Wednesday 07/02/08 ... Session-Ending Recap

Risk Aversion and Position taking abound.  The "leash" we spoke about earlier and actually ended up being a hot topic of conversation among insiders today.  Some of the Mega-Dealers as well as analysts at several of the data firms either commented on, or released their own data supporting my "leash" assertions from this morning.  Of course this is not a coincidence as they are looking at the same phenomenon I am: spreads have blown out so wide that the net yields on MBS are predicted to be too good to pass up tomorrow AS LONG AS there is not a market event that introduces unforeseeable levels of risk aversion.

I understand that the "leash" analogy as well as some of the more technical talk surrounding it today may be a bit esoteric for some.  Indeed, these are facets of the industry that most loan officers have never experienced and, for the most part, never WANTED to.  But if you grasp the impact it might have on your workflow, you may decide that you NEED to understand them.  If we are committed to being as educated as possible about the forces surrounding price movements, making an effort to wade through the technical jargon and abstruse concepts of the trading strategy reports released by the major financials begins to make more and more sense. 

So, at times, especially when we are introducing a new abbreviation or jargon term every minute, and switching topics to things we've never heard of before, this could be a bit overwhelming when all some of us want to know is: "should I lock or not!?"  Rest assured my fine friends, that the basic morning briefings and mid-day updates should not change.  If more abbreviations or jargon is introduced, it should always be accompanied by the legend at the bottom of the "At A Glance" post each morning.  More importantly, we're not happy unless you're happy so we will always make adjustments based on feedback (unless everyone else disagrees with you!). 

So back to the intermediate concept for the day...  If you want to go home early, no one's stopping you.  And if you want to stay after hours and join this discussion, you are welcome and encouraged.  Some day (perhaps some day soon), you MAY even have the ability to participate in this discourse in a forum where current blog topics can be discussed, thus allowing for other sets of experience and expertise to have a voice and opinion.  But I digress, back to the "leash."

Hopefully, we are all "trackin'" now when we talk about MBS being a "spread" product.  All this means is that MBS are a fixed income investment, like other bonds that have a price and yield, and that yield is higher than a risk-free benchmark (virtually) which, on this planet, is the Uncle Sam Special, AKA treasury bill.  So there is a SPREAD between these two products which allows investors to earn a higher potential RETURN in exchange for the higher RISK associated with potential default, prepayment, or extension (mortgage holders stay in the loan LONGER than the investor wants...  Especially troublesome when they have a 5% loan and the market has risen to 7%) of mortgage back securities.  In a world without default or consumer variability, all mortgages would return a predictable amount, and all homeowners would sell or refinance in the average amount of time.  In that world, mortgages would be about 2% lower in rate because there would be no reason to create incentive for risk that didn't exist. 

Bottom line, yields must rise with risk, so we have "spread" product in the form of MBS (and many other securities).  Much of what you don't see in terms of MBS price action, and indeed much of what CAN'T be seen until it's too late is eternal question put to investors on a daily basis: "Will you go with zero risk and buy treasuries, or will you go with an uncertain amount of additional risk and get the MBS in exchange for an extra couple points of yield?  Oh and by the way, we are just emerging from the worst mortgage meltdown in history, and oh yeah, also, the assets that secure those mortgages are in the middle of their sharpest slide since the great depression.  Here's your login to the trading software...  Good luck!"

This question, sarcasm included, is at the very heart of our leash analogy.  Treasuries are analogous to the "master" and MBS are analogous to the "dog."  The leash represents the spread which USUALLY can be thought of as having a relatively fixed range.  This is why we made the leash a simple 10 feet long.  Once that "dog" lags behind the master at distances approaching 10 feet, the forces exerted on the dog are very likely to keep him from lagging behind any more.  In other words, the spread (leash) would have gotten so wide (taut leash), that investors will be tempted to start buying MBS simply because the yield in excess of what treasuries are paying is too much to pass up.  The reason we give the leash from the analogy a little bit of elasticity is that the spread range is not a hard and fast rule.  If there is the proverbial "plate of bacon" placed behind the dog while the master is walking forward (think of the bacon as a mortgage meltdown perhaps?), it's possible the dog will try, even at the expense of its own neck, so hard to get that bacon that the leash might stretch a bit more, and the gap between him and his master will widen further (spread gets even wider because mortgages are even riskier so investors demand even more yield before buying them).

Ok, 10 minute break for punch and pie, and I'll see you all back after the break.

All back now?  We're almost done, I promise.

At any rate, now that we are (maybe?) getting a more internalized understanding of how the analogy of the leash relates to MBS spread, today's events and previous recommendations are a bit (maybe?) better understood.  Basically, our dog is tugging on the leash about as hard as it can.  From what looked like an already "taut" spread position this morning, MBS even added a few ticks to that spread here and there throughout the day, so much so that several analytical disseminations from analysts working at the billion dollar companies came out in support of MBS by the end of the day for the same reasons we argued MBS would find support.  Again, it's not that the author is a miraculous visionary, but rather, I know a dog being drug kicking and screaming 10 feet behind his master when I see it.  Insiders and I discussed this Phenomenon at the close yesterday, so I had a hunch that sentiment on "the street" was heading in the same direction.

NOW!  This is not a guarantee by any stretch of the imagination that rates will improve.  NOR is it any sort of guarantee that spreads will shrink.  It is simply a strong and well-supported opinion that spreads should not only hold steady, but that there is motivation for them to tighten due to the excellent buying opportunity that will present itself if the world doesn't blow up tomorrow.  I reference the catastrophic event for an important reason.  When the turmoil meter is high, simply moving from equities to fixed income positions is not enough risk-evasion for some.  They want to move their money all the way to the safest haven of treasuries. 

We'll often refer to this capital migration from risk to safety as "FTQ" or flight to quality buying.  It may often share a slot in a phrase with the word "bid."  In this case, bid refers to the general level of bids coming in for a particular reason.  So if tomorrows caption were to read "FTQ bid going to treasuries, MBS bid missed the morning train," we would know that the risk evasion buyers were buying treasuries as opposed to MBS.  This was the tenor today as things are so shaky that money continues to flow into treasuries even when MBS are ALREADY a bargain buy.  It is a very good sign that we discussed that this morning and the "big boys" are now saying the same thing in their internal memos.  It means that if tomorrow can keep from hitting us with news that takes the "risk nausea" to undiscovered highs, at least we will know that MBS will find some support from spread buyers (investors looking for relative value afforded by the wider spreads).  So if the NFP is bad tomorrow, it could be good for us.

Well folks, that's about it for today.  Let's phase out the written word and leave you with some pretty pictures.  Well, there's no "pretty" here.

 Here's the curve for today:

and here is a little perspective on that damage by looking at the curve over a 2 day period:

All in all, not too bad, especially when you consider that we have one of the most important reports of the month occurring on a Holiday weekend 3 days into new quarter.  Wow!  Talk about money being pulled off the sidelines in the past few days...  If we get big variations in numbers tomorrow, we could get slammed.  The great thing about our leash analogy is that if we get slammed for worse, we'd likely take a much smaller hit than treasuries, and if we get slammed for the better, our old friend inflation will likely keep treasuries from moving down in yield as quickly as we can.  Either way, it should be a fun one.  See you bright and early!