Bear Stearns' Billion Dollar Hedge Fund Bailout

The news that two Bear Stearns hedge funds were being forced to liquidate is a big sign of trouble in the bond markets. My previous post showed how the market for the types of securities held by the Bear Stearns funds was tanking. Had the forced liquidations gone through, they likely would have been a serious strain on the market.

Bailing out the fund by taking over the creditor role from Merrill and others saves the bond market from more forced sales and saves Bear from the negative publicity. As the mortgaged backed bonds continue to deteriorate the losses will go back to being slow and steady, rather than dramatic and eye catching. Meanwhile, high risk MBSs continue to tank. Bear will probably pull the plug somewhere down the line so that hedge fund investors are the big losers and Bear as creditor will be largely protected.

For now, Bear's response falls in line with what everyone in the industry seems to be doing - Pretend on your books that your asset backed securities or real estate owned is still worth far more than the market will actually bear. If you don't try to sell and continue to expand your borrowing you can keep up the charade for a long time. Eventually, losses will overwhelm the securities holders, but that doesn't have to be anytime soon if firms like Bear keep stepping up with more financing.

Toxic Waste Hitting New Lows

Mortgage Backed Securities are split up into different tranches so that fund managers can choose between securities that will actually make good on their promised yield and securities that will generate a high return for a short while before blowing up. The highest rated MBSs are holding up OK these days, but the toxic waste is trading down to new lows. Besides the direction of the chart, also note the coupon yields. Suckers who bought the highest yielding junk are not getting a good enough yield for the risk they took:

AAA Coupon 0.090%
AA Coupon 0.150%
A Coupon 0.64%
BBB Coupon 2.240%
BBB- Coupon 3.890%

These are 2007-01 securities. If you took the BBB- with the extra 3.890% interest, you're already down about 40% if you Mark to Market:



Most of the AAA rated bonds don't deserve the high ratings. Underwriters play games and work with the ratings agencies to get the ratings they desire and the agencies have a big conflict of interest the encourages them to overrate bonds. AAA stuff holds up because there is far too much money being created and stored in money market accounts that has to buy something. This chart from the St. Louis Fed is very telling:

Rising Interest Rates and the Carry Trade

Rising 10-year yields have been getting a lot of attention, although the rise hasn't been anything out of the ordinary given the uptrend in yields over the past 4 years:

It's also interesting to note that the yield hit a wall when it reached the same level as Fed Funds (5.25%). In normal times the 10-year yield would be considerably higher than Fed Funds.

However, it has made a big difference for home purchasers with the average 30-year contract rate up to 6.61% from 6.1% 5 weeks earlier. As rates rise, the "affordability" of homes for most buyers declines, adding more downward pressure to home prices. This all puts a greater strain on the consumer driven US economy. As I expect most long term US treasuries will either default or be devalued through inflation to the point that they deserve far higher rates to make up for the risk.

Rising yields also means falling market values for bonds already in the portfolios of carry traders. Fortunately for them, the dollar has also been rising fast enough against the Yen to avoid creating much margin pressure or forced liquidations.

Why yields are rising remains in question. Over the past two weeks custodial holdings of treasuries and agencies haven't increased at their usual rate, leading some to speculate that a lack of foreign buying is behind the rising yields. There have been plenty of statements from monetary officials suggesting they'd be reducing the rate at which they acquire new US treasury debt. This is probably having a small impact on rates, but I'm more inclined to stick with my original observation that primary dealers are the main factor influencing the shape of the yield curve.

The 1 1/2-month-stale data on TIC flows came out today, showing that private foreign investors were net sellers of treasuries, but that's normal in April because of the surge in US tax receipts. Major Foreign Holders TIC data showed that Official accounts also reduced short term treasury bill holdings.

Japanese Money Supply data keeps getting revised upward, suggesting that the carry trade is having a bigger impact than authorities realize. I expect that the Broad Liquidity is actually growing at about a 4-5% rate given the way the Yen has been pushed down in recent months, although it may take the Bank of Japan several more months before they realize this and respond to it:


Commentators have been asking for years what would happen if foreign demand for US debt declined. The answer now appears to be that US debtors would just start borrowing in foreign currencies to fund their needs. In my view this represents another escalation in the extent to which the global economy has become unbalanced. It's hard to imagine another escalation that would go beyond this, but with the versatility of the derivatives markets I won't assume this is the last stage. With the government providing tax free status to Samurai bonds it appears that those in control in Washington realize that expanding the debt pyramid is essential to keeping the game going for now.

