Corporate Bonds and the Banks

A race against time
By Gillian Tett

Published: May 8 2008 17:40 | Last updated: May 8 2008 17:40

So is it all over? That is the $36bn – or $360bn – question perplexing investors right now. Six weeks ago, the financial system was beset with gloom, as it reeled from the credit turmoil.

But now the sun is shining, in every sense: equities are rallying, credit spreads have tightened and investors are gobbling up new bonds. And after the Bank of England declared last week that the end of the credit crunch could be nigh, Hank Paulson, US Treasury secretary, has now told the FT that he too is “feeling better about the markets”. I believe we are closer to the end than the beginning,” he said this week. “I am encouraged.”

So should everyone else feel encouraged?

In reality, the answer is still hanging in the balance. For as conflicting signals swirl about, one of the best ways to make sense of the current situation is to recognise that the financial system – and policymakers – are currently engaged in a crucial “race against time”, as one senior official puts it.

The reason lies in the bifurcated nature of the credit shocks.

When the credit turmoil erupted last year, it was initially triggered by the revelation that defaults were rising in the subprime mortgage world. For while this sector is not very large, relative to the overall financial system, the losses took investors by surprise – and thus badly shook confidence in the processes which have underpinned banking in recent years.

However, nine months later, it seems that the financial system is slowly working its way through this subprime shock: the largest banks have now made more than $200bn in write offs and raised over $100bn of capital to plug this gap. Indeed, the writedowns have been so vast that some analysts expect to see some write ups in the next set of results.

But while this means that the subprime shock may be ebbing, the problem for policy makers is that this is not the only potential blow hanging over the banks: as the US economy slows, there is a good chance that defaults will soon emanate from the corporate and consumer debt world. And the more that banks are forced to tighten credit as a result of the subprime mess or other losses, the greater the risk that this second wave of defaults will emerge – creating the risk of a vicious spiral.

Now, if this second shock hits the banking sector in the very near future – or while it is still reeling from the subprime losses – then the double-whammy could potentially be very painful.

After all, investor sentiment is still fragile, at best, and some institutions are still operating with dangerously low capital ratios. The last adrenaline-pumped nine months have also left many policy makers and financiers ill-equipped to cope with a fresh war, simply because they are exhausted.

However, what some senior policymakers now fervently hope is that if this second potential wave of defaults can be delayed for a little while – say, even a few months – then the risk of a vicious spiral could be mitigated, or even removed altogether. Hence the race against time: somehow market sentiment has to be stabilised and the system recapitalised, before fresh signs of credit deterioration emerge and the clouds build again. What is needed, above all, is a breathing space.

Hopefully policy makers and bankers will manage to pull this trick off; and indeed, the odds of winning this race rise with every day that passes without a fresh financial shock. But let nobody assume that the race is entirely won yet.

If I was Mr Paulson, in other words, I would certainly be smiling in public right now, in a suitably soothing way. But I would also be quietly crossing my fingers for luck – and keeping them crossed for several months yet.

■ Some readers have kindly pointed out that I was inadvertantly too upbeat in last week’s column: although I wrote that no AAA tranches have suffered tangible losses, some investors tell me they have lost money on these instruments, and fear these losses will accelerate soon.

As I said, we are in a race against time – in the realm of AAA, and much else.

 

And the money market sends a similar message

Money Markets Signal Worst of Credit Market Crisis May Be Over

By Lester Pimentel and Liz Capo McCormick

May 7 (Bloomberg) — The worst of the credit crisis that prompted banks to restrict lending and the Federal Reserve to rescue Bear Stearns Cos. may be over, short-term borrowing rates show.

The difference between the yield on three-month Treasury bills and the rate on dollar-denominated loans in London, an indication of credit risk known as the TED spread, narrowed 7 basis points to 0.93 basis points, the smallest since Feb. 25. The gap reached 2 percentage points on March 19.

“It indicates at least that the worst part is over,” said Theodore Ake, head of Treasuries trading in New York at Mizuho Securities USA Inc., one of the 20 primary dealers that trade with the Fed. “There was a lot of panic built into that trade, which is going to continue unwinding. There was a massive flight to quality.”

May 12 (Bloomberg) — Global bond issuance jumped 42 percent in April to $1.1 trillion from March, the best month since June 2007, as concern about credit-market losses eased, according to Lehman Brothers Holdings Inc.

