More Thoughts on Treasury Market Weakness

October 10th, 2008 10:50 am | by John Jansen |

In my opening comments this morning I launched into a diatribe which suggested that the preeminent position of the Treasury bond market was about to fade away.

I have spoken with friends and read some emails which I receive from the street and that exercise leads to a different but plausible alternative hypotheses.

To distill there thoughts, it is about a giant systemic margin call and the means to meet the margin call is via sales of liquid assets. So, the wreckage floating in the street results from those sales.

One correspondent noted that the serious damage in the mortgage market resulted from the same phenomenon and stemmed from margin calls at leveraged S and P funds that were forced to raise cash. This particular trader reported that some of those funds were mortgage sellers.

Another portfolio manager made an interesting point about the manner in which large portfolios have chosen to operate recently. He suggests that many funds have moved to private equity funds from public stock. He also notes that many had retreated from individual stocks and bonds for the glitz of hedge fund returns.

The problem there is that the new technique of management parks money in a place from which it is not extracted with ease, speed and dexterity. So the only stuff that is not nailed down and available for sale is Treasury and mortgage paper.

I still think that if we are bursting bubbles, the Treasury bubble is the ultimate bubble. But certainly this other interpretation is a plausible explanation for some of the recent price action.

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  1. 22 Responses to “More Thoughts on Treasury Market Weakness”

  2. By bd on Oct 10, 2008 | Reply

    If certain investors are tied up in illiquid assets like “Private Equity” and “Hedge Funds”, then isn’t it clear that they are selling their liquid assets like not only bonds, but also publically traded stocks?
    It seems that these guys are selling stocks because that is the only efficient market in which they can sell stuff.

  3. By fatbrick on Oct 10, 2008 | Reply

    LEH CDS is 9.75 cents on the dollar. Is this the source of the massive margin call?

  4. By jdr on Oct 10, 2008 | Reply

    John, can you comment on the LEH CDS initial results — I’d like to understand what happens after the auction — ie when do the dead bodies come out of the closet? My understanding is that this auction is just a pricing mechanism for the underlying bonds, and the real impact of who has to pay who how much is disclosed later. Is this correct?

  5. By John Jansen on Oct 10, 2008 | Reply

    i will make a call or two and see what i can dig up as i am not that well versed in the mechanism

  6. By benagyerek on Oct 10, 2008 | Reply

    hedge funds / ins cos raising cash ahead of today’s lehman payout?

    why has the dollar been rallying? a huge squeeze caused by hedge funds deleveraging in anticipation of investor outflows, margin calls and inability to refinance. so sell foreign assets and park the money in treasuries. sell the treasuries when the cash call materialises..

    i think the treasury / dollar bubble will have to burst in the coming weeks, especially once deleveraging runs out of fuel. why finance export-led growth when nobody can afford to buy your cheap exports anyway? when people figure this one out, there will be a rush for the door, and pop goes the dollar..

  7. By Milton Arbogast on Oct 10, 2008 | Reply

    Is there a comparable bubble in European government debt? Superficially, I would think not, but I also have no expertise.

  8. By Dr.Dan on Oct 10, 2008 | Reply

    What level of LEH CDS is acceptable ?

    Is 9.75 *that* bad ?

  9. By nosajio on Oct 10, 2008 | Reply

    JDR, not sure if this answers your question, but here is the schedule for today’s LEH CDS:

  10. By Guilherme Diaz-Bérrio on Oct 10, 2008 | Reply

    That means the bond holders will lose +90% of their “money”, ie, the insurance provides will have to pay up.
    (For a company of Leh size and “stature”, you would expect something between 50 to 60 of a recovery ratio, if memory doesn’t fail me)

    @ 12, I think it meant a 400 bln USD setlement to the unlucky insurance provides.

    Now, we have net open interest of -4.92bln, which means it could settle for a less.

    This is being pointed as one of the causes for the cash hoarding: no one knows which banks are going to be on line for the 400bln+ payout on Leh bond insurance…

    So, yes, it is *that* bad

  11. By yagij on Oct 10, 2008 | Reply

    Dr. Dan:

    If my understanding is correct, 9.75 is not good. For every 1 USD the vehicle had been valued, it is fetching 9.75 cents. Ideally, you would like a 1-to-1 exchange depending on the interest rate it is paying. Here, you are getting 0.0975-to-1.

