Bond Market Update
by Brad Tottle
TARP Passes But Questions Remain
October 6th, 2008
After much debate, a $1.6 trillion equity washout, and some unbelievable, unrelated add-ons the TARP finally was passed and signed into law on Friday. Now we can all breathe a little easier... or can we? As discussed in the previous weeks, questions remain as to how effective the auctions will be and which firms will actually use them. Also still up in the air is how a fair price will be determined that won’t overpay (which protects taxpayers) but won’t underpay (which allows the plan to maximize its effectiveness). There remains a debate over whether the TARP was necessary at all or if the problem could have just as easily been dealt with by issuing a moratorium on mark-to market accounting rules (FASB 157). The problem here is that simply suspending the rules does little to restore confidence among the banks. At some point everyone is going to have to show their cards so that the healing process can truly begin. Another question that remains is how much banks will actually sell, especially since the market may view the use of the TARP in the same light that it views the discount window and the PDCF. Firms approaching either of these facilities are instantly thought to be in trouble even though the facilities are put in place to help them avoid it. Remember, it is all about confidence right now; the market is operating under the presumption of guilt until proven innocent mantra.
But before we can deal with any of that something has to be done about the frozen state of the short-tem funding market. The aftershocks from Lehman’s failure are still reverberating in the short-term funding markets, namely the commercial paper and inter-bank lending areas. The closing of two large money market funds after Lehman filed for Chapter 11 caused an institutional exodus out of money market funds and into front-end Treasury bills. Money market funds, which collectively account for the bulk of commercial paper purchases, were already trying to diversify away from corporate paper amid the fallout of numerous financial firms. Thus the seismic shift that occurred in T-bills was from both money funds themselves and from those pulling out of those funds in a panic-driven flight to quality at the same time. As a result, many firms have had to shift to borrowing in the overnight market at an extremely high cost. Banks, already operating under self-preservation mode, remain hesitant to lend – and those that did made sure that they charged heavily for it. Take a look at the spread between the yield on the 1-month T-bill and the rate on 1-month LIBOR. Over the last twenty years the average spread between these two rates has been roughly 60 basis points; it is currently 391 basis points. For overnight loans the story is the same with overnight LIBOR trading at roughly 132 basis points above the effective Fed Funds rate. Historically the spread ranges between 5-10 basis points over.
Speaking of effective Fed Funds rates, the Fed did get the timetable moved forward to pay interest on excess reserves held at the Fed in hopes of better managing the effective Fed Funds rate, which lately has looked a lot like the lie detector test of a nervous participant. By paying interest on excess reserves the Fed would give banks an incentive not to dump excess funds into money market instruments, which exerts downward pressure on the Funds rate. The Fed has tried to manage the target rate through large repurchase agreements and open market operations in addition to greatly increasing the amount it loans through the various facilities it has created (TAF, TSLF, PDCF) but it has done little to stop the markets from pressuring the Fed Funds rate all over the map. At one point after Lehman’s filing the effective Fed Funds rate shot up to 6% as banks completely abandoned loaning excess reserves. Since then the effective rate has traded significantly below the target rate, implying that the market wants more easing in the target. Paying interest on excess reserves would effectively put a floor on the Fed Funds rate while at the same time giving the Fed more available liquidity to pump into the system.
Corporate spreads remained volatile as reeling investors await the next shoe to drop in a market that resembles a Payless Outlet atop a fault line. GE Capital spreads tightened in quickly after news that Warren Buffet had entered into another sweetheart deal (for him) and the company raised some $12 billion through equity issuance but by the end of the week the spreads were back close to the wides, even after the TARP passed. Wachovia spreads remain all over the map as the market waits to see which path the courts will decide for the company; will they end up stuck in a shotgun wedding to Citigroup or will they elope with their new love Wells Fargo? Either way the fact remains that one of the largest commercial banks was staring into the abyss that has swallowed up so many other large firms already and was forced to reach for a helping hand.
