Just as Geithner is about to speak...
Details are emerging about the new financial rescue package. Some of the items the Wall Street Journal has reported sound far more market-friendly than what I had feared.
The centerpiece is the bad bank. While not exactly what I talked about last week, this bad bank will be funded with private sector money. Its daring, but if it can work, then I think it will achieve some of the goals I laid out in that post. A privately funded bad bank should involve less government intervention than would otherwise be.
Another key element will be a FDIC-insured covered bond program. I talked about creating a government-backed covered bond program backed by some limited government guarantee. Now it looks like it will be a reality. Basically banks will be able to issue FDIC-insured debt with maturities as long as 10-years as long as that debt is backed by loans. I'd expect this to be restricted to new loans, because the idea is to get credit flowing again.
Remember that covered bonds differ from securitizations in that the debt is an obligation of the issuing bank no matter what. So even if the loans which "cover" the bond go into default, the bank still has to pay. With a securitization, the bank sells all its risk to investors in the securitization. From a moral hazard perspective, the beauty of the covered bond program is that the risk stays with the bank who originated the loans. The FDIC (i.e. tax payers) are only on the hook in the event that the bank goes under. And we're already on the hook for that!
From a "fix" the economy perspective, the covered bond program gives banks a guaranteed profit as long as it can underwrite good loans. The bank's cost of funds for 10-year FDIC insured covered bonds would be about 4.5% (my own estimate, maybe lower). How easy is it to make loans well north of 4.5%? By implementing this program, the government is telling banks not to worry about their funding sources, just worry about lending the money to worthy borrowers.
The last piece of this bailout that I think will really matter is the TALF. Similar to the covered bond program, the TALF will guarantee profits to banks and other financial institutions as long as they can make good loans. Combined with the covered bond program, this should eliminate the hoarding of cash at banks.
The real trick is how the government is going to incent private investors into the bad bank. I think that if the government guaranteed some percentage of the initial purchase value, private investors would come in. I'm not sure how high this number has to be, but there is a number.
I recommended TIPs vs. nominal bonds in an earlier article. Since that time, the 10-year Treasury is down 4%, while the 10-year TIP is slightly higher. I think TIPs are probably overbought here, and its time to take profits.
First a chart of the breakevens. The blue line is 5-year, the green 10-year and the red 20-years. Breakevens measure the expected future inflation rate as implied by the TIP trading level versus Treasury bonds.
AI returns after a nearly 2-week hiatus. Well, semi-hiatus as I was traveling and not able to write much. If you've e-mailed me and I haven't gotten back, I'm sorry.
While every one is talking about Monday's big TARP Episode II release, there's been some other goings on. Big news today is the potential for Fannie Mae and Freddie Mac to be taken on balance sheet by the Federal government. This isn't such huge news from a practical perspective, but could radically change debt trading. Imagine if there is no more agency issuance!
More on this on Monday.
So what do we think of Geithner's Bad Bank idea? Is this the solution that will finally fix the economy? Will this mark a Bottom (tm)?
First of all, the universal bad bank idea is much better than how the TARP is currently being utilized, namely equity injections into private banks. When you have the government actually owning private companies, it opens up any number of Pandora's boxes. Already the government is trying to influence how banks operate by forcing them to lend out TARP injections. That's a terrible precedent.
On the other hand, if the government simply buys certain assets from banks, that could be the end of it. Congress could attach certain rules and regulations surrounding the asset purchases, for example, forcing banks to agree to executive pay restrictions. But once the purchases have happened, that could be the end of it.
If you want to some day return to real capitalism, then we need to figure a way to get through the current crisis. But we also need to do it in such a way that government interference in private business is minimized. As long as government owns banks, that isn't happening.
How should the purchases of bad assets be handled?
I'd like to see it done something like this. We form a new company, call it LoanCo. The Federal Government capitalizes LoanCo with some amount of money, say $500 billion. LoanCo agrees to hold weekly reverse auctions. Each auction is held with specific types of mortgages or mortgage securities. For example, one week might be OptionARMs with a certain FICO range, original loan size range, vintage year and interest rate. The next week would be a different set of characteristics.
Each bank would offer to sell their block of loans at some price, expressed as a percentage of original loan amount. LoanCo would have a pre-determined total amount they will be buying. The purchases would occur at the lowest price that "cleared" the market. Essentially, banks would be giving LoanCo limit sell orders. Bank of America might say they'd sell some set of loans at 60% of par or better. If LoanCo gets all the loans they want by paying 30%, then B of A is left out in the cold. If LoanCo winds up paying 70%, then B of A simply gets better execution.