Sales by governments, agencies and companies broke the trillion-dollar mark for only the fourth time since 1995, New York-based analysts led by Jack Malvey wrote in a report published today.

May 12 (Bloomberg) — The cost of protecting European corporate bonds from default fell, according to traders of credit-default swaps.

Contracts on the Markit iTraxx Crossover Index of 50 companies with mostly high-risk, high-yield credit ratings dropped 6 basis points to 449 today, according to JPMorgan Chase & Co. The index is a benchmark for the cost of protecting bonds against default and a rise indicates deterioration in the perception of credit quality; a decline, the opposite.

 

A tentative thaw in the credit markets?

SAN FRANCISCO (MarketWatch) - Blackstone Group launched three new collateralized loan obligations worth $1.3 billion on Tuesday, a move the private-equity firm said shows this corner of the credit markets is perking up.

CLOs are packages of leveraged loans that are sold to hedge funds and other institutional investors. Roughly $100 billion of the vehicles were issued in 2006 and about $58 billion were sold in the first half of 2007, according to Standard & Poor’s Leveraged Commentary & Data.

The fast-growing market helped fuel the leveraged buyout boom in recent years, which in turn had been a major driver of stock-market gains. However, that trend stopped abruptly in the summer as the subprime mortgage-fueled credit crisis erupted.

Only 11 new CLOs with aggregate volume of $6 billion were created in the first three months of 2008, a drop of 76% from a year earlier, Blackstone said on Tuesday, citing Standard & Poor’s data.

The slump is probably due to a lack of top-quality, AAA-rated loans to package into CLOs, Blackstone explained.

But the firm said its new CLOs are different from most CLOs that have been sold since last summer. Most of these vehicles have been used to get risky assets off banks’ balance sheets, the firm said.

Blackstone’s latest creations “have been established to buy high quality loan assets with an expectation for stable returns to all investors in the CLO’s capital structure,” Bennett Goodman, senior managing director and head of Blackstone’s GSO division, said in a statement.

 

Equity/Bond/Inflation

Inflation is the driver of both Equity and Bond yields. As inflation rises, so must the respective yields to compensate the loss of purchasing power.

Equity valuations are complicated by the fact that their coupons [dividends] are not fixed, and second, that their capital appreciation is in theory unlimited. Hence, we will in individual common stocks at almost all times, and within the index under rare occasions, decouple from the inflation anchor.

 

High Yield spreads

Since the St. Patrick’s Day inflection point, spreads on high yield corporate bonds are down over 20% from their high of 862 basis points (bps) versus US Treasuries (based on the Merrill Lynch Index of high yield debt). As long as spreads can continue to come in, the environment for equities should remain positive, but at a level of 685 bps, spreads remain over 180% off their lows last June

The spread twixt Treasury paper and Corporate paper, while on one hand a barometre of the risk the market is willing to assume, also has implications for corporate treasuries that need to raise financing. When the credit crisis was at it’s worst, even solvent corporations were potentially in trouble, should they have required finance for working capital.

Thus, with the easing, the outlook for equities [possibly excluding financial stocks, who might find capital ratio's under threat again], at least from default and solvency issues, is definitely on the mend, which was the purpose of the emergency measures put in place by the Fed.

I am actually in the camp of “no cuts” with a signal of interest rate hikes in the future. Here is a supporting opinion;

In what may be the last great act of his presidency, George Bush is sending many Americans tax rebates. The checks began going out this week. Some households may get as much as $1,200.

What is not clear is how many citizens will go out and buy a new washer-dryer set and how many will simply stuff the money into their mattresses. One would cause inflation, while the other would only serve to hoard money as many families are beginning to hoard food.

The Fed has several reasons not to cut rates again.

First among those may be that inflation is rising much faster than government figures would show, at least for the goods and services that count most. Gas will probably hit $4 this summer. A bagel could cost $10. The price of corn is up 23% this year.

The governors at the central bank have also become concerned, quite rightly, that banks are passing none of the Fed’s cuts on to consumers or businesses. Mortgages are only given to the most credit-worthy. Financial institution would rather keep cheap money to help build reserves against the next set of write-downs which are likely to come in Q2. Many soothsayers claim that banks are out of the woods. Their stock prices and the worsening housing crisis would portend otherwise.

