US Interest Rates Outlook 2011 - Tug of War

INTEREST RATES RESEARCH
December 2010
U.S. INTEREST RATES: OUTLOOK 2011
TUG OF WAR
PLEASE REFER TO THE LAST PAGE FOR ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES
Barclays Capital | U.S. Interest Rates: Outlook 2011
FOREWORD
US rates investors might be forgiven for suffering from whiplash. 2010 has been that kind of a year full of ups and downs. It started promisingly, with the prospect of sustained economic recovery pushing rates higher. The first signs that things were not going to plan came in May, when the European sovereign crisis hit. Investors who had avoided mortgage and corporate credit issues for several years suddenly woke up to credit risks on the sovereign front. Herculean efforts by European policymakers, including a last-minute rescue package for Greece, helped calm nerves. But just as investors were starting to breathe easier, the US economy hit a soft patch. With Greece still in the rearview mirror and the effects of the stimulus starting to fade, many investors as well as policymakers started worrying openly about a double-dip recession. Central banks responded to the twin threats of fragile financial markets and softer data by re-opening the monetary spigots. Markets therefore began pricing in a new round of quantitative easing by Q3, although the Fed actually announced the program only in November. The result a massive rate rally that began in May and peaked in September, pushing yields to all-time record lows in some cases. But the tone has changed once more in the fourth quarter. Data have improved noticeably and fears of a double-dip have faded, and US policymakers seem close to passing a large tax cut/stimulus package that should boost growth. While there was a new round of sovereign headlines out of Europe in November, US bond and equity markets essentially ignored it, suggesting that they now see limited risk of contagion from peripheral Europe. And rates have sold off hard in the belly of the yield curve, bringing them close to May levels. In terms of rate moves, 2011 should be a repeat of 2010, albeit on a smaller scale. We expect another round trip, with rates rallying early in the year, only to rise in the second half and finish 2011 near current levels. But while yield levels might not ultimately move much, there should be a number of opportunities to earn profits along the way. For example, the recent sell-off has opened a window for Fed-on-hold trades across asset classes for the first time in many months, whether through being long the reds, being short gamma on short tails, or simply by buying the 2y Treasury. Similarly, other opportunities should open up in the second half of the year, as the effects of quantitative easing start to fade and attention turns to the US fiscal picture. The purpose of this publication is not only to present such trading ideas, but also to highlight the macro views that drive these recommendations. We hope that our efforts help you, our clients, in your investment decisions.
Ajay Rajadhyaksha Head of US Fixed Income and Securitized Research Barclays Capital
16 December 2010
CONTENTS
OVERVIEW Tug of war 3 US rates are set to be pulled in opposite directions. An improving economy, worries about the US fiscal picture, and the boost provided by the tax cut/stimulus package all support a bearish view. But this is countered by a front end that should be pegged for several quarters, muted inflation, and heavy Fed buying. US RATES Money markets: Outlook 2011 10 Next year looks set to bring even lower rates and a flatter money market curve, as a result of the Feds renewed large-scale asset purchases (LSAP) and regulatory pressures. Politics will also likely play a role in front-end dynamics next year. Those investors hoping for some spread or extra yield may have to search elsewhere. Treasury outlook: Too fast, too furious 20 We expect yields to decline in Q1 11, led by the intermediate sector, as the recent sell-off has not been commensurate with the improvement in the growth outlook. Yield should then gradually sell off over the remainder of the year. We discuss the supply-demand dynamics in the fixed income market, relative value trades and the outlook for the STRIPS market. Inflation-linked: The debate evolves 36 We expect the 2011 trend in TIPS breakevens to be similar to that of Q4 10. However, with forward breakevens attractive only as inflation insurance, the focus is likely to shift to the short end. Liquidity and the demand base are likely to continue to grow, along with supply and increased interest in inflation derivatives. Agencies: With or without you 45 Political gridlock is likely to delay GSE reform far into the future. The Preferred Stock Purchase Agreements make agency credit effectively the same as Treasury credit, in our view. Importantly, the PSPAs do not expire after 2012, and we expect draws after that point to be well below the limit. INTEREST RATE DERIVATIVES Swap spreads: Caught in crosswinds 60 Front-end swaps are pricing in too much of a risk premium, despite our outlook for a volatile Libor. Spreads in the 5-10y sector should widen in Q1 11, before tightening in the second half. Fiscal concerns should continue to weigh on long-end spreads, which are likely to remain negative. Vol: The demand is not enough 73 Vols will likely decline in the early months of 2011, as traditional hedgers buy less than usual and investors stretch for yield in the low yield/tight spread regime. BMA swaps: Low and lower 84 BMA ratios should decline in 2011, driven by higher rates, Fed asset purchases and favorable technicals. SPECIAL TOPICS US housing finance: No silver bullet 91 We look at various housing finance alternatives and conclude that the government will play a dominant role in housing finance for many years. Any transition to the private sector should be a 15-20 year process, not the 3-5 years that many legislators are calling for. We think the focus should be as much on making mortgage loans safer as on the means of financing them.
16 December 2010 2
OVERVIEW
Tug of war
Ajay Rajadhyaksha +1 212 412 7669 ajay.rajadhyaksha@barcap.com
US rates are set to be pulled in opposite directions. An improving economy, worries about the US fiscal picture, and the boost provided by the tax cut/stimulus package all support a bearish view. But this is countered by a front end that should be pegged for several quarters, muted inflation, and heavy Fed buying. We expect the bulls to win over the next few months, given the magnitude of the December sell-off. But rates should rise in H2 11, as the recovery becomes firmly entrenched. We expect nominal 10s to finish 2011 at 3.5%, close to current levels. On the inflation front, we like TIPS breakevens in general, but especially at the front end of the curve. With the exception of the front end, swap spreads across the curve should widen in H1 11, but then tighten as the effects of QE2 fade and the US fiscal picture gets more attention. Libor should also rise, but not as much as implied by the forwards after the December move. Meanwhile, volatility should resume its decline, driven by the weakness of the mortgage option, callable supply, and the GSEs being in run-off mode. The agency MBS market is poised for big shifts in 2011. For the past decade, agency MBS have had heavy government support, through the GSEs and then through the Fed and Treasury. In 2011, we expect all these entities to move into run-off mode. But banks and money managers should be able to absorb this supply and prevent market dislocations. On the agency debt front, some investors have become wary of agency credit after YE 12. We think this fear is unjustified; the Preferred Stock Purchase Agreements make agency credit effectively the same as Treasury credit, in our view, and they do not expire after 2012. We expect draws after that point to be well below the limit. The debate over US housing finance is likely to heat up as Treasury submits its plan for the GSEs in January. A transition to any other system is at least a decade-long process, in our view, not the 3-5 years that many legislators want. For the foreseeable future, the agency MBS market should not just survive, but expand. The December sell-off has given investors the best entry point into the Fed-on-hold trades in several quarters. Whether it is being outright long the whites and reds, selling gamma on short tails, or just long the 2y Treasury, trades that fade the current sell-off and the aggressive steepening in the money market curve should do well.
The macro picture: Dj vu all over again?

The macro picture at the start of 2011 is surprisingly similar to the one 12 months ago. In H2 09, equities had a big run-up, rates sold off hard in December, 3m Libor declined sharply, the central bank was a buyer of US fixed income debt, and economic optimism was picking up. Compare that with H2 10 (Figures 1 and 2), when equities have again rallied since September, 3m Libor has dropped from the highs of mid-year, the Fed is aggressively buying Treasuries, and the recovery seems to be gaining steam. Skeptics (and Yogi Berra) might be forgiven for thinking they have seen this movie before and will caution that 2011 could bring another credit crisis, or a soft patch that raises doubt about the sustainability of the recovery, or a rate rally, and so on.
16 December 2010 3
Figure 1: Similarities between H2 09

S&P500 Index 1150 1100 1050 1000 950 900 850 Jul 09 3M Libor 0.65 0.60 0.55 0.50 0.45 0.40 0.35 0.30 0.25 0.20 Aug 09 Sep 09 Oct 09 Nov 09 Dec 09 S&P 500 Index (LHS)
Source: Barclays Capital
Figure 2: and H2 10
S&P500 Index 1250 1200 1150 1100 1050 1000 Jul 10 3M Libor 0.55 0.50 0.45 0.40 0.35 0.30 0.25 Dec 10
Aug 10
Sep 10
Oct 10
Nov 10
3m Libor (RHS)
S&P 500 Index (LHS)

3m Libor (RHS)
We beg to differ. The transition from the inventory/stimulus surge to a more sustainable expansion seems to be on solid ground. The jobless rate remains a disappointment, but personal income, consumption, wages and salaries are all showing steady growth, while both manufacturing and non-manufacturing ISM surveys indicate growth momentum. The extension of all the Bush-era tax cuts, as well as other parts of the agreement, should add another 0.3% to 2011 GDP. Importantly, the US is not alone. The Chinese economy seems to have overcome its own soft patch, with industrial production jumping back into double digits by October after slipping in Q2 and Q3. Germany has been a pleasant surprise; its 6% annualized growth in Q2 and Q3 has let Europe grow respectably despite sovereign debt issues. While not every major economy has pulled out of the mid-year slowdown (Japan and Brazil face a weak Q4), talk of a double-dip recession was clearly overdone. Despite the good news on European growth, euro area sovereign risks remain a major macro concern. The rescue packages for Greece and Ireland, the establishment of a stability fund, and the extension of ECB liquidity measures have all failed to calm bond markets in peripheral countries. But while another rescue package for a small country (Portugal) could be needed, we do not expect a similar situation with Spain. By our calculations, the latters debt problems are manageable, given time and the fiscal reforms it has already started (see Euro Area Bank and Sovereign Debt: Preemptive action needed, November 30, 2010). The risk is that market pressures push financing costs to unmanageable levels in the meantime. We expect European policymakers to be aware that they cannot let Spain fall prey to a crisis of confidence and to be more pro-active, if needed. Volatility will likely continue, but the European sovereign crisis should ultimately be contained. Notably, markets reached a similar conclusion in November as sovereign spreads widened unlike in the May episode, there was no flight to quality into US Treasuries or away from equities.
A round-trip on rates: First a rally, and then a sell-off

In this environment, rates should head higher in 2011, but not in the first half of the year. In fact, rates have sold off so swiftly in December that we have gone from recommending shorts to longs. There have been several theories put forward to explain the sell-off, including: Fed buying is being offset by rising inflation expectations, pushing nominal yields higher: This is patently not true. As Figure 3 shows, inflation breakevens have not really risen since early November. The bulk of the sell-off has been due to a rise in real rates.
16 December 2010 4
Foreign buyers are avoiding USD assets after the QE2 announcement: It is true that there were negative comments by officials from several countries after the Fed came out with a second round of quantitative easing. But the USD has held its own against most major currencies in recent weeks. An aversion to USD assets does not seem to be behind the sell-off. The tax agreement has renewed concerns about US fiscal problems: We have been discussing the deteriorating US fiscal picture for several months (see How risk-free are US Treasuries? January 8, 2010). But for now, investors seem to be giving the US the benefit of the doubt. 5y sovereign CDS for the US has tightened in recent weeks (Figure 4). While the CDS market is a small one, it does highlight concerns about sovereign credit, as seen in fluctuations in Spanish CDS. So US fiscal problems do not seem to be the culprit, either. Rather, we think the sell-off is the result of better-than expected data (excluding a weak jobs report), which has pushed out the last of the double-dip enthusiasts from their long positions. This has been exacerbated by a lack of liquidity in December, as well as the boost provided by the proposed tax cuts, which came with an unexpected stimulus package. But the sell-off is unlikely to continue, in our view. Indeed, rates should rally over the next few months before resuming their sell-off. Fair value for rates can be broken up into an expectations component (dictated by the expected value of the funds rate averaged over the next 10 years) and a term premium. Our expectations component is at 2.2%, which, while low by historical standards, is driven by the unemployment and inflation data. The term premium cannot explain the other 128bp; 10y yields appear 50bp cheap from a fair value standpoint (for more details on our views, please see At the crossroads on page 20). Investors seem to be underestimating the power of Fed buying. The Fed plans to buy $850-900bn in Treasuries by the middle of 2011, absorbing almost all the supply in the belly of the curve. The biggest holder of US Treasuries (China) has a similar portfolio, but it took a decade to build it up, while the Fed will take just eight months. The front end seems firmly pegged for the next several quarters. The sell-off has added 80-90bp of extra net interest margin to investors in the carry trade. The steepness of the yield curve, coupled with the low risk of fed funds rate hikes for several quarters, should get carry-conscious buyers back into the market at these yield levels. Figure 3: Real rates have driven the December sell-off
10y Breakeven 10y Real Yields vs 10y Breakevens 10y Real Yield 2.3 2.2 2.1 2.0 1.9 14-Oct-10 28-Oct-10 11-Nov-10 25-Nov-10 10y Breakeven (LHS)
Figure 4: US sovereign CDS has not budged recently

5y USD CDS 55 51 47 43 39 35 Aug-10 Spain vs US CDS 5y Spain CDS 400 350 300 250 200 150 Dec-10
1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 9-Dec-10
Sep-10
Oct-10
Nov-10
10y Real Yield (RHS)
5y US CDS (LHS)
5y Spain CDS (RHS)
16 December 2010
Core CPI has been trending lower for a few months and is now at 0.8% y/y. While we feel that core is bottoming, it is difficult for rates to rise with inflation so muted. Headlines out of Europe are set to continue. While we think the market will differentiate between the peripherals and the major countries, US yields should get some support from these headlines. All in all, while yields could rise a little higher for the rest of December in an illiquid market, we expect them to rally in the first few months of 2011. By mid-year, we expect the sell-off to resume, with 10y yields finishing 2011 at 3.5%, very close to current levels. We like TIPS on a breakeven basis across the curve, for various reasons. But we see most value in the front end, where short breakevens have under-reacted to the rise in commodity prices, even after factoring in weak consumer demand. Meanwhile, forward 1y breakevens in the 2012-13 sector have barely budged off late-summer lows, despite the tax agreements and the improvement in data. Finally, the 5y5y forward breakeven has risen nearly 90bp since late August. We still see value in longer forward breakevens, but mainly as inflation insurance. We believe the market should be pricing a higher inflation risk premium in forwards because of current monetary/fiscal policies, but also because the Fed has shown that it has an asymmetric reaction function around its inflation target of 1.75-2%. The reason for the asymmetry is that the Fed is not sure it can control deflation once it takes hold, but as Chairman Bernanke said recently, he is 100% confident that the Fed can prevent inflation from going too high. Because too much confidence can lead to excessive risk taking, we believe longer forwards still offer attractive inflation insurance.
Interest rate derivatives: Wider spreads but lower volatility

Swap spreads will, we expect, be driven by three factors in 2011: European sovereign risk issues, Fed purchases in the belly of the curve, and the deteriorating US fiscal picture. The first two should have an immediate effect, while the third should matter mainly as QE2 fades. That leaves us with wider swap spreads across the curve for the next several months as Fed buying of Treasuries sparks a rate rally. On the other hand, we think that the forwards are pricing in too sharp a rise in Libor in the coming months. We would not be surprised to see spot Libor-OIS averaging higher-than-current levels through 2011. But we do not expect forwards to be realized and recommend selling 1y LOIS spreads for the carry. The swap spread picture should change towards the end of the year. As the boost from QE2 to rates fades and as attention focuses on the US fiscal picture, swap spreads should take back some of their widening; this is a trade that we suspect will continue in 2012. Interest rate volatility is usually driven by uncertainty over Fed policy, weakness in economic data, and supply-demand dynamics including hedging needs from MBS accounts, insurance companies, etc. The first two factors should be bearish for volatility the Fed will likely be on hold for the year, and the recovery should continue. 2011 also looks to be a year of heavy volatility supply, largely through different types of callables and structured notes (for details, see The demand is not enough on page 73). Meanwhile, demand for options should stay weak, largely because the GSEs are in run-off mode and as the mortgage refinancing option has weakened in a world of tight credit standards. It is all adding up to be a gloomy year for option prices, and we recommend starting 2011 short large parts of the volatility surface.
16 December 2010
Government affairs: Agency MBS and agency debt

While the agency MBS investor base should be bearish for volatility in 2011, it is also going through major changes of its own. Over the past decade, the US government has (directly or indirectly) been a big buyer of agency mortgages. Fannie Mae and Freddie Mac led the charge in the first half of the decade, and the Fed and Treasury have picked up the slack in 2008-10. By 2011, the biggest holders of agency MBS the Fed, Treasury, and the GSEs will all be in run-off mode. Despite this, we recommend an Overweight on agency MBS: Weak home sales and anemic prices should keep net new issuance at a negative $60bn. While the Fed and the GSEs could add $365bn of supply, we expect banks and money managers to be aggressive buyers of agency MBS in 2011, purchasing about $150bn each through the year. The recent rise in yields should also help MBS, as it reduces the heavy premium risk that has affected valuations. Similarly, the declining prepay sensitivity to rate moves (which should persist) is also a positive. In fact, the Fed has already gone from being long the basis to effectively being short (by allowing portfolio run-off while buying Treasuries) this year. Yet agency MBS performance has not been too shabby. Figure 5 plots the cumulative hedged performance of the major agency MBS coupons over the year. On a fully hedged basis (rates, curve and volatility) and assuming daily re-balancing of hedges, every coupon had a positive profit in 2010, and investors in higher coupons made as much as 4-5 points. While we do not expect a repeat, agency MBS should navigate the end of government sponsorship without trouble. Indeed, agency debt investors seem far more concerned about government ties. Specifically, some investors have assigned particular significance to December 31, 2012, after which the nature of the Preferred Stock Purchase Agreements (PSPAs) changes. In our view, the capital support provided by the Treasury through 2012 and beyond makes agency credit effectively the same as Treasury credit: Through YE 12, any quarterly capital shortfalls as defined by GAAP net assets will be made up by the Treasury in full within 60 days of the reporting date. Draws made after 2012 will be subject to a cumulative limit of $125bn at FNM and $149bn at FRE. This does not apply to amounts before YE 12.
Figure 5: Agency MBS had a good 2010
Figure 6: Foreclosure backlog across states

25 20 15 10 5 0
YTD performance ($)

6 5 4 3 2 1 0 -1 -2 4 4.5 10y UST 5 5.5 6 10y swap 10y curve & vol 6.5
DC
US
NY
OH
MI
CA
NJ
AZ
NV
FL
(%Fcl + %90d) / %REO

% Seriously dq
16 December 2010
By distinguishing between FNM/FRE losses recorded before and after 2012, the Treasury has essentially made the timing, not the magnitude, of credit losses the main factor determining GSE creditworthiness. As long as losses are provisioned for before 2012, agency risk is analogous to Treasury credit risk. We believe that the GSEs have already recognized about 75% of the total credit losses they will ultimately face. We also expect the credit provisions that have yet to be taken to be recognized in full before YE 12. Worries about the 2012 deadline seem misplaced. For our views on the whole agency debt sector, please see With or without you on page 45.
Housing and housing finance

Our basic story on home prices has not changed for the past year, and we see no reason to do so now. With the foreclosure to REO pace reduced to a trickle, home prices should stabilize near current levels over the next few quarters. But this also means that the foreclosure pipeline will be an overhang in many states for several years, preventing a sustained rise in prices. For example, in New Jersey, there are nearly 15 times as many houses that could potentially be distressed sales (these loans are either 90 days delinquent or in foreclosure proceedings but not yet on the market) as the distressed houses currently on sale. This should prevent a sustained rise in home prices in several states. Most importantly, we believe the risk of another 15-20% decline in home prices is very low. For details on our home price outlook, see US Securitized Products: Outlook 2011 Hard act to follow, December 13, 2010. Even if home prices do not provide headlines in 2011, the debate over housing finance will, with the Treasurys plan for the GSEs scheduled to be revealed in January. There will likely be agreement among policymakers that the government needs at least to reduce its involvement in the mortgage market (the GSEs now provide over 90% of all mortgages). But as they wrestle with the trade-offs and choices available, they will realize that there are no easy solutions. None of the private sector alternatives private label securitization, covered bonds, or portfolio lending is a silver bullet that will easily replace the GSEs. And they all have drawbacks. But together, they can take over much of the role of financing mortgages, given time and (in some cases) the development of a regulatory framework. Any transition will likely take place over 10-20 years, not 3-5, as many policymakers have suggested. For the foreseeable future, the agency MBS market will, in our view, not just exist; it will thrive. Too much of the debate has been about ways to finance mortgages. A more important issue is simply how to make the mortgage product safer. This can be done by prescriptive means (where regulators detail what types of loans are allowed) or through rules such as risk retention guidelines (for details, please see US Housing Finance: No Silver Bullet, on page 91).
Making money: The Fed-on-hold trade

A discussion of various asset classes is useful only if it can be translated into actionable ideas. There are two overriding trading themes that drive our trade ideas for 2011. One is that Fed-on-hold trades make sense again from a valuation standpoint, after a gap of several quarters.
16 December 2010 8
The other is that rates have sold off too much and that the market has completely ignored any possibility of an extension to the $600bn in QE2. On the first point, we feel that the money market curve has steepened too aggressively in recent weeks, with forwards now pricing in some hikes as early as the end of 2011. We like being long both the whites and reds, as well as selling 1y LOIS spreads. On the option front, we recommend being outright short volatility, partly because rates should be range-bound in 2011 and not rise much from current levels. Our Fed-on-hold view also leads to a recommendation to be short gamma on short tails relative to 30y tails. The second point plays into our Treasury and swap spread calls. We recommend longs across the curve, but especially in the belly, where we expect heavy buying. For the same reason, we recommend swap spread wideners in the 5-10y sector. Meanwhile, being in 10s-30s steepeners and long TIPS are ways to position for any possible extension to QE2. If an extension starts to seem more likely, longer TIPS should benefit. As always, there are a few risks. The most prominent is a spreading of the European sovereign crisis to the bigger countries. But as mentioned earlier, we believe that the fiscal picture of the peripherals is different from those of Spain and Italy. Our base case is that the bigger countries should be able to manage their way out, though there will be plenty of headlines along the way. Another risk is an increase in the $600bn that the Fed has already committed to QE2. After the recent sell-off, the market seems to be ignoring this possibility. Yet if the current unemployment rate and inflation data are an indication, the Feds own models might show that it has to do more. In particular, if the jobless rate is not coming down as quickly as the Fed wants, an expansion of the Large Scale Asset Purchases (LSAP) program is not out of the question, as we show in At the crossroads on page 20). We think that the recovery should be sustained enough that the Fed will probably stay its hand after the first $600bn. But the market remains very vulnerable to a change in opinion after the December sell-off. Other risks include a big surge in worries about the US fiscal picture that causes yields to spike, though our analysis suggests that bond markets will give the US a few more years to show progress on the fiscal front. All in all, while there are risks in both directions, our base case remains a Fed on hold, a steady rather than spectacular economic recovery, and range-bound rates in 2011. Rates markets will likely undergo a tug of war without decisively breaking in either direction, at least in 2011. This might change in 2012 as investors buy into the idea of the recovery and as central banks start worrying about whether they are too expansionary. But that, as they say, is a story for another year.
16 December 2010
MONEY MARKETS
Outlook 2011
Joseph Abate +1 212 412 6810 joseph.abate@barcap.com
Next year looks set to bring even lower rates and a flatter money market curve, as a result of the Feds renewed large scale asset purchases (LSAP) and regulatory pressures. Politics will also likely play a role in front-end dynamics next year. Those investors hoping for some spread or extra yield may have to search elsewhere. We look for QE to pressure front-end rates lower 5-10bp and to flatten out the money market curve. Regulatory pressures are expected to prevent the supply of commercial paper from rebounding. Repo activity may decline in 2011 as window dressing ebbs and leverage remains limited. Money funds are likely to lengthen WAMs to 60 days while becoming increasingly barbelled. Foreign exposure is also expected to increase after a sharp reduction in December. Episodes of sharp risk aversion are likely to drift in and out of front-end markets throughout the year, causing rates to spike periodically. Front-end rates are expected to go through at least three phases in 2011 all headed lower. By the end of June, we see bill yields, repo and CP in the low to mid-teens. But periodic risk shocks can easily overwhelm the effect of massive liquidity in the front end.
I. QE2: Ease harder

Bank reserve balances are set to more than double
At the November FOMC meeting, the Fed announced it was re-launching its LSAP program to the tune of $600bn. Adding in MBS re-investments, the Fed is set to purchase nearly $900bn in Treasuries through the end of June 2011. At that point, the Feds balance sheet will have swollen to over $3.0trn, with a security portfolio of $2.7trn. And it will own 21% of all marketable Treasury debt. Bank reserves, which for years were below $50bn, are expected to reach $1.8trn by next June (Figure 1).
Figure 1: Bank reserves ($bn)

2000 1800 1600 1400 1200 1000 800 600 400 200 0 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11
Source: Federal Reserve, Barclays Capital
Figure 2: Fed funds and bank reserves (%, $bn)

IOER-FF (bp) 0 -5 -10 -15 -20 -25 500 600 700 800 900 1000 Reserves ($bn) 1100 1200 1300
Forecast
16 December 2010
10
Lowering OIS expectations

and more importantly, expectations should fall
While the Feds purchases are meant primarily to create a positive wealth effect and stimulate exports, they will likely also drag already low short-term rates lower. This will be felt through two channels: OIS expectations and GC collateral removal. Gauging the effect of each is a bit difficult and, indeed, there are some skeptics who believe that short rates are already as low as they are going to get. Instead, they argue, the Feds purchases and reserve creation will merely pile up in bank deposits at the central bank earning 25bp. After all, the direct link between the level of bank reserves and the effective fed funds rate has broken down, given the segmentation in the market (Figure 2). 1 However, we believe that the Feds very explicit commitment to bringing down term rates will be enough to pull OIS lower even if the OIS market is heavily influenced by the liquidity decisions of the GSEs. We believe the transparency of the Feds commitment with respect to the duration and scale of the LSAPs will be enough to lower overnight fed funds and OIS. It also suggests that the money market curve should get flatter in 2011. We look for the 3/6 Libor basis to narrow from 10bp, settling in to 5bp by next spring (Figure 3). For front-end investors, there is too little return to make purchasing short-term (ie, under 3m) paper attractive at current levels. As a result, they have begun aggressively pushing out the maturities of their investments. For instance, interest in 6m and 1y floating rate agency paper has been very strong in recent weeks. As demand pressures these rates lower and expectations about monetary policy stay flat in 2011, we look for the front-end curve to flatten.
We look for the money market curve to flatten
Collateral removal = lower short rates

Repo is expected to richen as the Fed buys $900bn in Treasuries
By contrast, the effect on repo markets from the entry of a large, price-insensitive buyer is easier to anticipate. We believe the removal of $900bn in Treasury collateral through midyear will drag Treasury repo rates down about 7bp as it crowds out money market funds and other private investors in the $2trn Treasury repo market. In 2009, the Fed purchased $300bn worth of Treasuries concentrated in the same sector of the Treasury curve. Over the seven-month life of the program, general collateral and other short rates fell sharply (Figure 4). The effect was exaggerated by the expiration of the SFB program and the generally anxious state of funding markets in early 2009.
Figure 3: Libor 3/6 basis (bp)

70 60 50 40 30 20 10 0 -10 Jan-09
Source: Bloomberg
Figure 4: Front-end rates, QEv.1 (%)

1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 Bills 0.0 Feb-09
Source: Bloomberg
Fed buys $300bn TSYs
Fin CP GC SFB winds down
Jul-09
Jan-10
Jul-10
May-09
Aug-09
Nov-09
See, The Mechanics of a Graceful Exit: Interest on Reserves and Segmentation in the Federal Funds Market, Bech, M. and E. Klee, Federal Reserve Bank of New York working paper, December 2009
16 December 2010
11
QE-driven substitution effects should drag other front-end rates lower
For most investors, Treasury repo is a close substitute for other short-term liquid investments such as bills and commercial paper. With 3m GC expected to trade around 15bp by the end of next June and traditional investors elbowed out of the market by the Fed, we expect bill and CP rates to come down. Unless credit risks rise (on a sustained basis), it is hard to see how the current 6bp spread between term repo and CP might widen. As a result, we look for a parallel move in CP rates with large AA banks likely to issue 3m unsecured paper at about 20bp. Netting out the effect of the expected SFB run-off, and given the calmer state of markets but scaling up for the 2011 operation, short rates are unlikely to fall as much as they did in 2009. In addition, to the extent that the Feds purchases are from real money accounts that are not being funded in the repo market, the effect of the Feds purchases on repo and front-end rates in general may be reduced. Nevertheless, we expect term repo and other short rates to fall 5-10bp by the end of June 2011. Puzzlingly, relatively little of this decline has been priced into the market, and bills, repo and AA financial CP seem a bit cheap at current levels. Instead, we reckon yields in the low teens seem fairer.
into the low teens
II. Supply and demand fundamentals in 2011

Front-end supply will be harder to find in 2011
We reckon it will be a bit more challenging for investors to find non-Treasury front-end supply in 2011. First, we expect regulatory pressures to encourage or even force issuers to modify their funding mix, preventing a rebound in commercial paper and repo activity. Second, politics will likely lead to the termination of the joint Treasury and Federal Reserve SFB program. And finally, we expect financial market leverage, although it is recovering, to remain under pressure. On the demand side, we expect money fund balances to face a tougher regulatory climate and more competition from banks for risk-averse depositors.
Regulatory pressures
because of regulatory pressure
Since financial markets stabilized in 2009, regulators have focused on systemic risks, in particular, how certain markets and counterparties exacerbated and spread contagion. Regulators from the Fed, SEC and the FDIC have taken a somewhat skeptical view of the repo market and the stable net asset value (NAV) money fund industry. Late in 2010, a flurry of proposals was submitted for market review. These include radical changes to money funds (insurance, liquidity banks, and floating NAVs), adjustments to the calculation of the bank deposit insurance assessment base, and the provision (at least temporarily) of unlimited deposit insurance on non-interest bearing checking accounts. In addition, banks have begun to focus on the liquidity coverage and net stable funding ratios contained in Basel III. Next year, we expect most of these provisions to take effect and begin reducing front-end supply. But the more than 2000 pages of legislation contained in Dodd-Frank have other rules that have yet to be fully fleshed out. For instance, there is an effort to limit or at least modify the bankruptcy remoteness of repo. 2 And while last years Miller-Moore provision never made it into Dodd-Frank, the law does require a study examining whether a haircut can reasonably be put on secured lenders or if there should be a temporary stay on all repo transactions in the event of a bankruptcy such that cash lenders are required to wait and seek FDIC approval before liquidating the defaulters collateral. Judging from some of the efforts now underway, it seems likely that some restriction on repo in the event of a bank bankruptcy is likely.
For a general discussion, please see Regulating the Shadow Banking System, Gorton, G. and A. Metrick, NBER, September 2010.
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Specials activity: A small recovery in volume Since September, there has been a noticeable pickup in specials activity, with both volumes and the average depth of specialness increasing (Figures A and B). The Feds purchases will be general collateral issues; however, given the scale of the operation, as well as its repeated tapping of some sectors (particularly 5-7y), we expect market float to decline. As the float or supply of individual issues declines, volumes in the specials market should theoretically increase. Although they may recover, it is hard to see much of a widening in the expected level of specialness, given the Feds 5bp SOMA lending fee. In effect, the spread cost of borrowing a particular issue from the Fed is low enough to discourage aggressive market price action even with the 300bp fails fee. Thus, while we expect some modest increase in the volume of specials activity, the specials-general collateral spread may only trade at -10bp for much of 2011. Furthermore, with no expectation of any shift in monetary policy toward tightening until late 2012, the market short base in Treasuries should remain fairly light next year. Dealers have been running a long Treasury position since February 2010, and their need to borrow securities in repo to cover short cash positions has evaporated. When interest rates eventually rise and monetary policy shifts, the short Treasury base may return and, along with it, a pickup in volume and individual specialness.
Regulating money funds

The SEC is planning additional regulations on money funds next year
Already in 2010, the SEC has focused on money market funds, which are now subject to tighter WAM limits and stricter counterparty and liquidity guidelines that limit their ability to generate higher returns. The Presidents Working Group recommendations are even tougher arguing that even the SECs new money fund changes would not have prevented the market disruptions caused by the runs experienced by prime funds in September 2008. While we strongly disagree with some of the PWGs recommendations as being both impractical and costly, we also recognize that the SEC is not finished with its money fund regulations. As a result, while we do not see the SEC imposing shorter WAM leashes on stable value money funds than their current 60 days, we can see, for instance, a requirement that raises overnight liquid balances to, say, 20% or more of assets under management and 7-day liquid balances of perhaps 50%. Furthermore, it is possible that the sponsors of stable NAV funds may be required to put up some amount Box Figure B: Volume weighted average specials spread to GC (bp)
0 -5 -10 -15 -20 -25 -30 -35 -40
Box Figure A: Specials volume (% total GC volume)
80 70 60 50 40 30 20 10 0 Jan-06 Oct-06 Jul-07 Apr-08 Jan-09 Oct-09 Jul-10
Jan-06
Oct-06
Jul-07
Apr-08
Jan-09
Oct-09
Jul-10
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13
of capital as a demonstration of their commitment to the fund. Money funds struggled earlier this year to meet the SECs initial requirements; additional regulatory burdens may not be quite as burdensome to meet in 2011. Nevertheless, they could significantly diminish the fund industrys appetite for longer-duration credit product and push it to hold more overnight repo.
and repo
and its efforts to eliminate quarter-end window dressing will reduce repo volumes
Similarly the SEC has begun to scrutinize repo market window dressing, where banks manage down their balance sheets at quarter-end to show higher capital/asset ratios. We believe quarterly average reporting, together with discussion narratives, will eliminate most of the incentive borrowers have to shrink term repo borrowings by an average of 15% in the final week of a quarter (Figure 5). To the extent that banks are comfortable reporting their current level of short-term borrowing, we expect the introduction of quarterly average reporting to reduce market volumes by about 15%. And while balance sheet renting intra-quarter will likely disappear along with peak supply, we expect one of the benefits to be longer duration trades that can now span quarter-end and significantly less volatility in rates. Quarter-end collateral rates should be little different than those at other times in the quarter.
Other related efforts

A change in the deposit insurance assessment base should also reduce supply
Other efforts, including the Basel III liquidity coverage ratio and the net stable funding requirement, are also likely to reduce front-end supply. Regulators are encouraging banks to term out their funding by issuing more longer-term unsecured debt and replacing flight-prone repo and other forms of wholesale funding with sticky retail deposits. Already, before the study period for Basel IIIs liquidity guidelines goes into effect, the FDIC has moved. Base assessment rates for deposit insurance will be adjusted higher for institutions that rely on brokered deposits. Similarly, the assessment rate will be lowered based on the amount of long-term unsecured debt the bank has outstanding. And in a break with tradition since 1935, the FDIC is severing the link between the assessment base and deposit insurance. Beginning next spring, all liabilities, including repo and commercial paper, will be subject to the FDICs assessment rate. We expect this to lower the attractiveness of both, with banks pulling back on their issuance of commercial paper and repo something the markets have already imposed on them. Since 2007, wholesale funding as a share of total large bank liabilities has fallen from 30% to 22% as deposit Figure 6: Net dealer leverage ($bn)
700 600
Figure 5: Intra quarterly repo behavior (quarter end =100)

