Bond Expert: Fear and Tension in the Agency Market

There has been an underlying fear in the market this morning and it is not fully reflected in spreads. It is reflected somewhat in the 2 year note which has traded to a cycle low close to 2.25 percent.

There is an interesting tension at work in the agency market. There is risk aversion at work and a generalized fear about the ultimate resolution of the problem

If the Treasury can find some way to keep the GSEs funded, there is a school of thought which holds that the cash flow which they generate in the normal course of business will be enough to get them through the very long rough patch until housing prices bottom and maybe even rebound.

The problem is that investors probably do not have that long a time horizon and at some point the aversion to lending to these financial lepers will lead to a funding crisis which will only be solved by the exercise of plenipotentiary powers recently granted to Secretary Paulson and his  successor. (As an aside, a Zogby poll has McCain ahead by 5 points and I noted that the realclearpolitics.com website has McCain leading in electoral votes for the first time. How do you say Secretary Gramm?)

One interesting problem for investors is that there are diminishing returns to being under invested or short agency spreads as spreads widen. At some point spreads will reach levels at which the agencies are unable to fund themselves and Treasury assistance will be necessary. At that point there will not be enough senior benchmark paper to satisfy demand as it will then become full faith and credit paper. There would be a tsunami of buying as investors look to ride that wave.

Benchmark senior debt is 1 basis point to 2 basis points wider today.

The CDS on the subordinated paper is perplexingly about 60 basis points tighter than previous day closing levels.

Comments

[whidbey:]

Very astute but likely wrong. Treasury will never let things go so far that panic drives the markets. I mean who would get so far into GSE paper that they would hope for FFC bail outs? Answer is surprising. Yes?

2008 Aug 20 03:45 PM