any cash is low.

Unfortunately, this kind of solution has a number of problems. First, it creates all kinds of moral hazard, as common equity holders wind up benefiting from the tax payers risk. Currently Fannie Mae and Freddie Mac preferreds are trading with 15% yields, and a new issue, if possible at all, would certainly come at a discount to current levels. So under this plan, the GSEs would be able to issue preferred equity about 500bps cheaper than would otherwise be.

Second, this plan doesn't move us any closer to a more permanent solution to the problem of macro risk and the GSEs. Its a plan that, while easy, doesn't really get us anywhere in the long-term. I suppose such a plan could be an interim step on the path toward full privatization, the idea being to stabilize the market now, buying time for a long-term solution.

Its looking to me like this administration won't do anything about Fannie Mae and Freddie Mac unless they are truly forced to do so. The closer we get to a new administration, the more likely that Paulson waits and lets the next Treasury secretary make the call on the GSEs. So I think we're in for another 6-months of the same with the GSEs. Its always possible that something happens in the interim that diminishes risk aversion and subsequently allows the GSEs to raise capital privately, but I'm not optimistic.

Would I buy agency securities given this outlook? Yes. Senior debt and MBS, but I remain underweight both. I'm probably negatively exposed should a full-on bailout occur. But that's a risk I'm willing to take.