Market update 4 28 09

My day is going well…I just found out that brokers are genetically so close to pigs that we have a built in immunity to the swine flu.

The late day update is that stocks were flat and bonds prices pulled back sending yields toward the high end of their recent range.

Today was the first time since the Fed announced their $300 billion Treasury purchase plan that the 10-year has traded above 3.00%. It is currently trading at a 3.01%. Yields can go anywhere from here but one thing we know for certain; the Fed has the means and the motive to drive Treasury yields back down. They’ve still got $240 billion worth of spending money and they plan to be in the market two to three times a week to keep downward pressure on Treasury yields.

Between the swine flu headlines, Air Force one accidentally re-enacting the 9/11 attacks, and the GM fiasco, MBS spreads have been quietly tightening in the background. You’ve heard us talking about the coming spread tightening for quite some time. Many of you purchased MBS securities last year to take advantage of this and it has worked tremendously well.

To provide a real live example I went back to October and pulled up a 10 year 5.00% MBS that I sold at 100-5. That same bond today is trading around 104-18. A small portion of this price move is explained by the fact that Treasuries are slightly lower today than they were then…the 2 year Treasury is 61 basis points lower. The rest of that price appreciation is due to spread tightening. That is a gain of just under $45,000 per million invested. That is the power of spread tightening.

Tomorrow is Fed day if anyone cares. I don’t know of anyone on the planet that expects the Fed to do anything with the overnight rate tomorrow, but we might get something out of the text that’s interesting. I’ll keep you posted.

If you have any questions on this material or if there is anything I can be doing for you just let me know.

Anatomy of a pullback

The market wanted more

As we all know the Fed has been conducting open market open market operations to buy Treasuries. The plan is to buy $300 Billion of Treasuries by June of 2009 (six months from start to finish). So far the Fed has purchased just under $60 billion. The Feds moves are basic market manipulation. They have a desire to keep interest rates low to facilitate low cost borrowing which will in theory stimulate general economic activity. Low rates are also an essential component of the plan to allow borrowers to refinance their mortgages. So you buy Treasuries to push rates down long enough to accomplish these goals.

With an 800 pound gorilla like the Fed in the market I begin to wonder how their activity will impact the market. When I began looking at this issue I thought that the first thing I’d find was evidence of rising Treasury prices on days when the Fed was conducting open market operations. It would be very useful obviously if we could isolate the effect of their buying to see how much of a price impact they have when they wade into the market. Additionally we’d like to see if we could isolate any price pullbacks in the absence of Open Market Operations holding all else equal.

Today we saw something a bit unexpected. The Fed conducted open market operations today to buy Treasury bonds with 7 to 10 year maturities. The Fed purchased $7 billion worth of the $26 billion in Treasury bonds offered up by the primary dealers. Treasury prices rose this morning until around 9:30 Eastern. The market was expecting a robust buying session out of the Feds operations today.

The Fed released their statement detailing the mornings activity at 10:30 eastern time. This report showed less buying than the market anticipated. The pullback in Treasury prices began immediately after the release of the statement. In the graph below you’ll see the speed with which the market reacted to the Feds statement. From pre-announcement to the market close we’re looking at almost a 1-point swing.

The Fed’s Open Market Operations will continue to have a big impact on the markets. Today’s activity shows that the impact isn’t always as predictable as one might expect.

Food for thought

We know that the Fed wants to keep rates low…and they have some ammo with which to keep them low IF nothing out of the ordinary happens. However, the Fed doesn’t have pockets deep enough to fight the market and if inflation begins to heat up the Fed won’t be able to buy enough Treasuries to keep the long end anchored. This could cause a dramatic steepening of the curve. Another factor that could cause Treasury rates to rise is a reversal of the flight to quality that has helped drive rates to these historic lows. If the market perceives that the macro-economic picture is getting better you’d expect to see money move out of the Treasury market and into other sectors, whether it be into corporate bonds to take advantage of tremendous spreads or back into equities.