But rather than get cash for the bad assets, the selling bank gets stock in LoanCo. All interest received by LoanCo is initially retained, but all principal is immediately returned to shareholders. The government guarantees half of the principal in these loans. In exchange, the government keeps all interest payments until LoanCo starts winding down and keeps any principal payments over the initial purchase price. So for example, if a loan was sold to the government at $60 but they eventually recover $80, taxpayers keep the $20.
(Note there is a somewhat similar plan being proffered in today's WSJ. Robert Pozen's idea is similar to mine in many ways, but I like mine better).
The advantage of my system is that banks would get capital relief, as LoanCo stock has a guaranteed value of at least $0.50 cents on the dollar. It would also make investors in banks feel more confident, knowing that the value of distressed mortgage assets can't be any worse than half of its current value.
This would also create a somewhat market-based price for the "bad" assets, at least more so than creating some model to determine a price. There is a good chance that LoanCo would suffer from selection bias. Banks would have to submit loans with certain criteria, but they would clearly pick the "worst" loans that fit that criteria. But in the scheme of things, this shouldn't be a deal breaker.
The downside of this plan is that banks get very little in fresh cash, only certainty as to the downside on their assets. But I argue that's not all bad. If we just give banks cash, they are essentially allowed to grow earnings on the backs of taxpayers. By issuing stock, the banks get the capital certainty they need, but have to figure out how to grow earnings on their own.
And I argue that banks will start lending once the fear of another round of bank runs diminishes. The margins on new loans should be excellent. I don't think we need to dole out free cash in order to incent banks to lend.
And the best part about LoanCo is that its clearly a one-time deal. The moral hazard and long-term government intervention problem is limited.
Remember when Obi Wan Kenobi lept up from that bottomless pit on Naboo and sliced Darth Maul in half? That's what comes to mind when I think about today's Citigroup news.
Citigroup's recent woes are a perfect reminder of what investors in corporate bonds and preferred stock are up against in 2009. Yes, government support is nice. But it isn't everything.
First the chart on Citigroup's credit default swaps (CDS). Higher CDS rates (also called the spread) indicate a higher price to insure against Citigroup defaulting.
I got several reader e-mails (accruedint *AT* gmail.com) asking questions about my MBS analysis. Here is a quick and dirty...
That's the basic Bloomberg screen for MBS yield analysis. The "FNCL 6" at the top indicates this is a generic Fannie Mae 30-year 6% mortgage. In the top right you can see the actual pre-payment experience. Where it says "Life 444 18.1" that means that generic Fannie Mae 6's have paid at a rate of 444 PSA or 18.1 CPR. Again, I don't want to go into the minutia how the prepayment models work, but 100 PSA is sort of a base prepayment level assuming no real refinancing incentive. 444 PSA is therefore 444% of the base speed. CPR is closer to a straight prepayment percentage. So this thing has actually paid at a rate of 18 CPR.
On the far left, near the middle you see 103-23. This indicates a dollar price of 103 and 23/32. Or 103.71875% of principal amount. Above this in the yellow boxes is the prepayment speeds which I've entered in. By default it comes up with Bloomberg's model estimates.
In the blue box below the 51 CPR speed is the yield (3.067%) assuming that speed. Then to the right of that is the yield at alternate speeds.
Near the bottom of the page is the average life at each given speed. You can see the average life at 51 CPR is 1.46 years. Note that this is how long it takes for half of principal to be returned. Not all of principal, which is a common misunderstanding.
Investors in MBS should always remember that when you type 15 CPR in for a mortgage, that's assuming a level prepayment rate. But in reality, given that interest rates will rise and fall over time, the actual prepayment experience will be lumpy. Under normal circumstances (which isn't now, for sure), I usually assume that my MBS positions will go through a prepayment spike at some point even if they are currently out of the money.
Post your questions to the comments or e-mail me.
Some clumsy and random thoughts on Bank of America...
For the rest of the 2009 Forecast series, click here.
I lump agency debt and MBS together because both are basically wards of the state at this point. They are also the best example of Quantitative Easing working that we have so far.
5-year bullet GSE debt (that is, non-callable) has declined in spread from about +150 in October and November to about +80bps. It will probably get down to about +50 before stalling there. Historically agency debt traded between +20 and +40bps, but I'd say that in a lower liquidity environment, agency paper won't get that tight.
