The following is a guest contribution from Annaly Capital Management:
Speaking to the Economic Club of New York in October 2007, Ben Bernanke was asked what kind of market data he needed to set effective policy. “I would like to know what those damn things are worth,” he famously replied, speaking about the extreme volatility of prices for credit products, particularly non-Agency MBS. Two years and a long market crisis later, Bernanke spoke before the same group. In his remarks last month, Bernanke echoed his earlier statement. “I’d still like to know what the stuff is worth,” he said.
Let’s examine that wishful thinking in the context of market conditions at these two points in time. The graph below shows the dollar price of the top three rated tranches of the ABX, an index of subprime MBS prices, and the top-rated tranche of the CMBX, an index of commercial MBS prices. In October 2007 all of these sectors were in the process of falling off a cliff. Assets that began their lives at par quickly lost value in the wake of the Bear Stearns collapse, the takeovers of Fannie, Freddie and AIG, and the Lehman bankruptcy. No one knew what those damn things were worth because of a dramatic reversal of liquidity. This process made John Paulson and some others extremely rich men, but it bewildered policy makers. Note from the graph that anything below AAA is still going begging, while the AAA portions of the market have had some recovery thanks to the introduction of PPIP and TALF for AAA CMBS.
Fast forward to today, and Bernanke still wants to know what those things are worth. The two graphs below tell a different version of that story. High yield debt, emerging market debt and AAA ABS securities collapsed in price around the time of the Lehman bankruptcy. Junk bond yields peaked out at 2000 basis points over Treasuries, emerging market debt got as wide as 1300 basis points over, while AAA ABS got as cheap as 600 basis points over. Since the turn of the year, these credit sensitive assets have appreciated heroically to levels just about where they were before the wheels fell off the market. Yes, TALF has helped, particularly for ABS, but so has the Federal Reserve’s massive buying program for Treasuries and Agency MBS and debt. We’ll let Brian Sack, head of open market operations at the New York Fed, explain the side-effect on credit-sensitive assets: “Put differently, the purchases [of Treasuries and Agency MBS and debt] bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets…. With lower prospective returns on Treasury securities and mortgage-backed securities, investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities. These effects are all part of the portfolio balance channel.”
In 2007 Bernanke couldn’t price these assets because no one wanted to buy them. In 2009 he is still uncertain because the Fed’s prodigious buying has sucked all the risk premium out of the market. Far be it from us to tell the Chairman what to do, but if he truly wants to know what these things are worth, he should let the market tell him.
Source: Annaly Capital Management