120 115 110 105 Avg 2008-10
500 400 300
100 95 90 -5 -4 -3 -2 -1 0 1
Avg 2002-07
200 100 0
Jan-06 Oct-06
Source: Federal Reserve
Jul-07
Apr-08 Jan-09 Oct-09
Jul-10
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balances have risen to 64% (from 52%). The effect is expected to be more pronounced in repo, given that most recent CP issuance has come from foreign banks that are not subject to the FDICs deposit insurance rules. 3 In other developments, ratings agencies are working to remove or reduce the systemic support implicit in some banks ratings (particularly BAC, GS, MS, and C). Removal of the ratings uplift would automatically reduce the short-term debt rating since the two are tightly mapped. Assuming the long-term debt ratings of these institutions are lowered to their stand-alone levels, their short-term ratings could slip out of Tier 1 and into the much smaller and lower-rated Tier 2 market. For the most part, Tier 2 issuers are blocked from the commercial paper and repo markets, given the limitations imposed on rated money funds with respect to their trading counterparties, even in overnight GC repo.
Less leverage = less repo

Dealers have reduced their leverage and need for repo funding
Finally, after peaking in early 2008, banks and dealers have significantly reduced their leverage. Low margins or haircuts in repo markets enable investors to leverage up substantially. In the case of a (standard) 2% haircut against Treasury collateral, an investor is able to borrow up to 50x her initial investment. A number of studies have pointed out the inherent riskiness of this amount of leverage. Falling prices lead to asset price and margin spirals that amplify deleveraging. 4 Interestingly, a recently published paper notes that during the financial crisis in 2008, repo lenders were more likely to pull funding outright than to adjust margins incrementally higher. 5 With this in mind, the amount of leverage created via repo that is, the difference between the amount dealers borrow and lend against collateral has fallen from more than $600bn in 2008 to $200bn in November 2010, although it has come off its lows (Figure 6). Chastened by the flightiness of this funding and sensitive about their capital levels, we do not expect leverage to rebound much in 2011, especially given the ratings pressures on banks. As a result, a limited rebound in dealer leverage next year is expected to keep repo supply-constrained.
Political stalemate
Politics are also likely to play a role in the dynamics of front-end supply next year. The election results in November make it likely that the debt ceiling will not be expanded automatically without a public political fight. As the Treasury struggles to keep its coupon auctions regular and predictable, it will be forced to cut back on bill supply, likely specifically targeting the $200bn SFB program. In September 2009 and ahead of the previous debt ceiling showdown, the Treasury allowed the program to run off. We look for it to run down steadily beginning in February. Since there is little need to drain reserves at the moment and the Fed has other effective tools, we do not expect this $200bn in supply to come back when the debt ceiling is ultimately raised. The run-off of the SFB program would partially offset an increase in regular bill supply caused by the recent changes to the tax code, resulting in a net decline in bills of $75bn.
We look for short-term Treasury supply to increase in 2011
However, this overstates the effect of reduced front-end Treasury supply, as there is a significantly bigger amount of short-coupons maturing into the 1-year bucket than last year. By the end of 2011, the volume of Treasury coupons rolling into the money fund
A final decision on whether bank reserves will be included in the calculation of the deposit assessment base will not be released until late January. As currently written, their inclusion is expected to pull all short rates lower, by roughly the average assessment rate for top tier banks, say, 5bp. 4 See, Market Liquidity and Funding Liquidity, Brunnermeier, M. and L. Pedersen, Review of Financial Studies, 2008. 5 See, The tri-party repo market before the 2010 reforms, Copeland, A., Martin, and M. Walker, Federal Reserve Bank of New York, working paper, November 2010.
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sector will have increased more than $400bn compared with December 2010. As a result, we look for much of the current relative richness in bills to dissipate as money funds shift into Treasury coupons with shorter than 1y maturities. At the same time, some short-term investors may turn to the TLGP market. TLGP paper was short-term debt issued by banks that was guaranteed by the FDIC. As a result, it trades fairly tight to regular agencies. Depending on how individual money funds treat this debt in their portfolios, the roll-down of nearly $100bn in paper over the course of 2011 may be an attractive alternative to Treasury bills and short coupons. By the end of the year, an additional $156bn will roll down into the under 1y sector.
Money fund appetite

Demand for bills, CP and GC depends critically on the money fund industrys appetite specifically, on the size of balances in taxable funds. Regulatory pressure meant to shrink the size of the money fund industry is expected to reduce the demand for repo, CP and bills. The regulations we judge most important with respect to money fund demand include the FDICs provision of (temporary) unlimited deposit insurance and likely additional changes from the SEC regarding money fund liquidity and credit risk. At the same time, institutional interest in money funds may continue to wane, with returns in the low single digits and, perhaps, an increased willingness to do-it-yourself that is, manage cash outside money funds by direct purchases of short duration assets.
We expect $250bn to leave money funds for bank deposits
Beginning at year-end, the FDIC will provide unlimited deposit insurance to non-interestbearing checking account holders. Given that money fund rates are practically noninterest bearing already and likely to become more so next year, traditional deposits with their government insurance guarantee are likely to pull some balances out of money funds. But determining the amount of redemptions is difficult since it depends on the interest rate sensitivity of institutional investors, as well as their demand for unlimited insurance coverage. Under normal market conditions, the stable NAV is a form of quasideposit insurance. However, unlike the FDIC guarantee, the stable NAV is backstopped only by the ability of the fund sponsor to buy out assets (at above market prices) from the faltering fund. Normally, institutional investors are willing to accept this weaker form of insurance, given the higher yields available on money funds balances than on bank deposits. And during bouts of financial market volatility, the value of deposit insurance goes up. Our working assumption is that perhaps $250bn of the $1.8trn in institutional money fund balances will leave for bank deposits. Given the average composition of money funds which is heavily skewed toward repo, commercial paper and short duration Treasuries we look for a corresponding decline in the demand for all three.
III. Money funds Another difficult year

Limited supply, tougher regulations and bank competition
Money market funds are likely to experience another difficult year in 2011. Our forecasts assume that short rates will all be 5-10bp lower than late 2010 levels, amid fairly constrained supply. At the same time, tougher regulations with respect to liquidity requirements and potentially stiffer competition from banks are expected to pressure the industry in 2011. Money funds are likely to compensate for the difficult operating climate by barbelling their portfolios. Since the end of June, they have aggressively lengthened their WAMs, which have climbed from a trough of 35 days to 50 days currently. That funds have managed to accomplish this while boosting the percentage of their assets invested in the seven-day maturity bucket from 29% to 38% and keeping the proportion of commercial
16
Money fund balances are likely to get more barbelled
16 December 2010
paper on their balances constant must mean that durations at the opposite end of the barbell (ie, in everything other than the week-long liquidity bucket) have lengthened considerably. Other circumstantial evidence comes from financial commercial paper issuance. CP is typically a fairly short-duration product with a WAM generally well below 1m. Federal Reserve figures indicate, however, that since nervousness about bank credit waned with the publication of the European bank stress test results this summer, the proportion of financial CP issued with a maturity greater than 81 days has increased. We expect average WAMs in money funds to continue to lengthen reaching the maximum 60 day limit before March.
with a large exposure to foreign CP
At the same time, CP holdings at money market funds have taken on a foreign flavor one that is likely to continue in 2011 after a sharp retrenchment in December 2010. On average, prime money funds hold 34% of their assets (or over $550bn) in commercial paper, just under one-third of which is asset backed. The ongoing shift in domestic bank funding has meant that the supply of domestic CP available to satisfy their demand has shrunk. In our examination of the published holdings of the top six prime funds (some 30% of the prime money fund universe), 72% of the dollar amount of their commercial paper comes from non-US issuers. Foreign exposure in the top money funds rises to over 56% once deposits are included. Interestingly, money fund exposure to Spanish and Italian banks is quite small. The largest money funds together held less than 5% of their assets in either deposits or the commercial paper of Spanish or Italian institutions at the end of October and before the latest credit flare-up. Of course, the asset allocation of these largest prime funds may not reflect the overall proportion of foreign sponsored paper across the industry. But given recent financial paper issuance, it is hard not to conclude that a substantial portion of prime money fund commercial paper holdings come from non-domestic institutions. One implication of this shift is that money funds are now more exposed to global financial events, such as the sovereign credit flare-up this month. In itself, this may not have much implication for money fund risk all prime fund holdings regardless of the locale of the issuer are Tier 1, and the paper itself is relatively short duration. Thus, under normal market conditions, the higher concentration of foreign-sponsored paper slightly boosts returns but is no less liquid than the domestic paper they would buy if it were available for sale. However, it does suggest that portfolio managers may have to get used to fielding questions such as those they were peppered with this spring and in December the next time markets get turbulent. In May and June, as LOIS spreads widened on concern about bank exposure to sovereign credit, some money fund investors began asking for details on specific regional and bank exposure. By contrast, in December, the money fund managers themselves volunteered information about their foreign bank obligations to forestall investor worries. In theory, fund redemptions could become more sensitized to international developments during these flare-ups. Indeed, it was recently noted that prime money funds sharply reduced their exposure to foreign banks in just the past few weeks. 6 However, so far in December, there has not been any increase in redemptions on the contrary, government only and prime balances have risen 1.6 and 0.8%, respectively, since the start of the month. This lengthening of WAMs is risky if redemptions pick up. However, while we suspect that the interest rate sensitivity of institutional investors may have increased, mass redemptions of the scale seen in September 2008 are unlikely. Moreover, unlike in 2008, (prime) money funds have ample liquidity their holdings of paper maturing in under a week exceeds $600bn, $200bn
increasing the importance of global financial events
See, Prime Funds Trim Foreign Bank Debt Exposure, Money Fund Report, December 10, 2010, imoney.net.
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greater than the peak 7d redemption rate in September 2008. Instead, while redemptions might pick up next year as investors search for somewhat higher yields, we expect the industry to remain a behemoth, with at least $2trn in (taxable) assets under management.
IV. Rate phases

We look for rates to head lower in three phases
There are a number of reasons to expect front-end rates to decline in the coming year: QE, the likely expiration of the SFB program, and the possible inclusion of reserve balances in the calculation of the FDICs insurance assessment base. We expect these effects, together with regulatory pressures, to reduce the supply of front-end products more than the anticipated shrinkage in money fund balances. Through next year, the declines in front-end rates are likely to be lumpy in three distinct phases (Figure 7). In phase 1, the initial rounds of QE will push rates lower; these effects should be fairly steady in phases 2 and 3. Phase 2 begins in mid-to late February as the SFB program is terminated and bill supply shrinks. We look for short rates to move lower thereafter. Phase 3 will begin in late spring something after April 1 when the FDICs proposed changes to the deposit insurance assessment base take effect. This final phase is the trickiest to forecast because there is still the possibility that the FDIC will exclude reserve balances from the assessment base calculation a final decision will not be reached until early January. Nevertheless, we have a strong downward bias in our rate projections through June. Assuming the Fed is unhappy with the unemployment rate and inflation outlook, additional LSAP could continue after June with correspondingly lower front-end rates.
Figure 7: Interest rate forecast table

Phase 3 Phase 2 --------------------------------Phase 1
Current O/N GC FF Bills 3m Bills 6m AA fin CP 3m Libor 3m Libor 3/6 basis
Dec-2010 0.19 0.17 0.12 0.17 0.25 0.30 0.10
Mar-2011 0.15 0.15 0.10 0.13 0.19 0.24 0.07
Jun-2011 0.13 0.13 0.09 0.12 0.15 0.20 0.05
Dec-2011 0.13 0.13 0.09 0.12 0.15 0.20 0.05
0.22 0.19 0.13 0.18 0.27 0.30 0.10
V. Risk flare-ups
Our projections assume no change in credit conditions. But as seen in the spring and again in November and December 2010, changes in credit can easily overwhelm underlying liquidity dynamics. For instance, concern over sovereign credit exposure in May pushed 3m LOIS to 30-35bp. In December, and amid rumblings of some issuers struggling to roll over their commercial paper, forward markets began pricing in significantly more credit premium. The forward LOIS spread widened from about 25bp in early October to 40bp in December through the end of 2012.
Decomposing LOIS
Credit concerns flared up in December
LOIS can be deconstructed into credit and liquidity subcomponents. The first is the compensation front-end investors demand for taking on bank exposure even if only for 3m. As Michaud and Upper (along with others) demonstrate, LOIS is strongly correlated
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with the average credit default swap of the underlying panel members, 7 which has risen from 108bp in mid-October to over 135bp in early December, is in line with its mid-May level (Figure 8). Subtracting out the risk-free rate (3m GC), we estimate the credit compensation embedded in LOIS has risen from a trough of 6bp in August to about 10bp in early December (Figure 8). Given where forward LOIS was in early December and where it got to in May and June, the market appears to be looking for some upside risk in Libor. Although we see little chance of a sustained back-up in Libor funding rates in 2011 amid QE and SFB expiration, we do expect the front end to go through periodic episodes in which credit flare-ups cause bank funding costs to move higher. In reviewing our forecasts for 2010, our biggest miss was not paying enough attention to potential credit tape bombs that caused CDS spread to widen dramatically and funding rates to react violently. Hopefully, we are not making the same mistake in this forecast round. Unfortunately, year-ahead forecasts have a way of coming back to haunt their authors.
Figure 8: 5y CDS spread of Libor panel members (bp)

210 190 170 150 130 110 90 70 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10
Figure 9: 3m LOIS deconstruction (bp)

35 30 25 20 15 10 5 0 -5 -10 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Liquidity Credit
Note: The average excludes Norinchukin, BTMU, and RBC, for which reliable data are unavailable. Source: Bloomberg
Source: Bloomberg, Barclays Capital
See, for example, What Drives Interbank Rates? Evidence from the Libor Panel, F. Michaud and C. Upper, BIS Quarterly Review, March 2008
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TREASURIES
Too fast, too furious

Anshul Pradhan +1 212 412 3681 anshul.pradhan@barcap.com
We expect 2y yields to decline, as the market seems to be pricing in the Fed to offset its securities holdings with hikes in the funds rate beginning in late 2011, which we believe is unlikely; if needed, the Fed would probably drain reserves as the first step. We expect intermediate yields to decline in Q1 11, as the recent sell-off has not been commensurate with the improvement in the growth outlook, which has been partly offset by worsening of the employment and inflation picture. Yields should then gradually sell off by the end of 2011 as the recovery gains strength (Figure 1). Net supply of fixed income securities should decline in 2011 from 2010 levels led by lower Treasury issuance and higher Fed involvement. In addition, there is potential for upside surprise to the Feds asset purchase program, demand from foreign central banks and domestic banks which tilt the balance further towards excess demand and should lower term premiums in the intermediate sector. Treasury is likely to resume cutting auction sizes in the front end by the middle of 2011 as forward-looking borrowing needs decline. Investors should not rule out a rise in long intermediates and bond auction sizes later as the Treasury will likely try to prevent the process of lengthening the average maturity of its debt from stalling. We therefore expect the 10s30s Treasury curve to re-steepen. Excess demand should lower the term premium in the intermediate sector relative to the long end. At the same time, long-term inflation expectations should rise as the market reassesses the potential for further large-scale asset purchases. Little action on long-term deficits so far also supports steepening. Fed purchases of Treasuries are also likely to iron out the kinks on the Treasury curve as it continues to focus on cheap securities in its purchase operations; old 30s in the 9-10y sector and old 3s in the 1.5-2.5y sector stand out as cheap on the curve. The STRIPS market has grown rapidly in 2010 led by activity in the long end, which was helped by a steep Treasury curve, higher bond issuance and strong demand from pension funds. We expect net stripping activity to slow and recommend that investors switch from P STRIPS to C STRIPS in the 15-20y area to gain 11-13bp.
Figure 1: Near-term rally followed by a sell-off; 10y rates to end 2011 at 3.5%
Rates forecast 2s 5s 10s 30s 10s30s
Spot 0.67 2.12 3.53 4.60 1.07
Q1 11 0.40 1.40 2.80 4.25 1.45
Q2 11 0.50 1.50 2.90 4.40 1.50
Q3 11 0.60 1.80 3.20 4.70 1.50
Q4 11 0.80 2.10 3.50 4.85 1.35
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Front end: Interaction with Feds LSAP

We recommend going long 2y Treasuries, as the market is too early in pricing Fed hikes
2y Treasuries rallied in 2010 to a historical low of 0.33% after spending most of 2009 and early 2010 at about 1%, as economic data weakened and the Fed maintained its language of exceptionally low levels for the federal funds rate for an extended period. With 2y rates at 0.67%, we think risks are skewed towards lower rates, as the Fed may stay on hold for longer than the market is pricing in. The market seems to be pricing in the Fed offsetting its high holdings of securities with hikes in the fed funds rate starting late 2011; however, we believe this is unlikely to be the first step. Rather, we believe the Fed is more likely to drain reserves first, then hike the funds rate if conditions warrant. In Figure 2, we plot the fed funds rate against our estimate, based on a rule similar to the Taylor rule, which links the fed funds rate to the unemployment rate and core CPI inflation. As can be seen, past moves in the funds rate can largely be tracked. With the current unemployment rate at 9.8% and y/y core CPI inflation at 0.8%, the implied funds rate is -4.1%. More importantly, even by the end of 2012, using the Feds own forecast from the November FOMC minutes, the implied funds rate is still -0.9% (turns positive only by the Jul-2013) as compared with 1.47% as priced in to Eurodollar contracts (average of EDM2 and EDZ2 minus the FRA/OIS basis). If the economic outlook does not warrant Fed hikes, then why are investors expecting them? We present one plausible explanation in Figure 3. Because the Fed is engaging in large scale asset purchases (LSAP) to achieve what it would by lowering rates, we plot the true funds rate by augmenting the Feds holding of securities ($500bn is assumed to be equivalent to 50-75bp in funds rate as estimated by NY Fed). With the Feds security holdings having risen to $2.1trn from $500bn the Fed has lowered the funds rate to 1.8%, which is still well above where it would be if the Fed could cut the funds rate to negative levels. However, if the economic outlook improves as the Fed is forecasting and the Fed keeps its security holdings unchanged beyond June 2011 then by the end of 2012, the desired funds rate should be above the true funds rate; -0.9% vs. -2.4% (Figure 3). The market may be pricing in the Fed to remove this extra stimulus by hiking the funds rate instead of taking an action on its balance sheet. We believe the Fed would start by either draining reserves by
A Taylor rule estimate suggests the desired funds rate should be negative until the end of 2012
LSAPs have, to some extent, bridged the gap between the desired and effective funds rate
The market is pricing in the Fed to offset its securities holdings by hiking the funds rate, but this is unlikely to be the first step
Figure 2: Desired fed funds to remain negative for the next two years
12 10 8 6 4 2 0 -2 -4 -6 -8 Dec-87 Dec-92 Dec-97 Dec-02 Dec-07 Dec-12 Actual Fed Funds Rate, % Estimated 1.41
Figure 3: Market may be pricing in the Fed hiking to offset security holdings, but that is unlikely to be the first step
2 1 0 -1 -2 -3 -4 -5 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Desired Fed Funds Rate, % True Fed Funds Rate with Fed Balance Sheet, % Fed Funds Rate, No action on Balance Sheet, % Market, FF contracts -2.4 -0.9 1.5
Source: Federal Reserve, Bloomberg, Barclays Capital
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engaging in reverse repos/expanding the supplementary bill financing program (SFP)/term deposits and/or by shrinking its portfolio by letting securities roll off (about $400bn would mature/paydown in 2012) rather than hike the funds rates.
Long 2y Treasuries or other variants such as receiving 1y1y OIS should perform well
Hence, while 2y rates at 0.67% are still quite low in a historical context, they are still high with respect to the current environment. We recommend going long 2y Treasuries. Investors should also consider receiving 1y1y OIS or swaps, the latter because we believe that the 1y1y Libor-OIS basis at 35bp is too high (please see the Swaps outlook).
10y rates: Near-term rally, followed by a sell-off

10y rates staged an impressive rally during the middle of 2010 as the economic outlook worsened and sovereign crises engulfed some euro area countries
10y rates remained in a tight range of 3.6% to 3.8% in the first quarter of 2010, before selloff to 4.0% as the first Fed purchase program came to an end but then rallied off sharply over the coming months because of the sovereign crisis in Europe as well as the weakening of growth outlook in the US; real GDP growth slowed down from the originally reported 5.6% in Q309 to 1.7% in Q210. Equally worrying was the disinflation trend; y/y core CPI inflation fell to 0.9% by mid-2010 from 1.8% at the beginning of 2010; breakevens and real yields contributed equally to the rally in nominal yields. Fedspeak then switched from exiting the stimulus to a need for more action, which culminated in the Fed announcing a new LSAP of $600bn in Treasuries in addition to reinvesting paydowns from its agency portfolio. As one would expect, this resulted in a sharp decline in real yields and a rise in breakevens; the latter blunting the effect on nominal yields to some extent, which fell to slightly below 2.4%. With fiscal policy becoming supportive of growth on the margin after the latest announcement, the market not only seems to have revised its growth outlook higher (our economists have revised their 2011 growth forecast higher by 0.3%, to 3.1%), but also has reduced the odds of the Fed expanding the LSAP, as evidenced by the sharp pickup in real yields to above preSeptember FOMC levels; 10y real yields are now trading at 1.17% versus 0.96%. At current levels, we believe 10y rates are 50bp too high, even before accounting for supplydemand dynamics tilting towards excess demand. In Figures 4 and 5, we breakdown 10y nominal rates into expectations and term premium; the former is derived from the expected evolution of fed funds rate over the next 10 years and the latter is the difference between Figure 5: 10y term premium 50bp too high at current levels, even before accounting for the excess demand
2.5 2.0 1.5 1.0 0.5 0.0 1.28 0.75
Change in the Feds stance towards more stimulus lowered real rates further and resulted in higher breakevens; the price action in real yields has been reversed
10y rates are 45bp too high given the current economic outlook
Figure 4: 10y rate expectations have declined to just 2.25%, given high unemployment rate and low inflation rate
9 8 7 6 5 4 3 2 1 0 Dec-90 Dec-95 10y rates, % Dec-00 Dec-05 Dec-10 3.53 2.25
-0.5 -1.0 -1.5 -2.0 -2.5 Dec-90 Dec-95 Dec-00 Dec-05 Dec-10
10y expectations, %
10y Term Premium, %

Estimate, %
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22
the actual rate and the expectations component. Figure 4 shows that the bullish trend over the past two decades is largely captured by declining expectations; the trend was driven by declining inflation. Even in 2010, the swings in 10y rates can largely be attributed to expectations. Current 10y expectations are at just 2.25%; while this seems low in a historical context, they are justified given the high unemployment and low core CPI inflation rate. 10y rates are 128bp above expectations, and as Figure 5 shows, this term premium is roughly 50bp higher than what can be explained by our model, which uses the 2y term premium/monetary policy stance and structural budget deficits as explanatory variables.
We expect intermediate yields to decline over the Q1 11; 10y rates should decline to 2.8% before inching higher to 3.5% by the end of 2011
As the data continue to improve, we believe that the expectations component will rise through 2011; however, the fair value of our term premium is biased lower in the near-term because of the supply-demand dynamics. With the Fed buying Treasuries through the first half of 2011, and given the potential for up-scaling of the program, overall net supply of fixed income securities that investors need to absorb should be lower in 2011 versus 2010. In addition, we believe there is the potential for upside risks to the demand side of the equation from foreign central banks and domestic banks. We therefore expect 10y rates to decline over the next few months to 2.8%, led by real rates, before rising to 3.5% by the end of 2011. We discuss the supply-demand dynamics in detail below.
Fixed income supply landscape: Less to go around

Net fixed income supply that investors need to absorb should decline in 2011
Figure 6 tabulates net supply across fixed income sectors (Treasury, munis, agencies, corporate debt and other securitized debt) for the past few years and our expectations for 2011. We exclude Fed/Treasury purchases from 2009, 2010, and 2011 numbers. For 2011, we assume that the Fed buys the announced $600bn Treasuries by June-2011 and continues to reinvest pay-downs in its agency portfolio into Treasuries through December 2011. Net term fixed income supply to the market should decline to $1.15trn from $1.77trn in 2010. Including short-term/floating rate supply, overall fixed income supply should be $0.96trn in 2011 versus $1.58trn in 2010, or ~$600bn lower. The biggest contributor to the swing is net Treasury coupon supply, which should decline by $825bn because of lower net issuance (-$365bn) and higher Fed involvement (+$460bn). Supply of agency debt/MBS should increase, led mainly by the pay-downs in the portfolios of the Fed, Treasury, and GSEs. The recent rise in yields has reduced our expectations of pay-downs in the Feds agency
due largely to a decline in Treasury supply and higher Fed involvement
Figure 6: 2011 fixed income supply ~$600bn lower versus 2010 due to higher Fed involvement and lower Treasury supply
FI supply, net, $bn Treasury, ex-bills Municipal Debt Agency Debt-ex discount notes Agency MBS Fixed Rate IG/HY Corporate Non-Agency MBS+CMBS+ABS Total Net Term Supply, $bn T-bills/Agency Discos/Floating Rate Corporate Grand Total, $bn Memo-Fed/Treasury Net purchases 2006 191 135 85 315 178 798 1,702 296 1,998 0 2007 101 156 -60 538 309 441 1,485 658 2,142 0 2008 332 1 -44 507 454 -270 980 1,025 2,005 0 2009-ex Fed/Tsy 1,256 31 -174 -860 928 -306 875 -714 161 1,760 2010E-ex Fed/Tsy 1,363 93 -197 -19 787 -255 1,773 -188 1,585 77 2011E-ex Fed/Tsy 540* 0 -40 305** 570 -230 1,145 -185 960 465***
Note: *Net Treasury coupon supply is expected to be $1.24trn, of which the Fed is scheduled to buy $480bn through the new program and $225bn through paydowns. **Net agency MBS supply of $305bn assumes GSEs are net sellers of $170bn. ***The Fed is assumed to purchase $705bn in Treasury, partly offset by $240bn pay-downs in the Fed/Treasury portfolio of agency securities. Source: Treasury, Federal Reserve, EMBS, Barclays Capital
16 December 2010
23
MBS portfolio, which result in lower Feds Treasury purchases but at the same time lower the supply of agency MBS that investors need to absorb. Corporate supply has declined from 2009 to 2010, and we expect it to do so further given high redemptions and record cash on balance sheet, the latter should gradually normalize. Other securitized net issuance should remain negative.
Lower net supply should put downward pressure on the term premium in the intermediate sector
Lower net fixed income supply should put downward pressure on intermediate real yields in the near term but the story does not end there. We see the potential pickup in demand at the intermediate sector from key investors: the Federal Reserve, foreign central banks and domestic banks. Before going into the demand side, we look at Treasury supply in detail below (for details on the supply outlook of spread products, please see respective outlooks).
Treasury supply outlook: Terming out to continue

Treasury has been gradually terming out debt; we expect a continuation
The Treasury has come a long way in reshaping the issuance landscape to manage its elevated borrowing needs. In 2008, when budget deficits spiked, it initially relied on bills expanding the bill universe to $2trn from $1trn. Although that helped in financing record deficits, the Treasury debt became shorter; the average maturity fell to a historical low of 49 months (Figure 7). Since then the Treasury has relied solely on the coupon universe to meet borrowing needs that are lower than in 2008 but still elevated. As a result, the average maturity has risen to 59 months (60 months excluding bills issued under the Supplementary Financing Program(SFP)) versus the historical average of 60 months. Over 2011, and next few years, we expect the Treasury to continue to extend the average maturity while faced with lower net borrowing needs (FY 11: $1.25trn, FY 12: $1.1trn versus $1.48trn in FY 10). We assume the Treasury lets bills issued under SFP mature. While the average maturity has risen in historical averages, we believe it is far from where it should be given the fiscal outlook; the debt/GDP ratio is well above the average during this period and is projected to continue to rise. Currently, the contribution from interest cost to the fiscal picture is low given the low level of yields, 1.4% of GDP and 9.5% of federal revenues. However, were yields to normalize and the outlook for primary deficits not improve, interest payments alone would increase to a little less than $1trn by 2020, and 20% of revenues would have to go towards servicing debt. We believe the Treasury should continue to extend the average maturity to reduce this sensitivity. Figure 8: almost solely due to the declining share of bills
Share, % Mar-09 Bills 33% 67% Nov-10 20% 80% Avg. Maturity, months Mar-09 3.0 72 Nov-10 2.8 73.25 8.4 1.0 9.4
as the bleak fiscal outlook demands government debt less sensitive to rates
Figure 7: Average maturity has risen from the lows

75 70 65 60 55 50 45 40 Sep-80 60 59
Coupons
Change in maturity due to lower share of bills, months Change in maturity due to higher maturity of coupons Total change in maturity, months
Sep-85
Sep-90
Sep-95
Sep-00
Sep-05
Sep-10
Source: Treasury
Average Maturity, months

Source: Treasury
16 December 2010
24
Treasury needs an Operation Twist: Higher auction sizes further out

Average maturity has risen from the lows, due largely to the declining share of the bill universe to 20%, already at a historical low
How should the Treasury achieve that? To answer this question, it is important to understand how has the Treasury managed to increase the average maturity so far and if the Treasury could simply keep doing more of the same. Figure 8 shows that the lengthening of debt so far has been almost entirely due to the falling share of the bill universe; the increase in the average maturity of the coupon universe has contributed little. Bills have fallen to a historical low of 20% and of the 9.4 month extension from the lows the former has contributed 8.4 months and the latter only 1.0 month. This seems a little surprising, as the Treasury has increased issuance at the long end quite considerably. The answer lies in Figure 9, which shows the breakdown of US coupon universe (ie, excluding bills) by maturity bucket. While the share of <1y debt has fallen and that of 5-10y debt has increased, both of which should have increased the average maturity, this has been offset by the rising share of 1-5y debt and declining share of >10y debt; the latter has fallen to just 13% of the coupon universe, a historical low. With the share of bills already low and average maturity also still low, the Treasury should therefore consider an issuance pattern that focuses on increasing the share of the intermediate and long-end sectors rather than relying on further shrinkage of the bill universe. The path of least resistance is to keep auction sizes unchanged; however, this has limitations. In Figure 10, we show the evolution of the average maturity if the Treasury were to keep auction sizes as is. As can be seen, the Treasury will not be able to extend much further; the average maturity would increase to 66 months by FY 14, after which it would start falling. More importantly, the share of bill universe will fall to below 15% by FY 15 without achieving much extension. An alternative is to keep auction sizes for 2y, 3y, and 5y unchanged and increase the size of the 7y, 10y and 30y by 20-25% each. Although this would clearly result in a higher extension, the share of bill universe will fall to even lower levels, which may be too high a cost to pay. The appropriate issuance pattern, in our view, is, therefore, one in which the Treasury cuts front-end auction sizes further but combines those cuts with an increase at the intermediate and the long end. We present one such scenario in Figure 11 where we tabulate auction sizes across the curve for 2011 and 2012. We recommend the Treasury resume cutting auction sizes for 2y, 3y, and 5y at about the middle of next year (May refunding onwards) Figure 10: Keeping auction sizes unchanged would not help extend the average maturity much further
72 70 Average Maturity of Outstanding Marketable Debt (ex-SFP bills), months 65 61 62 60 60 64 70 67 65 66 65 70
There is scope for reducing front-end auction sizes and increasing long intermediates and bond auction sizes
Not doing so will prevent the average maturity from rising well above current levels
We recommend the Treasury reduce auction sizes at the front end starting mid-2011 and increase sizes at the intermediate and long end towards the end of 2011
Figure 9: Room for front-end issuance to decline and longend issuance to rise
60% 50% 40% 30% 20% 13% 10% 0% Sep-90 11% 27% 49%
68 66 64 62 60 58 56 54
Sep-94 Coupon <1y
Sep-98 1-5y
Sep-02
Sep-06
Sep-10 10-30y
5-10y
End of FY-2010
FY-11
FY-12
FY-13
FY-14
FY-15
Proposed
Source: Treasury, Barclays Capital
Keeping Auction Sizes Unchanged
Source: Treasury, Federal Reserve, Haver Analytics
16 December 2010
25
and begin increasing auction sizes for 7y,10y, and 30y later in the year (November refunding onwards). This will ensure that the net cash raised from the market declines with improving deficits. The share of bill universe would decline to 17% over the next year and then stabilize there; the <1y universe would stabilize at a much higher level of 26% as coupon securities would roll into the <1y sector. More importantly, as Figure 10 shows, the average maturity would rise to 70 months by FY 15 instead of falling to 65 months in status quo scenario. Comparing the attribution to that in Figure 8, the declining share of the bill universe will account for 25% of the extension and the rising average maturity of the coupon universe will account for 75% a more appropriate allocation.
Overall net coupon issuance should decline from $1.6trn in 2010 to $1.24trn in 2011, led by the front end; we expect higher long-end issuance in 2012
Having said that, whether the Treasury actually moves along the path as laid out in Figure 11 depends on its resolve regarding how much and how fast it wants to further extend the maturity. We would not be surprised if the Treasury concentrated on cutting front-end auction sizes in 2011 and increasing long-end sizes in 2012 to avoid an overlap. Nonetheless, we believe investors should expect a rise in long intermediates and bond supply over the next two years.
Figure 11: 2011 and 2012 recommended auction calendars: Treasury needs an operation twist
CY 11-12 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Total CY 11 Total CY 12 Total CY 10 2y 35 35 35 35 34 33 32 31 30 29 28 27 26 25 24 23 22 21 20 20 20 20 20 20 384 261 474 3y 32 32 32 32 31 30 29 28 27 26 25 25 25 25 25 25 25 25 25 25 25 25 25 25 349 300 432 5y 35 35 35 35 34 33 32 31 30 30 30 30 30 30 30 30 30 30 30 30 30 30 30 30 390 360 459 7y 29 29 29 29 29 29 29 29 29 29 30 31 32 33 34 35 35 35 35 35 35 35 35 35 351 414 363 10y 21 24 21 21 24 21 21 24 21 21 25 22 22 26 23 23 27 24 24 28 25 25 29 26 266 302 265 30y 13 16 13 13 16 13 13 16 13 13 17 14 14 18 15 15 19 16 16 20 17 17 20 17 170 204 168 11 32 35 21 70 76 50 21 24 15 12 11 12 7 14 13 12 7 12 10 14 10 11 10 11 6 13 12 11 6 11 5y I/L 10y I/L 13 9 30y I/L Total 178 180 176 177 179 165 169 169 161 154 166 159 163 167 163 164 170 158 164 169 164 159 171 164 2,033 1,976 2,247 Maturing 65 75 54 72 49 55 57 82 58 57 81 85 92 106 82 98 86 77 103 95 82 86 104 86 791 1,097 641 Net 113 105 122 105 130 110 112 87 103 97 85 74 71 61 81 66 84 81 61 74 82 73 67 78 1,242 879 1,606
16 December 2010
26
Demand side of the equation: Upside risks

Hence, an overall decline in net fixed income supply, led by Treasuries, should push the term premium in the front to intermediate part of the curve lower. At the same time, demand from the Federal Reserve, foreign central banks and domestic banks is likely to surprise the market to the upside, putting further downward pressure. We discuss them in detail below:
Federal Reserve: $600bn and done?

