The Paragraph That Changed the World: Will Treasuries Crash?

From Sunday's Fannie Mae (FNM) & Freddie Mac (FRE) press release:

Finally, to further support the availability of mortgage financing for millions of Americans, Treasury is initiating a temporary program to purchase GSE MBS. During this ongoing housing correction, the GSE portfolios have been constrained, both by their own capital situation and by regulatory efforts to address systemic risk. As the GSEs have grappled with their difficulties, we've seen mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers. While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability. Treasury will begin this new program later this month, investing in new GSE MBS. Additional purchases will be made as deemed appropriate. Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and GSE MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains. This program will also expire with the Treasury's temporary authorities in December 2009.

Nowhere do I see language specifying limits to MBS purchases. This sends a message with potentially scary results for anyone vulnerable to a high interest rate environment, since a large fraction of MBS agency exposure now becomes a potential liability to the US government. Considering $5 Trillion of mortgageback debt added to a $9 Trillion deficit (only $5 Trillion of that being due to parties other than the US government itself), this has an unavoidable potential to impact US debt credit quality, not to mention capital inflows towards dollar purchases.

While the spread between agencies and treasuries will tighten, we may witness an environment where long dated debt of all types experiences skyrocketing yields, potentially undoing the benefit of this policy change.

I can only imagine the Fed will counter this deflationary prospect with further suppression of short term interest rates. At this rate, I could picture new mortgages being given with synthetically low rates created by some unnamed future program, not reflective of treasury yields or past agency spreads. This will incur further risk to government debt and call into moral question what level of involvement the government should have in the mortgage debt markets.

On the bright side, a gigantic spread between fed funds (1% or under potentially lower) and 30 year debt (8%?) would result in an accelerated refunding of the banking system, that is unless the volumes of loans slowed enough to undo the net benefit of this spread. Or worst case: we could turn into a nation where all consumer and house loans were done on short term floating rates, since nothing on the long end would be affordable enough. This only opens the door for further nightmares when the government must eventually raise rates as the economy accelerates too quickly.

The prolonged equity market reaction might not be as bullish as some of us hope either, since higher interest rates imply a higher demand for earnings yield, putting price support much lower. Furthermore, the effect of increased credit costs to companies does not need to be spelled out.

The prospect of a Japan repeat for the U.S, with short term rates hugging 1% for a while, is a distinctly viable possibility. In summary, never before in my lifetime have I seen the credit quality of U.S. debt be possibly challenged. I would be surprised if the markets opened on Monday with complete denial of this prospect.

For the sake of Pimco's Bill Gross, I hope he is short the spread between treasuries and agencies, because he may not get the pop he desires on agencies if he is long only.

While it is obvious home prices need to come down closer to fundamental values in many areas, I hope all of this is an incorrect postulation. The ramifications of this move could be disastrous and have depressive implications going forward. And since I am not exposed to nor short treasuries, I do not stand to benefit from this prognostication.

Stock position: Long SPY, QQQQ, XLF.

Comments

[Dirkyp:]

Complete fearmongering. You can't just add on the liabilities of Fannie and Freddie to the government's debt, because those liabilties are coming onto the government balance sheet with offsetting assets. And new MBSs will be much more secure than the old stuff - lending standards are high now so new mortgages will be done on already deflated home prices and credit quality will be high. All this does is allow banks to start offering lots of mortgage financing to those who qualify, and the bank's cost of capital will be much lower now, so the US Treasury gets high quality loans, the banks get cheap capital, borrowers get a lot of debt available at more attractive rates which will help the housing market stop declining and ultimately start to turn around.

2008 Sep 08 09:41 AM

[John Lounsbury:]

Talk about dilution! Essentially the federal treasury debt just doubled. Does this imply a sharply reduced value for the US$? Or will this lead to a large increase in treasury interest rates?

Maybe no to both. For yes answers, ownership of the mortgage debt would have to result in losses for the treasury. In spite of the doom and gloom of some, it may be that only a small percentage of all Fannie and Freddie mortgages will actually default. If the default is 10%, that is about $5T. However, the interest return on the other 90% is approximately the same amount, $4.5T - $5.5T per year. If the cost of operation is less than the interest return from the mortgages, the US Treasury (you, the taxpayer) might actually make money.

What is needed for this to turn out well? Treasury bond interest must stay below the interest rates on the mortgages. To know if there is going to be a good outcome or not, watch the spread between the GSE (now the GOE - government owned enterprise) debt and treasury bonds. As long as the 10-year (and shorter term treasuries) remain below the average return on the GSE paper, the taxpayer is whole. If the spread turns negative (ie, treasury yields rise above the yield on GSE paper), this entire enterprise is losing money and the national debt rises.

An even bigger question regards the future. Can the mortgage business be restructured and returned to the private sector in a short period of time? Or is the U.S. Treasury (you, the taxpayer) going to be in the mortgage business for years to come? Is the distinction between the managed capitalist economic model (the U.S.) and the managed socialist economic model (China) becoming blurred?

2008 Sep 08 09:56 AM

[woodsey:]

Dirkyp, "fearmongering" is too strong. Otherwise I wish I could be as optimistic as you, but I'm not.

2008 Sep 08 10:04 AM

[Michael B. ...:]

Many good points here. Furthermore, I've been doing some reading that suggests the proposed MBS purchase plan is only applicable for new auctions. That isn't nearly as scary.

