A Bloomberg story discusses that the Fed will have to lower rates further, despite January retail sales figures that came in better than expected, because lower short-term rates have not led to better terms for borrowers.
The story (and perhaps even the Fed) seems to miss why lenders are demanding higher rates: the securitization mechanism has broken down. Banks are looking at keeping loans on their balance sheets for a longer time, perhaps indefinitely. Bank intermediation is more costly than the “package and sell” model. And as bank and securities firms take writedowns and become capital constrained, they become more choosy about the risks they take and the returns they require.
Further rate cuts completely miss the point, and will create inflation without fixing the problem of high borrowing costs (in fact, for certain kinds of loans, like fixed rate mortgages, it will worsen terms directly by steepening the yield curve).
From Bloomberg:
The Federal Reserve’s interest-rate cuts last month have failed to lower borrowing costs for many companies and households, increasing the chance of further reductions from the central bank.
Companies are paying more to borrow now than before the Fed reduced its benchmark rate by 1.25 percentage point over nine days in January, based on data compiled by Merrill Lynch & Co. Rates on so-called jumbo mortgages, those above $417,000, have increased in the past month, making it tougher to sell properties and risking further price declines….
“The problem is that every piece of news we’re getting continues to be bad,” said Stephen Cecchetti, a former New York Fed bank research director, and now a professor at Brandeis University in Waltham, Massachusetts. “They will have to ease more. It’s the only thing they can do.”….
Traders now see a 100 percent chance of at least a half- point reduction at or before the Federal Open Market Committee’s March 18 meeting, up from 68 percent on Jan. 31…
The extra yield investors demand to buy investment-grade U.S. corporate bonds rose to 2.37 percentage point Feb. 12 from 2.24 percentage point on Jan. 21, Merrill data show. For high- risk, high-yield securities, premiums over Treasury securities have risen a quarter-point, Merrill data show.
“The increase in credit spreads has sort of worked against our policy,” San Francisco Fed President Janet Yellen told reporters at her bank yesterday. “The fact that the spreads went up so dramatically really resulted in an effective tightening of financial conditions that our cuts were partly meant to address.”
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When credit is being destroyed faster than it can be originated, any illusion of inflation will soon be fixed by a deflationary spiral. Don’t you get it?
“Further rate cuts completely miss the point, and will create inflation without fixing the problem of high borrowing costs (in fact, for certain kinds of loans, like fixed rate mortgages, it will worsen terms directly by steepening the yield curve).”
“They will have to ease more. It’s the only thing they can do.”….
So even though “the only thing they can do” doesn’t do what they want it to do, they have to keep doing it.
“Rates on $100 million of bonds sold by the Port Authority of New York and New Jersey, with bidding run by Goldman, soared to 20 percent yesterday from 4.3 percent a week ago, according to data compiled by Bloomberg. Presbyterian Healthcare in Albuquerque and New York state’s Metropolitan Transportation Authority also experienced failures, officials said.”
This is why the Muni market must not fail. 1600 basis points due to the uncertain future of the monoline insurers is unacceptable. Remove the uncertain environment and New York saves a boatload of money. Multiply it by 100…that’s the number of failed auctions yesterday, and you start talking about serious money being pissed away because the insurers decided they wanted to be hogs which always get slaughtered. Time for them to sleep in the bed they made!
can anyone here play this game?
zero sum game. nothing is pissed away unless you think you are a better arbiter than markets. every municipality that has to pay more in interest is making an incremented wealth transfer to whoever the payee is. its called a deal. why is paying what you have to under current conditions because you promised you would pissing away anything?
furthermore to the extent there is a dry up of further municipal borrowing because rates are too high, then there is either (i) a market dislocation because the rates shouldnt be that high and presumably someone like the new buffett insurer will come in to accommmodate both sides of the market; or (ii) a properly functioning market, and that rate delta correctly reflects the actual risk, in which case it’s simply stupid that for all these years the bond insurers were able to credit (or at least ratings) enhance muni bonds with so little reserve (as bill gross said, how can a monoline insure the debt of the state of california, the 5th largest economy in the world, with only $5B in capital?).
piss away presumes that whoever says it knows better than the markets what the proper destination of money is.
piss away presumes that whoever says it knows better than the markets what the proper destination of money is.
???????????????
When I could borrow for 4 and change last week, and I now pay 20 because some jackass decided to play fast and loose in the CDO market it’s pure bullshit. This has nothing to do with the Muni paper itself, but rather the solvency question of the jackass monolines who decided they could dance just like Mr. Prince…right off the frigging cliff!
“whoever says it knows better than the markets what the proper destination of money is.”
The idea that the “market” (whatever that means) knows better what the destination of the money is, is laughable.
The market is like a living organism. Well…guess what? Both can be afflicted by diseases, that can get VERY serious.
This is one of these times. The Muni bond market is very sick and it doesn’t have an auto-heal switch. Human intervention is required and soon.
That could piss off the ayatollahs of Free market or die?
Tough titties!
When I could borrow for 4 and change last week, and I now pay 20 because some jackass decided to play fast and loose in the CDO market it’s pure bullshit
No, it just means that risk was UNDERpriced last week, and the market has corrected. Maybe overcorrected, but do you remember that NYC tried to go bankrupt last time we had a severe recession?
20% sounds too cheap to me – though I might take a gamble at that price.
