Treasuries Show Paulson `Bazooka' Misfire; Bonds Gain

By Daniel Kruger

Sept. 15 (Bloomberg) -- U.S. bond prices show Henry Paulson's ``bazooka'' fired blanks when he took over beleaguered mortgage-finance companies Fannie Mae and Freddie Mac.

Instead of instilling confidence in the credit markets, the Treasury secretary's plan to place the government-sponsored enterprises in conservatorship on Sept. 7 only served to underscore weakness in the world's biggest economy and the plight of U.S. financial institutions. Lehman Brothers Holdings Inc., American International Group Inc., Merrill Lynch & Co. and Washington Mutual Inc. all plunged last week.

For the first time since May, bond investors from New York to Tokyo are piling into Treasuries on speculation the Federal Reserve may need to cut interest rates by year-end.

``They pulled out the bazooka, yet they only got 24 hours of favorable response from the financial markets,'' said Thomas Girard, a money manager who helps oversee $110 billion in fixed- income assets at New York Life Investment Management in New York. ``That's got to be a little bit worrisome.''

Girard said he is taking advantage of any decline in U.S. government debt prices to add to his holdings of the securities.

The yield on the benchmark two-year Treasury fell 12 basis points last week, or 0.12 percentage point, to 2.21 percent, and is down from this year's high of 3.11 percent on June 13. The price of the 2.375 percent note due August 2010 rose 7/32, or $2.19 per $1,000 face value, to 100 10/32, according to BGCantor Market Data.

Treasuries surged today in Asia, sending two-year yields down to 1.87 percent as of 11:19 a.m. in Singapore, as Lehman prepared to file for bankruptcy. It was the biggest decline since January. Bank of America Corp. agreed to buy Merrill, a person with knowledge of the deal said. American International Group Inc., the insurer struggling to avoid credit downgrades, is seeking a $40 billion loan from the Fed, the New York Times reported.

The Fed widened the collateral it accepts for loans to Wall Street bond dealers, while a group of 10 banks that includes JPMorgan Chase & Co., Goldman Sachs Group Inc. and Citigroup Inc. separately formed a $70 billion fund to ensure market liquidity.

`Not Enough'

Interest-rate derivatives imply that banks remain hesitant to lend amid speculation credit losses will increase as the slowdown deepens. It costs banks 1.35 percentage points more than the government to borrow cash for three months. The difference, or TED spread, was 1.04 percentage points on Sept. 5.

``We're still concerned about credit tightening by U.S. banks,'' said Masataka Horii, one of four managers of the $52 billion Kokusai Global Sovereign Open fund in Tokyo. ``The government GSE rescue plan will help, but it is not sufficient.''

Kokusai Global, the second-biggest actively managed bond fund behind the $132 billion Pimco Total Return Fund, increased its Treasury holdings to 27 percent of assets in August, the most since April 2007, from 20 percent in March.

Financial institutions have taken more than $500 billion in writedowns and losses since the start of 2007, according to data compiled by Bloomberg. Renewed concern that losses will increase, further weighing on an economy growing at the slowest pace since 2001, are driving investors to Treasuries.

Ease Speculation

Futures on the Chicago Board of Trade show a 36 percent chance the Fed will cut its 2 percent target rate for overnight lending between banks by at least a quarter-percentage point this year. Not since May have traders put on bets for a reduction in borrowing costs. On Sept. 5, futures were indicating there was no chance policy makers would lower borrowing costs. The Fed meets tomorrow to set interest rates.

Treasuries of all maturities returned 2.3 percent since June 30, compared with an average of 2.06 percent for all types of corporate and mortgage bonds, according to indexes compiled by New York-based Merrill Lynch & Co.

Paulson announced a plan on Sept. 7 to place Washington- based Fannie and Freddie, of McLean, Virginia, in conservatorship as their losses mounted, allowing the government to buy as much as $100 billion of preferred stock in the companies as needed.

Rescue Plans

Just two months earlier, when Paulson sought congressional approval to grant unlimited credit to Fannie and Freddie in times of financial strife, the Treasury secretary indicated that he would unlikely use those powers. Instead, he said the move would bolster confidence in the companies and markets.

``If you have a bazooka in your pocket, and people know you have a bazooka, you may never have to take it out,'' he said at the time.

Past efforts by the government and Fed to jump-start the credit markets only temporarily reduced demand for Treasuries.

Two-year note yields rose 26 basis points to 1.74 percent on March 11, the biggest increase since 1996, after the Fed said it would accept mortgage debt as collateral for as much as $200 billion in Treasuries to be auctioned through a new Term Securities Lending Facility. By March 14, yields had fallen back to their prior levels.

`Stop-Gap Measure'

Three months earlier, on Dec. 12, yields soared 21 basis points to 3.13 percent when the Fed announced a joint effort with foreign central banks to increase their lending programs. Three weeks later, yields were back down to 2.88 percent.

``The whole credit crisis is going to keep a bid in Treasuries for some time to come,'' said Mark MacQueen, a partner and money manager at Austin, Texas-based Sage Advisory Services Ltd., which oversees $6 billion. ``This is more of a stop-gap measure to pass it off to the next administration,'' he said of the takeover of Fannie and Freddie.

Traders in the forward markets, where financial instruments are sold for future delivery, are pricing three-month cash from December to March at 94 basis points over the expected federal funds rate. That's up from 85 basis points at the start of last week and an average of 7 basis points in 2006.

What's different now is that the budget deficit is accelerating, causing the Treasury to step up its borrowing as its supports Fannie and Freddie. Economists at New York-based Goldman Sachs Group Inc. forecast that the shortfall for fiscal 2009 beginning Oct. 1 will reach a record $565 billion. The Bush administration estimated a $490 billion deficit for the period.

`Falling Apart'

The median forecast of 32 economists and strategists is for two-year yields to rise to 2.64 percent by year-end, according to a survey by Bloomberg. If accurate, investors who by the securities now would have a loss of 0.37 percent.

Bond market bulls say the government's takeover of Fannie and Freddie may do little to encourage companies to hire, or for consumers to increase spending. The Commerce Department in Washington said Sept. 12 that sales at retailers fell 0.7 percent in August when excluding automobiles, the most this year. A week earlier, the government said the unemployment rate climbed to a five-year high of 6.1 percent in August.

``While it was a necessary step, it's not a sufficient step to prevent the economy from falling apart,'' said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG's Private Wealth Management unit in New York. ``It does not address the fundamental economic backdrop of a weak consumer, declining jobs, a weak global economy and a continued decline in housing prices.''

Buy Treasuries

Pollack said he favors Treasuries maturing in fewer than 10 years. Those securities tend to outperform longer-dated debt when the Fed cuts rates.

``Housing's problems go deeper than just mortgage rates,'' said Carl Lantz, an interest-rate strategist in New York at Credit Suisse Securities USA LLC, one of the 19 primary dealers of U.S. government debt that trade with the Fed. ``The concern was always what happens when unemployment starts rising and people are forced to sell the house.''

Credit Suisse told clients on Sept. 8 they should buy 10- year Treasuries, saying yields may fall to 3.3 percent. The yield on the benchmark 4 percent security due in August 2018 ended last week at 3.72 percent.

To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net