Page 3 of 5 THE FOLLY OF INTERVENTION, Part 2 No easy exit for nationalization By Henry C K Liu
period immediately after September 11 and until the aforementioned October 4,
10-year note reopening, the "special" rate applying to the loan of both current
5-year and 10-year notes was close to zero.
The repo market indirect influences the Treasury market and, more broadly, all
fixed-income valuations and new issuance. The Treasury market and by extension
the repo market is critical for everything from determining mortgage rates to
funding the federal budget. The panorama of recent events is a good reminder of
the role liquidity plays in the portfolio management process. This is
true not only within the Treasury market, but also beyond it, in the sister
fixed-income markets.
The Treasury market relies on the two-way flows of market participants, both
the buyers and sellers, the offer and the bid sides. The financing of forward
settlements of Treasury securities is typically accomplished in the repo
market. On one side of the transaction, an entity with Treasuries on hand may
chose to borrow money at a specified, often below market rate (repo rate),
using the specified Treasuries as collateral. This is known as a Repurchase
Agreement, or repo for short. Effectively, this participant is selling the
Treasuries and repurchasing them at a later date, with the forward price being
calculated using the special financing rate.
On the other side of the transaction, an entity seeking to borrow those
Treasuries will lend money at that same rate, effectively buying the Treasuries
and selling them back at a later date (reverse repurchasing them, or reverse
repoing them). The forward price of the transaction is calculated using the
aforementioned special financing rate. Thus for one side the transaction is a
borrowing, for the other a loan, accepting cash in exchange for securities, or
securities in exchange for cash respectively.
A true repo transaction involves collateral movement and often requires a
"haircut", or additional collateral, typically 2%, to be posted for the loan.
Also, the legal documentation for repurchase transactions is specific and
details the rights to control of the collateral. There are also types of repo
differentiated by who holds the collateral, and what rights of substitution, if
any, apply. The above is a simplistic example of the economics of a repo
transaction. Specifically, the analysis is actually that of a sell/buy back
transaction, where the securities transactions are entered into with
settlements occurring and ownership changing. This differs from a true repo,
where only journal entries are made as collateral is posted and returned and
ownership does not change.
The repo market affects how a broader arena of securities is traded. In the
Treasury market, the most liquid securities that trade among dealers are
typically the most recently issued benchmark Treasuries, the 2-, 5-, 10- and to
a lesser extent 30-year notes and bonds. Dealers trade these against other
Treasury securities that are mostly held in portfolios, whether for flow or
positioning reasons. Dealers use their expertise in the markets to evaluate the
differences among Treasuries as to coupon and maturity (quantitative
characteristics) as well as perceived availability, demand and other factors
(more qualitative characteristics) so they may ultimately price them relative
to the benchmarks.
By extension, in sister fixed-income markets to the Treasury market, such as
the agency, corporate, and mortgage-backed securities markets, Treasury
securities may also be used for the same risk and inventory management
purposes. Given the size of these markets (the Treasury market alone is over $3
trillion), the amount of activity in these benchmarks is great. Other
securities in addition to Treasury benchmarks are used in a similar manner,
including benchmark agency and certain large corporate issues and current
coupon mortgage-backed securities.
Derivative instruments, such as futures on Treasury securities are also
actively employed. These in aggregate create enormous liquidity but must
ultimately to some extent refer back to the cash and repo market fundamentals
in deriving their valuations. There is a multiplier effect stemming from the
use of benchmark securities. During periods of crisis in the financial markets,
particularly a crisis in the infrastructure of the Treasury market itself,
there is an extreme focus of both demand for and concern about the primary,
underlying securities that represent the source of the accumulated, multiplied
liquidity in the system.
Whether or not a fixed-income portfolio manager engages in repo or reverse-repo
transactions directly, there is a critical indirect relationship to the repo
market that must be evaluated in a number of term structure, sector and
security selection issues. Over the last several years, the Treasury benchmarks
have been reduced from 2-, 3-, 4-, 5-, 7-, 10- and 30-year securities to 2-,
5-, 10- and 30-year securities. Some of this reflects securities that have
simply stopped being issued, or issuance has dwindled significantly, as is the
case with the 30-year.
