Recent turmoil in the fixed-income market has sparked frightening rumors of failing hedge funds and overexposed financial firms. And there were the inevitable analogies drawn to past periods of upheaval. But with the Treasury market rallying late last week, the message from many on Wall Street was, "remain calm, all is well."
Of course, those Pollyannas could end up like Kevin Bacon's character in the celluloid classic "Animal House" -- flattened by panicked investors fleeing some currently unforeseen event. Still, rumors about hedge funds imploding and Wall Street firms facing bond-related losses are just idle chitchat until proven otherwise. Last week's stabilization in Treasuries and narrowing of risk spreads suggest the crisis has largely passed, many market participants contend, even while conceding some smaller institutions may yet be shuttered.
"This isn't 1998. There's no Long-Term Capital Management," said Jack Malvey, chief global fixed-income strategist at Lehman Brothers. "Did some investors have a tough July? Yes. But there's no confirmed evidence anyone sustained a significant problem. Having said that, it'll probably be another three or four weeks before we'll know for sure."
Malvey's comments were echoed by a number of sources. Quite possibly, either nobody interviewed for this story knows what's really happening or they're unable to speak publicly about some horrific financial accident that's already unfolding. Perhaps there's too much faith in the ability of derivatives and other modern financial tools to disperse and minimize risk.
Or maybe the sharpest selloff in Treasuries since 1987 will really pass without much more turmoil. If history is any guide, that's unlikely. However, the early evidence suggests limited near-term fallout.
In conjunction with rallying Treasuries, swap spreads, agency spreads and mortgage-backed security spreads all
narrowed considerablylast week. Swap spreads, which measure the difference between the fixed-rate and floating rate agreed to by two parties in a swap agreement, had widened from 36.5 basis points on July 11, to 66 basis points on Aug. 1. By Friday, they were back to 41 basis points.
"If there was a sustained problem, or a systemic problem waiting to claim more victims, I would expect more volatility
in spreads on a sustained basis," said Michael Ryan, chief fixed-income strategist at UBS Financial Services.
Preliminary data show the average global hedge fund had positive returns of 1.2% in July, according to John Van, chief financial officer of Van Hedge Fund Advisors International, a Nashville, Tenn.-based research firm, which maintains a database on about 5,000 hedge funds. Still, Van Hedge's income category was down 1.9% last month and MBS hedge funds were off about 2%, he said.
Additionally, there were some large macro funds and commodity trading advisers with losses last month. Campbell & Co.'s $4.4 billion Financial Metals Energy Large portfolio fell 4.5% in July and its Global Diversified LG portfolio was off 5%, while John W. Henry's International Foreign Exchange fund was down 5.3%,
reported. Over the weekend,
The Financial Times
reported Mail Capital lost 15% since the end of May and the $2.9 billion Rubicon fund, a London-based macro manager, shed about 7% in July.
But such losses pale in comparison to Long-Term Capital Management's reported 44% decline in August 1998. Five years ago this month, Russia's bond default triggered a massive widening of credit spreads, in opposition to the infamous hedge fund's highly leveraged position.
The amount of leverage use has decreased since then, which is another factor that gives some observers faith that losses due to the spike in Treasury yields will be contained.
In a survey by Van Hedge late last year, less than 28% of hedge funds that responded used leverage of more than 2 to 1. That's a far cry from the 100-to-1 levels employed by Long-Term Capital Management. LTCM's demise and the heightened volatility of the past three years contributed to the decreased use of leverage currently, Van said, adding, "I don't think there's been that much change between the end of last year and now."
Partying Like It's 1994
Of course, while the stock market suffered wild swings in 2000-2002 on its tearful trail to lower levels, the Treasury market was enjoying a relatively steady rally. The long-running advance created complacency among some fixed-income investors and brought yields to generational lows in mid-June. The yield on the benchmark 10-year Treasury fell to as low as 3.11% on June 11.
The Treasury market's historic rally started coming undone thereafter, amid continued strength in equities and corporate bonds, signs of economic revival and concerns about the yawning federal budget deficit. When the Fed undermined
hopes for extraordinary policy actions at its June 25 policy meeting, the rout began.