    As I stated in the Jargon thread, I am rusty on my FIN classes from undergrad, but that is the gist of it (I hope).

  12. By yagij on Oct 10, 2008 | Reply

    (Edit: I may have confused MBS with CDS so I may be totally wrong.)

  13. By scott on Oct 10, 2008 | Reply

    The actual cash settlement date for the Lehman CDS is October 21, not today. Today will set the price. for more details

  14. By benagyerek on Oct 10, 2008 | Reply

    won’t protection buyers already have called margin calculated at 10c in the dollar? if so, presumably settlement default risk is minimal, as net protection buyers already received most of the settlement payt as cash collateral.

    as i understand the auction, the final settlement is done by netting out all the contracts. this means that e.g. if a hedge fund sold protection to citi, it could end up being told to pay out settlement to jpm, meaning it has to get its margin back from citi first. is this right?

    even if so, should in theory be no settlement risk net-net as all margin will be released simultaneously..

  15. By jeff on Oct 10, 2008 | Reply

    Is it a recession or a crash. Seems like the recent action has really fit the definition of crash. Found a great article on this whole situation that goes pretty well with this one. Check it out here if you’re interested.
    Wish I had started reading this guy earlier; he recommended going all cash months ago. Would’ve been spared this pain if I had seen it.

  16. By ndk on Oct 10, 2008 | Reply

    TIPS are getting crushed relative to Treasuries. Real interest rates across the curve appear to be soaring. Is that a real effect related to deflation, or is it a relic of some trading strategy?

    And it continues today…

  17. By cyclingscholar on Oct 10, 2008 | Reply

    Not to be an optimistic Pollyanna…but Tbonds AND GOLD are a bit weaker today, and neither have rallied in the most recent crisis over the levels they had earlier this year. Maybe, just maybe, this is the ‘end of the beginning’ for this crisis, at least in the sense that flight to low risk/inflation hedges is concerned?

  18. By The Second Last Samurai on Oct 10, 2008 | Reply


    Rising interest accelerates deflation of housing market, which leads more deflation. I believe the long side of interest will fall back again, like I observed in Japan. (or your dad might have witnessed in 1930’s.)

  19. By benagyerek on Oct 10, 2008 | Reply


    i think i understand how the process works now.

    this auction determines the final price affecting all bilateral cds contracts, and therefore the cash settlement payment from protection seller to protection buyer. the final price is 8.625%, so the cash settlement amount is 91.325% of contract notional.

    the dozen or so dealers listed are the institutions that participated in the auction. i expect the amounts shown in the table “Physical Settlement Requests” is the net notional amount in usd mm that each dealer bid / offered. i think this must represent the net cds position of the relevant dealer prior to the auction (i.e. bnp offered 390mm bonds, meaning it is probably long 390mm protection).

    note that most dealers would appear to be net auction offerers / net long cds protection, which makes sense as they would have bought protection against their significant counterparty exposure to lehman prior to the latter’s bankruptcy. the overall net offered position of 4.92bn probably reflects the net long cds protection position of the banks, where the protection sellers are probably hedge funds and insurance companies.

    i would therefore infer that hedge funds / ins cos have to pay out a net cash settlement to these dealers under cds contracts equal to 4.5bn = 4.92bn x (100% – 8.625%).

    as lehamn was trading at 13c immediately prior to the auction, it is likely these net protection sellers will already have had to post 4.28bn in cash collateral, meaning that for the final settlement of these contracts they have to stump up an additional 220mm in cash.

    no bankruptcies today i suspect.

  20. By benagyerek on Oct 10, 2008 | Reply

    ndk, i believe the reason is fears of deflation. high real rates on a falling nominal notional.

  21. By Cornholio on Oct 10, 2008 | Reply

    The treasury bubble is the last Greenspan bubble. When it blows as our forgein creditors dump it in mass in disgust don’t get nay on your shoes.

  22. By kmw on Oct 11, 2008 | Reply

    Given today’s action in precious metals, I’m inclined to agree with the systemic margin call hypothesis. If the Treasury bubble were bursting, the dollar would not be rising against gold and silver at the same time; quite the opposite. This was a dash for cash, and as usual in such situations, the most liquid assets were dumped.

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