80bps ain't nothin' these days. With the 5-year Treasury now below 1.40%, one could argue that Agencies are generating 57% more income than comparable Treasury bonds. That's going to continue to attract real money buyers looking for something that's both safe and liquid.
MBS suffer from a severe negative convexity problem. MBS investors have essentially sold short an interest rate option to the underlying mortgage borrowers. Those borrowers are now almost universally in the money. Many borrowers will have difficulty actually refinancing (more on that below) but regardless, the price for MBS securities will have difficulty rising above $104 or so with an embedded in-the-money option with a $100 strike.
To see what I mean, notice the price spread across the coupon stack (using Fannie Mae 30-year MBS for February settlement):
This is the current dollar price for a mortgage security with the indicated coupon. Typically the underlying mortgages have a rate 0.5% higher than the coupon rate. Notice, for example, that the 6% bond at $103.656 is less than one point higher than the 5% at $102.75. To me that's telling you that if rates were to fall by 100bps from here (implying the 5-year Treasury is 0.40%), the 5% mortgage would only improve in price by 1 point.
All this is to say that those hoping for price appreciation out of MBS should look elsewhere. But those looking to just collect fat income may have found a home.
Say you buy a generic 6% Fannie Mae MBS at $103.656. According to Bloomberg, that bond will pay at approximately 51 CPR (if you aren't a bond person, just assume that means 51% of the loan will pay down each year, that's close enough). That produces a yield of 3.09% with an average life of 1.5 years.
That isn't half bad considering that Treasury bonds in 1.5 years are yielding about 0.40%. You have some reinvestment risk as the mortgage pays down, but by 1.5 years rates may be rising again, and so maybe that's a good time to be reinvesting anyway.
If you are willing to do a little more work, you can do much better. Say you can find a pool with mostly 2006 borrowers. Most of those borrowers have experienced negative home price appreciation to some degree (not as bad as you might think because we're only talking about conforming loans here, i.e., loans under $417,000). Anyway, couple this with a pool full of borrowers with 90+ LTV? Or mostly coastal geographics? Or relatively low credit scores? You might have a mortgage pool that will repay much slower than average.
Say you can pick a pool that pays at 40 CPR instead of 51 CPR. That increases your yield to 3.82%. 30 CPR? Now its 4.39% wih a 2.8 year average life. That compares very favorably with the 3-year Treasury trading at 1%!
Finding these kinds of pools is somewhat easier in hybrid-ARMs, which I love here on a pure relative value trade. But beware, the liquidity is much weaker in this sector. Otherwise I'd be a bigger overweight in hybrids than I already am. You can also get a lot of good high LTV loans in the GNMA space.
So if you are going to just buy and hold and don't care about keeping up with Treasuries in a rally, MBS are probably as good an investment as any. But I'm underweight MBS, focused entirely on the kinds of specialized pools that I described above. I've basically dumped all my 5.5% and lower bonds.
So to make a prediction about the sector, I'd say the the Fed's continued support will keep dollar prices relatively high, even if Treasury rates back off a bit. But overall I expect MBS spreads will perform extremely poorly should rates fall from here, and that has me cautious on the sector. I'd add heavily to MBS if the 5-year broke 1% or the 10-year broke 1.6%.
Callable agencies are kind of the worst of all worlds. There is no value-adding opportunities through pool selection akin to what can be done with MBS. And you have the same negative convexity problems, where if rates fall you get called away and if rates rise you get crushed. So I'd avoid most callable agency issues.
Selling 51% of Smith Barney only makes sense if Citigroup is going to sell 100% of Citibank (i.e., the rest of the firm) as well.
We know, or at least think we know the following.
Selling Smith Barney doesn't solve any of their problems. It neither raises any capital to speak of, nor does it unload bad assets. And why sell now? Supposedly they are going to book some $10 billion in gains on the sale, but so what? No one is fooled into thinking that's real capital right? Valuation on the brokerage unit is got to be at all-time lows!
In fact, by selling Smith Barney, Citi is giving away deposits. Many Smith Barney clients use Citibank deposit accounts as a sweep vehicle. I haven't seen numbers on this, but a friend of mine who works confirms this is very common.
Citigroup isn't doing this to focus on its classic banking division, because Citi has been more of a investment and commercial bank than a retail bank for at least 15 years. This would be reversing a generation's worth of "progress" toward transforming Citibank. Citi doesn't have the branch network to suddenly become a serious competitor with Bank of America or Wells Fargo.
