Treasuries are the only US financial asset that the rest of the world is still buying in large quantities

TO BE NOTED:

"Record demand, record angst

Posted on Friday, May 29th, 2009

By bsetser

The bond market vigilantes are (supposedly) back. And this time, they aren’t just Wall Street traders. America’s foreign creditors are no longer willing to provide endless amounts of long-term credit to the US at low rates. So argues Mark MacQueen of Austin, Texas- based Sage Advisory Services (via Bloomberg):

“The vigilante group is different this time around … It’s major foreign creditors. This whole idea that we need to spend our way out of our problems is being questioned.”

From all this talk, you would never know that the world is actually still buying record amounts of US Treasuries. In fact, Treasuries are the only US financial asset that the rest of the world is still buying in large quantities. Demand for Agencies — and asset backed securities — has fallen off a cliff. Demand for equities has been anemic (though the last data point comes from March). By contrast, the 52 week increase in the New York Fed’s custodial holdings is way, way up.

Over the last four weeks of data — basically the month of May — central bank Treasury purchases topped $70 billion even as their Agency holdings inched up. That is a big sum, almost a record sum. It implies that the rest of the world is currently shifting their US portfolio into Treasuries, not moving out of them.

To be sure, not all is well.

Foreign central bank demand is still concentrated at the short-end of the curve,* and the US is issuing more long-dated bonds.

And key emerging market central banks (predictably) ares still reluctant to allow their currencies to appreciate. Tim Duy, in a superb Fed Watch:

The Fed’s ZIRP policy combined with stable financial markets once again makes the Dollar carry trade attractive. Since old habits die hard, this should “force” foreign central banks to accumulate Treasury assets - and it has. In this scenario, stable financial markets are now pushing for further reduction in the US external deficit … And, once again, it looks like much of the world, from the Fed to the Treasury to the emerging market central banks, are resisting the adjustment as it requires continued soft domestic demand in the US to limit imports.

Central banks that effectively peg to the dollar make for a strange kind of vigilante. Countries that do not want their currencies to appreciate have to intervene more when inflows pick up, and they have to invest that money abroad. And if central banks believe that the only acceptable, safe alternative to long-term Treasury notes is short-term Treasury bills, they will end up lending to the US at incredibly low rates so long as the Fed keeps rates low.( NB DON )

Key countries end up piling up short-term Treasury bills at a rate that has to make everyone nervous.

US policy makers have to worry about the weak foreign bid for long-term bonds, and the risk that the rise in mortgage rates will choke off the recovery. And at some point, foreign central banks will have to worry about the lack of interest income of their (now once again growing) foreign portfolio.

* Central banks bought a surprisingly large share of the 5 year auction, so this may be changing. We will have to see."

as investors demanded higher yields to lend to the government for longer periods

TO BE NOTED: From Bloomberg:

"Treasuries Little Changed as Fed Readies Purchases of Debt

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By Dakin Campbell and Wes Goodman

April 13 (Bloomberg) -- Treasuries were little changed as the Federal Reserve prepared to buy U.S. government securities today and tomorrow in an effort to cut borrowing costs.

Investors seeking safety during the first global recession since World War II increased holdings of Treasury and agency debt to record levels, a survey of fund managers by Ried, Thunberg & Co. shows. Government and central bank reports this week will show U.S. retail sales rose in March, while a drop in factory production and slower inflation indicate the recession isn’t over, according to surveys of economists by Bloomberg.

“We traded off under the weight of supply last week,” said Martin Mitchell, head of government bond trading at the Baltimore unit of Stifel Nicolaus & Co. “Absent supply, the market will tend to drift lower in yield.”

The yield on the 10-year note rose one basis point to 2.93 percent as of 8:15 a.m. in New York, according to BGCantor Market Data. The price of the 2.75 percent security due February 2019 fell 1/32, or $0.31 per $1,000 face amount, to 98 14/32. U.K. trading of Treasuries was closed today for the Easter holiday, the Securities Industry and Financial Markets Association said.

Fed Buying

Ten-year yields will be in a range of 2.5 percent to 3 percent through the middle of the year, according to Kei Katayama, who oversees $1.6 billion of non-yen debt in Tokyo as leader of the foreign fixed-income group at Daiwa SB Investments Ltd., part of Japan’s second-biggest investment bank. The figure will fall to 2.75 percent by June 30, according to a Bloomberg survey of banks and securities companies with the most recent forecasts given the heaviest weightings. The yield has averaged 4.24 percent for the past five years.

The central bank plans to buy Treasuries due from March 2011 to April 2012 today and from September 2013 to February 2016 tomorrow, according to its Web site. The Fed has more than doubled the size of its balance sheet to $2.09 trillion in the past year by purchasing financial assets including Treasuries in an effort to spur growth.

Investors increased Treasury and agency holdings to 45 percent of their portfolios, matching the all-time high set in October 2002, according to Ried Thunberg, a research company in Jersey City, New Jersey. Agency debt is comprised mostly of securities sold by Fannie Mae and Freddie Mac, the two largest providers of funds for mortgages.

Decline Predicted

U.S. bonds may still fall, the survey showed. An index measuring investors’ outlook for Treasuries through the end of June declined to 43 for the seven days ended April 9 from 44 in the previous week. A reading below 50 means investors expect prices to drop. Ried Thunberg surveyed 25 fund managers controlling $1.35 trillion.

China, the largest holder of U.S. debt outside the nation, should buy more short-maturity U.S. Treasuries than long-term notes, the Oriental Morning Post reported today, citing a former adviser to the People’s Bank of China.

The government should “adjust the maturity structure, and keep asset and currency structures basically unchanged,” Li Yang said in Beijing, the Chinese-language newspaper reported.

Foreign holdings of Treasury bills surged to a record $486.9 billion in January from $207.1 billion a year earlier, according to the Treasury Department. Shorter-maturity bills tend to follow central bank interest rates while bonds are influenced more by inflation.

Yield Curve

The difference between two- and 10-year yields widened to 1.96 percentage points from 1.25 percentage points in December as investors demanded higher yields to lend to the government for longer periods.

Fed purchases have created a Treasury market “bubble” that may keep growing, said Jim Rogers, an investor and author of the book “Hot Commodities.” The Fed, like the Bank of Japan before it, is supporting government debt, he said.

“In Japan, long-term bonds were yielding one half of one percent at one time,” Rogers said on Bloomberg Television in an interview from Singapore, where he lives. “This can go to absurd levels, and bubbles usually do.”

Japan’s 10-year yields, little changed today at 1.46 percent, fell to 0.43 percent in June 2003, the lowest since Bloomberg data tracking the figure began in 1985.

Thirty-year mortgage rates rose to 4.87 percent in the seven days ended April 9 from 4.78 percent the week before, which was the lowest since Freddie Mac, the McLean, Virginia- based mortgage-finance company, began tracking the figure 37 years ago. Rates are 1.97 percentage points more than U.S. 10- year yields, widening from 1.46 percentage points two years ago.

TED Spread

Yields suggest U.S. credit markets haven’t fully recovered after last year’s decline.

The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, narrowed to 95 basis points from 96 basis points on April 10. The spread, which reached 4.64 percentage points in October, was about 36 basis points 24 months ago.

U.S. retail sales rose 0.3 percent in March, according to the median estimate in a Bloomberg News survey before the Commerce Department’s report tomorrow. Industrial production dropped 0.9 percent, the 14th decline in the last 15 months, figures from the Fed on April 15 may show, according to a separate Bloomberg survey.

The Treasury Department has ordered General Motors Corp. to prepare for a bankruptcy filing by June 1, the New York Times reported, raising speculation it will default on its bonds. The report cited people with knowledge of the plans.

Cost of Living

Treasuries fell last week as the government sold $59 billion of notes to help fund President Barack Obama’s spending plans. Government securities dropped 1.2 percent in April, extending a 1.4 percent loss in the first quarter that marked the worst start to a year since 1999, according to Merrill Lynch & Co.’s U.S. Treasury Master Index.

Fed Chairman Ben S. Bernanke’s efforts to spur growth may result in a higher cost of living, said Allan Meltzer, the central bank historian and professor of political economy at Carnegie Mellon University in Pittsburgh.

Inflation “will get higher than it was in the 1970s,” Meltzer said. At the end of that decade, consumer prices rose at a year-over-year rate of 13.3 percent. Rising costs erode the value of the fixed payments from bonds.

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices, was little changed at 1.35 percentage points from near zero at the end of 2008. The average for the past five years is 2.25 percentage points.

The U.S. consumer price index probably fell 0.1 percent in March from a year earlier, according to economists surveyed by Bloomberg before the Labor Department report on April 15. In February, the index rose at a year-over-year rate of 0.2 percent."

Stapley said he’s been selling Treasuries and buying agency debt and new corporate bonds less sensitive to consumer spending.

TO BE NOTED: From Bloomberg:

"Bernanke Treasury Plan Drives Pimco to Mortgage Bonds (Update4)

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By Daniel Kruger

March 30 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke’s plan to buy $300 billion of Treasuries is driving the world’s biggest bond investors away from government debt and may already be helping him lower consumer borrowing rates.

Mortgage and corporate securities are outperforming Treasuries this quarter for the first time since the period ended in June, before the collapse of Lehman Brothers Holdings Inc. drove investors to the safest debt and froze credit markets, Merrill Lynch & Co. index data show. A March 23 Ried, Thunberg & Co. survey said fund managers overseeing $1.19 trillion cut their government securities holdings to the least this year while they increased mortgage assets.

“We don’t think Treasuries are very thrilling,” said Barr Segal, a managing director at Los Angeles-based TCW Group Inc., which holds $90 billion in fixed-income assets. Bernanke wants to keep Treasury rates low so “investors do what we’re doing, that is, jump in and drive all the spreads down,” he said of the gap between yields of riskier assets and government debt.

