Treasury Takes Step 1 in Avoiding the Debt Ceiling

As expected, Treasury has announced that it will allow the $200 billion Supplemental Financing Program to run down to only $5 billion; that will save $195 billion of borrowing authority under the current debt ceiling:

Treasury Issues Debt Management Guidance on the Supplementary Financing Program
WASHINGTON – The U.S. Department of the Treasury’s Assistant Secretary for Financial Markets, Mary Miller, today issued the following statement on the Supplementary Financing Program:
“Beginning on February 3, 2011, the balance in the Treasury’s Supplementary Financing Account will gradually decrease to $5 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over. This action is being taken to preserve flexibility in the conduct of debt management policy.”​

Treasury created the SFP in order to help the Fed expand its balance sheet without “printing money” (or, more accurately, “printing reserves”). Under the program, Treasury issues bonds, as usual, but it deposits the proceeds in an account at the Federal Reserve, rather than using them to pay the nation’s bills. The Fed then uses those deposits to purchase assets. Since the money ultimately comes from investors who own the new Treasury bonds, the SFP allows the Fed to expand its balance sheet without creating reserves out of thin air.

With the program winding down — at least until the debt ceiling gets raised — the Fed will have to ask its electronic printing press for another $195 billion if it wants to maintain its targeted portfolio.



Investors Should Be Prepared to Face Financial Oppression

That’s the conclusion of a new report by Morgan Stanley analyst Arnaud Mares.

And what, you may ask, is financial oppression? Speaking from the perspective of investors in sovereign debt, Mares defines it as “imposing on creditors real rates of return that are negative or artificially low.” Which doesn’t require outright default. Instead, it

[C]an take other forms: repaying debt in devalued money (e.g., through unanticipated inflation), taxation or regulatory incentives on institutions to purchase government debt at uneconomic prices.

Mares sees sovereign creditors as tempting targets when over-indebted governments decide which of their many fiscal promises they can’t keep.  After all, elderly pensioners cast more votes than coupon-clipping bond holders. And he thinks current low yields provide little protection against that threat.

His piece is definitely worth a read if you want to consider a bearish view on U.S. and European sovereign credit.

How to Manage $3 Trillion

Shawn Tully at Fortune has a fun article recounting the rapid rise of Blackrock, which will soon be the largest asset manager in the world.

He contrasts the firm’s fixed-income investment strategy with other firms (e.g., Pimco) as follows:

BlackRock does not invest by forecasting which way interest rates are headed. Instead BlackRock wonkishly focuses on the other factors that drive bond values: prepayments and default risk. As a result, BlackRock was better equipped to analyze the complex mortgage securities that came to dominate the fixed-income markets and that caused so much havoc last year.

BlackRock’s approach works like this: Say mortgage bonds are selling at a big discount because rates recently rose. BlackRock’s models are expert at judging if those bonds are “rich” or “cheap” based on its technology for predicting prepayment trends and defaults. If the model predicts, for example, that prepayments will be higher than most investors expect, BlackRock can garner extra returns because homeowners will pay off their loans at full value, and the fund can reinvest the proceeds at higher rates.

The firm’s analytical modeling gets so granular that BlackRock found that people living near IBM offices prepay frequently because IBM executives are often dispatched to new cities.

I find that IBM tidbit very telling. It’s a great example of the information-processing that can, in principle, allow investors to earn super-normal returns (alpha, in the lingo). And if enough investors do it, market prices could approach the efficiency that finance theory often predicts. On the other hand, the need to get that “granular” suggests just how difficult it is for normal investors to value these kinds of securities. (Of course, experience has shown that many investors in mortgage-backed securities made much more basic errors — like trusting the ratings granted by the credit rating agencies — but that’s a topic for another day.)

P.S. For those too young to remember, the old joke is that IBM stands for “I’ve Been Moved.”