FW: The Fed, the auctions, and a volatile week

 

It’s been an interesting week.  Among the highlights, we’ve heard from both Ben Bernanke and Janet Yellen, and we’ve had a few Treasury auctions.  The news from the Fed is unchanged…low rates for an extended period…recovery needs continued low rates to be sustainable…high unemployment…low inflation.  To their credit the Fed is doing exactly what they said they would do…keeping rates low for a long time. 

The first time we heard the phrase “…likely to warrant exceptionally low levels of the federal funds rate for some time” was in the December 2008 FOMC statement.  They weren’t kidding then, and they don’t appear to be kidding now…15 months later.  That infamous phrase was still being used in the March 2010 FOMC statement.  It makes me wonder how long folks in Japan heard those types of statements as they waded further and further into their lost decade.  At what point did everyone look around and say “hey we’ve got a real sticky problem here…nothing we are doing is working”?

They ain’t just sayin’ it…they’re Yellen it

Some quotes from Fed officials this week might add some color to what’s going on inside the Fed:

Janet Yellen recently stated:

-           I don’t believe this is yet the time to be tightening monetary policy

-          The economy will be operating well below its potential for several years,

-          I don’t think we’re due for an outbreak of inflation, not in the short run, as a result of the Fed’s economic stimulus measures and not in the long run as a consequence of massive federal budget deficits

Here are a few from Bernanke this week:

-          The economy continues to require the support of accommodative monetary policies

-          …we have been working to ensure that we have the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus

Regarding low fed funds rates, Chicago Federal Reserve Bank President Charles Evans said earlier this week:

-          I would expect it will hold for the next three or four meetings, that’s about six months, I won’t be surprised if it carried into 2011

-          On March 4^th Evans said removal of accommodative policy is “still quite a ways away”

Other Fed officials such as St. Louis Fed President Bullard and New York Fed president William Dudley have also been in the news this month singing the same song as the others.

They are in no hurry to raise rates because there is no looming threat of inflation.  Unemployment is still running north of 9.00% and the housing market continues to weigh on the economy like a fouled anchor.  The problems that we face aren’t the type that go away quickly…nor do they lend themselves to bureaucratic “fixes”.

In the midst of a modest and fragile recovery I would expect them to continue telegraphing their thoughts on monetary policy long before any changes take place.   At present they continue to state that “exceptionally low levels of the federal funds rate” are necessary. 

Are they really done?

Another point to ponder is whether the Fed is REALLY done buying Treasury and MBS paper.  Given the current state of the housing market the Fed has to be experiencing some real heartburn watching the last two Treasury auctions.  The housing market is still in shambles and higher Treasury rates could begin pushing mortgage rates upward very soon.  Will the Fed allow mortgage rates to rise 50bps, 100 bps?  Or will they return to the market and take an even larger position to help keep rates low?

Auction time

The Treasury auctions commanded more attention than boring ole speeches by Fed officials.  Yesterday’s 5-year auction was fairly weak by recent standards.  That weakness spooked the market a bit and caused a decent selloff that continued late into the day.  By the day’s end the 10-year was trading just over a 3.80%.

Today we had the 7-year auction.  It was somewhat smaller in size than yesterday’s 5-year auction but this was a closely watched event.  If we had more weakness at today’s auction it could spark a rout in Treasuries that could push yields to levels we haven’t seen in months.  The 7-year auction turned out to be fairly weak as well and sparked another selloff in Treasury prices this afternoon. 

The 10-yr Treasury is now trading at a 3.89%.  That is the highest level at which it has traded since June 2009.  As we head into the close for today we’re seeing that the pullback is reversing to a degree.  The DOW was up over 100 points earlier today…at the close it is only up 5 points. 

Tomorrow we get GDP, Personal Consumption, Core PCE, and University of Michigan Confidence. 

What’s in it for me?

