The Bear's Lair: When bond bubbles burst

By MARTIN HUTCHINSON   |   June 21, 2004 at 11:38 AM

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.

Low short term interest rates also helped the home mortgage market, where records were repeatedly broken in the area of mortgage refinancing. Each refinancing meant a profit to the homeowner, a corresponding loss to the holder of the mortgage, and a fee to the agent for the refinancing. Consequently, in the short term, it was a very profitable business, for both homeowners and agents, with the losers being only those poor few benighted souls who had bought mortgage bonds believing with Andrew Mellon that they provided a steady income.

The Mellon approach to bonds is alas outdated, and has been outdated since President Franklin Roosevelt outlawed gold clauses in 1933. Since that date, the value of the dollars that a bondholder gets repaid depends entirely on the monetary policy of the Federal Reserve, whether it allows inflation or deflation. In practice, therefore, bonds have become a one way sucker bet; as we saw in late 2002 any even remote prospect of deflation (and it was never more than a very remote prospect) sends the Federal Reserve into paroxysms of money printing in order to restore the natural inflationary order of things, whereas inflation, insidiously devaluing the holder's principal (a devaluation for which he does not even get any tax credit) can get quite high before the whistle is blown.

Bonds have thus become a very different investment to what they were in the 1920s. Whereas before 1933 investors bore the risk of moderate changes in real interest rates (similar to those that have sent the price of the Vanguard Treasury Inflation Proof Securities bond fund up from $10 to $12.33 in the four years since its formation in March 2000) swings in long term bond prices can now be orders of magnitude greater than this. This can of course work to an investor's benefit; a buyer of a 30 year Treasury zero coupon strip in early 1982, at a yield of 11 percent or slightly more would have achieved a return of 13 percent per annum compounded in the period 1982-2004, more even than he would have obtained by investing in the Standard and Poors 500 Index, in the biggest and longest stock market boom ever.

The long bull market in bonds has in particular benefited those financial institutions which bet heavily on bonds on a leveraged basis. If bond yields decline more or less steadily for more than 20 years, short term interest rates will hardly ever be above long term rates, and then only for a few months at a time. This means that banks, traditionally the largest investors in government bonds, and what Wall Street analysts have termed "giant hedge funds" such as Goldman Sachs will almost certainly make money, year in year out, by borrowing at short term rates and investing in high quality long term bonds.

All the banks' highly paid bond traders are an irrelevance, simply skimming the high returns from the shareholders into their own pockets; the dirty secret is that the trading is simply noise and a "borrow, buy and hold" strategy would work just as well and be much cheaper to implement.

Even when the carry trade is only marginally positive, or marginally negative, bondholding banks have been able to offset any carry losses by realizing capital gains on bonds they have held for several years. The only year of the last 20 in which that strategy didn't work was 1994, not coincidentally the year of several hundred-million-dollar blowups in the bond market and its evil twin, the derivatives market.

Market participants and watchers under 45 will have forgotten, but it was not always thus. In 1980, the First Pennsylvania Bank managed to go bust through investing in government bonds (plain old vanilla ones, too, not agency or mortgage backed securities.) It built up a large government bond portfolio in the late 1960s through the mid 1970s, at yields of 7 or 8 percent, and then watched in horror as short term rates soared above 15 percent, long term rates went above 10 percent, the value of their portfolio declined and their capital base disappeared. They were unlucky in having regulators who looked at their balance sheet using the new-fangled "mark to market" basis, in which the actual market values of even long term assets are checked to ensure that enough capital remains for the bank to be solvent.

Many savings and loans, blessed with regulators still working on a historic cost basis, emerged from the 1980-82 interest rate peak with negative capital, on a true balance sheet basis, although of course their balance sheets didn't show this and the regulators were careful to gloss over this deficiency as they certified them seaworthy. However, had the underwater S&Ls just carried on after 1982 with their traditional business, borrowing short term and lending long, they would gradually have earned their way out of this problem, as the 20 year bond bull market took hold.

Unfortunately, two developments, the Garn-St. Germain Act of 1982 and the invention of the interest rate swap allowed them to diversify beyond home mortgage lending, and to match assets and liabilities. Needless to say, their diversification disastrously failed and the elimination of their interest rate gap risk was carried out at precisely the moment at which the gap became consistently profitable.

In the current market, the moderate rise in long term interest rates since last year has caused bond prices to drop, but not very much, and any capital losses on the portfolio have easily been covered by the continuing, even increasing (as the gap between short term and long term rates widens) carry income. However, if the Fed is forced by rising inflation to start raising short term interest rates, this will quickly change. For one thing, once the Fed tightens to fight stirring inflation it will have to raise short term rates quite a long way; estimates last week from Fed governors about where the "neutral" federal funds rate would be varied between 3 percent and 5 percent, both well above the "2 percent by the end of the year" modest tightening that the market expects.

My estimate of the "neutral" federal funds rate in a 2 to 3 percent inflation environment is at least 5 percent. In any case, even if inflation rises no higher than 2 to 3 percent -- and I believe a rise to the 5 to 6 percent range is already "baked in the pie" -- to remove it from the system, a neutral short term interest rate isn't enough, you have to tighten further. Any tightening of this order would put the gap gravy train into reverse, and produce substantial carry losses for all its passengers.

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.

Interest rate risk on long term bonds is heavily asymmetric -- inflation can go up ad infinitum, but deflation causes central bank panic and corrective measures. Credit risk is equally asymmetric; you can never do better than get repaid in full. For these reasons, bonds are a bad investment, for gentlemen or anyone else, except in those rare periods like the early 1980s when real interest rates are high, monetary policy is tight, and credit standards are austere.

Expect some financial sector default fireworks going forward!

(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, June 2004) -- details can be found on the Web site greatconservatives.com.

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