But it all starts to make sense if you assume that the rest of Citi is also for sale. Say the buyer is Goldman Sachs, who doesn't want Smith Barney's 14,000 brokers or their back office or their compliance headaches, etc. Goldman just wants the big fat bank and its deposit base to give them secure funding. To me I'd rather see Goldman buy up smaller banks with less baggage, but maybe Goldman expects some government help?
I just have the feeling there is more going on here than just Smith Barney.
Deflation is the new buzzword, especially now that the Consumer Price Index has declined or remained flat four months in a row. But that being said, its time to consider intermediate and long-term Treasury Inflation Protected Securities, or TIPS. Its one thing to price in deflation in the near term, but these bonds have priced in zero inflation for the long-term. But given the various stimulus plans currently in place and/or about to be enacted, long-term inflation remains inevitable.
First, take a look at the TIPS "Breakeven" curve. This is simply the nominal yield on a TIPS minus the yield on a traditional Treasury bond with approximately the same maturity. One can infer that this is the "priced in" inflation rate over a given period. All are quoted as of January 9.
5-years: -0.40%
10-years: 0.55%
20-years: 0.103%
30-years: 1.23%
Roughly speaking, if actual CPI comes in higher than those breakeven numbers, the TIPS will outperform the Treasury. If CPI is lower, then the Treasury outperforms.
Might the CPI decline by 0.40% per year for the next 5 years? Or rise by a meager 0.55% for the next 10? Consider the Fed's current tactics.
This is Part II of a indeterminate series on the Accrued Interest 2009 Forecast. Here I'll focus on general interest rates and Treasury Bonds.
The question on many lips is are Treasury bonds a bubble? I've already said that fighting deflation will be the major theme of 2009. Deflation will remain the primary concern of the Fed until housing prices start to recover. I don't see that happening until 2010. Until housing prices start to rise, we'll see persistently poor final consumer demand. This in turn keeps the velocity of money low and thus the money supply contracting.
I have a very simplistic mental model for Treasury rates. Real interest rates should reflect the opportunity cost of money. Thus a short-term Treasury rate should be the opportunity cost plus an inflation premium. Longer-term rates should reflect both opportunity cost, inflation, and a term premium. When economic growth is weak, opportunities are less, and thus interest rates should fall.
If we have negative inflation, then short-term Treasury rates should be extremely low. Near zero makes sense for T-Bills (although negative yields is questionable at best). Less than 1% makes sense for the 2-year. So I see no bubble on the front end of the Treasury curve. Not that there is a ton of upside on the 2-year at 0.75%, but could it go to 0.50%? Sure.
Longer Treasury bonds are the better bubble candidates. One might be able to argue that in the short term, both growth and inflation will be negative, thus the equilibrium nominal short-term rate should probably be negative. But longer term, we'll eventually have both growth and inflation, and thus long-term Treasuries should not be approaching Japanese-like levels.
So when the 10-year was pushing 2%, it felt bubbly. But still I resist the bubble label. To me, Treasury rates are clearly below "fair value" but given the extreme liquidity and economic circumstances, I doubt the 10-year can move above 3% until at least 4Q 2009. I think long-term Treasuries remain over-valued until its obvious that inflation is going to eventually become a problem.
What about Treasury supply you ask? Won't the massive debt load eventually push rates much higher? While acknowledging that supply is an obvious negative for prices always and everywhere, as it is, Treasury supply is clearly not overwhelming demand. The 3-year and 10-year auctions from last week went quite well.
Besides the theory that government debt crowds out private investment doesn't hold water right now. Private lending ain't happening in areas where the government isn't subsidizing. In essence, the Treasury is leveraging because the private sector can't.
Eventually, the Fed's programs will result in much higher inflation, and thus Treasury rates will rise substantially. But I think this is a year or more away, too far away to recommend a short.
The problem for real money investors is that Treasury yields are so low, that you pretty much have to own something else. The yield advantage on short-term Agencies versus short-term Treasuries is so large that there isn't any logical scenario where the Treasury outperforms. Therefore I'm playing this by remaining underweight Treasury bonds, but owning stuff that can appreciate if Treasury rates fall. This includes bullet agencies, and some very high quality corporates.
For most of my career, with an exception here and there, there have been two persistent trends. One is that in the debt markets, the fundamental outlook has generally been good. You had persistently low inflation, mostly low volatility, and a growing economy. Sure, some bonds went bad, but for the most part, the fundamental picture was good. The problem was always valuation. You'd look at a corporate bond and see a whopping 100bps spread or something and it would seem like all downside, no upside risk. But of course, you had to buy something, so you'd hold your nose and buy it.