The Fed has announced its intention to buy $600bn Treasuries through June 2011 and reinvest paydowns as well (both of which are already reflected in the numbers in Figure 6). We believe the risk is towards an extension of the program.
The Fed has announced its intention to buy $600bn Treasuries; the risk is towards up-scaling the program, as the desired fed funds rate would still be below the LSAP augmented effective funds rate
As shown in Figure 3, the true funds rate is well above where it should be (-1.8% vs. -4.1%), which suggests that the Fed needs to increase the size of the LSAP substantially, by another $1.8trn. However, if the economy does improve as the Fed is forecasting, in June 2011 it would be faced with a smaller shortfall to bridge. Figure 3 shows that the Fed would have to bridge a 1% gap requiring another $800bn in purchases. Although it may not expand the program as much as implied by a simple fed funds rate framework (as it did not do so at the November FOMC meeting) we believe investors should therefore not rule out an extension of purchases. The likelihood of this happening may have been reduced by the changes in fiscal policy, but only marginally. Our economists have revised their 2011 real GDP growth higher by 0.3% based on the latest announcement. However, this would only marginally affect the unemployment rate (by 0.15% using a 2:1 ratio) and even by June 2011, the Fed is unlikely to be comfortable with the miss on its dual mandate, both on the unemployment and the inflation front. This risk factor should put a relative downward pressure on real rates, which have risen beyond pre-September FOMC levels, and intermediate yields in H1 11. The NY Fed released the planned distribution of purchases, which shows a concentration in the intermediate sector; 46% in the 5.5-10y sector (Figure 12). As Figure 13 shows, Fed purchases would account for more than 100% of supply in the 7-10y sector and close to 80% in the 5.5-7y sector through June 30, 2011. Comparing purchases with gross supply can be misleading because it does not take into account the available float in that sector. However, even after adjusting for the float (forward as of June 30, 2011, excluding Fed holdings), the concentration is in the intermediate sector. Figure 13: Fed purchases should account for more than 100% of new issuance in the 7-10y sector
120% 100% 80% 63% 58% 29% 29% 14% 79% 105%
Intermediate sector should benefit the most, since that is where purchases are likely to be concentrated
Figure 12: Fed expected to focus on the intermediate sector; same to hold for a larger program
25% 20% 20% 20% 15% 10% 5% 5% 0% 0% 0-1.5 4-5.5 5.5-7 7-10 10-17 1.5 - 2.5 2.5 - 4 17-30 TIPS 2% 4% 3% 23% 23%
60% 40% 20% 0% 1.5 - 2.5 7-10 10-17 2.5 - 4 17-30 4-5.5 0-1.5 5.5-7 TIPS
27
Planned Distrbution of Purchases, %

Source: New York Fed
Purchases, share of new Issuance, % Purchases, share of Float, % June-11 Fed Holdings , share of outstanding, %
Source: New York Fed, Treasury, Barclays Capital
16 December 2010
Were the Fed to scale the program higher, we expect the Fed to maintain the current distribution and the intermediate sector should therefore benefit the most.
Foreign central banks: Smaller share of a growing pie

Foreign investors still heavily involved in the US FI markets, especially Treasuries
Foreign central banks could be another source of upside risk. Foreign investors have been a significant buyer of US fixed income securities; over the 1y ending October 2010 they bought $610bn. They bought $780bn in Treasuries notes and bonds, although part of that was a switch from spread products, (net sold $120bn), and T-bills (net sold $50bn). Demand from central banks in 2011 should be a function of two factors: growth in FX reserves; and the pace of diversification away from the USD. Figure 14 shows that if the USD were to stay unchanged, FX reserves would grow 15-20% next year, or roughly $1.5trn; if it depreciates, even more. How much of that is invested in USD assets would be function of whether central banks continue to diversify. Figure 15 shows that while reported share of USD in FX reserves has remained stable, the currency adjusted share fell from 65% in June Figure 15: only partially offset by diversification away from USD
74% 72% 70% 68% 66%
Demand in 2011 should be a function of growth in FX reserves and movements in the USD
Figure 14: Growth in foreign currency reserves should remain strong

30% 25% 20% 15% 10% 5% 0% Jun-01
64% 62%
Jun-03 Jun-05 Jun-07 Jun-09 Jun-11
60% Jun-98
Jun-00
Jun-02
Jun-04
Jun-06
Jun-08
Jun-10
Currency Adjusted Reserve Growth, yoy Estimated

Source: IMF, Bloomberg, Barclays Capital
% Reserves Held in $, Reported

Source: IMF, Bloomberg, Barclays Capital
Currency Adjusted
Figure 16: Long intermediates set to benefit most from any uptick in foreign demand
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Nov-08 May-09 2s/3s
Source: Treasury
Figure 17: US banking system has been steadily increasing its holdings of US Treasury securities
350 312 300 250 200 150 100
% Auction Alloted to Foreign Investors, 3M Moving Average 36%
Nov-09 5s/7s
May-10 10s 30s
Nov-10
50 Jun-06
Jun-07
Jun-08
Jun-09
Jun-10
Treasury Holdings of Banking System, $bn

Source: Federal Reserve Flow of Funds
16 December 2010
28
2009 to 62% in June 2010. In other words, foreign central banks have been investing less and less to offset the appreciation in USD. Even if they were to continue to diversify at the same pace, they would still end up buying $750bn, about $150bn higher than over the past year. If the USD depreciates 10% and the pace of diversification increases 50%, demand would increase to almost $1trn. This is because even though the US would be getting a smaller share of the pie, the pie would be growing quite rapidly.
Even if foreign central banks continue to diversify, the growing pie of FX reserves would ensure the need to buy USD assets; long intermediates should benefit the most
The 2010 experience suggests that all of this should be in Treasuries. With the Treasury issuing $550bn or so to investors (Figure 6) versus our expectation of total ex-ante demand of $750bn from foreign central banks, the entire 2011 net supply of Treasuries would be absorbed. Foreign central banks may also have to buy spread products or if they were to remain averse to spread products as was the case in 2010, they would force domestic investors from Treasuries into spread products. Either way, this is a source of upside risk to the demand side of the equation for the fixed income universe. We expect long intermediates to benefit more than front and short intermediates, as foreign investors have been steadily moving out the curve as indicated in auction participation data (Figure 16).
Domestic banks: A new entrant to the Treasury market

Liquidity and high cash on balance sheets would steer banks towards securities
The third source of upside risk is the US banking system, which has been switching out of loans to securities to maintain its NIMs. Although this is typical of a recession, what is different is that banks have increased holdings of Treasury securities by $215bn to $312bn since the crisis (Figure 17), almost as much as agency securities. Although this may been partially due to the non-availability of agency securities, as the Fed was buying agency debt/MBS, we believe that banks were buying Treasuries in anticipation of some form of liquidity regulation, which the Basel committee proposed in December 2009. The committee proposed two ratios to capture the liquidity profile of banks liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) to measure if banks have enough monetizable liquid assets to meet cash outflows in a 30-day and 1-year stress period, respectively. Although the date of implementation has been pushed to January 2015 and January 2018, respectively, banks seem to be trying to get there sooner to gain investor
Figure 18: Cash injected by the Fed going a long way toward improving the liquidity profile of the US banking system, Q3 10
Liquid portfolio, $bn Cash Govt. Debt/GNMA Unencumbered* Agency Debt/MBS Unencumbered* Corp/Muni Bonds Unencumbered* Other Securities Unencumbered* Monetizable Liquid Stock % of Liquid Stock in Cash and 0% risk weight % of Liquid Stock in 0% risk weight Total 1,029 595 337 831 471 332 188 883 500 Liquidity factor 100% 100% 85% 85% 0% Available stock 1,029 337 400 160 0 1,926 67% 17% Total Net Cash Outflow in 30 days 2,324 Net cash outflow in 30 days, $bn Core Deposit (Stable) Foreign Deposits (Less Stable) Other Deposits (Least Stable) Unsecured <1M Advances/Debt Secured ST Funding (Non 0% Risk Wt) Unused Commitments Illiquid Reverse Repo Total 6,716 1,239 1,318 126 383 6,047 239 Run-off factor 5% 10% 75% 100% 100% 10% -100% Cash outflow 336 124 989 126 383 605 -239
Note: * Total unencumbered securities distributed in the same ratio as total holdings. Foreign debt assumed to be foreign government debt. Agency debt/MBS assigned a 15% haircut. Corporate/Muni bonds assumed to be of the highest quality and have been assigned a 15% haircut. Core deposits assumed to be stable and foreign deposits less stable. 25% of <1y advances/debt assumed to be less than one month. Repo secured by non-0% risk weight assumed to be in the same ratio as holdings. Two-thirds of reverse repo assumed to be against illiquid securities. Unused commitments assumed to run-off at the minimum rate allowed in BIS guidelines; 10% is the weighted average of 5% on credit lines and 100% on liquidity lines. As of September 30, 2010. Source: FDIC, BIS.
16 December 2010
29
confidence. Within liquid assets, Basel has proposed two categories: Level 1, which would include cash and 0% risk weight assets, and Level 2, which would include 20% risk weight assets but with a 15% haircut and a cap of 40% of total liquid stock. Such a framework would encourage banks to own Treasuries or other 0% risk weight assets.
Banks seem compliant with the LCR, due simply to the Feds temporary injection of cash into the banking system
How much could the banks buy? To answer that question, we look at where the US banking system stands right now with respect to the LCR. In Figure 18, we compare the stock of liquid assets with the expected cash outflow over a 30-day period. Banks seem almost compliant with this guideline; they have $1.9trn in liquid assets to cover $2.3trn (or 83%). However, of the $1.9trn, $1trn is coming from a cash balance that is up from $600bn from pre-crisis levels (cash on balance sheets of foreign banks in US is up another $300bn and that on savings institutions/credit unions balance sheets is up $80bn) simply because of the Fed injecting cash into the system, which is temporary in nature. With the Fed buying another $600bn in Treasuries, the shortfall would be bridged. However, when the Fed drains cash, domestic banks will be forced to replace the cash balance with liquid securities, or buy roughly $1trn in liquid securities. Hence, unlike prior cycles when banks switched from securities to loans as the economy improved, this time banks would instead be forced to increase securities holdings. We believe banks will steadily to do so rather than ramping up when the Fed drains cash, as the high level of cash on balance sheets is already putting a tightening pressure on NIMs. The US banking system is therefore likely to be a growing investor base in the Treasury market. Hence, not only is net supply to the market set to fall in 2011, but there are also upside risks on the demand side in the intermediate sector that should push the term premium lower. We expect 10y yields to decline to 2.8% over the next few months, led by real rates, before selling off to 3.5% by end-2011.
Banks are likely to continue to buy Treasuries to become less dependent on Feds monetary policy and negate the downward pressure on NIMs
Long end: Expect the 10s30s curve to steepen

The 30y sector, by contrast, looks likely to underperform on the curve given: 1) our expectation of higher supply at the long end as the Treasury terms out debt further; 2) excess demand in the intermediate sector; 3) the Feds desire to boost long-term inflation expectations to prevent deflation; and 4) the bleak fiscal outlook.
Figure 19: 10s30s Treasury curve sharply steepened in 2H 2010

180 160 140 120 106 100 80 60 40 Jan-09 107 Overreaction to the Nov FOMC Statement
Figure 20: due to declining intermediate yields and rising inflation expectations
3.0 2.8 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 Dec-09 3.0 2.9 2.8 2.7 2.6 2.5 2.4 2.3 2.2 2.1 2.0 Dec-10
Mar-10
Jun-10
Sep-10
May-09
Oct-09
Feb-10
Jul-10
Dec-10
5y Treasury Yields, %, LHS 10y Liquidity Adjusted Breakevens, %, RHS

10s30s Treasury Curve, bp

Source: NY Fed, Bloomberg, Barclays Capital
Estimate
16 December 2010
30
Intermediate yields and longterm inflation expectations have been the key driver of the 10s30s Treasury curve
Figure 19 shows that the 10s30s Treasury curve was relatively stable through the first half of 2010 in the 90-100bp range before it started steepening aggressively in the second half. We believe the key difference was the change in long-term inflation expectations; rising long-term inflation expectations hurt the long end of the curve. Figure 20 shows that during the first half of 2010, as intermediate yields were declining, arguing for the steepening of the curve, 10y TIPS breakevens were steadily tightening offsetting that effect. But when the Fed changed its stance from unwinding stimulus towards providing more stimulus via buying Treasuries, 10y breakevens reversed the tightening trend. Accompanied by declining intermediate yields, this worked in favor of the steepener. A fair value framework using these two factors explains the movement of the 10s30s curve (Figure 19). Deviations from fair value were generally reversed. For instance, immediately after the November FOMC announcement, the 10s30s Treasury curve steepened to 160bp, even though fair value remained stable at 130bp (Figure 19). The fair value did not move higher on the announcement because both intermediate yields and 10y breakevens had already moved to reflect the Feds changed stance; by the end of November; the 10s30s curve came back in line with our model. Since then, as the market priced out the possibility of an extension of QE2, the curve flattened further, though mostly in line with rising intermediate yields. At 106bp, the curve is in line with our model. We expect the steepening trend to resume as, in our opinion, intermediate yields have room to decline and inflation expectations room to rise. The Fed expects the large-scale asset purchases to have an effect via lowering real yields. However, recently 10y real yields have risen to 1.17%, higher than where they were before the Fed began floating the idea of more stimulus. Although data have certainly improved, we believe that the Fed would still want to keep real yields low, given the level of unemployment and the inflation rate. In other words, there is a risk towards an extension of the LSAP beyond June 2011; as Figure 21 shows, the intermediate sector would benefit once again if real yields decline. This coupled with a further rise in long-term inflation expectations should steepen the curve; we expect the 10s30s Treasury curve to steepen back to 150bp by the end of H1 11.
At 106bp, the curve is fair on our model
We expect the steepening to resume, as intermediate yields have room to decline and long term inflation expectations have room to rise
Figure 21: Real yields have risen back to pre-September FOMC levels; a reversal would help the intermediate sector
60 40 20 0 -20 -40 -60 -80 -100 Dec-09 Mar-10 Jun-10 Sep-10 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Dec-10
Figure 22: Is there political will to alter the debt/GDP trajectory?

200 180 160 140 120 100 80 60 40 20 0 1790 1830 1870 1910 1950 1990 2030
%
2s5s10s Gross CMT Fly,bp, LHS 10y real yields,%, RHS

Source: Federal Reserve, Bloomberg
Debt as a share of GDP, Status Quo

Source: CBO
16 December 2010
31
Bleak fiscal outlook with no political will to rein in deficits supports a steepening
Finally, investors should also keep an eye on the fiscal outlook. The fact that the debt trajectory is on an unsustainable path is not new information, Figure 22 shows that in status quo, US debt/GDP will rise to 90% by 2010 and 185% by 2035, but whether the political will exists to change this trajectory will be revealed. Recent information in this regard unfortunately tilts towards less than more; the tax deal announcement with no mention of how to tackle the long-term outlook is disconcerting to us. We would look for signs in spreads of long-end Treasuries to other products such as swaps or corporate, which should eventually lead to the underperformance of the 30y on the curve as well.
Fed purchases: Ironing out the kinks

Fed purchases will not only have an effect on the sector-specific relative value, but also on issue-specific relative value. The Fed has been focusing on cheap securities in its purchases, which, in our opinion, should reduce the idiosyncratic errors over time in 2011.
The Fed has been focusing on cheap securities in its purchase operations
In Figure 23 we compare the simple average of the spread with our government spline of all issues in a given sector purchase to the weighted average of the spreads; the weights being the amount bought (for the purpose of this figure, we look at the first round of purchases during QE2, November-December 2010). A weighted average higher than the simple average suggests a concentration on cheap securities. In all purchase operations, the Fed has indeed concentrated on cheap securities. One sector that stands out is the 1.5-2.5y sector, where certain issues are still trading quite cheap. Figure 24 shows that this is largely due to the market attaching a discount to higher size. Old 2s and old 3s in that sector are much larger in size ($40-$45bn) than old 5s and old 10s ($15-20bn). We expect this to normalize over time as the Fed continues to focus on the cheap issues; in the one operation on November 16, of the $5.4bn that the Fed bought, $1.86bn was in old 2s and $3.56bn was in old 3s and none in old 5s/10s. The other set of issues for which the market has not yet fully reflected Fed purchases are old 30s in the 5-10y area. Figure 25 shows while some of the old 30s (high coupon issues) have richened over the past few months, issues in the back end of the bucket are still trading cheap; Feb 20s, May 20s, and Aug 20s in particular. Although the Fed already owns close to 50% of the outstanding amount in these issues, we believe the Fed will continue to purchase (though with a 5% limit per operation), until the spread normalizes.
Old 2s/3s in the 1.5-2.5y sector are trading at a discount due to the higher outstanding and remain attractive candidates for Fed purchase operations
Old 30s in the 5-10y area, Feb 20s, May 20s and Aug 20s in particular have room to richen
Figure 23: Fed purchases have focused on cheap securities

3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 1.5-2.5y 4-5.5y 5.5-7y 7-10y 7-10y 2.5-4y 17-30y 10-17y 2.5-4y 4-5.5y 5.5-7y 7-10y 2.5-4y 17-30y 4-5.5y 5.5-7y
Figure 24: Old 2s/3s in the 1.5-2.5y have room to richen

5.0
Spread to Govt Spline, bp
4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 10 20 30 40 Size Outstanding, $bn 50
Simple Average of Spread to Government Spline Amount weighted Average

Source: NY Fed, Barclays Capital
16 December 2010
32
STRIPS market: Growing in leaps and bounds

STRIPS market grew rapidly in 2010. led by a steep curve and strong demand from pension funds Net stripping activity in the long end has accounted for the entire pickup, and a few issues have been stripped disproportionately
One segment of the Treasury market that grew leaps and bounds in 2010 was the STRIPS market. It benefitted from the steepness of the curve, the Treasury increasing issuance at the long end, and the need for duration from long-term investors such as pension funds who were trying to rebalance their portfolios. Figure 26 shows that after remaining almost unchanged for most of 2009 at ~$150bn, the bond STRIPS universe had grown to $182bn as of end of November 2010. Not surprisingly, the rise has been led by the long end of the curve; STRIPS outstanding of 2036 maturity bonds and higher has increased to $92bn from $47bn and $25bn at the end of 2009 and 2008 respectively. The share of the 25y+ STRIPS has steadily increased to almost 50%. Not all issues in the long end have attracted the same attention. Figure 27 shows that Aug 39s, Nov 39s, Feb 40s and May 40s have accounted for $46bn of the increase, of which Feb 40s STRIPS outstanding alone has increased $18bn. By contrast, May 39s and Aug 40s have been all but ignored; the portion held in stripped form is only $0.7-0.8bn, versus $5-10bn for surrounding issues. We suspect this stems from investors not pricing in the coupon effect appropriately. These issues have a relatively lower coupon, which implies a longer duration of the underlying bond. Given an upward-sloping curve, this in turn implies that they should trade at a higher yield. However, if investors do not properly price in this effect, then the corresponding P STRIPS would trade rich (as coupon STRIPS are fungible), deterring STRIPS investors from demanding that broker/dealers strip them; both Feb 39s and Aug 40s P STRIPS trade rich on our spline. A simple regression of the portion of a bond held in stripped form and its coupon (both relative to neighbouring issues) shows a significant relationship (t-stat of 3.3). Hence, it comes as no surprise that just a few bonds in the long end have accounted for almost all the stripping activity.
Bonds with relatively lower coupons have been stripped only marginally, as investors have not appropriately priced the coupon effect, causing them to trade rich
Strong demand from pension funds: Expect a slowdown in 2011

Net stripping activity has picked up, due mainly to strong demand from defined benefit pension funds, which have continued to allocate out of equities into fixed income and within fixed income from agency securities to Treasuries. We expect demand to slow, as the asset allocation seems largely complete and a pickup in supply of spread products, agency MBS in particular, would provide competition to the Treasury universe. Figure 25: Feb 20, May 20 and Aug 20 Old 30s attractive
6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0
Feb 15 Aug 15 Feb 16 Aug 17 Feb 19 Aug 19 Feb 20 May 16 May 17 May 18 May 20 Aug 20 Nov 15 Nov 16 Nov 18
Figure 26: Bond STRIPS universe growing rapidly

185 180 175 170 165 160 155 150 145 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 55% 50% 45% 40% 35% 30% 25% 20% 15%
As of Dec 08, 2010

As of July 30, 2010
Bond STRIPS universe, $bn, LHS

%, 25+ years, RHS
16 December 2010
33
Demand from defined benefit plans has picked up sharply over the past year
Figure 28 shows that among the major long-term investors, defined benefit plans have increase their holdings by $151bn over the 1y period ending September 10, well above the increases among other long-term investors and accounting for a large share of the total increase of $243bn; a sharp contrast with earlier years. In Figure 29, we plot net inflows for private defined pension funds into equities, fixed income, Treasuries and agency securities over a four-quarter rolling window. For the past several years, they have been allocating out of equities into fixed income. Due to this continued asset allocation, the share of equity in directly held financial assets has declined to just 41% from ~65-70% a few years ago (Figure 30). While in earlier years, the move was to make the portfolio less invested in equities, the activity in recent years seems largely intended to maintain the share of equities at close to 40%
Figure 27: A few issues in the long end have accounted for almost the entire net stripping activity
20 15 10 10 5 0 -5
Aug-39 May-37 May-38 May-39 May-40 Aug-40 Feb-36 Feb-37 Feb-38 Feb-39 Nov-39 Feb-40 Nov-40
Figure 28: Private defined plans have increased their Treasury holdings at a much faster rate than other LT investors
20 15 160 140 120 100 80 60 40 20 0 10 151
5 0
28 5
33
35
31
29
ytd increase in 25+ STRIPS outstanding, $bn, LHS outstanding STRIPS amount, $bn, RHS
Private Private Life Insurance Public Defined Defined Companies Retirement Benefit Plans Conrtibution Plans Plans Change in Tsy holdings, $bn, Sep09 to Sep10 In 2008
Figure 29: Pickup in Treasury demand from private defined benefit plans due to switching away from agency securities
4Q Moving Sum, $bn 200 150 100 50 0 -50 -100 -150 -200 -250 Sep-05
Figure 30: Share of equities in defined benefit plans assets has stabilized at low levels
75%
151 90
70% 65% 60% 55% 50% 45% 40% 35% Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 41%
-94 -127
Sep-06
Sep-07
Sep-08
Sep-09
Sep-10
Equities of which Treasury

Fixed Income of which Agency Sec.
% Equity in Directly Held Financial Assets, Private Defined Benefit Plans

16 December 2010
34
Share of equity in defined benefit plans assets has stabilized at 40%
In other words, these plans have simply reinvested their gains from the equity market over the past year into fixed income, instead of increasing their equity exposure. The change in behavior is important in our opinion, as it implies that demand for fixed income securities will be governed mainly by the performance of the equity markets; for instance, a 20% gain in the S&P would lead to $90bn in demand for fixed income securities if the share of equities stays unchanged and vice versa. However, unlike in 2010, we expect spread products, not Treasuries, to attract this demand. Over the past year, defined pension plans have bought $150bn in Treasuries and $40bn in corporate bonds and net sold $95bn of agency securities. In other words, Treasuries have benefitted at the expense of agency securities. We believe this was due mainly to a lack of new supply in the agency MBS universe. With the supply picture changing quite dramatically in favor of agency MBS, we believe corporate bonds and agency MBS are likely to benefit and demand for Treasuries is likely to slow from elevated levels.
We expect agency MBS and corporate bonds to benefit more than Treasuries from fixed inflows if equity markets perform well
What are the implications? C STRIPS should richen to P STRIPS

A slowdown in net stripping activity in the long end should richen coupon STRIPS to principal STRIPS in the 15-20y sector. A fall-out from the expansion of the STRIPS universe is that coupon STRIPS have cheapened to principal STRIPS along the curve, despite other measures of liquidity premium having normalized.
C STRIPS trading at a heavy discount to P STRIPS; expect richening in 2011
Figure 31 shows that the spread between Feb 31 C STRIPS and P STRIPS is now trading at 13bp, compared with 1bp before the crisis and 11bp at the peak of the crisis. This is despite other measures of liquidity premium, such as the spread between on- and off-the-run 10y, having declined to pre-crisis levels. A comparison across issues in Figure 32 shows that C STRIPS are trading at a 11-13bp discount to P STRIPS in the 15-20y sector, compared with 4bp or so in the 10y and 30y sectors. We suspect this is a result of the pickup in stripping activity in the long end, which has increased dealer inventories of coupon strips in the 15-20y area (those further in may have been reconstituted with P STRIPS and sold to investors or the Fed). A slowdown in net stripping activity at the long end should alleviate this cheapening pressure and provide a trigger for richening.
Figure 31: C STRIPS cheapened over 2010 even as the liquidity premium declined
16 14 12 10 8 6 4 2 0 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Feb 31 Cs-Ps Spread, bp, LHS 10y On-Off Spread, bp, RHS
Figure 32: 11-13bp pickup in switch to C STRIPS from P STRIPS
75 65 55 45 35 25 15 5 Dec-10
14 12 10 8 6 4 2 0 Feb-20 May-20 Aug-20 Nov-20 May-21 Nov-21 Nov-22 Aug-23 Feb-25 Feb-26 Nov-26 Aug-27 Aug-28 Feb-29 May-30 Feb-36 May-37 May-38 May-39 Nov-39 May-40 Nov-40 Discount of C STRIPS to P STRIPS, bp
16 December 2010
35
INFLATION-LINKED
The debate evolves

Michael Pond +1 212 412 5051 michael.pond@barcap.com Chirag Mirani +1 212 412 6819 chirag.mirani@barcap.com Igor Zoubarev +1 212 526 5518 Igor.Zoubarev@barcap.com
We expect the 2011 trend in TIPS breakevens to be similar to that of Q4 10. However, with forward breakevens attractive only as inflation insurance, the focus is likely to shift to the short end. Liquidity and the demand base are likely to continue to grow, along with supply and increased interest in inflation derivatives. In the inflation derivatives space, we recommend being long the front-end TIPS ASWs relative to nominals, as they offer significant positive relative pickup and rolldown without going too far out the curve. In CPI options, we find the implied vols to be overly rich across maturities. While mark-to-market and liquidity risk remain in this space, we expect liquidity to improve in 2011. As we head into 2011, the deflation/inflation debate that began during the financial crisis has, for the most part, turned into a debate about how long it will be before inflation rises off a very low, but positive level and whether the Fed will be able to achieve its target without overshooting significantly. For most of 2010, we have viewed real yields as the simple plug factor between nominals and breakevens. We expect that trend to continue in 2011; hence, this outlook focuses on breakevens. Against the backdrop of low ex-Fed net supply and rising structural demand, we find that breakevens across the curve offer value in 2011, though the degrees and reasons vary across sectors.
Front end at odds with commodities

We believe the market is significantly mispricing the prospects for near-term inflation. TIIJul12 breakevens (Figure 1), which should benefit from positive inflation seasonals, are only just over 1%. This would make sense to us if TIPS accrued inflation based on core CPI; Barclays Capital is expecting Q4 11/Q4 10 core CPI growth of 1.1%. The recent trends in core CPI support low front-end breakevens. After rising to 1.7% in July, the 3m SAAR on core CPI has fallen back to 0.2% after three 0.0% m/m prints in a row (Figure 2). Many investors are avoiding the front end simply because of this trend and are waiting for a turn before they buy. We believe that shelter costs, the main drag on core earlier this year, has
Figure 1: TIIJul12 breakeven

% 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10
Figure 2: Trend in core CPI

% 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 (0.5) Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10
Core CPI (yoy %)

Source: BLS, Barclays Capital
Core CPI (3m SAAR, %)
16 December 2010
36
Figure 3: CRB and Headline CPI

7 6 5 4 3 2 1 0 -1 -2 -3 Dec-90 50 30 10 -10 -30 -50 -70 Dec-10
Figure 4: 1y breakevens and survey expectations

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Bloomberg Avg Survey of Professional Forecasters FOMC PCE U of Michigan Survey
37
2011 Inflation Expectations (%)
Dec-94
Dec-98
Dec-02
Dec-06
Headline CPI YoY (LHS, %) CRB YoY on 3m average (6 month lag, RHS, %)
Source: Bloomberg, BLS
turned sustainably and that recent weakness in core commodities is unlikely to continue. If core has bottomed as we expect, it should not be long before short breakevens do as well. While investors remain cautious on the front end because of the trend in core CPI, we believe they are fundamentally cheap. The main driver for this view is that short breakevens have under reacted significantly to the increase in commodity prices. The CRB has increased about 30% from July and this poses upside risk for our call for 1.5% headline inflation for 2011. The historical relationship would call for a 3-4% y/y headline CPI by mid-2011 given the rise in commodities. Because of the relatively weak consumer we understand that a lower than expected passthrough rate from raw to consumer goods should be expected. However, the market seems to be forecasting that almost none of the rise in inputs will find its way into the CPI. Market based near-term inflation expectations are also below any survey measure for 2011. TIIJan12 breakevens are not just well below Barclays Capitals forecast, but also the forecasts for 2011 headline inflation from the FOMC, the Bloomberg survey of economists, the Philadelphia Feds survey of professional forecasters, the University of Michigan consumer sentiment survey, and the Conference Boards survey of consumer confidence (Figure 4). Short TIPS also stand out on asset swap versus their nominal counterparts. The TIIJul12s ASW is trading slightly cheap to Libor, while the T 1.5% Jul 2012 nominal proceeds ASW is rich to Libor by about 22bp. The relative ASW spread, now at about 24bp, was as tight as 15bp at the end of October. The wide spread would make sense if the nominal was trading special or if there was a heightened concerned about funding pressures, but neither is the case. We expect this spread to compress over the coming year and this also supports our view that front breakevens are cheap and likely headed higher.
2013-14y sector still fighting the Fed

Despite the Feds commitment to push inflation higher, a new round of fiscal stimulus through tax cuts, and signs that the economic data (particularly with regard to the consumer) is turning, forward 1y breakevens in the 2012-2013y sector (Figure 5) have barely budged off late-summer lows and remain well below where they were six months ago. As indicated by the shift in the probability distribution of 5y inflation (Figure 6), the Fed has gained credibility on being able to avoid deflation but the market remains unconvinced that headline CPI inflation will be above 1.5% until around 2014.
16 December 2010
Jan12 BE
Barclays
Figure 5: Forward 1y breakevens

% 3.5 3.0 2.5 2.0 1.5 1.0 0.5
Figure 6: 5y inflation probability distribution

% 25 20 15 10 5 0
-6% to -5% -4% to -3% -2% to -1% 0% to 1% 2% to 3% 4% to 5% 6% to 7%
5y 3m Ago (%)
5y As of December 7 (%)
Jan-11
Jan-12 Latest Fwd BEI
Jan-13 Fwd BEI 3M Ago
Jan-14 Fwd BEI 6M Ago
Jan-15
Note: Latest as of December 7, 2010 Source: Barclays Capital
In addition to concern about the recent trend in core CPI, the Feds purchase program may be putting downward pressure on breakevens out to the 5y sector as well. Figure 7 shows that the relative maturity of the Feds purchases of TIPS had been much more heavily skewed to the longer end of the curve (Figure 7). Weve argued in the past that because the Feds TIPS allocation of around 3% is roughly in line with market volumes it was not likely having a direct impact on breakevens in general. However, because of the mismatch between the duration of TIPS and nominal purchases, the Fed may have been putting downward pressure on shorter breakevens and upward pressure on longer ones. The Feds recent purchase operations (Figure 8) may indicate a shift in its purchase strategy that should benefit the 1.5-5y sector, possibly at the expense of the relatively expensive 10y sector, in the coming quarter.
Figure 7: 2010 Fed purchases, pre-QE2

% 60 50 40 30 20 10 0 2.5 - 4 5.5 - 7 10 - 17 1.5 - 2.5 17 - 30 4 - 5.5 7 - 10 Nominal Purchases (%) TIPS Purchases (%)
Figure 8: 2010 Fed purchases, QE2

% 35 30 25 20 15 10 5 0 2.5 - 4 5.5 - 7 10 - 17 1.5 - 2.5 17 - 30
38
Nominal Purchases (%)
TIPS Purchases (%)
16 December 2010
4 - 5.5
7 - 10
8% to 9%
Longer breakevens and forwards

Our 10y fundamental breakeven model indicates that 10y breakeven rates should be close to 2.5% (Figure 9). The model is driven by gasoline, the slope of the 1m-6m fed funds slope, and a Barclays Capital measure of global industrial confidence. The fed funds slope has been constant and flat so it is the increase in gasoline and industrial confidence, a proxy for global manufacturing growth, that have been pushing the model value higher. While we view 10y breakevens as fundamentally cheap, we believe the economic value is only out to the 5y point. The 5y5y has increased nearly 90bp since late August and is at the higher end of the pre-crisis range (Figure 10). We do see value in longer forward breakevens, but in our view the value is as inflation insurance rather than versus a baseline inflation forecast. We believe the market should be pricing a higher inflation risk premium in forwards because of current monetary and fiscal policies, but also because the Fed has shown that, over time, it has an asymmetric reaction function around its inflation target of 1.75-2%. The Fed responded in a measured way when core inflation was, from 2004 to the middle of 2008, running about as much above its target as it is below now (Figure 11). Few would describe the Feds current policies as measured. The Figure 9: 10y breakevens and model
% 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Jan-98 Jan-00
Figure 10: 5y5y breakeven

% 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Oct-05
Jan-02 Jan-04 Jan-06 Jan-08
Jan-10
Oct-06
Oct-07
Oct-08
Oct-09 Fed (%)
Oct-10
10yr breakeven (%)

10yr breakeven model (%)
Barclays Capital (%)

Figure 11: Core PCE relative to the Feds target
Figure 12: CPI options implied 20y and 10y inflation probability distribution
% 25 20 15 10 5 0
-6% to -5% -4% to -3% -2% to -1% 0% to 1% 2% to 3% 4% to 5% 6% to 7% 8% to 9%
39
% 1.50 1.00 0.50 0.00 -0.50 -1.00 -1.50 -2.00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10
10y (%)
20y (%)
core PCE YoY - 'target' (%) core PCE 3m SAAR - 'target' (%)
16 December 2010
Fed also never discussed the concept of price level targeting when inflation was elevated and yet it has recently. While we think the Fed really would like inflation to be close to 2%, we feel strongly that most there would prefer 4% to 0% any day. The reason behind the asymmetric reaction function is that the Fed isnt sure it can control deflation once it takes hold but, as Chairman Bernanke said recently in an interview on 60 minutes, he is 100% confident that the Fed can prevent inflation from going too high. Because overconfidence often leads to excessive risk taking, we believe longer forwards still offer attractive inflation insurance. Another way to see the lack of inflation risk premium in the market is to compare 10y to 20y breakeven rates and/or 5y5y with 10y10y breakeven rates. Figure 12 shows that the implied probability distribution of 20y rates is only slightly to the right of the 10y distribution. We believe the implied deflation probability of 14% on 10y cumulative inflation is high, but on a relative basis the 12% deflation probability on 20y inflation appears even more out of line. The spread of forwards, with the 10y10y forward breakeven on BCAP2 close to that of 5y5y (Figure 13), indicates that there is little inflation risk premium in the longer end of the curve and the breakeven curve is either too steep from the 5y to 10y point, too flat from the 10y to the 20y point or, more likely in our view, both. The implied probability distribution of 20y inflation also appears out of line when compared with a long history of 20y realized inflation. Figure 14 shows the current implied distribution against a distribution of realized trailing 20y inflation from 1933 to 2010. The historical distribution is to the right of the current one and it is also strongly skewed to the right with a large weight in the 6-7% bucket. We certainly do not expect a pick-up in inflation in the coming years, but we do believe the market is under pricing the risk of super-normal inflation, as Chairman Bernanke termed it, over a longer period of time.
The Treasury giveth and the Fed taketh away