Chart of the Week: CDS Spreads on Financials Remain Elevated. Credit Default Spreads remain the derivative tail that wags the cash dog. Can’t short the stock of a financial? That’s ok, with the combination of options on the stocks, shorting the bonds, and buying the CDS the arbitrage accounts (those still left) can still take advantage of the fear in the markets. Spreads on these private insurance contracts on an issuer’s credit worthiness continue to vacillate with every passing rumor, adding more pressure to spreads on cash bonds. The beauty from the arbitrage player’s standpoint is that one does not have to actually own the bonds to purchase a CDS. What was once a way for large institutions to manage exposure to individual names without having to actually move the entire position has developed into a full-fledged speculator’s haven. Since no two contracts have the same terms and there remains no netting facility (sans the emergency meeting held by the ISDA the night of Lehman’s default) these contracts are hard to track outside of direct dealer quotes. Again, your contract is only as good as your counterparty’s ability to pay on the claim if the underlying issuer defaults so trading in the contracts has fallen to a handful of dealers deemed “to big to fail.” This only adds upward pressure on the costs of the contracts.
Paul Bunyan on the Loose
September 29, 2008
Another week and yet another redwood has fallen in the financial forest, forever changing the landscape. Last week’s seizure of Washington Mutual by the Office of Thrift Supervision (OTS) and subsequent sale to JP Morgan was the largest bank failure by assets in U.S. history. With just over $307 billion in assets as of June, the failure of Wamu made the previous record holder, Continental Illinois, look like chump change given that its assets totaled a mere $42 billion when it failed. While taxpayers were spared the brunt of the failure through the sale of the bank and assumption of most of its holdings the investors in the company were left holding the bag. It was not just the common and preferred stock holders who lost but the senior debt holders as well since the assets were moved from the bank holding company leaving the liabilities behind. As a result, the initial recovery estimates for the bondholders do not look promising. Yes, for investors the company’s former tag line of “Woo Hoo” read more like “Boo Hoo” by the close of trading Friday with its senior notes trading in the low 30s. There was a bit of a rally headed into the close with some large blocks printing at 40 cents on the dollar but this was most likely speculators in the credit default swaps (CDS) of the company positioning to execute on their contracts. The favored trade for a while among the arbitrage accounts (a.k.a the Leverage Lumberjacks) has been to short the stock (back when you could) and go long the CDS (now being investigated by NY A.G. Cuomo) and wait for the resounding cry of “timber!” from the company. Talk about a win-win trade; the stock goes to zero and the credit default insurance is activated entitling holders of the CDS to par value. Then it’s just a matter of buying the defaulted bonds at pennies on the dollar for delivery to the counterparty for payment. Of course in this environment it really depends on who your counterparty is for the trade to work. In many instances the counterparties were collateralized debt obligations or CDOs that sold securities with cash flows linked to the premiums received on CDS contracts written. In short, the shockwaves are not done spreading from the demise of large firms like Wamu, Lehman, and AIG. The vast interwoven derivative fabric on top of more vanilla securities only lends itself to more losses across more investors.
Not surprisingly, the fall of Washington Mutual further amplified the counterparty risk mindset of the street. Treasuries remained the safe haven place to be causing front-end yields to cave once again as the entire street watched Capitol Hill for signs of movement on the proposed $700 billion “Emergency Economic Stabilization Act of 2008” (the name on the draft of the bill released this weekend). When signs emerged that the “Troubled Asset Relief Program” or TARP faced an uphill battle, money again flowed into the front-end of the curve, pushing T-bill yields back towards the previous week’s lows, which were the lowest seen since Hitler invaded Poland. It appeared that Congress didn’t want the TARP to be viewed by the American taxpayer as simply a “Toxic Asset Relocation Program” to save the irresponsible banks on their dime. But given the dire picture painted publicly by both Paulson and Bernanke (and probably even more gravely behind closed doors) it appeared late in the week that something would be hashed out albeit slightly more involved than the initial three-page draft put before Congress by Treasury. Hence, we now have a 106-page bill sitting on Capitol Hill due to be voted on early in the week. Given the tightness in credit and the hoarding by banks (LIBOR/OIS spread spiked to 200 basis points and excess reserves held at Federal Reserve banks above the minimum requirements skyrocketed last week) any progress could be viewed as a short-term positive. But the longer-tem impact will depend on a number of factors, including what the government will pay and what strings are attached. At the onset it appears that there will be some say on executive compensation, but only on new contracts, and the Treasury will have the ability to take either an equity or debt stake in the companies as it sees fit. Presumably the government would evoke the latter option for those firms that need more aid than just simply deleveraging and hence, would pose a bigger risk to taxpayers. It seems plausible that the purchase price of these assets will have to be somewhere between the prevailing fire sale prices in the open market and the modeled intrinsic value in order for the program to be used effectively. Otherwise many firms may find themselves in a precarious situation of not being able to take even the improved bid from the government if it diverges greatly from their current marks. Even if they don’t, the government’s price will become the prevailing mark-to market level, and as such, further writedowns are still ahead. Basically the government has to think like a buy-and-hold investor and be willing to pay up for securities it hopes will pan out over time.
