Shares of Freddie Mac are soaring today, up more than 20 percent right now. The rise is being attributed to Freddie’s success in selling $1 billion of three-month and $1 billion six-month notes in a weekly auction, which has supposedly eased fears that the government sponsored mortgage company would have trouble financing its ongoing operations. But today’s debt sales may not be the endorsement of the financial health of Freddie Mac from bond investors that many believe it to be.
The pricing on Freddie Mac’s three-month notes was about 90 basis points more than similar-maturity U.S. Treasuries. The spread on the six-month notes was about 92 basis points. Last week the spreads were 61 basis points on the three month notes and 80 basis points on the sixth month.
The big boost of confidence in the shares, however, seems to have come from the fact that there were more bidders this time around, or at least bidders seeking more of the Freddie notes. Of course, the higher pricing is attractive to some bidders. But there may be a more technical and less transparent reason for the increased demand.
We don’t know who bought the Freddie notes today. But buyers of Freddie notes who have access to borrowing from the Federal Reserve would have found the decision to bid relatively easy. That’s because the ability to exchange the Freddie debt for Fed cash means banks can buy Freddie debt with a huge amount of leverage, dramatically increasing the return on their capital.
Here’s how it works. A bank that bought the six month notes from Freddie this morning could also bid to borrow from the Fed’s Term Facility, which held an $75 billion auction today. As collateral for the borrowing, the bank could offer the newly purchased Freddie notes, for which the Fed would give them credit for 97% of their market value. Recently, the TAF pricing topped out at 2.35 percent for 28-day borrowing. So a bank buying $100 million of Freddie paper yielding 2.858% could flip it to the Fed, borrowing $97 million at around 2.4% (assuming the pricing will be slightly higher this time around).
At the end of the day, a credit desk could buy $100 million of Freddie debt for just $3 million down. On that $3 million, the desk would receive a 17.7% annualized return, or 8.8% over six months, for paper that is thisclose to being explicitly backed by the Treasury Department. Not a bad deal at all.
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Change by to buy in the fourth paragraph please.
Otherwise very good article John, but I bet you don’t get as many comments…
either are really bad mistake or sheer desperation.
or the bazooka in the pocket.
@1: Thanks for the edit. Change made. On comments, I expect you are right. Especially with the great shirt debate raging.
[This was Carney, by the way. For some reason I'm logged out of my own website.]
At least somebody could comment on whether this actually works… Especially the pricing assumption?
Excellent take, Carney. I’d be curious to know how many clicks this gets.
Brilliant.
IRR is actually higher…I calculated at 17.7% versus 16.7% on annualized basis.
Definately works IF fed accepts your collateral and rates don’t move on you but at the spread, I have no doubt this is being done. It is a nice thing to have access to fed funds.
@8: You’re right. Just re-ran it and got your number. That’s what we get for doing math in public. Thanks!
Our tax dollars at work. Can’t wait to pay that bill again come April.
nice one carney
So brilliant I though timmmmmay may have written it
@10 – You actually pay most of it every paycheck, so probably this Friday you can do your part in recapitalizing the banks.
Luckily it only costs taxpayers about $350k net of taxes per $100m of the strategy so it pales in comparison to other things your going to pay for in the coming months like say, $100bn for FRE/FNM.
Interesting. Any penalties, stigma attached to TAF borrowing that would introduce some friction in this trade?
No stigma…people are doing it:
http://www.federalreserve.gov/monetarypolicy/20080825a.htm
couldn’t you use the same agency paper in a commercial repo transaction? would the economics be any different?
Can’t borrow at the rate from repo market. Same idea…not the same economics.
wtf? since when is Freddie paper explicitly backed by the treasury?
Give it two weeks
@18 – its not, but by putting the freddie paper up as collateral and receiving explicitly backed funding in return you have effectively made the freddie paper explicitly backed by the treasury. You are buying the riskier paper that is implied to be backed by the us gov and using it to get money that is explicitly backed by the us gov and making money on the risk premium between the 2 paper issuances. . .
