Mile High Insights
The Tail Wagging the Dog
The world continues to unload assets. Commodities continue correcting across the complex from gold to wheat to oil. Gold had its biggest weekly drop in 25 years. Oil fell below $100/b. Copper had its biggest 2-day decline in 7 mos. Everything that went up on the buying with borrowed money is correcting downwards on the selling of those positions. Barron's is talking about a commodities bubble and we hinted at that in January of this year. The CRB index fell from 420 two weeks ago to 394 last Friday, a 6% drop. Nevertheless, the index still resides some 30 points or some 8% above the level in January, when I advised caution in my mid-January newsletter. Timing is everything, as you know. While commodities markets are likely to correct further, the credit markets seem to have stabilized somewhat. The US central bank's steady campaign to improve liquidity in credit markets and changes in the regulation of Freddie Mac and Fannie Mae as well as the Federal Home Loan Bank system have improved liquidity in US agency mortgage bonds, which resulted in narrowing yield premiums. Much of the widening in agency debt came on the heels of massive selling by investors facing margin calls and dealer firms that had seized collateral. The first rounds of selling pushed spreads wider and this in turn spurred other margin calls and forced sales. Carlyle Group's Carlyle Capital is believed to have been one of the casualties of this spread widening and the liquidation of Carlyle Capital's $22 billion agency mortgage bond folio is believed to have contributed to the dramatic widening in yield premiums. What made matters worse for the US mortgage market was concern about Bear Stearns with its massive portfolio of agency debt and related derivatives. The improved conditions in the US mortgage market -- the largest credit market worldwide -- are tied to a series of moves by the Fed and by agency regulators rather than to a single factor.
The chart above shows the yield of 10 year T-Bonds (blue) and 30-year T-Bonds (magenta) and the difference between the two (green). It shows you the extent of complacency that existed in the credit markets until summer of 2007 and then the increase in risk aversion afterwards. Notice how the spread hovered around 0.1% and 0.2% during the first half of 2007 and how afterwards the spread increased in waves to its recent high of 1%. The difference between the two bonds can be viewed as a proxy for risk aversion. 30 year T-bonds are 20 years further removed from the fed funds rate set by the Federal Reserve than 10 year bonds. Nevertheless, both belong to the long end of the yield spectrum and (broadly speaking) both are used for similar purposes by institutional investors. So, if an investor needs to match long term liabilities with long term assets (such as long bonds) and he is increasingly risk averse, he may use 10-year bonds rather than commit himself for 30 years. Rising risk aversion thus translates into less demand, falling prices and rising yields on 30 year bonds. Most investors use 30 year mortgage bonds rather than 30-year T-bonds as a yardstick for risk aversion, but T-bonds work just as well in my opinion and they are easier to track. You can see that the yield difference between the two bonds has shrunk since March 10. No doubt the Fed actions are having the effect of reassuring market participants. On March 19 Fannie and Freddie were also allowed to lower their surplus capital requirements from 30% to 20%. Then, on March 24 the Federal Housing Finance Board allowed a temporary increase in the amount of agency mortgage debt that the Federal Home Loan Banks can purchase. In addition the Fed expanded its term auction facility to $100 billion from $60 billion and introduced a term securities lending facility that offered Treasury securities to primary dealers secured for 28 days by a pledge of other securities including agency mortgage bonds. All these measures seem to slowly unclog the credit markets. Some of that may have already been evident in the March 21 week when refinancing tracked by the Mortgage Bankers Association jumped over 80% and refinancing accounted for over 60% of loans processed by lenders.
The chart above shows you the spread between the 2-year T-note and the 10-year T-bond. As discussed in a previous newsletter this yield difference is a proxy for the profitability of our banks. Banks are always borrowing short, currently paying on savings accounts and CDs something like 2% as approximated by the 2-year yield and lending long by receiving 4% and over for consumer loans, mortgages and business loans. The green line shows you the degree of profitability. You can imagine that banks in 2006 and 2007 were not exactly printing money, since the green line actually went negative for a while. In order to stay profitable, many of them were forced into risky business ventures like sub-prime mortgage origination or leveraged loans to finance takeovers. These strategies backfired and we now have to clean up this leveraged mess. While leverage actually did enhance banks profitability during times of risk affinity, it destroyed that banks profitability during times of risk aversion. The unwinding of the global leverage trade is going to take a while longer. Just consider that global GDP amounts to some $50 Trillion, whereas the tail that wags the dog consists of $500 trillion in derivatives.