Thursday, September 27, 2012

David Stockman: This Market Isn't Real; FNMA MBS Spread Update

In an interview with Casey Research in July, former Reagan Budget Director and Congressman David Stockman made interesting points about how the Federal Reserve is mispricing the whole market. And this interview was conducted before QE3 was announced on September 13 (see Fannie Mae MBS activity below). I embedded the video of the interview below. But first are David Stockman's thoughts (via the transcript) on how asset classes and bank lending would react to a crisis in the Treasury bond market.

David: Because Greece is a $300 billion economy. Tiny. A rounding error in the great scheme of things. It's – last time I checked – about eight and a half months' worth of Walmart sales. Okay? That's a little different than when you have the $15 trillion heartland of the world economy, and the $11 trillion Treasury market which is at the center of the whole global financial system buckle and falter. That's the risk you're taking if you say, "Mañana. Kick the can; let's just wait for something good to happen."

This market isn't real. The two percent on the ten-year, the ninety basis points on the five-year, thirty basis points on a one-year – those are medicated, pegged rates created by the Fed and which fast-money traders trade against as long as they are confident the Fed can keep the whole market rigged. Nobody in their right mind wants to own the ten-year bond at a two percent interest rate. But they're doing it because they can borrow overnight money for free, ten basis points, put it on repo, collect 190 basis points a spread, and laugh all the way to the bank. And they will keep laughing all the way to the bank on Wall Street until they lose confidence in the Fed's ability to keep the yield curve pegged where it is today. If the bond ever starts falling in price, they unwind the carry trade. They unwind the repo, because then you can't collect 190 basis points.

Then you get a message, "Do not pass go." Sell your bonds, unwind your overnight debt, your repo positions. And the system then begins to contract – exactly what happened in September and October of 2008. Only, that time it was an unwind to the repo on mortgage-backed securities and CDOs and so forth. That was a minor trial run for the great unwind that is going to happen when the Treasury market is finally shattered with a lack of confidence because, on the margin, no one owns a Treasury bond: they just rent it on borrowed money. If the price starts falling, they'll get out of that trade as fast as they got out of toxic CDOs.

Alex: So when people run away from the US, they will run away all at once.

David: Well, if they run away from the Treasury, it sends compounding forces of contagion through the entire financial system. It hits next the MBS and the mortgage market. The mortgage market then scares the hell out of people about the housing recovery, which hasn't happened anyway. And if there isn't a housing recovery, middle-class Main-Street confidence isn't going to recover, because it is the only asset they have, and for 25 million households it's under water or close to under water.

Alex: We saw something much like that in 2008. All the markets correlated. Stocks went down. Bonds went down. Gold went down with them. It sounds like what you're saying is that the Fed is effectively paying bankers to stay confident in the Fed, and that the moment that stops – either because the Fed stops paying them or something else shakes their confidence – this all goes down in one big house of cards?

David: Yes, I think that's right. The Fed has destroyed the money market. It has destroyed the capital markets. They have something that you can see on the screen called an "interest rate." That isn't a market price of money or a market price of five-year debt capital. That is an administered price that the Fed has set and that every trader watches by the minute to make sure that he's still in a positive spread. And you can't have capitalism if the capital markets are dead, if the capital markets are simply a branch office – branch casino – of the central bank. That's essentially what we have today."


David: Yes. As I say, when the crisis comes in the Treasury market, it will be the great margin call in the sky. They'll start unwinding all of the carry trades, all of the repo. Asset prices generally will be affected, because this will ricochet and compound through the system.

Alex: When does this happen?

David: People looked at the housing market and the mortgage market way back in 2003 – there were some smart people looking at this. They looked at the run rate of gross mortgage issuance, the $5 trillion I was talking about, and said: "This is insane, this is off the charts, this is so far beyond anything that has ever happened before, something bad is going to come of this." It's obvious, if you pour debt into markets… I mean a lot of people leveraged 98%, or whatever they were doing at the time with so-called mortgage insurance, and just high loan to value ratios. They were driving up prices, and so there was a housing-price boom going on. It was sucking the whole middle class into speculation. So that's the nature of the system, and now they don't know how to unwind it.

Alex: That's a pretty stark picture. So as an individual investor, what are we to do? How do we protect ourselves in this type of situation? Should I be owning bonds and staying out of stocks? Should I be owning stocks?

David: No, I would stay out of any security markets. These are unsafe markets at any speed. It's all tied together. As I was saying when the great margin call comes and they start selling the Treasury bond, they'll take everything else with it. Real estate is priced off Treasuries. Mortgaged-backed securities are priced off Treasuries. Corporates are priced off Treasuries. Junk bonds are priced off Treasuries. Everything. The stock market will go into a panic. We don't know when the timing will come – we've never been in a world where there is $15 trillion worth of central-bank balance sheets, like we have today. The only thing I think you can conclude is preservation is the only thing you are about as an investor. Forget about yield. Forget about return. Just keep yourself liquid and preserve your capital, because you can't predict the day when, as I say, the great margin call in the sky comes down.

Read the full transcript here:

Now my opinions and an interesting update on agency MBS to Treasuries.

The Fed is destroying savers and forcing people to take on manipulated and mispriced risk so it can backstop the housing market and home prices, which economist Gary Shilling thinks could fall by another 20%. And some investment managers are now leveraging up government backed agency mortgage-backed securities (MBS) 8-10x in mREITs, with agency MBS currently part of the Fed's third round of quantitative easing (QE3). The current Fannie Mae 30-year coupon rate is at 1.68%, and today the 30y Fannie Mae MBS spread to 10-year Treasuries went negative. Or check out a similar chart, the FNMA 30 Year OAS (option adjusted spread).


So there are crazy distortions going on in government interest rates courtesy of the Fed. If the U.S. sees deflation and a deleveraging cycle worse than Japan's, maybe all of these rates will go negative. Or better yet, we'll see an inverted yield curve at some point. I mentioned all of these interest rate risks in my previous post on agency mREIT Annaly Capital Management, which has had the same performance as gold since 2002. More on agency MBS and mREITs at Sober Look: Mortgage REITs' leverage poses significant risks to the overall mortgage market; The Fed will buy over half of all new agency MBS. During the QE3 press conference, Fed Chairman Ben Bernanke said that the Fed couldn't backstop the fiscal cliff (fiscal tightening). So if fiscal tightening occurs at some point, asset markets fueled by Fed stimulus would just revert back to lower levels either way, right?

The main difference between now and 2004-2007 is that everyone is now knowingly putting money to work in an economy that has a manipulated and mispriced "risk free" rate (U.S. Treasury bond yield). As I see it, the credit market blew up in 2007-2008 because, 1) Congress failed to regulate OTC derivatives; 2) Former Fed Chairman Alan Greenspan lowered the Federal funds rate to 1% in 2003 (ended up having a fatal flaw in his ideology); 3) China kept investing in Treasury bonds which lowered rates; 4) Massive unregulated fraud (more) and speculation occurred in the mortgage and housing markets; and 5) Even Chairman Bernanke was wrong about the housing market between 2005-2007.

Now the Fed is blatantly mispricing risk in every market. So shouldn't the FBI be warning about this new epidemic of mispriced risk in the system like it did about mortgage fraud in 2004? Which regulators ignored by the way. Kind of similar.

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