Anything-but-Treasuries Credit Gaining After AIG Death in China 2009-09-07

By Liz Capo McCormick Sept. 8 (Bloomberg) -- Wall Street’s biggest bond dealers are loosening their grip on U.S. government debt at a record pace, signaling a continued rally in credit markets. Holdings of Treasuries by the 18 primary dealers of U.S. government debt that trade directly with the Federal Reserve fell to a negative $10.5 billion last month -- a so-called net short position -- from a record net long of $93.6 billion in June, according to data compiled by the central bank. The fastest turnaround since the Fed began tracking the data in 1997 shows dealers are purchasing and financing higher- risk debt even as investors express doubt about the economic recovery. Dealers typically place bets against Treasuries to hedge corporate and mortgage bonds, and net short positions averaged $63 billion in the 10 years before the collapse of subprime home loans caused credit markets to freeze in 2007. “It’s money going back to work again in some level of riskier assets,” said Donald Galante, the chief investment officer and senior vice president of fixed income at New York- based MF Global Ltd., the world’s largest broker of exchange- traded futures. “Panic has receded and you are in a more normal world, with dealers starting to take on a little bit more leverage. They are taking on some inventory in the corporate world and hedging with Treasuries again.” The two-month decline in net positions was interrupted last week, as net longs rose to $16.2 billion. The amount remains almost 60 percent below the weekly average this year. Increased Lending Fed data also show dealers, which include Goldman Sachs Group Inc. and Bank of America Corp., are lending more to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since 2007. They held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6. The jump suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia, or Ginnie Mae in Washington. “Dealer behavior in the fixed-income market has begun to return to normal,” said Joseph Abate, a money-market strategist in New York at Barclays Capital, another primary dealer. “The collateral hoarding, most particularly in Treasuries, that dominated earlier this year has started to abate.” Obama, Bernanke While the Federal Deposit Insurance Corp. is closing banks at the fastest pace in 17 years, shuttering 89 as of last week, none have sparked a panic like the collapse of Lehman Brothers Holdings Inc. and Bear Stearns Cos. in 2008. Net short positions add to evidence that efforts by President Barack Obama and Fed Chairman Ben S. Bernanke to spur the economy are working. Obama endorsed Bernanke again last month, when he nominated him to a second four-year term while on his family vacation in Martha’s Vineyard, Massachusetts. For all the progress, minutes of the Federal Open Market Committee’s Aug. 11-12 meeting showed that policy makers expressed “considerable uncertainty” about the strength of the recovery. U.S. Treasury Secretary Timothy Geithner and European Central Bank President Jean-Claude Trichet said it’s too soon to declare victory over the deepest recession since World War II, during a meeting of finance officials from the Group of 20 nations in London on Sept. 4 and 5. Two-Year Rally Treasury two-year notes rallied last week, pushing yields down 9 basis points, or 0.09 percentage point, to 0.93 percent as the unemployment rate jumped to 9.7 percent in August from 9.4 percent in July. The price of the 1 percent note due August 2011 ended last week at 100 4/32, according to BGCantor Market Data. The bond market is signaling doubt about the pace of the global recovery. Investors pushed yields on government debt down to 2.23 percent on average last week, the lowest level since April, Merrill Lynch & Co.’s Global Sovereign Broad Market Plus Index shows. “We are heading into what we call the New Normal, which is a period of time in which economies grow very slowly,” Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., wrote in his September investment outlook posted on the Newport Beach, California-based firm’s Web site last week. “The invisible hand of free enterprise is being replaced by the visible fist of government.” Growth Outlook The economy will expand 2.3 percent next year after shrinking 2.6 percent in 2009, according to the median estimate of economists surveyed by Bloomberg. Banks tightened standards on all types of loans last quarter, and said they expect to maintain strict criteria on lending until at least the second half of 2010, the Fed said in its quarterly Senior Loan Officer survey published on Aug. 17. The amount of leveraged loans -- the kind private-equity firms use to finance company purchases -- has shrunk to $67.7 billion this year from $311.2 billion in 2008 and $962.9 billion in 2007, Bloomberg data show. Leveraged loans are rated below investment grade, or