Did the Agencies Whack the Bond Market?

The price action in the bond market last week is worth re-looking at. We had a sharp run up in yields through Wednesday. That was followed by a pretty hefty correction through Friday. The obvious conclusion was that supply was the problem. “Too much Treasury paper”, said all of the media. No doubt but that supply was a factor. It is rarely as simple as it appears.

The bond dealers have a very good handle on what is coming from Treasury. They also are very aware of the demand side for these big auctions. I thought that the 2’s, 5’s and 7’s that were sold last week were well received given the size. If there is a supply ‘problem’, it was not evident in last week’s auctions. It is possible that the hiccup in the market last week was caused by something other than Treasury issuance. I think it was one of the Agencies. I believe that either FNM or FRE bought derivative contracts that created convexity on Monday, Tuesday and Wednesday. As a consequence the Street had to push more duration risk into the market. That was taking place while the Treasury was trying place $100 billion of coupons. It created the ‘fast’ market we saw last week.

The foregoing is speculation on my part. I have been observing the Agencies for many years. So call it an informed guess. I will say that the Agencies have done this type of market activity dozens of times in the past ten years. The market and business conditions that have forced them into the derivatives market in the past are aligned today. If the world were a different place and Fannie and Freddie were still private sector companies I would have bet a pretty penny that it was them who mucked up the bond market last week. The fact that they are today wards of the State, and they are still mucking things up comes as a surprise.

It is my contention that the Agencies have been mis-pricing mortgages every day, week, month and year for a very long time. I believe that they are well aware of that fact. The problems facing the Agencies today are credit related. They made loans that soured. Another reason for the failure of Fannie and Freddie is that they are derivative time bombs.

Take a plain vanilla mortgage. A 30-year with a fixed rate of 5%. Imbedded in this mortgage is an option to prepay in full at any time without a penalty. That option is potentially worth a great deal to the borrower. If interest rates rise to 6% that borrower is less likely to prepay that mortgage. However if interest rates fall to 4% that borrower is very likely to prepay because they can REFI and achieve significant benefits. The borrower can ‘win’ but they can’t ‘lose’. That is the definition of a long option position. The Agencies take all of the risk of that option but earn no premium income for it. They are writing free puts on the bond market as a result. The funded book of the Agencies is in excess of $1 trillion. These big numbers create very significant derivate risk. It is a very difficult and expensive risk to manage.

The average life of a mortgage pool increases when interest rates rise. Conversely, the average life falls when interest rates decline. The Agencies report and manage this risk. FNM defines this as their Duration Gap. Their stated objective is to have the estimated average life of their mortgage portfolio to be equal to the average life of their liabilities. They do a very good job at ‘managing’ this number. The reported results are generally in the 0-2 month level. From time to time, depending on market conditions, it will widen to 3 months. It is not often that the GAP goes to 4 months. In the past they managed the risk using derivative contracts when market conditions caused the Duration Gap to go beyond 3 months. They almost always do it before month end because they love to report numbers that look close 0. There is a degree of logic to this hedging strategy if you are a public company. It makes no sense if you are in receivership.

The following is a graph of ten-year interest rates over the past 9 months. The numbers I inserted over the vertical lines are the reported Duration Gap for Fannie Mae. Their most recent report provides March data. Note the sharp drop in yields from October through November. In that time period the FNM funding gap went from +2 to 0. The fall in rates shortened the average life by a few months. Intuitively one would think that the change in duration would be much larger given the very sharp drop in rates. However, the smart folks at Fannie know how to extend their average life. They write more 30-year mortgages. That automatically extends average life regardless of how much interest rates fall. FNM increased their Gross Mortgage Portfolio 28% and 9% on an annualized basis in the October/November 2008 period.


It is a horse of a different color when interest rates rise. Look at the relative change in numbers from February to March. The duration gap changed by five months. A large relative change. Writing new mortgages only compounds the problem. Sure enough, Fannie reduced its book of mortgages in March by 1.3% on annualized basis. We have not seen reductions in the Gross Book in some time. They are clearly continuing to manage the Duration Gap. In March they were being stingy about mortgage creation to minimize the risk of rising rates.

From March onward it is guess work. There are no FNM numbers to work with. The line for the Treasury yield has gone significantly higher since March. The impact to Fannie would be that their average life was being extended quickly. The duration gap probably widened to a level that was larger than Fannie wanted to report. Their response was to buy puts on the long bond (or a like derivative instrument). This creates the desired convexity. It also cost the taxpayers a fair bit more to sell those bonds last week. On the flip side, the dealer community must have made a bundle.