TIPS supply is expected to increase significantly in 2011. After bumping gross TIPS issuance from $58bn in 2009 to $86bn in 2010, we expect the Treasury to offer about $125bn next year. A bigger change in the trend from the past several years will be seen in net TIPS issuance. After holding relatively steady between $35-40bn from 2007-2010, net issuance is expected to more than double to over $85bn (Figure 15). However, because maturities of $36bn and Fed purchases of about $24bn are concentrated in the first half of the year, net issuance that the market will have to absorb over that time will likely be close to zero. Figure 13: 10y10y versus 5y5y Figure 14: CPI options implied 20y inflation probability distribution versus realized trailing 20y inflation, 1933-2010
% 35 30 25 20 15 10 5 0 0% to 1% 2% to 3% 4% to 5% 6% to 7% -6% to -5% -4% to -3% -2% to -1% 8% to 9%
40
160 140 120 100 80 60 40 20 0 -20 -40 Oct-04 Oct-05 Oct-06

Market Implied Distribution for 20y (%) Realized Distribution 20y Rolling Inflation (%)
Oct-07 Oct-08 Oct-09 Oct-10
16 December 2010
Figure 15: Recommended 2011 TIPS issuance calendar

5yr I/L January February March April May June July August September October November December Total 2011 Total 2010 % Increase 2010 to 2011
10yr I/L 13
30yr I/L
Total 13
Maturing (Inf adj par) 14
Net -1 9 11
9 11 12 11 6 13 10 11 6 11 10 32 21 52% 70 50 40% 21 15 40%
9 11 12 11 6 13 10 11 6 11 10 123 86 43% 36 46 -22% 22
-10 11 6 13 10 11 6 11 10 87 40 118%
Figure 16: 3m rolling average of daily TIPS trading volume

12 10 8 6 4 2 0 Oct-03
Figure 17: 10y TIPS auction allotments

% 70 60 50 40 30 20 10 0 Jan 00 Oct 02 Jul 04 Jan 06 Jul 07 Jan 09 Jul 10
Oct-05
Oct-07
Oct-09
10y TIPS takedown by domestic investment funds (%) 10y TIPS takedown by foreign (%)
Source: US Treasury
We believe the Treasurys plan of developing the TIPS market by showing a consistent commitment to the program and increasing the number and frequency of auctions is bearing fruit. After slipping to levels not seen since 2003, average daily trading volumes, while still choppy week-to-week, have moved back toward the range seen in 2004-08 (Figure 16). Additionally, auction demand from end-users has become more consistent and the base has broadened. Since the middle of 2009, the combined takedown by foreign investors and domestic investment funds of each of the seven 10y TIPS auctions has been above 35%. Reminiscent of the old adage if you build it they will come, this has occurred despite rising auction sizes, so the absolute buying from these categories has been growing in line with auction sizes. It is also a positive sign that the demand base has broadened out between domestic and foreign funds; this is one factor leading to more consistent demand. Increased trading, information and general interest in the linear and non-linear inflation derivatives market is also helping to broaden the market. We expect the demand base to continue to grow along with supply and thus do not think supply in 2011 will weigh on the market but instead will lead to its continued positive development.
16 December 2010 41
Figure 18: TIPS z-spread ASWs (relative to nominals) have richened through out 2010, we expect this trend to continue in 2011
60 50 40 30 20 10 0
Jul 14 Jul 15 Jul 16 Jul 17 Jul 18 Apr 11 Apr 12 Apr 13 Jul 19 Apr 32 Jan 14 Jan 26 Jan 28 Jan 29
Figure 19: On average, a front-end TIPS ASWs investor can pick-up anywhere between 5 to 35bp relative to nominals with a positive roll-down profile.
40 35 30 25 20 15 10 5 0 Apr 14 Apr 11 Apr 12 Apr 13 Jan 12 Jan 14 Jul 12 Jul 13 Jul 14
42
TIPS - Nominal Z-ASWs Jan 4, 2010 TIPS - Nominal Z-ASWs Dec 15, 2010
TIPS - Nominal Z-ASWs Dec 15, 2010

Inflation Derivatives
Long front-end TIPS ASWs relative to comparable nominal ASWs
Relative to their nominal counterparts, TIPS ASWs have richened from the beginning to the end of 2010 (Figure 18), as liquidity in the TIPS market has continued to improve. We expect this trend to continue. For reference, this differential in TIPS and nominal ASWs represents the liquidity between TIPS and nominals. It also explains the differential between CPI swaps and cash breakevens, all else equal. Specifically, Figure 18 shows that the relative richening of TIPS ASWs was most pronounced in the front end of the curve. While we understand investors may be reluctant to take on these relative positions much further out on the curve, given the mark-to-market risk in a volatile environment, we find that these positive relative values (being long TIPS ASWs relative to comparable nominal ASWs) are still attractive on the front end (Figure 19) in absolute terms. As mentioned earlier, the wide relative spread would make sense if the nominal security were trading special or if there were heightened concern about funding pressures, but neither is the case. We expect this spread to compress over the coming year and in a relative sense (compared with the longer end of the TIPS curve), the mark-to-market risk on the front-end relative ASWs is lower, in our view. In assessing how far one has to move out the curve versus the relative pickup in yield, we find Jul12s (+17bp pickup versus nominal) and Jul13s (+37bp) relative ASWs to be the best values. Investors will keep this pickup as long as the average relative funding differential between TIPS and comparable nominals does not exceed this amount. Also, the roll-down from 2014s to 2012s is about 20bp.
Implied CPI options vol remains high, sell OTM caps and floors when attractive
In our weekly inflation volatility reports, we have been noting that implied inflation vols in the CPI options market look fairly rich, especially for the lower-strike floors. For example, in DV01 terms, the TIIJul20 floor is trading at 11bp and is implying the probability of deflation over a 10y cumulative period of 14%. Given the current accommodative monetary and fiscal policies, we do not think outright deflation over a 10y period is likely and therefore recommend selling floors in the 5-10y sector. Figure 20 shows the Fed has largely succeeded in lowering deflation expectations since the beginning of 2009. This will continue to be the case, in our view.
16 December 2010
Figure 20: The longer-dated cumulative deflation probabilities still high, as priced by the CPI options market, in our view
Cumulative Proability of Deflation 75% 60% 45% 30% 15% 0% Feb 09 Jun 09 Oct 09 1y
Feb 10 5y 10y
Jun 10
Oct 10
Another way to understand the richness of implied vols in the CPI options market is to look at the breakeven range of selling cumulative ATM CPI straddles at various tenors. Figure 21 shows this information for various tenors. Specifically, investors can collect a roughly $6.6 premium (mid) on a $100 notional for selling 5y ATM cumulative straddles; the trade stays in the money if realized annualized inflation (the underlying CPI NSA) is between 0.70% and 3.10% (Figures 21 and 22). Investors can adjust a straddle to a strangle (different strikes) according to their views. For a 10y tenor cumulative straddle, the premium intake is roughly $13.6 (on a $100 notional), and the trade earns a positive profit if realized annualized inflation is between 1.4% and 3.6%. We recommend selling 1y to 5y ATM CPI straddles. For the 4y to 5y CPI straddles, we would hedge any move away from zero delta using April15 cash breakevens. Any downward move in the CPI/cash breakeven and the corresponding increase in floor vol would be partially counteracted by the embedded floor (which is slightly out of the money currently) on 5y TIIApr15s.
Figure 21: Breakeven points for selling ATM CPI straddles

Tenor 1 2 3 4 5 10 20 30 ATM CPI Rate 1.155% 1.383% 1.594% 1.772% 1.956% 2.564% 2.836% 2.888% Expiry 12/14/2011 12/14/2012 12/16/2013 12/15/2014 12/14/2015 12/14/2020 12/16/2030 12/14/2040 ATM strike 1.15% 1.38% 1.59% 1.77% 1.96% 2.56% 2.84% 2.89% Cap ($100 notional) 0.7 1.4 2.1 2.6 3.3 6.8 9.8 10.0 Floor ($100 notional) 0.7 1.4 2.1 2.7 3.3 6.8 9.8 10.0 Straddle ($100 Lower CPI Higher CPI notional) breakeven point breakeven point 1.3 2.8 4.1 5.3 6.5 13.6 19.6 20.0 -0.29% -0.05% 0.20% 0.46% 0.70% 1.41% 2.22% 2.58% 2.60% 2.80% 2.95% 3.03% 3.16% 3.61% 3.39% 3.17%
16 December 2010
43
Figure 22: Selling 5y ATM cumulative CPI straddle is profitable under a wide range (0.70 to 3.16) of annualized inflation
% of Notional 15 10 5 0 -5 -10 -15 -20 0.0 0.4 0.8 1.2 1.6 2.0 2.4 2.8 3.2 3.6 Annualized Realized CPI to maturity (%) Payoff selling 5y ATM CPI Straddle Payoff selling 10y ATM CPI Straddle
Figure 23: Being long covered April15 cash breakeven (selling 2% CPI cap), net effective breakeven entry (108bp)
Annualized Return 2% 1% 0% -1% -2% -3%
4.0
-4% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% Deflation/Inflation TII Apr 15

TII Jul 15
Alternatively, investors can go long April15 cash breakevens (currently at 168bp) and sell an OTM CPI cap at 2% (at roughly 60bp), at an effective breakeven entry level of 108bp (Figure 23). If there is a shock in the market that drives down the level of breakevens, the floor on the April15 cash breakeven will likely get bid up, richening the breakevens artificially. This partially hedges the sold volatility in the cap. The Feds unofficial long-term headline PCE target is 1.5-2%. The effective breakeven level of 108bp is well below this and is, hence, one of our favored trades in the inflation derivatives space. As always, liquidity and mark-tomarket risks remain in the inflation derivatives space; we expect the liquidity to improve in these products in 2011.
16 December 2010
44
AGENCIES
With or without you

Rajiv Setia +1 212 412 5507 rajiv.setia@barcap.com James Ma +1 212 412 2563 james.ma@barcap.com
Political gridlock is likely to delay GSE reform far into the future: the houses of Congress will likely be divided at least until the 2012 elections, and Democrats and Republicans have a vast difference of opinion on the future of housing finance. The Preferred Stock Purchase Agreements make agency credit effectively the same as Treasury credit, in our view. Importantly, the PSPAs do not expire after 2012, and we expect draws after that point to be well below the limit. There is also apparent political consensus not to disturb the existing agreements. Balance sheet shrinkage will become mandatory at FNM/FRE and should continue at FHLB, creating a positive supply technical. However, the increasing amount of NPA in the retained portfolios poses unique ALM issues and a drag on NIM. We expect continued negative net issuance at the GSEs in 2011, totalling -$130bn; this will be mainly from FNM, but also FHLB. While this supply technical should keep spreads rangebound and relatively tight, potential for term out remains. Foreign investors wariness of the YE12 date has created a demand vacuum, but domestic money managers and bank portfolios have filled it. We expect the latter group in particular to remain a strong source of demand given QE2 and Basel 3. In agency space, bellwether spreads give the most spread rolldown to Treasuries in the 3y part of the curve; the backup in yields and spike in vols has also made shorterlockout callables the most attractive in recent memory. We advise caution on overseas USD names given potential supply overhang from the EFSF. However, Canadian covered bonds should be much better-insulated from these concerns. We also assess the potential for a US covered bond market revival.
Future of the GSEs: Legislation unlikely in 2011

What is the timeline for housing reform?
Over the past few years, the GSEs have reported over $200bn in combined net losses and required taxpayer infusions of $150bn. While the magnitude of future losses will almost certainly continue to abate, taxpayer infusions are likely to remain necessary in 2011. Further, given the increased focus on US fiscal health that we expect next year in Congress, the spotlight is sure to stay squarely on the GSEs; adding to this will be the Treasurys proposal on GSE reform, due on January 31, 2011. Regardless of what Treasury recommends, ultimately it is up to Congress to decide the future of housing finance. One of the key Republican criticisms of the Dodd-Frank Reform Act of 2010 was that it did not address the GSEs. There are no easy answers when it comes to this topic in terms of workable solutions. 8 Further, it is clear that Republicans and Democrats have stark ideological differences on how to proceed.
US housing finance: No silver bullet, 13 December 2010.
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45
Our sense is that the Democrats remain committed to maintaining a substantial element of government involvement in housing prospectively, whereas Republicans are looking for a more radical overhaul of housing finance in general, as well as the abolishment of GSEs: Rep. Scott Garrett (R, NJ-5), chairman of the Capital Markets Subcommittee within the House Financial Services Committee: Winding down Fannie Mae and Freddie Mac will be priority number onewe need to be taking concrete steps to reduce the ongoing financial risk they pose to the country. Note that he had earlier introduced a measure creating a legal framework for US covered bonds. 9 Senator Shelby (R-Alabama), ranking member of the Senate Banking Committee, and likely to be a key figure in shaping GSE reform, has noted, Housing is important to America, but not housing at any cost. Senate Banking Committee Chairman Tim Johnson (D, SD): I would rather take time to explore the optionsthan push through legislation that could further destabilize housing markets. The composition of Congress, post-midterm elections, also lends itself to gridlock: Legislation is typically introduced in the House and then advanced to the Senate; the slim GOP House majority is likely to originate proposals hewing closer to privatization. Importantly, a 60-seat majority is needed in the Senate to force legislation through without bipartisan support. The Democrats have a simple majority of just 53 seats. Thus, we expect minimal progress to be made on GSE and housing finance reform. Given the sharp division in views on housing finance, we are hard-pressed to see Republicans compromise on housing finance reform over the next few years, simply for the sake of enacting legislation. Rather, in our view, they will likely prefer to wait and enact strict GSE legislation post-2012, after the next presidential elections. While the politics of housing will likely dominate the discussion over the next few years, the direction of GSE reform will also hinge on other factors. For one, Congress is likely to have its hands full getting US fiscal health in shape (Figure 1). As the CBO has highlighted, postFigure 1: Current government spending habits unsustainable
% GDP 200 150 100 50 0 1790
Figure 2: Outlays could outstrip revenues quickly

% GDP 40 35 30 25 20 15 10 5 0 1970
1830
1870
1910
1950
1990
2030
1980
Debt as a share of GDP, Status Quo Debt as a share of GDP, Target

1990 2000 Soc Sec Net Int Cost Total Revenues
2010 2020 2030 Medicare/caid Other Non-Int
Ibid.
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46
2025, without significant cuts in spending, government tax revenues will not suffice to service the interest costs on debt after entitlement payments, an unsustainable fiscal path (Figure 2). This inconvenient truth means that Congress must make difficult choices on a variety of fronts over the next few years; housing will not be immune. 10 Until consensus is achieved on the nature of GSE reform and the future of housing finance, the existing framework of FNM/FRE will come under increased investor scrutiny; in particular, unlimited capital support from Treasury expires in 2012. We examine the nature and amount of the capital supports for the GSEs next.
GSE credit: Glimmers of hope

How strong are the Preferred Stock Purchase Agreements?
Over the past year, it has become clear that some investors have assigned particular significance to December 31, 2012, after which the nature of the Preferred Stock Purchase Agreements (PSPAs) changes. In our view, the capital support provided by the Treasury through 2012 and beyond makes agency credit effectively the same as Treasury credit: Through YE12, any quarterly capital shortfalls as defined by GAAP net assets will be made up by the Treasury in full within 60 days of the reporting date. Draws made after 2012 will be subject to a cumulative limit of $125bn at FNM and $149bn at FRE. For the avoidance of doubt, this limit does not apply to any amounts before YE12. By distinguishing between FNM/FRE losses recorded before and after 2012, we believe that the Treasury has essentially made the timing, not the magnitude, of credit losses the main factor determining GSE creditworthiness. As long as losses are provisioned for before 2012, agency risk is analogous with Treasury credit risk.
Figure 3: Net income has improved since conservatorship

$ bn 10 0 -10 -20 -30 -40 -50 -60 -70 -80 2003 2004 2005 2006 FNM
Source: FHFA, Barclays Capital
Figure 4: Average FICO score of GSE origination has risen

780 770 760 750 740 730 720 710
2007
2008 2009
2010
700 Sep-03
May-05
Jan-07 FNMA
Sep-08 FHLMC
May-10
FRE
10
Ibid.
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Next, we project GSE results in order to estimate the amount and timing of cumulative losses that FNM/FRE could suffer and how much those losses will affect the $125/150bn capital support capacities present after 2012.
Projecting GSE credit losses: Light at the end of the tunnel

Quarterly results at FNM/FRE have shown a consistent improvement since the conservatorships (Figure 3). It is important to note that virtually all the GSE losses that have been recorded have stemmed from the pre-conservatorship book of business. Over the past few years, under FHFA control, the GSEs have generally been managed to conserve taxpayer money. For instance, the average FICO score on the GSEs book of business for 2009 and later vintages is 760 (almost 50 points above the 2007 vintage, Figure 4), and the average OLTV is less than 70%. As a result, credit losses from 2009-10 vintages should be de minimis; however, tighter origination standards have also resulted in lower refinancing opportunities for homeowners. Despite the reasons for optimism surrounding the newer vintages in the guarantee book, the question of legacy losses remains. As of Q3 10, we estimate that the GSEs have recognized 2.1mn non-performing loans by count (ie, 90d+ delinquent or worse), or $400bn by volume. Our base case estimates have presumed that 10-11% of the GSEs $4.6trn legacy book of business would default; this translates to a loan count of 2.5mn, or a par balance of $460-500bn (Figures 5 and 6). In other words, while NPA will likely continue to grow in 2011, the GSEs have already recorded 80% of our expectation for eventual cumulative defaults as of Q3 10. We expect the GSEs to recognize roughly $250bn in combined cumulative credit losses on their legacy books, split about 2:1 at FNM/FRE, respectively. As of Q3 10, FNM and FRE have recognized a cumulative $128bn and $64bn, respectively, in credit loss provisions; this is about 75% of our ultimate total credit losses estimates (Figure 7). Therefore, we can conclude that the GSEs recognition of provisions has kept pace with the NPA pipeline. Importantly, the credit provisions that are yet to be taken $32bn at FNM and $26bn at FRE by our estimates should easily be recognized in full before YE 12 (Figure 8).
Figure 5: Cumulative NPA will continue to increase

mn loans 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Sep-08
Figure 6: Ultimate defaults could rise 25% from the present

in 000 loans 90d+ delinquencies, as of Q3 10 REO on balance sheet, as of Q3 10 Cumulative REO liquidations, Q3 08Q3 10 Cumulative short sales/DIL, Q308Q3 10 Total NPA loans, as of Q3 10 Total loans serviced As a % of guarantees FNM 816 166 284 102 1368 17,90 5 7.6% 253 9.1% FRE 465 68 154 52 739 12,24 4 6.0% 137 7.4% Total 1281 234 438 154 2107 30,14 9 7.0% 390 8.5%
Sep-09
Sep-10
Sep-11
Sep-12
Total NPA loans, in $bn As a % of guarantees in $bn
Cumulative REO liq, SS/DIL

90d+ dq, forec, REO
Source: FHFA, Fannie Mae, Freddie Mac, Barclays Capital
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Figure 7: We estimate the GSEs are 75% through provisions

$bn 180 160 140 120 100 80 60 40 20 0 FHLMC Loss provision
Figure 8: Pace of provisioning has also decelerated

Expenses, $ bn 0 -5 -10 -15 -20 -25 -30 -35 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 1Q10
FNMA Estimated credit loss
Portfolio (OTTI)
Guarantee (Provisions + REO)
So what does this mean for draws?

Overall, we expect the aforementioned credit loss provisioning to remain the primary factor driving net income for the near term. However, there are a few other factors that bear consideration in assessing profitability over the coming quarters: The advent of large-scale delinquency buyout programs at FNM/FRE has led to a significant decline in net interest income, as an ever-greater portion of the GSEs balance sheets is allocated to NPA (Figure 9). This may prove to be an increasing drag on interest revenues. As cumulative FNM/FRE draws on the PSPAs mount, the 10% annual dividend paid to Treasury has already begun to outstrip GAAP net losses on the income statement (Figure 10). We would expect this annual levy only to increase as draws build further, although the Treasury has the discretion to change the coupon rate. While this has not been proposed, we would not be surprised if the Treasury lowers the rate if it feels taxpayer capital would be better conserved that way (similar to the AIG resolution process).
Figure 9: Increasing evidence of net interest income eroding

Revenues, $ bn 9 8 7 6 5 4 3 2 1 0 1Q07 3Q07 1Q08 3Q08 1Q09 3Q09 1Q10
Figure 10: Preferred dividends begin to outstrip net losses

$ bn 0 -10 -20 -30 -40 -50 -60 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 Net income
Portfolio (NII)
Guarantee income
Preferred dividends
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Figure 11: FHFA projects minimal losses beyond 2012

$ bn 180 160 140 120 100 80 60 40 20 0 2009
Figure 12: Portfolio limits likely to bind FNM more than FRE
$ bn 900 850 800 750 700 650
2Q10 2010 FHFA S2 FNM Barcap projections FNM
2011 2012 FHFA S2 FRE
2013
600 Jan-06
Jul-07 FNM
Jan-09 FRE
Jul-10
Jan-12 Limit
Barcap projections FRE
Source: Fannie Mae, Freddie Mac, Barclays Capital
Ultimately, we expect cumulative draws of $140bn at FNM and $90bn at FRE through YE 12. Moreover, we would not be surprised if the preferred dividend is cut post-2012, to minimize draws and bolster capital support for debt and MBS holders. Importantly, FHFA has publicized its official forecasts of FNM/FRE draws, crucially with a look ahead through 2013, across base- and stress-case scenarios. Notably, the projections through 2012 are well in line with our earlier forecasts (Figure 11); furthermore, the FHFA expects less than $5bn of draws in 2013 under its base-case scenario, where home prices decline 0-5%, and $26bn in a stress case, where HPA is -30%. As a result, we believe that from a credit standpoint, the existing PSPAs will provide more than sufficient cushion for debt-holders, even post-2012. In our view, $100bn plus in capital support for each entity should be more than sufficient to allay credit worries, especially taking into account the new regime of secular GSE balance sheet shrinkage. The only real risk in agency credit that we can see at this point (versus Treasury credit) is if Congress forces the GSEs to undertake wholesale loan modifications or other new loss-incurring initiatives that could push loss recognition out beyond 2012 which we think is highly unlikely.
Can the Treasury somehow renege on the PSPAs?

If the midterm Congressional election campaigns were any indication, the current scrutiny of government spending has made GSE-bashing an easy way to build political capital. This situation has helped stoke investor fears that the Treasury could somehow renege on the PSPAs. In our view, such an event would be effectively impossible and tantamount to a sovereign default, given the following factors and consequences: Legally, the PSPAs are bilateral agreements mutually entered by the Treasury and the respective GSE (FNM or FRE). Thus, they cannot be terminated prematurely, including before the limit is reached, by the Treasury unilaterally. The US government stands behind the [PSPAs] and will honor its commitments. Contracts are respected in this country as a rule of law. 11 With about half of Treasuries still financed by foreign savings and the US likely to run very large deficits, it is hard to
11
Frequently Asked Questions: Treasury Senior Preferred Stock Purchase Agreement, US Treasury, 11 September 2008.
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50
imagine the fallout if the PSPAs were changed arbitrarily the costs for Treasury would far outweigh any benefits. Recall that the Fed still owns $1.2trn of agency debt and MBS. Any substantial creditrelated haircut on these holdings could render the central bank insolvent. Curiously, after the elections, leading lawmakers on both sides of the aisle have indicated their understanding that the current GSEs should be handled with care, regardless of the ultimate future of housing finance, so as not to disturb the housing recovery: Assistant Treasury Secretary Barr recently asserted that the government is committed to ensuring the GSEs have sufficient capital to perform under any guarantees issued now or in the future and the ability to meet any debt obligations. Rep. Spencer Bachus (R, AL-6), expected to be the next House Financial Services Committee Chairman, on the transition from FNM/FRE: Itll be a four- or five-year process the commitments that have already been made would be honored, but there wouldnt be any new commitments. Overall, we are confident in our view that agency credit and Treasury credit are now analogous.
Portfolio growth: Significant shrinkage

Expect shrinkage to become a secular trend
Aside from addressing questions about the GSEs creditworthiness, the PSPAs also affect the GSEs by systematically reducing their funding needs. At YE10, FNM/FRE must observe limits on their retained portfolios of $810bn each; this restriction then steps lower by 10% per annum, such that the YE11 limit is $729bn, and so on. As of October 31, both GSEs were under their YE10 limits; looking ahead to 2011, FNM must shrink its $798bn portfolio by $70bn to be under the YE11 limit, while FRE, with its $703bn balance, already has $26bn of room versus that limit (Figure 12). Not to be overlooked, the FHLB System has been steadily shrinking its own balance sheet, as bank demand for advances continues to dwindle. Debt outstanding has shrunk by $131bn YTD, in line with the $130bn reduction in advance lending in Q1-3 10, as banks remain awash with cash in the wake of QE1. Increased regulatory scrutiny on wholesale funding sources, including the FHLB advance window, has exacerbated the situation. We expect this pattern to continue through 2011: the advent of QE2 is likely to result in a second influx of cash onto bank balance sheets, and the new regulatory regime continues to give banks an incentive to reduce their reliance on wholesale funding, as under Basel III. Lastly, legislative efforts to develop a US covered bond market could also be a competing source of bank funding, as we discuss later. Thus, we believe the main upshot for debt investors is that portfolio shrinkage and a general lack of bank demand for advances will be significant factors in keeping GSE funding needs across the board once again in 2011.
Inventory management: Now more than ever

While we believe the general supply backdrop should provide a positive technical for valuations, the outlook for how the GSEs will adjust their funding mixes is not as clear-cut.
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Figure 13: Fannie Mae paydowns to offset bought-out loans

$ bn 900 800 700 600 500 400 300 200 100 0 Jan-09 Jul-09 Jan-10 N-A MBS Jul-10 Jan-11 Jul-11
Figure 14: Freddie Mac already below its YE11 cap

$ bn 1,000 900 800 700 600 500 400 300 200 100 0 Jan-09
Jul-09 Agy MBS
Jan-10
Jul-10
Jan-11
Jul-11 DQ Loans
Agy MBS
Perf Loans
DQ Loans
N-A MBS
Perf Loans
Typically, the GSEs keep a diversified funding mix and retain flexibility, but we believe that greater uncertainty on the asset side could have an effect on their decisions in 2011. One of the main sources of uncertainty is a consequence of the delinquency buyout programs, which have rapidly increased the amount of NPA on FNM/FRE balance sheets (Figures 13 and 14). This is likely to continue through 2011 as REO liquidations are increasingly unable to keep pace with new acquisitions (Figure 15) a phenomenon that would be exacerbated by any foreclosure moratoria or other exogenous delay in the foreclosure workout process. From a funding standpoint, sea changes in the GSEs portfolio compositions would color any ALM-related decisions regarding the funding mix, given the spectrum of workout possibilities for these non-performing loans: Modification could result in two scenarios: a successfully modified loan should theoretically have the same or marginally longer duration as other performing loans, while re-defaulting loans would eventually tend toward foreclosure. Entering foreclosure also presents a variety of possibilities: a pre-foreclosure (short) Figure 15: REO acquisitions increasingly outpace disposals
000s loans 140 120 100 80 60 40 20 0 Mar-07 Dec-07 Sep-08 Jun-09 Dispositions
Figure 16: Estimate negative net issuance at FNM, FHLB

$bn 2010 Short-Term Bullet Callable Total Portfolio/ Advance Growth 2011 Total FNM 9 27 13 49 30 -80 FRE -30 4 -50 -77 -45 0 FHLB 8 -84 -56 -132 -131 -50
Mar-10
Acquisitions
Source: Fannie Mae, Freddie Mac, Barclays Capital
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sale or other workout would end the life of the loan before proceedings even begin, but the foreclosure process could take as long as 24 months, with risks towards an even longer period if the potential for moratoria persists. Finally, even if a loan progresses all the way to the REO category and falls out of the portfolio, it still needs to be funded until it is liquidated and the GSEs have demonstrated an increasing inability to stem the buildup of REO on their balance sheets. We believe that this ALM quandary should encourage the GSEs to retain maximum flexibility in their funding mix in 2011, not drawing down too much on any particular class of debt outstanding discount or term, bullet or callable. Note that the progression of buyouts and pay-downs at FNM/FRE is likely to have little peripheral effect on the agency MBS markets: additional buyouts should total $100bn at FNM and $60bn at FRE in 2011, offset by $100bn in pay-downs at each GSE. Depending on the foreclosure-to-REO roll rate (we expect $50bn at FNM, $25bn at FRE), by YE11 FNM would need to net-sell $20bn in agency MBS to hit its $70bn shrinkage target, while FRE has enough room to buy $100bn, although we expect it to keep its balance sheet roughly flat.
Supply outlook: Turn out the lights

Funding activity follows portfolios lower
Historically, the GSEs funding profiles have evolved in lockstep with their portfolios, even when allowed to grow further. This was notably true for both FNM and FRE in 2010, as despite being subject to debt limits equal to 120% of the portfolio limits as defined under the PSPA, both FNM and FRE have net-shrunk their debt outstanding (Figure 16). Ultimately, we expect net issuance of -$130bn from the GSEs in 2011; $80bn of the shrinkage will come from FNM and the remainder from FHLB, while FRE will keep its debt outstanding basically flat.
Potential for term-out could increase

While the aforementioned uncertainty about ALM for bought-out loans is certainly a wildcard for the 2011 term funding mix, we believe there are more prosaic reasons to expect the GSEs to place more emphasis on term funding: At FHLB in particular, short-funding of the balance sheet remains something of an issue (Figure 17). This becomes apparent when considering all callables outstanding at their first call dates, as the vast majority of recent issuance has been in structures with six or fewer months to their first call date. Another compounding factor may simply be the increased volume of maturing bellwethers in 2011; many of these were front-end issues placed shortly after the conservatorship through the early stages of QE1, when investor appetite could bear $10bn or greater issue sizes (Figure 18). The need to maintain a deep and liquid curve in the bellwether bullet market could keep net issuance from becoming too negative in this market segment. Mitigating this to some extent is the possibility that rates may drift higher in 2011. As a result, redemptions should taper off from the torrid pace this year, and a significant portion of the outstanding callable universe could extend. This implies that net term callable issuance should be less negative in 2011; there has already been evidence of this
16 December 2010 53
Figure 17: Current part of long-term debt is sizable

Percent of debt outstanding maturing in 1y 80% 70% 60% 50% 40% 30% 20% 10% 0% FNM Discount
Figure 18: Significant bellwether maturities in 2011

$ bn 60 50 40 30 20 10
FRE LT at maturity
FHLB LT at 1st call
0 Jan-10
Jul-10
Jan-11 Maturing Issued
Jul-11
in the last several weeks of 2010. If this phenomenon is sustained, it would allow the GSEs to lengthen the duration of their funding without having to tap the market; consequently, this is a risk factor for lower net bullet supply. Lastly, as QE2 takes hold, we expect the swap spread curve to steepen (ie, intermediate swap spreads should widen see Caught in crosswinds on page 60). With agency spreads versus Treasuries likely to stay well supported, agency/LIBOR valuations in intermediate tenors may richen, making issuing further out the curve more economic. Even with modest funding needs, given the better economics, the incentive for the GSEs to term out should be higher in 2011. We also think both GSEs will be proactive in securing longer funding, while they can, especially given investor concerns about the YE 12 date.
Demand: Trickle down

Shifting sands of agency demand
Our previous focus on the nature of the PSPAs and the change in their nature after 2012 was predicated on the pattern of investor behavior in 2010 we found most striking. By all accounts, some key foreign and official segments of the agency investor base essentially staged a buyers strike on any debt maturing after 2012 due to discomfort with the credit. However, this void was filled smartly by domestic investors (Figures 19 and 20). While foreign interest may be lower going forward, we believe the likelihood of sustained foreign sales of agency debt is fairly low. In addition, the market effect of the foreign investor base is lower than in the past, simply because the amount of agency debt held overseas is already at lower levels. For example, $444bn of long-term foreign holdings of agencies were reported in the June 2009 TIC data; since then, net sales have been another $52bn. Unlike indications in the Fed custody holdings data which include MBS foreign investors simply seem inactive (Figure 21); in our view, the more likely outcome is that demand remains moribund.
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Figure 19: US investors fill the void of foreign demand

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2y - 2009 2y - 2010 N. America
Figure 20: as money managers and banks also ramp up

100% 90% 80% 70% 60% 50% 5% 19% 4% 14% 38% 2% 7% 58% 8% 8% 6% 7% 21% 4% 15% 9% 9%
3% 6% 16%
14% 4% 23%
7% 7% 14%
2% 4% 14%
74% 60%
72%
81%
40% 30% 20% 10% 0%
47%
56%
63%
5y - 2009 Asia Europe
5y - 2010 Other
2y - 2009 Fund Mgrs

2y - 2010 Comm Bks
5y - 2009 Ins/Pens
5y - 2010 Ctr Bks Other
On the domestic side, we believe that bank portfolios will be a strong source of demand for agency debt: from 2004-08, banks reduced agency debt holdings from $250bn to $150bn, but from Q3 08 through 2009, they essentially bought back that $100bn with part of the influx of cash they received from QE1. With QE2 in its infancy, cash on bank balance sheets should grow from $1.0trn today to about $1.4trn by June 2011. We would expect the subsequent second wave of cash to flow through in some amount to agency debt demand. Also, we believe Basel III is a harbinger of the future regulatory environment in which banks are prudentially encouraged to buy low risk-weight assets such as agencies. Lastly, recall that a $100bn chunk of the TLGP debt issued in late 2008-early 2009 is beginning to roll off in 2011, with another $175bn to follow in 2012 (Figure 22). To the extent that the investor base in TLGP paper bought the names as another Treasury surrogate and may even have switched out of agencies to do so, we would expect a significant portion of this rolloff to be repatriated into agencies.
Figure 21: Foreign sales of agency debt have been choppy

$bn 15 10 5 0 -5 -10 -15 -20 Apr-09 Sep-09 Agency Debt Feb-10 Agency MBS Jul-10
Figure 22: TLGP maturities begin to ramp up by YE11

$ bn 70 60 50 40 30 20 10 0 Jan-11 May-11 Sep-11 Jan-12 May-12 Oct-12
Maturing TLGP debt

Source: Treasury International Capital reporting data, Barclays Capital
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Spread outlook and trades

US agencies: Business as usual?
Agency bellwether spreads have generally ground tighter in 2010; early in Q4, they neared their historical lows, but have widened back somewhat as concerns in Europe have pushed swap spreads wider (Figure 23). However, in general, agency-Treasury spreads have remained at levels near the low end of the range: 12bp in 2y, 20bp in 3y, and 25bp in 5y (Figure 24). We expect agency spreads to hew closely to these levels over the course of 2011, slowly moving tighter still, for the aforementioned reasons: Supply technicals are a substantial positive for valuations; our projection for net issuance of -$130bn is in line with the -$160bn realized in 2010. Although the effect of foreign investors could be less than in previous years, domestic demand should remain robust and even increase with QE2, particularly bank portfolios. Investors displaced from the TLGP market could also create demand for agencies. Along the curve, the 3y sector seems the most attractive from a spread roll-down standpoint, but the widest absolute level of spreads is the 25bp in the 5y point. Given the above discussion about GSE creditworthiness, we believe that any credit risk premium priced into this sector represents an opportunity for investors to pick up yield. In terms of agency asset swap spreads, we can envision a scenario in which the eventual steepening of the swap spread curve causes the agency-Libor curve to flatten. This could be particularly true in the 5s-10s segment, which has otherwise been a stubbornly Liborpositive, uneconomic place along the curve for the GSEs to fund (Figure 25). Lastly, in bullet space, we believe that TLGP paper makes sense to overweight versus agencies anytime the basis between the two widens to the 10bp area, as it has of late in the mid-2012 sector (Figure 26). Given TLGP papers explicit guarantee and 0% risk weight, there should be even less uncertainty about the creditworthiness of this paper than with the GSEs, in our view. While some might argue that liquidity premium should account for part of the spread differential between TLGP and agencies, note that the Fed purchased about 25% of the float in the mid-2012 part of the curve during QE1, making most issue sizes quite similar to TLGP.
Figure 23: Agency spreads have stayed rangebound

Fitted agency-Treasury spread, bp 45 40 35 30 25 20 15 10 5 0 Dec-09
Figure 24: Agency-Treasury spread curve

(bp) 40 35 30 25 20 15 10 5 0 -5 0
Mar-10 2y
Jun-10 3y
Sep-10 5y 10y
4 6 Years to Maturity FHLMC FHLB
10
FNMA
FFCB
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Figure 25: Agency asset swap curve

(bp) 20 15 10 5 0 -5 -10 -15 -20 0 2 4 6 8 10 Years to Maturity FNMA
Figure 26: TLGP should not trade too far behind agencies
ASW, bp 10 5 0 -5 -10 -15 -20 Jan-11
Jul-11
Feb-12 Agency TLGP
Aug-12
FHLMC
FHLB
FFCB
Agency callables: If not now, when?

