The naked truth
THE US TREASURY market, the foundation of government bond and corporate bond markets worldwide, is suffering a crisis of confidence at the worst possible moment. Investors in treasuries are the lenders enabling the US government bail-out of the countrys broken financial institutions. That leaves them financing purchases of equity of volatile and highly questionable worth and backing a ragbag of distressed assets. There are more, presumably, to come. For now, treasury yields are at record lows across the term structure as investors with cash to invest conclude that they can trust no one else with their money. But investors must wonder at what point the expanded supply of government debt and its use will make the borrower inherently less creditworthy.
There is an even more pressing concern for many participants in this increasingly swollen market: the settlement system has broken down. Following the collapse of Lehman Brothers in September, fails to deliver among the 17 primary dealers in the US treasury market have rocketed to more than $2 trillion over a period of weeks and still lie above $1.3 trillion. Broker/dealers have stopped delivering bonds. Holders of US treasuries are now scared to lend into the repo market in case their bonds are not returned, and potential buyers sit on the sidelines fearful of handing over their money to a counterparty that at best might not deliver a bond on time, and at worst might go under.
With global stock markets plummeting, investors are still turning to treasuries as a safe haven. But investors might become nervous if something is not done soon to sort out the markets problems. "As yet investors are still coming in, but in the longer term the worry is the lack of functionality in the treasury market. That could impact investor perception on a longer-term basis," says Mike Pond, US treasury and inflation-linked strategist at Barclays Capital in New York. If investors turn their backs on treasuries, the US government will find it increasingly difficult and expensive to raise money and roll over its maturing debts. Upward pressure on interest rates will occur at a time when the government needs to be loosening monetary policy in order to jump-start a domestic economy that is heading towards a depression.
As a result of fails to deliver, the most transparently priced instrument available now has investors scratching their heads. The natural balance of supply and demand has been altered and the true price of treasuries has become obscured. The effects are being seen across other bond markets. "The TIPS [Treasury Inflation Protected Securities] market is also clearly broken," says Pond. "An obvious trade right now would be to go long TIPS where real yields are high and short the nominal bond in a breakeven inflation trade but hedge funds are fearful that if they go through the repo market the borrow could fail. So we have a situation now in the 10-year TIPS where the market is pricing in zero or negative average inflation for the next 10 years. Inflation has not been that low since the 1930s." Economists also claim that fails have spread across to other bond markets such as municipals, agencies, mortgage-backed and corporates.
Why the Federal Reserve is not urgently considering regulation is bewildering. As yet, the US Treasury has merely asked for market participants to sort out the situation themselves. That might help reduce fails but it will not eliminate them, and in panic periods they will simply creep back up. The global economy has significantly contracted since the collapse of Lehman Brothers, which spurred the fails to deliver. More market-shocking events are certain to lie ahead. The solution is simple delivery needs to be enforced, and liquidity returned. If not, confidence in the US treasury markets will be lost. Loans made using treasuries as collateral will be reconsidered, bond markets priced off treasuries will further dry up and, with equity markets so volatile, central banks and investors will not know where to turn.
Fails to deliver in the treasury markets are not a new phenomenon. There is data for fails for treasuries, agencies and mortgage-backed securities as far back as 1990, says Susanne Trimbath, an economist at STP Advisory Services, and former employee of the Depository Trust Co, a subsidiary of Depository Trust and Clearing Corp.
"Investors are still coming in, but in the longer term the worry is the lack of functionality in the treasury market"
Mike Pond, Barclays Capital
What the treasuries market faces now, at this critical moment, is the consequence of long neglect of some murky aspects of short-term tactical trading in government bonds.
For years, efforts by the US Treasury itself formally to resolve the growing fails issue have been brushed aside by market participants as unnecessary. Jeff Huther, the former director of the Office of Debt Management at the Treasury, had battled for several years for a solution, getting as far as a White Paper produced in April 2006 suggesting stricter enforcement of delivery and penalties.
No need, responded the Bond Market Association. "The Association has worked with its members [bond traders and dealers] to address chronic fail issues with respect to risk, pricing and liquidity," it asserted. "Indeed, the Association has focused its efforts on developing pre-emptive practices that would make it unlikely that a significant fails event would occur."
