The new administration says they are bringing hope and change. In the case of the financial bailout/stimulus/TARP plan I hope the change isn’t as big as the numbers I’m hearing from some new administration insiders. Over the last two days there have been a number of interviews with key personnel in and around the Obama administration that have contained clues as to the direction of the financial stimulus plan. People like former Fed Chairman Paul Volcker, Democratic Senator Chuck Schumer, and tax-evading NY Fed President and soon to be Treasury Secretary Geither (If a lowly bond-salesman or perhaps even a banker landed before congress and was getting grilled over not paying their taxes I doubt if a simple “sorry ‘bout that guys” would do them much good.)
Geithner’s comments on the stimulus plan:
“The ultimate costs of this crisis will be greater if we do not act with sufficient strength now,” Geithner said in testimony at today’s hearing. “In a crisis of this magnitude, the most prudent course is the most forceful course.”
From Volcker:
“Volcker says to get through the crisis, “several trillions of dollars” will need to be committed by various government programs. Volcker apparently spoke at Geithner’s Dartmouth commencement 25 years ago. “My memory is that the public address system closed down” after beginning the address, Volcker says. He says Geithner has “unique qualifications” from hands-on experience, understanding of financial markets and support of President Obama.”
Senator Chuck Schumer:
“Sen. Chuck Schumer said he spent some time calling around Wall Street this weekend, and what he heard was that if the government wants to clean out all the toxic assets from the financial system, it will cost some three to four trillion dollars. Which is to say, an order of magnitude larger than the second $350 billion in TARP money the Senate just approved.”
With these early quotes coming out it has the feel of the start of a very large string of expenditures.
One final quote is from Nouriel Roubini, professor of Economics at NY University, and a guy that has been incredibly right during this economic cycle:
Jan. 20 (Bloomberg) -- U.S. financial losses from the credit crisis may reach $3.6 trillion, suggesting the banking system is “effectively insolvent,” said New York University Professor Nouriel Roubini, who predicted last year’s economic crisis.
Economic Data
This morning’s economic releases point to continued problems in the housing market and increasing numbers of initial jobless claims.
Yesterday Bloomberg ran an article stating that the median price of a home in San Francisco last year was $557,000. The median price today is $330,000. It would appear that we are not done with the depreciation in some housing markets.
Housing Starts were expected to post 605,000 for the month of December, they actual number was 9% lower at 550,000.
Initial Jobless Claims were roughly 8.5% higher than the survey expected. 580,000 new people applied for unemployment benefits in December. The outlook on jobs in the first quarter appears to be less than great. Each day on Bloomberg I see headlines that show which companies are letting people go and in what numbers. Circuit City alone will put 34,000 people out of work as they complete their liquidation. Bank of America is reported to be cutting 35,000 jobs over three years. The list gets longer each day.
Below I’ve attached a graph of the Unemployment Rate, which is currently at 7.2%. Given the current state of affairs I’m not seeing much that would indicate that this rate will experience a significant departure from its current trajectory. The current Bloomberg survey on the Unemployment Rate shows an average expectation of 8.00% for 2009 with the high estimate being 9.00%.
The highest point on the Treasury curve this morning is 3.15%...at the 30 year mark. Under a year in Treasuries you’re looking at 40 basis points or less in yield…MUCH less at the 1-month and 3-month marks.
MBS spreads are volatile but trending toward much tighter as the government purchases of MBS product continue. This is all part of the master plan to induce a refi wave. Refi’s have increased dramatically over the last few weeks. I would expect refi’s to be volatile as well because there are still a number of roadblocks in the way of the government’s plans to get the refi boom going. First is the fact that many homes are currently worth less than the outstanding mortgage, secondly many of the borrowers that they would like to see refi won’t qualify. There are a number of initiatives that the government is exploring currently that will allow them to get around these issues…none of which are great from the perspective of banks or fans of the free market.
I’ve run the Refi Index to show activity going back to 2000. Much like a child that has been burned by a hot stove I look at the prepay spike in 2001 and 2002 with great caution and respect. During that time period there were a lot of people burned by purchasing high premium bonds. As the prepays ramped up and some bonds payed at CPR speeds north of 70 CPR we saw everything from low yields to negative yields…even on products that had never before had a reason to do so.
Over the last few years I’ve heard many people say that we couldn’t see that again especially in a credit crisis as nobody can get a loan so it’s OK go buy any sized premium you want. I disagreed with that assessment as it is very one-dimensional, ignores history, and completely rules out the possibility of government intervention in the markets. Over this cycle we’ve tried to minimize premiums whenever we could. At this point it is almost impossible to find an MBS anywhere near 100. There was a joke back in 2001 and 2002 that 102 is the new par on MBS. That joke was unpacked and used again last week…as soon as I heard it I was reminded of the refi wave.
What do we do?
So with the government actively trying to induce a refi wave, banks holding large amounts of MBS securities, and concern mounting over runaway inflation sometime in the next few years what is one to do?
Many banks would like to sell into the government buying spree to take gains but if you sell…what do you do with the money? Full Faith and Credit has been popular but the yields on a standalone basis are fairly unattractive.
Many banks have the ability to take advantage of the government in two directions. The first is that you sell your higher premium MBS into the flurry of government buying to take gains of 2 points or more. With the proceeds you can purchase 2 year Full Faith and Credit issues from the FDIC’s TLGP program at yields around 1.30%. The 2.00% gain on securities combined with the 1.30% annual yield on the Full Faith and Credit bullets gives you a 3.30% yield for the year, shortens your duration, and allows you to capture those gains before the refi wave erodes them.
For those banks that can take some credit risk there are even better yields available from the non Full Faith and Credit issues from the same companies that are issuing FDIC paper. These issues get indirect support from the issuers ability to refinance currently outstanding paper at full faith and credit levels. The FDIC insurance program runs through June 20, 2012 as currently written. Buying issues that mature before this window closes adds another level of comfort. Yield levels on maturities of less than 3 years range from 2.00% to north of 6.00% on these issues.
Using either of these reinvestment options provides you with a great opportunity to position yourself very well for rising rates a year or two from now.
Factors that may aggravate inflation
As much as the Fed would like to keep rates low there is real concern regarding rising rates from factors outside of their control. China surpassed Japan as the largest foreign holder of US Treasuries this year. China will have less money to spend on Treasuries first of all due to our recession…we’re simply not sending them as many US Dollars because we’re not buying as many of their exports. Secondly, China is dealing with a recession of their own and are going to have to deploy some of their excess cash on domestic programs…this also means less money to invest in US Treasuries. Thirdly a decline in the value of the dollar will translate into lower investment returns for foreign holders of US dollar denominated assets. Another concern is that foreign central banks at some point begin pricing in higher yield requirements based on expectations of higher inflation in the future.
So despite the Feds actions so far there are some plausible scenarios that could cause this yield curve to steepen significantly over the next two years. If that happens you don’t want to be the bank that stretched on maturity or sacrificed structure to chase yield.
If you have any questions on this material or if you would like to see swaps that involve selling MBS to take gains and redeploying into short Full Faith and Credit bonds just let me know.
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