If the April report shows a gap of –1, we will know that it was FNM that sought rate protection early last week. In the scheme of things it is just noise. Last weeks bond market action is just old news.

A broader issue that should be considered is the interest rate risk practices of the Agencies. They have a $1 trillion book that they are earning less than one percent on. That is a very poor result when the yield curve is so steep. The US Treasury has 11 trillion of debt outstanding. The average life is currently 48 months and 1/3 is funded short term. If the Agency funding mimicked Treasuries it would result in incremental revenue from the mortgage portfolio of $100 – 150 billion per year. That money could come in handy given the credit losses that they face. I can hear Mr. Lockhart of FHFA saying, “Oh no, changing our duration limits would expose us to risk!” My response to that is, “Mr. Lockhart, if the ten year bond goes beyond 5% the Agencies are dead anyway so you might as well go for the ride.”

Agency mortgages should have a prepayment penalty attached to them. This would slow the churn, reduce the convexity problem and offset some of the expense of managing the prepayment risk. That will never happen unless someone new takes over at the top of this mess. Prepayment penalties would make Agency mortgages ‘less attractive’. The current leadership of the FHFA wants the government to be 80-90% of the mortgage market forever. That is a terrible long-term plan.

America's Health Care Debate

Now that the financial crisis has been averted (ahem) the attention of DC will turn toward the problems in America’s health care system. The economy of 2008 nearly destroyed our financial system. We have spent our grandchildren’s incomes to ‘fix’ our problems. That money will be lost if America’s health care crisis is not addressed in the near future. A few factoids to put the problem in some perspective:

-In 2008 America spent $2.4 trillion on health care. By way of comparison that number is approximately equal to the respective GDP of France, Germany or England. The US spending on health care is more than half of China’s GDP and is equal to two thirds of India’s entire output.

-Health care costs were equal to 17% of US GDP in 2008. That percentage is projected to rise to 20% by 2016. Germany and Canada spent 10.7% and 9.7% respectively on caring for its citizens. If US health care costs were to fall in line with Germany it would translate into a savings in excess of $1 trillion each year, significantly larger than the chronic US budget deficit.

-The United States spends six times more per-capita on the administration of the health care system than its peer Western European nations according to a McKinsey study.



On a per-capita basis we spend more on health care than any country in the world. The results are less than impressive.

-A Harvard study found that 50% of all personal bankruptcy were the result of a medical expenses. The study went on to conclude that every 30 seconds someone files for bankruptcy due to a serious health problem. About 1.5 million families lose their homes to foreclosure every year due to unaffordable medical costs.

-The World Health Organization reports that the UK spends less than half as much on its population than does the US. However one can expect to live two years longer in the UK than America. The infant mortality rate is 50% higher in the USA.

-The Center for Disease Control estimates that 15% of all American have no health insurance. If you add to that number the illegal population in America, the result is that approximately 60 million people living here have no health benefits. That is more than the population of Italy. One in ten children under the age of 18 have no benefits at all. That means ten million children.

-According to WHO the US ranks 28th globally in a statistic they refer to as Healthy Life Expectancy. Japan is on the top of that list. America is tied with Slovenia.

-The CDC estimates that on average, 75% of an individual’s lifetime health care cost is realized after age 65. The American population is rapidly aging. The percent of the population that is older than 65 will double from 10% to 20% in less than 20 years.

If the conclusion is made that we must cut health care cost as a percentage of GDP in order to maintain our global competitive position it is clear that the bulk of those cuts must come from those that are now and or will soon be 65 years old. That will be a difficult bridge to cross for the current administration and our society.


White House OMB Director, Peter Orszag, is leading the Administration’s health care initiative. Mr. Orszag is a proponent of “comparative effectiveness,” comparing various treatments — an idea that the drug industry is largely resisting and that some doctors fear could force them to follow treatment rules. The President recently announced that technology (HIT) would provide a key role in reducing future medical expenses. On that topic Mr. Orszag commented in 2007*:

“Simply installing an HIT would be unlikely to significantly reduce medical expenses”. “Claims that it would are very substantially exaggerated”.