That was in spite of warnings by Treasury Committee members themselves at the end of 2005 that the chronic fails had begun to affect the mortgage-backed and corporate bond markets. Trimbath believes that given that a blind eye was turned to fails in the treasuries markets, that in turn encouraged fails to deliver in the mortgage bond markets and to a lesser extent the corporate bond market. "In 2004 the failure to deliver rate for government agency MBS was 40%," she says.
Significant fails in 2003 caused chaos for treasury market participants, but still no penalty was introduced. In June 2003, the Fed Funds target rate had been reduced to 1%. As the specials rate (a repo rate only for a specific security) approached zero there was little incentive to borrow the notes to cover short positions and failures. For five weeks, fails to deliver in the treasury market were more than $1 trillion. The consequences, admitted the BMA at the time, were "most particularly, regulatory capital requirements imposed lost opportunity costs on dealers as capital requirements increased. Firm personnel spent significant time in back-office and industry-wide attempts to resolve fails. In addition, customer relations became strained as fails to receive and deliver in customer transactions increased."
But despite the inconveniences of the fails, fears that stringent prevention of fails to deliver would reduce profits deterred the market from supporting Huther and his colleagues attempts at solution. "It was politically difficult to convince the market to put a stop to fails to deliver in treasuries," claims one former Treasury employee. "There were some forceful voices insisting that if the Treasury got involved, they would take the incentives out of the specials market altogether. Those making their living as specialist dealers, as well as those making a living shorting securities outright, were worried about potential supply changes which would eliminate trading opportunities for them."
In 2002, Michael Fleming and Kenneth Garbade, now at the Federal Reserve Bank of New York, reported that some market participants might indeed fail "strategically". They claimed that by failing to deliver bonds on the initial sell order of a repurchase agreement, a broker-dealer can nearly triple its net revenue in two weeks over what it would have earned in the straight execution of the repurchase agreement, banking on interest rates rising.
By simply enforcing delivery or deterring failed delivery by penalties and forced buy-ins, this market manipulation could have been stopped.
The inaction has led to the build-up of $2 trillion in undelivered bonds. Moreover, the number of fails is almost certainly higher than is being reported, claim insiders, possibly substantially so. The $2 trillion in fails fell to $1.3 trillion at the week ending November 5, according to the New York Fed. However, Trimbath points out this is only data volunteered by about 17 primary dealers. The fail rate by those dealers in US treasuries hit 30% one week in October. By November 11 it was still at 22%. "And what about the 200 to 300 bond dealers who settle through the DTCC? The DTCC does not reveal publicly the fails to deliver there. Imagine the magnitude of the true amount of fails to deliver," she says.
The former Treasury employee also explains that the Fixed Income Clearing Corp (part of the DTCC) started netting fails in 2005/06, whereby FICC uses bonds due to a participant to offset bonds due from the same participant in the same security. "The actual amount of true fails appears to be less, therefore. You cant compare the figures now with historical fails."
At what risk
Although the catalyst that led to this record amount of fails in treasuries, spiking at $2 trillion, was the collapse of Lehman Brothers, it is the settlement system and lack of regulatory oversight that has led to this risk of market failure.
The treasury market has always been highly liquid. Dealers are able to sell treasuries without owning them, borrowing them in overnight through the repo markets in order to meet the T+1 delivery. The supply of treasuries into the repo market has, in calmer markets, been so bountiful that selling treasuries without owning them was not considered by most traders to be a concern. After Lehman collapsed, however, several things happened to dry up supply to the repo market, explains Rob Toomey, formerly with the BMA, which is now part of Sifma (The Securities Industry and Financial Markets Association). "There was a tremendous flight to quality so a lot more investors were buying treasuries," he says. "At the same time, holders of treasuries that would ordinarily lend the securities overnight in the repo markets stopped lending as they became fearful of counterparty risk."
Investors in treasuries are largely risk-averse by nature. Central banks, for example, and pension funds are large holders of treasuries. "Theyre not going to risk lending out treasuries in this environment," says Stan Jonas, director of Axiom Capital Management, a New York investment and banking firm. "If you lend stock in a bear market you get collateral in exchange and then if your counterparty goes belly-up youll keep that and the stock will have dropped so you can buy it back cheaper than when you loaned it. Not so in the treasury market. A lender receives just the interest rate on the bond for the overnight period but if the borrower goes under, the bond is not returned and the lender has lost everything."