As QE2 has been priced out of the market, the backup in yields and spike in vol have created opportunities in callable space. Two that we highlight may appeal to investors positioning for opposite macro outcomes: For investors seeking to fade the spike higher in rates and vol, 3nc6m and 5nc6m structures offer protection against an additional 45-55bp sell-off in rates over the next six months (Figures 27 and 28). We believe that the backup in rates should reverse per our H1 11 forecasts, and the Fed is almost certain to be on hold, as it will still be effecting QE2. A shorter-dated structure also is more insulated from any deficit- or inflation-related curve steepening. Lastly, the spike in vol has been driven by shorter tenors, which should lead the way lower in the event vols reverse course, as we expect. By contrast, investors looking for bullet alternatives may find a viable option in 3nc1 or 5nc1 bonds, which are issued slightly out-of-the-money forward and pick up 20-30bp over similar-maturity bullets. These bonds slightly outperform their shorter-lockout counterparts in scenarios with large selloffs, but of course this comes with the price of substantial underperformance in a rally as they are called away.
Figure 27: Summary of callable structures

3nc6m E Coupon OAD Cushion to Spot Similar OAD Bullet Bullet to 1st call YTM of Bullet 1.40 1.7 45 0.66 0.19 1.13 5nc6m E 2.42 2.3 58 0.81 0.19 2.12 3nc1 E 1.34 2.2 56 0.78 0.27 1.13 5nc1 E 2.34 3.1 67 1.13 0.27
Figure 28: Total return horizon analysis of callables

Excess return bp, 6m horizon 150 100 50 0 -50 -100
2.12
-100
-50
0 3nc6m
50 5nc6m 3nc1
100 5nc1
150
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Overseas names: Proceed with caution

As spreads of US names in the Treasury-surrogate space have compressed, investors have turned to USD paper issued by foreign names to pick up yield. However, turmoil regarding the peripheral euro zone has intensified, bringing with it the specter of potential issuance from the EFSF. USD supra valuations have cheapened in response (Figure 29), but we would not be surprised to see further underperformance; recall that this basis got as wide as 40bp during the first wave of European sovereign risk concerns in the middle of 2010. In our view, the EFSF overhang is likely to have a greater effect on supra valuations than will fundamental factors, particularly in the early stages, as the usual supra funding programs are a set amount each year. Recall the cheapening effect of the TLGP programs introduction on agencies, which was exacerbated by larger concessions on the initial TLGP deals in order to ensure smooth placements. We emphasize that competition from any potential EFSF supply (EUR17.7bn from the Irish assistance package is already planned) will have a larger effect early in the program because as more and more borrowers access it, the fewer guarantors will remain. While it is unclear how much supply the EFSF could ultimately create, our European counterparts have estimated this at EUR300-350bn, 12 and we would expect some portion of this to be USD-denominated, given the funding advantage provided by the negative EUR/USD cross-currency basis (Figure 30). We also carry over this recommendation to the foreign GGB space; while we continue to believe guarantor countries outside the euro area will ultimately be in sounder situations, they still may not be insulated from the knee-jerk widening in non-US names. Note that even now, the cost of insuring against a sovereign default in countries such as the UK and Sweden is less than the spread to Libor of their GGBs.
A sensible solution in Canadian covered bonds

In Canadian covered bond space, we believe names may have been unfairly victimized by sovereign risk concerns, more so than even the non-euro area GGBs. From a fundamental standpoint, the main attraction of these programs is the explicit Canadian government guarantee on the mortgage loans in the cover pool.
Figure 29: USD supra underperformance could worsen

ASW, bp 50 40 30 20 10 0 -10 -20 -30 Nov-09 Feb-10 3y EIB
12
Figure 30: Cross-currency basis swap turns more negative

EUR/USD Cross-currency basis swap, bp 0 -10 -20 -30 -40 -50 -60
Apr-10 3y FNMA
Jun-10
Sep-10 5y EIB
Nov-10 5y FHLMC
-70 Jan-09
Aug-09 2y
Mar-10 3y 5y
Oct-10
The AAA Investor: Implications of the envisaged EFSF rating, 28 September 2010.
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As we believe Canadian sovereign credit is well insulated from European concerns and more than a match for the US fiscally, we believe that investors would be well served to pick up the 30-40bp of spread that Canadian covered bonds offer over agencies (Figure 31). In terms of upcoming supply, this is one market that could grow another $70bn or so if the five existing issuers maximize their entire capacities (Figure 32). While we would expect the decision of Canadian issuers to tap the USD market to be more organic than with European covered bond issuers (as they naturally have more operational exposure to the US), we believe that new issues priced to sell also represent opportunities for domestic investors with the approval to expand to these names.
Sidebar: US covered bonds

One market that has provoked a considerable amount of discussion is the US covered bond market (ie, US names issuing USD covered bonds). We believe that several preconditions will need to emerge for this market to be successful: Currently, the GSEs represent the main obstacle for covered bonds: for banks, originating loans and selling them to FNM/FRE or GNMA offer better execution and more capital relief. The FHLB represents another significant source of competition for bank funding against a wide range of collateral. Thus, we believe the only way for banks to become volume issuers of covered bonds is by regulatory fiat; ie, the government legislates the market into existence. Moreover, only the largest issuers would have sufficient capital markets access to fund competitively. A legislative framework would also be needed to provide an adequate margin of safety for investors, by defining standards for eligible collateral, minimum overcollateralization, and other safeguards. Any framework would also have to resolve the conflict between covered bondholders and the FDIC in terms of collateral rights in an issuer liquidation. Lastly, the ALM mismatch between the typical covered bond structure an intermediate fixed-rate bullet and the 30y fixed-rate mortgage would have to be resolved. If all of these issuers were addressed, the US regulator could limit covered bonds to 4% of total bank liabilities (as per the Treasury best practices from 2007). This would result in $250-300bn of outstandings, assuming only large banks are able to tap the market. 13
Figure 31: Covered bonds offer significant pickup

ASW, bp 50 40 30 20 10 0 -10 -20 Jan-13 Jan-14 Canadian Covered
13
Figure 32: Canadian covered bonds could ramp up

$ bn Limit @ 4% 15.5 19.9 13.4 26.2 22.3 97.3 Total CB out 3.4 6.9 4.3 5.8 2.0 22.3
Issuer BMO BNS CIBC RBC TD Total
Assets 388 497 336 655 557 2433
$ CB out 2.0 5.0 4.3 1.5 2.0 14.8
Jan-15 Agency
Jan-16 EIB/KFW
US housing finance: No silver bullet, 13 December 2010.
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SWAP SPREADS
Caught in crosswinds
Amrut Nashikkar +1 212 412 1848 amrut.nashikkar@barcap.com
Libor could remain volatile, driven by European sovereign risk. FRA-OIS basis is pricing in a substantial risk premium. The widening priced into forwards has a very low likelihood of being realized. Buy white/red Eurodollars; sell 1y1y Libor-OIS spreads for carry. Spillover from the Feds Treasury purchases should lead to a correction of the inversion between 2y Treasuries and 2y OIS, as short positions on dealer balance sheets increase. Buy 2y Treasuries against OIS. Spreads in the 5-10y sector should widen in Q1 11. Near-term, we recommend buying 7y spreads. We expect spreads to give back most of their QE driven widening if the Fed decides to stop buying Treasuries, with significant tightening risk if deficits worsen. Mortgage hedging should not be a very big risk factor for spreads, but its effects could increase by H2 11 use any widening driven by such events to sell spreads. Fiscal concerns and receiving needs from hedgers will weigh on long-end spreads, especially in light of the agreement to extend the Bush tax cuts. We expect 30y spreads to stay negative, although a near-term QE-based widening is possible.
Key themes for 2011

Europe: A major source of uncertainty
2010 showed that developed-country sovereign risk can affect the US rates market in surprising ways. First, flight to quality flows into the US cause rallies in US Treasuries, and sell-offs in risky assets, leading to wider swap spreads. Second, Dollar funding costs in Europe rise because of the exposure of European banks to sovereign risk. This raises Libor expectations, leading to wider spreads. Both these effects served to widen swap spreads at times in 2010. There is a close connection between bank credit risk as expressed by bank CDS spreads and Libor expectations. With a permanent solution for European sovereign problems unlikely to be found in 2011, fears of Libor flare-ups will keep swap market participants on their toes, in our view.
QE II: Flow effects in H1 11

The second key theme dominating the rates market should be purchases of Treasuries by the Fed. There is little uncertainty around what the Fed will do up to June 2011 the New York Fed has already published a tentative schedule of purchases, along with its intended distribution by maturity of Treasuries. Fed purchases of Treasuries will distort the spread curve in the first quarter of 2011. The announced distribution of purchases is heavily skewed toward the 5-10y sector (Figure 2). In fact, by our estimates, the Fed will end up buying more in the 7-10y part of the curve than is likely to be issued in the 10y sector over the next eight months (Figure 3). However, in both 2s and 30s, Fed purchases are likely to represent only a small proportion of gross issuance. In the near term, this should serve to widen spreads, and the effects should reverse once the end of Quantitative Easing is in sight.
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Deficits: Treasury supply as far as the eye can see

The third theme will be the continuation of high fiscal deficits, which has been underscored by (at the time of this publication) the likely extension of the Bush tax cuts for two years. It is commonly understood that swap spreads are influenced by Treasury issuance. However, the effects of expectations of future Treasury supply are equally, if not more, important. Spread markets are forward looking. For example in the late 90s and the early years of the past decade, swap spreads widened dramatically on expectations that the Treasury would continue to run surpluses, thus eventually leading to massive cuts in Treasury supply (Figure 5). However, actual 10y issuance changed very little throughout this period. Similarly, in late 2008, 30y swap spreads went negative, despite the fact that the Treasury only started raising long-end auction sizes in mid-2009 most of the initial issuance in late 2008 came in the form of Treasury bills. Part of the reason behind the significant tightening of long-end spreads was an expectation of continued deficits by the market, leading to high future issuance of long-end Treasuries. With the economy not improving much, mandatory Figure 1: Link between front-end swap spreads and European sovereign spreads had weakened, is now strengthening
30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% Jan-10
Figure 2: Fed purchases of Treasuries skewed toward intermediate sector

25% 20% 15% 10% 5% 0%
Mar-10
May-10
Jul-10
Sep-10
Nov-10
0 1.5y
1.5 2.5y
2.5 4y
4 5.5y
5.5 7y
7 10y
10 17y
17 30y
30 day beta between SovXWE and 2y swap spread

Planned Distribution
Source: New York Fed, Barclays Capital
Figure 3: Fed will purchase nearly all the gross issuance in the intermediate sector over the next six months
$bn 300 250 200 150 100 50 0 0-1.5y 1.5 2.5 2.5 4 4-5.5 5.5-7 7-10 10-17 17-30 Fed Purchases (E)
Figure 4: Libor sets of European banks have been higher than those of US banks
bp 60 55 50 45 40 35 30 25 20 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 US banks European banks
UK banks Libor
Next 6M Gross Issuance (E)

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spending by the Federal government continuing to rise, and the extension of the Bush tax cuts, the outlook for deficits is bleak. We think this will weigh on swap spreads in the second half of 2011 as it did in 2010.
Regulation: Dodd-Frank changes market structure

There will be significant changes in the OTC market caused by the Wall Street Reform and Transparency act of 2010. We expect three major changes. First, by July, nearly all plain vanilla interest rate swaps and related products are likely to be centrally cleared, since they are already eligible for clearing at proposed CCPs. In our view, the costs of clearing are unlikely to be very high for banks. On the other hand, a substantial proportion of end-user derivative positions are uncollateralized. Some end users such as the GSEs are unlikely to get exemptions from the clearing requirements. Market participants with one sided exposure to the OTC derivative markets, such as the GSEs (natural payers) or insurance companies (natural receivers) are likely to face higher collateralization requirements for swaps. However, in the absence of hedging vehicles that do not require margins and the presence of ample amounts of cash in the system that can be used as collateral, it is difficult to see how they may react. Second, we expect plain vanilla swaps to start getting listed on swap execution facilities by the middle of 2011, and public reporting of all swap transactions, in some form, as required by Dodd-Frank. This has significant implications for the liquidity of the swap market while improved transparency should decrease bid-ask spreads and increase liquidity along that dimension, the public reporting requirement also exposes market makers to larger losses, possibly leading to a reduction in the depth (or the ease with which large transactions can be executed) in the market. Third, we think a substantial portion of the market will migrate to OIS-discounting based market curves for most OTC interest rate derivative products. This is because Dodd-Frank will lead a vast proportion of the swap universe to be centrally cleared, and therefore collateralized. This could mean significantly improved liquidity in the OIS market, and the possibility that OIS comes to be used as a benchmark curve for pricing other financial instruments.
Figure 5: Swap spreads widened on expectations of future surpluses in the 90s

160 140 120 100 80 60 40 20 0 May-97 May-98 May-99 May-00 May-01 May-02 -5 -10 10 5 0 (bp) (% GDP) 20 15
Figure 6: Foreign financial CP has increased, while US financial CP has decreased

280 260 240 220 200 180 160 140 120 100 Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Oct-10 700 650 600 550 500 450 400 350 300 250 200
10y spread (LHS)

5y surplus (RHS)
Foreign($bn)
Domestic ($bn)
Source: Haver Analytics, Federal Reserve, Barclays Capital
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Front-end spread outlook

The outlook for Libor is a key determinant of the outlook for swap spreads at the front end of the curve. Since the beginning of the credit crisis, the shortage of dollar funding in Europe has meant that dollar funding costs for European banks have, on average, been higher than those for US banks. This has translated to higher Libor sets (Figure 4). US banks have directly benefitted from the ample liquidity provided by the Fed (and this should only get better as $600bn of liquidity is added to the system). This excess liquidity is available to non-US banks only indirectly, through US money funds that buy short-term debt issued by them. Since Libor is a trimmed mean where the lowest settings are ignored, the divergence between US and European banks means that Libor is essentially driven by dollar funding costs of European banks. Money funds are likely to continue to term out their investments. Further, the shortage of US CP issuance (figure 6) means that money funds are increasingly likely to be forced into foreign bank-issued commercial paper over time, which should be positive for Libor. There are strong inter-linkages between banking system risk and sovereign risk. First, many European banks hold debt issued by peripheral European countries, which was the focus of much market concern in 2010 and will continue to be so in 2011, in our view. Second, financial institutions benefit to a great degree because of support from their sovereigns. With sovereign spreads on core European countries such as France and Belgium beginning to widen, a spillover to the banking system, and hence a Libor spike, cannot be ruled out.
Libor and Europe: Changing dynamics

During the Libor scare of May, when 3m Libor rose to 55bp, there was a strong relationship between the markets perception of sovereign credit risk and bank credit risk in Europe. After the European bank stress tests in July, this relationship became much weaker because of a market perception that peripheral European sovereign risk would not create problems for the big money center banks that constitute the Libor panel. More recently, as the contagion has spread, these fears have come back. This has led to an increasing sensitivity of Libor-OIS expectations to sovereign risk and, recently, a stronger relationship between front-end swap spreads and European sovereign spreads (Figure 1). We expect this relationship to continue in 2011. Figure 7: Risk premium in FRA-OIS spreads is high, as evidenced by the slope between forward and spot Libor-OIS Figure 8: Intercept of a rolling regression of 2y LOIS basis on bank CDS spreads shows a negative correlation with Banking system cash
1,400 1,300 1,200 1,100 1,000 900 800 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 700 Oct-08 150 125 100 75 50 25 0 -25 -50 Apr-09 Oct-09 Apr-10 Intercept (bp, RHS)
60 50 40 30 20 10 0 -10 Feb-10
9X12-3m LOIS (bp)

3X6-3m LOIS (bp)
Bank cash ($bn, LHS)

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Despite volatility, selling spreads is attractive

Despite Libor remaining volatile, forwards may not be justified. Our view is that forwards do not necessarily imply expectations of Libor-OIS to widen, but are pricing in a substantial risk premium. In the base case, excess liquidity in the system means a continuation of lower interbank borrowing rates, but there always remains the risk of a spike in Libor and, consequently, mark to market risk in spread tighteners. We believe that FRA-OIS spreads reflect a substantial risk premium as compensation for this uncertainty. This is reflected by their difference with respect to where Libor-OIS is trading, which is at the levels it had reached in May 2010 (Figure 7). While increases in Libor are certainly possible, it is unlikely that the experience of May 2010 will be repeated. The big difference going forward is that the European Financial Stability Facility is available in case contagion spreads, policy makers in Europe are demonstrating that the euros backing remains firm, and the ECB has shown a willingness to supply liquidity to the European banking system through LTROs. We also believe that the market is not adequately pricing in the effect of additional liquidity injections (Figure 8). After controlling for bank credit risk, it does not appear as if FRA-OIS spreads are pricing in any additional benefit from QE2. Thus further supports our tightening view. Thus while we would not be surprised to see spot Libor-OIS averaging higher than current levels through 2011, we do not expect forwards to be realized. Investors who are willing to accept the mark-to-market risk should consider selling 1y1y LOIS spreads (Figure 9). Alternately, buying EDU1 or EDZ1 are also attractive carry trades, in our view, especially in light of the recent sell-off because of which markets are pricing Fed funds to average 44bp by December 2011, which we think is unlikely.
Regulatory concerns are a risk

A potential source of concern for us at the beginning of 2010 was the effect of regulatory reform on bank balance sheets. Our view was that there were a number of potential changes that would increase the cost of funding for banks, and hence would put upward pressure on spreads. These were: 1) the prospect of rating downgrades related to the imposition of too-big-to-fail resolution authority in what later became known as the DoddFrank act; which had the potential to shut some US banks from the CP market 2) liquidity requirements imposed by Basel III that would move banks into costlier, but stable, sources of Figure 9: FRA-OIS spread curve peaks at 1y + expiries
40 35 30 25 20 15 10 5 0 10 X 13 11 X 14 12 X 15 15 X 18 18 X 21 21 X 24 7 X 10 8 X 11 9 X 12 0X3 1X4 2X5 3X6 4X7 5X8 6X9
Figure 10: 2y Treasuries trade cheap to OIS

25 20 15 10 5 0 -5 -10 -15 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10
FRA-OIS (bp)
2yOIS-2y Tsy yield (bp)

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funding such as deposits and long-term debt. These factors are likely to remain important in 2011, though perhaps to a lesser extent than we thought at the beginning of 2010. While the language coming out of ratings agencies has been negative since the passage of Dodd Frank, reliance on CP by US banks has decreased over the past two years (Figure 6). The second issue is not as much of a concern, since the implementation of Basel III has been pushed back. The more stringent of the liquidity requirements the net stable funding (NSF) ratio has been delayed to 2018, although monitoring will start by 2014. The second liquidity requirement, the liquidity coverage ratio (LCR), which is a measure of short-term liquidity, will only be implemented by 2015. By our estimates, if the liquidity coverage ratio were to be imposed in 2011, the US banking system would be able to meet the requirements. This is because the current shortfall is under $300bn and a large part of the $600bn QEII injections will flow to US banks in the form of cash held as excess reserves at the Fed, which qualifies as a 100% liquid asset under the Basel liquidity guidelines.
The puzzling 2y OIS-Treasury spread

While the focus of much discussion in spreads tends to be around Libor-driven moves, in tight Libor-OIS environments characterized by excess liquidity, OIS-Treasury spreads make a large contribution to spread volatility. Historically, OIS-Treasury spreads were, to a large extent, determined by repo market specialness. But given historic levels of Treasury supply, Treasuries have often traded cheap to OIS spreads. At the front end, 2y Treasuries continue to trade cheap to 2y OIS (Figure 10). When this inversion developed, it was thought to be a result of expectations of the Fed draining reserves through reverse repos, which would have led to GC trading above OIS consistently. However, with no prospect of the Fed hiking any time soon, we believe that the continued dislocation is because of constrained dealer balance sheets. We expect the Fed purchasing Treasuries in other parts of the curve to lead to richening of 2y Treasuries to OIS. This is similar to the effect we saw between March and October 2009, when the Fed conducted $300bn in Treasury purchases, which were also primarily concentrated in the intermediate sector. Therefore, for those who want to express a front-end spread widening view, 2yTreasury-OIS wideners should be preferable to swap spread wideners. Figure 11: 5y matched maturity spreads widened as QE expectations came to be priced Figure 12: Fitted vs actual 5y spreads, based on a model driven by deficit expectations, issuance, Libor-Bill spreads, and mortgage convexity
bp 140 120 100 80 60 40 20 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 5y spread (bp)
35 30 25 20 15 10 5 0 -5 -10 Jun-10
0 1991
1994
1997
2000
2003
2006 Fitted
2009
10y spread (bp)

5y spread
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QE and spreads: Two steps forward, one step back

Fed purchases of Treasuries will be an important driver of intermediate spreads, because that is the sector where we think most of its distorting effects will be felt. Of the $600bn in additional Treasury purchases that the Fed plans to accomplish over the next few months, over 60% will be in the 5-10y sector (Figure 2). Both 5y and 10y spreads widened since expectations of another round of QE came to be priced in by the market in mid-August 2009. (Figure 11). Despite a belief prevalent in the market that the effect of purchases on spreads has been fully priced in and the recent narrowing seen in spreads as rates have sold off, we believe that spreads in the intermediate sector should widen in the near term. Large scale purchases of Treasuries by the Fed have both a stock and a flow effect. In a Federal Reserve paper titled Flow and Stock Effects of Large-Scale Treasury purchases, DAmico and King (2010) distinguish between the flow effect and the stock effect of Treasury purchases. They define flow effects as the response of prices to ongoing purchase operations, while stock effects are persistent changes in prices that result from purchases. Specifically, they show that flow effects occur even when a purchase is perfectly anticipated by the market. We expect something similar over the coming months as the market feels the effect of the Fed buying $70-80bn of Trreasuries every month.
Fundamentals suggest widening in H1 11

We have updated our fair-value framework to incorporate the effects of both the long-term supply outlook and variations in near-term treasury supply on swap spreads. Our fair value framework uses Libor-bill spreads, cumulative 5y deficits/surpluses according to CBO forecasts, sector specific issuance in particular sectors, as well as other variables such as the model duration of the mortgage index (as a proxy for convexity paying needs) (Figure 12). The reason for using 5y projections of deficits is to account for the forward looking nature of the market. By our estimates, using the CBOs baseline forecasts adjusted for likely alternatives, deficits are likely to be near $1trn, on average, for the next 10 years, which means that treasury issuance will continue to be high for the foreseeable future.
Figure 13: Correlation in changes in spreads and changes in mortgage durations is very low, mortgage hedging is not as significant for spreads as it used to be
100% 80% 60% 40% 20% 0% -20% -40% 2000 2002 2004 2006 2008
Figure 14: Mortgage duration extension comparable to May 2009, yet spreads not significantly wider
4.5 4.0 3.5 30 3.0 20 2.5 2.0 10 1.5 0 1.0 -10 0.5 -20 0.0 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 40 10y matched maturity spread (bp, RHS)
50
10y spd - Mortgage index duration correlation (60 days)

Mortgage fixed rate index duration (yrs, RHS)

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In our framework, 2y spreads are most sensitive to Libor, while, as you move further out the curve, the importance of supply-related factors in explaining swap spreads increases. 10y spreads and 30y spreads are most sensitive to both dimensions (current and expected) of Treasury supply. We believe that Fed purchases of Treasuries in individual sectors are equivalent to an effective reduction in near-term Treasury supply in that sector, while the outlook for longerterm supply is unchanged. This allows us to use our estimated sensitivities to translate any given amount in Fed purchases to a basis-point impact on swap spreads. The fair value model suggests that with $600bn in purchases, there is room for both 5y and 10y swap spreads to widen further from current levels, before they give back their QE driven widening in the second half of 2011(Figure 15). In 2011, supply will weigh on long-end spreads: long-end auction sizes are likely to be cut the least and only 6% of the Feds purchases of Treasuries are at the long end of the curve. Our fair value model for spreads suggests that 30y spreads are likely to remain in negative territory. Given that the Fed will be purchasing nearly 25% of gross Treasury issuance in the sector, we expect long-end spreads to widen over the near term (Figure 15) but head back to -30bp by the end of 2011. Figure 15: Swap spread forecasts for 2011
2y Current 1Q11 2Q11 3Q11 4Q11
5y 22 30 30 20 20
10y 11 20 20 10 10
30y -25 -20 -20 -30 -30
24 20 20 20 20
Technical factors
Mortgage hedging: Diminished importance?
Convexity hedging was not as dominant a driver of spreads in 2010 as it was in 2009, as reflected by the lower correlation between moves in spreads and changes in the mortgage durations. There are a number of reasons for this. First, there has been a substantial change in the holders of mortgages over the past two years because of purchases of mortgages by the Fed and the runoff of GSE portfolios that tend to be actively hedged. Between Freddie and Fannie, we expect their portfolios to run off to the tune of $320bn and delinquency buyouts of nearly $200bn in 2011. This should leave net free cash of around $120bn at each. The Freddie portfolio is already below its 2011 cap, which means that further shrinkage of the Freddie portfolio is not required. In fact, FHLMC could possibly use cash freed up by the run-off to buy mortgages. On the other hand, FNMA will need to shrink by nearly $80bn, which means that FNMA will probably need to sell some MBS. Between the two, we expect mortgage portfolios that are either smaller or unchanged, which should lead to GSE mortgage hedging needs that are comparable or smaller than 2010.
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Second, refinancing has been difficult a fact that can be attributed to a number of factors such as the number of borrowers with negative equity, as well as more stringent underwriting standards and aversion to put-back risk by originators. As a result, pre-pay speeds have been driven less by rallies in rates, resulting in a mortgage universe that is less convex. Further, with the recent sell-off in rates, our models indicate that servicers are skewed toward more receiving in rallies than they are toward paying in sell-offs. To add to these dynamics, the Feds reaction function increases its purchases in Treasuries in response to a prepayments), and vice versa, which should counter through swaps. All these effects should contribute to mortgage rates than they were historically. to mortgage pay-downs is that it fall in mortgage rates (and rising the effects of mortgage hedging keeping spreads less sensitive to
The last major convexity event in rates occurred in late May 2009. This was a period when the fed was buying mortgages and there was a belief that it would not let mortgage rates rise above a certain level. As a result, through an initial sell-off in Treasuries driven by better economic data, mortgages richened significantly with respect to Treasuries. When mortgage rates did rise, it led to a significant extension in mortgage durations (Figure 14) and, consequently, duration shedding needs that exacerbated the sell-off and the spread widening. The lack of such a reaction in the recent sell off of 110bp in current coupon rates suggests that extension risk in the mortgage universe is lower (Figure 14). However, even with slow prepayments, the coupon profile of the mortgage universe should change because of new originations as well as refinancing. We expect this process to be gradual over 2011. Together with our forecast for higher rates by the end of the year, this means that extension risk in mortgages could become important for mortgage hedgers toward year-end. This represents a risk to our base-case forecast for long-end spreads to tighten in the second half of 2011.
Corporate issuance will weigh on spreads

Fixed rate corporate issuance, particularly by financial institutions exposed to Libor funding costs, is typically swapped back to floating by receiving in swaps. This leads to downward pressure on swap spreads. In 2010, corporate issuance was a major driver of spreads in the 5-10y sector negative 10y swap spreads were associated with high levels of activity in financial issuance (Figure 16). Figure 16: Negative 10y swap spreads were associated with periods of high corporate issuance
35 30 25 20 0 15 10 5 -5 -10 15 10
40
Figure 17: European financial institutions can reduce their funding costs when they issue dollar denominated debt
bp 60 USD bond swapped into 6m Euribor (bp) EUR ASW curve
20 0 -20 -40 -60 -80 1
Maturity (y)
0 -15 Jan-10 Feb-10 Mar-10 May-10 Jun-10 Jul-10 Aug-10 2-wk fin issuance ($ bn)
10y spread (bp, RHS)
Note: EIB Curve as of Dec 14, 2010. Source: Barclays Capital
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Our credit strategists believe that gross corporate issuance will slow down in 2011 ($760bn) from the pace it reached in 2010 ($860bn), although the gross financial issuance, which is most likely to be swapped, will be unchanged at around $300bn. However, we expect issuance of dollar denominated debt by European banks to be high. A big reason for this was that the slopes of the relative asset swap curves between USD and EUR denominated bonds of the same institutions, together with the EURUSD cross-currency basis swap, made it attractive for European names to fund themselves in dollars (Figure 17). If the crisis in Europe continues, the gap between dollar assets and dollar liabilities for European financial institutions should continue to keep the cross-currency basis negative and USD denominated issuance from Europe high. Not all of this is expected to be swapped back because some of it is used to address the asset-liability currency mismatch. 2010 showed that European issuers are willing to take advantage of the differentials between their euro and USD denominated asset swap curves and issue USD denominated debt. Given the seasonality in issuance (Figure 18), with a particularly high concentration in January, higher-than-usual issuance is a major risk to our call on wider spreads in the first half of 2011. However, high issuance in July, August and September is supportive of the view that spreads should tighten in H2 11.
Long-end duration hedging needs

Spreads at the long end of the curve were driven by a backdrop of high 30y Treasury supply, along with a rally in the second half of the year that caught many liability-side hedgers, such as insurance and pension funds, by surprise. Insurance companies use off-balance sheet instruments to hedge ALM mismatches as well as separate account liabilities such as variable rate annuities, with the latter being hedged more frequently. Anecdotal evidence suggests that most large insurers hedge equity market risk, but it is not clear to what extent the interest rate exposure of variable annuities with guaranteed withdrawals is hedged. We estimate that nearly $1.5tn in variable annuities is outstanding in the US insurance market. Assuming that this entire amount has a minimum guarantee, that they are all linked to the S&P 500 and have been initiated over the past decade, and modeling in the rate sensitivity as the rate sensitivity of a 10y put option on the S&P, suggests that the current level of the index should translate to receiving needs of Figure 18: Seasonality in corporate issuance; January tends to be a high issuance month
% of annual 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Jan Mar May Jul Sep Nov
30y matched maturity spread (bp, LHS) 30y yield (bp, RHS)
Figure 19: 30y spreads and long end rates: sustainable correlation?
0 -5 -10 -15 -20 -25 -30 -35 -40 -45 Jun-10 4.5 4.3 4.1 3.9 3.7 3.5 Dec-10
Aug-10
Oct-10
2004-2009 average
2010 (annualized)
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$20-25bn in 10y equivalents for every 5% change in the S&P. A large rally in equities could lead to unwinds of rate hedges that have been put on over the past six months. This, together with rising rates, is a risk to our call for tighter long-end spreads in H2 11. The other major sources of duration buying needs arise from defined benefit pension plans that follow liability driven investment (LDI) strategies. During the second half of 2010, the funded status of many pension funds deteriorated substantially, as the equity market sold off and rates rallied. Based on annual filings by the top 100 companies between 2008 and 2009, we estimate that their pension benefit obligations have durations of 1015y. If fundedness in the average defined benefit plan is similar to those of the top 100 companies, this translates to overall duration needs of $2.6 trillion in 10y equivalents, compared with a median 40% allocation to fixed income, out of assets of $2.1 trillion. The past two years have clearly highlighted the sensitivity of funded status to interest rates. As a result, more pension funds are likely to want to immunize their liability durations, in our view. Our base-case forecast for 2011 is for the equity market to rally and for 30y rates to be at nearly 4.7% by Q4. This should translate into a considerable improvement in the funded status for plans, which should put them in a better position to immunize their liability durations with assets that deliver minimum required returns. We would thus expect their allocations to fixed income to increase. If this is achieved by receiving in swaps, it should contribute to tighter long-end swap spreads, The other source of hedging demand that affects long-end swaps is dealers hedging option portfolios that arise from issuing structured notes such as zero coupon callables. Dealers become short vol as rates rally and their exposure to further rallies in rates increases, leading to long-end receiving and a spread tightening. This is one reason for the positive beta between 30y swap rates and 30y spreads (Figure 19). Our expectation is for issuance of structured notes to remain high in 2010 as investors search for yield. If this results in increased directionality in 30y spreads and rates, it would represent a risk to our expectation of a tightening in 30y spreads in the second half of 2011, because of our view on 30y rates.
Trade recommendations
1. Earning mispriced risk premiums: Buy white Eurodollars outright or against fed funds; Receive 1y1y Libor swaps. We have already argued that FRA-OIS spreads are too wide relative to where baseline expectations around Libor should have them. Further, the market seems to be pricing in a very aggressive rate hiking path as far as the Fed is concerned. Our economists believe that any hikes are unlikely before the second half of 2012. The Fed is unlikely to hike before taking some action to drain excess reserves. This means that Fed funds futures at 0.5% by the end of 2011 or nearly 0.75% by June 2012 are incorporating an excessive term premium. This makes buying white EDs or receiving in 1y1y swaps an attractive trade. The 1y rolldown in the trade is nearly 70bp. There is the additional potential of additional tightening as Libor realizations come in below where forwards are currently priced. 2. Near term, buying 7y swap spreads; Conditional (bearish) widening using TY options and matched maturity swaptions. Our view is that the market is not appropriately pricing in the flow effects of Fed purchases on swap spreads in the intermediate sector. As a result, an attractive trade over Q1 11 should be putting on wideners in intermediate space, with 7y swap spreads being particularly attractive. Further, given the richness of Treasury futures options vol
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to swaption vol, high strike conditional wideners (puts-payers) can be initiated at zero cost at levels tighter to spot. Thus, even though not our base-case view, we think that such trades are attractive hedges against a convexity-led sell off. 3. Auction cycle trades: 5s-30s spread curve steepeners/flatteners Cyclical patterns in spreads made a comeback in the second half of 2010. One such pattern was the steepening of the 5s-30s spread curve after the 30y auction at the beginning of the month to the intermediate auctions toward the end of the month, and a subsequent reversal of the trade. While we do expect a $5bn per month reduction in 5y auction sizes, we expect long-end auction sizes to be unchanged. With balance sheets still constrained in 2011 as delivering continues, we expect this trade to perform consistently in 2011 (Figure 22). 4. Buying synthetic USD bonds of foreign issuers.
Figure 20: Treasury vol higher than swaption vol as a result of QE