No, it just means that risk was UNDERpriced last week, and the market has corrected. Maybe overcorrected, but do you remember that NYC tried to go bankrupt last time we had a severe recession?
fwiw, anon, this reasoning presumes a “right” rate of interest — a theoretical abstraction with no empirical manifestation, as far as i can tell. money was cheap; now, money is dear. which is “right”? neither — there is no “right”.
i think it should be enough to see that this market is undergoing a liquidity — not solvency — squeeze. the issuers of these securities can and will refinance into other vehicles. when they do, they won’t be paying 20%, which is reflective of a liquidity premium.
i’m sure my plaudit mean nothing, mr smith, but your blog is excellent. one observation:
Further rate cuts completely miss the point, and will create inflation without fixing the problem of high borrowing costs (in fact, for certain kinds of loans, like fixed rate mortgages, it will worsen terms directly by steepening the yield curve).
i think the extent of bank credit contraction will have much more to say about the direction of treasury rates toward the long end than the fed. so far, short of a recapitalization, it looks like it will be considerable and international. i don’t imagine inflation will be a concern going forward.
but what cutting the overnight rate DOES do is increase the carry for the banks by steepening the curve — a de facto stab at recapitalization, though in slow-motion. the fed is doing this, imo, as much to aid the banks’ cash flow and ultimately balance sheets as anything. i expect they’ll cut more and keep rates low for some time to come, and rely on contraction in the money multiplier to keep inflation in check.
gaius marius,
Your point re a steep yield curve being a subsidy to the banking industry is key, and not mentioned often enough.
Greenspan engineered a very steep yield curve after the S&L crisis for the very same reason. But prevailing interest rates were higher then, so he did it primarily by dropping the short end. Here we’re likely to get it by virtue of rising inflation expectations.
could very well be, mr smith, but the spread between 5-year treasuries and TIPS has actually compressed somewhat to 2.05%. the marketplace may certainly be experiencing significant capital flux and transient effects throwing whatever slight predictive value markets have into the trashcan, but i can’t find a way to make the inflation (hyper or otherwise) argument go at this moment. it certainly may come to pass in time, but not yet? that’s my best guess.
expectations for inflation may indeed increase if all this stimulus and a bailout or two somehow rights the ship — and then we’ll see an expansion of that spread — but they’ll be increasing from very low levels. until TIPS yields start showing real duress, i imagine the fed will keep cutting.
the supreme court is not always right because its smart, its always right because by definition its the supreme court.
as a tax lawyer i work with the concept of fair market value. the fair market value is by definition what a willing buyer would pay a willing seller in the absence of duress on either side.
whether an observable market value in a functioning but sick market is fair or not is a debatable point but the issue is not whether its fair the issue is whether its a market value.
i submit that even a huge jump condition such that munis have to pay more to refi a 30 day float given what appears to have been an auction that attracted real if insufficient bids does not create economic waste.
we all read the stuff about fat tails.
its a fat tail event.
im sure no bond counsel would have agreed to a 20% default rate if he or she thought there was a chance in hell of having to pay it.
but here we are.
one of the advantages of age is perspective. i recall a line from guys and dolls, 50 years ago, that “my daddy once told me, son, if a man comes up to you and bets that he can make the jack of spades jump up out of his pocket and squirt you in the eye with cider, do not take that bet, because sure as hell you will get an eyeful of cider.”
i can tell you from 30 years of experience in all kinds of fields that clients always scream and yell that you’re spending too much time on the fine point and killing deals.
im sure harry macklowe didnt spend a whole lot of time on the fine points of what would happen if he actually couldnt refi that debt. i was close to that deal and i can tell you the whole real estate deal world was congratulating each other on how good they all were that huge deals like that could trade so fast and who needs to take time being cautious.
so some boiler plate filler in an option bond that no one looked at for years actually now matters.
shock.
the one thing i can guarantee you is that this happens every so often and always will human nature being what it is.
as someone once said in a similar post, “all the gas molecules in a closed system rarely all panic and run to one corner of the box at the same time; but people do, a lot more than you would think”
suggested research topics are how isaac newton, not exactly an idiot including as to calculus, blew up financially.
when i design quant funds, i tell the client “this will work till it doesnt. its a matter of luck in the end. sooner or later all risky funds will blow up to some degree. the probability of such an event happening converges to one as time goes to infinity. you may be lucky enough to participate so long that you keep your profits, or you may be unlucky and be killed early. things work until they don’t.”
therefore, yes auction markets can overshoot up and down, but to all those who feel that this is an unusual situation, i refer you to another quote, this time from ayn rand, in the fountainhead, where an architect who is suddenly unfashionable is complaining to an architecture journalist that he doesnt understand why no one hires him anymore, and the journalist replies, i dont suppose it occurred to you to wonder why anyone ever hired you in the first place.
why is it “somethings wrong” when a tail event occurs rather than “i guess it was all mispriced for a long time?”
perhaps the years when this crap could be stuffed into the retail channel were the anomaly and the natural state should be much more risk averse.
only the perspective of time will tell.
but for everyone paying 20% instead of 5% there is someone receiving 20% instead of 5% and that money doesnt go to heaven it gets put back into the economy and the arrogance that presumes the money is better off in the hands of the municipality than this payee is the same arroagnace that presumed the true risk-adjusted price of the debt was 5% to begin with and tail events would never happen.
hows that working out for you?
The fundamental problem with auction-rate securities, as Accrued Interest pointed out, is that there’s little upside for bargain hunters. Sure, 20% is a great yield, but it might only last 7 days (or 28 days, or whatever).
For fixed-rate securities, if you buy them during turmoil at a discount and conditions later improve, you make a nice profit. For auction-rate securities, if you buy them during turmoil and conditions later improve, all you get is a much lower yield.
So you have an illiquid security with little upside. Compare more traditional bonds, for which there’s always a market: even North Korean bonds that defaulted 32 years ago still sell for 30 cents on the dollar (!)
Oops, the above comment at 7:49 PM was intended for the muni bond post. I’m not sure why prior commenters are also seemingly posting about it here (mentioning the 20% rate) instead of there.