FTDs of US Treasuries balloon out of control
Primary dealer reportings to Federal Reserve Bank of New York
Source: Federal Reserve Bank of New York
Investors are essentially facing the proposition of being paid the Fed Funds rate overnight while waiting for delivery. That is the same as receiving US government yield for broker/dealer risk, says Trimbath. Thats not a great trade with risk premia on financial credits rising to record highs. "Those investors are being paid the "risk-free" rate of interest what lenders charge the US government," she says. "As far as Im aware Warren Buffett is getting paid 10% for taking on Goldman Sachs risk. So how is this being allowed to happen?"
With interest rates so low, and in some cases negative, there is even less incentive to lend out treasuries as the amount to be gained from lending out overnight is too small to compensate for the counterparty risk. The Fed Funds overnight rate was 0.37% on November 17, with the repo rate lower still and on occasions in negative territory.
The dramatic and rapid seize-up in overnight treasury supply resulted in a sharp uptick in the number of fails to deliver.
"The repo market was a great invention," says Jonas. "It was thought to be the safest form of lending and borrowing but that assumed you could complete the trade. Since we now know that is not the case, confidence has deteriorated." He points out that swaps are viewed as less risky than treasuries today.
Further discouraging the supply of treasuries into the repo market is the very fact that failure to deliver has not been punished. Huther and his colleagues were never able to enforce a severe enough repercussion for failure. At present, failing to deliver incurs only a continued overnight interest rate. When that interest rate is close to zero, and the penalty for failing is zero there is little incentive to deliver a bond.
This failure to deliver also has the effect of creating phantom securities a higher number in the system than actually exist. "In a sense, the repo market is like a Ponzi scheme," says Jonas. "If no delivery is forced then that bond can be lent over and over again. One security can underlie a hundred trades. So the amount of securities traded is far more than exists. That is the way the world works today. If it doesnt break, thats great. But when one link in that system breaks, those trades have to be unwound..."
Sifmas Toomey admits that "maybe there are more bonds sold than are available" although he claims that it is not a good metric for assessing fails to deliver.
Trimbath, however, is less sanguine about the impact that phantom bonds have on the financial system. She compares the situation to musical chairs. "Who is going to get the chair when the music stops? Its not the individual investor. Ive seen positions just deleted from peoples statements without investors even knowing as the security they supposedly owned turns out to not exist. When push comes to shove, and the buy-ins start, who will not receive their delivery? The individual investors or the institutional clients who are more profitable for the broker/dealers?"
Time to crack the whip
More bonds being traded than exist defies the natural laws of supply and demand. While greater demand for treasuries should be allowing the US government to lower borrowing costs, the inflated supply through duplicated bonds could lead to higher borrowing costs. "These undelivered treasuries represent unfulfilled demand demand by investors willing to lend money to the US government," says Trimbath. "That money has been intercepted by the selling broker-dealers. By selling bonds that they cannot or will not deliver to the buyer, the dealers have been allowed to artificially inflate supply, thereby forcing prices down. These artificially low prices are forcing the US government to pay a higher rate of interest than it should in order to finance the national debt. It shouldnt take a PhD-trained economist to tell you that prices are set where supply equals demand. If a dealer can sell an infinite supply of bonds then the price is, technically speaking, baloney. And the resulting field of play cannot be called a market.
"If regulators and the central clearing corporation will only enforce delivery of treasury bonds for trade settlement at something approaching the promised, stated, contracted and agreed upon T+1, there will be an immediate surge in the price of treasury securities. As the prices of bonds rise, the yield falls. This yield then translates into the interest rate that the US government will have to pay in order to borrow the money it needs to fund the budget deficit [and to refinance the existing national debt]."
Huther also pointed to the higher borrowing costs for the Treasury as a result of fails in November 2005 when proposing a securities lending facility. The reduced secondary market liquidity resulting from fails might lead to erosion of the liquidity premium the Treasury receives for securities at auction, he pointed out. Compliance would also increase costs for all participants, and ultimately fails could lead to "the potential erosion of benchmark status," warned Huther.
At present, investor appetite has not been discouraged. The auctions and issuance in two-year and five-year notes in October were well received by investors. The governments $34 billion sale of two-year notes on October 28 drew a yield of 1.60%, the lowest since March 2004. The US also auctioned $24 billion of five-year notes on October 30 at a yield of 2.825%, less than the rate drawn in the previous months sale.
