What I don't understand about the DMO

FT alphaville has a post on the DMO at the tail end of last week, setting out the auction catalogue for the next quarter and setting out progress to date. It includes this summary of the year so far:This squares with my understanding that the DMO has a policy to keep index linked issuance at less than 20% of the total. My question is why. There is massive demand for long-dated linkers from pension funds and life insurers. Given the need to sell a lot - really a lot - of gilts next year, why is the DMO not giving the market what it actually wants to buy?

Buy bonds now, Tonto

I am reminded of the terrible joke about the Lone Ranger and Tonto. They are surrounded by hostile Indians, their horses are dying, they have no cover, and their enemies have arrows pointed at them. The Lone Ranger turns to Tonto and says "What shall we do?" Tonto replies: "Who's this 'we' white boy?"The bond market is similarly one way at the moment. The FT comments on the spread widening in high grade debt here, while FT alphaville discusses the related turmoil in the CDS market here, the latter partly related to concerns over the stability of Bear, Stearns. Yet actual experienced defaults are low and even taking into account a severe recession, many high grade bonds represent excellent compensation for default risk. The problem is that they may be even better value tomorrow, given that some of that compensation is also for liquidity risk, and liquidity is terrible in many parts of the market right now. Until we can kick the 'they will be even cheaper tomorrow' mindset, spreads will remain wide.

Why are Agencies so wide?

Following yesterday's announcement that a Carlyle fund is in default over its repo arrangements on Agency RMBS, Bloomberg comments on the agency/treasury spread:

Yields on agency mortgage-backed securities rose to their highest relative to U.S. Treasuries in 22 years 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 7 basis points, to 223 basis points, the highest since 1986 and 89 basis points higher than Jan. 15.

Why? There are a number of reasonable explanations. Firstly and most obviously there are more buyers than sellers of treasuries and more sellers than buyers of agency MBS. Why does no one step in to arbitrage the spread? Because there is little risk capital in this market that is not deployed, and/or anyone with money is waiting for things to get worse.

Next, even if we do accept that an arbitrage relationship holds between treasuries and agencies, (1) the liquidity premium on agencies is high; (2) the credit spread on agencies is increasing [since as the agencies lose money and become more highly leveraged, the likelihood of government support must decline somewhat]; and (3) regulatory risk in the mortgage market makes it unclear what the cashflows of the underlying assets will be anyway. (Remember even if the agency guarantee holds good, a reduction of principal on the asset pool causes prepayment, thus regulatory risk effects the optionality of the pass through.)

A cure for Ebola?

The mot de jour for the last few days was 'tsunami'. Now it seems we need something more potent. Bloomberg quotes Ed Steffelin: ``People are calling it financial Ebola,''. Certainly the moves in ABS spreads are impressive:

Yields on three-year, AAA rated credit-card bonds with floating rates rose to 75 basis points over the London interbank offered rate, up from 40 basis points at the start of the year [...] Spreads over three-year swap rates for three-year, AAA rated fixed-rate auto-loan securities rose to 140 basis points, up from 75 basis points. The average spread over U.S. Treasuries on AAA rated commercial-mortgage securities climbed to 364 basis points, from 167 basis points on Dec. 31

Meanwhile, a sticking plaster is in sight. Henry (when did he become Henry? I thought it was always Hank - perhaps that's the best sign of how serious things are) Paulson is to release new proposals within weeks:

``We're looking at the mortgage-origination process, we're looking at the securitization process, we're looking at rating agencies, we're looking at disclosure issues, we're looking at capital issues and regulatory issues,'' he said in an interview today with Bloomberg Television. More specifics will come ``in the weeks ahead,'' he said.

Now clearly action is needed. But speedy action has its dangers too, and Paulson has a big list of maladies there. Treat at haste, autopsy at leisure perhaps?

Corporate bonds are good value...

...according to Deutsche Bank:

Euro investment-grade company bonds are pricing in defaults 15 to 20 times worse than the average since 1970, and six times the worst on record in that period, Deutsche Bank said, due to the turmoil in the structured credit market.

The sharp widening in spreads has come even though actual defaults on investment-grade bonds are extremely rare events, and even the global high-yield default rate remains close to historic lows.

The average five-year default rate for euro investment-grade bonds is just 0.8 percent, with the worst on record 2.4 percent, while current spreads are pricing in a rate of 15 percent, Deutsche Bank said in a note.

Buy bonds then. If you can fund them.

Spread wide

Friday market update: from Bloomberg, we learn that

Merrill's 6.4 percent notes due in 2017 pay a spread of 2.24 percentage points, almost double the premium of 1.21 percentage points a month earlier

Meanwhile

Citigroup paid 1.90 percentage points more than Treasuries of similar maturity to sell $4 billion of 10-year notes on Nov. 14

That's nothing compared with the monolines in the CDS market. According to FT alphaville there is a one in three chance of monoline default, while Bloomberg gives more detail:

Credit-default swaps on MBIA more than tripled to 410 basis points since Oct. 15, according to CMA Datavision in New York. The price suggests that investors see a 28 percent chance MBIA will default, according to JPMorgan Chase & Co. valuation models. Contracts on Ambac have climbed to 620 basis points, CMA data show. They imply a 40 percent chance of default.

Things are interesting out there. Have a good weekend folks.

Update.Naked Capitalism estimates the likely cost of a monoline downgrade as $200B. (Is that all of them or just a big one?) Anyway, with the kind of impact, we had better hope someone at the FED plays golf with someone at the New York State Insurance department this weekend.