That’s all I’ve got. It’s late in the day, it’s nice out, the Mexican joint across the street has a patio in the sun and $3 beers…and I bet your town has something just like it. Go stimulate the local economy.

If you have any questions or if there is anything I can be doing for you just let me know.

Market update _ 4 14 09

Treasury yields have been dropping like Somali pirates over the last two days. The Fed was in the market yesterday buying Treasury bonds in their continuing effort to keep rates low. Plan “A” is to purchase $300 billion in Treasury bonds to keep a lid on borrowing costs. The Fed purchased $7.37 billion of Treasury bonds yesterday. Today’s Open Market Operations will purchase Treasury bonds with 4 to 7 year maturities. There is no listed target amount that they are trying to purchase today. The Fed provides a list of cusips that they are interested in to the primary dealers, the dealers submit bonds, then the Fed determines which are the best fit for their program. We’ll know at the end of the day how many bonds were offered by dealers and how many the Fed bought for the program.

The 2009 total amount purchased by the Fed as of yesterday’s close is just under $44 billion in Treasuries. This program is designed to keep rates low and the Fed will remain active in this arena. They have $256 billion more to spend and they plan to be in the market two to three times per week buying Treasuries. All this talk about Treasuries might make you forget that the Fed also plans to purchase more than $1 Trillion in Agency debt. The end result is that rates are low and the government is going to do everything they can to keep them low.

Inflation concerns are what will cause the yield curve to steepen and ultimately cause the Fed to begin raising rates to fight it. The PPI numbers this morning coupled with advance retail sales data paint a picture of an economy that is not about to begin sprinting. There is nothing inflationary in this morning’s economic data. Bernanke’s remarks on the economy this morning were intended to put a more positive spin on our current situation. Essentially he believes that the pace of the decline in business conditions is slowing. Essentially he says we are no longer in a “sharp decline”, but have moved into a period of slower decline. So still falling, just not as fast. Bernanke perceives this to potentially be a sign of the first step toward recovery.

Below are this morning’s economic releases. All releases posted numbers worse than the Bloomberg estimates.

MBS Spreads

MBS spreads have collapsed from their highs back in November of 2008. Calmer markets and massive purchases by the Fed are two of the factors that have combined to push these spreads tighter. Driving spreads on MBS product tighter to the Treasury curve is an essential piece of the government’s plan to drive down borrowing costs. You’ll recall that they have committed to spend north of $1 Trillion on Agency product…most of it on MBS.

Keep in mind that prices and spreads move in opposite directions so the lower that spread goes, the higher the price of the bond. All of this spread tightening has pushed prices higher on MBS product. This has given many banks an opportunity to sell bonds at very nice gains. Whether you need to fund loans, make earnings, or restructure some things in the portfolio there are a number of reasons one might take gains in this environment. If you have any questions about selling for gains in this environment just let me know and we can discuss recent activity in this area.

A quick look at the shape of the curve.

The graph below shows the spread between the 2-year Treasury and the 10-year Treasury going back to 1989 (as far back as Bloomberg will allow with daily data).

This is a graphic way to display the steepness of the yield curve over time. In the top panel of the graph below you will see periods with large gaps between the orange and white lines. These indicate periods with steep yield curves (a wider spread between the yield on the 10 year and that of the 2 year is by definition a steeper curve). The periods with small gaps indicate narrow spreads and represent flatter yield curves. You can see our current situation on the far right of that graph. While we have an overall low level of rates at the moment we’ve got a fairly steep yield curve with 200 basis points separating the 10 year and 2 year spots on the curve.

The bottom panel of the graph below is a different view of the same information. The bottom panel maps only the spread (not the actual yield levels of the two bonds). At the yield curves steepest point over the sample period, the spread widened out to 275 basis points (back in 2002). A steepening yield curve is an indication of rising rates on the horizon. Yields on the long end of the curve will rise as investors begin to price inflation into the picture.