However, concerns about the system and its functioning did have an impact on the governments $10 billion reopening of 30-year bonds in November. One trader says that investors were nervous how the process would turn out, resulting in the reopening being 20 basis points cheaper by the end of the day to yield 4.35%. That has since dropped to 3.64% as confidence and therefore demand has returned.
The Federal Reserve should now be running out of patience with industry participants that have allowed fails to deliver to continue for as long as they have. Promises from market participants to reduce fails have not only been broken fails have in fact increased in number. Jonas says: "From a macroeconomic perspective, the Fed has to be annoyed. The repo market is not here to help dealers make money. Its how the Fed implements monetary policy." Perhaps, the Treasury will finally crack the whip. It might have to.
The Treasury was forced to reopen some notes in the first week of October, a response which is credited with reducing fails to the reported $1.3 trillion. Such drastic action was also taken following 9/11 when cumulative fails to deliver in treasuries hit $1.3 trillion from just $1.7 billion the week before. The Treasury responded with a snap auction that brought daily average fails back down to $63 billion by November that year. At that time, Treasury under-secretary Peter Fisher warned that such responses would not happen again and that the market should resolve the issue itself, although he admitted "never is a long time".
Investigations into broker behaviour in certain notes is at least under way. On November 7, the Treasury called for reports from entities with $2 billion or more in two specific notes. These were to be submitted by November 14.
Both Sifma and the Fed-sponsored Treasury Market Practices Group have been rallying to offer a solution to the fails to deliver without formal regulation.
The TMPG is comprised of market participants. Tom Wipf, chairman of the group and global head of institutional securities group financing at Morgan Stanley, says the group was set up a few years back and is designed to deal with treasury market issues before they get to the point of additional regulation.
In November, the group recommended several changes. The first is a financial penalty on fails. While buy-ins are supposed to be enforced by the NYSE and Finra, up to now penalties have been undefined. The new recommended penalty is between 300bp and zero depending on the Fed Funds target. "History has shown us that fails only occur in excess when the Fed Funds target rate is near zero. At 3% and beyond, fails are less frequent," says Wipf. He adds that the DTCC will be responsible for charging the dealers. The penalty should encourage lending even in the low interest rate environment. At Sifmas November 4 meeting, members pointed out there was little economic incentive to lend securities when general collateral rates stood at 20bp and the penalty for failing was zero basis points.
Sifmas Toomey says the association is working with its members to implement some of the suggestions made by the TMPG. "The fails are steadily coming down but it can take time to find the bonds. We are looking at best practices for preventing fails to deliver, but we think it is important to take care not to limit liquidity by dampening shorting."
The former Treasury employee says he believes penalties alone will indeed dry up liquidity. "The chains involved in treasuries can often result in fails if one party does not deliver," he says. "If the penalty rate is too severe then it will simply deter borrowing and lending of treasuries, as parties will not want to open themselves up to fines for what could be simply a result of counterparty failure or administrative error."
He suggests that alongside the penalty there must be a backstop supply that the party that owes the fine can go to and pay for. This alternative supply will encourage more lending initially and eventually will not be required unless in extreme circumstances. TMPG is suggesting a backstop facility be created in the future.
"This issue has gone unanswered for years. What is going on is simple stealing. We dont need new laws against that, we already have them. If the Fed wont step in, then the Department of Justice has to"
Susanne Trimbath, STP Advisory Services
Trimbath is less optimistic that something will be done to prevent fails to deliver from continuing. "This issue has gone unanswered for years. What is going on is simple stealing. We dont need new laws against that, we already have them. If the Fed wont step in, then the Department of Justice has to. The problem is, however, that if delivery is forced, then the real price of treasuries will be much higher to the point where counterparties will go bust when they have to buy in. Thats when the music stops."
If nothing is done to correct prices, Trimbath says, investors will turn their backs on debt markets as their confidence in benchmarks and pricing deteriorates. Instead they might have to look to equity markets in their pursuit of better returns. Prices of equities will rise and public companies will be able to return to equity markets for financing. "But that assumes that broker/dealers also have to deliver securities in the equity markets," says Trimbath. Throughout 2008 it appears that has not been the case (see following story).