By moving money out of Treasuries, TCW, along with Pacific Investment Management Co. and Fifth Third Asset Management, may be helping Bernanke, who said in a March 20 speech in Phoenix that “credit market dysfunction” is countering efforts to fix the economy. The Fed’s March 18 plan to buy Treasuries and $750 billion of mortgage-backed securities from Fannie Mae, Freddie Mac and Ginnie Mae is “intended to improve conditions in private credit markets,” he said.

Wal-Mart Bonds

Bonds of industrial companies, a category that includes Bentonville, Arkansas-based Wal-Mart Stores Inc., Oak Brook, Illinois-based McDonalds Corp. and Pfizer Inc. in New York, yield 4.68 percentage points more than Treasuries, down from 5.57 percentage points at the start of the year, Merrill Lynch data show.

Yields on Washington-based Fannie Mae’s current-coupon 30- year fixed-rate mortgage bonds declined to 3.85 percent on March 19, the lowest in two months. The difference between the rates and those on 10-year Treasuries shrank to 1.18 percentage points last week, the narrowest since July 2007 and down from 2.32 percentage points in November.

Central bank policy makers are determined to lower consumer rates relative to interest paid by banks so Americans can increase spending and end the deepest recession since 1982. Gross domestic product shrank 6.3 percent in the fourth quarter, the most since 1982, and the Commerce Department in Washington said March 27 that consumer spending growth slowed to 0.2 percent in February from 1 percent the prior month.

Consumer Rates

Even with the Fed’s target rate for overnight loans between banks at zero to 0.25 percent, 30-year mortgages are 2.17 percentage points higher than the yield on 10-year Treasuries, or 0.63 point more than the past decade’s average, according to data compiled by Bankrate.com and Bloomberg. Car loans are 7.71 percentage points above the one-month London interbank offered rate that banks charge each other for loans, compared with the 1.92-point average, Fed data shows.

Attempts by the Fed may be showing some signs of success after the central bank and Treasury poured more than $13 trillion into the U.S. financial system in a 16-month-long effort to revive the economy. Shrinking the supply of mortgage bonds and reducing their yields would allow banks to cut rates on new mortgages and sell securities tied to the debt at a gain.

The average rate on a 30-year fixed mortgage fell to 4.85 percent last week, according to Freddie Mac, the lowest since the McLean, Virginia-based mortgage finance company began keeping records in 1971. The rate is down from last year’s high of 6.63 percent in July.

Home Sales

Lower borrowing costs and falling prices helped spur new home sales in February. The Commerce Department said March 25 that sales of new house jumped 4.7 percent to an annual rate of 337,000 from a record low pace in January.

Merrill Lynch’s U.S. Treasury Master Index lost 1.92 percent this quarter, while its main mortgage index rose 2.12 percent and the index of non-financial corporate debt gained 2.16 percent.

Investors reduced their holdings of Treasuries and agency securities to 26 percent from 37 percent the week before, according to Jersey City, New Jersey-based Ried Thunberg. Mortgages rose to 35 percent from 23 percent.

“There are much cheaper assets than Treasuries,” said Stuart Spodek, co-head of U.S. bonds in New York at BlackRock Inc., which manages $483 billion in fixed-income. BlackRock is selling Treasuries to buy AAA-rated commercial mortgage bonds, residential mortgages and investment-grade company debt.

Clipping Coupons

Investors in 10-year Treasuries would earn no more than the 2.75 percent coupon rate if yields hold steady through year-end, Bloomberg data show, compared with returns of 14 percent last year, including prices gains and reinvested income, according to Merrill Lynch’s indexes.

Investors got burned last year when they dumped Treasuries and said credit markets were recovering from the seizure that began with the meltdown of subprime mortgages in August 2007. Treasuries lost 2.07 percent in the second quarter of 2008 as futures on the Chicago Board of Trade showed traders saw a 67 percent chance the Fed would increase rates by the end of the year. Instead, Lehman went bankrupt in September and Treasuries gained 14 percent for the year.

Bill Gross, manager of the world’s biggest bond fund, said in May that government debt was “overvalued.” Seven months later, the co-chief investment officer at Newport Beach, California-based Pacific Investment Management, or Pimco, said he regretted not buying them.

Treasury Yields

Gross, who manages the $138 billion Total Return Fund at Pimco, said March 19 that 10-year Treasury yields “probably” won’t fall much lower. Since then, the yield on the benchmark 2.75 percent note due in February 2019 has risen from 2.54 percent.

The yield on the 10-year note rose 13 basis points, or 0.13 percentage point, to 2.76 percent last week, the most since increasing 23 basis points to 3.02 percent in the period ending Feb. 27. The price of the note fell 1 4/32, or $11.25 per $1,000 face amount, to 99 29/32, according to BGCantor Market Data.

The yield fell six basis points to 2.70 percent as of 5:55 a.m. in New York.

Pimco may buy mortgage loans and manage funds that acquire mortgage bonds as part of a plan announced by Treasury Secretary Timothy Geithner last week to fund purchases of soured assets from banks using $75 billion to $100 billion from the $700 billion Troubled Asset Relief Program, Gross said in a March 23 interview with Bloomberg Television.

Rates Capped

Many investors still favor Treasuries because they expect Bernanke will add to purchases of government debt. Strategists at JPMorgan Chase & Co. said in a March 20 report that 10-year Treasury yields will likely fall. Srini Ramaswamy wrote that Treasuries will gain because of the imminent growth in the Fed’s balance sheet and continuing weakness in the economy.

“The Fed views anything over 3 percent on the 10-year as an area where they’d need to intervene,” said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer for Grand Rapids, Michigan-based Fifth Third.

Stapley said he’s been selling Treasuries and buying agency debt and new corporate bonds less sensitive to consumer spending.

Regulatory filings show that Fifth Third bought 4.375 percent bonds issued by Minneapolis-based Medtronic Inc., the world’s second-biggest maker of medical devices, maturing September 2010 and 5.82 percent mortgage bonds sold by Wells Fargo & Co., maturing October 2036, in the three months ended Jan. 31.

Narrowing Spreads

The $149 million TCW Core Fixed Income Fund bought Freddie Mac 5.25 percent notes due in July 2011 in the three months ended Feb. 28, regulatory filings show. It also purchased part of Wal-Mart’s $1.25 billion of 5.8 percent bonds maturing in February 2018 and 6 percent Credit Suisse Mortgage Capital Certificates that were cut to BB from AAA by Fitch Ratings on Dec. 16.

The extra yield investors demand to own the Wal-Mart bonds instead of Treasuries has shrunk to 176 basis points from 187 basis points in January, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

“The cumulative effect of many of the programs announced by the Treasury and the Fed is going to be supportive for asset prices,” said BlackRock’s Spodek. “There certainly is opportunity in a number of them to capitalize on some pretty attractive returns.”

The corollary of that fall, though, has been the rise in the price — and fall in yields — of comparatively safe financial assets

From Brad Setser:

"Last week’s move in the Treasury market …

Posted on Sunday, March 22nd, 2009

By bsetser

When financial historians get around to writing the history of the great crisis of 2008 (or great crisis of 2007-09?), they will no doubt focus on the collapse of the market for securitized mortgages — and in reality, almost all forms of credit risk. The corollary of that fall, though, has been the rise in the price — and fall in yields — of comparatively safe financial assets. And US Treasuries are still considered safe.

The first year of the crisis was marked by three upward spikes in the price — and sharp falls in yield — of short-term Treasury bills: one in August 2007 (subprime, quant funds), one in the spring of 2008 (Bear) and one in September 2008 (Lehman, AIG, Merrill and in all probability nearly every other financial institution but for the extension of a government backstop to the system).

The ten year Treasury bond didn’t really rally until late November, well after Lehman. It then soared (i.e. yields fell) in late 2008 before selling off this year — before the Fed stepped in.

My guess is that gyrations in the ten year bond will mark the next stage of the crisis. Bank bailouts — and counter-cyclical fiscal policies — are very expensive. Last week the CBO confirmed what students of Reinhart and Rogoff already suspected. But the Fed rather clearly doesn’t want yields on the ten-year to head back to the 3.5-4.0% range of early last fall. Not when the economy is weak.

Christoph Schmidt is concerned about the risk of future inflation in the US. But the Fed — like Jan Hatzius of Goldman and Dr. Hamilton of UCSD — is far more worried about the immediate risk of deflation. And with so much spare capacity globally, I tend to agree with the Fed. German industrial production is now down over 20% y/y. Eurozone output is now almost 20% below its level a year ago. And parts of Asia — like Taiwan — are in even worse shape."

Me:

Don the libertarian Democrat responds:

“they will no doubt focus on the collapse of the market for securitized mortgages — and in reality, almost all forms of credit risk. The corollary of that fall, though, has been the rise in the price — and fall in yields — of comparatively safe financial assets. And US Treasuries are still considered safe.”

I’m still not sure that I’ve yet heard a good explanation for this. I assumed in September that, after Lehman, everyone was operating under the assumption that we might fall into a Debt-Deflationary Spiral, beginning with a Calling Run. That’s what led to the Flight To Safety, and then Lehman caused a serious problem by leading to the belief that implicit guarantees might not be honored. I still believe that, but there are lots of other explanations. It seems a real puzzle, especially since the jitters about these problems seemed to begin in August.

One of my main points about this is William Gross missing out in the US Treasury moves. Since then, he’s been doing very well. I assume that he believed that the government would not allow Lehman to fail and would honor implicit guarantees. Since then, he’s been betting, and making money, assuming no more Lehmans and that the government is honoring guarantees.