"What really turbocharged the selloff was the mortgage convexity-related trade," said UBS' Ryan. As interest rates fell in the months prior, MBS investors sought to hedge the risk of prepayments by buying long-dated Treasuries or fixed-rate swaps, he explained. As rates started to rise and refinancing activity slowed, the duration of those MBS portfolios lengthened and those investors needed to liquidate their Treasury holdings. (Duration refers to the measure of fixed-income securities' sensitivity to movements in rates.)
So a "virtuous cycle driving rates down" -- low rates leading to increased mortgage prepayments, spurring more buying of Treasuries by MBS investors, spurring still lower rates and yet more refinancing activity, etc. -- "became more of a vicious cycle and there was an unwinding of that" mortgage-convexity trade, he said.
The yield of the 10-year note rocketed to as high as 4.60% intraday on Aug. 1, and closed as high as 4.45% on Aug. 5. (On Friday, the benchmark 10-year note was yielding 4.28%.)
The ferocity of the move generated speculation that somebody had to be caught leaning the wrong way.
"I'm sure there's somebody hurting," said Jeff Matthews, president of Ram Partners, a Greenwich, Conn.-based hedge fund, and a contributor to
. "The backup was too fast and too many guys were playing rates going down forever." (As with many others, Matthews couldn't, or wouldn't, name names.)
Sharply rising yields in 1994 contributed to steep losses by hedge funds such as Askin Capital, as well as
decision to sell its Kidder Peabody unit. Orange County, Calif.'s derivatives-related disaster unfolded later that year, with the fallout hitting
Procter & Gamble
, among others.
"The 1994 precedent is not at all encouraging,"
contributor Howard Simons recently opined. "Given the more fragile state of the economy at this point and the more stretched state of the fixed-income markets, it's not unreasonable to expect a few bodies carried out on stretchers in 2003."
Myriad observers have speculated the profitability of big financial institutions such as
will be hampered by recent declines in Treasury prices. Meanwhile, concerns about the accounting, leverage and MBS exposure of
are seemingly the subject of daily discussion in major news outlets, the latter also being hit with multiple lawsuits on Friday. (Notably, Lehman Brothers' shares are down 13.8% since June 11, while Fannie Mae's are off 8.4% vs. a 2% decline for the
But other financial-market indicators -- and the lack of specificity about which firms might be imploding -- suggest otherwise. The 1998 scenario, when one institution's woes threatened to undermine the entire financial system, is unlikely to repeat itself this fall. The 1994 playbook, when various institutions suffered big losses related to a sharp rise in rates, appears more applicable to the current environment.
However, 1994's rise in yields was sparked by an aggressive tightening campaign by the Fed, something nearly unthinkable at present. On Friday, fed fund futures were pricing in zero probability of a rate hike at Tuesday's Federal Open Market Committee meeting.
Meanwhile, other observers have noted comparisons to the current day and 1987. In addition to the recent sharp selloff in Treasuries, bearish sentiment in the
survey recently reached its lowest levels since, yep, 1987.
However, the dollar was in free-fall in mid-1987 and the Dow Jones Industrial Average was powering toward a then-record high in late August 1987. Currently, the greenback has shown strength after pronounced weakness in late 2002/early 2003 and the Dow is struggling to avoid breaking through the bottom end of its recent trading range, and remains far below its January 2000 peak.
Keep the Lights On
Just as there were and are significant differences between 2003 and 1991 (the bulls' favorite comparison), there are major differences between the current environment and past eras of fixed-income upheaval. On some level, the fact that discussions of 1994, 1998 and even 1987 are circulating suggests this episode will turn out differently.
"It's the things you're not looking for that wreak havoc on a greater scale," observed Mark Haefele, an economic historian and
contributor. "It's always the differences between scenarios that become important, not the similarities."
Just as few were worried about a crash on Aug. 11, 1987, the concept of "systemic risk" was not being widely discussed on Aug. 11, 1998. Still, that's not to imply the dangers have entirely passed.
"Another down-leg in Treasuries could begin as soon as Tuesday, if we get some surprises from the FOMC," Ryan speculated.
Most fixed-income participants blame the Fed for the recent rout in Treasuries. Curiously, few seem terribly concerned the central bank will back off its deflation rhetoric or opine effusively about the economy this week. If they do, and Treasuries swoon again, rumors about financial institutions under stress will surely begin again, and quite possibly move into the realm of reality.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.