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.