As for China, they made clear that they agreed with Gross. What puzzles me to this day, is that, since Bernanke feared Debt-Deflation, he allowed Lehman to go under. I’m starting to feel that he really didn’t feel that he could save them

"The flight from risk averse assets into riskier and less liquid paper manifested it self in the Treasury market."

From Across The Curve:

"Closing Comments January 5 2009

January 5th, 2009 5:41 pm | by John Jansen |

Prices of Treasury coupon securities registered very bifurcated results as the first fully staffed trading session of the new year produced a rout in the long end. Investors returned from the holidays with the animal spirits racing and poured money from risk free assets into riskier fixed income assets( THIS IS WHAT I'D EXPECT. ).The yield on the 2 year note declined 2 basis points to 0.80 percent. The yield on the 3 year declined a basis point to 1.07 percent. The yield on the 5 year note glided ever so slightly higher by 4 basis points at 1.69 percent. The yield on the 10 year note jumped 11 basis points and the yield on the Long Bond catapulted 24 basis points and sliced right through the 3.00 percent level to finish at 3.03 percent.

The 2 year/10 year spread widened 13 basis points to 168 basis points.

The 2 year/5 year /30 year spread closed the day at 45 basis points after opening at 27 basis points.

The flight from risk averse assets into riskier and less liquid paper manifested it self in the Treasury market( GOOD NEWS. A POSSIBLE DIMINUTION OF FEAR AND AVERSION TO RISK. ). I have chronicled here over the last couple of months the story of several off the run bonds which had become extremely cheap on the curve or had recounted instances of off the run issues which had had produced strange relationships.

As an example the 8 1/8 August 2019 bond has traded as much as 70 basis points cheap to the 10 year note. The 10 year note is a November 2018 maturity and there is no reason why one should pick up 70 basis points for a three month extension. That spread narrowed 6 basis points today and has narrowed over the last several days to 57 basis points.

Then there is the story of the August 2023 bond and the November 2024 bond. The yield curve is positively sloped in which case rolling back on the curve should cause one to give up Not so in the relationship between these bonds. That spread had been such that you could sell the 2024 and roll backwards to 2023 and pick 36 basis points. That spread is 28 basis points today.

If the Fed is serious about keeping the funds rate at zero (and they are) then these and numerous other anomalies along the Treasury curve will correct as yield hogs scour the curve for incremental value.

Money managers continue to buy MBS and paper is closing about ½ point tighter to Treasuries."

"there's a very good chance that Treasury will step in to prevent America's largest companies from going bust."

Felix Salmon with a few cautious words about bonds:

"The Riskiness of Bonds

Yesterday I questioned the wisdom of retail investors buying bonds in this market, and boy did I get an earful back, especially from many of the commenters at Seeking Alpha. They accused me of not drawing the distinction between Treasuries and credit, and of not appreciating the record spreads being seen in the bond market( I THINK THAT THEY SHOW OPPORTUNITIES FOR SERIOUS INVESTORS, BUT NOT AVERAGE INVESTORS. ).

This morning, Henry Blodget gives us a useful chart, showing that the Lehman Aggregate bond index -- which is the benchmark for most of the bond funds that retail investors buy -- rebounded sharply in the last two months of this year, and ended solidly in positive territory. Which is quite an achievement for any asset class in 2008( THE FLIGHT TO SAFETY ).

Now yes, the rebound is largely a function of the Treasury bubble( SO HE AGREES ) -- but so are record spreads in the credit market( TRUE. IT'S ALL THE FLIGHT TO SAFETY. ). And since retail investors don't short Treasury bonds, they can't play spreads( VERY TRUE ). Instead, they have just three choices: going long Treasuries; going long credit; or some combination of the two.( NOT A GOOD IDEA NOW )

Clearly the Treasury market is treacherous right now, and could implode as quickly as it rose( THAT'S THE FEAR ). I can assure you that this kind of chart (from a very useful blog entry by Richard Shaw) is not the kind of thing that dealers in US debt ever expect to see( I SHOULD THINK NOT ):

Yes, that's a 35% annual return on long-dated Treasury bonds, in a year which started with pretty low interest rates. So clearly anybody buying Treasuries right now is doing so at extremely frothy levels( TRUE ).

But what about credit? The flip side of Treasury outperformance has been a collapse in prices of credit, and in general the riskier the credit, the more it has fallen. Junk bonds and emerging-market debt cratered in 2008, but the bulk of the bonds that retail investors are likely to buy -- US investment-grade corporate bonds -- actually staged quite an impressive rally at year-end.

If you believe that mid-October's bond-market panic was overblown( I DO ) and that we'll never see such levels again, then feel free to dip a toe into this market( HANG ON OLD CHAP ). But if you do so, be clear that you're entering into a speculative trade: you're not putting your money in a safe place like an FDIC-insured CD( FOR SURE ). (And you can do that with any amount of money, not just $250,000, thanks to CDARS.)

But bonds certainly aren't any kind of hedge against stock-market underperformance. If the stock market goes down from its present levels, it will do so because of a wave of defaults wiping out the equity in a wide range of companies. The bond market is pricing in an uptick in defaults, but no one knows just how much of an uptick, and there's a very good chance that if a few large and heavily-indebted public companies go under in quick succession, the bond market could lurch back down to its October lows and possibly even fall further still.( VERY TRUE )

None of this makes investing in bonds a bad idea for a sophisticated investor( I AGREE ): they do seem to be more attractive, from a risk-return standpoint, than stocks, just as they have been since the summer of 2007( I AGREE ). And there's a strong moral hazard play right now as well: there's a very good chance that Treasury will step in to prevent America's largest companies from going bust( I AGREE ). But if you're looking for safety, cash is still very much your friend. And if you're investing in bonds, know the risks that you're taking."

I pretty much agree with this entire post.

“Bubbles are born of greed; this is fear,”

More on the Flighty To Safety and a possible bubble on Bloomberg:

By Daniel Kruger

Jan. 1 (Bloomberg) -- Treasuries recorded their biggest annual gain since 1995 as falling stocks and frozen credit markets drove investors to the relative safety( FLIGHT TO SAFETY ) of U.S. government debt.

Yields of all maturities touched record lows as financial firms’ losses in the credit crisis exceeded $1 trillion and policy makers made unprecedented moves to rescue the country from recession. Foreign companies and institutions increased their stake in U.S. government debt by 29 percent in the first 10 months of the year, Treasury Department data shows.

“It’s one heck of a run for 2008,” said George Goncalves, chief Treasury and agency strategist with Morgan Stanley, one of 17 primary dealers that trade with the Fed. “The capital markets are going to be about the Treasury market next year.”

Treasuries returned 14 percent in 2008, according to Merrill Lynch & Co.’s Treasury Master index. It was the best performance since 1995, when they rose 18.5 percent after the Federal Reserve began lowering its benchmark interest rate from 6 percent. The Standard & Poor’s 500 Index lost more than 38 percent for the year, the most since 1937.

The U.S. economy entered a recession in December 2007, the National Bureau of Economic Research said this month. The Cambridge, Massachusetts-based group sets dates on U.S. business cycles. The slump began about four months after financial markets started seizing up as rising defaults on subprime mortgages began to affect the value of other assets in the credit markets.

‘Most Trying Year’

The Fed cut its target rate for overnight lending between banks to a range between zero and 0.25 percent, from 4.25 percent at the start of the year. It rescued insurer American International Group Inc. and committed $8.5 trillion to sustain the economy.

The Treasury put mortgage-finance companies Fannie Mae and Freddie Mac into conservatorship, purchased bank stock and bailed out automakers General Motors Corp. and Chrysler LLC. It spent half of a $700 billion bank-rescue fund, the Troubled Asset Relief Program, authorized by Congress.

Policy makers let Lehman Brothers Holdings Inc. collapse in September, sparking a panic about the safety( GUARANTEES. BRAVO! THAT'S IT. ) of financial institutions.

“This has been the most trying year that most people will ever live through,” Ray Remy, head of fixed income in New York at Daiwa Securities America Inc., another primary dealer, said yesterday. “Time to end it.”

The tumult is unlikely to be over. The U.S. said it may sell as much as $2 trillion in debt to fund various bailout and stimulus packages and the U.S. budget shortfall.

‘Tons of Supply’

The year will open with the auction of $8 billion of 10- year inflation-indexed securities on Jan. 6, a sale of three- year notes on Jan. 7 and an auction of 10-year notes Jan. 8; the size of the note sales has yet to be announced.

“Next week we have tons of supply, so the market has to pay attention to that,” Remy said. “As soon as we walk in here on Monday, I would imagine the selling will start.”

Demand for Treasuries last year reached the “bubble” phase seen in technology stocks in 2000 and real estate in 2006, David Rosenberg, chief North American economist at Merrill Lynch, wrote in a research note Dec. 1. He forecast the 10-year note’s yield could fall below 2.3 percent, which it did for the first time barely two weeks later.

“This next leg down in yield will undoubtedly represent the classic mania-turn-to-bubble phase( I HAVE TO SAY THAT I AGREE ),” New York-based Rosenberg wrote.

With the economy losing 1.9 million jobs in the first 11 months of 2008, according to Labor Department data, others saw different factors behind the record low yields.

‘Nowhere Else to Run’

“Bubbles are born of greed; this is fear( CORRECT. FEAR AND AVERSION TO RISK AND THE ACCOMPANYING FLIGHT TO SAFETY. ),” T.J. Marta, a fixed-income strategist at RBC Capital Markets in New York, said this week. The firm is the investment-banking arm of Canada’s biggest lender. “There’s nowhere else to run( A CALLING RUN ) at this point. This is a lot more like Japan in the 1990s or the U.S. in the 1930s than the U.S. in the 1980s or 1970s.”