No mean to fearmonger - just evaluate reality.

2008 Sep 08 10:23 AM

[John Lounsbury:]

I said in my comment above "the interest return on the other 90% is approximately the same amount, $4.5T - $5.5T per year"

The correct staement would have said " about half of the same amount, $2.2T - $2.7T per year"

Sorry for the sloppy math.

2008 Sep 08 10:26 AM

[Econ 101:]

If all of this BS about saving FRE/FNM werent a cover for the bond holders and keeping housing prices artifically high then average people could actually buy and PAY FOR a house. This is just another phase of putting most of American into surfdom.

2008 Sep 08 11:51 AM

[sumosama:]

According to the author's logic, there is no value in any of the mortgage bonds held. Sorry, not even close on the most horrific of assumptions.

On the plus side, at least he included his positions!

2008 Sep 08 01:04 PM

[wagman:]

the only certainties are death and taxes and you can be certain that our tax burden will rise as a result of this bailout and for what? to stabilize housing markets and help us to be able to get affordable mortgages. hardly. politicians are once again wanting to be reelected and are throwing their sponsors a bone and hoping that the rest of us will reelect them as we do with regularity so they can continue to slop at the trough of government largess. i'm with econ 101 here. let the markets work things out for themselves. that way those who overpaid for their houses, stocks, bonds or whatever can take their losses and those who were more responsible with their investment choices and saved rather than spent during this long period of credit inflation are not being penalized for the sake of "special interests". good luck to all of you who are buying this rally and looking forward to this being the new "signal event" indicating a market bottom. credit deflation is inevitable and will march onward until satisfied. this action does nothing but delay it for awhile, benefitting certain sectors and individuals, hurting others, and being passed off as needed for the greater good. the ultimate irony will be when they are forced to reduce and eventually eliminate the mortgage tax deductions that have been the other ongoing stimulus to encourage you to overpay for what is really just another consumption item.that is when john q. public will know that he has once again been fleeced and left on the hook for the biggest housing bust we are going to see in our lifetime. great time to be a renter and protect whatever you have for the time when there really is "blood in the streets" and then buy whatever you can with whatever you have left.

2008 Sep 08 01:39 PM

[John Lounsbury:]

Pangea - - -

Please read before you comment. Here is what I said:

"If the default is 10%, that is about $5T. However, the interest return on the other 90% is approximately the same amount, $4.5T - $5.5T per year."

and

"In my comment above 'the interest return on the other 90% is approximately the same amount, $4.5T - $5.5T per year'

The correct statement would have said " about half of the same amount, $2.2T - $2.7T per year"

Your apology is accepted in advance.

2008 Sep 08 01:56 PM

[John Lounsbury:]

Pangea said "Also don't forget they only make money on the spread, not the entire coupon. Try again."

In my comment that you criticized I said:
"What is needed for this to turn out well? Treasury bond interest must stay below the interest rates on the mortgages. To know if there is going to be a good outcome or not, watch the spread between the GSE (now the GOE - government owned enterprise) debt and treasury bonds. As long as the 10-year (and shorter term treasuries) remain below the average return on the GSE paper, the taxpayer is whole. If the spread turns negative (ie, treasury yields rise above the yield on GSE paper), this entire enterprise is losing money and the national debt rises."

Are you reading anything or just online to hurl insults?

2008 Sep 08 02:00 PM

[John Lounsbury:]

Pangea - - -

One final point: I see little in your opinions that differ with my opinions that you chose to attack.

Huh???

2008 Sep 08 02:02 PM

[OldLimey:]

Let me get this straight. Those responsible for the world's most significant economy have just told us:

1. Regulatory supervision of the financial system is ineffective.
2. The professional competence of at least some of those at the heart of managing this system is inadequate.
3. The ethics of many of these same people are questionable.
4. The state (sounds a bit 'socialist' doesn't it??) is now formally the beating heart of the residential mortgage market and there is no plan in place to privatise it.
5. There was no practical alternative to the public sector rescue of two of the world's most significant financial institutions just two months before a tightly contested election.
6. Nobody can put a figure - to the nearest few hundred billion dollars - on how much this may add to the debts of an already heavily indebted country.

.....and this is GOOD news!!

OK, let's strip aside the ethical stuff and resist the temptation to jibe at the innovative blend of crony capitalism and socialism that now lies at the heart of the US 'free market' model, and lets not spend too much time wondering about who else will be next in line with a begging bowl. If the GSE balance sheets - with their creative accounting and tasty Level 3 assets - belong on the fiction shelves and nobody in the regulatory system had apparently worked this out, what trust can be placed in the rest of the financial system?

I have no idea whether or not the author is 'scare-mongering' - but how can anybody else?

2008 Sep 08 02:15 PM

[nukldrager:]

Of serfs and surfing, cabbages and Kings. Still more Jaberwocky from the slithy toves. Off with their heads!!

2008 Sep 09 07:00 AM

[Mark McHugh:]

If you have any doubts, check Mike's track record. He's pretty much the sharpest pencil in the box. His article "Time to Short Both Long-Term Bonds and Crude" was brilliantly timed, and his logic amazing. I regret not following his advice.

Just tell us when to put the trade on, Mike.

2008 Sep 15 01:35 PM