230 210 190 170 150 130 110 90 70 50 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10 3m7y swaption vol (abp)
Figure 21: 7y spreads have tightened the most in the recent sell-off
Match maturity spread (bp)
35 30 25 20 15 10 5 0
-5 15-Sep-10
15-Oct-10 10y
15-Nov-10 5y 7y
15-Dec-10
TY implied vol (abp)
Figure 22: Cyclical patterns in the matched maturity swap spread curve around the 30y auction
-40 -45 -50 -55 -60 -10
Figure 23: Yield pick-up offered through synthetic USD bonds of European issuers using cross currency basis swaps
bp 70 60 50 40 30 Eur bond swapped into USD (bp) USD ASW curve (bp)
-6
-2
10
20 10 0 1 2 3
Maturity (y)
Days to 30y auction Jun-10 to Nov-10 Nov-09 to May-10
Jun-09 to Oct-09
Note: EIB Curve as of Dec 14, 2010. Source: Barclays Capital
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With the Eur-USD currency basis likely to continue being negative through 2011 because of a mismatch between dollar assets and dollar liabilities in Europe, we think investors will continue to find opportunities to pick up yields by buying euro denominated bonds issued by high-quality European names and swapping them back to USD. The trade involves buying a EUR denominated bond on 6m Euribor asset swap, turning the asset swap trade first into a 3m Euribor asset swap using the Euribor 3m6m basis, and then converting the package back to USD using a cross currency basis swap. The drawback is that it exposes the investor to swings in cross-currency spreads, as well as making the trade illiquid. However, for buy and hold investors, this should not be a problem, as long as they are set up to do trades like these (Figure 23).
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VOLATILITY
The demand is not enough

Piyush Goyal +1 212 412 6793 piyush.goyal@barcap.com
Vols will likely decline in the early months of 2011, as traditional hedgers buy less than usual and investors stretch for yield in the low yield/tight spread regime. On the supply side, there should be $495-620mn supply of vega next year, with most of it from callable zeroes, FHLB callable debt, GSEs, capped floating rate notes, and explicit selling from asset managers, which would stretch for yield, albeit opportunistically, as Fed asset purchases keep yields low and spreads tight. This would prove more than needed to meet the demand of $270-$360mn from mortgage servicers, insurance companies, hedge funds, and asset managers looking for protection against an unabated rise in rates. Admittedly, the supply would be spread across the year, while the demand would cluster. However, for the first few months of 2011, the vol surface should cheapen as the rates sell-off runs out of steam, supply from callable zeroes resumes, and the servicer buying becomes a smaller deal. We recommend selling 2y*10y straddles to benefit from the decline in vol, as well as rangebound rates for the next few months. In relative value, entry levels are good and fundamentals are supportive to 1) buy swaptions against Treasury future options, 2) buy gamma on long tails versus short tails, and 3) monetize the skew on short expiry options via payer ladder and sell 100bp out-of-the-money 5y*10y payer versus deep out-of-the-money 5y*10y payer. Additionally, the Dodd-Frank rules should shape up during the first half of 2011. Besides increasing the cost of trading, public reporting of transactions could cause option dealers to demand a wider bid offer. Accordingly, the supply-demand dynamic could assume a bigger role than in previous years.
The supply and demand of it

The structural shift in supply and demand of options, visible in 2010, would confirm in 2011. On one hand, the supply from investors, explicit or implicit via callable notes as they hunt for yield, would continue and probably increase. On the other, the demand from traditional hedgers, such as the GSEs and other mortgage hedgers, fall clearly on the wayside. The intermediate expiry options, such as 2y*10y, could suffer, especially as the bond sell-off abates. We explore each aspect of the supply-demand dynamic in detail.
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Figure 1: The big picture for 2011

Callable Zeroes ($300-400mn) Total Supply = $495-620mn
Figure 2: Expect large option supply from callable zeroes

25 20 15 300 250 200 150
Servicers ($100-130mn)
FHLB Callable ($75-100mn)
OPTION DEALER
Insurance Co. ($70-130mn)
10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
100 50 0
Real money, GSE ($120mn)
Total Demand = $270360mn
Hedge Funds ($100mn)
No longer outstanding ($ bn, LHS) Still outstanding ($ bn, LHS) 2-10 swap curve (bp, RHS)
Source: Bloomberg
Supply: The song remains the same

Callable zeroes, agency issued callable debt, and other kinds of structured notes are the largest source of options for the market. We start by taking a closer look at the issuance, which was high in 2010 and will likely remain high next year.
Callable zeroes and other structured notes

Expect $300-400mn vega supply from callable zeroes
There was a record issuance of callable zero notes during 2010 (Figure 2). Roughly $23bn initial notional of zeroes printed during the year, delivering roughly $300mn vega to the option market. We expect the issuance to remain robust in 2011, and likely increase. Our reason is two fold: 1) proceeds from redeemed 2009-10 securities should be reinvested into callable zeroes, and 2) the Fed asset purchases would likely keep yields low and spreads tight, pushing yield buyers into riskier securities, including callable zeroes. Even a repeat of 2010 should deliver $300mn vega to the options market. Separately, the existing notes would extend as rates rise. As Figure 2 shows, dealers are managing a large inventory of callable zeroes issued over the past several years. If rates rise 50bp over 2011, as we expect, option dealers would gain $84mn in vega exposure 14. So, the total vega supply from callable zeroes alone could be $300-400mn in 2011. Other than callable zeroes, capped floating rate notes have been the apple of the investors eye lately (Figure 3). Roughly $6bn of these notes was issued in 2010. A typical note matures in 10y with a high coupon for the first year and then floats to Libor +150bp. The coupon is capped typically within 5-7%. The issuer, in most cases Federal Home Loan Bank (FHLB), swaps the optionality and achieves a cheap funding. Accordingly, the dealer desks absorb 10y Libor caps struck at 3.5-5.5%. $6bn notes in 2010 delivered about $7-10mn vega.
Expect $7-10mn vega supply from capped FRN
The issuance of capped floating rate notes should continue as the structure is attractive. Few investors expect the Fed to start hiking aggressively. Accordingly, capping the coupon at such high levels is not a difficult choice. A $6bn issuance of capped floating rate notes should deliver $7-10mn vega to the option market in 2011, as it did on 2010.
14
Total 2000-2010 issuance still outstanding ~ $50bn. To be conservative, we assume only 2009-10 issuance is being still actively managed by dealers => $30bn. Since $100mn 30yr NC 1yr callable zero extends by $280k log vega if rates rise 50bp in one year, $30bn notes would extend by $84mn log vega (=30bn * $280k/ $100mn).
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Figure 3: Supply from Capped FRN Larger than usual

7 6 5 4 3 2 1 0 2003 2004 2005 2006 2007 2008 2009 2010 150 100 50 0 300 250 200
Figure 4: Agencies are tapping callable notes for funding

250 200 150 100 50 0 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 Still outstanding ($ bn)
Source: Bloomberg
avg =$227bn avg = $161bn
Issuance (LHS, $ bn)

Source: mtn-i
Curve (RHS, bp)
No longer outstanding ($ bn)
Agency callable notes

Aside from callable zeroes, agency-issued callable debt forms the backbone of the option supply. About $850mn securities were issued in 2010, 40% more in 2009 (Figure 4). More importantly, FHLB issuance, which has an explicit effect on the options market, as it is swapped to the option market, was one third of the total issuance. The majority of securities matures in less than five years and are non callable for the first three to six months. Accordingly, the supply is concentrated to the top-left part of the swaption surface and amounted to roughly $90mn in vega supply.
We expect $75-90mn supply from FHLB callable notes
For 2011, we expect the supply to drop a bit, given the smaller funding need for the agencies but it should still be higher than 2009. Accordingly, we foresee a $75-90mn supply from new issuance of agency callable notes, still focused on the short term and short locks.
Real money
In effect, long-term investors sell options via callable notes. However, some real money investors sell options explicitly as well. For example, PIMCO sells short-dated options opportunistically on the belly of the rate curve. According to the quarterly filings, PIMCO was short $90bn and $41bn in out-of-the-money payer and receiver swaptions, respectively, at the end of first quarter. Both rates and vols were high at the beginning of the year and their positions probably were intended to monetize a long duration view. Subsequently, their option positions declined to $99bn at the end of second quarter and $30bn by the third. We expect bond investors to monetize option premiums at appropriate levels.
Demand: Falling on the wayside

The demand side of the option market consists primarily of mortgage servicers, GSEs, insurance companies, asset managers, and hedge funds. There has been a clear decline in demand from mortgage hedgers. We begin the discussion by looking at the GSE option needs.
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GSE demand The emperor has no clothes

If there was any doubt that Fannie Mae and Freddie Mac have not been buying much in options lately, their quarterly filings put it to rest. Figure 5 shows the total notional of swaption the two agencies hold. After buying all through 2009, they unwound/let expire a large amount of options. We think they still have roughly $200bn notional swaptions to sell for three reasons: 1. They have a declining mortgage portfolio to hedge (Figure 6). The shrinkage is structural: the cap on the overall portfolio would fall by 10% each year ($810bn by end of 2010) and the portfolio is composed more of delinquent loans. 2. Even among the agency securities, the portfolio consists mostly of high coupon, which has much smaller vega exposure. Unless rates rise in a jiffy, which is not our base case, the vega exposure of the portfolio would be limited. 3. They are able to source a large amount of optionality via callable notes, as discussed above. Investors are devouring the agency-backed securities, due to extra yield, while the agencies are able to fund the portfolio cheaply. This should limit their explicit buying needs.
GSEs would be net sellers: We expect ~$120mn
We expect half of the remaining $200bn to be unwound in 2011. Crudely, this could amount to about $120mn vega 15.
Servicers Holding the fort

Servicers likely to buy $100130mn in 3m*10y vega equivalents over the next year
Alongside the GSEs, mortgage servicers form a large demand base for options. They own Mortgage Servicing Rights (MSR), which are negatively convex, due to the homeowners prepay option. Figure 8 highlights the convexity of the overall servicing index, according to the Barclays Capital model. Given the convexity profile and assuming servicers hedge 30-40% of the negative convexity, the total demand from servicers could be $100-$130mn 3m*10y vega equivalents in 2011. The actual demand would likely be smaller for two reasons: 1. The convexity would be smaller as rates move either way. An intuitive explanation is that the mortgage universe is roughly 75bp in the money currently (average mortgage
Figure 5: GSEs are buying fewer options

450 400 350 300 250
Figure 6:because they own a smaller MBS portfolio

950 850 750 650 550 Nov-06 Jan-06 Jun-06 Sep-07 Feb-08 Apr-07 Jul-08 May-09 Dec-08 Oct-09 Mar-10
200 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10
FNM+FRE Swaption Notional ($ bn)

Source: Fannie Mae, Freddie Mac quarterly earning statements
15
FNM+FRE Agency MBS ($ bn)

Source: Fannie Mae, Freddie Mac monthly volume summary
$100bn of 1y*10y ATM payers is equivalent to $120mn log vega
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76
coupon ~5%, mortgage current coupon ~4.25%). If rates decline by, for example, 100bp, the MBS universe would be deep in the money and small changes in rates would not alter the homeowners incentive. On the other hand, if rates rise by, for example, 100bp, the average homeowner would have little incentive to prepay and, again, small changes in rates would not matter. 2. The above analysis is premised on a Barclays Capital MBS model. In reality, the convexity could be smaller or larger, depending on the assumption of the sensitivity of prepay speeds and interest rates. Typically, as Figure 7 shows, a large rate incentive and high prepay speeds have gone hand in hand. However, such has not been the case for roughly two years now. This is because actual prepays are more a function of availability of credit than affordability of credit. For various reasons, it is onerous to refinance, so borrowers remain inactive despite large rate incentives. Theoretically, the mortgage servicing index would have no convexity if rates do not matter to prepay. Besides the above two factors, the discretion of the hedgers would determine how smaller than $100-$130mn vega the actual demand would be in 2011. For analysis purposes, we are conservative and expect $100-130mn vega demand from the hedging community.
Insurance companies The dark horse

Insurance companies should buy $70-130mn vega in long-dated options
Insurance companies could be a big source of option demand for the next few quarters. They need to buy options to protect themselves from a rise in liabilities if rates fall a lot. The rise in liabilities arises mostly due to variable annuity (VA) products, which have minimum rate guarantees. To hedge, variable annuity sellers buy low-strike protection, such as long-dated long-tail CMS floors. However, the larger hedgers unwound a significant portion of protection in 2009 because hedges maximized their value (Figure 10) and the VA business plummeted (Figure 9). However, two things have happened over past two years. 1. The VA business has bottomed out. VA sales should increase by roughly $6bn/year for the next three years, according to LIMRA, a third-party research and data source for insurance business. 2. There has been a consolidation in the VA industry. The top three issuers accounted for more than 35% issuance in 2009, compared with 24-27% in the previous three years. Concentration of risk should espouse increased hedging and cause a larger option demand.
Figure 7: Prepay speeds remain insensitive to rates

70 60 50 CPR 40 30 20 10 0 -100 2000-2008 2009-2010YTD Sep 2010
Figure 8: Servicers will not be more convex than now

change in duration (10y eq., $bn) 200 150 100 50 0 -50 -100 -150 -300 -200 -100 0 100 200 300
-50 0 50 100 FN 30y incentive to no-point mortgage rate
parallel change in rate (bp) 12/10/2010, CC = 4.154

10/15/2010, CC = 3.4
Source: CPR, CDR
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Given an increasing book of business, consolidation in the industry, and the underhedgedness of the usual suspects, the option surface will likely see demand from insurance companies. Assuming hedgers buy back half of the $30bn notional hedges unwound over past two years, the total demand could be $70-130mn vega equivalents 16 in 2011.
The unlikely occurrence The Feds efforts with inflation

Everything will change if inflation starts picking up. This is because a couple of high inflation data prints could push the inflation expectations higher. This could cause longer rates to rise, which could worsen, due to the precarious fiscal situation of the US. While we do not think the sovereign issues will be a problem for next year, this line of thinking could engender demand for out-of-the-money payer options from asset managers. However, the key is that demand is contingent on signs of the Fed losing control of inflation. As this is not our base case, we do not expect a demand large enough to change the option dynamic in favor of sellers. Nonetheless, we will keep an eye on data and factor possible demand of $100mn vega.
Supply More than needed

Put together, the supply of options would far exceed the demand in 2011
To sum up, there should be $500-$600mn supply of vega in 2011, more than half of it from callable zeroes. This supply should be more than adequate to meet the roughly $300mn vega demand: $100mn vega each from mortgage servicers and insurance companies. The Fed losing inflation control could upset the supply-demand dynamic, and option investors need to closely watch for early signs of inflation. What makes the above analysis even more crucial is the formulation of Dodd-Frank rules governing the derivative markets, which we touch upon next.
Figure 9: The VA business has clearly bottomed out ($bn)
Figure 10: but insurance companies do not hold much low-strike protection
Floors outstanding (notional, $ bn) 80 70 60 50 40 30 20 10 0 4Q05 2Q06 4Q06 4Q07 2Q08 2Q09 4Q09 2Q07 4Q08 2Q10
50 45 40 35 30 25 1Q09 1Q10 1Q05 3Q06 3Q05 1Q06 1Q07 3Q07 1Q08 3Q08 3Q09 3Q10
1600 1500 1400 1300 1200 1100 1000 900 800
VA Sales (LHS)
Source: LIMRA, Bloomberg
16
S&P (RHS)
Source: MetLife, AXA SEC Filings
Metlife
AXA
$15bn 100-200bp low-strike 5y CMS Cap on 10y swap rate is roughly $70-130mn log vega.
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Derivatives reform
The Dodd-Frank Wall Street Reform Bill, which was signed into law by President Obama on July 21, 2010, could carry great weight on the derivative markets in 2011. The regulators the CFTC and the SEC have until July 2011 to detail rules and are on track to fulfill the obligation. To illustrate the pace of progress, the CFTC has already held seven meetings to consider the issuance of proposed rules. In the first seven meetings, the commission proposed about 34 rules, most of which are open for comments. The commission expects to finish with the proposal phase within the first few weeks of next year. Of the several aspects addressed by various rules, the following could be meaningful sooner than the others: Central clearing Public reporting of transactions Exchange or exchange-like trading (Swap Execution Facility) The first two would increase the cost of trading derivatives: central clearing via a rise in collateral needs and public reporting via wider bid-offers as market makers worry about predatory behavior.
Central clearing
It would be mandatory to clear interest rate swaps by H2 11, as various clearinghouses already offer. LCH has been around for more than 10 years it already clears about 50% of the outstanding swaps (Figure 11). Other clearing houses, such as IDCG and CME, are vying for market share. As swaptions are offered by clearing houses, more than 90% of the outstanding interest rate derivatives market would be clearable by the end of 2011 (Figure 12). As clearing becomes mandatory, end-users, dealers, and clearinghouses will fret about the cost of clearing. The debate about who comes under the purview of a swap dealer or major swap participant, as reflected by the comments posted on the CFTC website, highlights such concern. Initial margin and variation margin are the two components of collateral requirement, and could affect dealers and end-users differently.
Figure 11: LCH already clears a large amount of swaps

300 250 200 150 100 50 0 1998 2000 2002 2004 2006 2008 2010 June 0% 0% 0% 0% 4% 29% 21% 18%19% 15% 10% 45% 49% 60% 50% 40% 30% 20% 10% 0%
Figure 12: Swaps form most of the rate derivatives

Others 8% Options 8% FRA 12%
Swaps Outstanding ($ trn) Cleared by LCH ($ trn) % Cleared

Note: The BIS data are adjusted for double counting. Source: LCH annual report, LCH website, BIS
Swap (libor + OIS) 72%
Note: As of November 19, 2010, total outstanding = $492trn. Source: TriOptima
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Dealers may not see an increase in collateral need, as they have a hedged book (limited increase in initial margin 17) and already collateralized derivative positions among each other (limited increase in variation margin). But end-users have a directional book, so could see an increase in initial margin. In addition, some of the corporate end-users do not post full collateral on their positions and could see up to a total $200bn increase in collateral needs. Without going into further detail here, the point we like to emphasize is that the rules governing the derivatives market will likely be defined within the first few months of 2011. The participants in the derivative markets will watch these developments closely, which could increase the illiquidity of some parts of the market. Less liquidity means prices will be driven more by fundamental flow than ever before. Therefore, any analysis about supply and demand in options needs to be carefully monitored.
Trade Ideas for 2011

Given our expectation of excess supply, especially in the first few months of 2011, and a decline in rates, we like selling intermediate expiry options such as 2y*10y straddles. In relative value trading, we like 1) selling Treasury future options versus swaptions, 2) buying long tails versus short tails, and 3) selling high-strike versus low-strike long-dated options. We discuss each in detail next.
Macro
Gamma: Cheap and steep
Sell vol
The gamma surface should cheapen and steepen across tails, with 30y tails the most expensive and 2y the least. For now, the opportunity lies in 5y tails, in our view, which should trade increasingly like 2y tails, due to the accommodative Fed policy.
Sell gamma on 2y, 5y

The recent price action has opened the market for Fed-on-hold trades. An unchanged funds rate is typically detrimental for options on 2y. We like selling 3m*2y, which suffers the most during a Fed-on-hold period. But the bigger opportunity lies in 5y tails. With the Fed trying to stimulate the economy with asset purchases, a Fed on hold for the next several quarters is extremely likely. Accordingly, 5y should become rangebound in the same way as 2y has been for the past two years. So, 3m*5y vol should drift closer to 3m*2y. We saw a glimpse of the price action in the last two months of 2010 18. However, this is just the beginning. We expect 3m*5y vol = 3m*2y, and not at a 40% premium, which is where it currently trades. Since we like selling 3m*2y standalone, 3m*5y is better trade, in our view, especially given the weight of forthcoming supply of agency callable notes.
Expect range for gamma on 10y, 30y

For longer tails, two things could occur next year one, the 30y may price more volatility than 10y, and, two, vol on 10y might be capped at about 8-8.5bp/day.
17
Total Initial margin posted at LCH ~ EUR 26.65bn or $40bn, according to the LCH 2009 annual report. Of this only $11bn if for ~ $220trn swaps cleared. This is only 0.5bp of the notional outstanding => illustrates the hedged nature of the dealer swap books. Additionally the IM has not gone up much for the last several quarters years even as the volume of swaps has almost doubled. 18 The ratio of 3m*5y to 3m*2y implied vol declined from roughly 2 at the beginning of November to ~ 1.5 by December 8, 2010
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Essentially, as inflation expectations become the primary driver of rates, 30y tails should become as volatile as 10y, if not more. So, 3m*30y and 3m*10y should price similar vols. At the same time, as Figures 13 and 14 show, the only time when 60d realized vol on 10y swaps was more than 8.5bp/day has occurred during a crisis or mortgage convexity hedging episodes. That the economy is not doing well is not news to anyone and the link between prepay speed and interest rate is weak; so, neither can be factor next year, in our view. Accordingly, 3m*10y would unlikely see levels higher than 8.5bp/day during 2011. On the lower end, it should be bound by the median volatility of 5.5-6bp/day.
Sell intermediate expiry options

Given our expectation that 3m*10y will likely not trade beyond 8.5bp/day and given the supply-demand backdrop, intermediate expiry options on the belly of the curve, such as 2y*10y, are unlikely to sustain levels above 7.5bp/day. So, we suggest selling 2y*10y at current levels to likely profit at roughly 6bp/day.
Relative value
Sell short tails versus long tails In view of the above line of thinking, one obvious relative value opportunity, in our opinion, given current levels, involves selling 3m*5y versus 3m*30y tails. 30y tails will likely become more volatile than 2y and 5y tails as inflation expectations whip around. So, we suggest initiating the trade whenever the 5y tails are more expensive, as is the case now.
Sell Treasury future options versus swaptions

This is our favorite relative value trade for 2011. In general, swaps are more volatile than Treasury rates. This is because most of the convexity hedging occurs in swaps. However, the relationship is the other way currently. This can justify itself in two macro-economic backdrops. The first is when the economy is sliding into recession. There is a flight-to-quality-related decline in rates, which is more pronounced in Treasury than swaps. So, Treasury futures options are, and should be, more expensive. The other time could be when the market is worrying about an increase in the Feds asset purchases. All the past episodes suggest larger moves in Treasury yields on announcement days. Figure 13: 3m*10y needs a crisis or convexity episode to trade beyond 8.5bp/day
16 14 12 10 8 6 4 2 0
Apr-90 Apr-92 Apr-94 Apr-96 Apr-98 Apr-00 Apr-02 Apr-04 Apr-06 Apr-08 Apr-10 Frequency
Figure 14: 3m*10y likely to trade between 5.5-8.5bp/day
Lehman Bear Stearns
convexity hedging
900 800 700 600 500 400 300 200 100 0 0 5 10 15 60d Realized vol (bp/day)
Note: Data Period: December 1989 December 2010. Source: Bloomberg
median = 5.5bp/day
vol > 8.5bp/day in crisis or convexity episodes
60d realized vol of 10y swaps (abpv)

Source: Bloomberg
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Figure 15 illustrates the above line of thinking. As shown, swaptions are usually more expensive. However, the relationship was the other way round during H2 07 (imminent crisis) and the end of 2008 beginning of 2009 (QE1). Of late, the Treasury future options have stayed noticeably richer than swaptions. The relative pricing was justified during July and August when the market just started pricing the second round of the Feds asset purchases. However, now that Fed purchases are common knowledge, Treasury future options should be as expensive as swaptions, if not cheaper. We recommend selling TY future options versus buying matched-duration, matched-expiry swaptions on 7y tails. The trade should be kept un-delta-hedged and held to expiry. It would typically take in premium at initiation, which we expect to keep by option expiry, as swap and Treasury yields drift a similar amount away from the option strike.
Sell skew
For roughly two years now, out-of-the-money payer options have traded expensive compared with out-of-the-money receiver options (Figure 16). Two things can rationalize such high premiums. Low rates: If rates are low, like in Japan, normal vols should be directional with the level of rates, i.e., higher rates => higher vols => high payer skew. The specter of rising rates. If rates rise unabated, vols should be higher in a higher rate environment => high payer skew. Rates are not low in the US. So, the high skew in US options is a reflection of the worry about rising rates. If the 2010 euro area experience is anything to go by, the vol of 10y rates should increase 30-50abpv 19 for every 100bp rise in rates if the debt market goes into a tailspin. Given the current skew valuations, one could say the option market is pricing a 1525% 20 likelihood of a massive rise in rates 5y down the line. We think the priced possibility is about correct. So, the skew on longer expiry options is not an outright sell. However, the opportunity lies in the relative valuation of out-of-the-money options. If rates rise in a controlled manner, for example, only 50-100bp in the next one year, dealers would become long vol under the weight of callable zero inventory. Their selling would spark a decline in vol. So, we like being short vol if rates rise by only a limited amount but long vol if rates increase by a massive amount: sell 100bp out-of-the-money payers and buy 300bp or further out-ofthe-money 5y*10y payers. The trade stays short vol if rates stay unchanged or rise a limited amount, but gain vol exposure if rates increase a very large amount. Additionally, the euro area sovereign issues will likely remain in the news over the next few months. And, accordingly, the uncontrolled rise in rates is an unlikely scenario for the near term, in our view. Combined with the recent rise in vol and rates, we suggest monetization of skew via 1x1x1 1y*1y and 1y*10y payer fly.
Position for higher rates

Besides outright and relative value trades in vol, we would look for opportunities to position for higher rates. The key to the success of any strategy lies in the timing of the rate move.
Regression beta between yield and realized vol during 2010 is 30, 36, and 48 for Spain, Portugal, and Ireland, respectively 20 5y*10y 100bp OTM vol = 8abpv higher than 5y*10y ATM vol => 15% (=8abpv/50abpv) to 25% (=8abpv/32abpv) chance of an unabated rise in rates five years down the line
19
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Figure 15: Sell Treasury future options versus swaptions

1.3 1.2 1.1 1.0 0.9 0.8 0.7 Jul-04 beginning of crisis Jul-05 Jul-06 Jul-07 Jul-08 QE1 Jul-09 QE2 Jul-10
Figure 16: The payer skew is comparable with Japan

35 30 25 20 15 10 5 0 -5 -10 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 US: 5y*10y 200bp wide skew (abpv)
3m*7yr to TY option vol ratio

Source: Bloomberg, Barclays Capital Source: Barclays Capital
JPY: 5y*10y 200bp wide skew (abpv)
Lately, rates have increased and payer options have richened quite a bit, so we suggest waiting for a pull back before buying outright protection via payer swaption, CMS caps, or collars. We think it should take a couple of months before the market opens up for an opportunity we suggest buying 3x13 Libor caps when it does. Libor caps are superior to payer or CMS caps, as they not only gain from higher rates, but also benefit from an increase in long-dated vol and a steeper curve, which would likely accompany the rising rate environment. Also, Libor caps decay slower and allow investors to hold the position for longer. For now, we like a payer spread on 30y tails hedged with shorter expiry payer on 10y tails: Buy $100mn 2y*30y payer spreads (ATM versus 100bp high strike) Sell $100mn 3m*10y ATM payer The trade is essentially a calendar spread + 10y-30y swap curve steepener + monetization of payer skew. We like all three exposures. The calendar spread should work well, in our view, as the recent rates sell-off abates in the first few months of 2011. The payer spread would essentially be financed 40% cheaper 21 in such a scenario. The 10y-30y curve has flattened a large amount in the recent sell-off and forwards are pricing an even flatter curve. So, the 10y rate would not only need to continue to underperform the long end, but cover the forwards to just breakeven. With the Fed showing little signs of pulling back on its pro-inflation efforts, the 10y-30y curve flattening should be limited. And, finally, the payer skew is high and probably justified over the long run, but monetization for the near term is not be a difficult choice. The risk to the trade is a quick rebound in the economy, causing the Fed to change its inflation stand and start talking about hikes. The curve can bear flatten a large amount in the short term, exactly the worst scenario for the trade. While the economic data may start showing signs of improvement, we believe it will take several months of high inflation prints to convince the Fed to take its step off the inflation pedal. Accordingly, the 10y-30y curve will most likely bear steepen and the trade losses should be limited.
21
2y*30y payer spread (ATM vs. 100bp high) costs ~ 575 cts while the payer spread hedged with 3m*10y ATM payer costs only 360cts, as of December 7, 2010. If the 3m*10y payer expires worthless the payer spread would have been financed at 63% of the 575cts.
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BMA SWAPS
Low and lower

Piyush Goyal +1 212 412 6793 piyush.goyal@barcap.com Kishlaya Pathak +1 212 412 2906 kishlaya.pathak@barcap.com
BMA ratios should decline in 2011, driven by higher rates, Fed asset purchases and favorable technicals. Action in the front end will likely be driven by widening of the Libor-OIS spread and excess demand for short-term municipal paper. In our view, a short 2y BMA ratio also offers superior protection against worsening of euro-area sovereign problems. The long-end BMA ratio will likely drop given the Feds efforts to avoid deflation. The ensuing Fed asset purchases should skew long-term inflation expectations higher and the liquidity premium lower, causing long-end ratios to fall. For macro trades, we suggest selling 2y and 30y ratios. In relative value, we like the 2y5y ratio curve steepener. We start by looking at SIFMA, which forms the backbone of the BMA market. The key driver, we think, will be the expected supply-demand mismatch, which could tilt further in favor of buyers if the recent Dodd-Frank-related CFTC proposal becomes final in its current form. Next, we analyze the long end in the context of the Feds reflationary efforts and variable rate demand bond (VRDB)-related swap unwinds. Last, we set out our trade ideas for 2011.
Lower SIFMA
The short-term municipal debt market will likely turn the corner by mid-2011 in terms of supply-demand in the sector.
Redemption of VRDB should accelerate in the next few quarters
On the supply side, issuers have raised more funding via long-term notes and less via shortterm notes. It was not like that in 2008. The general illiquidity in the fixed income markets then caused issuers to depend heavily on short-term funding. However, the market mended itself, and with support from the Build America Bond program, issuers termed out their debt obligations. Short-term debt issuance has suffered as a result, falling below pre-crisis levels (Figure 1). The decline in issuance has caused a drop in the availability of short-term notes. The decline should accelerate in 2011 as bank liquidity facilities for a large amount of variable rate demand bonds (VRDB) come up for renewal. Because of costly renewal fees, issuers will likely substitute VRDBs with longer notes. We estimate that at least $25bn of the $80-100bn 22 in VRDBs coming up for renewal in 2011 will be termed out. So the outstanding universe of variable rate notes looks set to shrink by at least an extra $6-7bn per quarter next year. The effect of the declining supply has not manifested itself so far, as demand has weakened in tandem. Tax-exempt money market funds, which form the primary buyer base, have been hit hard by low yields in the short end. For comparison, government-only money market funds fell by $700bn at the same time as tax-exempt funds declined by $175bn. 23 In 2011, this should continue, albeit at a slower pace, because at least some of the drain since
22
but tax-exempt money funds could stabilize next year
Moodys and S&P have individually released reports showing that $80-100bn in line-of-credit and standby bond purchase agreements will mature by the end of 2011. Two banks have already announced that they will not be renewing their portion, which totals roughly $25bn.
23
Government-only money market funds have declined from $1.5trn at the beginning of 2009 to $800bn now. During the same period, tax-exempt money market funds declined from $500bn to $325bn.
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Figure 1: More issuance in the long end, less in short end

140 120 100 80 60 40 20 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 450 400 350 300 250 200 150 100 50 0
Figure 2: Expect fewer short-term notes by mid-2011

550 500 450 400 350 300 250 200 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Outstanding ($bn)
Source: Thomson Reuters, IMoneyNet
Variable-Rate Issuance ($bn, L) Fixed-Rate Issuance ($bn, R)

Source: Bond Buyer, Thomson Reuters
Tax Exempt Assets ($bn)
early 2009 was a result of normalization to pre-crisis levels. In addition, the passage of the recent CFTC proposal to limit the investment of 1.25 and 30.7 funds by various Futures Commission Merchants and clearing houses could tilt the dynamic decisively in favor of buyers. The proposal, if finalized in its current form, could generate extra demand of roughly $12bn for short-term municipal debt (Figure 3). The CFTC will likely issue the final rule early next year, and BMA investors, among others, will keep a close eye on developments for clues about the direction of further price action in the front end.
Figure 3: Recent CFTC proposal could generate additional demand for short-term debt
Instrument Treasuries Municipals GSE securities (GNMA) GSE securities (FNM, FRE) CDs CP (TLGP) Corporate notes (TLGP) Foreign sovereign debt Money market mutual funds Total
Source: CFTC, Barclays Capital
Current allocation ($bn) 60 negligible 18 4 4 4 negligible 30 120
New allocation ($bn) 66 12 30 negligible negligible negligible 12 120
Change ($bn) 6bn inflow 12bn inflow 30bn inflow 18bn outflow
18bn outflow
Put together, smaller new issuance, the redemption of VRDBs, and possible demand from investors of segregated funds could limit the availability of short-term notes for money funds. Even if we assume that the CFTC rule is modified but does not generate additional demand and tax-exempt money funds assets decline by a similar amount, there would still likely be fewer notes than assets chasing them by middle of next year (Figure 2).
The resulting excess demand could push SIFMA lower
The effect on SIFMA would be conspicuous, as it is computed on the highest rated shortterm paper, which is only $45bn of the total $350bn. The BMA market would likely price the favorable dynamic in the first few months of 2011, with the effects felt mostly as a decline in front-end ratios.
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The long end: Headed lower

30y BMA ratios will likely decline in 2011 because of higher rates
While the short end would likely be driven lower by the favorable supply-demand environment, long-end BMA ratios would be driven by higher rates, Fed asset purchases, the unwind of VRDB-related swaps, and an increase in structured note issuance.
The prospect of higher rates

Figure 4 shows that the level of 30y ratio is well explained by two variables. The level of the 30y Treasury yield Higher yield means lower ratio. This is because the tax incentive becomes more meaningful in a higher rate environment. The same dynamic is reflected in a lower BMA ratio. Municipal credit premium (ratio of 30y MMD to 30y Treasury yield) Municipal creditworthiness could become a driver of BMA ratios if rates are range-bound and relative value in the municipal cash versus derivative market opens the BMA market for hedging opportunities for cash investors. However, the level of the Treasury rate is the major driver of the ratio. This is intuitive, given that the BMA ratio is an average of SIFMA rates, which in turn reflect the most pristine municipal credit and, arguably, are similar to US sovereign creditworthiness. Thus, general muni credit issues would likely affect the BMA market to only a limited extent. As detailed in our rate forecast, 30y rates would likely stay range bound in the first quarter, but start rising by midyear. By year-end, 30y Treasury bonds should yield about 4.85%. Even assuming no change in municipal creditworthiness, this should cause the ratio to trade closer to 85%, or roughly 2-3 ratios below current levels. In addition, the Feds asset purchases should push liquidity premiums lower. The Fed may even end up buying more than the $600bn already announced, given Chairman Bernankes commitment to avoid deflation. This should be reflected in a smaller municipal credit premium also. Assuming that 30y municipal yields trade at 95-100% of 30y Treasury yields by the end of next year, the 30y BMA ratio could go as low as 81-82 ratios. This represents roughly 5-6 ratios worth of P&L on a bearish ratio position.
Figure 4: 30y ratios are well explained by the level of 30y Treasury yield, municipal credit
120 110 100 90 80 70 Dec-05
Aug-06
Mar-07
Oct-07
Jun-08
Jan-09
Sep-09
Apr-10
Nov-10
Actual 30y Ratio
Regression Value
The regression value is computed by regressing the 30y BMA ratio with 30y Treasury yield and ratio of 30y MMD to 30y Treasury yield on a 1y rolling basis. Source: Bloomberg, Barclays Capital
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VRDB-related swap unwind

an unwinding of VRDB-related swaps, and...
Besides the specter of rising rates, the unwinding of pay fix swaps typically associated with VRDBs should help pressure the long end lower. As detailed in the prior section, municipal issuers would likely substitute variable debt with longer notes because of high bank liquidity fees. The redemption of VRDBs is important for the derivatives market because some issuers execute long-end swaps alongside VRDBs to create cheaper synthetic fixed-rate debt. Figure 5 shows the details of a few swaps on the back of such debt issuance. Typically, these are long-term swaps (20y+) in which the issuer pays a fixed rate and receives a variable rate. As the debt securities are redeemed, the associated swaps are unwound. Given the typical characteristics of the associated swaps, BMA should outperform Libor swaps rates => lower BMA ratios.
Figure 5: Issuers pay fix on long-term swap alongside VRDB securities