Foreign entities hold $3.04 trillion in U.S. securities, about 52 percent of marketable Treasury debt. That’s up 29 percent from $2.35 trillion they owned the end of 2007, according to Treasury Department data.

The Fed’s custodial holdings of Treasuries for foreign entities including central banks rose 37 percent in 2008 to $1.68 trillion as of Dec. 24, the largest jump since at least 1984.

The central bank’s custodial holdings of so-called agency securities, including mortgage securities issued by Fannie Mae and Freddie Mac, fell( ONLY IMPLICIT GUARANTEES ) 0.6 percent to $825 billion, the first decline since at least 2001 when the Fed began reporting the data. Agency holdings had risen between 22.7 percent and 53.3 percent in each previous year.

TED Spread

Yields indicate the Fed’s interest-rate reductions have made banks more willing to lend than earlier in 2008. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, narrowed to 1.35 percentage points yesterday from 4.64 percentage points in May. That was the most since Bloomberg began compiling the data in 1984.

Ten-year Treasury note yields will climb to 3.4 percent by the end of 2009, according to a Bloomberg survey of 58 economists, with the most recent forecasts given the heaviest weighting.

The Securities Industry and Financial Markets Association recommended that Treasuries markets be shut around the world today for the New Year’s Day holiday."

"They found that the financial markets are always vulnerable to what they called a liquidity shock"

Another interesting NY Times post:

"Yes, History Has Much to Say About This Market

By MARK HULBERT

IN bull markets, it’s wise to guard against thinking that “this time is different ”( THIS IS WHEN YOU SHOULD BE THE MOST FRIGHTENED AND CAREFUL ) — that stocks will keep rising forever. Sooner or later, the laws of economics reassert themselves. And it’s wise to remember that major market declines follow some common patterns, too.

Right now, it’s tempting to think that this bear market is so unusual that history’s lessons are of little use( THEY ARE ), and that the types of investments that are weakest now will keep dropping indefinitely. No two market environments are identical, of course, but there is plenty of precedent for the credit crisis of the last 18 months — and for its profound effects on the stock and bond markets.

In fact, you can view the markets’ behavior since mid-2007 as a textbook illustration of a statistical pattern uncovered years ago by two finance professors, Lubos Pastor of the University of Chicago and Robert F. Stambaugh of the Wharton School of the University of Pennsylvania. They found that the financial markets are always vulnerable to what they called a liquidity shock — a sudden tightening of credit( HERE CAUSED BY A CALLING RUN ). Aside from the current crisis, two recent examples are the market conditions during the market crash of October 1987 and the wake of the near-collapse of Long-Term Capital Management in the fall of 1998.

Some types of securities — high-yield, or junk, bonds, for example — are usually more vulnerable than others in such an event. The most immune from liquidity problems are those for which there is always robust demand, so they can be sold anytime( LIQUID ) without pushing down their prices. As has become abundantly clear over the last 18 months, Treasury securities are a good illustration. At the other extreme are those securities that, without an abundant supply of available credit, become difficult if not impossible to sell at any price( TRUE ).

The professors’ research was the focus of this column in August 2001, and their study appeared in the June 2003 issue of The Journal of Political Economy. According to Google Scholar, no fewer than 623 academic articles and studies now cite their study.

This research provides a good template for understanding the last 18 months, according to Lasse Pedersen, a finance professor at New York University who has conducted a half-dozen studies in recent years into the market’s reaction to liquidity crises.

In the current crisis, Professor Pedersen said in an e-mail message, “securities with high liquidity risk have done very poorly,” just as we should have expected. A good example is convertible bonds, which previous research found to be particularly vulnerable to liquidity shock.

“They have gotten killed,” he wrote.

Though the large body of research into liquidity shocks may offer little comfort to investors who’ve lost so much in the last 18 months, it is an antidote to the argument that history has nothing to teach about the current crisis. The research has found that when liquidity shocks occur, they are so intense that the securities most vulnerable to them predictably provide higher longer-term returns. This happens, Professor Pastor said in an interview, because these securities must compensate investors for the risk of big losses during those shocks.

This doesn’t mean that anyone can predict such shocks with certainty. Instead, according to Professor Pastor, there is a small but significant risk that one could happen at any time — and that investors are deluding themselves if they don’t take that risk into account( VERY GOOD ).

Investors who despair that this credit crisis may never end may therefore be guilty of the mirror opposite of a mistake made earlier in this decade( THAT'S WHAT I BELIEVE ), when liquidity was plentiful. Just as many investors forgot several years ago that another liquidity crisis was destined to happen someday, many may now be forgetting that liquidity shocks don’t last forever.

WHICH securities will perform best after the current credit crisis, and which will fare worst?

According to the research, once a liquidity crisis passes, other factors come to the fore, and securities that have risen in price, like Treasury bonds, are then likely to perform poorly. By contrast, the best performers will be those securities that have lost the most during past credit crises — not just during the current one. Convertible bonds and junk bonds are two obvious categories that should do particularly well, but others, including stocks, should also benefit( I AGREE ).

If you can tolerate short-term volatility, you should consider such securities for the long term, Professor Pastor said, even if you’re worried that the credit crisis has longer to run. That’s because it is impossible to predict the exact end of the bear market( TRUE ), and because these investments should provide high-enough returns over the long term to make the risk worth taking.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com."

A Liquidity Shock ends up in a run. In this case, a Calling Run, in which financial concerns were forced to quickly increase their capital. In order to do this, they must quickly sell some assets. If this can't be done, a ripple effect occurs throughout the system as people flee to the safety of liquid and guaranteed assets, since many of the assets, which are not guaranteed, will probably have to be sold at fire sale prices.

History does provide some help here, but it is nothing more really than being prudent when you invest.

"It kept spreads on “Agency” MBS high even after the US government effectively guaranteed Agency bonds "

Brad Setser about the US Treasuries aspect of the Flight To Safety:

"The central bank flight to safety

Posted on Sunday, December 21st, 2008

By bsetser

Floyd Norris of the New York Times highlights a theme that I have touched on many times: foreign demand for US assets with any hint of credit risk has disappeared ( TRUE ). Foreign demand for US corporate bonds( THIS IS MORE ABOUT US INVESTORS AND THE FLIGHT TO SAFETY ) — a category that includes “private-label” asset-backed securities( WHICH ACCRUED INTEREST BELIEFS TALF WILL HELP ) like repackaged subprime mortgages — fell sharply in 2007 and hasn’t recovered. * And more recently foreign demand for US “Agency” bonds — the debt issued or guaranteed by Freddie Mac, Fannie Mae, Ginnie Mae and the like — has fallen sharply( IMPLICIT VS EXPLICIT GUARANTEES ).

Norris highlights this shift effectively( I POSTED ABOUT THIS POST ). But he didn’t quite go as far as he could have( NONE OF US EVER DO MATE ).

I would add three additional points:

1) Foreign central banks — not private investors — have led the shift out of Agencies toward Treasuries( AN IMPORTANT POINT ). We know this because of the data in the Fed’s custodial accounts, which show a clear shift at the end of July. From the end of 2004 to the mid 2008, central banks were only slowly adding to their holdings of Treasuries while their holdings of Agencies the the New York Fed ballooned from something like $250b at end of 2004 to close to $1 trillion at the end of June 2008. And since mid 2008, central banks have been selling Agencies and buying Treasuries in big way( I'VE WONDERED ABOUT THE TIMING AND HAVE SUGGESTED THAT THIS WAS A HARBINGER OF THE CRISIS ). The following chart plots central banks’ custodial holdings at the Fed against my best guess of central banks true holdings of Treasuries and Agencies. That guess comes from a model that I have been working on with Arpana Pandey of the Council that reattributes purchases through London to the official sector in real time, and thus avoids the jumps associated with the survey revisions.** Think of it was anticipating the outcome of the next couple of surveys of foreign portfolio investment (The survey data consistently revises central bank holdings of Treasuries and Agencies up and the UK’s holdings down).

2) The shift from Agencies to Treasuries continued in November and December. There isn’t any “TIC” for those months, but the New York Fed’s data shows a $43 billion fall in central bank holdings of Agencies in November and another $38 billion fall in the first three weeks of December. Since the end of September( LEHMAN ), central bank holdings of Treasuries are up by over $210b and central bank holdings of Agencies are down by close to $130 billion — as the following chart illustrates.

3) This shift destablized the Agency market( IT HAS TO ). It kept spreads on “Agency” MBS high even after the US government effectively guaranteed Agency bonds ( IMPLICITLY. YET, HE'S STILL CORRECT )— and that kept mortgage rates up( OK ). Agency spreads only came down when the United States Fed indicated it would increase its purchases of Agency bonds( OK ) — effectively substituting a Fed bid for a Chinese bid.

The TIC data suggests that the big sellers of Agencies recently have been Russia and China. Russia I understand. Its reserves are falling, and its main goal is to stabilize its own market. China less so. Its reserves are apparently still rising. And while the Agencies have some risk, they have less risk than they did before the US government stepped in to backstop them( VERY TRUE, BUT, IF THERE WAS A DEFAULT OF ANY TYPE, THE AGENCIES WOULD LIKELY BE HIT FIRST. THINK OF THEM LIKE A TRANCHE ). My best guess is that China’s leadership was surprised to learn that they held something like half a trillion of Agencies in the summer, and they told SAFE to reduce its holdings (and generally cut the risk in SAFE’s portfolio).

Fair enough. No country is obligated to take even a tiny bit of risk with its reserves. But actions have consequences. China’s swing away from Agencies means that it will soon have a close to $1 trillion Treasury portfolio — which is a risk of another sort.***( TREASURY BUBBLE IF THEY START SELLING ) It also raises the question of whether China has been quite as stabilizing a presence in the market as the US Treasury claims. China certainly didn’t have to sell Agencies to raise cash.

