The Worlds' Largest Hedge Fund (yes, that one, the one owned by you and I, the U.S. taxpayer) may now be adding additional securities to its portfolio. According to a recent Bloomberg article, the Fed is considering expanding the Term Asset-Backed Securities Loan Facility (TALF) to include loans for the purchase of Commercial Mortgage Backed Securities (CMBS). As you may recall, the TALF was developed to provide low-cost Federal Reverse loans that would be used to buy securities backed by consumer debt - essentially using taxpayer money to provide debt to help other taxpayers purchase the debt of still other taxpayers that took out too much debt [Yes, I know, using debt to solve a problem caused by too much debt does not really make sense, but I digress]. Anyway, since the TALF has previously been used to purchase securities tied to automotive debt and credit cards by offering three-year loans, why not try it now using five-year loans for commercial real estate? After all, it has been so successful for the auto and credit card industries (GM, Chrysler, and a White House Presidential scolding of credit card executives, notwithstanding - tongue in cheek, of course).

All kidding aside, it is hoped that such loans will create buying pressure for CBMS, thereby decreasing yields - many of which are near junk levels, making it unprofitable for banks to make new loans at such high yields. The down fall, of course, is that with such loans having a five instead of three year maturity, it will be even harder for the Fed to timely withdraw money from the system in later years, just when inflation is likely to creep back with a vengeance as the economy begins to hopefully recover. While maybe too late, at some point we are going to have to ask, are we preventing collapse and saving entire industries, or are we simply, and needlessly, juicing the system in order to save a few select companies, all the while unnaturally speeding-up the recovery? If the later, we may want to start planning for the hangover now.

The gap between the 10-year Treasury note and the 15-year / 30-year fixed-rate mortgages has narrowed, not surprisingly, since the Federal Reserve began actively buying mortgage securities in January (see Bloomberg article). The average rate on a 30-year fixed mortgage fell to 4.96 percent in January, the lowest it has been when considering data that goes back to 1971. Rates were recently at 4.98 percent. With a promise to increase mortgage-backed security purchases by an additional $750 billion, along with as much as $300 billion in Treasury purchases over the next 6 months, rates should continue to be under pressure in the near term. As the Fed continues to support low rates in hopes that consumers will either refinance or make a new home purchase, others are also encouraging consumers to purchase now, but for different reasons. Given the flood of money entering the market, consumers will eventually begin seeing inflationary pressures. Now may be the time to act while both rates and prices are low.

Changing rules, even when the change may ultimately be good, can be disruptive. As a result of the change in the TARP from buying troubled assets to injecting capital directly into companies, the credit markets have once again reversed course (see Financial Times article). The fact that now there are no buyers for some toxic assets has the value of some mortgage-related securities falling to new lows. Jay Mueller, portfolio manager from Wells Capital Management, said it best:

“Now those markets will go back to being completely illiquid as there will be no price discovery process started by the Tarp. It is tremendously difficult to trade when the rules of the game change.”

Now that the government has realized that it cannot justify and support non-market prices, the banks and other holders of toxic debt will have no choice but to further discount and account for reduced asset values. For the rest of us, this just means more volatility, lower asset values, and a market that continues to suffer under its own weight. At this point, "building a bottom" may be the best we can hope for in the near term.

Initial results show that the Credit Suisse / Tremont Hedge Fund Index was down 5 percent in October (see MarketWatch article) - final numbers will be released on November 17th. Not surprising, fixed income arbitrage suffered some of the worst monthly losses, losing 17.75 percent. Emerging markets were close behind with 15.36 percent in losses. Fixed income managers have suffered as a result of loses in mortgage-backed securities and corporate bonds, each of which have fallen in price due to a combination of decreasing credit quality, forced selling, and decreased liquidity. Managed futures and short bias funds are both up for the month, and year-to-date. Convertible arbitrage is down the most year-to-date, losing 19.45 percent (which while bad is still better than the broader market losses).

Jerry Webman of Oppenheimer Funds discusses bond market pricing and value. No specific names, but mentions that some individual mortgage-backed tranches offer value if you can find securities that are tied to financial companies with strong balance sheets, or at least companies that have the ability to repair their balance sheets. You need to be a long-term holder, but at least you are getting paid to wait (hopefully).

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