Summary statistics for a sample of large VRDBs Number of variable rate demand notes Total size at issuance ($bn) Number with pay fixed swaps1 Number SIFMA based/floating rate on the bond SPA/LOCs slated for renewal in 20112 Number of issues Amount ($bn) Number of swaps by final maturity >10y >20y
1
189 40 120 39
59 11
3
177 131
In many cases, information is not sufficient to associate a swap with a specific issue and the floating leg index is not specified. Consequently, both the number of issues with pay-fixed swaps and those with SIFMA/bond rate-based floating leg may be understated. 2 In some cases, SPA/LOC renewal dates are not up to date, suggesting an upward bias to the 2011 renewal estimate. 3 Swap maturity is assumed to mimic that of the underlying bond being hedged. Source: Bloomberg, Issuance Official Statements, CAFRs; Barclays Capital
Cusip 74440DAA2 841316AB8 56036YEJ0 154871BJ5 452151MZ3 24919PGA6 59259NML4 13066YAK5 452252EJ4 452252EK1
Size at issuance 1,030.8 898.3 774.0 718.4 600.0 450.0 440.0 400.0 383.1 383.1
Maturity 8/1/2016 8/1/2027 8/1/2040 8/1/2039 10/1/2033
Associated swaps Pay fixed 4.017% rec floating rate on the bond Pay fixed rec floating rate on the bond Pay fixed rec floating rate on the bond; basis swap: pay floating rate on the bond and rec alternate floating rate Pay fixed rec floating rate on the bond; basis swap: pay floating rate on the bond and rec alternate floating rate Pay fixed (3.89%) rec floating Libor or SIFMAbased on (Libor >< 2.5%) Pay fixed (4.06%) Rec actual bond rate until 4/10/2010 and SIFMAthereafter Pay fixed (3.325%) rec 64% of Libor Pay fixed (3.774%) Receive floating rate based on SIFMA Pay fixed (3.764%) Receive floating rate based on SIFMA
12/15/2037 Pay-fixed (4.859%) rec Libor 11/1/2022 5/1/2022 1/1/2031 1/1/2031
Note: Size at issuance may be different from amount outstanding, as some of the issues may have been partially called. Source: Thomson Reuters, Bloomberg, Issuance Official Statements, CAFRs; Barclays Capital
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We estimate that roughly $90bn of VRDBs should be unwound during 2011, with $25bn due to liquidity renewals. As Figure 5 shows, roughly 20% (39 out of 189) of outstanding securities have SIFMA-based swaps associated with them. Accordingly, roughly $18bn notional of long-end swaps could be unwound during 2011. Admittedly, a key determinant of whether this ends up having an effect on long-end valuations is when and how the issuers chose to unwind the swap, which in turn can be driven by many other factors. Nonetheless, it should add to the downward bias on ratios given the broader rise in rates and possible flow from structured notes, which we discuss next.
Structured note issuance

an increase in structured note issuance
In 2010, robust issuance in interest rate-linked structured notes stood out. As Figure 6 shows, callable zero issuance was roughly 35% more than in 2009, which was the largest issuance year of the past decade. Other kinds of structured notes, such as capped floating rate notes, have also seen an unusually active market as investors hunt for yield. By comparison, the market for BMA-linked structured notes has been rather slim. However, in 2011, we think this market will head up. A typical note matures in ten years and has a coupon computed as follows: Coupon = fixed rate + leverage x (% of 3m Libor average weekly SIFMA rate) with cap at a certain level and floor = 0%. An example is the largest-ever BMA-linked note, issued by Fannie Mae in 2007. The note expires in 30 years and the coupon = 7.6%+8 x (65% of 3m Libor SIFMA). (Cap=10% and floor=0%) Given the typical structure, a BMA-linked structured note puts downward pressure on 10y+ ratios. The absence of any issuance in the past three years (Figure 7) is one reason dealers have been unable to source ratios, pushing the BMA rate higher relative to the Libor swap rate. Any BMA-linked note issuance could have a meaningful effect on ratios given that dealers have been subject to almost nothing for so long. To sum up, long-end ratios will likely come under pressure during 2011 as a result of a rising rate environment, the possible unwind of VRDB-related swaps, and some issuance of structured notes. Given this backdrop, we suggest the following trades.
Figure 6: Unprecedented pickup in callable zero issuance

25 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 300 250 200 150 100 50 0
Figure 7: BMA-linked note issuance looks set to rise

600 500 400 300 200 100 2006 Q1 2007 Q1 2008 Q1 2009 Q1 2010 Q1 Q3 Q3 Q3 Q3 Q3
88
Gross Issuance ($mm)

Source: Bloomberg
2-10 swap curve (bp)

Source: mtn-i
Issuance ($mn)
16 December 2010
Figure 8: 1y ratio is inversely proportional to Libor

Jun-09 0 5 10 15 20 25 30 35 40 45 3m libor -OIS (bp, L)
Source: Bloomberg
Figure 9: SIFMA ~ 3m Libor unless dollar funding is expensive

0.60 110 0.50 100 90 80 70 60 0.40 0.30 0.20 0.10 Dec-09 Feb-10 Apr-10 SIFMA
Oct-09
Feb-10
Jun-10
Oct-10
Jun-10
Aug-10
Oct-10
1y BMA Ratio (%, R)
3m Libor
Trade #1: Buy cheap insurance against a blow-up in Europe

Sell 2y ratios to position for/hedge the increase in sovereign issues in Europe
Our favorite trade for 2011 is selling 2y ratios. Besides the favorable supply-demand backdrop for short-term municipal notes, the trade is an expression of rising woes in the European Union. With the Fed on hold, front-end BMA ratios will remain hostage to the Libor-OIS spread. Wider spreads mean lower ratios and vice versa (Figure 8). As an example, 2y BMA ratios declined from about 82 ratios to 76 ratios at the same time 3m Libor inched from 25bp to more than 50bp. As dollar funding in Europe becomes expensive, Libor and Libor-OIS should start to widen. Accordingly, the 2y ratio is likely to decline. Why not express the view in Libor-OIS itself? Admittedly, the liquidity is better and investors do not have to deal with the additional issues posed by the municipal market. The reason is two-fold. First, entry levels are better: front-end BMA ratios are historically high and have not responded to the recent uptick in Libor. In comparison, Libor-OIS spreads have already widened. Second, the trade carries better. Even if SIFMA = 3m Libor for the next two years, the loss would be roughly a 3 ratio equivalent. However a 1y forward 3m Libor-OIS position would lose 10bp, a notable amount.
Trade #2: Sell 30y ratios

Sell 30y ratio to position for an accelerated unwind of VRDB notes and to benefit from rising rates
As set out above, we expect 30y BMA ratios to decline. Even if VRDB-related swap unwinds do not happen and the gloomy state of affairs in the BMA-linked note market persists, one thing that should still work out well for the view is the risk that the Fed could spark inflation expectations. There are few buyers of long-term US sovereign debt as it is, and runaway inflation could push yields far beyond our expectations of a 40-50bp rise by year-end. This should favor a bearish long-end ratio position. The attraction of this trade is that it does not carry negatively the way any other bearish rate position does. To compare, a short 30y swap and a long 1y*30y payer position would need 22bp and a 60bp increases in rates, respectively, over one year just to break even. The short BMA ratio trade would break even with a small rise in rates.
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Trade#3: Steeper 2y-5y ratio curve

Buy 5y ratios and sell 2y ratios
The belly of the ratio curve has lagged the recent rise in front-end ratios. As an example, the 5y ratio is almost unchanged since the beginning of July. During the same period, the 2y ratio jumped roughly 8 ratios. Over 2011, we expect Fed-on-hold expectation to extend out the curve. This should cause forward short rates to decline and the belly of the ratio curve to inch higher. The trade is currently at attractive entry levels (Figure 10) and carries well. It should gain from a decline in front-end ratios anyway for the reasons described above.
Figure 10: 5y ratios are low relative to 2y ratios

10 8 6 4 2 (2) (4) (6) (8) Jan-05 Sep-05 Jun-06 Feb-07 Nov-07 Jul-08 Apr-09 Jan-10 Sep-10
2y-5y BMA ratio curve (%)

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SPECIAL TOPIC: HOUSING
US housing finance: No silver bullet

Ajay Rajadhyaksha +1 212 412 7669 ajay.rajadhyaksha@barcap.com Rajiv Setia +1 212 412 5507 rajiv.setia@barcap.com Amrut Nashikkar +1 212 412 1848 amrut.nashikkar@barcap.com Sandeep Bordia +1 212 412 2099 sandeep.bordia@barcap.com Jasraj Vaidya +212-412-2265 jasraj.vaidya@barcap.com James Ma +1 212 412 2563 james.ma@barcap.com
In January 2011, the US Treasury will submit a GSE overhaul plan to Congress. We look at the choices and trade-offs that US policymakers will face and discuss what the future holds for US housing finance. In our view, the US government will need to stay involved in housing finance if the housing market is not to be disrupted. While many politicians have talked of winding down the GSEs in 3-5 years, we expect any such transition to take 15-20 years. Notwithstanding our expectation of a long transition, we believe the government should find a way to decrease its share of the mortgage market. The implicit guarantee model on which the GSEs are based cannot be fixed; the conflicts are inherent and unavoidable, in our view. We do not believe the public/private model suggested by the Mortgage Bankers Association solves the problem of privatizing profits and socializing losses either. On the other hand, there is no way to transition $5trn of risk to the private markets quickly. Any housing finance solution will need to be a slow process that uses several private channels. The governments share of mortgage origination is now at record highs, rising from 22% in 1990 to over 90%. But we do not see a compelling argument for that level of involvement over the long term. There are two ways in which the government can stay involved in housing finance. One is nationalization; the second is a public-private partnership. Both have clear drawbacks. If policymakers decide that the government has no role in housing finance, there are two options in the capital markets: covered bonds and non-agency securitization. We have a hard time seeing the covered bond market growing beyond $250-300bn, with issuance mainly by the big banks. Non-agency securitization suffers from hurdles such as reps and warranties, more onerous capital requirements, risk retention rules, a reliance on ratings, etc. Portfolio lending by banks is a more likely private sector alternative over the next few years and harkens back to the pre-securitization era. However, reliance on this financing method could increase the systemic risk posed by large banks and raise rates to unreasonable levels for a large segment of borrowers. All private sector solutions face the problem of pro-cyclicality. For example, as the credit crisis worsened in 2008-09, the private sector completely vanished as a source of mortgage financing in the US. As a result, we do not believe there is a private sector substitute for the GNMA program, which has been countercyclical. However, given our forecast for heavy FHA losses, the credit risk in this program should be priced closer to economic reality through higher guarantee fees. Eliminating the GSEs without disrupting the housing market can only be accomplished slowly. The limiting factor is the domestic savings rate: without a government guarantee, international savings will not finance US households, given recent experience.
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Because there is no silver bullet as far as financing is concerned, policy initiatives should be focused on making the mortgage product safer, by prescriptive means, if needed. We lay out our definition of such a qualified residential mortgage. The other mechanism for improving product safety is risk retention. For this to truly work, the way in which deals are structured needs to change. We suggest that banks should be made to hold the second loss piece instead of the first loss piece, with constraints on the overall proceeds. The future of housing finance is a long and complex issue, so we divide this article into six sections. Section I: We look at what government involvement in housing finance has achieved in recent decades. Section II: We discuss housing finance models in which the government stays involved namely, either nationalization of the GSEs or a public-private partnership. Section III: We look at private sector solutions such as private label securitization and covered bonds. Section IV: We discuss portfolio lending as an alternative source of mortgage financing and ways in which a transition from the current system can be achieved. Section V: We discuss how any transition to private sector balance sheets would work and where funding would come from. Section VI: We turn from the financing aspect and focus on ways to make mortgage lending safer, including changes in risk retention.
Section I. What has government involvement achieved?

The first step to recommending any changes is to look at the current landscape. Specifically, what has government involvement in housing finance accomplished over the past few decades? While there are several ways to measure the effect, we focus on two major metrics: homeownership and housing affordability.
I. A) Homeownership rate and US housing policy

Figure 1 shows that the homeownership rate has held steady at 64% for the past several decades. It started rising in the mid-1990s and peaked around 68% a few years ago. But the rise in homeownership was transient. Pro forma for the foreclosure pipeline, the rate should dip below the 64% long-term average, a result of the bursting of the housing bubble.
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Figure 1: Historical home ownership rates

70 68 66 64
Figure 2: Rising government involvement in housing finance

100% 80% 60% 40%
62 20% 60
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
58 1965 1971 1977 1983 1989 1995 2001 2007 2013 Homeownership rate (%)
Source: Haver Analytics, Barclays Capital
0%
GSE
FHA / VA
Private Label / Portfolio
Meanwhile, most other countries do not have a government guarantee (Figure 3). And in no other developed country is the guarantee so extensively used (Figure 2). But this does not seem to have greatly lowered homeownership rates in most of these countries relative to the US, as Figure 4 shows. In other words, the focus on the homeownership rate that has been central to US housing policy does not seem to have been particularly effective.
I. B) Affordability and housing policy

Housing policy has also been focused on improving affordability and making mortgage credit more widely available. Has this worked? The traditional affordability metric plots the median mortgage payment as a percentage of the median household income, assuming that the borrower takes out an 80% LTV loan with a 30-year agency mortgage rate. The lower line in Figure 5 tracks this ratio over the past 25 years the higher the line, the worse the affordability. Clearly, affordability did not improve very much in the 1990s, and actually worsened in the first half of the current decade.
Figure 3: Government involvement in other countries

Governmen t Mortgage Insurer? Denmark Germany Ireland Netherlands Spain UK Australia Canada Japan Korea Switzerland US None None None NHG None None None CMHC None None None FHA Government Guarantees? None None None None None None None CMHC JHF None None GNMA
Figure 4: homeownership rates in those countries

100 Homeownership rate, %
GSEs? None None None None None None None None Possible KHFC None FNM, FRE, FHLB
80 60 40 20 0
li a Ca na da De nm a rk Ire l an d Jap an Ge rm any Ne the rl a nd s Sp a in Sw itz e rl an d UK Au str a US
93
Source: Mortgage Bankers Association (MBA), Barclays Capital
Source: MBA, Barclays Capital
16 December 2010
The fact that homes were unaffordable during the boom years is inconsistent with the fact that demand for housing remained strong during this period. We believe this is because the traditional affordability metric is flawed, as it does not capture an important dimension of affordability, namely the required down-payment. An enhanced affordability metric is shown by the upper line in Figure 5, which factors in average down-payment requirements over time the lower the requirement, the better the affordability. By this metric, homes were not particularly unaffordable during the boom years, which is intuitive. In Figure 6, we decompose our enhanced affordability metric into changes driven by home prices, down-payments, and interest rates. The figure shows that housing became steadily less affordable as home prices rose from 2000-06. This was offset because down-payment requirements for the industry as a whole fell at the same time (though the drop in mortgage rates also helped). Hence, our LTV-adjusted affordability metric shows that affordability did not worsen (Figure 5) even as home prices rose from 2000-06. But a system that keeps housing affordable mainly by lowering down-payments is unsustainable, as we found out in the subprime crisis. Low down-payment requirements led to borrowers having very little incentive to stay in the house once home prices dropped and wiped out their equity. Thus, evidence is mixed as to whether making credit more widely available through affordable housing initiatives actually helps affordability or whether the bigger effect is simply on increasing home prices. By the metrics of homeownership or housing affordability, the track record of government involvement in housing finance is far from stellar. What are the alternatives? We start by looking at solutions that preserve a role for the government in financing the housing market.
Figure 5: Using an LTV-adjusted affordability metric

40% 35% 30% 25% 20% 15% 10% 1986 1989 1992 1995 1998 2001 2004 2007 LTV-adjusted affordability Affordability (debt service/income)
Figure 6: Rising home prices offset by low down payments

15% 10% 5% 0% -5% -10% 1986 1989 1992 1995 1998 2001 2004 2007
Price effect Interest rate effect (RHS) LTV effect
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Section II. Nationalization or the public-private model

If policymakers decide that the government does need to remain involved in housing finance, there are a couple of roads they can take. One leads to full nationalization; the other is a variation of the current GSE model of public-private partnership.
II. A) Nationalization
Nationalization of the mortgage market is the simplest option available to Congress. In fact, many would argue that with 95% of new originations currently sourced from either the GSEs or GNMA, the mortgage market is already effectively nationalized. Nationalization does have its merits. For one, without an explicit (or implicit) guarantee, it is doubtful whether many large foreign buyers would continue to participate in the US mortgage market; in fact, a wide swath of the domestic investor base would also likely step away or demand a higher risk premium to remain engaged in MBS absent a government guarantee. Hence, nationalization would certainly help preserve liquidity in the MBS market, a feature that is important. Another key feature of a nationalized mortgage market would be its countercyclical nature. Ensuring that mortgage credit remains available to homeowners across geographies in all economic scenarios should be an important feature of any mortgage finance system. In times of crisis, typically only the government can ratchet up the extension of mortgage credit; in contrast, private lenders tend to tighten standards dramatically. Historically, portfolio lending and FNM/FRE originations have been fairly well dispersed along the credit spectrum (Figure 7). However, given the pressures on the banking system over the past few years, the primary source of financing available for new home purchases for low FICO borrowers has been FHA (Figure 8). Even FNM/FRE have tightened standards dramatically post-conservatorship: the FICO score of post-2008 vintages averages 760, and average OLTVs are below 70%. While the positive aspects of a nationalized mortgage market are certainly worth highlighting, there is significant downside to full nationalization, as we highlight next.
Figure 7: FICO distribution of homeowners with mortgages

16% 12% 8% % of Outstanding Mortgage Universe
Figure 8: FHA has become the sole source of low-FICO loans

20% 16% 12% 8% FICO distribution of 2009 loans
4% 0% <500 500525 525550 550575 575600 600625 625650 650675 675700 700725 725750 750775 775800 >800
4% 0%
<500 500525 525550 550575 575600 600625 625650 650675 675700 700725 725750 750775 775800 >800
95
Private Label/Portfolio
GNMA
GSE
Private Label/Portfolio
GNMA
GSE
16 December 2010
Paying the piper: A look at likely losses at FHA

The main drawback is that the costs of such a system are borne by the taxpayer. Evidence of this can be seen in the FHAs Mutual Mortgage Insurance Fund, which is flirting with outright insolvency. This state of affairs exists because the GNMA program has drastically underpriced the risk of its guarantees (Figure 9): GNMA has historically charged borrowers two sets of fees: 1.5pts upfront and 50bp running. 24 Assuming a 4-year average life, fee income collected by GNMA totals 3.5pts. In contrast, we project cumulative default rates in the 20% area on average, with lossgiven default rates of 60%. This represents average losses of about 12pts, of which 8.5pts could flow back to taxpayers. On an original balance of $1.4trn, this translates to $130bn. Note that the ultimate tab will likely be small compared with the $150bn of taxpayer losses already recorded by FNM/FRE, which we expect to reach $230-250bn. However, FNM/FREs guarantee book of $4.6trn is more than three times larger than GNMAs. This issue of underpricing tail risks is not limited to the GNMA program, however; the FDICs Deposit Insurance Fund has experienced (paper) insolvency for the same reasons. As such, it would take considerable institutional will for the new nationalized entity not to become commandeered by the political process in terms of rate setting. In all, we think that scaling the full nationalization model to the size of FNM/FREs guarantee books could become a significant source of losses for the taxpayer. In a regime in which the affordability of the US public debt is becoming problematic due to its sheer size, we doubt that a full nationalization is politically feasible or fiscally appropriate. While there may be a valid argument for a fully guaranteed subsidy to a strictly limited subset of lower-quality borrowers, as we discuss in a later section, we do not envision full nationalization as an outcome for the US system of housing finance.
Figure 9: FHA losses are due to underpricing of risk; taxpayers would be unable to afford scaling up to full nationalization
Vintage 2002 2003 2004 2005 2006 2007 2008 2009 2010 Original Balance $bn 50 137 81 65 69 94 250 402 243 1,391
Default Rate % 10% 13% 19% 28% 32% 36% 27% 20% 15% 21%
Defaults $ bn 5 18 15 18 22 34 68 80 36 297
Premium Earned 3.5% 3.5% 3.5% 3.5% 3.5% 3.5% 3.5% 3.5% 4.0%
Loss Rate % 6% 8% 11% 17% 19% 22% 16% 12% 9% 13%
Losses $ bn 3 11 9 11 13 21 40 48 22 178
Income $bn 2 5 3 2 2 3 9 14 10 50
24
Historically, FHA fees were 1.5pts upfront and 50bp running; the upfront fee was increased to 2.25pts in March 2010. Beginning in December 2010, the upfront fee will be lowered to 1.0pts, but the running fee will increase to 85bp. We have time-averaged the premium for 2010 assuming a constant 4y average life..
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II. B) Enhancing the mixed public-private model

One of the most widely suggested proposals aired at the Treasurys housing conference in late 2010 was also a commonly mentioned topic during the various Congressional hearings on potential forms of the GSEs: the Private Lender Cooperative Utility (PLCU) model (Figure 10), endorsed by the Mortgage Bankers Association. In short, the structure of this model entails: A new cooperative that securitizes mortgage loans, to take the place of FNM/FRE; Originating banks paying in capital for the right to sell loans to the cooperative; and The federal government providing an explicit guarantee on the MBS issued by the cooperative, in exchange for a guarantee fee ultimately paid by the banks. Arguments favoring this model have highlighted the strong involvement of the private sector, as well as its multi-layered approach to protecting the taxpayer: Minimum down-payment requirements: the PLCU model is designed to service only the conventional/conforming segment of the market, leaving the affordable housing mission to the FHA; Guarantee fees paid to the government; and Capital in the PLCU contributed by its member banks. Ultimately, however, the taxpayer would remain accountable for any losses greater than the sum of these safeguards up to the value of MBS issued. And the governments track record of pricing risk adequately is poor.
Doing the same thing over and over, and expecting different results
In our view, the PLCU structure would not be very different than the existing GSE structure, except that the new securitization agency would be cooperatively owned (like the FHLBs) and pay the government an explicit fee for insurance. We foresee the following unintended consequences of implementing this model:
Figure 10: PLCU model combines private securitization, government guarantee

Member banks
Cash Equity stakes
Loans Guarantee fees
Mortgage securitization cooperative Guarantee fees Securities Cash Explicit guarantee Federal government
Investors
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Concentration risks: The PLCU would be owned by, and therefore concentrate power in, the hands of a few large banks, continuing a pattern of consolidation that accelerated following the S&L crisis of the 1980s. Currently, the top five mortgage originators control more than 60% of all origination; this is triple their market share during the early 1990s and well up from 5% in the 1960s (Figures 11 and 12). This outcome would seem to be at cross-purposes with legislative reform efforts to end the too big to fail paradigm. Taxpayer losses from government guarantee: As with the aforementioned examples of the FHA and FDIC, the government has a long history of underpricing risk, with the taxpayer ultimately bearing some of the costs. This could arguably also be extended to the regulatory history of FNM/FRE; recall that capital requirements under OFHEO were 2.5% on the portfolio (ie, 40x leverage) and 45bp on off-balance-sheet guarantees. Even though we have no reason to believe that the (explicit) guarantees on PLCU MBS will be underpriced today, it may be difficult for regulators to stay ahead of the curve a few decades in the future. If the PLCU becomes the preferred option for the future of housing finance, we would favour keeping the risks we know, ie, those posed by the existing GSEs, under stricter regulatory oversight, rather than creating a new model that could have unforeseen, unintended consequences.
Figure 11: Market share of originators skyrockets

2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 Mortgage originations, $bn
Figure 12: Total number of institutions keeps falling

20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 Mar-84
62% 21% 79% 38%
1997 Rest of originators

2009 Top 5 banks
Jun-89
Sep-94
Dec-99
Mar-05
Jun-10
# of FDIC-insured institutions
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Section III. Private sector solutions

The US mortgage market is large relative to US GDP, compared with other developed nations, in large part because of the role the government has played in housing finance. The mortgage universe can be broken into three buckets, viz., good, average and weak credit. Figure 13 shows the distribution of the existing universe and new production across the buckets. Roughly speaking, about a quarter of the universe can be categorized as weak credit, another quarter as average credit and the balance as good credit. In our view, the private sector has little appetite to make risky loans, but is willing to lend to good credit borrowers. However, that is exactly the kind of borrower profile that the GSEs, through their tight underwriting, are financing. Further, once conforming loan limits were raised to $729,000, all houses up to $1mn effectively became eligible for a government guarantee. Moreover, risk weights for the purpose of regulatory capital are lower for agency securities than for loans. As a result, we believe that the GSEs are crowding out the private sector. As long as the GSE subsidy remains entrenched, portfolio lending will continue to be crowded out by the GSEs. This underscores the need to constrain GSE growth in some way if government involvement in housing is to be reduced over time.
Figure 13: Distribution of mortgage credit universe

Credit Type (% of Universe / % of 2009 Purchase Loans) FICO Range <600 600-625 625-650 650-675 675700 700-745 725750 750-775 775-800 >800 Mtg Universe 6% 5% 8% 9% 11% 13% 13% 15% 15% 6% 2009 Purch. Loans 1% 4% 9% 10% 11% 12% 13% 15% 18% 7% 20052008 Purchase Loan LTV 2009 Purchase Loan LTV
Financing Solutions Will require government subsidy. Need to reduce leverage over time. DTI and other standards need to be tightened to reduce the subsidy Will need government support till housing stabilizes Can potentially be priced economically Is economic to originate Private and public solutions possible
Weak Credit (28% / 25%)
84%
95%
Average Credit (24% / 23%) Good Credit (48% / 53%)

83%
92%
77%
84%
There are three private market options: portfolio lending by banks, private label securitization and financing via covered bonds and three key questions that arise when considering them: 1. 2. 3. How much financing can the private sector provide through these channels? What is the effect on mortgage rates? How do we achieve the transition without disrupting the housing market?
The alternatives are not mutually exclusive; more likely, all three channels of private mortgage lending will be needed. Encouraging the resurrection of private sector financing alternatives should be a critical part of GSE reform. In the next three sections, we attempt to answer these questions.
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III. A) Private sector solutions: Non-agency securitization

1. Private-label securitization
It its heyday, the traditional private-label securitization model was attractive for lenders mainly because it provided capital relief, as originated loans remained off-balance-sheet. With regulators prescribing 5% risk retention for private label securitizations, there is no longer any capital relief relative to holding the loan in portfolio. Further hurting the near-term viability of the market is the fact that not only does GSE securitization continue to provide capital relief for issuers, it also provides more favorable execution than private label securitization. For instance, good credit conforming loans are being originated at about 5% WAC. For a typical 93-7 senior-sub structure that rating agencies would require for a private label securitization, the loan could be originated at about 5.25% WAC (Figure 14). In other words, despite massive tightening in non-agency spreads over the past two years, execution for good credit loans is still about 25bp better in the GSE space. So unless the share of the GSEs is reduced prescriptively, by lowering loan limits for example (see Section V), private label securitization can only play a limited role in the near term. Over time, though, if GSE subsidies are rolled back and there is a resurgence in private label MBS demand, it is conceivable that private label securitization may become more efficient than portfolio lending.
Figure 14: GSE execution superior to private label securitization

Super-senior (93%) Yield: 4.5% Overall Yield: 5.0%
Servicing fee: 25bp
Collateral Pool WAC = 5.25%
Mezzanine (7%) Yield: 12%

Source: Inside MBS/ABS, LoanPerformance, Barclays Capital
Non-agency securitization: Regulatory and legal hurdles

Even though the economics of private label securitization suggest that it could be a feasible source of housing finance, regulatory changes pose headwinds in the near term. It is hard to get past the fact that the flaws that were inherent in the securitization model contributed to the housing crisis. Regulators are continuing to study every aspect of the model, including the roles of originators, servicers, and ratings agencies, in an attempt to minimize conflicts of interest. The Dodd-Frank legislation also encourages regulators to prescribe rules diminishing the importance of ratings agencies, which is at odds with the concept of credit tranching. The Dodd-Frank Bill, FDIC Safe Harbor NPR and SEC Reg A/B all prescribe some form of risk retention for mortgages and will make it harder to offload risk and could increase capital requirements. Our view is that while risk retention does not derail the economic viability of securitizations, it certainly tilts the balance in favor of keeping loans in portfolio.
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In time, we believe that private label securitization should recover, but we doubt that regulators will encourage private-label securitization to be the primary source of mortgage finance in the US, given recent experience. We discuss portfolio lending as well as risk retention in detail in sections IV and V, respectively. But before that, we turn to another capital market solution for housing finance that has worked internationally.
III. B) Private sector solutions: Covered bonds

Covered bonds, long the dominant source of mortgage finance in Europe, have also been endorsed by prominent Republicans as a viable private sector alternative to the GSE-centric housing model. Recall that a covered bond allows banks to fund mortgages and/or other loans directly by pledging them as collateral (the cover pool). Because the cover pool remains on balance sheet in a segregated account, issuers retain the risks of the loans and receive no capital relief. Hence, covered bond issuers retain skin in the game and have every incentive to originate prudent loans. While we certainly think covered bonds can play a role in financing housing, there are many hurdles that must be addressed to make the sector viable in the US. We believe the largest obstacle is structural. As a source of on-balance-sheet funding, covered bonds are significantly more capitalintensive than FNM/FRE origination. When banks originate conforming mortgages, GSE securitization is almost always preferable, simply because even if the banks want to retain the risk on-balance sheet, they get capital relief via securitization. Thus, banks have typically offloaded the majority of residential mortgage credit to the GSEs (Figure 15). Further, as discussed below, for non-conforming mortgages, the FHLB System offers direct competition to covered bonds via advances, which in concept are no different than covered bonds.
What will it take for the US market to grow?

a) Legislative framework
We believe that the main lesson to be learned from the European experience in establishing covered bond markets is creating a legal framework for the asset class. For example, the Figure 15: Sources of mortgage finance in the US
Other, 561, ABS pools, 5% 1386, 13% FNM/FRE assets/ pools, 4734, 45% Other bank funds, 2419, 23% FHLB advances, 540, 5%
Figure 16: Largest banks could create a $300bn market

$ bn BAC JPM C WFC GS Top 5 Others Total Liabilities 1992 1867 1702 1129 777 7467 4176 11642 4% of liabilities 80 75 68 45 31 299 299
FHA pools, 1005, 9%
Total = $10,645bn
Source: Federal Reserve Flow of Funds report, Barclays Capital
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German Pfandbrief market has had its structure enshrined in law for over 200 years and has never recorded investor principal losses. In order for US covered bonds (USCBs) to gain as much global acceptance as the Pfandbrief market, we believe the following two aspects of the German market should be emulated: Lending standards, eligible cover pool collateral, overcollateralization, frequency of asset coverage tests, and other features should be specified in law, preventing regulatory capture. Maximum LTV ratios should be set at a prudent level, say, 70% for residential mortgages; this represent significant loan-level margins of safety. In our view, limiting the collateral to high-quality residential mortgages as a start is the key to ensuring rates investors maintain interest in the asset class. In this context, we are concerned that the most recent legislative proposal (HR 5823), suggested by Congressman Scott Garrett (R, NJ-5), may be suboptimal, as it allows virtually any asset to be financed by covered bonds, not just residential mortgages, and leaves the origination standards to be defined by the regulator. Importantly, covered bond legislation must also define the rights of the investor in the event of issuer insolvency. This aspect has provoked conflicts with the FDIC, which has argued that covered bonds create a preferred class of debtholders whose rights to the cover pool conflict with the FDICs powers as receiver of a failed bank. To this end, the FDIC has warned that an ailing bank with covered bond funding would eventually segregate its best assets into the cover pool to meet asset maintenance tests, thus adversely selecting the FDIC, and by extension depositors. As a compromise, it would not surprise us if the FDIC acquiesces to a 4% of liabilities limit for covered bond issuance by financial institutions, which is similar to guidelines adopted in Canada and in line with what the agency had agreed to in conjunction with other regulators in mid-2008.
b) Forcing the FHLB System to make room by regulatory fiat

In many respects, the FHLB System provides a similar source of collateralized borrowing for banks via the advance window. From a banks perspective, advances are superior to covered bonds:
Figure 17: Comparative rates for advances, covered bonds

2y GSE funding (FNMA) Advance rate (FB Boston) Covered bond (CFF USD) Bank unsecured (BAC) 0.61 0.98 1.32 2.70 3y 0.92 1.32 1.63 3.45 5y 1.67 2.11 2.69 4.35 7y 2.33 2.96 3.22 5.14
Figure 18: Advance lending ramps up, down with the crisis
1,100 1,000 900 800 700 600 500 Dec-06 ` $ bn $ bn 1,400 1,300 1,200 1,100 1,000 900 800 Oct-07 Aug-08 Jun-09 Apr-10
Advances (LHS)
Debt Outstanding (RHS)
Source: FHLB Office of Finance, Barclays Capital
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Funding is cheaper. The FHLB uses its GSE status to fund at advantageous levels, similar to FNM/FRE; to a large extent, it can pass on this cost savings to the borrowing banks (Figure 17). Furthermore, it has wide scope to adjust its collateralization requirements higher during periods of stress or lower to stave off competitors such as the USCB market. Advances offer enormous structural flexibility and are available across a wide range of esoteric collateral. In contrast, investors are likely to accept a low covered bond spread only if the cover pool assets are safe and easily understood. By contrast, the FHLB lends against a very wide range of collateral at appropriate haircuts (including CMBS and HEL), due to its careful monitoring of loans and local knowledge. Because it is government-sponsored, advance lending is countercyclical. This was demonstrated to great effect during the financial crisis, when advance borrowing ballooned from $600bn to more than $1trn over a few quarters due to demand from large banks and has since shrunk to half that size (Figures 18 and 19). This is in direct contrast to covered bonds, which froze along with other credit markets in late 2008, only to thaw gradually of late. Therefore, unless regulation and a legislative framework are created to essentially force covered bonds onto the market, the FHLB System may simply crowd out a USCB market by continuing to perform its existing functions. c)
ALM concerns
Last but not least, a key reason for the prevalence of covered bonds in Europe and their relatively slow progress in the US is the difference in the typical residential mortgage loan. In Europe, the ARM is much more prevalent, whereas the archetypal loan in the US is a 30y FRM (Figure 20). As such, while a covered bond can fund a shorter-duration loan with little convexity risk, there becomes a much starker hedging mismatch when funding a 30y FRM with, for example, a 5y bullet covered bond. Historically, this is why securitization became so popular after the 80s S&L crisis: the theory was that via securitization, convexity risk would be transferred from banks to institutions that were able and willing to bear it. For covered bonds to take off, banks will have to manage convexity risk aggressively or originate fewer fixed rate mortgages.
Figure 19: Largest borrowers at FHLB are the largest banks

Advance lending, $bn Citi JPMorgan Chase Bank of America/Countrywide Wells Fargo/Wachovia Hudson City Others Total Amount borrowed by top 10 4Q06 72 39 28 35 9 458 641 36% 3Q08 84 79 65 82 17 685 1012 36% 2Q10 31 14 62 24 18 392 540 40%
Figure 20: Prevalence of 30y FRM in US outstrips others