Indeed, the Fed has done a lot more to stabilize global markets in the second half of this year than the world’s reserve managers( GOOD POINT ). Since the end of June, the Fed has lent close to $600 billion to foreign central banks that were short on dollars.**** The Fed effectively sold off its Treasury portfolio and took on risk in a downturn( TRUE ). Big reserve managers did rather the opposite: the data suggests that they were reaching for yield when times were hood (pushing down spreads) and then reversed course (pushing up spreads) when the going got tough( VERY TRUE, BUT THAT IS THE FLIGHT TO SAFETY. ).

*Much of that demand wasn’t really coming from foreign investors so much as from offshore vehicles that borrowed dollars short and lent long( THIS IS MORE ABOUT US INVESTORS ).
** My formula for adjusting official holdings requires positive purchases through London. In 2000 and 2001 the US was paying down the stock of Treasuries, so there weren’t net flows through London. as a result, the adjusted data series starts in M7 2002. Having annual survey data also helps.
*** Stay tuned for more on the details of China’s current portfolio — I am putting the final touches on a set of revised estimates.
**** Other reserve assets — the line item that corresponds with fx swaps — have increased from a bit over $100b at the end of June to $682 billion in the last week of data. That is a rather substantial flow.

I've made that point that one way to view this crisis is to see a rising spread between US Treasuries and Agencies as a rising spread between Implicit and Explicit Guarantees. In a crisis, such a small difference means everything. Let's now think of the two levels as Tranches, with US Treasuries being Senior and Agencies being Mezzanine. To the extent that investors see a rising risk of the US Defaulting ( All I mean by this is taking actions that clearly lessen the value of the investments they hold. It actually doesn't matter, at this stage, how that devaluation would occur. That's too far in the future. ), the Spread between US Treasuries and Agencies will continue.

I do, however, see an end to this, if the guarantees are made explicit, and investors see our actions going forward to be dedicated to taking the steps necessary to not see their investments devalued. At that point, higher yields will matter once again, even small differences.

On the home front, we need to attack the problem of Corporate Bonds with Tax Cuts.

"there is some lingering doubt that the government would actually stand behind their debts if their situation grew much worse."

Floyd Norris in the NY Times talks about the power of Explicit Government Guarantees as against Implicit Government Guarantees. In fact, I would argue that one could view this entire crisis through this lens. Before the crisis, Implicit Government Guarantees sufficed. The crisis began when investors began doubting them:

"AS foreign investors pour cash into United States securities, particularly short-term Treasury bills, they are pulling it out of the higher-yielding bonds issued by the government supported-entities Fannie Mae and Freddie Mac.

Skip to next paragraph

Multimedia

Graphic

Foreign purchases of government securities

The moves appear to indicate that even after the government bailout of the two agencies, there is some lingering doubt that the government would actually stand behind their debts if their situation grew much worse ( THAT'S IT ).

The Treasury Department reported this week that in October, overseas investors and governments were net sellers of $50 billion of agency securities( TOO RISKY, IMPLICIT GUARANTEE ), even though they yield significantly more than comparable Treasuries ( LESS RISKY. EXPLICIT GUARANTEE ) , which the investors bought at a record rate.

Over the summer, prices of agency securities fell as the financial crisis grew worse and some investors began to doubt whether the “implicit” government guarantee behind the agencies could be trusted ( THAT'S IT ). In July and August, foreigners were net sellers of $64 billion of such securities, an outflow unlike any previously seen.

That flight was one reason the government stepped in on Sept. 7 to effectively nationalize the agencies, although shares remain publicly traded. At first investors seemed reassured, but the confidence has now waned ( PARTLY BECAUSE OF THE AUTOMAKER'S BAILOUT, AND PARTLY BECAUSE THE GOVERNMENT HAS NOT BEEN EXPLICIT ABOUT GUARANTEES ).

Despite the nationalization, the government has stopped short of putting its full faith and credit behind the bonds ( A BIG MISTAKE. THIS IS THE CRISIS IN A NUTSHELL ). The new data is the first indication that may have mattered to many overseas investors ( TRUE ).

The accompanying chart at the top shows the monthly flows this year of foreign cash into Treasury securities and agency securities. More foreign money came into Treasuries in October — almost $91 billion — than in any previous month.

Most of the money — $56 billion in October — has gone into Treasury bills rather than into longer-dated bonds and notes. That flow ( DEMAND ) helped to push down interest rates on bills to historically low levels, sometimes even a bit below zero, as investors sought complete safety( THE FEAR AND AVERSION TO RISK AND THE ACCOMPANYING FLIGHT TO SAFETY ).

Until the housing market began to show significant weakness in 2007, foreign flows into agency securities were running at almost $300 billion a year, and the flow stayed strong until the summer scare ( TRUE. EVERYONE BELIEVED IN A COMPLETE AND EFFECTIVE BAILOUT ).

The other chart shows that over the 12 months through October, foreigners put just $65 billion into Fannie Mae and Freddie Mac, the lowest for any such period since 1998( FURTHER PROOF ). Unless there was a revival of overseas interest in those securities in November and December, 2008 could become the first year to see net sales, at least since the data became available in the early 1990s.

Until the late 1990s there was relatively little overseas investment in agency securities. But as the Clinton-era budget surpluses reduced the supply of available Treasuries, foreign investors discovered these investments, which seemed to be close substitutes ( THEY ARE ). Even after large budget deficits resumed early this decade, the overseas demand for agencies continued to grow until questions about their solvency( GUARANTEE ) began to be heard.

Now, virtually all the foreign money is going into Treasuries — at a rate of more than half a trillion dollars a year. "

"At least a crisis marked by a run out of risky US assets and into safe US assets. "

Brad Setser looks at Balance Of Payment Data:

At least a crisis marked by a run out of risky US assets and into safe US assets (THE FLIGHT TO SAFETY ). Right now Agency bonds — think Freddie and Fannie — are considered risky assets while Treasuries are not ( WHY ? BECAUSE THEY ARE EXPLICITLY GUARANTEED BY THE GOVERNMENT I PRESUME, WHILE THE AGENCY BONDS ARE IMPLICITLY GUARANTEED. TO ME, THIS UNCERTAINTY SPRINGS MAINLY FROM LEHMAN. I AM ALONE IN BELIEVING THIS APPARENTLY )

A run out of all US assets and the dollar would look very different.

The October TIC data tells a striking story — one marked by a massive surge in demand by both private and official investors for “safe” assets. Foreign investors bought $182 billion of Treasuries — including $147.4 billion of short-term Treasury bills. There is no real mystery why bill yields dropped so low even as the supply of bills surged. And foreigners added $207 billion to dollar bank accounts.

Sum that up and it works out to close to $400 billion in demand for safe dollar denominated assets. If that kind of monthly inflow is annualized it is a shockingly large number. ( THAT'S A MEASURE OF THE FEAR AND AVERSION TO RISK AND ACCOMPANYING FLIGHT TO SAFETY )

It isn’t hard to figure out why the dollar rallied.

$400 billion in a month is far more than the US needs to cover its trade deficit. It allowed foreigners to reduce their holdings of Agencies by close to $75 billion (including a $25 billion fall in short-term Agencies), their holdings of long-term corporate bonds by $13 billion and their holdings of US equities by $6 billion without causing any strain on the dollar.

Indeed, the fall in foreign holdings of US corporate bonds and US equities (though not the outflow from the Agencies) could have been financed by the sale of $36 billion of foreign assets by US residents …

Usually I argue that the TIC data understates official flows. And this month’s data may well do so.

Some of the $35 billion in long-term Treasury bonds bought by UK investors were probably bought by central banks, and selling by central banks could have contributed to the $13.8b in net sales of long-term Agencies. But in broad terms I don’t doubt that private demand for “safe” US assets soared as a result of the crisis — and much of the inflow came from private investors seeking to increase their holdings of the most liquid dollar assets ( LIQUIDITY IS ALSO IMPORTANT AS A RESULT OF THIS CRISIS ).

In October, China was about the only central bank adding to its reserves (I suspect, it hasn’t formally released its reserves data). Most central banks were selling. That shows up in the US TIC data. South Korea, Brazil, Mexico, Russia and Ukraine were all net sellers of long-term US Treasury bonds …

The big central bank flow was a reallocation away from Agencies toward Treasuries. And specifically toward short-term Treasury bills.

China increased its holdings of short-term Treasury bills by a stunning $56 billion while also buying $10 billion of long-term Treasuries. That flow alone would have been enough to cover the trade deficit in the absence of any offsetting outflows. Russia cut its holdings of short-term Agencies by a little over $22 billion while increasing its holdings of short-term Treasuries by almost $12 billion.

So much for talk that central banks are always a stabilizing presence the market. They clearly have destabilized the Agency market. The fall in demand for Agencies over the past three months — and most Agency demand has come from central banks until recently — has been sharper than than the fall in demand for US corporate bonds (think securitized subprime mortgages, the category “corporate bonds” in the BoP data includes asset-backed securities) after the crisis of last August.

The fall in demand for corporate bonds (the redline) is what generated a rather scary graph after the initial crisis last August. Things haven’t gotten any better since …

The Agency market is a rather important market. Increased lending by the Agencies offset the fall in demand for “private” mortgage-backed securities after the crisis last August. More recently, the absence of a “central bank bid” has kept Agency spreads wide even after the US Treasury bailout of Freddie and Fannie. And that in turn has pushed the US to adopt other measures to bring down long-term mortgage rates. The Fed and the Treasury are literally now buying the Agencies that foreign central banks are selling. Action, reaction …"

"“You still have a massive paranoia in the marketplace and you’ve got that safety-at-any-cost mentality,”

You can see the following behavior as sensible or over the top. From Bloomberg:

"By Matthew Benjamin and Liz Capo McCormick

Dec. 15 (Bloomberg) -- Bill Clinton was forced to abandon spending initiatives to boost the economy at the start of his presidency when advisers warned him that the borrowing needed to fund the programs would push interest rates higher. President- elect Barack Obama may not have the same problem.