The upside of this activity is that yields are improving everywhere along the yield curve.  Even if you’re a buyer of 2.5 year paper you’ll see some improvement in yields.  If you’ve been waiting for a pullback, the market just gave you two in a row.  You could buy a bunch of bonds tomorrow with better yields than you’ve seen in weeks and go into the weekend happy…and your broker could go into the weekend the same way. 

No signs of improvement locally

Yesterday I noticed my neighbor was having some work done on her house.  Being a good neighbor I walked over to inquire.  While I was there I asked the contractor to stop by my place and give me a quote on some work I need done.  He never showed.  My neighbor told me that this was his last job.  He’s been a contractor for 20 years, he’s seen good times and bad, but he’s never seen it like this.  Two years after the recession started the economy is still so poor that this guy is having to fold. 

Last month I was talking with a friend of mine who owns a speed shop here in town.  He and I get along pretty well despite the fact that he was in the Navy and I was in the Marines.  He does performance work on Mustangs and Corvettes.  He’s worried that his business might not make it through this recession.  People have absolutely quit spending money on luxury items like nitrous kits for their sports cars.  He said he used to have to close the doors an hour early every day because he couldn’t fit any more cars in the garage…he pointed to the 3 cars in a garage that can hold up to 10 and said “this is all I’ve had all day.”

Lastly, I spoke with a bunch of car dealers this month.  One of them is the highest volume Ford dealership in the region.  They say sales are up over the last month or so but using the numbers they gave me in my informal survey, sales are still about 30% off the old “pre-recession” numbers…and they are having to offer huge incentives just to get to that level.

The trend in the national economic data combined with anecdotal evidence from my local economy tell me that we are a long ways away from returning to a normal unemployment rate of 4.5%.

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

Steve Scaramastro, SVP

800-311-0707

 

FW: Market Update 3 11 10 _ A sign of the times

Sign of the times

On the way in to work this morning I find myself sitting at a red light with an interesting view.  On the corner across the street from me stood a guy in his mid-twenties with a goatee beard, a big ring piercing in his bottom lip, a sleeveless t-shirt, baggy jean shorts, tattoos galore…and he is marketing something.  He is holding a big plastic arrow with an advertisement on it.  Now THIS has my interest…who in the world would hire this guy as the “face man” for the company.  This guy looks like he could easily be on one of those “most wanted” sheets you see at the post office…yet instead he’s here helping out with the marketing effort for a local business.  Unless this ad is for a bail bonds place or a tattoo parlor I’m going to be very surprised. 

When my light turns green I ease across the intersection and I see that the sign is telling me that his employer buys gold.  Yep…in case you can’t find a place that will buy gold…you can sell it to this guy.  At this point I try to envision a conversation where I come home and my wife tells me she made some cash by selling her gold rings.  If I ask her where this commodities transaction took place and she told me “I found some dirt bag leaning up against a light pole at Poplar and Kirby and sold it to him” I’d have some real questions about the deal.

So I drive the rest of the way to work trying to figure out the economics of how and why someone is paying this particular spokesperson an hourly wage to stand on a corner and hold their advertisement.  I never did get to a point where I could envision myself paying this guy $8 an hour to hold a sign with my name on it.

I’m hopeful that this is an inflection point for the economy.  When you can run a business buying used gold in the retail market and your advertising “campaign” is built on paying shady looking folks to act as billboards…the economy CAN’T get much worse.  Hopefully this is the low water mark and we start to improve from here.

The auction

The 30 year Treasury auction went off today and it was very strong.  There is still plenty of demand for Uncle Sams IOU’s.  The 30 year bond was up 5/8’s of a point immediately following the auction.  The rest of the Treasury curve is flat to slightly lower on the day (prices lower).

The data

The economic data for today consisted of Initial and Continuing Jobless claims.  Initial Claims were expected to come at -460k…the actual release was -462k.

Continuing Claims were expected to come out showing 4.5 million people still on the roles…the actual number was 4.55 million. 

The data were close enough to the estimates that they’ve had no material impact on Treasury activity.

Tomorrow we get Retail Sales and University of Michigan Confidence.

