Failed Fed Auction an Early Warning?

Not widely reported except by Bloomberg, the Federal Reserve (Fed) had a rare failed auction last week of mortgage-backed securities (MBS) "purchased" by the Fed from AIG during its $182.5B bailout in 2008/9. The Fed bought a total of $52.5B of MBS from AIG as part of the bailout package, forming the "Maiden Lane II" portfolio of distressed crisis assets on its balance sheet. Why should investors and traders care about this event? Keep reading.

In a June 8 dutch auction, investors only bought $1.9B of $3.8B of debt offered, causing market spectators to question the quality of MBS assets that AIG dumped on the Fed (or that the Fed overpaid for). The byline is that the Fed ended up selling the assets into a weak(ening) market, a casualty of bad timing. The irony is that the Fed was offered $15.7B from the rescued-and-lingering AIG for repurchase of the remaining $31B Maiden Lane II portfolio in March. Perhaps the Fed saw such a discount repurchase (reverse repo, actually) as a giveaway that would get too much press attention as a taxpayer loss, and decided that selling into the open market was a more tenable option. Credit markets in February-March were at a 2-year "high" of health, but have since deteriorated somewhat, with both MBS and corporate high-yield (junk) debt spreads increasing along with the price of credit default swaps for major banks and bond insurers.

So why should investors and traders care about this event? First, failed Fed auctions are a rarity. Second, the Fed has some $2.8T of "crisis assets" on its balance sheet [1], with ~$2T collected since fall 2008. Yes, the majority of those assets are Treasuries bought via quantitative easing asset swaps, and are AAA-rated, of the very highest quality debt (for now). Likely, the Fed won't be unwinding its balance sheet anytime soon, given some show of recent economic weakness and calls for even more quantitative easing from some quarters. The questions that arise are: Is selling into a weak market a destabilizer for credit/debt markets, and what is the risk of more failed auctions as the perception of quality deteriorates? Could those failed auctions ever be mint-Treasury auctions by the Treasury [2], forcing the Fed to continue loading its balance sheet and monetizing debt? And then there's always the question of all that muni-debt...

Note I am not just another "chicken little" on the issue of failed auctions and bond market turmoil, as the quality of debt has always been, and always will be, the paramount concern. If the 2008 crisis taught us anything, an oversupply of debt in the market can have destabilizing consequences, especially if quality of that debt declines. Investors and traders need to be vigilant of any signs of worsening conditions.

[1] Public view of the Fed's balance sheet can be found HERE.
[2] Newly-issued Treasury auctions can be tracked HERE.

Japan's Downgrade is Bearish For U.S. Treasuries

The recent rally in U.S. Treasuries has many of us wondering when the trend is going to end. One party disruptor may be Japan, a major foreign creditor holding some $900B of U.S. Treasury debt, second only to China, who holds ~ $1.15T. Japan may yet decide to liquidate some of its holdings to divert capital to post-tsunami rebuilding efforts or to invest in higher yielding debt or other investments elsewhere.

Japan's recent sovereign credit rating downgrades are perhaps warranted, but a tad nonsensical in comparison with a lack of an actual downgrade of U.S. sovereign credit. Though Japan's government debt/GDP approaches ~220% of GDP, the U.S. debt/GDP at ~100% of GDP is growing at a much faster rate and does not account for unfunded obligations that will easily exceed projected tax revenues.

The Yen carry trade that financed arbitrage-fancy T-bond purchases is not as lucrative as it once was, given the persistent strengthening of the Yen (USD/JPY is now trading again below 80). Given the U.S. debt profile, sitting on long-term U.S. debt has growing risks unless hedged. The Bank of Japan could see a sale of Treasuries and a purchase of higher yielding debt from other countries with stronger currencies as a prudent move as Treasuries continue to push higher on what I call a technical rally.

(Major foreign holders of Treasury securities are tracked by the Treasury here: http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt.)

Money Market Funds and Risk

Money funds carry risk, and taxpayers should not be expected to bail out poorly managed funds.

Are money market funds safe investments? With yields at historic lows the question is a good one to ask, especially if the risks outweigh the yields. The highest current yields may only be slightly over 1%, with the bulk of funds yielding far less than 1%. At such low yields, some consider these funds not as an investment, but as a place to reserve or "park" cash. Money market funds typically peg their net asset value (NAV) to $1/share to "guarantee" against principal loss, though in reality there is no inherent guarantee, and these funds are distinctly different from bank savings accounts.

Regulators, such as the SEC, are reportedly working on (you guessed it) more regulation of money funds, with possible reclassification as banks, and perhaps even the charter of a new FDIC-like entity to buy securities from the funds in liquidity, flight of capital, or quality of capital crises. The industry's trade group is even lobbying the SEC and the Federal Reserve to set up a "liquidity bank," one that would have access to the Fed's discount window.

A history lesson is useful here. The money funds that had trouble in Fall 2007 had bought short-term commercial paper from structured investment vehicles (SIVs), which in turn used this funding to buy risky/toxic collateralized debt obligations (CDOs) and mortgage backed securities (MBSs) - In effect to circumvent regulatory capital rules that restricted debt. The value of these SIVs plunged with CDO/MBS prices, imperiling the value of that paper. There were about a dozen money funds in this timeframe that suffered from potential losses and "breaking the buck," and some of them were names that would later succumb to essential failure or takeover (e.g. Wachovia). The problem funds simply replenished their capital to avoid further market turmoil.

In Fall 2008, the problem resurged, with one fund, the Reserve, the flashpoint - for holding some 1.2% of their assets in paper (debt) from Lehman after the bankruptcy. The irony with the Reserve fund is that it was started by the so-called creator of money funds, Bruce Bent, who in 1972 opened the first money fund to "invest in a diversified group of short-term credit instruments." Bent promoted the idea of maintaining the $1 NAV to attract investors interested in total preservation of capital. The irony is that Bent was also a staunch advocate "against the dangers of reaching for higher yield by stooping to inferior credits...denouncing commercial paper as overly risky." A run on the Reserve immediately following the Lehman bankruptcy (savvy investors noted the 1.2% interest in Lehman paper on the fund's websites) prompted Reserve management to "frantically seek help from the Fed." [Source for historical info: R. Lowenstein, "The End of Wall Street," c.2010.]

The Reserve Primary fund has since liquidated all assets after an SEC-ordered pro-rata distribution, with shareholders getting back ~0.9875 cents on the dollar.

My commentary: Does anyone read prospectuses and keep track of fund investment holdings? Money funds may promise a $1 NAV, but in practice many not be able to keep it, especially if they buy commercial paper secured by faulty collateral or credit. The same goes for any other poor-quality short-term debt. Money funds carry risk - and it rewards investors to seek funds that are conservative compared to others.

Not all commercial paper is "bad;" what matters is the collateral behind it. If it is a diversified set of solid businesses with solid balance sheets, great - but if it is Ponzi finance, such as SIVs seeking short-term funding to buy suspect MBSs to juice the yield spread, then something is wrong.

Money fund investors need a dose of caveat emptor, even with the perceived safety of more regulation, which may also mean even lower yields due to increased regulatory costs.

As for the idea of a liquidity bank, it's a fine one, and investors who have a perceived need for such a service or insurance should elect to pay for it. Allowing money funds to access the Fed's discount window in times of stress is akin to a taxpayer subsidy, given the discount rate charged for any liquidity.