While the total amount of U.S. government debt outstanding rose to $10.7 trillion in November from $9.15 trillion a year earlier, the amount of interest paid in the last two months fell by $10 billion, according to the Treasury Department.

Instead of shunning the U.S., where losses on subprime mortgages in 2007 triggered a global seizure in credit markets that led to the downfall of securities firms Bear Stearns Cos. and Lehman Brothers Holdings Inc., investors can’t get enough Treasuries. Even as estimates of Obama’s stimulus package and the budget deficit rise to a record $1 trillion, demand continues to increase as investors flee risky assets around the world and put their cash into U.S. bonds paying, in some cases, nothing in yield just to ensure the return of their principal.

“You still have a massive paranoia in the marketplace and you’ve got that safety-at-any-cost mentality,” said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee. “People are not buying Treasury bills because they think the yields are attractive. They are buying them because they are afraid to put money anywhere else.”

This Fear and Aversion To Risk and the accompanying Flight To Safety are not driven but fundamentals and clear analysis. Could these investments prove sensible? Of course they could, but the Flight To Safety appears overdone.

Why to the US?

"Foreign central banks and other institutions are accumulating Treasuries at the fastest pace since 1988, boosting their holdings 12 percent since September, compared with a 7.7 percent increase last quarter, according to the Federal Reserve.

Purchases accelerated even as the yield on the benchmark two-year Treasury note tumbled to 0.76 percent last week from this year’s peak of 3.11 percent on June 13. Rates on three- month bills turned negative on Dec. 9 for the first time. The same day, the U.S. sold $30 billion of four-week bills at a zero percent rate. Yields on two-, 10- and 30-year Treasuries last week all fell to lowest since the U.S. began regular sales of those securities.

The two-year note yielded 0.73 percent as of 2:32 p.m. in New York, according to BGCantor Market Data, after falling as low as 0.66 percent on Dec. 12.

The drop in yields drove bond prices higher, pushing returns to 12.4 percent on average this year, the best performance since they gained 13.4 percent in 2000, according to New York-based Merrill Lynch & Co.’s U.S. Treasury Master Index. The returns compare with a drop of 41 percent in the Standard & Poor’s 500 Index and average losses of 15 percent in Merrill Lynch’s broadest corporate bond index."

If you had purchased bonds with higher yields, then you would be doing quite well now, which is why William Gross wishes that he had done so.

“This is not about return and yield and value; investors are functioning out of raw fear,” said Barr Segal, a managing director at Los Angeles-based TCW Group Inc., which oversees $90 billion in fixed-income assets. At the same time, “this is fabulous for the Treasury because they are borrowing at virtually nothing,” he said.

Japan’s bond market suggests that low yields may remain for a sustained period. In an effort to revive sagging growth in the 1990s, the world’s second largest economy ran its national debt to 1.5 times of gross domestic product. Yields on Japanese bonds are near the lowest in three years, with the country’s benchmark 10-year bond paying 1.40 percent, compared with 2.59 percent in the U.S. The national debt in the U.S. is 72 percent of GDP.

“It’s good news,” said James Horney, director of federal fiscal policy at the Center on Budget and Policy Priorities in Washington. “Even though we’re borrowing larger amounts of money, the total amount we’re going to pay in interest is going to be somewhat lower.”

Why aren't the people who claim that buying Toxic Assets during this crisis and Spending Money On Infrastructure now because wages and other costs are lower, recommending that we borrow freely now for no interest?

"Interest was $92.5 billion from August through November 2007 on the $9.15 trillion in total debt outstanding, resulting in interest expense of 1.01 percent. In the same period a year later, interest was $87.5 billion on $10.66 trillion in total debt, dropping the expense to 0.8 percent.

While the median estimate of 49 economists and strategists is for 10-year Treasury yields to end 2009 at 3.65 percent, that’s still below the average of 6.91 percent paid on the securities since 1962. The security helps determine corporate and consumer borrowing rates.

Obama plans an economic stimulus package that may approach $1 trillion, in addition to a middle-class tax cut and universal health care, which may add $4 trillion or more to the national debt over 10 years, according to the Tax Policy Center in Washington and health-care economists."

So we will borrow for less?

"The U.S. already posted a record $401.6 billion budget shortfall for the first two months of fiscal 2009, which began Oct. 1, according to a Treasury report last week. The largest postwar budget deficit by the U.S. was $412.7 billion in 2004.

“The role of the deepening economic slump in this deterioration coupled with the escalating size of the likely fiscal stimulus puts the deficit on course to exceed $1 trillion,” Edward McKelvey, a senior economist in New York at Goldman Sachs Group Inc., wrote in a Dec. 8 report to clients. “This implies upside risk to our $2 trillion figure for Treasury supply.”

Clinton’s proposals to spur the economy early in his administration in 1993 were stymied by concern how bond investors would react, according to James Carville, a Clinton consultant during the 1992 presidential campaign.

“Early in the Clinton days, the hallmark of policy was if you did this, how would it affect the bond market,” Carville said in an interview last year. “Every time I would talk to someone they would say ‘you can’t do that, it will freak the bond market out.’ I said ‘goddamn, whoever the bond market is, these bastards are powerful.’”

The potential for massive deficits has done nothing to damp demand for government debt as the U.S. prepares to spend $8.5 trillion to bailout financial institutions, homeowners and the economy. The biggest deficit as a percentage of the economy was 6 percent in 1983. A trillion-dollar 2009 gap would top that.

To prevent yields from rising, Fed policy makers indicated that the central bank may buy Treasuries. Fed Chairman Ben S. Bernanke suggested in a Dec. 1 speech that he would consider such a measure, saying one option is to buy “longer-term Treasury or agency securities on the open market in substantial quantities.”

“If there is a whiff of anything getting worse, the Fed can just go downstairs and start that printing press,” said Kevin Gaynor, head of economics and interest-rate strategy at Royal Bank of Scotland Group Plc in London. “They can easily stop targeting the federal funds rate and start targeting a two- or five-year Treasury yield.”

Policy makers may also cut interest rates again, which may keep bond yields low. The Federal Open Market Committee will reduce its target rate for overnight loans between banks by a half-percentage point, to a record 0.50 percent, when it meets Dec. 15-16, according to the majority of economists surveyed by Bloomberg News.

The U.S. economy has been in a recession for a year, the National Bureau of Economic Research declared on Dec 1. The economy will continue to contract through June, with unemployment rising above 8 percent the end of 2009, from 6.7 percent last month and this year’s low of 4.8 percent in February, according to Bloomberg surveys of economists. That would make the current slump the longest since the Great Depression.

“In some ways it’s ironic,” said Meg Browne, senior currency strategist at Brown Brothers Harriman & Co. in New York. “The U.S. turned down first and the crisis appeared first in the U.S., yet people continue to flock to the U.S. government debt market because it’s the biggest and deepest market in the world and still has a low risk.”

The U.S. will eventually have to commit to balanced budgets, said Alice Rivlin, former Fed vice chairman and founding director of the Congressional Budget office.

“We can’t press our luck,” said Rivlin, now a scholar at the Brookings Institution in Washington. “Eventually, we’ve got to show the world that we are fiscally responsible.”

This post went far and wide, then wider, but the points about printing money and showing that eventually we're going to handle this debt and deficit are correct points to be made.

"An investor I know, repulsed by prevailing government yields, has a timelier description – “return-free risk”.

I'm a big James Grant fan. Here he is in the FT:

"US Treasuries are the investment asset of the year. The less they yield, the more their fans adore them. Then, again, these fearful days, yield seems to have nothing to do with investment calculation. Purported safety is all."

This is what I have called an overreaction, based on an overdone fear and aversion to risk, and the accompanying flight to safety. I don't get it, and it's killing me, because I couldn't invest in this situation even if I wanted to.

“Super-safe Treasuries”, the papers call these emissions of a government that, this year, will take in $2,500bn but spend $3,500bn. “Toxic assets” is how the same papers characterise orphaned mortgage-backed securities—or, for that matter, secured bank loans, convertible bonds, junk bonds or almost any other kind of debt obligation not bearing the US imprimatur.

“There are no bad bonds, only bad prices,” the traders used to say. They should say it again, only louder. In the spring of 1984, long-dated Treasuries went begging at yields of nearly 14 per cent in the context of an inflation rate of just 4 per cent. Those, too, were fearful times, the recollected horror being the great inflation of the 1970s. Inflation was ineradicable, the bondphobes said. Now a new generation of creditors espouses the opposite proposition. Deflation is baked in the cake, they say.

The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price. At the right price, a lowly convertible bond is a safer proposition than an exalted Treasury. Watching the government securities market zoom, many mistake price action for price."

This just seems like basic common sense to me, so I can't really judge the opposing point of view fairly. It's how I feel about Taleb. I just so basically agree with him that I can't really argue the points against him fairly.

"Yes, Treasuries might conceivably redeem the hopes of their besotted admirers. Maybe a deflationary chasm is about to swallow us all. Never before has the US been so leveraged. And—just possibly—never before were lending standards so reckless as the ones that brought joy to so many astonished mortgage applicants in 2005 and 2006."

As you know, I don't believe this scenario is likely.