Now its just the opposite. The fundamental outlook is piss poor, but the valuations look extremely cheap across all risk sectors.
Risk assets are pricing in Armageddon. As long as no one spies any horsemen running around, those risk assets ought to pay off well for investors in the very long term. But that's the real trick isn't it? When to jump in?
I think the key to bond investing in 2009 is two fold.
1) Protect your liquidity. Professional investors, whether leveraged or not, never know when their clients will need cash. And the cost of turning bonds into cash has never been higher than now. Non-pros tend to underestimate the probability of needing cash, and frankly, non-pros don't have as many resources for producing liquidity in bonds. No offense, but its true.
I believe that liquidity has probably bottomed, or put another way, that liquidity won't get any worse than it is now. But when I say probably I mean like 65%. There is still a decent chance of another blow-up causing another spate of deep illiquidity.
That being said, bid/ask levels are going to remain very wide, probably for the next several years. We've seen improved liquidity in high-quality sectors, like agencies and munis, but even there, I expect liquidity to wax and wane with buyer demand. Remember that dealers used to be the guardians of liquidity. That's gone and it ain't coming back.
2) Buy what you can hold. This isn't to say you can't put money into a bond as a trade, but given how wide bid/ask is, and given that you don't know when bids are going to suddenly disappear, you can't assume you can flip a position. So when buying a bond, ask yourself: would I hold this bond for the next year? Two years? To maturity? Is this credit strong enough that, if I had to, I'd hold this bond indefinitely?
I argue that you shouldn't buy anything in 2009 where you can't answer that question with a confident yes.
So with all that being said, here is my basic economic forecast for 2009. I'll follow this post up with thoughts on some of the major bond sectors. As always, I'll discuss a most likely scenario along with a less likely but possible scenario.
Growth
Most Likely: Sharply negative real growth in 4Q 2008, continuing (at a less severe pace) at least through 1H 2009. 2H 2009 likely near zero. Meaningful recovery doesn't start until 2Q 2010.
Less Likely: Government fumbles stimulus, and growth is negative through 2010 and possibly into 2011, with a deeper trough.
I think the immediate period after the Lehman/AIG/GSE/WaMu/Wachovia failures resulted in a massive pull back in economic activity. We saw it in Existing Home Sales in October/November, in auto sales activity, bank lending, everything.
That took what was already going to be a recession and turned it into something much worse. I had thought that mortgage foreclosures could bottom in mid-2009, because that seemed like long enough for the bad loans to burn out. But the sharp contraction in 4Q 2008 will result in much higher unemployment, I suspect around 10% by the end of 2009, and thus the foreclosure party will continue on.
And it will take a slowdown in foreclosures for housing prices to bottom. I suspect it will be government intervention that is the catalyst for this. We've already seen the government move to lower mortgage rates, which really should give us pretty good affordability. And while part of the initial problem with housing was over-building, but that ship has sailed. Housing starts have plummeted, and now all starts are pretty much multi-family or made to order.
Anyway, you need demand to outstrip supply in order for prices to start rising. As long as foreclosures are rising, that means supply is rising. Demand is going to be tepid until the employment picture improves. Rising supply and unchanged demand equals falling prices.
So I see home prices falling throughout 2009, absent direct government intervention either buying foreclosed properties or subsidizing banks to prevent foreclosures. Obama & Co. may actually take these steps, but I'd say it'll take several months for such a thing to pass Congress, then several more months to actually be implemented. So we're still looking at late 2009 at best.
GDP growth will probably be worst in 4Q 2008, then more modestly negative in 1Q and 2Q 2009. Beyond that is difficult to say. My base case is for 2H 2009 to be about zero real GDP growth, with a meaningful but tepid recovery in beginning in 2Q 2010.
The risk to this forecast is that the government bungles the bailout attempts, most likely by letting another financial institution fail. It currently doesn't look like that's their strategy, but then again, after Bear Stearns it didn't seem like they wanted to let another institution fail. But then came Lehman.
Another risk to this forecast is...
Inflation
Most Likely: Inflation? What inflation? The Fed will spend most of 2009 fighting deflation, although by 3Q or 4Q it will be apparent that the Fed will indeed win the battle. Headline CPI will print negative multiple times in 1H 2009, predominantly on falling food and energy prices.
Less Likely: We fall deeper into deflation, most likely because the less likely growth scenario comes to pass.
I've written a few times on deflation, which is truly the primary concern of the Fed right now. The Fed has plenty of tools to fight it, and Ben Bernanke is the right man for the job, having spent his academic life studying how the Fed blew it in the 1930's.