“What is everyone buying?”

This is a question we get a lot.  Bond activity among banks has been quite strong the last three weeks or so.  The one thing I can say that happens regularly is that we get inquiries for 6 to 18 month paper…then when we relay what the yields are people recoil and ask for something further out on the curve.  The yield curve is steep and short rates are exceptionally low.  A small extension in maturity can bring a material improvement in yield at this point. 

There are currently 147 basis points separating the 2 year Treasury and the 5 year Treasury.  Most banks own a lot of 2 to 5 year paper so this part of the curve provides a nice example. 

If you’re looking at 2 year Agency callable paper you’ll be looking at yields in the 1.15% range.  It’s not beautiful but if it’s what you need then it is what it is.  IF however you have a bit more flexibility you can extend out a bit and pick up 3.00% to 3.05% on 5 year callables…a 185 basis point pickup (or $18,500 in income per million invested).

So, on the 2 to 5 year portion of the Agency callable curve you have at least 190 basis points of yield to play with as you extend from 2 years out to 5 years.  You can wring a little more yield out of things by buying continuous calls.  You get more yield by selling more optionality…if your outlook is that rates are going up you pick up the extra yield of the continuous call without having to pay for it in the form of the bond actually being called away.

I guess that’s the long way of saying 2 to 5 year agency paper has been selling well.

Another very big hot spot on the curve is Agency Step-Ups in the 7 to 15 year range.  The idea here is that you pick up an initial coupon in the 2.50% to 3.00% range, then look for an aggressive structure that lets your bond keep up if rates begin rising.  Yields to the short call dates are way better than Fed Funds and yields on the longer dates are high enough that you can live with the bond if it extends.

A lot of this paper has traded over the last few months.  The current steepness of the yield curve combined with a defensive mindset on the part of buyers has combined to make step-ups a very active sector. 

MBS spreads are very tight.  Trades here now require more looking on our part to find a “deal”.  There is still plenty of activity in MBS…it just requires more legwork to find the right bond.

Signing off

That’s all for now…it’s Conference Tournament week, Memphis is losing to Houston right now and I can hardly think because George is yelling at the TV.  I can tell from the tone in his voice and the look in his eyes that he really believes those players can hear him.  He puts the “fan” in fanatic.

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

 

 

Market Update _ Barney Frank and why he must be smoking something

Why Barney Frank is wrong…and I am right        

Barney, Barney, Barney…today Mr. Frank is in “fear monger” mode.  I don’t know if he is trying to flex a little muscle to get some attention or if he is trying to prove that ignorance truly knows no bounds inside the halls of Congress.  This morning he made a statement to effect that the future of Fannie and Freddie debt holders might involve haircuts or bonds not being paid back at all. 

Mr. Frank either doesn’t understand the nature of the global financial system, or he’s willing to look like a complete buffoon to get some attention.

Before anyone gets too worked up about Barney’s statements let me point out a few facts, and then we’ll look at why we will never see anything like what he just mentioned.

In the beginning

Fannie and Freddie were created by the by the government, they were allowed to trade in the market with lower risk premiums due to their quasi-government nature (the implied full faith and credit), and they were mismanaged by the government (think “congress appointing their cronies to positions within the GSE’s and forcing them to lower their lending standards and help create this mess in the process”).  They have become so large that their debt is distributed throughout the global financial system, and I don’t know of a single bank in this country that doesn’t own their paper.  If you buy bonds and you don’t own GSE paper then you are in an exceptionally small minority of institutions.  Another material point is that they currently have “unlimited” lines of capital from the US Government.  The government owns responsibility of the GSE’s…Barney Frank can’t come out and say he’s bailing anyone out by allowing the GSE’s to meet their commitments.  The politicians created the mess at the GSE’s and they are responsible for cleaning it up.

If Mr. Frank thinks that he has the ability to force a “haircut” on the holders of this paper then he needs to be tested for drug use right now.  This is a move that would destroy much of the US banking system virtually overnight…it would also extend to foreign countries…some of whom own a tremendous amount of our debt and who would quite willingly punish us by dumping it on the market and causing interest rates to skyrocket.

