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Trade of The Day: Buy Freddie Paper With Fed Leverage

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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.