In the same 2007 presentation Mr. Orszag also said:

“I have not seen a credible plan for Medicare solvency”. “We should have started this 15 or 20 years ago.”

The Obama administration will kick off its grass roots effort to achieve, “Real Health Care Reform” on June 6th. It should be an interesting debate.


*The comments by Mr. Orszag are on the following video link.
http://video.google.com/videosearch?q=peter%20orszag&oe=utf-8&rls=org.mozilla:en-US:official&client=firefox-a&um=1&ie=UTF-8&sa=N&hl=en&tab=wv#

End to Quantitative Easing?

In the past year the financial markets have set many new Guinness Book of Record levels. ‘The biggest one day drop’, ‘the largest one months gain’, ‘the lowest interest rate’, the ‘highest volatility’. It is already a pretty impressive list of firsts. We are in the process of setting another of those records. The steepness in the yield curve is about to set a new record. Not since 1992 have we experienced the levels that the market now finds itself at.

In 92 the two-year ten-year spread reached 262BP. At that time short rates were at 4.25% and the ten-year at 7%. Today the 2’s / 10’s rates are .97% and 3.72% respectively. In 92 the economy grew at 4%. The prevailing economic conditions as well as the general level of rates at that time gives us few clues to what may happen in today’s bond market. Those rich bond yields and the steep slope went away in the years that followed. For an extended period of time thereafter the yield curve was actually inverted.

The visible bond supply by Treasury is the biggest factor today. The Treasury has offered up $500billion in new paper per quarter for the last nine months. The future calendar is also very heavy. The forecast is for an additional $900 billion of new borrowings in the coming six months. The market understands that those forecasts understate the actual borrowing to come. It is easy to see why we have indigestion.

The next problem for the bond market is all these green shoots that DC and Wall Street keep seeing. Who in there right mind would want to buy a bond at 3.7% when after tax that will be a loser versus inflation?

Those issues have been in the market for quite a while. It is hard to explain a 150 BP rise in rates over two months based on things we knew about. Other factors are weighing on the bond market.

-You can’t get short. The market provides us plenty of options to get short. All those alternatives just cost a fortune. Shorting the bond using standard 20 to one leverage produce a negative carry of 40% per annum. If you are a day trader or a bond dealer you can be short and make money. But longer term this negative carry is a wall to climb so there are few strategic shorts out there.

-Someone in mortgage land is leaning on the market in an effort to extend their average liabilities. Both Fannie Mae and Freddie Mac publish a monthly report that measures their funding gap. They proudly report every month their book of assets and liabilities are roughly balanced. This is a bad measuring metric. It forces the Agencies to seek ‘convexity’ when interest rates change significantly in a short period of time. Collectively they have spent hundreds of billions in derivative costs over the past ten years. Historically they have come into the market and bought high and sold low. It would be interesting to confirm if either Fannie or Freddie were contributing to the mayhem in the market these past few days. If they were, it would be a slap in the face of Mr. Geithner who is trying to sell a 100 billion of bonds this week. My guess is that the Agencies were involved.

-The bond market does not know what to make of ‘quantitative easing’. After all, this concept has been with us for a very short period of time. The Fed has committed to buy up to 1.7 trillion of MBS and Treasuries. The knee jerk reaction to this was, “Wow, with this much demand rates are going to stay low forever!” A mere sixty days later that has turned into, “They are running the printing presses 24/7. Massive inflation is sure to follow”.

Quantitative easing was an important step in stopping the slide in the economy last fall. It was an emergency measure. The emergency is over. Quantitative easing is now problem, it is no longer a solution.

It is extremely unlikely that the Fed will recognize this reality in the near term. It is more likely that they will vote to expand their purchases of government securities as was indicated in the Fed’s recent minutes. Mr. Bernanke actually believes that he can control the market. This observer believes that he is in for a rude awakening.

When forecasting interest rates there are normally three possibilities. Either rates can remain stable or the can go up or down. Today there are only two possibilities. Rates can remain stable or the can go up. There is no risk that they will go down. In the short run it is possible that the rapid run up in rates in the last two months will result in a few months of relative stability. However rates are going to have to move significantly higher by the end of this year. My guess is that the next leg up will happen in September. If I am wrong it will happen by the end of the month. Either way those green shoots will turn brown by autumn.

Social Security - At the Crossroad?

