Distortion is the new normal for markets
(James Saft is a Reuters columnist. The opinions expressed are his own.)
LONDON (Reuters) – The evaporation of borrowed money has fundamentally changed the way markets function, and what look like crazy anomalies may end up being closer to the new reality.
Across financial markets, especially in fixed income, strange things are happening. Take two examples:
The U.S. government takes Fannie Mae and Freddie Mac into conservatorship, essentially guaranteeing their debts. Investors first narrow the premium they demand to lend to the two mortgage giants, then stage a strike and send these premiums to all-time highs.
Treasury inflation-protected securities (TIPs) hugely underperform standard Treasuries, and are factoring in precious little inflation in comparison to market expectations.
And while fundamental explanations and official policy errors may explain some such moves, they probably don’t account for all of them.
The common denominator is the rapid disappearance from the market of leverage, money borrowed by investors to magnify what they can buy.
Leveraged holders of debt, notably hedge funds, are forced sellers due to redemptions from their clients, margin calls and the fact that it is tougher and more expensive now to borrow money with which to speculate.
That latter factor is also central to why markets aren’t righting themselves. Simply put, the investors, or arbitrageurs, who in the past would have jumped on these “mispriced” trades like the proverbial rats on cheese now can’t get access to money or are fearful that a trap will snap down on their heads if they bite.
The trap is liquidity, which having been ample across so many markets is now thin to nonexistent. Investors are having to factor in the likelihood of whether a given smaller market will be liquid and will make them a good price for a bond if in six weeks’ time their own investors want their money back or if the investment bank providing their lines of credit folds.
“Right now, as the excess leverage is being unwound, there are so many forced sellers of bonds — and other assets — that it’s creating these huge dislocations. But since the deleveraging is far from over, no one can say at what level spreads will peak,” said Tom Graff, a managing director of fixed-income specialist Cavanaugh Capital Management in Baltimore.
“What will probably happen is that spreads will slowly revert to some economic reality as the deleveraging unwinds and real money investors soak up the excess.”
COME HOME ARBS, ALL IS FORGIVEN
Yield spreads on bonds Freddie Mae and Freddie Mac issue to fund themselves have hit record highs in the past week of 150 basis points or more above equivalent government debt, making them seemingly great value given an effective U.S. government guarantee.
Two fundamental factors have affected Fannie and Freddie debt. Some investors are worried about the exact terms of government support, though their regulator has moved to reassure that the United States “stands behind them.” And secondly, a separate government plan to guarantee bank-issued debt has attracted money away from the mortgage giants as investors buy bank paper.
But leverage is also playing a big role.
“When you could lever 30-1 on agency debt you didn’t need much spread and that caused a lot of demand,” said Paul Miller at FBR Capital Markets in Virginia.
“When you are levering 15-1 you need more spread to hit your (target) on returns.”
That of course implies that those who have access to leverage are still trying to make the same kinds of overall returns, which may prove optimistic in a low-leverage, low-growth world.
As for TIPs, the most plausible explanation for the divergence between them and traditional treasuries is that they are far less liquid, so forced selling hits them disproportionately.
One way to think of it is that the ecology of various parts of the financial markets has been fundamentally changed by the scaling back of leverage. To the extent that a market had a lot of leveraged buyers it now needs to find a new balance. Pools of the market that formerly were connected by leveraged investors are now comparatively isolated.
This is not an event, like an earthquake, which once over can be recovered from, but a process like an ice age. Look for permanently higher prices for access to credit, with a very hefty premium for bonds that are smaller and harder to sell.
The upside: the process of finding a new normal means there are some fantastic opportunities out there if you have money. The downside: history and fundamental analysis seem to be poor guides to what is a good opportunity, and even if you guess right you may have to wait until your old age for the market to follow you.
I guess not much has actually changed since before the bubble.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org)