Question : What Will Happen To The Banks If The Market For Treasuries And Gilts Blows Up ? ?

[stormymonday_2011]

Yesterday I was looking at the crash in the US Long Bond that took place between 1930 and 1932 when the Great Depression was at its height

In that period there was over 30% drop in the price of this Treasury instrument.

Now as I understand most of the bailout money given to banks to prop up their ailing balance sheets has taken the form of government gilts etc rather than cash. My question is how are these items valued in the event of a government bond market crash ?

Are they always valued at their maturity value of 100% or do they have to be marked to their current value(unlike CDOs there will never be any doubt about their price on a given day)?

In addition if they slump in value will they not lose some of their liquidity as banks will be loath to trade them for cash as it will force them to take a write down ?

Is this why Bernanke is getting so twitchy about "bond market instability." ?

I have to confess the more I look at that 1930s chart the more uneasy I feel.

Edited January 27, 2009 by up2nogood

[wonderpup]

I'm no expert, but I thought the plan was to bypass this trivia and just print up the cash?

[BXLONDONMAN]

I'm no expert, but I thought the plan was to bypass this trivia and just print up the cash?

they are but the result will be the same bust !!!

[stormymonday_2011]

I'm no expert, but I thought the plan was to bypass this trivia and just print up the cash?

I think you might want to read the attached

http://market-ticker.denninger.net/archive...-Game-Over.html

[kilroy]

Yesterday I was looking at the crash in the US Long Bond that took place between 1930 and 1932 when the Great Depression was at its height

In that period there was over 30% drop in the price of this Treasury instrument.

Now as I understand most of the bailout money given to banks to prop up their ailing balance sheets has taken the form of government gilts etc rather than cash. My question is how are these items valued in the event of a government bond market crash ?

Are they always valued at their maturity value of 100% or do they have to be marked to their current value(unlike CDOs there will never be any doubt about their price on a given day)?

In addition if they slump in value will they not lose some of their liquidity as banks will be loath to trade them for cash as it will force them to take a write down ?

Is this why Bernanke is getting so twitchy about "bond market instability." ?

I have to confess the more I look at that 1930s chart the more uneasy I feel.

If you want to feel really uneasy, read about 1873

[KingBingo]

Now as I understand most of the bailout money given to banks to prop up their ailing balance sheets has taken the form of government gilts etc rather than cash.

My question is how are these items valued in the event of a government bond market crash ?

Are they always valued at their maturity value of 100% or do they have to be marked to their current value

A bond is almost always issued with a face value of £100. In addition you will receive a coupon. Normally these are sold at a slight discount.

So a 6%, 5 year bond might be issued by say Tesco. It will cost you £98.75 to buy the bond. Each year it will give you £6, and if you hold it to maturity you get £100 when it is redeemed.

So if you hold the thing for 5 years no big deal.

However, you can trade bonds, the current interest rate dictates their price. If in an extreme example interest rates where to increase to 12%, you would not buy a new bond from Tesco at 6%, when you could simply leave your money in the bank and get double that. So obviously Tesco would need to either drop their price, or more likely increase the coupon it pays.

But there might be existing bonds. So let’s say you bought a 6% Tesco bond at £98.75 when interest rates are 4.5%. Your gaining £1.25 over 5 years, plus a 6% coupon. Or the risk free rate plus the risk premium of 1.5%

Then a week later interest rates now shoot to 12%. You cannot sell your riskier asset at the same price. You need to reinstate the risk premium, and you do that by selling the bond for a lower amount, so that the capital gain to maturity becomes a more significant part of the return.

So this explains what drives a bond price.

Now a gilt is government backed, so it has no risk premium, it is considered riskless (almost) which is why it would be a very very bad thing if Britian lost its AAA rating. Spain for example was downgraded to AA+. This means it has to issue gilts with a risk premium, increasing its already high cost of borrowing.

So in answer to your question yes they have to be marked to their current value. That should not happen to gilts unless things get so bad we get rerated.

