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.

Told you about the long bond...

30-year Treasury up 2 1/2 points this morning. Told ya so. Wouldn't be surprised to see it get down to 4.15% but there is resistance there.

Meanwhile, Assured Guaranty, the insurer I pronounced dead a few months ago, is buying FSA. Might be more accurate to say Dexia is dumping FSA. More on this as I get more info on the transaction. Anyone who is hearing anything about this should e-mail me: accruedint AT gmail.com.

30-year auction: They're just not in demand anymore

The 30-year auction was... something less than good. You don't need to hear any of the auction statistics (which can be deceiving, don't trust them). Just look at the trading action. See if you can guess when the auction was held...

The subsequent large rally in stocks didn't help and left the 30-year down 3 points on the day. For most of the day the 10-year held in until stocks really got going, and is now down more than a point.

I'm positive you'll see a bunch of media yakers claim that this is evidence that no one wants U.S. bonds. Bullshit. If that's true why is the 2-year threatening to break 1%?

The reality is that even the U.S. Treasury isn't immune from the deleveraging contagion. The Treasury used to be able to count on primary dealers to take down all their bonds. Dealers are crunched for capital. Plus what capital they have isn't getting committed to low margin business like inventorying Treasuries.

Look for this Treasury supply to get digested over the next 5 trading days, and the 30-year will be right back in the 4.15% area.

Asset-backed securities and the future of consumer lending

So... no buying of mortgages from banks in the TARP. What are they doing?

On the same day they pulled the rug from under our banking system, Treasury announced they would be "exploring" programs to improve liquidity in the AAA-rated asset-backed security (ABS) market. Although securitization has in many ways been a big part of the problem, revival of the ABS market would make a big difference.

Remember the covered bond idea? Its a structure used extensively in Europe where a bank pledges a pool of mortgage loans to "cover" a piece of debt. In theory, the bank enjoys a lower interest rate on such debt because it is both a general obligation of the bank as well as "covered" by the mortgage loans.

In July, the Treasury proposed covered bonds as an alternative to the traditional securitization markets. It never really got going in large part because the corporate bond market continued to deteriorate, and thus was not receptive to new products. But the idea was sensible enough. Covered bonds better align the bank's incentives with the investor, because the bank remains on the hook for the debt no matter what. This is in contrast to a straight securitization, the bank off loads all the risk to investors.

From a macro-economic perspective, a vibrant covered bond market would have allowed banks to lend knowing there was a ready source of cash. Banks will not lend until they are confident in their sources of cash. If the covered bond idea is dead, for now anyway, perhaps the ABS market can pick up the slack.

Historically, ABS have typically been backed by consumer loans, including credit cards, auto loans, home equity, and student loans. ABS were typically structured with a senior/subordinate credit enhancement, meaning that certain tranches of the deal would take losses first and only once those tranches were wiped out would other tranches take a hit.

Of course, there have been numerous problems with the ratings agencies allowing too little in subordination in certain deals. But there is nothing inherently wrong with the senior/sub concept. In fact, if its kept as a simple sequential loss structure, analyzing the credit of an ABS deal becomes relatively straight forward: its just losses versus available subordination. Sounds a hell of a lot more transparent than trying to decode a bank's balance sheet!

So what if the ABS market could be revived? Lenders who could not access the unsecured debt markets could access the ABS markets, raising loanable funds. If the lender also kept a sizeable residual on the deal, the result would be similar to the covered bond idea.

Many companies would benefit directly from an improved ABS market. Credit card issuers, such as American Express, Citigroup, and Capital One. Student lenders such as Sallie Mae. Even the autos would benefit, although obviously the GM and Ford situation is much deeper, Toyota and Honda would also benefit.

It wouldn't solve all our problems. I still wish they were buying mortgage assets. But this is better than nothing.

AI to Paulson: A Jedi must have the deepest commitment

Hank... Hank... you've got to be kidding me. Its clear to you that buying illiquid mortgages "is not the most effective" way to use the TARP. Seriously. Can some one please let Secretary Paulson know that mortgages are, in fact, the crux of the problem. Why do we have a problem with banks lending to each other? Because no one trusts anyone else's balance sheet. Because the mark-to-market price of mortgage assets just keeps falling.

Let's talk about the reality here. This doesn't represent a shift in strategy by Paulson. Banks have forced his hand.

There was whispers for a week or two that banks didn't want to participate in the TARP asset purchases. As individuals, they can't see the incentive. Its a classic free-rider problem. All banks would benefit if all banks participated, but each bank looking at its own situation individually isn't incented. Or more accurately, it isn't clear whether a bank would benefit individually or not, and given all the strings attached to participation in the TARP, banks are passing.

So where does this leave us? Worse. Undoubtedly worse.

We'll still get through this, but now you have to figure that home prices will bottom well in advance of the general economy. Why? Consider a possible progression:

1) Home prices bottom. Put whatever time frame on this that you'd like. I actually think it could happen sooner than many expect, but I digress.

2) Home lending is relatively robust for borrowers with good credit (It must be, or home prices wouldn't have bottomed!), but this is solely because the GSEs are there to securitize these loans. If the government is actively supporting the ABS markets, then credit card, auto and student lending markets will be performing OK as well.

3) But actual bank capital will remain challenged. By the time home prices bottom, banks will have taken more losses on foreclosures and commercial loans. And beyond the TARP, most banks will not have been able to raise significant outside equity capital.

4) So commercial lending will become very rare indeed until such time as banks have rebuilt their capital base. Therefore new business formation, acquisitions, capital projects, all will become difficult if not impossible.

What kind of economy does that leave us with? A long recession that's what. Recessions are caused by misallocated economic resources. Some businesses need to downsize or be eliminated, and those resources need to be allocated elsewhere. The recession is the pain that occurs in between.

But resource reallocation takes capital. And if banks won't lend, its going to take a long time indeed for that reallocation to occur.