 Bond
Convexity From Mortgages
Jim Willie
CB
Jim Willie CB is the editor of the "Hat Trick
Letter"
Jun 22, 2007
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The cancer that is mortgage
bonds does not linger in isolation. Everything in the bond world
is connected to almost everything in the bond world, at least
within the US sphere of speculative madness. The financial credit
market is a confusing jumble of speculation, risk reducing hedges,
and leveraged insanity found mainly in the hedge fund arena.
Mortgages are causing problems from their bond hedge schemes,
both on the loan portfolio side and the bond security side. Always
one should consider both, and never are they inseparable. The
only separable aspect is who the loser is nowadays. Negative
convexity dictates the sale of bond futures in the absent midst
of cash flow on the portfolio side, and in hedge book management
of losses in the securities (bond) side. The mortgage debacle
might be finally hitting the US credit market on a wider scale,
despite the claims of no contagion made by corners bereft with
common prostitution. Heck, abject liars, carnival barkers, shell
game artists, and self-interested promoters might be a better
description, so as not to insult prostitutes who offer a worthwhile
honest service in the oldest but illegal profession in most societies.
A hidden force is this convexity, alluded to by astute bond market
students and observers with eyes trained on the Chicago pits.
The deception offered is that
the USTreasury Bonds are rising in long-term interest rates because
of stronger imminent economic growth. The opposite is true, the
reality, the harsh foul breeze founded in unwanted facts. Why
the shallow reporting? Because to identify the bond convexity
would reveal how it is lined up to deliver a lusty vicious circle
of blows likely to inflict round after round of nasty blows to
the bond market. The story of stronger growth implies good continuity
of corporate earnings, what Wall Street wants you to incorrectly
believe. The reality is especially ugly when one notes that
borrowing costs are every bit as important as commodity and energy
costs for corporations. Falling borrowing costs were the
primary driver of the 1990 decade-long stock bull market. Rising
borrowing costs might be the main story for the next two years,
during the Great Unwind of the Bond Bubble. The other big story
is the global revolt against the USDollar and USTBond vehicles
which carry the US$ license plates, halted at border crossings.
That is not the focus here with this article
THE PURPOSE OF BOND HEDGES
If a mortgage lender
has a mountain of mortgage loans in portfolios, the firm will
want to hedge against the FALLING interest rate. Believe it or
not, a lending institution is harmed by falling rates, since
their interest yield income is reduced by bond held, and since
lower interest income is integrated within the newer contracted
mortgages. A refinance is actually a major headache for lenders,
closing out a contract and replacing it with one promising the
lender a lower return on the loan. The smiles at the loan originator
office are connected to the origination fee earned, NOT the lender
dealing with turnover.
So the lender will match the
loan portfolio, dollar for dollar, with a similar volume of USTBonds.
A falling bond yield scenario will hurt the lending business
side from business losses, but benefit the hedge in the form
of long USTBond futures from contract gains. Some firms less
prone to the wild side will work with actual USTBonds on the
cash market. However, since much less money is required on the
futures contract side, most tend to deploy leveraged futures
contracts, figuring they are smart and nimble enough to walk
through raindrops. They also impress management by diverting
a smaller amount of valuable corporate funds in the hedge, deemed
efficient. The hedge is rate neutral, thus the name of 'hedge'
associated. Hedge funds long ago were hired to eliminate risk.
Over time, typical of US insanity, hedge funds decided to sell
accounts in the management of gigantic leveraged risk games which
dwarf casinos. The world's largest casinos are located in New
York City (Wall Street, NYMEX) and Chicago (COMEX). The entire
USEconomic financial system can at times be depicted as a hedge
fund, rising the fortunes with high leveraged contraptions. The
victims are little things like your pension fund or life savings
or sale of an asset held for most of a lifetime.
Things go wrong when interest
rates rise. The lending institution sees the worst of both worlds,
instead of a neutralized state of affairs. Their loan portfolios
suffer delinquencies (reduced immediate income), defaults (assured
reduced future income), and foreclosures ($80k loss per property,
no more income forever). Their bond hedges go into leveraged
losses. A typical USTB contract involves 30-to-1 leverage. So
a 5% loss on the bond principal (in held asset or underlying
derived asset) can wipe out the entire initial quantity devoted
to the hedge. The loss from the 108 level to the 105 level constitutes
almost a 3% loss suddenly. Given the leverage (remember the EFFICIENT
hedge), the hedge has been just about wiped out!
