There's a little problem poking its head up out of the ground here in the form of the 10 year Treasury (TNX.)
You can see the technical gap that turned back the rally in yields (upward) earlier this spring. This time it looks like we're going go through and head higher.
Around the top of that gap, which is near 2.2% or a bit higher, is a potential landmine in the form of a hedging problem.
See, the MBS market (mortgages) is more-or-less correlated with the 10 year Treasury. As Treasury yields rise the duration of existing mortgages tend to extend, because you have a rate you cannot beat and in addition if you buy a different house you have to get a new mortgage at a higher rate. The direct impact on affordability is a problem for the housing industry but for the holders of MBS the nightmare scenario is to hold very low interest-paying debt into a rising rate environment where the duration of what you hold is extending!
Remember that the change in current value of a bond is more-or-less the change in interest times the remaining duration. Debt that the debtor can choose to prepay at any time without penalty (e.g. mortgages) have a variable duration that is under control of the debtor rather than the creditor, as a fixed-term, fixed-interest mortgage can be prepaid by the homeowner but the creditor cannot force the homeowner to either refinance or prepay out.
This means that losses in a rising rate environment in these instruments tend to feed on themselves, as the higher rates go the more duration on existing debt extends.
In turn the usual means of addressing this risk is to hedge it off by using the instrument most-closely linked to that market, which is the 10 year Treasury.
The problem is that The Fed has basically become the market for that issue.
This could get a bit interesting in that the market has this concept that "The Fed is in control."
There may well be a lesson to be taught here as to exactly how "in charge" The Fed really is if this trend in the bond market continues.
There was much gnashing of teeth in the mortgage-backed securities industry last April, when U.S. District Judge William Pauley of Manhattan ruled that mortgage-backed certificates are debt, not equity. That finding, in turn, led Pauley to conclude that MBS trustees are subject to the federal Trust Indenture Act of 1939, which imposes duties on bond trustees. Under the TIA, Pauley said, MBS trustees can be liable if they fail to notify investors of deficiencies in the trust's underlying mortgage loans and fail to act on those deficiencies. Beth Kaswan ofScott + Scott, who represents the Chicago pension fund that brought the suit before Pauley (which named Bank of New York Mellon as Countrywide's MBS trustee), told me at the time that the "watershed" decision was a way for investors to get around MBS pooling and servicing agreements, which typically require 25 percent of a trust's investors to band together before they can bring any action against an issuer.
There's been relatively little notice of this, but it has potentially-enormous consequences. If this ruling -- that MBS certificcates are in fact debt, then liability could be extended under the TIA which would upend the attempt to play the game that a trustee has only a "ministerial" duty.
At issue is the fact that MBS trustees are typically paid a relatively-nominal fee and do basically nothing, other than have their name on the deal. If they suddenly are responsible for monitoring and reporting breaches of reps and warranties on the underlying loans, then suddenly they have a duty to surveil those notes and actually be a gatekeeper on the integrity of the deal itself.
This, of course, would include whether the physical notes bearing endorsements were ever delivered to the trustee in the first place!
It would be a grand day indeed were we to finally get a ruling that when you claim to be something (e.g. "Trustee") that you really have to act like one!
This fight isn't over, needless to say, and probably won't be in the immediate future -- but it does bear watching.
Private-equity firms are adding debt to the companies they own in order to fund payouts to themselves, a controversial practice now reaching a record pace.
Leonard Green & Partners LP, Bain Capital LLC and Carlyle Group LP are among the firms using the tactic, which rose in popularity before the financial crisis.
In these deals, known as "dividend recapitalizations," private-equity-owned companies raise cash by issuing debt. The proceeds are distributed in the form of dividends to buyout groups.
Let's just call this what it is -- a screwing.
It's nothing other than a cynical version of arbitrage for the simple reason that it attempts to goad the market into providing a forward arbitraged level of cash "now" against prospective future operating earnings which the private equity shop takes today, leaving the execution risk with the debtholders.
It's clever and legal, but only works when you can find a bunch of rubes that will take on the risk at an undersized rate of return. That, in turn, is stoked by interest-rate "policies" that are suppressive of risk-adjusted rates (ZIRP and QE anyone?) which Bernanke and others assert are all "positive" in their impact on the economy.
