Credit Markets "Utterly Unhinged"

The credit markets are casting a big vote of no confidence in the idea that the Federal government can rescue the housing market.

As we noted before, spreads on agency securities have widened to extreme levels. This renders the Fed’s rate cuts largely ineffective, at least if the intent was to give relief to the housing market via lower rates (note some believe the Fed wants to steepen the yield curve. Since banks borrow short and lend long, a big gap between short and long term rates will allow them to rebuild their battered balance sheets faster).

Some of the sources in the Bloomberg story seem close to panicked, and investors contend that investment banks are backing away from making a market. This is in securities historically considered to be virtually as solid as Treasuries, and the market is nearly as big as the Treasury market. There’s plenty of reason to be worried.

When will the Fed get the message that its plan of action is actually backfiring? It can’t remedy a solvency crisis via monetary action. What is needed is considerably more transparency, so that counterparties become less reluctant to conduct business with each other. I don’t have a clear idea as to how to achieve that (full transparency would any firm with trading positions at a disadvantage). However, the Fed has access to top experts and has know since last August that counterparty worries are a big part of the problem. Dealing with it indirectly is no longer effective.

Note there are also worries that hedge fund unwindings could lead to seize-ups in other sectors of the credit market.

From Bloomberg:

Yields on agency mortgage-backed securities rose to a new 22-year high relative to U.S. Treasuries as banks stepped up margin calls and concerns grew that the Federal Reserve may be unable to curb the credit slump.

The difference in yields, or spread, on the Bloomberg index for Fannie Mae’s current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened about 11 basis points, to 227 basis points, the highest since 1986 and 93 basis points higher than Jan. 15. The spread helps determine the interest rate homeowners pay on new prime mortgages of $417,000 or less.

The markets have become “utterly unhinged,” William O’Donnell, a UBS AG government bond strategist in Stamford, Connecticut, wrote in a note to clients today. A lack of liquidity has “led to stunning air-pockets in price levels.”

Investors are realizing that banks have little room to make new investments amid rising losses and a flood of unwanted assets, said Scott Simon, head of mortgage-backed bonds at Pacific Investment Management Co. The world’s top banks have reported more than $181 billion in asset writedowns and losses, been stuck with $160 billion of leveraged buyout loans, and bailed out $159 billion of structured investment vehicles.

“Everything is telling you the financial system is broken,” Simon, whose Newport Beach, California-based unit of Allianz SE manages the world’s largest bond fund, said in a telephone interview today. “Everybody’s in de-levering mode.”….

The widening spreads prompted speculation the government may step in to support securities guaranteed by Fannie Mae and Freddie Mac, said Tom di Galoma, head of U.S. Treasury trading in New York at Jefferies & Co., a brokerage for institutional investors. The Treasury Department said the rumor isn’t true.

“The Fed can’t really save the mortgage market,” di Galoma said. “As they keep cutting, mortgage rates aren’t going lower.”

The spread of current-coupon fixed-rated securities guaranteed by Ginnie Mae against 10-year Treasuries has climbed 39 basis points this month to 189 basis points, also the highest since the 1980s, according to Bloomberg data. Debt guaranteed by Ginnie Mae is explicitly backed by the U.S. government, and based on loans already insured or guaranteed by its agencies. A basis point is 0.01 percentage point…..

“The capital issues at commercial banks are making them, in general, reluctant to lend, so lending is either harder to find or when you do find it, it’s more expensive or the other terms are more-limiting.” Steven Abrahams, an analyst with Bear Stearns Cos., said in a telephone interview yesterday.

“If there’s less money to finance positions and less balance-sheet available to warehouse positions, the markets are going to become more volatile,” he said….

“The single biggest concern right now is who’s the next hedge fund to blow up, and how big are they,” Arthur Frank, the New York-based head of mortgage-backed-securities research at Deutsche Bank AG, said in an interview today. “The more the market widens, the more likely it is that another leveraged player has to sell, so it does feed on itself.”….

“Traders are putting their phones down and backing slowly away from their desks,” O’Donnell said today in a telephone interview. “Relatively little” agency mortgage-backed securities are being traded, Pimco’s Simon said.