The cost of money for the man in the street is high and may go higher.

There are almost no reasons for the Fed to cut rates again now and plenty of reasons for it to stand pat. If Bush and Congress are right, they have done something to stimulate the economy. Doing two things at once as the price of everything from Cheerios to bug spray is going up does not increase the chance of inflation.

Inflation is already here. Fighting it has become the new priority

Douglas A. McIntyre

 

Japanese Bonds…implications for Yen?

I have been waiting on this development for a while, via my FXY position [see portfolio] This increase in interest rates, should it eventuate, is long overdue…however, we shall see.

From Financial Times;

Amazing action in the normally sedate Japanese government bond market actually forced the Tokyo Stock Exchange on Friday to order an unprecedented 15-minute halt in trading of JGB 10-year bond futures. The Exchange made the move in an effort to calm hectic dealing in what Reuters described as “one of the worst sell-offs in the past decade”.

JGB bond futures ended down 1.40 per cent after plunging as much as 1.8 per cent - causing the biggest jump in five-year yields in nine years after inflation accelerated, global stocks climbed and the dollar rallied against the yen.

Behind the extraordinary rout was new speculation that the Bank of Japan would increase its target interest rate this year. Yields on five-year notes have risen half a percentage point since reaching a 2.5-year low on March 17 as the dollar rebounded, commodity prices jumped and traders bet new central bank governor, Masaaki Shirakawa, will focus on curbing inflation.

Driving the concerns, the Japanese statistics bureau said consumer prices climbed 1.2 per cent from a year earlier in March.

JGBs had rallied since June last year as some of the biggest global funds, including Pimco, bought the world’s lowest-yielding debt on expectations the yen would gain and the US and Japanese economies would enter recession, noted Reuters. But so far this month, they have handed local investors a loss of about 1.2 per cent, according to a Merrill Lynch index, while the Nikkei 225 Stock Average has climbed 11 per cent, according to Bloomberg.

According to one man who knows more about JGBs than most - Tohru Sasaki, forex strategist at JPMorgan Chase in Tokyo - Friday’s drastic movement in Japanese yields should be regarded as driven by technical, rather than fundamental, factors.

A Lex note (coming later) will note that what could have been an orderly unwinding “turned into a rout on the back of technical issues”.

“Golden Week”, a string of national holidays kicking off on Tuesday, means trading volumes will be feeble over the next fortnight. That period coincides with a couple of big events: the Fed meeting and the BoJ’s release of its quarterly economic outlook, which is widely expected to prune growth expectations. It would “take a brave bond holder to take a contrarian stance ahead of a week like that”.

The market is now pricing in more than 100 per cent probability of a Japanese interest rate hike by next February - it was only 50 per cent on Thursday, he says. Bloomberg adds that the odds the central bank will raise rates this year climbed to 83 per cent from 39 per cent on Thursday, according to calculations by JPMorgan using interest-rate swaps. This is compared to last month, when the market was betting that the chances of a rate cut were more than 70 per cent, according to JP Morgan.

“It’s hard to think the Bank of Japan’s stance on monetary policy will change just because of a rise in cost-push inflation,” Mamoru Yamazaki, chief economist at RBS Securities, told Reuters.

“But it may stir talk among market players that it may become more difficult for the BOJ to lower interest rates … so I think it is negative for Japanese government bonds.”

It’s seldom said, concludes Lex, “but the JGB market will be no place for the faint-hearted in coming weeks”.

 

Junk Bonds

Of course Merrill don’t actually specify which Junk Bonds they are referring to, but can we assume that AAA MBS are in there somewhere?

 

Repo. market on “special”

Authors: Michael J. Fleming and Kenneth D. Garbade

Contrary to popular belief, interest rates can drop below zero. From early August to mid-November of 2003, negative rates occurred on certain U.S. Treasury security repurchase agreements. An examination of the market conditions behind this development reveals why market participants are sometimes willing to pay interest on money lent.

Short-term interest rates fell to their lowest level in forty-five years in 2003. The low rates, coupled with a sharp increase in intermediate-term yields during the summer, gave rise to significant settlement problems in the ten-year Treasury note issued in May. To ease those problems, market participants lent money at attractive rates on investment contracts that provided the note as collateral. From early August through mid-November, such repurchase agreements (”repos” or “RPs”) were sometimes arranged at negative interest rates.