less than Baa3 at Moody’s Investors Service and BBB- by Standard & Poor’s. Net short positions reached a record $193.7 billion in July 2007, just before subprime mortgages contaminated credit markets, leading to $1.61 trillion in writedowns and losses at the world’s biggest financial institutions, according to data compiled by Bloomberg. Lehman Effect Holdings turned positive by December 2008, accelerating after the collapse of Lehman three months earlier, as the bailout of insurer American International Group Inc. and the forced sale of Merrill Lynch & Co. sparked concern the global financial system was close to collapse, driving traders to the perceived safety of U.S. government debt. Those fears have since abated. AIG, founded in Shanghai in 1919, has announced sales of some $9.3 billion of assets, including an auto insurer, an equipment guarantor and a Japanese office tower, to help repay Fed loans extended as part of the firm’s $182.5 billion bailout. AIG is soliciting bids for its Taiwan unit, Nan Shan Life Insurance Co. The company is the island’s second-biggest life insurer, with 4 million policyholders. The move back to a net short position “is a sign that dealers are better able to provide liquidity to customers,” said Louis Crandall, chief economist at Jersey City, New Jersey- based Wrightson ICAP LLC. The research firm, which specializes in government finance, is a unit of London-based ICAP Plc, the world’s largest inter-dealer broker. “This is a positive development for the market, and over time more pieces will fall into place.” Corporate Spreads Extra yield demanded by investors to own corporate bonds instead of Treasuries narrowed to 3.82 percentage points on Sept. 4, from the peak this year of 8.09 percentage points in March, according to Merrill Lynch’s Corporate & High Yield Master Index. Spreads contracted as companies sold a record $926 billion of debt this year through last week, compared with $872.9 billion in all of 2008, Bloomberg data show. The senior-most bonds backed by adjustable-rate Alt-A home loans, or those with little to no documentation of a borrower’s finances, jumped to 52 cents last month from a low of 35 cents in March, according to Barclays. Credit markets have gotten help from the Fed’s Treasury purchases, according to George Goncalves, chief fixed-income rates strategist at Cantor Fitzgerald LP, another primary dealer. To help thaw credit markets and contain borrowing costs, the central bank began buying $300 billion of the debt in March. Purchases under the program total $276.4 billion. Credit Risk “If the market was left to its own devices, it would mean much wider funding and credit spreads as we have now moved from focusing on liquidity risk to true credit loss risk, which still is plaguing the system,” Goncalves said. S&P says the U.S. speculative-grade default rate will rise to 13.9 percent in July 2010, from 10.2 percent last month, even as the economy emerges from the worst recession since the 1930s. Deutsche Bank AG analysts Karen Weaver and Ying Shen in New York forecast last month that as many as 48 percent of mortgages may be “underwater,” or exceed the value of the property, as home prices drop through the first quarter of 2011. “The actual level of yields now is consistent with a forecast for lethargic economic growth, which will be way below what we are used to in terms of coming out of recession,” said Campbell Harvey, a finance professor at Duke University’s Fuqua School of Business in Durham, North Carolina. He is also a research associate of the National Bureau of Economic Research, which determines when recessions begin and end. Money Markets Money markets are showing increased confidence. After soaring in October 2008 to 4.64 percentage points, the difference between what banks and the Treasury pay to borrow money for three months shrank to 0.19 percentage point last week. The so-called TED spread is now below its average of 0.32 percentage point this decade before mid-2007. The Libor-OIS spread, another gauge of the reluctance of banks to lend, contracted to 0.14 percentage point, from a peak of 3.64 percentage points in October. Former Fed Chairman Alan Greenspan said in June 2008 he would consider credit markets back to “normal” if the spread was 0.25 percentage point. While S&P expects defaults to rise, the number of non- financial companies having their credit ratings reduced is declining. Some 2.5 percent of borrowers outside the bank, insurance or real estate industries were cut in July, down from the peak of 6.4 percent in March, S&P said in an Aug. 20 report. “There is a lot of cash and liquidity” in short-term debt, said Derrick Wulf, a money manager who helps invest $70 billion in mostly fixed-income assets at Dwight Asset Management Co. in Burlington, Vermont. “There is plenty of confidence about the relative stability of the financial system in the short term.”