Thanks to the Fed, We Have Narrow Spread

Today will be rhyming day...

While the broad economic recovery has been teetering along, assets classes have been another story. Agency MBS is now trading at Treasury levels (i.e. no spread) and Investment Grade Credit spread is at narrower than levels seen in June '08 (i.e. pre "system might crash"). I think "we've come a long way in 12 months" is probably too much of an understatement.



Source: Barclay

Putting the Credit Crisis in Perspective

While I am still relatively bearish with regards to a further economic / market recovery, I am amazed at how fast a recovery we have had in credit markets. We were on the verge of a Great Depression type crisis until just ~6 months ago (so soon we forget), but have rebounded with unreal zeal.

How unreal? Lets compare the recent ongoings in the credit market with that of the Big D to put the crisis (and recovery) in perspective. While they never blew out to the level seen in the 1930's, the spread between AAA corporates and BBB corporates are now within 100 bps of the levels at the start of the crisis, just 2 years after the blowout began. That is 3x faster than seen in the Great Depression.



My question (which may be getting old) is... have we come "too far, too fast"? My view is a resounding yes, thus tread carefully.

Source: St. Louis Fed

GE Rated Aaa = Aaa Joke

In my post regarding the shift in the composition of the Barclays Capital Investment Grade Index, I was asked:

Any idea why most recent data points show Aaa at higher yields than Aa??

In fact, I do... the Aaa (FYI- Barclays Capital refers to this ratings 'tranche' as Aaa, not AAA) is made up predominantly by GE Capital (predominantly is an understatement).



And since mid-2007, spreads on GE Capital bonds have blown out, especially after the Lehman failure in mid-September 2008.



A 450+ bp spread for the CDS (as wide as 600 bp) on a Aaa rated security? As a refresher, an S&P triple A rating is saved for:

The best quality borrowers, reliable and stable (many of them governments)

So why are spreads so wide? According to Morgan Stanley (in reference to GE):

“Investors do not want to own a stock with dividend cut risk. Investors do not want to own a stock with rating agency risk. Investors do not want to own a stock where substantial earnings tailwinds come from past tax reversals. And lastly, investors do not want to own a stock with a financial sub, particularly one which is substantially under-reserved.”

This doesn't sound like a "best quality" "reliable" "stable" or "government-like" entity. Surely the ratings agencies must think differently. Lets get the opinion of S&P analyst Robert Schulz:

The quarterly results show that 2009 may be more difficult than expected for GE Capital. The financial arm makes loans for everything from consumer credit cards to big commercial energy projects.

How difficult? According to Schulz:

Credit losses are now expected to be $10 billion, $1 billion more than GE forecast in December. Losses in the company's real estate portfolio are also expected to reach $4 billion, compared with a $2 billion gain.

So, in the worst financial crisis since the Great Depression, S&P's own analyst declared that after GE needed a $139 billion in FDIC backed debt just two months ago, was put on negative outlook in December, and has its hands in everything from consumer credit cards to big commercial energy projects (again, in the worst financial crisis since the Great Depression) they still deserve a triple A rating.

And this is why the most recent data points show Aaa at higher yields than Aa.

Spreads: Not Seen Since the Great Depression

JG provided an interesting insight in the comments section of my "Real Yields Matter" post. Credit risk premium, as defined by the difference between the yield of the Moody's Baa and Aaa rated indices (more detail regarding Moody's here), recently moved above 3%. What is the significance?

As of Nov. ‘08, the Baa-Aaa risk premium moved above 3.0%, to 3.07%; in December, it was 3.38%.

When were the last times that the Baa-Aaa risk premium rose above 3.0%? August ‘31, October ‘32, October ‘33, and March ‘38, in the depths of the Lesser Depression (first two) and its protracted recovery (last two).

We are one year into The Greater Depression.

In plotting the data, JG is correct. Although we were awfully close in the early 1980's and 338 bps is a a lot smaller than the 560+ bps we saw in 1932, this does put the current crisis into the correct context.

Source: St. Louis Fed (BBB) / St. Louis Fed (AAA)

Another Post on Swaps????

I admit it... I've posted WAY too much about swap spreads, but in my last post on the subject of the 30 year swap spreads (defined here), I received this comment:

Not sure why this is considered good or bad. Seems indifferent to me as banks are basically an extension of the Fed balance sheet and federal government for all intents and purposes now. This doesn't have any impact on credit to the real economy. Just filling in holes of the banks balance sheets.

How's this for importance? For the past 8 years (I could only find data going back 8 years) 30 year swap spreads have followed equities with alarming regularity (I smoothed the changes by averaging the change over the past month):


HOWEVER, over the last month, 30 year swap spreads have rallied significantly more than the equity market.