The 2009 Social Security Trustees Report * has received a great deal of attention. The report clearly shows deterioration in the footings of the Fund. This was to be expected as their income was going down due to the recession while their costs are ballooning with the baby-boomers becoming eligible for retirement. In it’s summary the Trustees were very clear that this matter must be addressed sooner versus later.

The Trustees missed a great opportunity. If they truly wanted to accelerate the debate on the future of the system they would have highlighted the urgency of the problem. The Trustees chose to focus the attention of the media on two less important dates:

-2037 is now the year that the Social Security fund will be depleted.

-2017 is the revised date that the Medicare fund will be exhausted.

These dates are irrelevant. The focus of attention by the Trustees, our leaders in Washington and the American people should be on the more imminent date where Costs Exceeds Tax Income (“CETI”).

CETI is important to us now, as that will be the demarcation point for a very long slide in the dynamics of the Fund. At that point, the pain will start to be felt. Every month from then on, the pain will get worse.

For nearly 70 years the American economy has been the beneficiary of the SS system. The Social Security Trust Fund has been a major source of savings. Those savings have been reinvested back into the economy through the purchase of U.S. Treasury securities. As of year-end 2008 the Fund held $2.4 Trillion of Federal IOU’s, the largest single holder of our debt. Those holdings represent 1/4 of the entire National Debt.

In the period 2000-2008 the Fund purchased a total of $1.34 trillion of additional government bonds. The Fund has provided the liquidity for the entire costs of the Iraq/Afghanistan War, 911, Katrina and a significant portion of the remaining deficits.


This powerful engine of our growth is decelerating very quickly at this point. The Funds capacity to buy any new Treasury securities will be eliminated in a few years following achieving CETI.

The Trustee report provides a range of estimates as to when CETI will be achieved. They suggest that there is a 2.5% probability that it will be reached in 2009 and a 10% chance it will happen in 2010. I love long odds. I will take ten to one that CETI is achieved in 2010. I think it is an even money bet. The following graph shows the range of probable outcomes. My wager is on the lines at the bottom of the curve that are marked 2.5% and 10%.


The next graph describes more clearly the range of possible outcomes. I believe that the Fund is currently performing below the bottom line marked III. Also make note of the ‘blip’ at the year 2008. Notice that the line not only levels out but also appears to be turning negative. That blip is a result of the 2008 economy. The lines all turn upward after the 08 period. These ‘up-trends’ are based on the projections used by the Trustees. I maintain that these projections overstate the level of recovery in the economy over the next 18 months.


The key short term economic assumptions in the Trustees WORST-CASE analysis are as follows:

2009 GDP = –3%
2009 UNEMPLOYMENT = 8.5%

It is possible that the economy will recover over the balance of the year such that year over year growth will be near to the level in the Trustees forecast. However, unemployment today is at 8.9% and as a lagging indicator of economic activity it will certainly rise from the current level. Unemployment means less receipts for the Fund. 2009 will bring us very close to achieving CETI. If the economic recovery is anemic, CETI will be achieved in 2010.

One more graph on this topic. This one plots the timing of CETI based on the Fund’s Base Case assumptions. Note the gap that opened from the 2008 to 2009 reports on the far left. This revision in assumptions reflects the damage from 2008. Note also the upward trend that immediately follows. Here again, that up-trend is based on economic assumptions for 2009 and 2010 that will not be achieved. The bold line is based on the revised 2009 assumptions; it suggests that CETI will be achieved by 2015. It will certainly happen sooner than that.



A review of the first three months of 2009 data confirms that the Fund’s internals are continuing to deteriorate. This final chart shows the raw monthly surplus numbers for 2006 – 2009. There is a 40% drop in the surplus so far this year versus the average of the prior three years. This number should be growing, not falling, if that upward blip in the Trustees forecast is to be realized. Note also that February 2009 is a deficit cash flow month. I anticipate at least three additional negative cash flow months in the summer and the fall of this year. These negative months began appearing in 2008. Prior to that there have been no negative months for more than a decade.


The foregoing has been an effort to create a sense of urgency regarding the SS problem. I maintain this issue is staring us in the face. If I am correct the positive effects of SS are evaporating as you are reading this.

The Trustees have proposed significant increases in withholding taxes or reductions in benefits to ‘cure’ the problem. Tax increases are simply off the table in 2009. That leaves cuts. The approach by the Trustees is to identify a solution that would entail the ‘least’ amount of cuts. I would like to see a proposal that created the ‘largest’ amount of cuts. Perversely, the larger the cuts, the better off we will all be.