Secondary effect

Any failure to pay 100% principal WILL result in a downgrade.  There is no way around it.  Fannie and Freddie would be immediately downgraded to “D” by the ratings agencies.  Now a “D” in high school was a passing grade for me…but for the GSE’s it stands for “Default” and it occupies the absolute lowest rung on the credit ratings scale.  This downgrade would cause a massive secondary effect.

To help you visualize the impact of a downgrade I’d like you to think back to all of the Gulf War footage we got to see on TV.  Footage where an F15 Strike Eagle drops a laser guided 500 lb bomb right on top of a tank…you get the initial explosion which is pretty impressive, but then you get what is called a “secondary”.  The “secondary” is where the fun really starts…it’s where all of the fuel and ammo that was onboard that tank blows up as a result of the first explosion.  The secondary is what spreads the damage far beyond what would have been done by the initial impact.

The secondary effect from any failure to pay on the part of the GSE’s will come right after the downgrade.  Every bank in the country that owns this paper will have an immediate and ginormous loss that runs straight through to capital.  If you have 30% of your assets in the portfolio and 80% of that goes into default you’ve got a real problem.  Imagine the impact to capital if you have to mark all of your Agency debt from 100 down to say…20.

Your losses will be compounded because you’re not allowed to own “D” rated paper which means you will be forced to realize the loss by selling it.  When you go to sell your junk bonds you’ll quickly realize that a crowd has formed because everyone is selling their bonds.  More and more people sell which pushes prices lower and lower in what is commonly referred to as a fire-sale.  The GSE market will spiral into the deck where it will leave a giant smoking crater similar in size and historical significance to the meteor impact that killed the dinosaurs (I’m watching a lot of Discovery Channel lately so please forgive the analogy).  And this is just the impact on the domestic banking system.

Now look at the situation faced by foreign central banks.  Some of these folks are ALREADY talking about selling US Securities…this type of action will solidify and accelerate those plans.  This will add even more selling.  “Panic selling” doesn’t really begin to describe that activity that will be taking place at this point.  I wouldn’t expect US Treasuries to be the safe haven after this.  I don’t think investors will continue to view debt from the same folks that just blew up the financial system with the GSE default as “safe”. 

If you’d like to take it further you could even move on to how many American citizens would have their retirement savings wiped out by this move.  It will be tough to get reelected after you torpedo the entire country’s banks, jobs, and retirement dreams.  Feel free to come up with some more and shoot them back to me…the possibilities are almost endless.

And do you think anyone would be willing to buy a US “Housing Finance” bond EVER in the future after this fiasco? 

Prove it

Lest you think I am merely being an alarmist look at the “secondary effect” we got from the failure of Lehman Brothers.   Lehman is a much smaller institution than the GSE’s yet their demise pushed the US financial system to the verge of collapse.  When the powers-that-be decided that Lehman was where the bailouts stopped it set in motion a very unintended set of consequences.

Lehman’s default shook the foundation of our economy because their debt was widely held by money market funds.  Money markets are tremendously important pools of capital that provide the liquidity for our economy.  These funds are the oil in our economic engine.  When Lehman defaulted it caused losses in money market funds.  Money market funds aren’t supposed to “do” losses.  You put a dollar in and you get a dollar out.  If you get less than a dollar than the fund “broke the buck” as we say.  Breaking the buck is the death knell for a money market fund.  So Lehman caused a lot of losses for money market funds.  Losses were so widespread that concern that began as a ripple from a corporate bond default, then formed waves, which in turn became a tsunami.

Half of the liquidity in money market funds in the country was poised to leave OVERNIGHT.  The sell orders were on the books and ready to be executed when the firms that run the order books raised the alarm.  Treasury got a phone call describing the carnage that was about to unfold and they immediately put a Full Faith and Credit Guaranty on all money market funds to avoid the panic.  Think about that for a moment…they let Lehman fail and in turn were forced to insure all money market funds in the country against loss.  This huge impact was just from the default of a single corporate issuer…Lehman Brothers.  This example should provide some very recent insight into what type of events can be triggered by a default of a big institution.  If Lehman can do that much damage just think of what the GSE’s hold in store.

