Thursday, March 27, 2008
And Now The Real Crunch Hits
The bottom line is that the collapse of the muni insurance racket is pushing up costs and yields on that market, especially the short-term variable rate segment. That is going to keep sucking up the available cash from investors. Current mortgage bonds out there are devalued as a result.
Nor is this all credit-related. It's important to understand that even high-quality mortgage paper - government-guaranteed stuff - can't compete with the yields I can get on good quality individual munis now, and therefore it has been devalued. The difference is taxation. Tax-free munis have a huge tax advantage which overwhelms the proceeds on mortgage bonds even if you account for risk in munis by assuming that absolutely no bond insurance is worth anything.
Individual investors are the most probable source of liquidity on the good stuff, and they now have absolutely no reason to buy mortgage bonds. The cure for liquidity crunches is the income investor (buy/hold) and the income investor will do a lot better buying munis in most cases.
So this is structural, and the losses are structural. The collapse in the mortgage bond market is more related to returns than risk, and therefore nothing the government can do will restore this segment of value to the instruments.
The real reason why these bonds were marketable at those returns in the first place was because they were used to obtain the additional long-short leverage through ABCP pools of various sorts. They were also used as instruments to obtain leverage. Well, with the unwind of all of the bad risk assumptions, that value premium is mostly gone.
So what options does the government have? The idea that banks and other financial firms should be able to stop marking to market is insane. That would mean that banks and financials would in effect be forced to trade with no knowledge. It would make the liquidity crunch worse rather than better.
The only way to restore yiold value to the prime mortgage bond market would be for the federal government to institute a super financial holdings tax - a property tax, in other words. That would get at the high net-value individuals who make so much non-taxable income off munis, but it is unlikely to happen. The other way is to institute a flat tax, which would help some because it would cut the premium for these instruments to individuals paying high taxation rates.
There is just no way that agency paper paying 5.5% can compete with investment-grade munis paying 4.5% when you consider the net tax premium to someone paying a state and federal marginal rate of over 30%. Not only that, but proposals to raise tax rates are going to devalue mortgage bonds yet again. Current federal tax rates are approximately 28% above 77,000, 33% above 160,000, and 35% above 350,000. Then add state tax. We'll use an average of 6%, okay? That takes me to 34%, 39%, and 41%.
Look at the returns for 100K:
No AMT Munis= 4.5%, $4,500 net.
Agency = 5.5%, $5,500 before tax
Agency Net @34% $1,870 tax = net of $3,630.
Agency Net @39% $2,145 tax = net of $3,355
Agency Net @41% $2,255 tax = net of $3,245
Liquidity concerns for high tax rate individuals are less of an issue. The backstop of value for all bonds is the expected yield to first call or maturity. Prime mortgage bonds now have to pay the investor around 7% to get an equivalent return. Therefore the housing market can't recover in a meaningful fashion for years to come.
The auto/CC/small commercial crunch is about to start showing up on smaller banks' balance sheets and will continue for some time. This adds fuel to the equity destruction fires in a major way later this year.
The only way the Fed can restore value to the agency mortgage bond market is by making them Fed collateral (a liquidity premium), which is exactly what they are doing. It still doesn't compensate much.
Update: See this Bloomberg article regarding mortgage rates:
Lenders aren't helping the central bank even after they've been given seven interest rate cuts and a new program designed to jumpstart borrowing.This is total nonsense. Banks aren't defying Bernanke. Investors are defying Bernanke. If investors can get better returns elsewhere, they are not going to buy mortgages. Why should they?
The difference between the 10-year government bond yield and the average U.S. fixed mortgage rate was 2.7 percentage points last month, the widest spread since 1986, data compiled by Bloomberg show. Banks are defying Bernanke and hoarding cash after writing down the value of more than $200 billion of mortgage-related securities since July.
Banks don't sit on tons of 30 year mortgages because banks can't afford the duration risk. The mortgage market is an investor-driven market, and mortgages are now competing with munis. That's what is primarily driving rates.
Anyway, we lucky Californicators get hit with 9.3% on top of Fed income taxes.
Here's a local double tax free:
"OXNARD WTR 5 34 6918" 5.000 coupon 6/1/2034 call 5.100 yield 98.56 price A3 Moody A S&P
5.1% double tax free is like 10.4% in the top bracket. A3 may be the lowest investment grade and Oxnard is as dysfunctional as they come and the price may drop but they aren't going to default on a freaking water bond and from what I suspect they won't even be able to call early either.
Here's a favorite site: http://www.syllc.com/services/inventory.asp?ob=ytm
Yeah on CA taxes. It's no coincidence that CA's latest muni issues sold out so quickly. I wonder when the states will start to realize that the higher they raise their taxes, the lower their muni rates will go?
Thanks for the site link.
I suspect the rates will go up for other reasons having to do with total indebtedness and the public appetite for more debt and the competition for money. Even at 5.1% the idea of getting back in 2034 pesodollars for the 2008 dollars I lent doesn't attract me.
It's painful to think of how much trouble some of the states are in now.
I doubt CA could sell bonds now at those rates without the state tax premium.
Hey if JPM can go to the window why can't California? A little 25 liquidity and we can put up say the Santa Monica Mountains as collateral.
I'm waiting for a spate of revenue anticipation bonds. If those are effectively non-recourse or whatever they get called in the muni world they might go begging at any price.
Good luck, Anon.
I want to see these govt. entities to file public pension fiscal emergency bankruptcies. Ratcheting all down all--past,present,future-- down to basic soc. sec. levels.
All govt. entities have to trim way back. Been nothing but another casino.
Been way too much arbitrage gaming and layered schemes with anticipated tax revenues, tax anticipations, bonds, etc.
Bonds were generally used well by grandparents era.
These modern govt.and financial crooks & schemers have been using Bonds for public pension obligations, etc.etc.
Also if I want to set up life insurance do I need insurance bonds? Or can I simply open a policy with a company? I’m a little confused by some of the jargon. I am not moving anytime soon but thought I should be aware of things I will need to understand.
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