With the Fed committed to keeping rates low and the market just beginning to price future inflation expectations into the yield , we’re at an interesting point in yield curve history. The last thing the Fed wants is higher interest rates…so we get the $300 billion Treasury purchase program. One has to wonder how effective the Fed can be in keeping rates low if we see a large change in sentiment on inflation. When the economic data begin printing inflationary numbers there will be a massive change in investor sentiment. Will $300 billion be enough to replace the demand of the investors that flee the long end of the curve? Time will tell. For now it looks like a nice time to keep things short.

If you have any questions on this material just let me know.

Market Update 4 9 09

Today’s market activity is being defined by Wells Fargo. Wells announced this morning that their Net Income was up around 50% on a year over year basis. They earned roughly $3 Billion in the first quarter. This was significantly more than the estimates and it has sparked a rally not only in Wells shares but in the financial sector as a whole. I can’t wait to see what the media does…criticize a bank for making money, or report the happy news that everyones 401k received a shot in the arm today…decisions decisions. The Dow Jones is up 200 at the moment putting it over the 8,000 mark early in the day. Treasury prices are off across the length of the curve pushing those yields higher. The 10-year Treasury is back on the north side of 2.90%.

Initial Jobless Claims continue to stay well above 600,000 per week. This morning’s release is the 10^th consecutive week that saw more than 600 thousand new applicants for jobless benefits. Since the first week of January we have see 8.6 Million people file for Initial Jobless Claims. Today’s report showed that 654,000 people filed last week.

Refinance?

There has been a lot of speculation surrounding mortgage refinance activity. To provide some perspective I’ve attached the latest print of the Bloomberg Refi Index. I took the timeline back to 2000 to show the history of the last cycle which made history with the speeds it produced. You’ll see that in 2002 the refi index hit 10,000 (the relative level here is important not the actual number 10,000). You’ll also notice that the index has been jumping up recently.

The current situation finds us with big gains in MBS securities, and many bonds that were purchased at premiums. As this refi index picks up you will see increased prepay speeds in your MBS portfolio. If you own a significant amount of MBS you’re already seeing the increased speeds. Increased speeds on bonds purchased at a premium will reduce your yield. An opportunity here is to sell MBS at a gain before the speeds pick up to the point that the yield burns down and the average life shortens dramatically.

There is no shortage of reasons to sell for gains at the moment. Some banks are using gains to pay for the FDIC special assessment, some banks are using the gains to improve earnings for the year, some banks are taking gains and adjusting portfolio allocations. There are a number of reasons that make good sense.

Will refi’s be different this time?

Should we expect to see 10,000 on the refi index again? While it’s impossible to say for certain I think we can look at the evidence and feel comfortable that we will not hit that level again.

As badly as the government would like to see a giant refi wave that puts more money in the pocket of the consumer they are some serious obstacles to that goal.

Back in 2002 EVERYTHING was different…and different in a way that was far more conducive to refi activity. The first and biggest factor is that 2002 falls smack dab in the middle of what we term the global mis-pricing of risk. Money was cheap and everyone was looking for a way to borrow and loan it out. Leverage was the magic that created earnings in this low rate environment.

In 2002 there were hundreds more mortgage companies than there are today. You couldn’t open your mailbox or check your voicemail in 2001-2003 without getting an offer to refinance your home. Money was cheap, mortgage companies were on every corner, new mortgage products were dreamed up that allowed EVERYONE to be able to refi. Sub-Prime, Interest-Only, Neg-Am, if you had a pulse you could get a mortgage in this most efficient of markets. No down payment? No problem, we’ll loan you that too. You don’t make enough to qualify? No problem, we’ll do a “no doc” loan. Can’t afford the monthly note on a traditional mortgage? No problem, we’ll do a sub-prime ARM and we won’t do a stress test to see what happens if rates go up. Helping this process along was an equally impressive shift in the securitization market for ALL of these mortgage products. Given the worldwide demand for yield in a low rate environment there was almost nothing that couldn’t be securitized and sold to someone…somewhere. Every type of mortgage that you could dream up was packaged, sliced, diced, rated and sold on down the line to an investor eager to take advantage of this market.