The SSTF has both the intellectual and the computing capacity to provide the country with a range of options to consider. I would like to have an analysis that answers the question:

“What benefit cuts are required to achieve a 50% reduction in payroll taxes?”

Substantial cuts will be necessary to achieve that goal. It would require a ‘means’ test for both existing and future beneficiaries. The benefits for younger workers would be substantially eliminated. The actuaries at the Fund could be more specific on the parameters that would be required.

In exchange, America’s 110 million workers would get a permanent 6% pay increase, a sounder basis for the long term economy and a substantially improved health care system. This change in tax policy could lay the ground for renewed and lasting prosperity.

The Obama Administration needs to raise taxes. They have indicated that these new taxes will be levied on high income earners. Although undesirable, that is necessary in the current environment. The best way to tax wealth is to create an eligibility means test for Social Security retirement benefits. It will be more palatable than an increase in the top tax brackets, the capital gains tax, or worse, an increase in withholding taxes that hits all workers.

Full disclosure: I am 60 years old. I already have my SS letter describing when and what checks I will receive. I would give that up in a heartbeat if in exchange I got a valid promise of health care at an affordable cost. A significant portion of the Boomers would agree with my position. On balance, we thrived as a generation. Now it is time to give back.

One more estimate. If we delay in addressing this problem it will cost us more. I will put a number on that. $10 billion incremental cost for every month that goes by without addressing this problem. About the same monthly cost as the Iraq war.

* Link to the Social Security Trust Fund Report:http://www.ssa.gov/OACT/TR/2009/index.html

2009 Social Security Trustees Report - Trouble

I wrote a Blog on April 30th titled Social Security – Trouble Ahead. In that report I drew some conclusions regarding the status of the Social Security System. I based those projections on information contained in the 2008 Trustees report. I overlaid the economic conditions of the past twelve months and concluded that the 2009 Trustee Report would show a significant foreshortening of the day of reckoning for the Fund.


The 2009 Social Security Trustee Report was released today. That report showed that the Day is now four years closer than it was just a year ago. The Trustees now believe that the Fund will deplete its assets by 2037.

In my report I tried to make the case that the dynamics of the Fund are in transition currently. A quick review of the information in the 2009 report confirms that to be the case.

The news media are reporting on this tonight. The headlines are reporting the 2037 date. Exactly what the Trustees want us to focus on.

“This is twenty-eight years away. We have a lot on our plate today. Let’s worry about Social Security next year.”

That is bunk. We’re staring at it.

Because of the headlines there will a lot of discussion and analysis on this report. I for one will give it a close look. I will let you know what I see.

Goldman Folds in Boston - What Does It Mean?

There are approximately 1.2 million register lawyers in the United States. 1.1 million of them saw this headline today. The 100,000 lawyers who did not see it were on vacation and will be aware of it soon enough.



The net of this story is that Goldman has agreed to pay the state of Massachusetts $60 million to settle a dispute regarding Goldman’s “predatory lending” practices in and around Boston. $50 million will be made available to reduce the loan principle on 714 individual mortgages. Of note is that the agreement called for reductions in principal of as much as 30% for traditional mortgages and up to 50% on second mortgages. Also of note is that the State of Massachusetts gets to keep $10mm for their efforts. Not bad for Attorney General Martha Coakley.

This means next to nothing for Goldman Sachs. However, a very dangerous precedent has been set. In the critical years 2005-2007 Goldman was ranked 15th in the League Tables for sub prime and Alt-A origination/securitization. Goldman’s management must be pleased as punch with that poor showing today. Those that ranked high on that list are no doubt consulting with their attorneys.

If Goldman gets its hand slapped for $60mm over 714 mortgages what does this mean for Countrywide Financial? They were very big in Boston. Merrill Lynch was at the top of those securitization tables. That is what got Stan O’Neal fired. If the settlement in Boston is representative of what will be forthcoming then Bank of America is going to be facing a very big number. And that is just Massachusetts. The AGs in the all of the other states, especially Florida, Nevada, Arizona and California must be licking their chops at this news.

One hears a lot about loan modifications these days. So far there are two basic approaches.

I) The borrower is given relief in the form of a lower interest rates and stretched-out maturities. The homeowner stays in the home.

II) The bank will accept a deed in lieu of the mortgage. The homeowner is out of the home.