This episode of negative interest rates is interesting for several reasons. For one, it refutes the popular assumption that interest rates cannot go below zero because a lender would prefer to hold on to its money and receive no return rather than pay someone to borrow the money. This may be true for uncollateralized loans, but a lender may be willing to pay interest if the securities offered as collateral on a loan allow it to meet a delivery obligation. Researchers (D’Avolio 2002; Jones and Lamont 2002) have reported cases of negative interest rates when equity securities are offered as collateral. The events of 2003 show that negative rates can also occur when Treasury securities are offered as collateral.

The 2003 episode is also interesting because of the specific circumstances that led to negative interest rates. The option of Treasury market participants to fail on, or postpone, delivery obligations with no explicit penalty usually puts a floor of zero on repo rates. In 2003, however, ancillary costs of failing increased as settlement problems in the May ten-year note persisted. The increased costs ultimately led some participants to agree to negative interest rates on RPs that provided the May note as collateral.

Finally, the episode of negative interest rates is interesting because it illustrates how market participants adapt old contract forms to satisfy new needs as economic conditions evolve. In particular, market participants devised “guaranteed-delivery” RPs that allowed for negative interest rates without unduly penalizing a lender of money if a borrower failed to deliver collateral as promised.

This edition of Current Issues explores the recent episode of negative interest rates in detail. We begin with a brief review of repurchase agreements. We then describe how market conditions led to an extraordinary volume of settlement fails in the May ten-year note. Finally, we explain how the fails problem became so severe that some market participants chose to lend money at negative rates in order to borrow the note.

Repurchase Agreements
Repurchase agreements play a crucial role in the efficient allocation of capital in financial markets. They are widely used by dealers to finance their market-making and risk management activities, and they provide a safe and low-cost way for institutional investors to lend funds or securities. The importance of the repo market is suggested by its immense size: dealers with a trading relationship with the Federal Reserve Bank of New York—so-called primary dealers—reported financing $2.41 trillion of fixed-income securities with RPs in August 2003.1

An RP is a sale of securities coupled with an agreement to repurchase the same securities on a later date and is broadly similar to a collateralized loan. As shown in Figure 1, a dealer can borrow $10 million overnight from a corporate treasurer at an interest rate of 3 percent per annum by selling Treasury notes valued at $10,000,000 and simultaneously agreeing to repurchase the same notes the following day for $10,000,833. The payment from the initial sale is the principal amount of the loan; the excess of the repurchase price over the sale price ($833) is the interest on the loan. As with a collateralized loan, the corporate treasurer has possession of the dealer’s securities and can sell them if the dealer defaults on its repurchase obligation.

General Collateral Repurchase Agreements
A general collateral RP is a repurchase agreement in which the lender of funds is willing to accept any of a variety of Treasury and other related securities as collateral. The class of acceptable collateral commonly includes all Treasury securities, but it might be limited to Treasury securities maturing in less than ten years or it might extend to agency issues as well as Treasury securities. The lender is concerned primarily with earning interest on its money and having possession of assets that can be sold quickly in the event of a default by the borrower. Interest rates on overnight general collateral RPs on Treasury securities are usually quite close to rates on overnight loans in the federal funds market. This reflects the essential character of a general collateral RP as a device for borrowing and lending money.

Special Collateral Repurchase Agreements
A special collateral RP is a repurchase agreement in which the lender of funds designates a particular security as the only acceptable collateral.2 Dealers and others lend money on special collateral RPs in order to borrow specific securities needed to deliver against short sales. A short sale is a sale of securities that the seller does not own and that it has to borrow to make delivery. Dealers sell Treasury securities short in the expectation that prices will be lower in the future, to hedge the risk of other fixed-income securities, and to accommodate customer purchase interests.

The interest rate on a special collateral RP is commonly called a “specials” rate. The owner of a Treasury security that a dealer wants to borrow may not have any particular interest in borrowing money, but can nevertheless be induced to lend the security if it is offered an opportunity to borrow money at a specials rate less than the general collateral rate. For example, if the rate on a special collateral RP is 2 percent and the general collateral rate is 3 percent, then—as shown in Figure 2—an investor can earn a 100 basis point spread by borrowing money on the special collateral RP and relending the money on a general collateral RP.

