Reply #34: The Bear's Lair: When bond bubbles burst

[54anickel]

http://www.upi.com/view.cfm?StoryID=20040618-032512-6704r

WASHINGTON, June 21 (UPI) -- "Gentlemen prefer bonds" responded Treasury Secretary Andrew Mellon when asked his opinion of investing in the 1920s stock market bubble. Well not today they don't, if they've got any sense.

The bond market has been the principal prop of most of the financial services industry since 2000. Just as income from investment banking activities took a precipitous drop, at the end of 2000, the Federal Reserve began to cut short term interest rates to historically unprecedented levels, currently 1 percent for federal funds, providing a large "carry" whereby you could borrow in short term markets and buy long term Treasury bonds, locking in a profit of 3 percent per annum or more, which may not sound much but is pretty juicy when you're allowed to leverage the position 15 or 20 times.

This allowed the major banks to write off a high proportion of their bad loans, incurred during the bubble years -- banks made billion dollar write-offs on such borrowers as Enron and Global Crossing, and still managed to report record profits for the year in which the write-offs were made.

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If a bank tells you it can hedge this interest rate risk in the derivatives markets for swaps and options, don't believe it. Particularly don't believe it if it is a participant in home mortgage lending, let alone Fannie Mae or Freddie Mac themselves. The price risk on holdings of long term bonds can be hedged, it's true. So can the gap risk between short term funding and long term assets, although almost nobody does hedge this risk since it's been profitable for the last 20 years. However, the duration risk, from home mortgages being refinanced if rates drop but not if they rise, has never been hedged successfully, because models predicting the pattern of refinancings are highly inaccurate. In addition, whereas a mortgage lender's losses when rates drop from early refinancings are easily matched by its profits from refinancing fees, the losses on below-market interest rate mortgages stuck in its portfolio for 30 years have no corresponding match -- holders of mortgage bonds have at that stage turned themselves into 1970s S&Ls.

Even more unhedgeable is credit risk, which increases as interest rates rise, borrowers find it more difficult to service their debt, asset markets cool and asset prices decline. While you can on-sell credit risk to a third party, the overall volume of credit risk cannot be hedged away, it just lands on the insurance companies or whoever has bought the credit risks.

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