from Follow the Money

1.54, 105, 1.45 — deleveraging continues …

March 6, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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It just seems like yesterday when the euro broke $1.50 and oil broke $100. Now the euro trades closer to $1.54 than $1.50 and oil trades closer to $105. Macroman doesn’t watch his Bloomberg screen quite as closely as he used to, but on Thursday morning he reported that a two year Treasury yielded 1.6%. By late Thursday in the US (early Friday in Asia), the two year was only yielding 1.45%.

The corporate credit market by contrast isn’t doing well. Nor is the housing credit market -- including the Agency MBS market. (Agency MBS spreads are now significantly wider than in this chart) Agency MBS are mortgage backed securities guaranteed by one of the Federal Agencies. Thank Carlyle Capital, and perhaps others.

Talk of deleveraging has replaced talk of decoupling. And if Carlyle Capital is really geared up 32 times (it borrowed $32 for every dollar raised from investors), there may be more to come.

I am not close enough to the market to know what is going on. But experienced hands like John Jansen seem worried.

"The rolling crisis has turned the markets dysfunctional and malfunctioning. Liquidity has dried up and small chunks of bonds can drive spreads quickly tighter or wider. ...

the cacophonous sounds emmanating from the fixed income trading rooms of the world can be deciphered into a warning that something is terribly wrong with the system.

That, together with the alarming quotes from bond market insiders that pop up regularly on Bloomberg and the latest from financial anthropologist Gillian Tett is more than enough to leave me worried.

I do have one question though.

Why aren’t the reserve managers of the world’s central banks stepping in to buy Agency MBS, and thus providing liquidity to the market?


Central banks have a ton of cash to invest. They haven’t shied away from Agencies: over the past year, the FRBNY’s custodial holdings of Agencies have increased by $230b while its Treasury holdings are only up $70b. The official sector is supposedly filled with investor with long time horizons who can afford to wait out temporary market disturbances.

True, most central banks -- China excepted -- have preferred the bonds the Agencies issue to the bonds the Agencies guarantee. But at some level Agency credit is Agency credit.

Agencies aren’t Treasuries, and the US will never suggest that they are. But I at least would be surprised if the US government allows the Agencies to fail at a time when they are a key source of support for the troubled housing market. And, well, a 3.5% spread should be attractive to central banks looking for a bit of yield. Mollenkamp and Ng:

In the early stages of the financial turmoil, the riskiest securities -- such as those backed by subprime mortgages to people with poor credit -- were hit by selling. Now, as margin calls intensify, hedge funds and others find they must unload even assets perceived as high-quality, such as bonds backed by the government-sponsored mortgage giants Fannie Mae and Freddie Mac.

Fannie and Freddie are perceived as having the backing of the U.S. government, so they’re usually seen as a safe haven.

"The fact that this is happening in top-quality agency paper is really worrying," said Tim Bond, a strategist at Barclays Capital in London. "It’s marking an extension of this stress into the group of players who only invest in the safest mortgage-backed stuff."

Amid waves of selling, bonds backed by home loans that are guaranteed by Fannie Mae and Freddie Mac were yielding 3.51 percentage points more than ultrasafe five-year Treasury securities. That spread is a record. A year ago it was 1.23 percentage points, and a month ago it was 2.48 percentage points.

I understand -- I think -- why central bank reserve managers (and even the managers of many sovereign funds) might be reluctant to jump into the market. They aren’t paid to take risks. They are paid not to loose money. To my knowledge, most central banks do not mark their bond portfolios to market (Japan is an important exception). But any central bank holding Agencies is also likely quite aware than Agency spreads have widened, and they are sitting on mark to market losses. That -- and the risk that prices might fall still further -- probably makes most reserve managers reluctant to seek permission to buy Agency MBS.

Judging solely from the widening of Agency spreads, a lot of sovereign money still seem to be in a defensive crouch.

Fair enough.

But it is a bit hard to argue that central bank reserve managers are an intrinsic source of stability if they are acting much like the rest of the private market at time of stress.

The Treasury market isn’t short of liquidity. Some other markets -- including some markets that are close to traditional reserve assets -- are.

UPDATE: The world’s central banks have plenty of euros too.  They could perhaps consider providing a bit of "liquidity" to the market for Spanish and Italian government bonds as well.

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