The difference between the general collateral rate and the specials rate for a security is a measure of the “specialness” of the security. If the demand to borrow the security is modest relative to the supply available for lending, a dealer borrowing the security will usually be able to lend its money at a rate no lower than about 15 to 25 basis points below the general collateral rate. If the demand to borrow is strong, or if the supply is limited, the specials rate for the security may be materially below the general collateral rate and the specialness spread correspondingly large.3

A Lower Bound on Special Collateral Repo Rates?
Interest rates on special collateral RPs nearly always stay above zero because, instead of lending money at a negative interest rate to borrow a particularly scarce issue, a short seller can choose to fail on its delivery obligation. In a “fail,” a seller does not deliver the securities it promised to a buyer on the scheduled settlement date and, consequently, does not receive payment for the securities. The convention in the Treasury market is to reschedule delivery for the next day at an unchanged price.4 As detailed in Box 1, the cost of failing is about the same as the cost of borrowing a security on a special collateral RP at an interest rate of zero. It follows that failing is usually preferable to borrowing a security at a negative specials rate.

The zero lower bound on specials rates depends on the absence of any costs or penalties for failing other than a delay in the receipt of the invoice price. However, the events of 2003 show that fails can sometimes have significant ancillary costs and that those costs can lead to negative interest rates on special collateral RPs.5

Short Sales and Settlement Fails in the Summer of 2003
Intermediate-term Treasury yields rose sharply during the summer of 2003. Yields on ten-year notes rose from about 3.15 percent in mid-June to 3.50 percent at the end of June and to 4.50 percent in mid-August. The rise led to an extraordinary volume of short sales of the on-the-run (or most recently issued) ten-year note (the 3 5/8 percent note maturing in May 2013) as holders of fixed-income securities sold the note short to hedge against the possibility of further rate increases.6 Demand to borrow the note (to deliver against short sales) expanded commensurately.

With the general collateral rate at about 1 1/4 percent until late June, and subsequently at about 1 percent, the specials rate for the ten-year note did not have far to fall before it hit zero. Demand to borrow the note drove the specials rate to within a few basis points of zero by June 23 (Chart 1). The rate hit zero on July 10, after which additional borrowing demand spilled over into settlement fails.7

In the absence of any evidence that interest rates had stopped rising, hedgers maintained their short positions through July. Demand to borrow the ten-year note remained strong and the specials rate for the note remained at zero. The persistence of the specials rate at zero left sellers with little economic incentive to borrow the note to cure their settlement fails. In late July, one market participant commented, “the issue . . . has totally stopped clearing.”8

Strategic Fails
The fails situation worsened when some market participants realized that they could acquire a free (or nearly free) option to speculate against an increase in the specials rate for the ten-year note by contracting to lend the note against borrowing money at a zero (or near zero) rate of interest for a term of several days or weeks and then intentionally—or strategically—failing to deliver the note. Understanding the nature of this option requires an appreciation of the consequences of failing to settle the starting leg of a repurchase agreement.

Market convention holds that if a collateral lender fails to deliver securities on the scheduled starting date of an RP and thus fails to receive funds from its counterparty, it nevertheless owes the counterparty interest on the principal amount of the borrowing for the full term of the RP. The full amount of interest is owed regardless of whether the collateral lender delivers the securities late or not at all. (The repo contract terminates on the originally scheduled closing date even if the securities are delivered late.) Among other things, this convention provides an incentive for the collateral lender to deliver the securities on the scheduled starting date.

Consider, however, a trader who does not own the ten-year note but who nevertheless agrees to lend the note over the interval from July 15 to July 29, 2003, against borrowing $10 million at a zero rate of interest. Suppose the trader fails to deliver the note on the scheduled starting date. Regardless of whether the trader delivers the note late or not at all, the trader will not owe its counterparty any interest because the interest rate on the repo contract is zero. Suppose also that the specials rate on the ten-year note for RPs ending July 29 rises to 0.50 percent on July 22. The trader can then borrow the note from July 22 to July 29 against lending $10 million—thereby earning $972 interest [$972 = (7/360) x 5 0.50 percent of $10 million]—and deliver the borrowed note against its original repo contract—thereby borrowing $10 million at a zero rate of interest for the seven days remaining on that contract. The $10 million borrowing funds the trader’s loan of $10 million and the trader makes a net profit of $972.

