Thursday, November 27, 2008

Even Krugman doesn't get how plainly irrationally bad it is out there

I used to think that if the government only made the GSE obligations full faith and credit (FFC) obligations the remaining problems in the conventional mortgage market would go away.  Paul Krugman still thinks it:

The Fed is confusing me

OK, so the Fed is planning to buy obligations of the GSEs — as well as securities guaranteed by the GSEs. This is in an effort to lower spreads. The Fed will in effect pay for these purchases by having the Treasury issue U.S. government debt.

But the GSEs have been nationalized. Their obligations are already U.S. government debt. What’s going on here?

It’s true, as the Fed’s statement says, that

Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late.

But that’s presumably because the Bush administration, weirdly, has refused to declare that GSE debt is backed by the full faith and credit of the US government. Why not just make that declaration, turning GSE debt into Treasury obligations, rather than stuff the obligations onto the balance sheet of the Federal Reserve?

Is this some kind of strange political game? Is there something else going on here? Inquiring minds want to know.

He is of course wrong.  The Goldman Sachs obligation is full faith and credit of the US Treasury - and trades at an irrationally wide spread.  Nobody has given a plausible explanation (except lack of trust in the government) as to why the spread on FDIC paper issued by Goldies but backed by the full faith and credit of the US Treasury is 200 bps.

For once the world is even stranger than Paul Krugman thought and stranger than his models.

Now there is an implication here - which is if the market will not believe that something is full faith and credit of the US Government then the government should buy it, issue treasuries and make an arbitrage profit.  There is a free lunch here.  Of course this mucks government accounting around (the debts wind up on balance sheet of the government rather than just contingent).  However it does not change the economics from the government perspective.

And in the process we go from the government buying the troubled assets of financial institutions to the government buying the guaranteed liabilities of financial institutions.

John Hempton


Anonymous said...

Could it be that people are pricing the GSE debt as being lower than that of treasuries? i.e. They view the debt as being like common stock to preferred?

Just a thought.

Anonymous said...

This is a bit off topic, but Krugman is wrong on another point as well.
The Treasury is not going to fund the Fed purchase of Agency debt and MBS. The SFB program is done. The purchases are ‘funded’ by newly minted currency, which have the chance of bypassing the neither of bank balance sheets as they are potentially sprayed into the wider financial community. Whether they gain velocity from them is another question. What is without question is that this is from the ‘not letting it happen here playbook’ and its assorted corollaries. Read them and we know where this goes next..

Anonymous said...

John -

Speaking of treasury arbitrage opportunities, I'm having a hard time figuring something out. The government can essentially issue debt for free right now; 3-month bills are at zero and the 1-year is under 1% and the 2-year is at 1.09%.

Meanwhile, you've got aging coupon paying issuances paying 4-5%.

Normally, the more debt you have, the more expensive it is to take on more debt. In this case, however, the market has an insatiable amount for US Gov'T debt, and is willing to accept absurdly low yields on it.

In this situation, if I'm the government, I would just issue absurd amounts of debt to buy up the old debt yielding much higher rates with the new debt yielding lower rates.

The only reason I can imagine this not already happening is because the government is planning on issuing just crazy, crazy amounts of debt in the future and doesn't want to saturate the demand now.

John Hempton said...


I am sorry to disappoint you but all short dated treasuries are trading near zero yield irrespective of the original coupon.

There is probably an arb opportunity buying TIPS which people have pointed out are irrationally expensive compared to Treasuries.

But it is the quasi-government debt that has the big yield.

MS issued at a slightly tighter spread than GS. Still irrationally high...


GC said...

Awake, That is what the Fed is doing. In choosing which security to buy for temporarily unsterilised QE ops, it chooses cheap Treasury backed ones : GSE.

Big question is whether the huge funding to come can be done at low rates or whether the deluge will drive rates high like a drag racer, as the US supply arrives when the economy is stabilising and other government are buy doing the same thing ( as Roubini reminded us yesterday). .

Anonymous said...

sounds facetious, but the simple answer is there are more sellers than buyers of this debt at the moment. arb funds have lost mandates. risk committees have become highly risk averse and are refusing investments in anything other than govt debt. yes there is a free lunch, but your perfect market theory isn't relevant in a crisis - psychology is the driver.

Stephen said...

It seems to me that this would indicate that the public at large sees the treasuries as "senior" i.e in the event of default the treasuries would be made whole before the "government backed" debt.

I have heard others suggest that certain large debt fund investors cannot yet invest in the "government backed" debt the same way they can in treasuries. Basically, since the goldy and other offerings are so new that the rules placed on institutional investors have not yet been changed to recognize the "governement backed" nature of these obligations. I have no idea if this theory is real or not... but have heard it suggested.