@18 – I was just going to say something to the same effect – people assume there is an implicit guarantee or minimal risk.
Just ask the BSAM fund managers.
Of course, this is an excellent way for the banks to force the implicit guarantee to become explicit. Put on this trade in volume and raise fears of “global financial meltdown” should the guarantee/bailout not materialize.
yes but what john says is not accurate. phrased like that, an investment manager would get sued by his clients.
Timmy? As if.
You know what they say about positive carry. I wiill say that that this ‘trade’,if you can call it that, is not taking place. I don’t know if you guys remember, but there’s still a credit crisis. The dealers that have access to the TSLF have a limit of schedule1 (agy/agymbs) and schedule2(pvt lbl, cmbs, aaa abs, agy cmos), 5bln per 28day operation. There are no 3mo tslf operations, there are 84 day TAF operations. Assume on a biweekly schedule, going over a given month-end(bangbros and lehman bros report month end #s) you can have a max of 20bln (4operations 2 of each schedule). Sounds like a large # but i can assure you that most large dealers hold a lot more than 20bln in tslf eligible collateral. Otherwise we wouldn’t be in a credit crisis. And in order to accomodate this 20bln of fed tslf you are going to box out your normal sources of funding (i.e. asset managers, mmkt funds…)this guys are helping you fund non-tslf eligible collateral, so you don’t want to piss them off. So while the dealers are being helped out, i don’t think any agy/dn cash trading desk is getting clearance to buy fnma/fre paper from the Repo trading desk that control the balance sheet and access the tslf. Good thinking, but we’re not all morons, stick to blogging.
I guess you also should bake in a parameter to deal with refinancing risk – you are short term borrowing to buy a long term asset. What if the world looks different in 28 days and you need to pay the FED back and rates went up – you’re negative on the trade.
Now you need to get rid of (some of) the paper to maintain capital ratios, everybody was doing this trade so high supply / low demand -> prices go down.
No guts no glory, of course, but there’s more to it.
- ari
I will add, that i was fibbing when I said this trade was not taking place. Trading desk had been putting this trade on in limited sizes into december. They were taking issuance at the discount window at 2.80 and executing a repo-to-maturity at 2.35,repo market having a strong bid because of TSLF. A foreign based dealer,on of ze germans, was the lead behind trying to execute this trade in large sizes 4-5bln as opposed to 300-500mm. Lets just say that in an environment where your hedge on credit risk might not pay off, no responsible dealer wants to be the guy that lays off all this gse risk on the GSCC. managers quickly put an end to this trade. The funny thing about all this is how socialistic(or at least cooperative) wall st seems to become when the shiz hits the fans. No one wants to be seen as taking advantage of the fed/tsy.
layman’s terms, 24/26?
24/26 here. There’s a credit crisis. Balance sheet is the most precious asset on wall st. Even thought the TSLF is a balance sheet free transaction, you can assume that over balance sheet reporting dates the auctions are being used to fund EXISTING inventory, or held as insurance in case your liquidity is pulled so you can protect your balance sheet. The people at top would be very pissed if a trader was padding his PL with a carry trade while they are looking for ways to sell $30bln cdos for $5bln. Moreover, it seems that while wall st. has a short memory with regards to risk, it has a long memory with regards to who the date rapist at the party are. That is why no one shed tears at bears passing. that is why when cioffi’s funds couldnt meet their calls no one gave them breathing room. You dont want to be the guy arbing the fed/tsy.
@28, In the league tables I have access to (Prime Broker hard numbers), some/majority of the funds are running 80% cash or more now… The current market Vol has pushed them to the sidelines… The Equity boys are hiding…
What are the real bank desks running that you know of, as a % of typical size? Can anyone put on any major trades these days with the balance sheets so trashed at every major bank player?