A similar analysis applies if the specials rate is positive but small. For example, if the fourteen-day specials rate for the ten-year note is 0.05 percent, a trader would pay only $194 for the implicit option described in the preceding paragraph [$194 = (14/360) x 5 0.05 percent of $10,000,000].

Ancillary Costs of Fails
By early August, dealers were beginning to incur substantial ancillary costs as a result of their fails. Opportunity costs stemming from regulatory capital requirements are one example. The net capital rule of the Securities and Exchange Commission provides that dealers have to maintain additional capital—that is, assets in excess of liabilities—for fails to deliver more than five business days old and for fails to receive more than thirty calendar days old. Additional capital is required because “aged” fails are a source of credit risk. If two parties agree to a securities transaction and the buyer becomes insolvent prior to settlement, the seller will incur a loss if the price of the security has fallen and it has to find a replacement buyer at a lower price. The buyer will incur a loss if the price of the security increases after the trade is negotiated and the seller subsequently becomes insolvent. Capital charges for aged fails soak up capital that would otherwise be available to support profitable risk-taking activities; in this way, they impose opportunity costs on dealers.9

By early August, dealers were also experiencing increased labor costs and deteriorating customer relations. Labor costs rose because dealers were forced to divert back-office personnel from their usual assignments to efforts aimed at reducing the backlog of unsettled trades.10 Customers became unhappy when they did not receive the securities they had purchased, even after long delays. This left them in the position of involuntarily financing dealer short positions and meant that they themselves had nothing to deliver in the event they decided to sell.

Negative Specials Rates
In the strained environment of early August, some dealers became willing to pay interest on money lent to borrow the ten-year note. They concluded that it would be less expensive to pay interest to borrow the notes needed to remedy their settlement fails than to continue to incur the capital charges, labor costs, and customer dissatisfaction associated with the fails.

Loan Fees in the Federal Reserve’s Securities Loan Auctions
The first indication that the specials market for the ten-year note was undergoing a major change came in the Federal Reserve’s securities loan auctions. As described in Box 2, the Fed offers to lend securities that it owns on a daily basis. Dealers who borrow securities from the Fed pay a fee, expressed in percent per annum, which is equivalent to the difference between the rate paid for borrowing money in the general collateral market and the rate earned on lending money in the specials market. When transactions are settling normally, the loan fee that dealers are willing to pay the Fed to borrow a security will not rise above the general collateral rate because the specials rate for the security will not go below zero.11

The average auction loan fee for the ten-year note rose materially above the general collateral rate for the first time on August 5 when it hit 1.25 percent (Chart 2). The general collateral rate was 0.95 percent that day so the implied specials rate for the note was -30 basis points (Chart 3). On August 11, 12, and 13, the loan fee exceeded 1.20 percent and the implied specials rate was less than -20 basis points. Thus, the Fed’s loan auctions in the first half of August gave a clear indication of unusual stress in the market for borrowing the ten-year note.

That stress eased a bit following issuance of a new ten-year note (the 4 1/4 percent note maturing in August 2013) on August 15. Average auction loan fees for the 3 5/8 percent note moderated to about 1 percent and the implied specials rate rose to about zero. However, at 11 a.m. on September 8, the Treasury Department announced that it would reopen the 4 1/4 percent ten-year note in an auction on September 11. This quashed any hope that it might reopen the 3 5/8 percent note in order to alleviate the fails situation in that note.12 On the same day, the loan fee for the 3 5/8 percent note moved back above the general collateral rate and the implied specials rate fell to -11 basis points. The implied specials rate stayed well below zero through the beginning of October, reaching a low of -146 basis points on September 26.

Specials Rates for the 3 5/8 Percent Note
Comparing Charts 1 and 3 raises the question of why the specials rate for the 3 5/8 percent note remained at zero when the implied specials rate for the same note in the Fed’s loan auctions was well below zero. Part of the answer lies in the difference between the certainty that the Fed will deliver securities following an auction and the likelihood that a private collateral lender would deliver on a loan of the notes. Dealers were willing to pay a premium to borrow from the Fed because the Fed never fails to deliver securities. (As noted in Box 2, the Fed only auctions securities that are actually in its account at the time of an auction.) In contrast, a private collateral lender may fail to deliver securities on a special collateral RP just as a private seller may fail to deliver securities on an outright sale. This was a material risk in the case of the 3 5/8 percent note because, as explained earlier, specials rates at or near zero created an incentive for market participants who did not already own the note to agree to lend it and then intentionally fail to deliver. The absence of any widely accepted convention for how interest payments would be treated in the event of a settlement fail also contributed to the difference between the zero specials rate in the private collateral loan market and the negative implied specials rate in the Fed’s collateral auctions.