I don't see Japanese-style deflation taking hold, at least not for the same reasons as it took hold in Japan. The Bank of Japan maintained a ZIRP policy for many years to no avail. They still suffered from deflation. Why? Because you can't get consumer inflation without consumer spending. I argued this multiple times when energy prices were rapidly rising. Energy doesn't "create" inflation, rising money supply does.
But even in the face of rapidly rising money can't create inflation unless consumers are spending. Right now, money is contracting and consumers are pulling back. In fact, those two things are usually correlated. But in the case of Japan in the 1990's, consumers refused to spend despite massive fiscal and monetary stimulus.
But here is where I think the U.S. differs from Japan. The Japanese are fundamentally savers. Americans are fundamentally spenders.
Unemployment is going to be bad in 2009, heading toward 10%. But the other 90% of Americans will keep spending their income. Now they won't be able to spend their home equity, as in the past, but basically we're a nation of spenders. Once the American stimuli take hold, consumer spending will advance anew. That's not to mention the fact that the U.S. Fed has been far more aggressive far earlier than the BoJ ever was.
Eventually this leads to some inflation problems, probably not till 2H 2010. To suggest that the Fed will provide just enough stimulus to avoid deflation but not create a significant inflation problem down the road is ridiculous.
Key to the Fed's success is the progress on quantitative easing. The TALF is the quintessential example of QE, where the Fed targets interest rates away from overnight bank lending rates. There will be no limit as to how far the Fed goes to fight deflation. They could buy corporate bonds, municipal bonds, commercial mortgages, anything. Beware what you short!
However, if we get another big leg downward in economic growth, resulting in even tighter consumer lending conditions, then the deflation fight becomes more difficult. I'd still see the Fed eventually winning, but such an outcome would result in a much longer period of ZIRP and eventually much bigger inflation spike.
In the next couple days, I'll be discussing my investment strategy around this forecast.
Let's compare two companies, thinking in terms of credit-worthiness. Note that on May 1, 2008, credit-default swaps (CDS) on both companies were around 55bps. By way of comparison, CDS on the United States of America current trade at 67bps.
Company A:
Municipal bonds have posed an impressive rally in the last few days: the Barclays Municipal Index is up 3.78% since 12/15. That is better than either the Treasury market (+1.55%) or the S&P 500 (+0.57%) over the same period. As much as I think munis are a great value here, this rally has more to do with illiquidity than anything else, and it is a stark lesson for anyone looking to trade fixed income over the next year.
First, consider why municipals have performed so poorly recently. The Municipal Index had fallen over 9% from September 11 through December 15 before rallying this past week. During the same period, the Treasury market rose over 7%. Its easy to point to credit worries about municipal issuers, after all, state budget woes are a constant headline. But this can't explain poor muni performance in its entirety, after all, even munis backed directly by Treasury bonds in escrow haven't been immune from the sell-off.
A better explanation is that many of the biggest holders of munis have become forced to raise cash in recent months, particularly mutual funds and insurance companies. In the old days, the broker-dealer community would have bought up these bonds, held them on the balance sheet, and eventually sell the bonds to another customer for a profit. In essence, dealers used to serve a sort of wholesaler function, holding bonds in inventory while looking for an end-buyer.
Today, dealers are no longer willing to hold bonds on balance sheet. This means that if customers want to sell municipal bonds an end buyer must be found first. If the seller needs immediate liquidity, s/he is at the mercy of whatever end-buyer happens to have available capital at any given moment. Not surprisingly, this results in lower prices on bonds.
But that same illiquidity cuts both ways.
Recently, buyers have emerged in the municipal market, spurred in part by the Fed's aggressive rate stance as well as a desire to add duration before year-end. But whatever the reason, buyers are finding that dealers have no bonds to sell. Buyers want to buy at "forced sale" prices, but are finding a dearth of forced sellers.
Now those that want to buy are having to pay prices high enough to entice current municipal bond holders to sell, thus pushing the trading price of municipal bonds dramatically higher in a short period of time.
You can imagine brokerage firms having once acted like a buffer between buyers and sellers. They were willing to buy when the market wanted to sell, and then sell when the market wanted to buy. Now they are acting like true brokers, matching buyers and sellers, but not putting the firm's capital at risk either way.
What does this bode for municipals going forward? Difficult to say. Munis offer very strong long-term value, but the technical picture is cloudy. But this whipsaw trading should serve as a warning to anyone involved in the fixed income markets. The lack of market making activity isn't unique to municipal bonds. The situation is similar in almost all bond types other than Treasuries and large issue government Agencies. And we should expect the same kind of whippy price action in other sectors as well.