There have been very few cases where a homeowner is allowed to stay in the home and achieve a principal reduction. The Boston settlement opens the floodgate for principal reduction. It is the essence of the agreement. All 714 borrowers are now eligible for principal reduction and the money is just sitting there waiting to be collected.

One can imagine the conversations between neighbors in Boston:

A: “Good news finally! I just got 35% net off my first and second mortgage.”

B: “Wow! How did you manage that?”

A: “I was lucky enough to get my mortgages through Goldman Sachs. They did a deal with the Mass AG and I win the lotto!

B: “I have my mortgages with Indy Mac Bank can I get reduction too?

A: Sure. Here is the number to call. Now lets party!


This is lining up badly for the banks. The States are broke. They will see this as a source of revenue. Politicians will also like it. They will be able to claim that they are helping their constituents. Word on this will spread quickly from borrower to borrower. Every one of them will be looking for a break.

The settlement makes an important distinction between first and second mortgages. The rights of the second mortgages are clearly subordinated in the deal. This is how a bankruptcy court would treat the two classes of debt. This provides a clue on how these ‘seconds’ will be treated in the future.

One of the largest sources of these second mortgages is the Mortgage Insurance Industry. They provide a guaranty of payment on the first loss of 20%. This product competed with the second mortgage industry. It created the same result for the borrower, the ability to buy a home with no money down. Precisely what Goldman is paying up for. In this case what quacks, walks and swims like a duck is likely to be treated like a duck.

Fannie Mae and Freddie Mac hold tens of billions of these insured or ‘enhanced’ mortgages. FHFA recently reported that the Agencies collectively held or guaranteed 30.2 million mortgages. Of that amount 16%, or 4.8 million are identified as “Non Prime”. Put differently, the Agencies hold 6,000 times more non-prime mortgages then Goldman originated in Boston.

At this point it is not at all clear what the broader implications of the Goldman settlement will be. This development has put the issues of lender liability and principal reduction on the table. It is unlikely they will come off the table anytime soon.

Stressing Fannie and Freddie - What Does It Mean?

The stress test process disrupted the markets for several weeks. In the end, the government’s effort has delivered some benefits. As a result of the mandated capital increases our banks will be stronger. The idea that all 19 are now ‘sound’ is not correct. However, they certainly will be ‘more sound’. Provided that the broad economy does not resume a significant downward slide in the next eighteen months our major banks and financial institutions will make it through this period.

The Fed and Treasury put the Financials through the wringer on this one. There is no precedent for this. The group of 19 were given one choice in this matter; either they consent to the process and agree to the conclusions or they go out of business. The circumstances justified the heavy hand of the government. There was a very troubling question in depositors minds, “Is my bank safe?” Even more significant was the question in investors minds, “Should I risk my capital in theses entities?” As of Friday both of these questions appear to have been answered in a positive manner.

Unfortunately, the two largest financial institutions in the United States were able to avoid the rigors of the stress test. Fannie Mae and Freddie Mac should be put under the same microscope as the commercial banks. This is very much a case of, ‘What is good for the goose is also good for the gander’.

Putting Fannie and Freddie to the stress test is relatively easy. Unlike the commercial banks they do not have a diversity of assets. The Agencies only risks are in residential mortgages. The two Agencies have the same business model. They both have a large book of funded mortgages and a significant off balance sheet guarantee business.

The following chart sets out the Feds parameters for evaluating mortgage assets.


On a combined basis the Agencies have approximately $1.4 Trillion of Sub Prime and Alt-A exposure. Based on the Fed’s criteria this would require at least $200 billion of new equity just from this category of the Agencies balance sheet. An average rate to evaluate the Agencies total book of business would have been in the 6-8% range if the Fed had used the same standards to evaluate the Agencies as they did when evaluating Wells Fargo Bank. For the basis of this discussion a modest 7% will be used to stress test Fannie and Freddie.

This chart shows the current amounts outstanding in the Agencies funded and guarantee books.


Multiplying the total risk book by the 7% haircut produces an addition capital requirement of $700,000,000,000. This amount is approximately 10 times the total amount of capital required for the 19 public financial institutions that were subject to the Fed’s stress test. The average Baseline haircut of 4% suggested by the Fed produces a capital shortfall of $400 billion. Applying the Federal Reserve Board's rules to the Agencies demonstrates just how large our problem is.

