Credit Markets "Utterly Unhinged"

The credit markets are casting a big vote of no confidence in the idea that the Federal government can rescue the housing market.

As we noted before, spreads on agency securities have widened to extreme levels. This renders the Fed’s rate cuts largely ineffective, at least if the intent was to give relief to the housing market via lower rates (note some believe the Fed wants to steepen the yield curve. Since banks borrow short and lend long, a big gap between short and long term rates will allow them to rebuild their battered balance sheets faster).

Some of the sources in the Bloomberg story seem close to panicked, and investors contend that investment banks are backing away from making a market. This is in securities historically considered to be virtually as solid as Treasuries, and the market is nearly as big as the Treasury market. There’s plenty of reason to be worried.

When will the Fed get the message that its plan of action is actually backfiring? It can’t remedy a solvency crisis via monetary action. What is needed is considerably more transparency, so that counterparties become less reluctant to conduct business with each other. I don’t have a clear idea as to how to achieve that (full transparency would any firm with trading positions at a disadvantage). However, the Fed has access to top experts and has know since last August that counterparty worries are a big part of the problem. Dealing with it indirectly is no longer effective.

Note there are also worries that hedge fund unwindings could lead to seize-ups in other sectors of the credit market.

From Bloomberg:

Yields on agency mortgage-backed securities rose to a new 22-year high relative to U.S. Treasuries as banks stepped up margin calls and concerns grew that the Federal Reserve may be unable to curb the credit slump.

The difference in yields, or spread, on the Bloomberg index for Fannie Mae’s current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened about 11 basis points, to 227 basis points, the highest since 1986 and 93 basis points higher than Jan. 15. The spread helps determine the interest rate homeowners pay on new prime mortgages of $417,000 or less.

The markets have become “utterly unhinged,” William O’Donnell, a UBS AG government bond strategist in Stamford, Connecticut, wrote in a note to clients today. A lack of liquidity has “led to stunning air-pockets in price levels.”

Investors are realizing that banks have little room to make new investments amid rising losses and a flood of unwanted assets, said Scott Simon, head of mortgage-backed bonds at Pacific Investment Management Co. The world’s top banks have reported more than $181 billion in asset writedowns and losses, been stuck with $160 billion of leveraged buyout loans, and bailed out $159 billion of structured investment vehicles.

“Everything is telling you the financial system is broken,” Simon, whose Newport Beach, California-based unit of Allianz SE manages the world’s largest bond fund, said in a telephone interview today. “Everybody’s in de-levering mode.”….

The widening spreads prompted speculation the government may step in to support securities guaranteed by Fannie Mae and Freddie Mac, said Tom di Galoma, head of U.S. Treasury trading in New York at Jefferies & Co., a brokerage for institutional investors. The Treasury Department said the rumor isn’t true.

“The Fed can’t really save the mortgage market,” di Galoma said. “As they keep cutting, mortgage rates aren’t going lower.”

The spread of current-coupon fixed-rated securities guaranteed by Ginnie Mae against 10-year Treasuries has climbed 39 basis points this month to 189 basis points, also the highest since the 1980s, according to Bloomberg data. Debt guaranteed by Ginnie Mae is explicitly backed by the U.S. government, and based on loans already insured or guaranteed by its agencies. A basis point is 0.01 percentage point…..

“The capital issues at commercial banks are making them, in general, reluctant to lend, so lending is either harder to find or when you do find it, it’s more expensive or the other terms are more-limiting.” Steven Abrahams, an analyst with Bear Stearns Cos., said in a telephone interview yesterday.

“If there’s less money to finance positions and less balance-sheet available to warehouse positions, the markets are going to become more volatile,” he said….

“The single biggest concern right now is who’s the next hedge fund to blow up, and how big are they,” Arthur Frank, the New York-based head of mortgage-backed-securities research at Deutsche Bank AG, said in an interview today. “The more the market widens, the more likely it is that another leveraged player has to sell, so it does feed on itself.”….

“Traders are putting their phones down and backing slowly away from their desks,” O’Donnell said today in a telephone interview. “Relatively little” agency mortgage-backed securities are being traded, Pimco’s Simon said.

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  1. doc holiday

    I just bought you tickets to the dog and pony show:

    Re: Dr. William Poole, president and CEO of the Federal Reserve Bank of St. Louis, will speak on “Finance: Engine of Growth, Engine of Instability” at 6:30 p.m. Thursday, March 6, in Brookens Auditorium at the University of Illinois at Springfield. Brookens Auditorium is located on the lower level of Brookens Library on the UIS campus.

    At the conclusion of his formal remarks, Dr. Poole will also take questions from the audience. The program and a reception immediately following are free and open to the public.…gy/ uislive.html

    UIS LIVE !

  2. Anonymous

    Of course the FED can remedy a solvency crisis. Just go out and buy mortgages. Raise the price level so home prices start going up. Give tax benefits to real estate investors like they did to dividend paying stock investors.

  3. Yves Smith

    Anon of 5:50 PM,

    The Fed can’t change the tax code; that requires an act of Congress. The Fed has substantial latitude in terms of the collateral banks can post, but I am not certain it can buy any type of asset it chooses.

    More important, the measures you describe again are effective only in dealing with a liquidity crisis. By all accounts, there is plenty of cash on the sidelines. Investors don’t want to buy these assets because a lot of the borrowers are defaulting. That’s what is meant by a solvency crisis, deadbeat borrowers.

    Similarly, the Fed can’t justify buying bad debt. That is way way outside anything that would fly politically.

  4. Anonymous


    The FED is part of the government. Acts of congress do not require divine intervention. Nothing like a depression to concentrate a legislature’s mind.

    Of course raising the price level will solve the solvency crisis. Raise the price level and house prices will go up and before you know it banks become solvent.

  5. Yves Smith

    The insolvency is at the borrower level. Borrowers cannot afford mortgages they entered into.

    The Fed is not “part of the government. ” It is not an executive branch like the Department of the Treasury. it’s quasi public.

    The spreads in the agency market are saying that this problem is bigger than the government can handle. Estimates of size vary, but the mortgage market is bigger than the Treasury market by at least a factor of two.

    Oh, can can the government also bail out the commercial mortgage crisis, the coming credit card crisis, plus a meltdown in the CDS market? Don’t bet on it.

  6. doc holiday

    Here is some old Poole speak:

    “The dangers of recession and inflation are both very real,” said William Poole, president of the Federal Reserve Bank of St. Louis, who voted against the Fed’s last interest-rate cut on Jan. 30.

    “If inflation develops while the Fed is concentrating on avoiding recession, the consequence will be to delay recession but not to avoid it,” Poole said.

    Poole told the U.S. Monetary Policy Forum in New York that a delayed reaction would be “worse than a mild recession” right now, in remarks that directly contradicted testimony by Fed Chairman Ben S. Bernanke this week and added to the turmoil in financial markets.

  7. Anonymous

    You are getting caught up in semantics. The FED needs the approval of congress. Its a political entity. Note Ben’s multiple meatings with Sen Dodd.

    Subsidize mortgage payments further. Its doable and if push comes to shove it will be done.

    I bet a few years ago you would have claimed the FEDs TAF would be unthinkable. Guess what it happened.

  8. jest


    the fed does not need approval of congress for anything. the federal reserve charter explicitly severed the link between the two b/c of conflicts of interest.

    and yes, the fed can go buy AAA mortgage paper, but that necessarily won’t improve the mortgage market; it would just add liquidity to banks.
    buying mortgage paper has nothing to do with solvency. gov. poole has said himself they can’t do anything regarding solvency issues.

    and stop capitalizing “FED” it’s annoying.

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