Or existing gilts can lose tradable value if the interest rates move up.

[KingBingo]

Another point to make about the 1930’s. All bonds crashed as the risk premium demands shot up before anyone would buy them. Additional there was very little liquidity in the system to buy any bonds.

I used earlier the example of the Tesco bond having a risk premium of 1.5%. Actually theirs is lower.

Usually BBB rated bonds have a 150 basis point (1.5%) premium. Like it was before 1929. Like it was before 2008. A BBB bond is about as low as you can go before it gets referred to as a junk bond.

It was as if there was no appreciation of risk. I felt this was perhaps due to greed. Now its around 800 basis points. It suggests to me that there is now too much risk aversion. I think its down to fear. Which is why I’m now buying into bonds.

I mentioned above if you hold a bond to maturity you get your £100 back. Unless the issuer cannot pay. Which is also why Government bonds are considered riskless. They can always tax us enough to pay up.

What happened in the period you showed in your graph was that defaults rates went from 2-4% to 25-30%. And interest rates remained high.

Then as now suggested a buying opportunity.

Edited January 27, 2009 by KingBingo

[domo]

This might have just started, look at the animated yield curve on yieldcurve.com and its happened to the longs ends of both US and Gilts, both up 1% just recently. I guess its like the opposite phenomenon of the yield curve going very inverted when the economy overheats, and when the economy slumps real bad the curve uninverts dramatically.

[GordonGekko]

A bond is almost always issued with a face value of £100. In addition you will receive a coupon. Normally these are sold at a slight discount.

So a 6%, 5 year bond might be issued by say Tesco. It will cost you £98.75 to buy the bond. Each year it will give you £6, and if you hold it to maturity you get £100 when it is redeemed.

So if you hold the thing for 5 years no big deal.

However, you can trade bonds, the current interest rate dictates their price. If in an extreme example interest rates where to increase to 12%, you would not buy a new bond from Tesco at 6%, when you could simply leave your money in the bank and get double that. So obviously Tesco would need to either drop their price, or more likely increase the coupon it pays.

But there might be existing bonds. So let’s say you bought a 6% Tesco bond at £98.75 when interest rates are 4.5%. Your gaining £1.25 over 5 years, plus a 6% coupon. Or the risk free rate plus the risk premium of 1.5%

Then a week later interest rates now shoot to 12%. You cannot sell your riskier asset at the same price. You need to reinstate the risk premium, and you do that by selling the bond for a lower amount, so that the capital gain to maturity becomes a more significant part of the return.

So this explains what drives a bond price.

Now a gilt is government backed, so it has no risk premium, it is considered riskless (almost) which is why it would be a very very bad thing if Britian lost its AAA rating. Spain for example was downgraded to AA+. This means it has to issue gilts with a risk premium, increasing its already high cost of borrowing.

So in answer to your question yes they have to be marked to their current value. That should not happen to gilts unless things get so bad we get rerated.

Or existing gilts can lose tradable value if the interest rates move up.

Not really true - securities are held on balance sheets in one of three categories - Held for trading, available for sale and held to maturity. To cut a long story short, if the company plans to hold the securities for their entire life, they are amortized over the security's life and are not affected by changes in value in the financial markets.

[interestrateripoff]

What happened to the Souths bonds during the US civil war? They printed money.

[rw42]

I think you might want to read the attached

http://market-ticker.denninger.net/archive...-Game-Over.html

Holy crap :/

And our esteemed leaders are considering doing the same :s

[Gone baby gone]

What will happen to banks?

Well, let's say there are going to be plenty of opportunities for J.D.Wetherspoons.

[uncle rogi]

Is this why Bernanke is getting so twitchy about "bond market instability." ?

I have to confess the more I look at that 1930s chart the more uneasy I feel.

he is twitchy because he knows that what is coming is worse than the depression for example debt to GDP is now 100% more than it was then.