In summary

SO…the GSE’s fail to pay or force a haircut, they kill most of the banks in the country in the process (through OTTI capital write-downs on their GSE debt), they anger foreign central banks to the point that they sell their holdings partly out of self defense and partly as a punitive measure, the secondary effect that we love so much roils through to the rest of the investing world in the form massive liquidations in response to the  downgrade to “D” and giant swathes of the American public see their retirement portfolios wiped out.

In my opinion there is nobody in politics that is going to light the fuse on that scenario.  If your goal were to destroy the US economy and set us on an equal economic footing with say…Kurdistan…then I’d say it’s a good plan.  Short of that…ain’t gonna happen.

I believe that my view on the GSE’s is far closer to reality than Mr. Franks’.  It seems to me that the most likely scenario is that existing debt of the GSE’s gets “grandfathered” into a Full Faith and Credit status, then they can re-invent the GSE’s and release them into the wild as healthy institutions whose debt going forward will have a much clearer status. 

This allows you to avoid nuking the financial system, and at the same time privatize a function that should have been private this entire time anyway.  It moves a few trillion worth of obligations onto the Federal balance sheet but hey…that doesn’t seem to bother anyone nowadays.

Wrap it up already

In summary the GSE’s do not have the ability to miss a payment or force a haircut on bondholders.  The markets seem to agree with this assertion as well…they are unmoved by Barney’s blabbering today.  Don’t lose any sleep over the misguided ramblings of one Congressman. 

I’m sorry if I’ve gone on longer than you or I wanted…but I can get passionate about these topics.  Halfway through this piece it began looking more like a manifesto of some sort rather than a market update but some things just need to be said.  In my view it is pure ignorance for someone of Frank’s stature to be spouting off in such an irresponsible manner on a topic like this.  I can only imagine the phone calls his secretary is fielding this morning…most of them from people far more important than me.  “Congressman Frank you’ve got Bernanke on line 1, Geithner line 2, Obama line 3, and some fixed income guy from Memphis on 4…”

I hope everyone has a great weekend.  If you have any questions or if there is anything I can be doing for you just let me know.

 

FW: Market Update _ The day of reckoning for High Premium MBS

The Reckoning

Last month Freddie Mac issued a statement telling us how they would use their unlimited lines of capital.  They would purchase out of their MBS pools ALL loans that were greater than 120 days late.  This news caused a lot of concern in the markets, bids on long paper dropped like a rock, and everyone held their breath and waited for the speeds to come out.  This morning they came out.

Most of the community banks that we call on don’t hold the type of paper that is most affected.  30 year paper, Interest Only paper, and Hybrid ARMs issued around 2007 would be the most at risk of experiencing high prepays. 

Freddie decided that they would take the hit all at once…they would clear the logjam of late loans all in one month and then get back to business as usual.  Fannie decided that they would spread the pain over several months so those pools will see a lower spike…but it will last longer.

So…the numbers.  In aggregate Freddie 30 year bonds saw the following speeds this month:

5.50% coupons – 49.0% CPR

6.00% coupons – 67.2% CPR

6.50% coupons – 78.3% CPR

7.00% coupons – 83.6% CPR

2007 apparently had the loosest underwriting standards as measured by delinquencies…the 2007 pools fared as follows:

5.00% coupons – 52.8% CPR

5.50% coupons – 61.9% CPR

6.00% coupons – 74.8% CPR

6.50% coupons – 89.7% CPR

7.00% coupons – 97.9% CPR

Interest only paper was also expected to fare poorly in this evolution and it did exactly that.  Freddie interest only paper saw these speeds:

30 year I/O 6.50% coupons – 92% CPR

40 year I/O 6.00% coupons – 95% CPR

40 year I/O 6.50% coupons – 97% CPR

It is important to keep in mind that these are one month speeds and that they are not expected to continue at this level.  This was the clearing of the logjam so to speak.  The plan at Freddie Mac is to be much more diligent in keeping these pools clear of late loans.  This shouldn’t be a problem as new accounting rules favor purchasing late loans out of the pools AND they have unlimited lines of capital from the US Government.