Guaranteed-Delivery Special Collateral RPs with Negative Interest Rates
In mid-September, some dealers began to enter into “guaranteed-delivery” repo contracts for the 3 5/8 percent note at interest rates as low as -3 percent.13 The guarantee of delivery on these contracts was weaker than a contractual commitment that the collateral lender would bear the costs of any damages caused by its failure to make delivery, but it was stronger than the obligation to deliver collateral against a conventional repo contract. Participants in the guaranteed-delivery market had a common understanding that an offering for guaranteed delivery would be made only if the notes were already in the lender’s possession and available for settlement. Participants also had a common understanding that a negative rate contract would be canceled if the collateral lender failed to deliver the notes on the scheduled starting date. This precluded the use of guaranteed-delivery contracts as vehicles for speculating against an increase in the specials rate for the notes.

Negative rate RPs did not make financing a short position in the 3 5/8 percent notes more expensive than it had been; they merely converted the implicit ancillary costs of failing—including incremental capital charges, higher labor costs, and customer dissatisfaction—into the explicit cost of lending money at a negative rate of interest in order to cure an outstanding fail. Moreover, the negative rates likely provided some additional incentive for holders of the notes to lend their securities.

After mid-October 2003, market stresses in the 3 5/8 percent ten-year note gradually eased and dealers began to make progress in reducing their outstanding fails through industry efforts to identify and net offsetting fails among multiple counterparties.14 Bids and offers for the note in guaranteed-delivery RPs at negative interest rates disappeared and the frequency with which the Fed’s auction loan fee for the note exceeded the general collateral rate declined.

Conclusion
From early August to mid-November of 2003, some market participants lent money at negative interest rates to borrow a particular Treasury note. The episode is instructive because it refutes the popular assumption that interest rates cannot go below zero and demonstrates how the collateral value of a security can lead to negative interest rates. The episode also shows that the ancillary costs of failing on an obligation to deliver Treasury securities can sometimes be significant. Finally, the episode shows that market participants will modify old contract forms to meet new needs—demonstrated in this case by the appearance of guaranteed-delivery repo contracts—as economic conditions evolve.

 

Gold

From the comments section, a question on Gold.

Gold currently is simply trading as a currency. The US$ being the reserve currency has been in serious trouble recently due to the Banking crisis. Make no mistake the intrinsic value of Gold as a commodity with regards to industrial use and jewelry is far below current levels. This mega-run by Gold is in response to the almost collapse of the US Banking system.

This crisis has necessitated the cutting of interest rates in an emergency fashion. Thus has an already weak US$ plunged in tandem with the falling rates.

Here we see as the interest rates have fallen, so the 10yr Bonds have increased in price. The market is now starting to suspect that further rate cuts may not be required to further bolster the Balance Sheets of the majority of the Financials, thus, their price has come off, increasing their yield. This will [and has] cause a rally in the US$

With the rally in the US$, the alternative reserve currency, Gold, has sold off.

Therefore with regards to the question of Gold, we basically arrive at the following question; what will the Federal Reserve policy be on further interest rate cuts?

The answer is really in two parts;
*The Banking system has been saved.
*One more rate cut may be required, as momentum is difficult to stop dead in it’s tracks.

Thus, in the longer timeframe, Gold has probably pretty much topped out in this cycle. However, there will be Gold bulls who refuse to buy this argument, thus there will be increased volatility, as there may well be at the bottom of the US$

For my money, Gold as a LONG trade is finished, you missed the boat at $300oz. As a SHORT trade, you are looking at high volatility and the difficulty of staying in the trade.

 

Derivatives

Derivatives seem to create a lot of confusion for investors, possibly even traders if they utilise any fundamental analysis within their methodology. I’ve picked an article that appears on the iBank coin site.

