Of Haircuts and Helicopters

By: Michael Ashton | Thu, Jul 28, 2011
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Bonds shrugged off somewhat-upbeat economic news and stocks managed to fade late in the day. As bullishly as the equity market was behaving two weeks ago on bad news, it's now behaving bearishly on good news.

Initial Claims came in nearly 20k better than consensus (although there was a slight upward revision to last week's figure), tossing a 398k figure onto the screens at 8:30ET. Two out of the last 3 weeks have been below the 420k line, and it's probably the case that the underlying trend is improving modestly. Whether 380k or 400k or 420k, though, it isn't anything to write home about and other measures of labor market health - notably the "Jobs Hard to Get" subindex of the Consumer Confidence survey - continue to look poor. Labor is a lagging indicator, sure - but it is unusual for it to lag this much, this far into what most economists would call a recovery.

The Administration made a play late in the day to get an equity rally going, by leaking the news that "The U.S. Treasury will give priority to making interest payments to holders of government bonds when due if lawmakers fail to reach an agreement to raise the debt ceiling." Well, duh. Anyone with a sharp pencil can see that there's enough revenue to pay the interest on the bonds, and the military, and social security, and a few other things as well. I haven't yet seen an apology from anyone for the scare tactic of threatening to not send Grandma her Social Security check, which I presume is prioritized over, say, the National Endowment for the Arts.

It is somewhat scary that the Administration felt the need to leak such "news;" it implies that they are starting to think there is a pretty good chance that a debt ceiling deal doesn't get done, or at least doesn't get done before the markets melt down. Tomorrow is the next-to-last trading day before the August 2nd deadline, so prepare to go into the weekend not knowing. Will investors on Friday bet that there will be a deal announced over the weekend, and so go home long? Or will they bet that there will not be a deal announced, and so go home short? Or will they have some common sense and go home flat? (Don't put money on the "flat" bet.)

It also seems increasingly likely that Treasury debt will be downgraded by one or more of the agencies. I have noted a number of times here why that's nonsense: the Treasury can always replace interest-bearing notes with non-interest-bearing notes called dollar bills, regardless of the debt ceiling. Therefore, the only reason the U.S. would ever default is because it just doesn't want to pay. But no issuer is creditworthy if it simply chooses not to pay - the rating is supposed to evaluate only the ability to pay and as long as the U.S. controls its own printing press there will always be a 100% ability to pay.

I find the gnashing of teeth over the downgrade in the 'borderline humorous' category. I think it mainly affects Americans in the ego department. The Wall Street Journal today said "Still, it's hard to grasp a world in which the one security regarded as 'risk-free' is rated lower than the government debt of Austria, Denmark, Finland, the Netherlands and Hong Kong (all AAA.)" Really? Is it that hard to grasp that people incorrectly regarded something as risk free that isn't? It isn't like that hasn't happened in a while. Home-ownership and 'stocks for the long run' spring immediately to mind. Besides, nominal debt is never risk-free, because it is exposed to inflation, so it's the "regarded as" that is the error here. TIPS are the true risk-free instrument (or as close as one can get) in the U.S., and TIPS do not have competition from Austria, Denmark, Finland, the Netherlands, or Hong Kong. Maybe we can finally dispense with the idea of nominal Treasuries as the risk-free instrument, which is a Ptolemaic view of the fixed-income heavens anyway. Let's start calling them Treasury Inflation-Exposed Securities, which is after all what they are.

Now, fortunately most of Wall Street (the people who should know because they talk to all of the investors) finally seems to agree that a downgrade from AAA to AA (which, by the way, would be a large single-downgrade move - be prepared for a rally if it's just AAA to AAA- or AA+) would not cause most investors to sell Treasuries. Double-A is still very good and it is very rare to have a mandate that distinguishes between really-good credit and really-good (but not quite as good) credit.

One place where people worry is that in principle, a downgrade could cause dealers to require larger "haircuts" on Treasuries used as collateral. For the non-initiated, a "haircut" is when your dealer says you can only borrow, say, 95 cents against an asset that is worth one dollar. In general, a haircut is larger the higher (a) the volatility of the collateral's price; (b) the illiquidity of the market the collateral trades in; and (c) the difficulty of assessing the value of the collateral. A dollar bill receives no haircut. A T-Bill receives very little haircut, maybe 1% or less, because its price is highly stable, the market is very liquid, and it is very clear what the value of the collateral is. A long Treasury bond receives a larger haircut, because its price is more variable even though the market is liquid and the price clear. A corporate bond gets a bigger haircut still, because it is more variable, the market for any particular credit is less liquid, and a structured corporate bond on the same name, compared to a bullet bond, gets an even bigger haircut (at least in principle) because it is less clear what the price really is.