To compound the problem, the
lack of new loans hurts the cash flow. The thin volume of
refinances also hinders the cash flow. The lending firm needs
cash to fund its operations. The salvage process of hedge
sales can help to raise valuable cash. That is the source of
the VICIOUS CIRCLE though. The unwinding process aggravates the
situation tremendously. Everybody loves the leverage when it
pushes rates down, like it did in 2003, 2004, 2005. Those days
are over. Next comes the hangover from the Greenspan Animal House
drunken bacchanalia celebrated as banking policy management.
His only brilliance was leaving Dodge City and handing Sheriff
Ben the bag. The effect of this latest round will be further
bond hedge sales soon, which take long-term rates toward 5.5%,
then toward 6.0%, perhaps higher. Should rates meander up to
the actual consumer price inflation 10% rate?
The next few months will see
continued horrendous stories about panicky collateralized bond
sales. Reports emanating from Bear Stearns dominate so far. They
are called isolated, until they become undeniable in their systemic
nature. Look to hedge fund blowups also. They are the primary
knuckleheads in the bond speculation game gone bad. They really
should be required to don propeller hats when showing up at the
office, especially when meeting with clients.
THE VICIOUS CIRCLE
As bond hedges are
sold, leverage applies to lift long-term interest rates. In
the single week of June 15th, the 30-year fixed mortgage rate
rose 20 basis points to hit 6.74% in a punishing blow. The
10-year USTNote bond yield rushed toward 5.25% and 5.30%, urged
higher by European markets, dampened lower by US markets the
next morning, day after day. The microcosm is the bond market.
Its extension is the stock market, greatly dependent upon the
low bond yield to encourage investment in stocks which promise
higher earning yields of return than bonds. The macrocosm is
the USEconomy, where consumers retrench, where corporations rein
in capital expenditures, and not incidentally, where lending
institutions go bust and shutter operations. Get back to me when
the only bankrupted such firms are the subprimes. What a lie,
one in a long list of lies, and if not pure deception, then shallow
analysis. The participants in hedge schemes are all across the
entire financial sector, from small and medium and large banks
and mortgage firms, to small and medium and large banks and capital
management firms.
Each quantum step up in long-term
interest rates generates a new round of business decisions, to
assess the effectiveness of the bond hedges, to rejigger the
actual hedges still on the books, to judge the needed cash flow,
to make urgent decisions for survival of businesses, and to plan
for lawsuits against broker dealers on Wall Street. The VIRTUOUS
CIRCLE a few years ago saw steps in what were called 'new rounds
of refinancing' by Secy of Inflation Sir Alan (Magoo) Greenspan,
chief alchemist and designated charlatan, protector of bankers
and scheister to households, mythology spokesman of politicians
and shylock to homeowners. NEXT COMES THE VICIOUS CIRCLE, whose
end is not determined. In the first couple weeks of June,
we finally saw the TNX move above the 5.0% mark, which will surely
serve as the new support level for long-term bond yields. The
TNX resistance is at 5.25%, which when exceeded, will lead to
a surprising and gut-wrenching move to 5.5% or higher in the
long-term bond yields.
Remember, economists and financial
firm analysts do not care about correct forecasts. They strive
to produce credible forecasts, the basis for promotional programs,
glossy leaflets, and advertisements stated during media interviews.
They do have nice dresses and suits. That is why they continually
shift their story to focus on the next half of the year. They
perpetuate their errors, managing credibility, doling out the
lies.
The degree of risk to lenders,
both in portfolios and collateralized bonds, is enormous. Risk
has never been so great in bonds since 1973, 1974, 1975. That
is the onliest similarity to that 1970 decade in my book, as
the commodity story is the exact opposite. Demand drives higher
prices in this decade, whereas OPEC demanded higher prices back
in the 1970 decade. The common thread to the contagion spreading
across bonds is the lax lending across numerous classes of loans
to numerous types of borrowers. Here is an example of the depth
of insanity, which continued into 2006. In the last calendar
year, over 40% of California first-time buyers used no down payment
in the purchase of their new nestegg homesteads, as in 0% equity
out of the gate. Across the state, among all home buyers, over
21% used 0% down payment loans. The lenders associated, and the
bond holders who were suckered into investing in related tranches,
they will be even more pressed to hedge their acidic investments.
Let's not even touch upon the mortgage resets. Is it painfully
clear that the bond bubble spawning the housing crisis and mortgage
debacle has numerous facets???
