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Wednesday, May 27, 2009

Listen to Yo' Mama

Friends, Romans, countryman! Here is how to lose your a$$ writing creditworthy mortgages, or shall we call it Bernanke's Folly?

For the non-financial types, the important thing to remember is that bond yields rise as bond prices drop. Bond market prices on existing obligations will rise and fall to conform to differences between the face rate between the older bond and current market rates at for the remaining term, as well as to account for the risk of loss. As price drops, yield rises. Naturally, investors want to receive more in the way of yield when the risk of loss rises.

Treasury Yields for May. An alert reader will note that the yields have risen 50 basis points each for the 7 year, 10 year and 30 year. The six month and the 1 year are still flat to lower than the beginning of the month. Article:
“The markets are starting to grapple with the issue of what happens when the Fed exits and the Treasury needs to continue at the same pace,” said David Greenlaw, the chief financial economist in New York at Morgan Stanley, one of the 16 primary dealers that trade with the Fed and are required to bid at government bond auctions.
And investors don't want to be holding long dollar-denominated debt at this time for low returns.

The other thing non-financial types should know is that mortgage bond yields are most often compared to the 10 year Treasury. The face term may be 30 years, but in fact most houses are sold or refinanced long before that. Mortgages that have adjustments inherent in them may have effective maturities far lower than ten years, though, and one of the reasons that the recent crop of "innovative" mortgages was so favored were that the mortgages were structured to prepay very quickly, so real duration was very short, and the spread between short-term rates on the mortgage bonds and short-term rates in the money markets was very high, thus profits were very high. (Until the losses arrived.)

But no matter how they are structured, when you fiddle the marketplace to push mortgage bond face rates artificially low, you are baking in future losses on those bonds. If the government is holding them, the taxpayer gets another turn bent over the barrel. For one thing, your expected duration extends, because people who are holding a substantially below-market rate mortgage do not refi. The payouts you get are from foreclosures and sales, and in this market that is where you expect to take your losses. So you are looking at short-term losses and long-term losses, and consequently an urge arises to leave the burning building before the exits are jammed.

So of course the Treasury and Whiskey Rebellion of 2009 is causing havoc in the mortgage market:
Yields on Fannie Mae and Freddie Mac mortgage bonds rose for a fourth day, after exceeding for the first time yesterday their levels before the Federal Reserve announced it would expand purchases to drive down loan rates.
...
“Market participants may be asking themselves the same question as Scorpio in ‘Dirty Harry’: ‘Do I feel lucky?’ ” Rosenberg, the bank’s head of credit strategy research in New York, wrote in a report yesterday, referring to a character in the 1971 Clint Eastwood film who may be shot.
Funny, that. But nobody's laughing, because as Treasury yields rise, the value of those mortgage bonds is collapsing. So people are running to the exits trying to unload those hunks of junk, which is pushing up yields quite quickly.
The difference between yields on Fannie Mae’s current- coupon 30-year fixed-rate mortgage bonds and 10-year Treasuries narrowed to 0.92 percentage point today, from as high as 2.38 percentage points in March 2008, according to Bloomberg data. The Fed’s purchases drove the spread to 0.70 percentage point, the lowest since 1992, on May 22. The yield gap jumped from 0.71 percentage point yesterday.

Many investors who felt MBS spreads were too tight thought it might be time to take chips off the table,” Credit Suisse’s Swaminathan said. “This is something we anticipated would build up” as many mortgage-bond holders who were previously wary of lightening their positions on the view the Fed buying would continue to support the market finally decided to act.
This was strategy doomed to fail. Always. The more the government buys of these assets, the more inflation expectations grow. It's like playing russian roulette with five of the six chambers loaded.

The lesson is that one should not mess with market rates for mortgages, because if you do, you create another round of financial instability.

What do you think of this?
7 year Treasury yield:
5/1: 2.72
5/27: 3:22 (+ 18.3%)
10 year Treasury yield:
5/1: 3.21
5/27: 3.71 (+ 15.6%)
30 year Treasury yield:
5/1: 4.09
5/27: 4.59 (+ 12.2%)
I see chaos and disruption.

One sees much written about the power of monetary policy, but monetary policy in the Greenspan era acquired an aura of invincibility that was unrealistic. Monetary policy only works when it is exercised within realistic boundaries and when it attempts to get out ahead of current trends, in other words, when monetary policy is exercised to get the market to change earlier to adapt to the expected future trend. That keeps market adjustments smaller, increases confidence, and reduces unexpected "events".

I still want to know why and how investors are supposed to buy mortgage bonds with no government guarantees in light of the fact that Congress or some Congressionally-authorized authority may just decide to change the rules on the investor? Why? Why would anyone do it?

Comments:
The term is "playing Russian roulette with an automatic." The player always loses.

What we are going to get is a reprise of the capital strike of 1937.
 
John - moving jobs overseas by trying to pull back in corporate taxes is suicidal, I can certainly say that.
 
John,that has been done,see the Darwin Awards for details.MoM this has been expected by most for some time.With Rahm driving the Bus there will be no return of the Rule of Law,just more looting.I had hoped that the new Administration would not be as stupidly destructive as the last one.It appears that the Republicans have lost all credibility and the Dems have as much left as a crack whore.....that might knife you and steal your wallet,or just give an an incurable STD if you are lucky.
 
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