The liquidity of these issues has become more concentrated, as the size of the
Treasury market overall has been reduced and there is consolidation amongst
market participants. Spreads of other securities to these benchmarks have
generally widened over this period, to reflect the difference in liquidity and
to reflect the economics of more favorable repo rates in benchmark Treasuries
than elsewhere. The benchmark Treasuries typically have lower yields than
surrounding issues on the maturity spectrum to reflect this premium.
Since Treasury issuance is itself managed to promote liquidity, the benchmark
model would be incorporated in the sister fixed-income markets. The benchmark
effect drives key rates on the term structure. These key rates, in turn, act as
fundamental valuation pillars for the different fixed-income sectors, some of
which have greater clarity to the term structure than others (bullet agency or
corporate as opposed to variable cashflow mortgage-backed securities). Finally,
the actions of key rates have a great deal of impact on security selection
decisions, as maturity or duration decisions are the most critical determinants
of fixed-income total return.
The repo market is very large and pervasive, extending both directly and
indirectly to the sister fixed-income markets. The key nexus for transmission
from the repo markets is in the pricing of liquidity of the benchmark issues.
The multiplier effects of liquidity in the system and the displacements that
occur are substantial when either systemic de-leveraging or re-leveraging
activities are conducted.
Impact on state and local government finance
State and local government finance departments across the US were hit with an
abrupt spike in borrowing rates as the auction-rate securities (ARS) market, a
$330 billion component of the municipal bond market, collapsed in February
2008. ARS are debt instruments issued by corporations or municipalities with a
long-term nominal maturity for which the interest rate is regularly reset
through a Dutch auction.
Ronald Gallatin at Lehman Brothers invented ARS in 1984 and Goldman Sachs
introduced the first auction rate security for the tax-exempt market in 1988.
Student loan auction rate securities (SLARS) make up a large percentage of the
ARS market. (See
Developing China with sovereign credit - section on ARS fraud
investigation - Asia Times Online, September 4, 2008.)
The $2 trillion public finance market where state and local entities raise
money for roads, bridges, schools hospitals, airports and even prisons stopped
functioning in early 2008. Traditionally, municipal bonds were a quiet and
orderly segment of the financial markets. Returns were predictably stable and
the investor base was mostly individual US tax-exempt savers. The 50,000 odd
issuers, though ranging from tiny local fire departments to the gigantic state
of New York, were standardized through insurance, giving the market a de facto
triple-A rating.
Municipal bonds as a group lost 7.6% in 2008, the worst year ever for a
low-yield "save" investment vehicle. Auction-rate securities, which normally
had been a source of low-cost funding for many issuers, have disappeared from
the market. Long-term borrowing costs even for top-rated, triple-A
municipalities have risen to nearly 6%, an eight-year high, and a backlog of
more than $100 billion in postponed bond sales spilled into 2009.
Big municipal bond insurers, such as MBIA and Ambac, also had written similar
policies on risky sub-prime mortgage debt. When the mortgage market cracked, so
did the monolines, prompting a massive re-pricing of municipal debt to the
issuers' underlying ratings. It also upset financing arrangements like auction
rate securities. (See
THE ROAD TO HYPERINFLATION - Fed helpless in its own crisis Asia Times
Online, June 26, 2008.)
At the same time, hedge funds, a growing group of buyers of municipal debt in
recent years, became net sellers, unleashing huge supply on an already bruised
muni market. The final straw that broke the market's back came with the
bankruptcy of Lehman Brothers, which drained liquidity abruptly from the whole
financial system.
Lured by the high relative yields, some adventurous retail investors have
stepped in, but not enough to sustain normal level of issuance. The market is
expected to remain under pressure in 2009. With the economy in a recession,
states and local governments are facing growing budget deficits. The federal
government appears to favor stimulus for state and local economies over direct
aid to state and local governments, Consequently the credit derivatives market
is pricing in a greater risk of default for muni debts than for high-grade
corporate bonds.
Near zero short-term interest rates are sharply corroding the smooth
functioning of the government repurchase (repo) market, a foundation stone for
the financial system and trading Treasury debt.
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