This is the entire article; http://www.ibankcoin.com/peanut_gallery/index.php/2008/03/18/derivatives-prime-brokerage-financial-alchemy-and-the-credit-meltdown/#comments

Quote;

In finance, an instrument that depends on the value of something else is a derivative. Stock and index options are derivatives. ETF’s are derivatives. The futures that people hedge with (and speculate with) are derivatives. Crude futures are based on the price of delivery of oil. S&P futures are based on that underlying index. One could even go so far as to state that stocks–shares of a company, like (BSC: 6.82 +41.79%)–are derivatives, because they have no real intrinsic value, apart from any “guaranteed” dividends. They are based on the perception of the value of the underlying business. The fundamentals of a company don’t change that often, but stock values swing wildly based on actual supply and demand for these “derivatives

*ETF’s; Exchange Traded Funds are not derivatives. From investopedia; A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange, thus experiencing price changes throughout the day as it is bought and sold.

Because it trades like a stock whose price fluctuates daily, an ETF does not have its net asset value (NAV) calculated every day like a mutual fund does.

By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you’d pay on any regular order.

One of the most widely known ETFs is called the SPDR (Spider), which tracks the S&P 500 index and trades under the symbol SPY.

SPDR S&P 500: Top holdings

Top holdings
Company name……………………………………… % Net assets
ExxonMobil Corporation………………………………… 4.07%
General Electric Company…………………………….. 2.87%
Microsoft Corporation …………………………………1.88%
AT&T, Inc……………………………………………… 1.81%
Procter & Gamble Company………………………….. 1.76%
Chevron Corporation…………………………………. 1.57%
Johnson & Johnson…………………………………… 1.52%
Bank of America Corporation……………………….. 1.51%
International Business Machines Corp…………….. 1.34%
Altria Group Inc……………………………………… 1.32%
Percentage of holdings ………………………….. 19.65%

*Common Stock; represents a fractional ownership of the corporation. After all expenses, the common share accures a proportional share of any profits/losses. The common share thus possesses intrinsic value.

*Fundamentals of the underlying business change all the time. The investor perception of business conditions, may however change at a faster rate, thus accounting for wide fluctuations in the share price.

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”. Credit Default Swaps are a contract where one party pays another a premium, and receives back a payout should the underlying entity default on debt. Most times, the underlying entity is not even a party to the CDS transaction!

Inaccurate. Credit Default Swap contracts are derivatives. However payouts are not based solely on “Default” There are a number of conditions that may trigger a liability. In fact, each contract can provide unique conditions as they are not standardised contracts as are say exchange traded Equity Options contracts. Triggers may include a widening spread relative to LIBOR, or a detrioration in financial condition, etc.

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It’s the creation at will of a contract to transfer some risk from one party to another, for a fee. That last sentence is very important! It’s the crux of the entire financial meltdown that we are in. It’s not the derivatives themselves that are bad, but the creation at will and the fee that are the problem.

Bush and Bernanke might say that they have the situation under control, but the fact is that financial market participants have created credit money without restraint for years, and it will unwind without restraint. The financial alchemy of credit money creation is not the problem in and of itself, as I said before. It’s the free creation of credit and the fee for the derivative risk transfer that is the culprit. There have been no limits on the creation of derivatives, which coupled with a risk premium that is way too low has set us up for a massive credit default and risk repricing. We have far more derivatives out there than actual underlying assets.

Disagree.
The crux of the problem is not the theory of derivatives.

The problems are;

*Bad loans
*Excessive leverage
*Maturity mis-matches, compounded by differences in liquidity
*Marked-to-market accounting standards
*Regulatory forced sales due to Credit Grades
*Improper Credit Grading
*Negative Convexity [duration mis-matches]
*Relaxation of previous Regulatory conditions [Glass-Steagall Act 1933]

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This is massive deflation of credit money on a global scale. The Fed can inject trillions of dollars into the system, and we will still have a monetary contraction. The inflation we are seeing is the world repricing the downside risks to our economy, currency and assets, not Bernanke directly diluting our dollar with his printing press.

Incorrect.
Injecting “trillions of dollars” will not create a “monetary contraction”…it will create monetary expansion. This “expansion” would futher fuel inflation.

The current inflation that the US is experiencing is due to a loose, or “expansionary monetary” policy as the Fed seeks to increase credit, primarily to the Banking system. Thus as the US dollar is inflated by US policy, export partners, who price in US$, reflect this inflation.