The cost to the taxpayer for cleaning up the Agencies will take many years to calculate. It may take a decade to stabilize these important institutions. The guidelines established in the Fed stress test do provide some insight as to the magnitude of the losses we may face. Those losses will certainly exceed the Baseline Case of $400 billion. It is quite likely the losses will approach three quarters of a trillion dollars.

It is difficult to put these very big numbers into perspective. By way of comparison, the losses at the Agencies will probably be larger then all of the costs that will be incurred in the Iraq war.

B of A and Bernanke: Unstressed

The Stress Test process is a triumph of form over substance. The entire effort is being highly orchestrated for the benefit of the public. I give Bernanke and the Fed an A+ for ‘managing the news’.

Yesterday Bernanke spoke. On three separate occasions he repeated this theme:

Banks that require additional capital as a result of the stress test will have the choice of (i) Raise equity in the public market (ii) Sell assets to raise capital (iii) Convert ‘existing’ securities into common stock and finally (iv) Additional equity from TARP.

Each time that he said this he followed it with, “I do no not think that we will be forced to use option iv”.

Shortly thereafter there is a leak to the press that Bank of America needs $34 billion. This actually had the markets down early, but then more leaks. The capital shortfall will be addressed with a ‘conversion’ of the TARP preferred into common stock and a sale of a BAC’s remaining interest in China Construction Bank (“CCB”).

My guess is that the significant details on the convert and the assets sales will be on the tape by Friday. Over the weekend Bernanke will be on the talk shows saying:


“Yes we had some issues with the banks. Our largest concern was with BoA. We solved that problem. It only took us 48 hours. The good news is that we did not have to spend any more taxpayer money. So, stop worrying and go back to Wal-Mart. I need to boost consumer confidence and spending ASAP. If I do not, my rosy forecast for the year-end economy will not be met and I probably will be out of a job.”



When one looks at a potential investment in a corporate debt obligation the first question to ask is, “How much is below me?” If you want to buy a senior bond you need to understand what the subordinated debt layers are about. If the Sub debt matures before you do, then it is not Sub debt at all. It is senior to you. The same thinking goes to the preferred level of the balance sheet. Is that money really there? Can it be redeemed? The equity has to be looked at too. Is this an air ball of deferred tax assets and goodwill?

When you apply these rules to the Bank of America $34 billion fix, the deal comes up very short of substance.

Converting the TARP Preferred stock into common equity will improve BoA’s position. They will no longer have to pay the TARP dividends (sorry tax-payer). Overtime that will help BoA earn its way out of trouble. It has very little short-term benefit. On the assumption that the amount of Tarp Pref to be converted to common is $26 billion the net savings amounts to only $1.3 billion a year. A rounding number.

The conversion of Tarp Preferred into common improves BoA’s Tier 1 capital ratio. It is an accounting event, not an economic event. If you want to ‘fix’ BoA you have to put real ‘cash money’ equity into it.

The rumored asset sale of CCB will have a more beneficial impact.But not much. BAC’s remaining holdings could be worth $8 billion. The interest in CCB that is now being sold was purchased in November of 2008. That acquisition was done by the holding company. The investment was financed with debt, not equity. The sale will improve the overall gearing ratios. It will add some ‘equity’ back onto the Tier 1 capital line. It will help make BoA look better. But, at what cost? When BoA completed the purchase of CCB five short months ago they said:

"Bank of America intends to remain a long-term and significant strategic investor in CCB,"

All of the shareholders of BAC including the taxpayers would have reaped benefits from the CCB investment for many decades. To sell it now, in order to create a short term accounting advantage, is just bad business. This is an example of the bad choices that will be made when DC owns the common stock.

I suspect that this ‘white wash’ is likely to work for the time being. At some point in the next six months BAC is going to come to the market with a new Sub Debt deal. It is going to have a fat coupon. It will be a tempting purchase. I will look at it and likely conclude; the Pref is distressed money that does not want to be there, the common is controlled by the Feds, the equity underneath me does not cover the book losses, the earnings power has been diluted by asset sales of good ‘stuff’, the senior debt above me is guaranteed by the FDIC, the deposit base is not captive and they can no longer pay for the talent that they need. I will take a pass on those ‘beautiful’ bonds. Push come to shove they will get converted to equity and the investors will end up side by side with the Fed. No thanks.