If you compare the efficiency and risk tolerance of THAT market to the market today you see significant differences. The first thing we can do is look at the mortgage “implode-meter”, a website that tracks the death of mortgage companies. The most recent update shows that since late 2006 there have been 342 mortgage companies that have gone belly up. That figure alone would indicate that we have less of a chance of returning to the go-go days of refi activity. The global financial meltdown that killed Bear Stearns, Lehman Brothers, Countrywide, Merrill Lynch, AIG, and tried to take down many more has obviously reduced the efficiency of the securitization market. So in 2009 we’ve got fewer people able to make mortgages, fewer people able to package and sell the mortgages, and fewer people willing to buy those mortgages. Those are some of the big factors that lead me to believe we won’t see quite the refi wave we saw the last go-round. I don’t know that it’s structurally possible to hit those levels first of all…even if it were you’d need enough willing buyers and at this point we’re seeing a markedly reduced appetite for risk world-wide. When the Fed has to step in to the market to buy over $1 Trillion in mortgage product it’s another sign that refi activity is struggling to take place on its own.

The big factor that supports higher refi activity in this market is that the government wants it to happen…and they now own significant portions of commercial banks. We’ve seen no shortage of plans from the government to ignite refi activity. From outright market manipulation in terms of the Fed buying MBS paper to push spreads down and buying Treasuries to keep the curve low, to congress pushing the idea of cram-downs and other half baked ideas.

To sell or not to sell

The question we need to answer is whether the government activity in this arena is enough to offset the structural changes in the mortgage and securitization markets, along with lower risk tolerances across the globe.

In my opinion we’ll see a heightened wave of refi activity but we won’t reach the lofty levels of 2001 through 2002.

Even if we don’t get back to the highs of the last cycle there are still issues to deal with. If you own MBS at premiums greater than 102 it’s worth a look at a rate shock to see how your cash flows and yields look. If you find something in the rate shock that you don’t like you probably have a gain and can sell it.

If you’d like us to run an analysis on your MBS portfolio just send us the information in the attached word document and we’ll run a custom analysis and get back to you.

To give you an idea of the changes in the market for Fannie and Freddie mortgage product I’ve attached the spread monitor that tracks the spread between new issue Fannie 15 yr MBS and the 5-year Treasury. At the height of the liquidity crisis this spread blew out to 311 basis points. This morning new issue 15 yr MBS are trading 169 bps over Treasuries. This spread tightening has translated into better prices on MBS securities. If you are wanting to sell…now is a very good time.

If you have any questions on this material or if there is anything I can be doing for you just let me know.

Market Update 3 30 09

On the road again

Through the modern science of logistics, US Airways was able to get me from Orlando Florida to Memphis Tennessee in a mere 13 hours. For those not familiar with the trip it would have taken Ford about 12 hours to accomplish the same task. I checked in at Orlando International at noon on Friday and I walked through my front door around 1 AM Saturday. Apparently the dog was as tired as I was because he couldn’t muster the energy to get up and meet me at the door…after a quick glance to ensure it was someone he knew he went right back to sleep. I’m not certain that his reaction would have been different if it had been a complete stranger coming through the door at that hour but it’s a difficult thing to prove.

My travels and meetings taught me a few things, the first of which is that nobody is happy with the FDIC special assessment. I’m frequently surprised at the range this newsletter has after everyone gets done forwarding it. I know that several of these updates have ended up in high places and I want to let Sheila Bair know (if she is reading this) that you can save yourself the airfare…I’ve spoken with the banks and they don’t like the special assessment.

I also discovered that roughly 15 months into the worst recession since the 80’s, the average American understands very little about what’s going on in the economy. During my travels over the last week I spoke with cab drivers, college kids, housewives, hourly workers, and small business owners. What I found was that the average American (outside of the banking/finance/investment sector) doesn’t have a good grasp on what is taking place in this economy. The fact that the average American watches 3 hours of TV per day combined with the fact that they don’t understand the largest financial crisis to hit their country since the Great Depression confirms for me that the media is doing a terrible job. If you got all of your news from the TV you would likely be convinced that all bankers get $165 million in bonuses and that all investments are a ponzi scheme. One needs only to watch CSPAN for 20 minutes to realize that congress is no better. Most of the people that are trying to “fix” the problems have no background in economics or finance. They appear to be less interested in the facts and more interested in sound-bytes, votes, and their share of the “free” money. Here we have a real problem; politicians trying to balance their own short term interests (re-election) with the long term interests of the average American (not becoming a debtor nation whose citizens work simply to service the interest owed to foreign investors). It’s become clear that these interests aren’t necessarily aligned with each other.