Will swap spreads lead the market higher or should we view this recent rally in credit markets as short-lived? Or should we ignore it altogether. Interesting post at Infectious Greed about just that. According to Paul:

The risks of financial history are higher than ever though. We have more data, better analytical tools, and more people crunching the data, so we can expect to see data on pretty much anything we want to see. There will always be someone tearing apart something to find something interesting, so something interesting will be found. My friend James Altucher has always been great on this subject, ripping holes in pretty much every data-driven rule of thumb by which people claim to trade and/or find market tops and bottoms. They mostly don’t work.

Agreed.

Curve: Swaps vs. Treasuries

A post on the FT from back in 2006:

Much as in other derivatives markets, swaps are becoming preferred among many investors as a means of increasing exposure to interest rate moves rather than direct investment in cash Treasuries, which is narrowing the differences between the behaviour of both markets.

When the US Treasuries yield curve inverted during 2000, swap spreads, a measure of the difference between the rate available from the swap market and the Treasury yield, widened, led by longer-dated maturities.

The wider spread pushed swap rates higher and prevented the swap curve from inverting.

We are truly in unprecedented times. The last time 10-30 swaps inverted was back in 2000, when Treasuries were even more inverted. Now, 10-30 Treasuries are more than 50 bps steep.

Up is Down... Down is Up

Swap spreads are currently trading through Treasuries on the long end of the yield curve. Not just a few bps, but 30+ bps.

What does this imply? It "implies" that investors are willing to lend to a counter-party (bank, hedge fund, etc...) at a lower rate than the U.S. government. While this isn't the reason for the inversion (I detailed back in October some technical factors that caused this), it still shows how distressed this current environment is.

How strange is this? Well back in October when the spread first inverted, we get this from the FT:

“Negative swap spreads have been considered by many to be a mathematical impossibility, just like negative probabilities or negative interest rates,” said Fidelio Tata, head of interest rate derivatives strategy at RBS Greenwich Capital Markets.

In this environment, nothing is impossible.

All is Still Not Well in Credit Land

Corporate bond analysis via Across the Curve:

Regarding the near term course of spreads I did speak to one portfolio manager who held a less than sanguine view.

He cited three factors for his caution:

• The injection of public money is a worthy first step but the crisis will not resolve until there is a groundswell of optimism from private investors.
• The second factor is time. It will take time to repair and rehabilitate the market.
• Finally, the economic fundamentals are suggestive of a sharp contraction lasting three quarters or four quarters. Against that background, a cautious approach to corporates is in order.

Corporate / Mortgage Backed Security Spreads

High Yield Spreads: out close to their cyclical highs; ~800 bps above Treasuries

Investment Grade Spreads: at their cyclical highs ~300 bps above Treasuries (higher than High Yield spreads just last summer)

MBS Spreads: down a whopping 60 bps and STILL some room to go to reach levels when they were only "implicity" guaranteed by the government

A Picture is Worth 1000 Words... Fannie MBS Edition

Bonds Sure Look Cheap...

The option adjusted spread to Treasuries of the Lehman Aggregate Index is currently at a historic level. Is this a buying opportunity, a view of things to come, or just mispriced options?

Single A Corporate Spread Curve

Now wider than at Bear Stearns bail out levels:

S&P: Fannie Subordinated Debt Holders May be In Trouble

Per Dealbreaker:

Will the government's bailout of Fannie Mae and Freddie Mac wipe out holders of their preferred stock and subordinated debt? That's what S&P warned today with its statement that it was placing these instruments on a negative credit watch pending a review of the legislation on Capitol Hill.

"Although there is still ambiguity on the part of regulatory authority as it applies to how nonsenior creditors of Fannie Mae and Freddie Mac would be treated if the U.S. Treasury ever acted on its three-point liquidity plan, the language in HR 3221 increases the likelihood that subordinated debtholders and preferred stockholders would face greater subordination risk," S&P's analyst wrote.

Update: Yves over at Naked Capitalism points out the downgrade:

Validates some of the critics' worries about Fannie and Freddie but also signals the possibility that not only shareowners could be wiped out, but even preferred stockholders and sub debt owners are exposed even with the government rescue effort. Put more simply, this move the view that the firms are undercapitalized.

Are Fannie Mortgages Cheap or is its Debt Expensive?

The government is willing to backstop Fannie so Fannie can backstop their Mortgage Backed Securities "MBS" if needed to.

So why is the MBS trading ~100 bps cheap to their debt (OAS less CDS) after trading MORE EXPENSIVE JUST SIX MONTHS AGO? Interesting times...