Brad Delong thinks that the failure of Citigroup is about “risk premium”. I think it is about trust – and I guess in some sense these are the same thing. However it is about trust then no plausible amount of capital solves the problem – whereas in the Brad DeLong model there is a reasonably estimable and plausible quantum of capital that is sufficient.
Anyway today was a deal that proved to me just how strange these markets are.
Goldman Sachs got to issue some FDIC bonds. These bonds are guaranteed by the FDIC and are hence full faith and credit of the US government. They were issued at over 200bps of spread. The spread traded to about 200bps.
That spread makes no sense whatsoever unless you really believe that there is a chance that the US government is going to selectively default.
Once upon a time Long Term Capital Management traded “on-the-run” versus “off-the-run” Treasury bonds, noting that a 29 year bond (which was off the run) had a different yield to the current 30 year bond (which was the reference bond and hence more liquid). If you went long the illiquid bond and short the liquid bond you might make 16-20bps. Lever that 100 times and you get quite a nice return on equity. However if the spread between them (call it a liquidity premium) blows out you can get into some trouble.
Now we have an FDIC bond with a spread of 200bps or more. No need to lever 100 times – ten times will make you a super-profitable hedge fund. And you are leveraging 10 times to term matched US Government obligations which should be less risky than the slightly term mismatched positions taken by LTCM.
Of course it is a little harder these days to borrow the government securities needed to pull the LTCM stunt. (There has been a problem with fails in the Treasury market.) But the margin leaves me gob-smacked.
If anyone has an explanation other than trust (a belief the US government might default on full faith and credit obligations) or liquidity let me know. If Brad Delong is right – and it is about capital then this should be able to be levered 5 times as there should be little capital risk.
But I don’t think it is about capital – it is about something else – something altogether darker and harder to solve.
In the Wizard of Oz all you needed to do was click your red shoes together.
I have been trying all day!