THE BANKERS STOCK INDEX
Convexity in hedged
risk management produces leveraged bond futures sales, doing
great harm to bankers. Their chief operation is not lending,
but gambling, errr speculating at trading desks, managing the
arbitrage game in the Wall Street and Chicago casinos. The distress
in the BKX banking stock index only begins to tell this story.
This will continue. They finally will have a chance to lend at
long rates and borrow themselves at short rates, enough to provide
an actual profit margin. For two years, this group has reported
heavy lending losses, huge trading gains, and solid net profits.
Their story is in the process of profound change. The BKX index
is struggling mightily to stay above the 50-week moving average.
So far it is faring relatively worse than the overall S&P
stock index, as shown in the June report posted for the Hat Trick
Letter. Note the rounded top and breakdown in progress.
Bankers will be forced to report
losses from lending operations, since their loan loss reserves
are woefully inadequate. As the proportion of loans tied to
real estate grew versus overall loans, they decided to devote
a piddling amount, less each year in fact, to loan loss reserves.
As realized losses come to a boil (imagine a kettle with water
or a blemish filled with puss), look for more loan loss reserves
from funds set aside, doing great harm to corporate profits.
Bankers have taken hefty stock options, just like the rest of
the white collar bandidos, reluctant to set aside much lately.
To do so would have reduced stated earnings!
USFed Chairman Bernanke threw
a wrench in the entire bond engine works. His message in early
June was quite clear. No official interest rate cut is likely
in the foreseeable future. One can quickly infer that the
USFed will defend the USDollar, not housing. The problem for
the USFed is that housing will enter the next phase of decline,
and take the USEconomy into an undeniable recession. The
immediate problem is the bond market modification. With no rate
cuts coming, the bond market has been forced to adjust on the
low-end maturities in direct response to a slower economy. Forecasts
probably changed overnight to anticipate some continued USEconomic
slowdown without the needed stimulation. Rising long-term rates
were addressed, at least the confusing elements identified, in
last week's article. Bonds throughout the entire USTreasury spectrum
must adjust to a more salty reality. The story not properly
reported is how short-term interest rates are actually coming
down, ADDING to pressure on the US Federal Reserve to cut official
interest rates.
HEAVY COLLUSION FROM RATING AGENCIES
The mortgage bond world might not be so easily contained through
vested interest collusion. The ratings agencies (Moodys, Fitch,
Standard & Poor) and broker dealers have a wink system to
prevent debt downgrades, with tremendous conflict of interest
at work. These three firms are sitting on their hands or
asleep on the job, in a vise of their own relationships. They
have failed to respond to delinquencies and foreclosures which
have a direct bearing on collateralized bond performance. Big
downgrades might be imminent, just around the corner. Delinquencies,
defaults, and foreclosures in recent months have seemed not to
matter to the price structure of asset-backed bonds such as mortgage
bonds, to the mystery of many experts. Income from loan performance
is vividly clear. The collusion is ugly. The vested interest
of ratings agencies is obvious. They do not receive full payment
for services if their customers deem the ratings to be unfair.
Or is it they don't pay out if the agencies do harm to their
clients or their issuance process? Even the rating agency heads
are making disclaimers, as they deny their impartiality and any
charter for disclosure.
The big banks are unloading
damaged mortgage bonds to their hedge fund clients. They are
doing so quietly, probably at heavy discount, with the assured
purpose of preventing big declines in the bond principal value.
Such cuts in price do not see the light of day, observed by the
public or most investment circles. These acidic mortgage bonds
are being levitated in value, as their owners seek suckers to
buy them before the rating agencies lower the boom. My guess
is the agencies will be told when to issue the cascade of debt
downgrades, only when the banker customers give the green light
on finding hapless pension funds and mutual funds to buy the
garbage. Bear Stearns is on the campaign trail trying to pitch
their acidic assets to the institutions. They are junk bonds
masquerading as high grade investment grade bonds. The key here
is maintain investment grade, so that large institutions are
kept from selling en masse. That event is certain.
SYSTEMIC RISK & USDOLLAR &
GOLD
The risk so deeply
engrained within mortgages seems finally to have crept into USTreasury
Bonds. Since USTBonds are no longer acting in a contained fashion,
the vulnerable mortgage bond holders are reacting. All the above
problems have an additional dynamic to deal with, that being
mortgage bond holders react to their own situations. The claim
of no 'CONTAGION' from the mortgage debacle is pure poppycock
propaganda drivel denial nonsense. The avenues of contagion are
too numerous to cite. The effect of higher long-term rates
has created a vicious circle, whereby mortgagors and owners of
mortgage backed securities react again and again to higher further
rising long-term rates, selling more USTBonds and their derivatives.
