The Occasional Seemingly Free Lunch

hmf asks, “David – if possible, whenever you have a chance, could you please explain why there is any spread whatsoever between govt-guaranteed bank-issued debt (e.g., the GS TLGP bonds) and comparable treasuries.  It would seem they’re one and the same – thus no default risk.  Thank you very much!”

I left a comment on this on John Hempton’s blog, who also addressed this question.  The comment is still in moderation, so I will attempt to recreate my argument.

There are many US Government securities, some of which are “Full Faith and Credit” [FFC] that trade with a spread over on-the-run Treasury securities:

  • Off-the-run Treasuries trade at a discounted price (higher yield) due to illiquidity.  Note: On-the-run securities are the ones that have recently been issued.  They are often used by Wall Street for hedging purposes in other bond issuance, which adds to the liquidity (most of the time).
  • Title XI shipping bonds (full faith and credit) trade at a spread to a ladder of similar maturity Treasuries.  They are less liquid, but there is usually good demand for this paper.
  • Aid to Israel and TVA bonds are full faith and credit [FFC] and usually trade at a spread over Treasuries.
  • Overseas Private Investment Corp bonds (FFC) often trade at a spread over Treasuries.  I once bought some OPIC put bonds where the option adjusted spread was 2% over Treasuries.  I had to buy the whole issue, so, again, it was illiquid, because anyone you would try to sell it to you would have to educate them on the bond.  Not easy, why should the seller trust your explanation, particularly as you no longer want the bond?  (That’s what brokers are for…)
  • I used to manage a portfolio of Credit Tenant Leases.  Most of my leases were on buildings leased by agencies of the US Government, and the lease payments were not subject to appropriation, so I did not have to worry about the budgeting process of Congress.  These were not FFC, I had a cut-through claim to the lease payments; I had priority over the building owner in getting paid.  If the US were to fail to pay, I had recourse to the building owner (can’t squeeze blood from a stone, though), and failing that, I could take possession of the building.  So with a hard asset behind the loan, I was doing secured lending to the US Government, and getting 1.5-2.0% over Treasuries to boot.  Though the CTLs were fungible, they were definitely illiquid.  But when you think about the extra spread versus the possibility of loss — the property was high quality, the return was disproportionate to the risk.
  • Another [not FFC] piece of paper was a first mortgage note on a building that served a critical government purpose, where the government could not move because of old computers which they could not move due to fragility and security reasons.  We got roughly 3% over Treasuries in a small deal where I ended up buying 20% of the issue.
  • Are Fannie and Freddie guaranteed by the government?  They seem to be, but you can pick up an additional 100-140 bps if you lend to them.

So, it’s not unusual for FFC securities to trade at spreads over Treasuries.  And, it is normal for pseudo-government securities to so trade.  But it is weird for the 3+ year Goldman Sachs securities to be issued at 2.2% over the relevant Treasury security.  It’s not an illiquid issue — $5 billion is a big deal.  There is a little structural complexity, but it is in the nature of a financial guarantee from the government.

There is the matter as to whether the Government would ever selectively default on FFC guaranteed issues, but the courts would have something to say on that, unless Congress deleted their authority on the matter.  You can’t fight city hall; you certainly can’t fight the US Government, and it has been behaving erratically of late.

So, if I were managing insurance/bank assets, would I buy these issues with a FFC guarantee from the FDIC.  Yes, all day long unil I was full of them.  The reasons cited for not buying them don’t add up, and they seem really cheap.  I would use them as a substitute for Treasury and Agency securities.

PS — A note to the new administration: want to save money?  Easy.  Create a capital account for the budget, and borrow using Treasuries to buy the buildings that you use.  Don’t do CTLs anymore.

Here’s a bonus idea off of yesterday’s post.  Offer longer-dated floating-rate debt indexed to 3-month T-bills.  It would be a TIPS substitute, and cheaper.