On the Sunday talk shows this weekend Mr. Bernanke should speak candidly about B of A and the stress test:

“Bank of America showed up as the weakest of the 19 banks we stress tested. This is because we had previously converted the bulk of the Citibank TARP Preferred investment into common stock. As a result the Citi Tier One capital ratio has already been gimmicked up. We will do the same deal with BoA. It is a band aide approach for these important institutions. We are going to do it with most of the other 17 big banks as well.”

“We had to do it this way. We wanted to put more new equity into them so that they could really address their balance sheet problems and earn their way out of trouble. We could not do that. We only have $90 billion of TARP money left. Congress will not give us any more money, so we had to make do. We have to keep the rest of the TARP money available if there is another emergency. Our cupboard is almost bare.”

“We know that we are making short-term choices that are in conflict with our longer-term best interests . We simply do not have the resources to address the problem today. The banks can’t raise sufficient capital on their own. Therefore we are trying to buy time to fix our weaknesses. We are doing everything that we can to improve the optics of the situation. Because we have no alternative we are going down the exact same road that Japan did twenty years ago.”

“We have saved the system. The cost will be high. As was the case in Japan, the result will be an extended period of sub par growth.”

Bernanke's Conundrum

Mr. Bruce Kasman of JP Morgan Chase updated his GPD forecast on Friday afternoon. His prior forecast was on the rosy side. His revised assessment is decidedly optimistic. Several other street economists rushed to joined Mr. Kasman’s sunny view this weekend.

The JPM view is that GDP will recover by the 3rd quarter and resume positive growth in the 4th quarter. I believe that this is overly optimistic, but, Mr. Kasman is a fine economist and while his targets might not be achieved, the direction of things to come is becoming clearer. Some form of recovery is in the making. As green shoots go, the Morgan-Chase report is as ‘green’ as I have seen.

Assume this happens. It means that by the end of the summer things are going to ‘feel’ a lot better. The year over year numbers will be looking progressively brighter. Demand for all manner of things will be on the up-tick. It is likely that prices will be on the rise.

It is very difficult to imagine how Mr. Bernanke can expand his program of dynamic easing if those are the conditions that we will be facing in six short months. I would go as far as to say that it is virtually impossible for the FED to continue to print money at the rate they are currently doing if the economy is actually in recovery.


Mr. Bernanke is an excellent student of history. He knows what excessive expansion of money supply did to the economy in the early 80’s. If Mr. Bernanke is forgetful, he has the benefit of Paul Volker looking over his shoulder.

Correlations in financial market are always fun to observe. They come and go. While they exist they provide clues to the market. When they end there are usually fireworks. The ten-year Treasury bond and the S&P 500 have been highly correlated for the past 200 days.

The following graph plots the daily moves of the S&P and the ten year bond. The graph measures the percentage change of the index versus the average for the period. Notice the many points in this chart that ‘line up’. When both short-term ‘blips’ as well as longer-term trends move like this I get interested.


On March 18, 2009 Mr. Bernanke revealed that the Fed would buy up to $300 billion of Treasury bonds in support of it’s goal of lower interest rates. On that day the ten year Bond closed with a 2.53% yield. Now, only 30 trading days later, the bond is yielding 3.16%. In bond land that is a very big change. It is also a red alert for both the Fed and Treasury that they are not going to get a recovery and low interest rates. Something will have to give.

This week is yet another record setting auction schedule. The dealers are getting fat with the predictable supply. Getting short in front of the auctions is proving to be good business. Money making trades become self fulfilling. The pressure on rates will continue with every headline that shows any renewed life in the economy and the unending supply of paper in front of us. The Treasury has $2 trillion of paper to sell and the Fed has about $250 billion left to buy. That is nearly 10 to 1. And the market knows it.

The correlation between bond yields and the stock market is about to end. It is likely that this will be a protracted war that takes many months before a conclusion can be drawn. The first battle may take place this week. If the employment report is on the ‘good’ side then the bond market is going to take another hit. The stock market will certainly take notice if yields break toward 3.5%.

If the scenario painted by Mr. Kasman is the one that plays out over the next six months it will have to be coupled with a rise in bond yields back to the 4% of a year ago. Anything above that level will push mortgage rates back up to a level that re-starts the downward cycle. It is difficult to imagine how the ‘recovery’ can sustain itself for more than a few quarters if that is the case.

We are stuck between a rock and a hard place.