There is the key word, credit
derivatives. These heavily leveraged instruments are connected
to everything, as described in the May Special Report for HTL
readers. There is no need for a 50% annual rise in credit derivatives
if all things are placid, within normal bounds, all well on the
bond front. Things have already begun to unravel, and soon things
will noticeably appear to unravel above the surface. THIS CREDIT
DERIVATIVE RISK SEEMS BADLY MISJUDGED BY BERNANKE AND THE ELVES
AT THE USFED. They have been minimizing the threat for over a
year like either idiots or amateurs. JPMorgan and Goldman Sachs
are keenly aware of the threat, since they manage the upside
down pyramid of derivatives. My conjecture is that JPM and GSax
are active agents in the convexity trades to sell their mortgage
hedges placed in USTBonds, along with Fannie Mae & Freddie
Mac. The Wall Street firms are on the job selling bonds and related
futures contracts. Morgan Stanley has already warned its clients.
They assess that the US housing slump is far more serious than
widely believed. They expect a potential full-scale global crisis,
since US mortgage bonds and Fannie Mae bonds are so widely held
among foreign banks. The US might not export much, but inflation
and acidic bonds surely are exported in droves.
Higher interest rates do attract
more investments. That is the USGovt story on stability claims
for the USDollar. Corporate earnings are slowing down, the exact
opposite of the Wall Street story. They promote the story to
claim that rising earnings will offset rising bond yields which
affect stock valuations. They overlook that borrowing costs are
an integral portion of the corporate cost structure. Rising interest
rates are the important phenomenon, rendering stocks overvalued,
delivering shock waves.
As interest rates rise, investments
find gold, lifting gold demand. The reality of 10% consumer price
inflation is not properly told. That is the reality, as explained
by the Shadow Govt Statistics folks, who eliminate gimmicks and
chicanery from statistical calculations, whose motive is truth
and not painting a deceptive rosy picture. The conflict of interest
in almost every conceivable USGovt agency is staggering, obvious,
and a grand undermine.
GOLD HAS THRIVED IN ALMOST
EVERY PERIOD WHERE LONG-TERM INTEREST RATES RISE. This time is not much different. The
primary risk pertains to liquidity drains, the sea pulling water
away from shores, and accidents sure to demand asset sales in
times of emergency to desperate funds, both hedge fund and institutional
players. As the banking crisis continues, gold will thrive.
Recall that 40% of all US bank assets are related to mortgages.
The USDollar will be repeatedly tarnished with a brush, enough
to make it fade below the critical DX=80 support. As the credit
derivative crisis continues, gold will thrive. A systemic problem
is gradually becoming obvious. As price inflation and general
systemic risk become more clear, gold will thrive.
Foreign USTreasury Bond holders
have two risks. Their bond principal is falling, tied to rising
bond yields. The USDollar translation has been damaging in recent
years, and in recent months. The claim of higher long-term yields
attracting foreign investments is true ONLY for new bond issuance.
Given that current foreign ownership is a million times larger,
this is an empty truism. Gold is prepared to rise in the second
half of this year, during its favorable season. The main storm
cloud on the golden horizon is the planned sale of 250 tonnes
of gold bullion by the corrupted Swiss National Bank, once a
paragon of discipline, wisdom, and leadership. They plan to dump
this gold in the many months up to 2009 in what they describe
to be a currency reserves adjustment. One can only wonder what
the powers that be, or the Euro Central Bank, offered them in
return. Perhaps a bigger seat at the table.
Thanks to Joe Martin and the
Cambridge House staff for another fine gold & metals conference
in Vancouver (HongKouver). What a pleasure! What a great gang
of people! What excellent speeches, the most memorable to me
being by Frank Holmes and Rick Rule. Good chocolates too, but
not enough eye candy!
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Jun 21, 2007
Jim Willie CB
 Jim Willie CB is the editor of the "HAT
TRICK LETTER"
email: jimwilliecb@aol.com
Willie Archives
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Jackass
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Trick Letter
Jim Willie CB
is a statistical analyst in marketing research and retail forecasting.
He holds a PhD in Statistics. His career has stretched over 26
years. He aspires to thrive in the financial editor world, unencumbered
by the limitations of economic credentials. Visit his website
at www.GoldenJackass.com. For personal questions
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