Update: 10/27 10AM: Bond Newbie is correct. TVA securities are not FFC — I slipped on that one because of a project that I worked on long ago, and my knowledge was garbled. Here is an incomplete list of all FFC securities:

  • Farmers Home Administration Certificates of beneficial ownership
  • General Services Administration Participation certificates
  • U.S. Maritime Administration Guaranteed Title XI financing
  • Small Business Administration Guaranteed participation certificates and Guaranteed pool certificates
  • Government National Mortgage Association (GNMA) —  GNMA-guaranteed mortgage-backed securities, and GNMA-guaranteed participation certificates
  • U.S. Department of Housing & Urban Development Local authority bonds
  • Washington Metropolitan Area Transit Authority Guaranteed transit bonds

If anyone knows where there is a full list, I would be happy to post it.

7 Comments

  • hmf says:

    David,

    Thank you for taking time to provide this comprehensive, crystal-clear & insightful answer – which addressed every follow-up question I had planned. I thoroughly appreciate your willingness to interact with your audience. As a reader of your blog from its inception, I’m very grateful to have this resource, especially over the past three months. I hope you & your family have a happy Thanksgiving.

  • Bond newbie says:

    David, you answered HMF’s question, but I’m not sure if everything you wrote was correct:

    DM: “TVA bonds are full faith and credit.” TVA Web site: “TVA debt securities are not obligations of the U.S. government, and do not carry a government guarantee.” Link:
    http://www.tva.gov/finance/opportun/index.htm

    You mention spreads, but only touch on liquidity briefly. Liquidity is at such a premium that investors don’t want to lose 6 months’ worth of coupon income because of a horrid bid when selling a callable agency bond or a “headline risk” name like Morgan Stanley paper (FDIC insured or not — some people just won’t touch it). For buy-and-holders like the insurance companies you reference, probably a good opportunity.

    Second, I am not too sharp on the repo market, but a commenter on Bronte Capital blog said there are distortion in the repo market that will make corporate bonds (FDIC-backed or not) more costly to finance through repo — 25% haircut. So this would reduce demand, too.

    Lastly, let’s acknowledge the Chinese central bank as the marginal buyer of government and GSE debt. With the net selling of GSE debt they’ve been doing for two-plus months now (and continuing to buy Treasurys), is it any wonder that they are skeptical of any “government backed” bond that doesn’t say “U.S. Treasury”? They have had enough of “implied” and “effective” guarantees, or “full faith and credit” of an underfunded government unit.

  • Bond Newbie — Thanks regarding the TVA. Not sure how I missed that. I recognize the liquidity and financing issues, thanks for fleshing them out further.

    As for the Chinese, if they don’t accept FFC, they shouldn’t own Treasuries. Just wait for the Argentine-style forced conversion, or the creation of a two-tier currency system… they will get paid back in something called US dollars, but what those will be worth is questionable.

  • Kurt Osis says:

    oh, I don’t know that the discount is so unreasonable. The only point of the security is to keep say Goldman from failing, if Goldman did default would the FDIC really need to bother providing its insurance since it will have already failed in its purpose? What if Goldman Citi and Morgan Stanley all failed, would the government choose to pay Treasuries first or weirdo FDIC backed notes?

    Who knows how the heck these things will really be settled in the event of default.

    P.S. Why doesn’t Goldman just LBO itself with FDIC backed paper?, don’t think Lloyd hasn’t run the numbers….

  • Kurt Osis says:

    P.S. not content at having blown up GS, Hank Paulson has turned the FDIC from an insurance company into a CDS desk…. hey didn’t AIG… never mind.

  • dWj says:

    Kurt: A significant portion of Lloyd’s wealth is still in the firm, though not to the degree that his predecessors’ was. Hank, on the other hand, had to liquidate his position on moving to Washington. A buyout of outside shareholders should involve him, and maybe Corzine and/or Rubin, too.

  • Andre says:

    If one of the issuers did default, how quickly would FDIC have to pay up?

    In theory it can take quite a while after a bank fails for insured depositors to be made whole, although in recent practice FDIC has been moving pretty quickly.