How can you see if you’re affected?

Lucky for you…you’re friendly neighborhood fixed income firm (ahem…Vining Sparks…ahem) already has the framework in place for you to track your portfolio performance online.  If we have a copy of your investment portfolio you can log on to the website and go to the “My Portfolio” section to see the speeds for all of your pools.

If you need some help with the website, need a password, or need to get your portfolio loaded so that you can use these features…just let me know.  It’s a piece of cake to get it all going.

The strategy that got killed by reality

The interesting thing about this cycle is that in some corners of the investment world it spawned the idea that prepays wouldn’t be a risk factor this time around.  The idea was that because nobody could qualify for a refi that we wouldn’t see high prepays and therefore…huge premiums are a safe play.

We disagreed with this idea from the outset.  We could not get comfortable with the “buy the biggest premium that you can find” strategy.  Our view was that the risk of loading the boat with high premium paper far outweighed the potential benefits.  We had some heated debates even with our own trading desk about this…and this morning we get to call them and say “I told you so.”  Normally we wouldn’t be so juvenile as to actually call and tell them that but they started it by calling us crazy for not seeing the value in huge premiums so we feel it’s our obligation to make the call.

It reminds me of a conversation I had with my 6-year old daughter as I was dropping the kids off at school last week.  I’m in the carpool line and someone up front blocks the bus entrance with their vehicle and turns the normally smooth system into complete gridlock.  I’m working on my first cup of coffee, and I’m generally not a “morning person” to begin with, and I’m watching this like it’s a bad movie on TV and before I know it I’m muttering “look at this dummy…messing up traffic  because they’re blocking the entrance.” 

At that point my 6 year old leans forward, surveys the situation and she says “Yeah Dad…you know not to do that, and you’re not a genius.”  And just like that I was dragged back to reality…humbler than I was just 10 seconds earlier.  

If a non-genius like me could see the problems on the horizon with huge premiums I don’t know how the really smart folks could miss it.  Maybe more investment houses need to have 1^st graders on staff for a reality check every now and again. 

Oh yeah…the Unemployment Rate was released

In my mind the prepay story is the news of the day BUT…the Unemployment Rate also came out and it is a hugely important number so we need to look at it too.  Before we start a discussion on the Unemployment Rate it’s important to point out that there is a tremendous amount of “noise” surrounding this number right now. 

You’ve got hugely disruptive weather patterns across much of the country cited as a factor that could push the rate higher.  You also have about a million people being hired to help run the census which should offset some of the negative factors temporarily.  Complicating things further is that you have the normal ebb and flow of workers losing their jobs, finding new jobs, and perhaps the toughest factor to quantify…some number of workers even leaving the workforce. 

So…what did the Unemployment Rate do?  Nothing.  It remained at 9.7%...the Bloomberg Survey estimate was 9.8%. 

Elsewhere in the economic news…

Change in Non-Farm Payrolls was -36k jobs vs. an estimate of -68k jobs.

Change in Manufacturing Payrolls was an addition of 1 thousand jobs vs. a -15k estimate

Avg. hourly earnings Year-over-Year for All Employees 1.9% growth vs. a 2.00% growth estimate

So overall today’s data paints a picture of an economy that still has a very high unemployment rate, is losing jobs at a slower rate than expected, and whose workers aren’t earning as much income as the survey anticipated.  The data do not point to a robust recovery, nor to inflation, and this tends to validate the Feds view that they won’t be raising rates anytime soon.

The market is pulling back across the length of the curve.  The 10-yr Treasury is off just over half a point to trade at 3.68%. 

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