This is Just Criminal

On Wednesday stock of Novastar Financial was up almost 11%. The day before the stock of Accredited Home Lenders was up a similar amount. The excuse to pump up the stock in both cases was that the companies had found a way to transfer much of the toxic waste they had created to unsuspecting investors. In the case of Accredited, the company may arrangements to be acquired by Lone Star, a private equity fund. The investors in Lone Star 5, most likely pension plans and public endowments, will be stuck holding the bag for the defaulted loans stinking up Accredited's portfolio (it's so bad that their auditor quit and they still haven't filed their Q1 report with the SEC). In the case of Novastar they managed to complete another securitization for $1.4 billion of their subprime garbage. It's hard to imagine a responsible investor purchasing new Novastar securities after seeing what has been happening in the way of defaults within recent securitizations:



Each line above represents a different securitization over time. The y-axis shows the percentage of loans in the securitization that are at least 60 days delinquent, The x-axis shows shows the age of each securitization. The February 2007 loans are going bad even faster than the amazingly bad 2006 loans.

May was an especially bad month for loans entering the 30-59 day delinquent category. Most of these will add to next months 60+ numbers:



30-59 day delinquencies on the February 2007 securitization rose from 1.44% in April to 2.55% in May as the newer loans are going bad in a hurry.
On the March 2004 securitization they rose from 1.23% in April to 2.94% in May likely as a result of resets of 3 year ARMs resulting in higher payments that can't be met.

Countrywide Financial's Real Estate Owned has reached $1.75 billion dollars as of June 5th (real estate listed for sale on their website). Of course Countrywide is just one of many lenders who are riding a wave of foreclosures and putting off the day when they'll have to recognize the losses.

The sub-prime time bomb has not been contained, and it hasn't difused. It's been getting steadily worse, but the bond market hasn't had a dramatic reaction. This has given Wall St. time to dump toxic securities and companies into the portfolios of public and private pension plans.

Retail Sales at a Snail's Pace

As a greater percentage of US consumers struggle with large debt burdens and tighter credit standards, this is predictably hitting the retail sector. Companies like Bed, Bath and Beyond have begun issuing earnings warnings, and it's not just home related retailers. According to the chain store sales data even Apparel stores were hit hard in April (only drug stores did well).

April was off partly because of the earlier Easter, but a larger downtrend is evident among multiple data series. Chain Store Sales:


ShopperTrak:


Jobs:


Russ Winter has been doing a great job tracking data on shipping volumes and sales tax receipts. It all points to a slowdown in sales, with debt service burdens being a likely culprit. Now that retail jobs appear to be in decline, the problem could compound as unemployed consumers will have even less to spend.

On the bright side retailers who cater to high end consumers still seem to be doing well. These firms showed good year over year comparisons for April:
+7.3% JoS A Bank
+1.0% Neiman Marcus
+3.1% Nordstrom
+11.7% Saks Inc.

Bond Curve Normalizes Following Sub-Prime Meltdown

There has been a very interesting divergence in the direction of short term vs. long term treasury yields since the market turbulence of February and March:



The yield curve had been severely inverted for many months, but with long yields rising and short yields falling most of the curve has normalized.

The uptrend for long yields and the downtrend for short yields have been very steady and well defined:




My best guesses at what has been happening behind the scenes are:
1. Primary Dealers want higher long bond yields and lower short term rates.
2. Excess liquidity has created high demand for T-bills for money market accounts.
3. The opening of new carry trade positions has hit a fevered pitch in the past 3 months. Short term treasuries were the highest yielding and most liquid part of the curve, so much of dollars purchased with borrowed yen ended up there. The Yen has been pounded down by new carry trades and now is threatening to break through long term resistence in the 122/Dollar range:



Demand created by carry traders for leaves banks with very little desire for cash from the Fed. The repo rate has been well below the fed funds rate since Mid-April and Fed repos have been low.

Meanwhile, foreign investors are still buying very large amounts of Treasury Bonds, probably because theiry the ones with the most dollars in need of a long term investment vehicle. Just about all of the Indirect bidder orders get filled as they still don't seem to be very price sensitive. (Indirect bidders are largely foreign central banks and overseas hedge funds.)

Primary Dealers, on the other hand, make up the biggest percenatage of bids and have (by far) the most unfilled orders at each auction. What they as a group are willing to pay effectively determines the interest rate coming out of auctions. They're generally the ones who are hurt the most by an inverted curve because their traditional business is to borrow money at short term rates and lend it out at long term rates.

Therefore, I expect primary dealers are the ones who are normalizing the curve on both ends as they seek to boost their profits in a time when they're facing large losses from mortgage defaults. This may help them in the short run, but it is having the effect of raising interest rates for new mortgages and refinancings. This will only put more pressure on the housing market as homes become less affordable to new buyers.

We'll see where rates go from here. There should be some resistance for 10 and 30-year bonds at 5%. That may put a lid on rising rates for a little while. Housing was in bad enough shape as it is. If rates break out above 5% that could be a nail in the coffin.