I am hearing rumors that fixed income (corp) is at its worse in the last 6 months, paper that is not UST and on the run is not moving. Its more then just the average last week of August, third stringers on the phone shit…
The deleveraging still has a ways to go over all, but it appears that allot of the street already has deleveraged and its a waiting game now…
Thoughts or comments to share?
29 here again,
The PB book I am referring to is a referring B/D to GS E&C, so obviously not a major book but still an interesting list of 9 and 10 digit funds, some famous, to see on the sidelines…
The most interesting part was how many different types of funds are on the sidelines… no one was taking real risk in this market…
Its a traders dream market, and an analyst’s nightmare…
@24/26/28
1) This trade is definitely happening
2) There are a lot of banks (even those with access to window) that are fucked. No, wait, not just fucked, seriously fucked.
3) You talk about balance sheet, etc. but, at the end of the day, if one fails, everyone fails…
4) The derivate contracts that your firm has (through hedging, speculative investment, taking counterparty risk for a mark-up, etc.) will be your end. Taking 1 to 2% margin on derivative contracts was a terrible idea. What are you going to do when your counterparties can no longer post collateral to maintain the trade?
The end game: What will happen is that the internal “risk” systems will start to fail. You had hedged xyz asset with abc counterparty contract but, unfortunately abc counterparty is SOL and you can follow the asset through bankruptcy but I guarantee your recovery will not be adequate to hedge your assets.
how did you calculate the return on this trade? simple question, but i want to understand this better
I have no means of knowing whether this trade is actually being done, but if traders see a way of making money they are likely to do it. It would probably take a very explicit “no you’re not going to do this” from the top floor to make them refrain from it. After all, a guy’s got his bonus to think of. Any idea what mistresses and Maseratis cost these days?
@32: 3MM*17.7%=100MM*2.858 – 97MM*2.4
How long will people tolerate such a massive raid on the Treasury by the big banks? It’s outrageous that this is even legal.
@35
Grow up and welcome to the ugly side of capitalism. Quit bitching you bimbo.
@35 lol – yes government handouts are a critical part of capitalism. Sounds more like Soviet central management to me
bill gates has been accepting suggestions on a web sit as to how we can improve our economy.
http://creativecapitalism.typepad.com/
your post regarding buy freddie paper with fed leverage is a must read for bill gates if he wants to understand how capital is wasted in american AND how the most powerful people and the brightest minds are wasting resources playing paper games to “create” wealth this is phony economy.
mock turtle
This is not an arbitrage. First of all, the agency paper is longer maturity. You could also borrow from the Fed at 28 days and buy 30-year treasuries. You also make money doing this over the 28 days. As long as you can refinance your borrowing at 2.3% you keep making money. But when the Fed raises rates you might end up at negative carry. So there is interest rate risk.
There is also credit risk. If the agencies get downgraded, you suffer a capital loss. If they default and are not saved, you are screwed. I mean, what stop at agencies. Go buy Countrywide debt and get an even higher return. It is the usual risk versus return tradeoff.
Plus FNM and FRE have a risk weighting of 20% so they add to risk-weighted assets and affect capital ratios. If you buy GNMA securities, there is zero risk weight so that is closer to an arbitrage.
@39 – pretty sure you can’t use Countrywide debt as collateral . . .
31 i will say, yes the trade is happening but not in the volumes you’d think. Moreover, its the point of my last post was to express, without divulging too much information (lest i get canned for posting on dealbraker, but shit my stock is worthless anyway), that while SOME dealers are executing this trade, most aren’t. Not because it’s not an easy way to make a buck. But because dealers are face with an existential crisis, it’s not the type of environment where you’re as worried about your PL. First, if you do have the benefit of expecting a huge PL based bonus in 2008, its probably cause youre at an aggressive, liquid hf, you WONT find balance sheet. And if youre not at such a hf but at a dealer, you’re not going to get paid anyway, so why set a high bar in 2008 that you wont jump in 2009. Just show team spirite. Firm first. Haven’t you heard, there’s a credit crisis. Have fun on quarter end.