100 80 60 40 20 0
Au st ra Ca lia na D en d a m ar Fr k an G er c e m an I re y la nd Ja pa n N Ko et he re a rl a nd s Sw Sp itz ain er la nd UK US
Variable
Source: FHLB Office of Finance, Barclays Capital Source: MBA, Barclays Capital
ST Fixed
MT Fixed
LT Fixed
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Conclusion
We believe that ultimately the US covered bonds market cannot exist in the absence of regulatory fiat that is, regulators encouraging and/or requiring banks to fund a small percentage of their balance sheets with covered bonds. However, regulators may need to limit FHLB advance borrowing at the largest banks artificially, to, say, a maximum of $25bn, or covered bonds will likely remain crowded out. If the FDIC agrees to a 4-5% limit on covered bonds as a proportion of total liabilities, the USCB market could eventually reach $250300bn (large banks have roughly $7trn in liabilities, Figure 16). While this is a good start, transitioning away from the GSEs needs $4trn+ in private sector financing. Covered bonds cannot be the single answer for housing finance, but they could certainly be a part of the solution. Thus far, we have argued that private label securitization and covered bond financing can provide only partial solutions to housing finance needs, especially if the existing GSE universe must also be gradually transitioned to the private sector. Therefore, in a system with minimal government involvement, the onus for meeting mortgage demand in the near term must fall on direct portfolio lending, which was the dominant paradigm pre-1990s, and indeed still is across most of the developed world.
Section IV. Is portfolio lending the answer? Be careful what you wish for
If the system moves from one that relies heavily on securitization to one in which bank portfolios are the key source of credit for the housing market, the single most important consideration for Congress would be the potential effect this might have on mortgage rates. While many prominent observers have postulated that mortgage rates might rise 400bp or more, we think the answer is far more nuanced: the credit curve would likely steepen massively. To provide some intuition behind our assertion, let us evaluate how a bank would price mortgage loans for different borrower categories, based on their risk profile: 1) First, we estimate the general cost of funds for banks. A good proxy is the blended cost of deposits and unsecured funding, which is about 2% for the US banking system.
2) Next, we estimate expected losses for a given cohort of borrowers (Figure 21). For example, our credit models suggest that borrowers with a 660-700 FICO who put down about 15% historically would cause losses of about 3% (assuming a 3% HPA environment). This means that three points of expected losses need to be recovered in the form of a spread to the cost of funds. Further, if three points are recouped in, say four years, this would imply an additional spread of about 75bp running in rate terms.
Figure 21: Expected losses by FICO and LTV buckets

FICO/LTV <620 620-659 660-699 700-739 740+
Figure 22: Unexpected losses by FICO and LTV buckets

95-99 12.9 9.5 5.5 4.2 1.6 FICO/LTV <620 620-659 660-699 700-739 740+
<=70 1.4 1.1 0.7 0.4 0.2
71-80 2.1 2.1 1.6 0.8 0.3
81-89 4.7 3.2 3.1 1.6 0.5
90-94 9.3 7.0 4.1 2.3 1.2
<=70 5.2 3.9 2.6 1.5 0.9
71-80 13.0 9.7 6.0 3.6 1.2
81-89 20.9 16.7 10.7 7.9 3.6
90-94 25.7 17.8 13.1 9.1 6.1
95-99 24.5 22.7 16.4 10.4 7.8
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Figure 23: Mortgage rates under a portfolio lending-only solution

FICO/LTV <620 620-659 660-699 700-739 740+
Figure 24: Distribution of purchase-only loans from 20042009

FICO\LTV <620 620-659 660-699 700-739 >740
<=70 5.6 5.2 4.8 4.5 4.3
71-80 7.8 6.9 5.9 5.1 4.4
81-89 10.4 9.0 7.4 6.4 5.0
90-94 12.7 10.2 8.3 6.8 5.8
95-99 13.2 12.0 9.4 7.6 6.3
0-70 0 0 1 2 12
70-80 0 1 4 8 29
80-90 0 0 1 2 9
90-95 0 1 1 1 3
95-99 0 8 10 0 0
3) Next, we estimate the cost of economic capital that needs to be set aside to make the loan (Figure 22). The internal model-based approach advocated in Basel II, as well as FDIC guidance for its implementation, suggests setting aside enough capital so that losses in an extreme downturn can be absorbed. We assume down 20% HPA (three standard deviations) as an extreme event; this would cause additional losses of eleven points over and above the three points in expected losses. This means that eleven points in capital need to be set aside for every $100 of the loan. To earn a 25% ROE on this capital, the lender would have to charge another 270bp running in rate terms. 4) Lastly, we account for convexity and servicing costs (assumed to be 100bp each). Adding the four components results in a mortgage rate of around 7.4% for a 660-700 FICO/ 85 OLTV borrower. Mortgage rates for other risk buckets are also shown in Figure 23. The results are revealing. For about 50% of the population (Figure 24) the relatively clean credits (shown in light green) the mortgage rate in a privately financed system would not be too far removed from agency mortgage rates today; we estimate 4.3-5%, which is low by historical standards. In comparison, for about 25% of the population, or the poor credits (FICO less than 700, shaded orange), rates could jump to well over 10%, as the credit curve would steepen. For context, unsecured credit or credit card debt costs north of 20%. If poor credits are more likely to default, private mortgage rates should approach unsecured debt levels less the recovery value of the house. Also, it is unclear if banks will even participate along the lower end of the credit spectrum, given recent experience. This is the segment where GNMA has been typically involved and where we see continued government involvement as vital in order to maintain housing affordability. For the remaining 25% of the population, or the average credits, we suspect the private sector will eventually be willing and able to fill the void left by the GSEs, although it will likely be at spreads commensurate with the risk involved. Until the private sector is in better shape and able to provide unfettered credit to this segment of the population, government financing may prove necessary in order to prevent housing price declines. Our analysis clearly highlights that banks should be willing and able to fill the gap for borrowers with clean credit, even in the current environment and offer them rates comparable to where conforming GSE loans are priced. So why arent banks retaining more loans on their balance sheet? We go back to a familiar answer: as long as the GSE securitization option is available, it is more capital-efficient to do a GSE securitization and buy back that risk as securities. Unless the relative capital costs of
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Figure 25: Government will need to be involved for borrowers with poor credit
FICO/LTV <620 620-659 660-699 700-739 740+ <=70 5.6 5.2 4.8 4.5 4.3 71-80 6.8 6.8 5.9 5.1 4.4 81-89 6.8 6.8 6.8 6.4 5.0 90-94 6.8 6.8 6.8 6.8 5.8 95-99 6.8 6.8 6.8 6.8 6.3
Figure 26: Reduction in GSE loan limits required to allow emergence of private market
12% 10% 8% 6% 4% 2% 0% 0-25 125-150 250-275 375-400 500-525 625-650 750-775 Price ('000s) 400-425
holding high-quality mortgages and agency MBS are equalized, portfolio lending will remain inhibited and the governments role in housing will become even more entrenched. If private sector participation in the housing finance market is to be encouraged, the role of the GSEs needs to be reduced over time (Figure 26). We discuss ways in which this can be done in the next section.
Section V. Managing the transition to privately financed housing

Decades-long process; low savings rate is a constraint
The key constraint for any transition from the GSE model to one dominated by portfolio lending is the low savings rate in the US. After the subprime crisis, it is highly unlikely that international investors will invest in US mortgages that do not come with either an explicit or an implicit government guarantee. Currently, foreign investors buy US agency MBS and debt and GNMA MBS because of the government guarantee. They will almost certainly not buy covered bonds or unsecured debt issued by banks in the same size which means that the dominant source of funding for housing finance will need to come in the form of domestic savings in the US. In turn, bank balance sheet growth and, therefore, the ability to make mortgage loans are likely to be governed by how quickly banks can raise deposits. This limits the pace at which a transition from a GSE-based housing system to a bank portfolio-based housing finance system can be achieved (Figure 27). At a savings rate of 6%, household savings in the US is running at about $600bn per annum. Historically, banks have captured only about 30% of these savings, which today would be about $200bn. Meanwhile, by our estimates, new financing needs for the housing market, factoring in new home sales as well as a homeowner mobility rate in the US of about 5%, should run closer to $500bn per annum. Banks would have to capture 80% of household savings to meet this need in the near term and then apply all that balance sheet growth towards mortgage lending both of which are implausible (Figure 28).
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Therefore, the only way, in our view, that a transition can be realistically achieved is if the GSEs continue to exist for however long it takes before the private sector can easily fill the financing gap. Over time, the deficit between required financing and available savings can be bridged, and a sustainable portfolio-based model of mortgage finance can be achieved. When we model new household formation and mobility, together with the financing constraint imposed by the savings rate, we find that the transition period required should be well in excess of 20 years. Clearly, even if the government decided to phase out GSE financing, it should be a decades-long process, at least. We do not believe it can be done in 3-10 years, as various Congressional proposals have recommended, without risking significant disruptions in housing markets.
Phase-in based on loan limits

As we have discussed earlier, as long as the GSEs are present in their current form, banks are likely to prefer securitization to portfolio lending. So how does one achieve a transition, even allowing for a period as long as 20 years? One possible solution is to constrain the GSEs in terms of the specific kinds of mortgages they can securitize. The obvious parameter that comes to mind is loan size. Conforming loan limits for the GSEs were raised from $417K to $729K during the crisis. Our analysis suggests that these can immediately be tightened to $450K right away, without being too disruptive. Keeping the constraint imposed by bank balance sheet growth in mind, we also believe that the conforming loan limit can be reduced further, all the way to the median home price of $170K in current dollars over the next few decades (Figure 29). The key is to ensure that this is a gradual process; this will allow the portfolio lending channel to grow over time and fill the financing void created by tightening the limits on GSE securitization. Another key aspect of the transition will be to ensure that GSE borrowers switch to private borrowing and do not simply shift to GNMA-backed mortgages, which also have favorable capital treatment for depositories. This can be achieved by ensuring that GNMA charges rates sufficient to cover at least base case expected losses, instead of providing subsidies.
Figure 27: Decades-long process : Banks can only slowly take the place of GSEs
$bn 6,000 5,000 4,000 3,000 2,000 1,000 0 0 5 10 yrs 15 20 25 GSE MBS outstanding Bank resi loans 12,000 10,000 8,000 6,000 4,000 2,000 0
Figure 28: A large part of domestic savings will need to flow to banks to be available for housing finance
90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2011 2016 2021 2026 2031 2036 Historical % of savings captured by deposits Required mortgage financing (% of household savings)
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Using the expected losses framework outlined in the prior segment, we estimate that while the all-in cost for a GNMA loan is just over 5%, the fair rate is, in our view, closer to 7% (Figure 25). If this fair rate is what the government charges, it will achieve two goals: it will minimize taxpayer losses and provide an incentive for high-quality borrowers transitioning away from agency loans to stick with the private sector, instead of moving to more costly GNMA mortgages. We are not suggesting the subsidy for poor credits be totally removed; rather, we think it makes sense for the government to tighten the box for GNMA mortgage availability in normal times and grow it countercyclically in times of crisis. Without such a constraint, instead of transitioning to a private market, GSE mortgages will simply move to GNMA, and the US housing market will end up de facto nationalized.
Unintended consequences: Risks from banking system will increase

It goes without saying that if the banking sector is to be a replacement to the current GSE based system of housing finance, its role in the economy should grow even larger. Needless to say, this can have unintended consequences. As Figure 30 shows, the growth of the shadow banking system kept US bank balance sheets relatively small as a fraction of the economy. Banks are only 80% of GDP in the US, compared with 600% of GDP in the UK and 300% of GDP in Germany (Figure 31). Part of the difference in the relative sizes of the sector can be explained by accounting differences; but even controlling for this, the banking sector undoubtedly plays a far more prominent role in most other developed economies. As the ongoing sovereign crisis in Europe highlights, a large banking system carries its own risks. For instance, even though delinquencies on residential loans in mortgages were only 3% in Ireland (Figure 33), the resulting banking system losses have been large enough to create concerns about the creditworthiness of the sovereign. By extension, if all residential lending in the US had been on bank balance sheets (Figure 32), with a 10% delinquency rate, banks would have suffered losses many multiples higher than currently absorbed, threatening financial stability even more.
Figure 29: GSE loan limits can be brought down in stages, giving enough time for private sector to fill the void
500,000 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 2011 2013 2015 2017 2019 2021 2023 2025 GSE limit (2010 dollars)
Figure 30: Growth in securitization kept the banking system small relative to GDP
200% 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% 1950 1957 1964 1971 1978 1985 1992 1999 2006 Banking assets/GDP Banking + Shadow banking / GDP
Source: Federal Reserve Flow of Funds, Barclays Capital
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Figure 31: US banking system is compared with other countries when measured against GDP
7 6 5 4 3 2 1 0
UK Au st ra lia Sw ed N en et he rl a nd s G er m an y Be lg iu m D en m ar k Ca na Un da ite d St at es Fr an ce
Figure 32: Aggregate real estate exposure of banks, including loans and securities, should grow over time
60% 55% 50% 45% 40% 35% 30% 1992 Banking system real estate exposure (%)
1998
2004
2010
2016
2022
2028
Banking assets/GDP
Source: Haver Analytics, Barclays Capital
Therefore, if we transition to a system in which mortgage risk will be retained on bank balance sheets, rules must also be put in place to make products safer. This is the topic of the next section. Figure 33: US delinquency rates far outstripped other countries globally
10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Jan-04 Jul-05 Australia
Source: Moodys, Barclays Capital
Prime RMBS serious delinquency rates
Jan-07 Spain UK
Jul-08 US GSE
Jan-10
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Section VI. Making the product safer QRM and risk retention
Policymakers have two options in their effort to make mortgage lending safer: They can be prescriptive and specify exactly the kinds of loans that banks are allowed to make. This leads into the discussion of what such a qualified residential mortgage (QRM) should look like. They can make originators eat their own cooking; risk retention rules and reps and warranties both fall into this category.
VI. A) How should a qualified residential mortgage look?

Our view is that the residential mortgage as a product can be made safer if its features are standardized and restricted. Specifically, we suggest the following suite of features: 20% down-payment Full documentation Fully amortizing mortgages only 5/1s and longer terms, including 15- and 30-year fixed No prepay penalties Stop the focus on FICO. Back-end DTI < 40% + loan/income ratio of 4
Down-payments, not mortgage insurance

Although down-payments may not appear to be an important loss-mitigating factor when mortgage insurance is available for the lender, the housing crunch clearly showed that the benefits of higher down-payments go beyond loss mitigation. Credit performance of a 20% down-payment borrower (80% OLTV for the GSEs) was much better than that of a 5% down borrower, with 15% guaranteed by the MI (Figure 34). The reason is that a higher down-payment not only offers an economic cushion against a fall in housing prices, it also signifies a much safer borrower those who have higher equity in their homes are simply less likely to default even in a housing downturn. Even in terms of economic value, mortgage insurance has not turned out to be as effective as was expected. Mortgage insurers have shown, in hindsight, that they might not pay off the GSEs if there is a widespread decline in housing prices. Further, the amount of capitalization required in the future will likely render the MI model unviable.
Full documentation
During the housing crisis, the performance of loans to otherwise similar borrowers but with different degrees of documentation has been dramatically different (Figure 35). It is also not very clear what economic purpose no-documentation loans serve. While there is a clear benefit to lower down-payments (they allow new homeowners with low savings to buy houses), the benefit of less than full-documentation loans (apart from being able to exaggerate their income and assets) is not apparent.
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Fully amortizing mortgages

At the very least, lenders should require borrowers to have the ability to pay down the principal amount of the loan. The stated reason for allowing option ARMs, for instance, is that it makes it easier for borrowers with variable cash flow streams to purchase houses. However, it is not clear why the lender of the mortgage should take on the risk arising from the variability of a borrowers income. Economically speaking, a responsible borrower with a variable income can smooth payments out by saving during periods of high income and using those savings to pay down an amortizing mortgage during periods of low income there is little reason for a mortgage lender to be making this feature available to the borrower. Interest-only mortgages sharply increase the leverage the borrower is allowed to take. In addition, the payment shock is massive and a significant source of default, far more than the shock associated with mortgage rates resetting higher. Negative amortization loans are even worse in every respect more leverage, bigger payment shock, and worse credit performance.
Limits on loan terms

Short reset periods take interest risk away from the lender and give it to the borrower. This can be counterproductive because banks are in a better position to manage rising rate risk at the front end than are individual borrowers. Further, the shorter the reset period, the higher the implicit leverage. This is because borrowers effectively get lower mortgage rates in return for taking on interest rate risk. If DTI is used as a measure of leverage, lower rates translate to larger loan amount, and, hence higher leverage. If increasing the amortization term of the loan implies higher leverage, there needs to be a constraint on how high terms can be. Empirical evidence suggests that the average borrower stays in a house for at least five years. This makes us suggest at least 5/1s or longer (15y or 30y) loan terms.
Disallow prepay penalties

The lack of prepay penalties is an attractive feature of the US mortgage market. Just as they are unable to evaluate interest rate risk, borrowers are not, in our view, in the best position to evaluate the economic value of the prepay option. Further, in the absence of prepayment penalties, convexity risk can be aggregated into the books of banks that can manage it more effectively. More important, borrowers can waive the prepay option as another means Figure 34: Performance of loans with similar OLTV but different levels of PMI are very different
60 d+ DQ 45 40 35 30 25 20 15 10 5 0 0-60 60-70 70-80 OLTV
Source: Barclays Capital Source: Barclays Capital
Figure 35: Performance of loans with full documentation is significantly better than those with limited documentation
60 d+ DQ 50 45 40 35 30 25 20 15 10 5 0 Limited doc Full doc
PMI
No PMI
80-90
90-100
0-60
60-70
70-80 OLTV
80-90
90-100
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to leverage up. This is because waiving the prepay option allows the borrower to reduce the mortgage rate, thus allowing for a bigger loan amount.
Credit evaluation
We believe that the reliance on FICO for evaluating the credit-worthiness of borrowers is misplaced. FICO is a model, and like any model, its accuracy is limited. During boom years, many borrowers who may not be otherwise able to, remain current on their payments and that might even lead to an inflation in FICO. Our view is that credit decisions should not be based on just one number, but on the whole credit file. Constraints on leverage should be imposed through back-end DTIs and loan/ income ratios. A focus on back-end DTI would also strengthen the documentation process. Similarly, loan/income ratios (which many other countries enforce) are economically logical and move to an equilibrium over long periods. We suggest constraints such as back-end DTI <40% + loan/income ratio of 4.
Recourse
In the US, the laws governing how much recourse lenders have to a borrowers other assets vary state by state. In many states, lenders can pursue deficiency judgements that allow the lender to recover the difference between the remaining loan amount and the fair market value of a house if the borrower defaults on an underwater mortgage. Despite being a form of recourse, in practice, this is difficult to achieve because it entails significant legal costs. Internationally, recourse is generally a feature of mortgage markets, and this has kept delinquency rates lower in other countries that have also seen a boom and bust cycle in housing similar to the one that the US experienced. There are many pros and cons to allowing lenders to pursue other assets of a borrower. Some of the arguments in favor are as follows: Concept of personal responsibility if one wants to take debt, one should assume responsibility for it. This is true of all other consumer debt, so why not for MBS also? Bankruptcy is always an option to get out from under debt. Borrowers are far more likely to buy only houses that they believe they can afford, given the concept of recourse. Lack of recourse can skew incentives, as seen in this cycle, in which some borrowers have defaulted on their first liens while continuing to pay second liens (due to the threat of recourse in the second). Private lenders can make loans without recourse if they like, and borrowers can go there. But there are also arguments against recourse: Recourse can lower the incentive for banks to perform due diligence when making the loan (the seat-belt theory). Recourse can increase the incentive for banks to sell houses cheaper at the point of foreclosure, in the knowledge that they can get the rest of the money back from the borrowers other assets. It is difficult to ensure that banks would sell foreclosed houses for the best possible price. Changing the laws governing recourse is a complicated process, perhaps more complicated than reform of the housing finance system itself.
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Nevertheless, aiming for a system in which borrower and the lender incentives are aligned during the foreclosure process is preferable to the current process, which pits the lender against the borrower (or, at best, leaves the borrower indifferent to the foreclosure price). Such a system would likely involve some form of recourse, along with restrictions on lender behaviour, such that the borrower is not unfairly penalized in the process. We realize, of course, that enforcing recourse is legally cumbersome that said, we believe that if the other changes we recommend are implemented, this would significantly weaken the argument for recourse.
VI. B) Risk retention to deter bad lending

Various post-crisis regulations being formulated will address the fact that in prior private label securitizations, the originator of the mortgages did not have any skin-in-the-game Below, we discuss ways to increase originators skin in the game by looking at various risk retention proposals and their effect on credit availability. Our conclusion is that 1) this effect of current risk retention proposals on credit availability is manageable and 2) it may not be enough to force banks to hold on to the first loss piece; instead, forcing them to hold on to the second loss piece with constraints on the overall proceeds might be a better way to reduce bad lending and systemic risks.
Problems with proposed risk retention structures

There are three broad risk retention proposals being considered in the public discourse so far. We look at each of these and potential issues with their implementation.
1. Hold first loss piece/horizontal slice

For much of early part of the decade, banks were able to originate loans and quickly sell them at a profit as whole loans or by securitizing. Ignoring rep- and warranty-related risks, they would come out making some riskless money within weeks of originating the loan. More importantly, the loan would not necessarily have to make economic sense for the originator, as long as securitization proceeds were more than par plus the costs to originate the loan. To be sure, originators such as mortgage REITS did have to retain the equity piece even in 2002-07. But they could mark it at zero value and still make money because proceeds from securitizations were much higher than par. In our view, the solution is not to have skin in the game but to have enough skin in the game and for long enough. In other words, even a bottom 5% loss piece does little unless it is locked out of all cash flows until the top 95% is completely paid off. In typical structures that required retention of the first loss piece (such as REITs), the structures still allowed the first loss piece to deleverage before more senior tranches were paid down through excess spread that could be diverted to pay the first loss piece. In such a structure, a bad loan would still be originated if proceeds from selling the top 95% and excess spread or servicing value exceed par plus costs. Figure 36 shows the typical economics of securitizations from 2002-07 and why a first loss piece is not really meaningful if structured without any restrictions on the proceeds from the securitization.
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Figure 36: Sample securitization economics example Horizontal slice

Loan Net Coupon 5% Incentive to originate high SATO loan with good execution AAA 90% of deal at 3.75% cpn Mezzanine Bonds 5% of deal at 8% coupon Risk retained 5% of deal by originators at 12% coupon Excess spread 62.5bps per annum
Sold at par for $90 Sold at par for $5 Can be held for $2.5 instead of $5 (24% carry) Sold for $2.5 at a 4x multiple
2. Hold on to vertical slice of the deal (or a certain percentage of every tranche)
This is the structure that has been proposed in the FDICs safe harbour rules as one of the alternatives. The idea is to ensure that the originator has an interest in the entire capital structure and, as a result, acts in the same way as if it had owned the loan on portfolio. While in theory this is likely to work well, there are still some potential issues and ways to arbitrage this structure. For example, depending on the execution of the other 95% and the value of the servicing, the originator would typically end up holding the 5% vertical slice for a lower cost basis than 5% of the notional. Figure 37 shows the potential execution for a securitization with a vertical slice held by the originator. As with the 5% horizontal slice, the originator has some incentive to originate worse credit quality loans with higher WACs (but those which other investors/rating agencies view more favourably) and create a higher excess spread tranche (about 62bp) that can be sold as an IO for $2.5 on a $100 notional loan. We further assume that ethe equity can now be sold at an $80 price (15% carry). This leaves the originator holding the 5% vertical slice at a cost basis of $3.45. Without going into detailed calculations, this is equivalent to the originator owing a 31% credit enhanced tranche at 6.3e% current yield, more attractive than owning a super senior tranche that trades in the secondary market.
Figure 37: Sample securitization economics example Vertical slice

Loan Net Coupon 5% Incentive to originate high SATO loan with good execution Risk held by bank at $3.45 instead of $5 Bank does not get hit by first 31% loss AAA 90% of deal at 3.75% coupon Mezzanine Bonds 5% of deal at 8% coupon Equity 5% of deal at 12% coupon Excess spread 62.5bps per annum
95% of tranche sold for *85.5 ($90*95%) 95% of tranche sold at par for $4.75 ($5*95%) Sold for 80c/$ for $3.8 ($4*95%). Some benefit to equity buyer Sold for $2.5 at a 4x multiple
3. Hold on to representative sample of loans

The other alternative method proposed in the FDIC safe harbor rules is to hold a representative sample of loans instead of a slice of the capital structure. In terms of pure dollars, this has the same effect as the vertical slice structure as long as the slice is a true vertical slice. As a result, this method shares the same issues as the ones described above.
However, this approach also has an additional problem of asymmetric information. On what is the representative sample based? To be able to create a small 5% sample that matches the characteristics of the larger pool, we may only be able to match the mean characteristics along a few dimensions such as FICO/ LTV/documentation, and so on. While not necessarily intentional, there would be cases in which the sample is better than the rest of the pool on other dimensions such as DTIs, borrowers other assets, geographies etc.
We favor modified risk retention structures to prevent systemic risks

Overall, none of the proposed solutions completely prevents originators from making loans that they would not originate for their portfolios. To make the risk retention effective and prevent originators from making such loans, we propose two potential solutions. While not foolproof, both are ways to ensure that the risk retention is not in name only but also works better in practice.
1. Limit on securitization proceeds

Our first proposal would be to place a limit on proceeds from selling securitized bonds. This would ensure that the cost basis at which the risk is retained by the originator is what was intended by the regulation, and not a lower number to begin with. At the risk of oversimplification, assume that the appetite for risk comes back. In some scenarios, it might be possible to sell 95% of the pool at $98, retain excess servicing worth more than 2 points, hold the 5% retention piece at zero and still make money. By forcing net proceeds at $95, the originator is forced to retain the risk they were intended to. Further, the risk retention rules would specify that the originator is not allowed to deleverage the position before bonds more senior in the capital structure are paid off. This can be done, for example, by limiting the coupon on the equity tranche and ensuring that the excess spread in the structure, if any, is used to pay down the bonds based on seniority in terms of loss.
2. Hold the second loss piece

Our first proposal brings the capital requirement of securitization closest to that for holding a loan on portfolio and, as a result, is likely to lead to more portfolio loans than securitization, at least initially. As a result, this particular setup with either a horizontal or a vertical slice is potentially too constraining and can put pressure on credit availability. Another potential solution, therefore, would be for banks to hold the mezzanine tranches (second loss pieces) of securitizations, typically rated single A to BBB- (Figure 38). This approach is beneficial in many ways. One, it would be much harder for banks to create structures in which the second loss piece deleverages quickly. They would be required to sell the equity and most likely need to divert excess spread cash flows into equity to be able to sell that. Two, the mezzanine piece would be hit only in scenarios that are significantly worse than expected. This would make banks care more about correlation risk from their originations and prevent loans that are likely to lead to widespread losses. Three, they would continue originating modestly risky loans. Four, this will prevent the servicer conflict of interest since the originator owns neither the senior nor the subordinate bonds, which are typically the easiest to benefit from changing ways to deal with delinquent borrowers. Last but not the least, since the mezzanine piece would be rated investment grade, this will not be as capital constraining on the originators as retaining unrated pieces.
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Figure 38: Sample securitization economics example Second loss piece

Loan Net Coupon 4.525% No incentive to originate high SATO loan as proceeds are capped AAA 90% of deal at 3.75% cpn Mezzanine Bonds 5% of deal at 8% coupon Equity 5% of deal at 15% yield No excess spread
Sold at par for $90 Held for par at $5 by originator Sold at par for $5
Best place to retain risk is the originator

Irrespective of the risk retention solution, another issue that regulators need tackle is to avoid informational arbitrage that leads originators to make loans that they themselves would not have owned on their portfolios. Additional data disclosures to investors could certainly help alleviate this issue. But to the extent credit can be assessed best at retail level, and given that we want to avoid making loans that might pose systemic negative implications, all retention should be at the originator level.
Risk retention effect on credit availability

From a theoretical standpoint, the economics of the securitization as a whole and, subsequently, the overall lending rate should not be affected much. This is because the required return on equity whether held by banks or sold to others should be similar. Clearly, the recent experience with mortgages has raised the risk premiums across the board, but there is no reason to believe that return on equity capital required by bank investors as a whole will be substantially different from returns required by hedge fund investors. As a result, the overall effect of risk retention on credit costs should be minimal and related to capital constraints at banks. It does, however, prevent some informational arbitrage by which banks could have made loans they believed to be bad but which the investors as a whole were willing to buy (ie, bad loans where execution was profitable). At the same time, it can even be argued that this should reduce the return required on equity somewhat, assuming that banks have more information/ability to pick good loans than investors in securitized vehicles.
Risk retention favors private portfolios versus private securitization

To the extent originators are forced to retain a slice of securitization, FAS 166-167 would bring the asset on to the balance sheet, triggering capital requirements similar to loans. As such, in going from 0% required risk retention to 5%, the capital benefit of securitizations versus portfolio loans would be reduced substantially. At the same time, banks are flush with cash and can achieve much cheaper funding through portfolio lending than through securitizations. Therefore, risk retention requirements might lead to more loans being held in the portfolio than before (Figure 39). The portfolio solution is limited by capital constraints that banks have. (discussed more in portfolio lending section). If more loans do end up in the portfolio, the more likely mediumterm outcomes would be that some of the capital from securitization markets will find its way into existing or new mortgage banks/ originators and non-bank origination companies will crop up. There have already been some hints from large insurers and asset managers
(such as Blackrock) in that direction. We believe, however, that as the funding advantage for banks goes away, the eventual outlet for these loans would be through new private label securitizations.
Figure 39: Risk retention will render capital benefit of securitization ineffective and favor portfolio loans in the current environment
Capital Requirement GSE None. Likely to remain the same under Senate bill, if regulators create exemptions High, 50% risk weight, ~5% capital Based on FAS 166167, would be similar to portfolio Economic Risk Rep and Warranty claims Funding Levels Agency basis remains tight Deposits, very low Type of Funding Term funding
Portfolio Securitization
100% economic risk
Floating
New proposals mandate 5% Secondary market, high Term funding retention, Rep and Warranties at present
Conclusion
Housing has enjoyed extraordinary support from the government for decades. But given the growing fiscal constraints that the nation faces in coming years, it is likely that the government will have to scale back support for the sector. We expect the debate on housing reform to continue over the next few years. We hope that this article provides a framework to help investors understand the choices and trade-offs involved and helps policymakers in their stated goal of constructing a new paradigm for US housing finance.
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US RATES RESEARCH
Ajay Rajadhyaksha Head of US Fixed Income and Securitised Products Strategy +1 212 412 7669 ajay.rajadhyaksha@barcap.com Chirag Mirani Fixed Income Strategy +1 212 412 6819 chirag.mirani@barcap.com Joseph Abate Fixed Income Strategy +1 212 412 6810 joseph.abate@barcap.com Piyush Goyal Fixed Income Strategy +1 212 412 6793 piyush.goyal@barcap.com James Ma Fixed Income Strategy +1 212 412 2563 james.ma@barcap.com
Amrut Nashikkar Fixed Income Strategy +1 212 412 1848 amrut.nashikkar@barcap.com
Michael Pond Treasury and Inflation-linked Strategy +1 212 412 5051 michael.pond@barcap.com Igor Zoubarev Fixed Income Strategy +1 212 526 5518 igor.zoubarev @barcap.com
Anshul Pradhan Treasury and Inflation-linked Strategy +1 212 412 3681 anshul.pradhan@barcap.com
Rajiv Setia Fixed Income Strategy +1 212 412 5507 rajiv.setia@barcap.com
Vivek Shukla Fixed Income Strategy +1 212 412 2532 vivek.shukla@barcap.com
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Analyst Certification(s) We, Ajay Rajadhyaksha, Michael Pond, Chirag Mirani, Igor Zoubarev, Joseph Abate, Anshul Pradhan, Rajiv Setia, James Ma, Piyush Goyal, Kishlaya Pathak, Amrut Nashikkar, Sandeep Bordia and Jasraj Vaidya, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. Important Disclosures For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to https://ecommerce.barcap.com/research/cgibin/all/disclosuresSearch.pl or call 212-526-1072. Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays Capital may have a conflict of interest that could affect the objectivity of this report. Any reference to Barclays Capital includes its affiliates. Barclays Capital and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research with respect to, the asset class covered by the analyst. To the extent that any historical pricing information was obtained from Barclays Capital trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. Barclays Capital produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in other types of research products, whether as a result of differing time horizons, methodologies, or otherwise. 16 December 2010 LAST PAGE
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US Interest Rates Outlook 2011 - Tug of War

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INTEREST RATES RESEARCH

U.S. INTEREST RATES: OUTLOOK 2011

Barclays Capital | U.S. Interest Rates: Outlook 2011

Barclays Capital | U.S. Interest Rates: Outlook 2011

Barclays Capital | U.S. Interest Rates: Outlook 2011

The macro picture: Dj vu all over again?

Barclays Capital | U.S. Interest Rates: Outlook 2011

Figure 1: Similarities between H2 09

S&P 500 Index (LHS)

A round-trip on rates: First a rally, and then a sell-off

Barclays Capital | U.S. Interest Rates: Outlook 2011

Figure 4: US sovereign CDS has not budged recently

1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 9-Dec-10

10y Real Yield (RHS)

5y Spain CDS (RHS)

Barclays Capital | U.S. Interest Rates: Outlook 2011

Interest rate derivatives: Wider spreads but lower volatility

Barclays Capital | U.S. Interest Rates: Outlook 2011

Government affairs: Agency MBS and agency debt

Figure 5: Agency MBS had a good 2010

Figure 6: Foreclosure backlog across states

YTD performance ($)

(%Fcl + %90d) / %REO

Source: Barclays Capital

Barclays Capital | U.S. Interest Rates: Outlook 2011

Housing and housing finance

Making money: The Fed-on-hold trade

Barclays Capital | U.S. Interest Rates: Outlook 2011

Barclays Capital | U.S. Interest Rates: Outlook 2011

I. QE2: Ease harder

Figure 1: Bank reserves ($bn)

Figure 2: Fed funds and bank reserves (%, $bn)

Source: Federal Reserve, Barclays Capital

Barclays Capital | U.S. Interest Rates: Outlook 2011

Lowering OIS expectations

We look for the money market curve to flatten

Collateral removal = lower short rates

Figure 3: Libor 3/6 basis (bp)

Figure 4: Front-end rates, QEv.1 (%)

Fed buys $300bn TSYs

Fin CP GC SFB winds down

Barclays Capital | U.S. Interest Rates: Outlook 2011

QE-driven substitution effects should drag other front-end rates lower

into the low teens

II. Supply and demand fundamentals in 2011

Barclays Capital | U.S. Interest Rates: Outlook 2011

Regulating money funds

Box Figure A: Specials volume (% total GC volume)

80 70 60 50 40 30 20 10 0 Jan-06 Oct-06 Jul-07 Apr-08 Jan-09 Oct-09 Jul-10

Source: Barclays Capital

Source: Barclays Capital

Barclays Capital | U.S. Interest Rates: Outlook 2011

Other related efforts

Figure 5: Intra quarterly repo behavior (quarter end =100)

500 400 300

Apr-08 Jan-09 Oct-09

Source: Federal Reserve

Barclays Capital | U.S. Interest Rates: Outlook 2011

Less leverage = less repo

Barclays Capital | U.S. Interest Rates: Outlook 2011

Money fund appetite

III. Money funds Another difficult year

Money fund balances are likely to get more barbelled