The Treasury Market Bubble

Recall how the US banks bolstered their balance sheets by swapping the putrid toxic mortgage backed debt for US Treasuries?

To me it seemed like a bad idea at the time, but now it seems like a looming disaster.

It looks quite possible that the price of the Treasuries could head south quite dramatically, taking the banks' capital positions down there with it. Aside from seeing more insolvent banks, the real problem is that this would reduce credit flow to business, risking a double dip recession.

The Fed has been propping up the wobbly-looking US Treasury market by purchasing over $750 billion of Treasuries so far. The problem now is that the Fed plans to stop its shopping spree at the end of the month, taking away a substantial amount of support for the price.

Don't forget too that the Chinese are losing their appetite for the stuff as well. If both parties were to stop buying bonds then prices would fall fast.

John Paulson, the owner of hedge fund Paulson and Co has made billions from successfully shorting the US housing market and the UK banks. He has a good eye for something that is about to implode. He told Bloomberg that, "shorting long-term US debt is the only attractive bet going at the moment".

He went on to say, "I always like to think about assets that are likely to experience a breakdown; the only thing I am really comfortable with right now is US treasury securities and US agency mortgage-backed securities...I think they are overpriced and make attractive shorts."

By keeping the Fed funds rate at close to 0%, banks have virtually no choice but to borrow cheap dollars to buy Treasuries and other assets. Traders within the banks have been having a party with it.

Gillian Tett, the assistant editor of the Financial Times wrote this week about a recently retired banker who gave her an interview about what's going on behind banking's pinstriped exterior. He said, "Highly leveraged short term trades are back in vogue as players jostle to load up. When money is virtually free, they feel stupid of they don't leverage up. Any sense of control has been thrown out of the window."

US banks now have nearly 15% of their bank holdings in Treasuries. This has risen rapidly in the last eighteen months from $1.1 trillion to $1.5 trillion. Interest rates will have to start rising at some point, and when they do the banks will be stuck between a rock and a hard place. Their Treasury assets fall in value as the amount they have to pay on their deposits rises.

Despite this conundrum, banks are still leveraged an amazing 10 times the value of their equity. So a 2% fall in the price of Treasuries would be amplified ten times. Bear in mind that US banks have a stack of money in other less "safe" investments as well, such as commercial property. These could fall even faster. On top of this, 43% of total bank assets are in the form of real estate loans, which are not exactly bomb-proof either.

In an article in SafeHaven, Daniel Aaronson and Lee Markowitz discuss this situation really well, and sign off their article with the chilling conclusion. They wrap it up by saying "It is feasible that even without loan losses, the entire banking system would be insolvent if Treasury yields rise high enough."