Either way, I agree that it seems like a decent arbitrage opportunity for the government. But sadly, having the governmnet balance sheet (i.e. national debt clock) look horrible, as opposed to atrocious, is a bigger priority than making some money to pay for it all.

Anonymous said...

To Awake: rollover risk. You're advocating they borrow short, lend long. Can you think of a recent instance where this cause problems?!

Anonymous said...

Actually, FDIC is not formally full faith and credit, as this opinion letter from the fdic website makes clear.

"Your October 7, 1987 letter asks whether the full faith and credit of the United States Government stands behind the Federal Deposit Insurance Corporation and its deposit insurance fund......While any final conclusion on this matter rests with the Attorney General of the United States and ultimately with the courts, it is our opinion that Title IX of CEBA merely represents an expression of the intent of Congress to support the FDIC's deposit insurance fund should the need arise."

sugam said...

In a strange way buying liabilities is better than outright buying assets since if u buy assets u need to dispose them later, which the govt would do at a loss since they will pay higher than fairvalue. On the other hand buying liabilities pay you arbitrage profits for something that you had guaranteed anyways...

Anonymous said...

maynardGKeynes: according to Credit Suisse, the prospectuses will include the following:

"This debt is guaranteed under the Federal Deposit Insurance Corporation’s Temporary
Liquidity Guarantee Program and is backed by the full faith and credit of the United
States. The details of the FDIC guarantee are provided in the FDIC’s regulations, 12
CFR Part 370, and at the FDIC’s website,"

jck said...

it is "proclaimed" by the FDIC to be full faith and credit but it doesn't get the risk-weight of the full faith and credit obligations of the U.S. which is 0 against 20% here, and the tax treatment for foreign holders isn't the same as for treasuries, so the pricing isn't as irrational as some people think.
for the GSE, their debt is specifically NOT guaranteed by the U.S., see prospectus, explicitly guaranteing would require an increase in the statutory debt limit and again the risk-weight and tax treatment is different so even if it was explicitly guaranteed there would be a spread.

Anonymous said...

In the good times of fixed income, REFCO (thinks S&L bonds) and AID bonds, both guaranteed or back by treasuries, used to trade 10-20bps cheap to like treasuires. That was in the age of unlimited liquidity for any investor. GS/FDIC bonds are cheap, but ultimate 70-80bps spread to like treasury seems fairly reasonable to me given current market conditions. Inside 50 would seem fairly rich.

Anonymous said...

There seem to be three reasonable sources of spread out there: Funding--even if it's Treasury credit, repo markets pretty clearly differentiate between Treasury/Non-Treasury and that could get worse; Liquidity--going to be more expensive to convert the GS/MS to cash; Credit--FDIC is not truly Treasury. The guarantee could theoretically be denied in the future.

Market's currently pricing those three spreads to 200--seems high to me, but it is what it is.

Anonymous said...

MW is right in response to awake. Short-term treasuries are cheap because the USG is not going to default in the next 5 minutes - they still operate as a reserve currency, have plenty of room to raise taxes from current rates, and can print money. But they can massively inflate in the long run, and that's part of why the yield curve is fairly steep. If they load up too big on short-term debt and then start inflating to service it, foreigners will start charging us much higher borrowing costs.

What baffles me is how cheap TIPS are and why the yield curve isn't even steeper. I would say the best bet for continued USG solvency is to borrow as long as possible at today's rates and then inflate out of this crisis. I think risk-averse investors would fall for 5% nominal "guaranteed" returns on very long debt. People are so stupid about nominal/real discrepancies that those who won't sell their houses at today's "low prices" would be happy to sell them for inflated dollar prices to make a nominal profit and salvage their self-esteem. I can just see the people at cocktail parties in 2011 now - "Yeah, I was smart and held onto my house through the downturn of 2008. I just sold it for a $100,000 profit on my 2005 purchase price, and now I can just barely afford the new Prius!" "I lost 40% in the stock market before I got out, but now I'm safe in these 30-year Treasuries - I'm sure I'll be able to afford college for John". Oops, college costs 200k/year now.

BTW, although I've posted about some of the fears regarding the FDIC that might cause investors to demand a higher price for these bonds, I don't think there's a significant risk of the USG hanging the FDIC out to dry. The debt is all dollar-denominated, so why would they encourage a run on banks rather than just causing some inflation?

Anonymous said...

The FDIC insured bonds are trading cheaper for several reasons:
- worse risk weighting
- unfavorable tax treatment for foreigners relative to USTs
- practically no funding market (this is a big driver of short term security valuations)
- relative liquidity (deal size is smaller, and market making will worsen with time)

Balance sheet plagues all levered buyers, and most real money players are probably full on mortgages and agency paper, and keeping high cash balances. If you were a holder of short dated USTs in your PA, these are great alternatives.

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