That latter assertion is a knowing lie; there is no such thing as a free lunch but there are plenty of people who hope that when you see a pretty face poking out from the under the sheets you'll immediately strip and jump in bed without pulling back the covers to ascertain whether what's there is actually a pretty girl!
These bets always eventually end in disaster for someone, and the PE firms that pull this crap are simply insuring that the disaster isn't theirs, it's yours.
That's real special, isn't it?
But is this something that should be prohibited? I don't know. There's a fairness issue here that rears its head, but then again, it's damn hard to swindle an honest man, isn't it?
Anyone remember stories about how housing bears finally threw in the towel in the 2000s, only to buy the top?
Jay Mueller, who manages $3 billion of bonds for Wells Capital Management in Milwaukee, resisted buying Treasuries for four months, anticipating the Federal Reserve would drop its pledge to keep interest rates at a record low through late 2014.
No more. With the economy growing at a 1.5 percent annual pace, the odds of a recession have risen to 60 percent, making 1 percent yields on 10-year notes a possibility, he said. Wells Capital’s parent, Wells Fargo & Co., boosted its Treasury holdings 32 percent to $11.5 billion in May alone, according to the latest data compiled by Bloomberg.
“We’re in a low-rate environment for a long time, longer than I had thought,” Mueller said in a July 26 interview at Bloomberg headquarters in New York. “I’m finally throwing in the towel.”
The problem with these folks is that they're really not buying for the yield -- that is, to clip the coupons. They're looking for the price movement, and the longer the duration the greater the move you get when rates change.
This works great when things go your way. It's disastrous when they don't and is exacerbated by the fact that it's very easy to take on leverage using Treasuries as collateral, as they are regarded as "always good for face value" (if held to maturity.)
All of these things are very nice when life treats you well.
They'll ruin you when life -- or just bad luck -- treats you poorly.
Of course when you're a bond fund, what options do you really have?
The real nightmare comes not in these firms or the price moves in Treasuries (or lack thereof) but rather what happens to those institutions that require coupons in order to make their nut. I speak specifically of pensions, including Social Security, along with Medicare and other long-term obligations (e.g. annuities.) As older Treasuries mature the only replacements available have much-lower yields and this severely erodes the fiscal stability of these plans.
Four years in, this is the real story of "extremely low" interest rates -- yet nobody is talking about it.
And by the time they start it will be too late to take remedial action.
Investors are plowing cash into new U.S. Treasuries at a record pace, making economic growth rather than budget austerity a key issue as President Barack Obama andMitt Romney face off in November’s presidential election.
Bidders offered $3.16 for each dollar of the $1.075 trillion of notes and bonds auctioned by the Treasury Department this year as yields reached all-time lows, above the previous high of $3.04 in all of 2011, according to data compiled by Bloomberg. The so-called bid-to-cover ratio was 2.26 from 1998 to 2001 when the nation ran budget surpluses.
I love this sort of misdirection.
First, investors are "plowing cash into Treasuries" because they are convinced that they will at least get their money back, and further, they believe that a positive real rate of return can be had.
The latter means deflation will win. The former means that investors believe they will lose money in anything else.
Now maybe you can construe that as "bullish" on Treasuries, but that's a bit of a stretch.
Actually, it's more than a stretch -- it's really bad, especially when a distorted market sends bad signals into the market and people listen to that in making policy decisions. Japan has bricked themselves inside a building of their own design; if rates go up ever the nation's government will be immediately bankrupted. We're not far from the same position; run our figures with a 5% average coupon across the curve and you find that we have a $750 billion annual interest cost, or 20% of the federal budget or more than three times what it is today.
That would make interest expense greater than we spent on any of Defense, Social Security or Medicare and Medicaid last year! Needless to say that won't happen without bankrupting the Federal Government -- yet that sort of average coupon was normal just a few years ago.
This sort of market distortion is not good, it's ruinously bad. And as we have seen repeatedly over in Europe, rates have a habit of going from "heh, this is really nice" to "screw you" in extraordinarily violent moves, often with little or no effective warning.
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