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Reducing Risk Budgets Leaves More For Everyone Else


The stock market came into the day a trifle weak after a miserable Japanese GDP number overnight (is there any other kind of Japanese GDP number?) forced investors to confront the possibility of another front in the war against global recession. Economists had been looking for 2.3% annualized; they got 0.4%. That’s a miss!

The indices weren’t off very much, but bonds on the other hand were very well bid. While the S&P floated around unchanged for most of the day and ended there, the 10y yield fell to 2.57% as the September 10yr Note contract rallied 20/32nds. Moreover, interest rate volatility was also up sharply today.

It is odd that the stock market seemed so sedate when the rates market was moving significantly and seeing a sharp rise in options premia. This suggests that the phenomenon in rates is not global macroeconomic in nature, but more centered on rates space (if stocks go bananas tomorrow, I may have to edit that statement of course). On the one hand, it could be a positive sign if the surge in implied volatilities and in bonds was caused by mortgage servicer activity. In the “old days,” before the economic crisis began, movements in rates occasionally took on a life of their own when mortgage portfolios extended (in a selloff) or prepaid (in a rally), causing servicers to sell more in a selloff and buy more in a rally. When we would hit an inflection point in rates, it would also tend to trigger a volatility rise.

This would not be awful news, on some level. Prepayments are generally caused by refinancings, and the refi market has been pretty dormant for a while because credit has been scarce (it is hard to refinance if no one will extend you the loan at the new rate). The chart below of the Mortgage Bankers Association Refi index shows that activity has been picking up recently although it remains well below the standards of previous refi waves.

Refi index is showing some life - not lots, but some.

However, in mid-August that could be enough especially when you combine it with another fact: banks, under directions to constrain their proprietary risk-taking operations, are less likely to serve the market-smoothing function they have in the past. Historically, the big refi waves would leave dealer casualties because the size of demand was huge and the direction known to all – so if you were just lifted on a yard (that’s $1bln) of 1y10y swaptions or 10y swaps, it was very likely that the guy you are meeting in the broker market saw the same flow and he is likely to prefer to buy with the flow rather than sell to you (moreover, he probably is still trying to lay off his risk as well). The net result would be big rate movements in short periods of time, usually associated with vol spikes.

These moves would be exacerbated when they happened in November or December, because some dealers had fiscal year-end in November and others in December, so the aggregate trading liquidity was smaller due to shrinking year-end risk budgets.

The problem now is that risk budgets are being seriously constrained, partly by rule, whether it is year-end or not. I don’t know if this is really the beginning of a significant refi wave (indeed, I’m a little skeptical because I think credit is still pretty scarce), but if it is then rates may quickly go lots lower. Less liquidity means this will happen more often too, by the way.

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A friend who doesn’t like me to sleep much, apparently, sent this link to a story (and video) on Yahoo! Finance. In the story William Black (at one time he was associated in a senior capacity with the Federal Home Loan Bank Board, FSLIC, FHLB-San Francisco, and Office of Thrift Supervision) claims that the FDIC is letting banks skate by as solvent when they know that with an accurate assessment of the assets there would be many more insolvent banks. Black claims that the FDIC doesn’t have remotely enough money to pay for such a disaster – that part isn’t news; we all know the FDIC doesn’t have the funds and most of us feel it’s pretty likely the FDIC will need (and doubtless will get) a bailout at some point. It is an interesting argument that the FDIC is delaying that point as long as possible (a bailout would surely be easier in December than in October!) by ignoring banks that would otherwise be insolvent. You can read the article/see the video and assess Black’s credibility for yourself.

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Tuesday’s data includes PPI (Consensus: +0.2%/+0.1% ex-food-and-energy), which is especially irrelevant in months when it follows CPI; Housing Starts (Consensus: 560k from 549k); and Industrial Production/Capacity Utilization (Consensus: +0.5%/74.6%). The latter is likely to be reasonably strong because of the heat wave that swept the country in July, so be sure to look ex-utilities.

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