So will haircuts change on U.S. Treasuries? I don't see why they would, since (a) the market shouldn't be any more volatile (in the medium-term, anyway), (b) the market will be just as liquid and (c) just as transparent. Remember, the question for a haircut is "how fast can I sell it at receive something close to the marked price?" If the price changes, then the collateral may be worth less, or more...but the haircut percentage shouldn't change just for that reason.

Now, there is one ex-theoretical reason that haircuts might change, and that's because a downgrade would give dealers an excuse to change haircuts on their clients. This is a dangerous game, because it would decrease the leverage available to hedge funds and would force some position unwinds - not just in Treasuries, but in all kinds of asset classes where risk positions are collateralized by Treasuries (that is, all of them); moreover, if the customer repo haircut changes then there will be pressure on the interbank haircut to change. Since dealers rely on the leverage afforded by being able to use their bond inventory as collateral, this would force dealer leverage to decline, causing some unwinds and by-the-way reducing further the future ROE (one element of which is the financial leverage used).

In the worst case, a change in repo haircuts could cause a significant unwind of long Treasury positions, driving interest rates higher and - as a side note - leaving dealers with lots of cash and lots of reserves rather than lots of bonds and lots of reserves. The latter configuration is positive carry; the former is flat carry and increases the incentive to lend these funds (especially as rates would be rising). Perversely, then, we could get higher rates but also an expansion of credit and the attendant inflation pressures, simply because Treasuries are less valuable as collateral. This would be good for an inflation consultant/trader/advisor (ahem) and good for the small business that can finally get credit, but bad for everyone else.

Let me highlight that that's the "worst case." I doubt that haircuts on Treasuries will change, even with a downgrade, unless dealers are just looking for an excuse to squeeze more collateral out of clients.


A good friend who writes a daily note I'm lucky enough to receive made a very insightful point tonight. He said, and I echo him, that it's important to remember that the market can only be preoccupied on one point at a time; as soon as the debt ceiling deal is sealed, the markets will start focusing again on the European mess. Or, I would add, on the CMBS mess.

The Commercial Mortgage-Backed Securities (CMBS) market has been tagged as the 'next disaster' by many observers for quite some time. We have become all-too-familiar with the risks of issuing high loan-to-value mortgages to unqualified homeowners in a real estate market downturn. Well, the same thing happens in the commercial world, although there aren't really any 'no-doc' or 'liar' loans. The problem is still that high LTV mortgages were made on properties that are now worth much less.

This is one reason, I think, that CMBS issuance has been so heavy recently - dealers have been trying hard to limit their direct exposures as much as possible. The hammer has not yet come down, but there are some signs that it is hovering. Today Citigroup and Goldman withdrew a $1.5bln CMBS offering after S&P said the transaction would not get the rating that Citi and Goldman expected. Now, the firms could have added some more credit enhancements and gotten the deal to the rating needed, or raised the interest rate it was packaged to, but then investors in other CMBS deals would start (and probably already are starting) to question why their CMBS deal doesn't have that yield. Pulling the deal is a curious move that either says the rating was way off or, possibly, that some investor group was willing to buy the whole thing without the rating.

But if it was for the latter reason, I don't think the head of Citigroup's CMBS group and the head of Goldman's CMBS group would have both resigned this week. Indeed, if there is a lot of money still to be made there, it would be weird to see either guy resign, much less both of them. Keep a watchful eye on CMBS headlines in the near future! This would be a surprise that isn't, really, a surprise except for the timing.


Tomorrow, we get a slew of economic data. The 2nd quarter ECI (Consensus: +0.5% versus +0.6% in Q1), and GDP (Consensus: +1.8%, +0.8% personal consumption) will be released at 8:30ET. The Chicago Purchasing Managers' Report (Consensus: 60.0 vs 61.1) and NAPM Milwaukee (Consensus: 56.9 from 59.3) will come out at 9:45ET and 10:00ET, respectively. There is also the revision to the month's Michigan Confidence figure. But the real point of the trading day is what happens going into the weekend (which is also the month end). I have no real feel for what is going to happen, so I will maintain my current, conservative, stance.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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