It thus represents both an opportunity and a danger. If you are willing to buy when others are selling, you can buy good bonds cheap. This is true in various sectors, from hybrid-ARM MBS, to municipals, to commercial MBS, to corporate bonds.
But one also needs to be careful assuming that fixed-income sectors are moving for fundamental reasons. Right now, to assume that the current muni rally is some sort of all-clear sign is a mistake. The muni market didn't suddenly forget all of the problems facing municipal bonds, both fundamental and technical. Rather certain buyers came into the market, found the primary calendar empty and secondary supply sparse. The result? Higher prices. There really isn't anything more to it.
Mark-to-market accounting has got to be one of the most controversial topics of the year. Unfortunately, its also rife with bias and downright zealotry. You have on one side apologists for financial companies and/or people looking for a one-trick excuse for the whole financial meltdown. On the other hand, you have people who believe all of Wall Street is just lying and everything they own is worthless.
But somewhere in there is a legitimate, rational debate.
First let's consider what accounting is supposed to achieve. Broadly speaking, accounting should have a few simple goals:
1) Accurately reflect the current economic situation of a firm.
2) Allow for comparison of a firm's results and position over time.
3) Allow for comparison of one firm to another.
4) Be as objective as possible.
Now let's consider how mark-to-market as a concept fits in with these goals. I call mark-to-market a "Liquidation Theory of Accounting." In other words, by marking all assets to where they could be sold, one is valuing a firm based on what it might be worth in liquidation.
This is clearly appropriate with any pool of assets intended to be traded in the open market. But in other assets, it isn't obvious that mark-to-market serves the 4 basic goals above. Take a life insurance company which bought the longest available Treasury Strip (5/15/2038) on August 8, when it was first trading. The position is an offset to their long-term liabilities, say the life insurance policy of a young person. For the sake of argument (and brevity) let's assume that the actuarial life of the policy holder is exactly 30-years, and the accrued interest on the strip will exactly cover the life policy with a small profit.
The strip was trading at $25.6 on 8/8, but is now about $42.5, an handsome 66% return.
But has the life company's economic situation changed? Is that firm 66% better off? We'd all agree that no, it isn't. The basic economics of the firm haven't changed at all. They have the same liabilities and same cash flow stream. If we followed strict mark-to-market theory, we'd mark both the asset and the liability higher, leaving the firm's balance sheet unchanged.
Or would we? Under current market conditions, "selling" the life insurance policy liability to another firm might be possible, but it would be highly unlikely to have the same gain as the Treasury position.
That example is very black and white, and of course, the real world is much more grey. Its easy to use a Treasury bond as an example, where we know the change in market value isn't reflective of a change in asset quality. But where there has been a real change in asset quality, the situation becomes more grey.
But still, mark-to-market still doesn't fully satisfy. Let's say that we have two firms, both have made loans to XYZ Retailer. But one is a bank which has made a traditional loan, and the other is a brokerage which holds a private placement bond. The broker almost certainly has to mark that loan to market, but the bank may not.
And in both cases, the rapid changing liquidity premium in the market place alters the "mark" for this asset. By this I mean, say the retailer is performing reasonably well, and thus the risk of non-payment remains remote. Given the weak economy, its obvious that the risk has increased by some degree, but given the extremely weak liquidity across fixed income products, the larger portion of the assets price decline would reflect liquidity. If the firms don't intend to trade the loan, is the changing liquidity premium relevant?
There are other problems. Say you are a bank that has a private loan to a company with traded CDS contracts. Your best mark-to-market estimate would be to price the loan based on the cost of hedging out the credit risk. But in many cases, the CDS and cash bond markets have decoupled. Many bonds are trading a drastically wider levels than the CDS market, owing in part to easier funding of CDS. Take Amgen, where cash bonds are trading at a LIBOR spread of nearly 300bps, but the CDS are around 90bps. On a 10-year loan, that implies a valuation differential of about 15 points!
So here again, we have a situation where two firms can use "market" prices to price non-marketable assets, and come up with wildly different valuations. We hear mark-to-market and assume that the "market" is some kind of observable thing. But that is just not the case.
I argue that when the current fair value accounting standards were cooked up, a rapid change in liquidity premia was never envisioned. It was assumed that the market would deliver an efficient price which was primarily reflective of the real economic risks of a security. Thus a change in price would reflect a change in risks. It makes perfect sense in theory, but clearly does not reflect economic reality for some firms, nor does is it creating balance sheets which are comparable across firms.