We face an array of complex problems that can’t be adequately summed up in a 4 second sound-byte so when I watch congress on CSPAN I’m reminded of the old adage that it’s easier to stir a man’s emotions than to stir his intellect. I watched a Senator grilling Bernanke last week in what came across as an amateur hour version of Law and Order where the Senator was trying to steer Bernanke into answering “yes” on a politically loaded question. Getting Bernanke to say “yes” to this particular line of questioning would garner that coveted 4 second “gotcha” sound-byte. The Senator asked this question no fewer than five times, using techniques from shouting to sarcasm in an attempt to get a “yes” out of Bernanke. To his credit it appears that Bernanke learned a few things from Paulson on the art of dodging questions before he left Treasury.

Is congress helping or hurting?

Short-termism is a phrase used to describe behavior that values near term performance at the expense of all else. This is what I see in congress right now…the attitude seems to be “do ANYTHING to have some impact now” with very little regard for the long term implications. The problem is that unlike congress, the market is full of people that DO have a solid understanding of economics and finance. The market understands the long term implications of all of this spending, of short-circuiting the incentive system, and of altering the risk/reward relationship that keeps our markets efficient. At a minimum the implications are higher future taxes with which to pay back the debt we’ve issued, and lower GDP as a result of less after-tax money that individuals can invest in economically viable projects. It’s like the old saying goes “a poor man never gave anyone a job.” By the time they get done taxing the money makers in this country there won’t be a lot of money left over with which to spur economic growth. That is a very serious problem and it is one that I hear very few in our government attempting to address currently.

If the solutions offered by the government continue to involve using taxpayer money to subsidize losses that should be absorbed by the risk-takers that generated them, then we are in for a long and painful process.

On a lighter note I have to say that I am actually a bit surprised to have made it back from this last trip. I had a meeting scheduled with a friend in northeast Florida. In our last correspondence before I left he said that all of the meeting rooms in the bank were full and that we’d be meeting in the “back-room” at the deli across the street from the bank. The imagery gave me some pause…my first thought was that this would end up like a scene out of the movie Goodfellas. I’ve got pictures running through my head of Mike taking me into the back room to introduce me to Joe Pesce and Robert Di Nero where one of them caps me for selling them a bond that yields 1.00%. “You don’t sell a 1.00% bond to a “made” man! Capice?!”…that type of thing. I figured I’m an easy target because nobody would miss a transient like a fixed-income salesman…it might be a year before anyone reported me missing. In actuality it was a far more pleasant experience as I got to have breakfast with a great bunch of folks, and nobody produced a gun. In fact the closest I came to death was the side of bacon that came with my eggs, but it’ll be years before that catches up with me.

The market

On to the market news this Monday morning. Treasuries are rallying and the Dow is down about 200 at the open. News over the weekend of the Treasury announcing that more banks may need substantial help along with the Obama administration telling GM’s Chairman to go home are the source of some nervousness.

Below I’ve highlighted the activity in Treasuries this morning.

To provide a bit of perspective as the 1^st quarter comes to a close I’ve attached two graphs that highlight the general trends in Treasuries. The graph below shows the steepening of the yield curve that we’ve experienced over the first quarter of 2009.

The trend in the 10 year Treasury over the 1^st quarter has been volatile. It is apparent that toward the end of January the 10 year moved into a new trading range. It’s yield has been bouncing around between 2.60% and 3.00% with a quick dip down to 2.50% after the Fed announced a massive new round of asset purchases.

If you have any questions on this material or if there is anything I can be doing for you please let me know.