"In their magnum opus Security Analysis Benjamin Graham and David L. Dodd advise that “bonds should be bought on their ability to withstand depression”. They wrote that in 1934. So far is that rule from being honoured by today’s financiers that not a few bonds—and boxcars full of mortgages – could hardly withstand prosperity. Two urgent questions present themselves. One: does something far worse than recession loom? Two: does that certain something definitely spell much lower interest rates?"

A few months ago, when Megan McArdle did her Depression Reading List, I recommended reading Graham. I got zero positive feedback.

"We can’t know, but we can at least observe. What I observe is a monumental push to reflate. The Federal Reserve is creating more credit in less time than it has ever done before – in the past three months the sum of its earning assets, known in the trade as Reserve Bank credit, has grown at the astounding annual rate of 2,922 per cent. Are the bond bulls quite sure that these exertions will raise no inflationary sweat?"

You know my position. We should reflate, and inflation will result.

"Evidently, they are—at least, forward swap rates betray no such concern. The market’s best guess as to what the 10-year Treasury will yield in 10 years’ time is 2.78 per cent, never mind the famous (and now, as it seems, prophetic) remark of Fed Chairman Ben Bernanke that the Fed could drop dollars out of a helicopter in a deflationary pinch."

They're ready to fly, fly, fly. The 10 yr situation is flight to safety well beyond the safe point.

"The non-Treasury departments of the credit markets have crashed. No surprise then that prices and values are deranged. Market makers have closed up shop for the year, while hedge funds cower in fear of redemptions. You’d suppose that professional investors – doughty seekers of value – would be combing through the debris for bargains. Alas, no. Most seem content to lend money to Henry Paulson (subsequently to Timothy Geithner) at 2 per cent or 3 per cent."

I agree. Anyone want to let me try my hand at a Hedge Fund?

"In corporate debt and mortgages, anomalies and non sequiturs abound. They are especially prevalent in convertible bonds. More so than even the average stressed-out fund manager, convertible arbitrageurs have been through the mill. It was they—and almost they alone—who owned convertibles. Now many of these folk must sell them."

Here's another reason I love Grant. He writes things like "anomalies and non sequiturs abound". He's right, and he's just used a phrase that I wish I had written. Every Buiter column makes me feel that way.

"Few buyers are presenting themselves, however, though extraordinary bargains keep popping up. Thus, at the end of October, a Medtronic convertible bond with a 1.5 per cent coupon with the debt maturing in April 2011 briefly traded at 80.75. This was a price to yield 10.6 per cent, an adjusted spread of 1,600 basis points over the Treasury curve (adjusted, that is, for the value of the options embedded in the convert, notably the option to exchange it for common stock at the stipulated rate). Contrary to what such a yield might imply, A1/AA minus rated Medtronic, the world’s top manufacturer of medical devices for the treatment of heart disease, spinal injuries and diabetes, is no early candidate for insolvency. Almost every day brings comparable examples of risks not borne by people who, in this time of crisis, have come to define risk as “anything not guaranteed by Uncle Sam”."

I tell you what. I would buy these Corporate Bonds now if I knew how. Does anybody know?

“Risk-free return” is the standard tag attached to the government’s solemn obligations. An investor I know, repulsed by prevailing government yields, has a timelier description – “return-free risk”.

That's enough. That's another phrase I agree with and wish that I'd written. Return Free Risk.

"They said that they didn't quite understand it, so I'm going to try to explain what a synthetic bond is. "

This post is going to go all over God's green earth, so put on a decent pair of shoes. Also, if you carry a shillelagh, please don't prod me. I'll move as fast as I can.

I need to first introduce a new hermeneutic rule called "Searle's Sagacity", which I learned from my teacher John Searle. I believe that he acquired it from Austin, but I'm not sure. Anyway, here it is:

If a person can't explain something simply, then they don't know what they're talking about. The only exception being Kant.

Now, there's also a corollary to this, which is that questions should be simple and comprehensible, and meant to elicit a simple explanation. This rule is constantly violated, because you have to, in effect, appear less educated than you are. Most people find this one a bit rough, preferring to ask questions that demonstrate that they know more than the person being questioned.

Here's another rule, not so pleasant for me. It's called Hardy's Harangue. It's not really a harangue, but, since it's a bit rough on me, I'm giving it the flavor or taste of overdone:

"There is no scorn more profound, or on the whole more justifiable, than that of the men who make for the men who explain. Exposition, criticism, appreciation, is work for second-rate minds. "

Frankly, I'll take being a second-rate mind. Since my blog is based upon exposition, don't expect any first-rate thinking on it. But you didn't, in any case, so no problem here.

If you want to blame people for my "compulsory mis-education", although I chose to go to college, you can blame John Searle, Hubert Dreyfus, Gregory Vlastos, George Lakoff, Bernard Williams, and Paul Feyerabend. Actually you can't, since they were excellent teachers.

Williams, Vlastos, and Feyerabend have passed on, but Searle, Dreyfus, and Lakoff, are still with us, thankfully. Williams and Vlastos were wonderfully kind and decent human beings, who tolerated my presence out of pity, probably, besides being geniuses. Feyerabend and I had a different relationship. He was never, actually, my teacher, since I eventually dropped three courses of his that I started. The final straw was when he claimed that Wittgenstein knew nothing about math. My feeling was that, even if true, it shouldn't be pointed out. Even though never truly his student, I had innumerable hours of conversations with him, that involved mutual criticism bordering on insult. Nevertheless, we got along very well over a long period of time until his death.

Most people remember the ending of The Brothers K where Alyosha tells the boys to remember this moment, in order to have it as a reference point to guide them in their lives. Something similar happened to me with Prof. Vlastos. When I was tossed out of graduate school, I went by his office to see him. I was feeling sad, but also elated, because I had been very unhappy in graduate school. Professor Vlastos told that he was very sorry that this had happened, and that he didn't think it was good for philosophy, since I reminded him so much of Walter Kaufmann. Now, even if he had said this just to make me feel better, it still means more to me than anything that has ever been said to me about myself. Once Gregory Vlastos has compared you to Walter Kaufmann, you don't really care what anyone thinks about you. This kind of moment is important for all of us, because it helps protect us from the vagaries and vicissitudes of human life. Even though I'm melancholy by nature, this moment is with me always. Hoorah For Vlastos! And Walter Kaufmann has had a huge influence on my life, which I might talk about someday. As an aside, the Gargoyle Of Emerson Hall was Prof Dreyfus.

This leads us to Felix Salmons explanation of Synthetic CDOs. Here it is:

"Over the past few days, two very smart people have asked me about a passage in Michael Lewis's cover story for Portfolio in which he talks about synthetic CDOs without actually using the term. They said that they didn't quite understand it, so I'm going to try to explain what a synthetic bond is. Once I've done that, the Lewis passage should be a lot more comprehensible."

I have to admit to not liking the Lewis piece, precisely because I didn't feel that he did a decent job explaining these investments. I did a previous post on his post.

"Let's start with a simple single-credit synthetic bond. You're an investor, and looking at the credit markets, you see that IBM debt is trading at attractive levels, especially around the 5-year mark, where they yield about 150bp over Treasuries. You'd really like to buy $100 million of IBM bonds maturing in five years, but IBM isn't returning your calls (they have no desire to borrow money at these spreads), and there aren't any IBM bonds with exactly the maturity you want. What's more, even the bonds with maturities nearby are illiquid, and closely held: there's no way you can just blunder into the market and buy up that many bonds without massively skewing the market, since the overwhelming majority of the bonds are just not for sale."

Why do you want these IBM Bonds? Do you know something special about IBM?

"So you buy a synthetic IBM five-year bond instead, taking advantage of the much more liquid CDS market. Essentially, you take the $100 million that you were going to spend on IBM bonds, and you put it into a special-purpose entity called, say, Fred. (In reality, it'll be called something really boring like Synthetic Technology Invetments Cayman III Limited, but Fred is easier to remember.) First, Fred takes the $100 million and invests it in 5-year Treasury bonds."

Fine. You've created an artificial IBM bond for yourself. Good for you. Game over?

"Next thing, Fred goes out and sells $100 million of credit protection on IBM in the CDS market, using the $100 million of Treasury bonds as collateral. The buyer of protection will pay $1.5 million per year (150 basis points) to Fred, and in return Fred promises to pay $100 million to the buyer in the event IBM defaults, less the value of IBM's bonds at the time. The buyer knows that Fred is good for the money, because it's already there, tied up in Treasury bonds."

The answer is "no", because Fred has to go out and sell these things. Here's my question: Doesn't Fred have to believe that there's a demand for his product in order to sell it? So, whose going to buy insurance on IBM bonds? And why? See, I'm sensing that Fred has an agenda here beyond mirroring unavailable IBM bonds. Are you?

"So long as IBM doesn't default, you get not only the $1.5 million per year from the buyer of protection, but also the interest on the Treasury bonds. You wanted to buy IBM bonds yielding 150bp over Treasuries, and that's exactly what you're getting: the 150bp from the CDS counterparty, and the Treasury interest from the Treasury bonds. At maturity, assuming IBM still hasn't defaulted, you get your $100 million back, the CDS contract has expired, and Fred has no contingent liability any more."

It's like an insurance transaction, including premiums.

"The effect is identical to holding an IBM bond -- and you can even sell your interest in Fred, just like you could sell an IBM bond. If IBM defaults, you lose your $100 million, but you get back the value of an IBM bond -- which again is the same outcome as if you'd bought an IBM bond for $100 million and IBM defaulted."

Should you sell these things it is. Otherwise you just own Treasury Bonds.

"But the key thing to note is that IBM itself is not involved in the transaction at all. It doesn't matter how few bonds IBM has issued, there can be many times that amount in synthetic IBM bonds, just so long as there are enough people out there willing to buy and sell credit protection on IBM."