The Treasury curve will most likely bear flatten initially as the fear bid in the front-end eases a bit, and long-term rates start to prep for the terming out of the commitment. As the plan progresses the curve will likely switch to a steepening bias which poses its own challenges in terms of keeping mortgage rates in check since they are tied to the long-end of the curve. While mortgage spreads will most likely tighten, especially as the government ups Fannie and Freddie’s purchasing power, the bearish steepening likely to accompany debt financing of the bill will be somewhat counterproductive to solving the larger problem underneath this mess; the ongoing weakness in housing. But hey, at this point some credit is better than no credit, right? Corporate spreads may snap back in as shorts cover (yes, you can still short in the credit markets) yet given the tender nature of the credit markets over the last month it will hardly be business as usual. Also looming large on the horizon is the need next year for corporations both in and out of the financial sector to roll terminating debt issued at the low yields in 2003-04. Aside from the fact that spreads are well above what was paid then, the appetite for risk has changed and the perception is that covenants will have to be strengthened in order for investors to come to the debt side of the financing table.
As for the start of this week, the fallout overseas of Fortis Bank, and Bradford & Bingley are keeping Treasuries well bid this morning, despite the announcement of the proposed bill. Given the payroll data coming at the end for the week I expect that the underlying bid will remain opportunistic at the dips.
Chart of the Week: 10-Year Breakevens Signal Slowing Growth Fears Trump Fears of Inflation... For Now. The flight to quality over the last two months has caused nominal on-the-run Treasuries to trade “special” due to the greater depth and breadth of trading in them compared to their inflation-linked counterparts. Inflation fears have also been replaced by more concerns over growth going forward. As a consequence, the 10-year breakeven rate has plunged nearly 85 basis points since the 4th of July. The breakeven rate is a rough proxy for inflation expectations over the term of the notes and is equal to the spread between the two yields. A current BE of 1.77% make TIPs look like a cheap inflation hedge given the debt financing to come with any rescue package. But be patient, they could get cheaper if headline inflation cools into the end of the year.
Chart of the Week Part II – Time for another rate cut? As the effective Fed Funds rate has fallen substantially below the target rate the Fed has sought to expedite the ability to pay interest on reserves held by the reserve. By paying interest the incentive is for banks to keep them at the Fed banks instead of piling into the money markets; thereby pressuring front-end yields. This is a mechanism that essentially puts a floor on Fed Funds. This chart shows the incredible volatility around the target as of late and seems to show that there is plenty of room to cut rates if need be.
The author of this material is a Proprietary Trader/Desk Strategist in the Fixed Income Division of Raymond James & Associates, not a Research Analyst. Any opinions expressed may differ from opinions expressed by other divisions of Raymond James including our Equity Research Department and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but Raymond James does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitutes a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities, and/or derivatives that Raymond James may have positions, long or short, held proprietarily. Raymond James may have also performed investment-banking services for the issuers of such securities. Investors should discuss the risks inherent in bond with their Raymond James Financial advisor. Risks include, but are not limited to, changes in interest rates, credit quality, volatility, and duration. Past performance is no assurance of future performance.