But what's the alternative? Those that are calling for an end to mark-to-market are out of their mind. First of all, there is no clear alternative. Second, we have enough trouble trusting firms' balance sheets as it is. Imagine if mark-to-market were suddenly suspended!
And it doesn't help that so many critics of mark-to-market in the recent past have been managers of firms who were, in fact, fudging the real economic position of their firm.
So I don't know what the answer is. And I don't blame accounting for the financial crisis that we're going through. But I'd like to see some better ideas.
The Fed has expanded the Term Asset-Backed Loan Facility (TALF), which AI first discussed here. Here is the quick recap of the facility.
1) Fed will loan funds for purchase of recently issued ABS. This was clarified to mean ABS issued after January 1, 2009 made up of loans no older than October 2007. The ABS must be rated AAA, and be made up of student loans, auto loans, small business loans, or credit cards.
2) Loans will be non-recourse and not marked-to-market. The borrower will not have to deal with margin calls due to price declines.
3) The loan term will be up to 3-years, originally was only 1 year. That is extremely positive for the potential success of this program. See below.
4) The loan rate will be set at "yield spreads higher than in more normal market conditions but lower than in the highly illiquid market conditions that have prevailed during the recent credit market turmoil." In other words, lower than the rate paid on the asset.
So what has the Fed done here? Created an easy arbitrage. All investors have to do is do accurate credit work, and this is a guaranteed profit. Note that the 3-year term seals this thing. 3-years is basically the entire life span of most eligible collateral, so it eliminates the last thing an investor needed to worry about. Given a 1-year term, investors would have worried that the end of 1-year, new financing might not be available. But by the end of 3-years, the asset will be all but gone.
Also through this facility, the Fed can really control consumer lending rates. The rate on newly issued AAA ABS will be stuck at a level slightly higher than the Fed's lending rate. Banks which are currently hoarding cash will fall over themselves to buy ABS and pledge them into this facility.
Now don't read this as especially bullish for the overall economy. I still see this as a facility intended to aide in quantitative easing, and not a "fix" for the recession. Or put another way, a means of preventing the economy from getting still worse. But as far as ABS go? Should get that market rolling again.
Yields on U.S. Treasuries have fallen to levels once thought impossible, and we are now hearing the "B" word (bubble) used to describe these formerly staid securities. Just a few days ago I was resisting the bubble label, but with the 10-year dropping below 2.10%, its getting very hard to argue. But more important than assigning labels like "bubble" is to discern what could cause the Treasury market to move in the other direction. In other words, if its a bubble, when can you short it?
First, consider who is driving the Treasury market to these levels. It isn't relative value investors, like money managers and mutual funds. Sure they might hold some amount in Treasury bonds for liquidity and duration management. But these kinds of managers are generally assuming that Fannie Mae and Freddie Mac debt has equivalent credit quality as Treasuries with substantially better yield. So investors who are willing to consider relative value have already reduced Treasury holdings as much as they are likely to any time soon. So selling pressure isn't likely to come from relative value buyers.
Foreign buyers have dominated the demand side of things, buying up just over half of net Treasury issuance in October. Why are they willing to buy at historic low levels? Classically foreign buying of U.S. bonds has been due to recycling of trade dollars. In other words, foreign money will keep flowing into the U.S. so long as U.S. consumers are buying foreign goods. Foreign buying of Treasuries has been especially robust among private accounts (not central banks), which suggests that foreign financial institutions are driving demand.
A slowdown of foreign buying would clearly push rates higher, but in the near term, what would be the catalyst? Note that foreigners have been paying for their Treasury bonds by selling government Agency debt, $50 billion worth in October. This is reflective of a lack of confidence in any security not directly backed by the U.S. Government. The Treasury could make the backing of Fannie Mae and Freddie Mac explicit, but even this won't instantly reverse selling of Agency securities. Foreign trading is notoriously slow-moving, often waiting for bond maturities to reinvest rather than trading their portfolios.
Many of those calling the Treasury market a bubble are ignoring the threat of deflation. Under deflation, normal perceptions of interest rates as well as relationships among interest-bearing instruments break down.
Of course, we don't need investors to sell to create selling pressure. The Treasury is doing plenty of selling of its own. If investors, both foreign and domestic, gained more confidence in financial institution generally, they would move out of Treasuries and into better yielding, high quality bonds. But that will be a slow process. But until this happens, demand for ultra-safe investments will continue unabated, keeping a lid on Treasury rates.