Actually, IBM is involved, because you might have an influence on their bonds and stocks. You just didn't buy a bond from them, although, since a bond is a loan, I don't see why they couldn't accomodate your enthusiasm to loan them money.

"And just as you can create a synthetic IBM bond, you can create a synthetic bond portfolio, made up of credit default swaps on any number of corporate names or even mortgage-backed securities. The special purpose vehicles in those cases sometimes sell protection on a lot of different names; sometimes they just sell protection on a liquid CDS index. Either way, the returns that those vehicles offer are basically the same as the returns on buying the underlying securities -- if those securities were easily available."

Okay. We get the "pro" argument. Liquidity and efficiency of capital.

"Now that we've understood all that, we can return to Michael Lewis's piece, where he's talking about a chap called Steve Eisman, who was buying protection in the CDS market, and is sat at dinner next to one of his counterparties, who was selling protection.

Whatever rising anger Eisman felt was offset by the man's genial disposition. Not only did he not mind that Eisman took a dim view of his C.D.O.'s; he saw it as a basis for friendship. "Then he said something that blew my mind," Eisman tells me. "He says, 'I love guys like you who short my market. Without you, I don't have anything to buy.'¿"
That's when Eisman finally got it. Here he'd been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren't enough Americans with shitty credit taking out loans to satisfy investors' appetite for the end product. The firms used Eisman's bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn't create a second Peyton Manning to inflate the league's stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. "They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford," Eisman says. "They were creating them out of whole cloth. One hundred times over! That's why the losses are so much greater than the loans. But that's when I realized they needed us to keep the machine running. I was like, This is allowed?"

What Eisman is saying is that there were mortgage-backed securities, and then there were synthetic mortgage-backed securities; when the banks ran out of actual MBS to sell to investors, they sold them synthetic MBS instead. And yes, that was allowed."

They created products to fill the demand for a sold out product.

T"here is some hyperbole here, though. While there were undoubtedly a lot of synthetic MBS issued, they weren't a large multiple of the real MBS issued, as the "one hundred times over" quote would suggest. Which is quite obvious, if you think about it: there weren't a lot of people like Steve Eisman willing to short the MBS market -- and you need them, to take the other side of the trade."

Yes. The other side of the trade is actually the issue. Who's buying these things? And why? What's the demand being filled?

"In fact, most of the synthetic MBS issued were issued by banks which kept the underlying mortgages on their own balance sheet. Rather than put the mortgages directly into a CDO and sell that to investors, they kept the mortgages themselves and bought protection from the CDO on them -- creating a synthetic CDO which mirrored (and which they could sell to hedge) their own holdings. Why did they do that? That's the story of the super-senior tranche, and will have to wait for another day."

They keep them on their own sheet, which allows them lower capital requirements for the other tranches they sell. They also make more money by divvying the bundle up, and selling it in parts, as well as fees.

Here's my comment, which didn't get answered:

Posted: Nov 29 2008 11:11pm ET

"So you buy a synthetic IBM five-year bond instead, taking advantage of the much more liquid CDS market.'

What's your fascination with IBM bonds? There are lots of bonds out there. Does this investor have some special knowledge?

"Next thing, Fred goes out and sells $100 million of credit protection on IBM in the CDS market, using the $100 million of Treasury bonds as collateral."

Fred's motives are somewhat clear to me, in the sense that you've explained what he says his interest in these IBM bonds is. But whose the buyer? Someone who actually owns IBM bonds, and wants default protection? Or someone who doesn't like IBM's chances? Surely someone needs to feel they need this default protection before they purchase it? In other words, when Fred looks at IBM, since he's creating a product to sell, doesn't he need to have seen some reason for assuming that there's a demand.

By DonthelibertarianDemocrat

Basically, the points I made above. I think that the motive for a product is more important than the product. But Felix has descibed a product without telling us where the demand comes from. In order to mirror the IBM bonds, Fred has to Sell a Product.

Now, Robert Waldmann comments on Angry Bear:

"Given this story about the use of CDSs, I understand why Felix Salmon is convinced that they are not financial WMDs and why he is so angry that AIG was allowed by counterparties to issue CDSs without posting collateral. I also think that the story is very different from CDS reality.

Over at his blog, I asked Felix Salmon three questions

1) Why wouldn't interest rate swaps serve just as well ?

2) Why set up Fred when Fred's assets must be worth more than Fred's liabilities so there is no obvious point limited liability 100% share ownership of Fred.

3) Also if 100% collateral is posted, how can the notional value of CDSs be greater than the US national debt ?

After the jump, I explain why I find these questions challenging."

Now, these are interesting questions, but they are still technical. Who is Fred selling his product to? And why?

"1) If I want to be long IBM bonds and Own Treasury bonds I can make a synthetic IBM bond with interest rate swaps can't I ? I think the cash flows with my counterparty are exactly the same, if neither of us goes bankrupt. Thus, I think that the immense popularity of CDSs must be based either on bankruptcy law (related to the super senior tranche ?) or on accounting standards and capital requirements, or both. "

Well, here he's correct. It's the capital requirements. But that only explains the seller again, and is frankly what Felix said that he was going to explain.

"2) Why set up a a special purpose entity. I mean that has to cost something. They are set up for a reason, either to limit liability or to make balance sheets look better. "

The reason is more fees and lower capital requirements. Yes, it does cost something, which is why you have to sell it. Again, the buyer?

"3) Clearly not every dollar in CDS was collateralized 100% by US debt. There isn't enough US debt. I think it must be true that most were only partially collateralized. AIG might be an extreme case, but I think it just must be true that CDSs were used to leverage up and not just to synthesize bonds."

Correct. But here again, Felix will probably explain that next. My problem is still there's no good explantion of a simple transaction involving buying and selling, supply and demand, the basics.

"OK now my efforts at answers. Remember I am very ignorant and mostly guessing."

Join the crowd. At least Felix answers you.

"On bankruptcy law, you have to realize that it's not your father's bankruptcy code.
Bo Peng explains

Generally speaking, in bankruptcy code, derivatives counterparty claim[s] can go right through Chapter 11 protection and force liquidation. Chicago Fed in fact had a research paper in 2004 (thanks to Seeking Alpha reader emrald) analyzing the original rationale behind and the unintended consequences -- cliche of the month? -- of this exceptional treatment of derivatives.

oh my.

I think this means that if Fred's parent (I'll call it Zeke) goes bankrupt, Fred's counter-party gets to grab the T-bills and no bankruptcy court can stop it. This would not be automatic from the definition of CDS, but Zeke and Fred's counter-party would both benefit from writing the contract that way."

I don't see it quite the same way. They can force liquidation, but other claimants, taxes, for example, could preceded their claims.

"Now if equity in Fred is counted as one of Zeke's assets and Zeke has a binding capital constraint, a fast one has been pulled. These assets are not part of the pool split up among creditors in the case of bankruptcy, because Fred's losses (value of collateral minus value of the CDS) go 100 cents on the dollar to the counter-party. Also if equity in Fred appears on Zeke's balance sheet, then Zeke's creditors may be mislead. If they assume that all equity in special purpose entities is quite likely worthless now, then a whole lot of crisis can be explained."

Surely these people know the law, otherwise they wouldn't use it. I don't see the evidence that someone is being fooled here.

"Clearly not all CDSs were used to make sythetic bonds. For one thing Lehman brothers had liabilities including CDSs on its balance sheet (OK its 10-Q report). For another they were listed at fair market value which was vastly below notional value until recently. Now it seems to me clear that if firms can goose their equity to debt ration they will and clear that CDSs are very useful for that purpose so long as they are not 100% collateralized. "

That's the plan.

"I'd guess that Fred wouldn't own Treasury securities equal to 100% of notional value, but rather a lower ratio with a trigger that if the market price CDS reached ninety something percent of the value of the collateral, the collateral could be seized immediately. This means Fred could suck money out of Zeke or Zeke would have to lose 100-ninety something suddenly. Now a totally unexpected actual default would not be insured by Fred (which would go bankrupt). That is, this use of the CDS market would be to take opposite bets on the CDS price, not to insure risk. But, I mean we know that was going on."

If that's the law. I'm not sure how these CDSs are being used in his example. He seems to believe that bets on this company's viabilty take precedence over actual debt obligations of the company. I simply don't know the law.

If IBM defaults, the CDSs will work out independetly of IBM, between the Insured and the Insurer. The CDS in Felix's example are completely independent of IBM. They're simply tied artificially to its fate.

But Waldmann asked some good questions.

Here was Felix's response:

"Posted: Nov 30 2008 11:49am ET

Hi Robert -- I really was just trying to explain synthetic bonds, not anything about the larger CDS market. And synthetic bonds are really a very small part of the CDS market.

I'm not sure how you could possibly create a synthetic IBM bond using interest-rate swaps alone -- where would you get the credit-risk component from?

As for Fred's structure, it's worth remembering that these are synthetic bonds we're talking about here -- and the whole point of a synthetic bond is that it can be bought and sold in the secondary market, just like a normal bond. You can't talk about "Fred's parent" because no one ever needs to know who Fred's shareholder(s) might be.

By Felix"

So, my bottom line is that neither the post by Lewis or Felix Salmon really explained the problem. What people want to know is why people buy them. In this explanation, they seem to be creating a product without a clearly defined market, which doesn't make sense. I'm not saying that either doesn't know what they're talking about, but that explanations are much harder to construct than many people believe because they involve, not simply knowing something very well, well enough to simplify it, but also being able to explain it clearly.

So, I'll keep Hardy's Harangue, although I think explanation much harder to accomplish than he seems to believe. And I'll keep Searle's Sagacity, even though a person who knows a subject very well can have a hard time explaining it simply.