Geithner Vs Gross Round 2: Is The Latest "Market Normalization" Proposal By The Treasury A Warning Shot Fired Straight At Alarmist PIMCO?

Tyler Durden's picture

For months Bill Gross has been very vocally antagonizing the US Treasury by telling anyone who cared to listen that US debt is nothing short of the world's biggest ponzi and that Ben Bernanke is satan. For the longest time Tim Geithner took this effrontery peacefully, always willing to offer the other cheek. Until last night. In what is quite possibly a direct warning shot fired straight at Pimco's primary revenue driver, the Treasury has made it clear Bill may want to focus on unicorns and rainbows in his next monthly letter.

What happened?

Earlier this week, The Treasury Borrowing Advisory Committee ("TBAC"), a advisory group chaired by JP Morgan's Matt Zames and Goldman Sachs, which also counts PIMCO among its members, basically made it clear that the hedge fund crew is firmly behind the debt ceiling hike, as an alternative would result in fire and brimstone falling from the sky - in other words the end of the Ponzi would mean the end of the world. And they should know: after all it is the same Matt Zames of whom JPM's John Hogan said back in 2007: “For whatever it[’]s worth, I am sitting at lunch with Matt Zames who just told me that there is a well-known cloud over the head of Madoff and that his returns are speculated to be part of a [P]onzi scheme.” Considering how right Zames was about Madoff, perhaps we should take his word for that far, far bigger ponzi scheme, the United States. In other words, the TBAC made a mortal enemy out of living within one's means (let alone austerity): surely such a mindboggling concept would be the end of Wall Street (which urgently needs to double world GDP to $200 trillion by 2020 to keep record bonuses flowing). Oddly enough the TBAC's sister organization at the New York Fed: the Treasury Market Practices Group ("TMPG"), which has most of the same member firms (except for PIMCO, relevant in a second, and also "curiously: has Matt Zames presiding on that particular group) may have made a comparable, though far more powerful enemy, out of PIMCO, after it proposed the introduction of fails charges for MBS trades, an action that is a direct affront to none other than Bill Gross' PIMCO, one of the world's most active managers of MBS/Agency securities. Should the proposal by TMPG, which as Bloomberg's Jody Shenn summarizes would affect traders in agency debt and mortgage bonds, forcing them to pay as
much as 3 percent in penalties in the case of trade fails, be enacted, PIMCO will not be happy. In fact, PIMCO has already said this fee "would damage the market." In other words, we now have the group that has perfected MAD to an artform, seeing splinters within it, which are warning of itheir own version of MAD. In yet other words, PIMCO is now threatening with MAD if the debt ceiling is hiked and if MBS traders are forced to actually pay for delivery failures. How long before one actually runs out of MAD cards? And did the Treasury just directly take on the $1.4 trillion bond manager which has made its feelings about US debt all too clear over the past few months.

So just what has gotten PIMCO's panties in a bunch? Bloomberg explains:

The U.S. central bank’s decision to hold benchmark interest rates at record lows has encouraged failures by reducing the cost of uncompleted trades, while its purchase of $1.25 trillion of mortgage bonds through March 2010 has made it more difficult to find bonds to settle contracts in a timely manner.

Uncompleted trades in agency mortgage securities remain elevated after rising to a record of almost $2.4 trillion during a week in November, according to Fed data.

Failures to receive or deliver the securities, which totaled $1.5 trillion in the week ended April 20, averaged about $330 billion weekly over the past 10 years, according to Fed data. The tallies are inflated by incomplete trades that continue over multiple days and are increased by strings of failures that can occur when a single party doesn’t settle a contract.

So, as a result, in order to "normalize" the market suddenly even though this has been happening for a long, long time...

The Treasury Market Practices Group, which the Federal Reserve Bank of New York helped form in 2007 to offer advice on debt markets, today proposed [that] Dealers and investors that fail to complete trades in agency debt and mortgage bonds may pay as much as 3 percent in penalties. That followed the introduction of a similar practice for U.S. government bonds that the organization backed in 2009...[This is] a fee Pacific Investment Management Co. says would damage the market.

More on a proposal that is so overdue, one can't help but wonder "why now."

The new charges could be as much as 3 percent of the trade size, with the formula based on a similar system for U.S. government debt, said Wipf, also a Morgan Stanley banker, in a telephone interview. The daily charge would be reduced by the Federal Open Market Committee’s lowest current target for the federal funds rate and divided by 360.

The answer to the above question comes when reading PIMCO's response:

The fail charge is too high and will be counter- productive,” Scott Simon, Newport Beach, California-based Pimco’s mortgage-bond head, said in an e-mail. “While it will reduce intentional fails, we believe it will sharply reduce liquidity and incent accounts to attempt short squeezes.”

A 1 percent fee “would be a much better level,” said Simon, whose firm manages the world’s largest bond fund.

Well, it may not lead to "market wide" short squeezes. But it will certainly lead to pain for the biggest private market participant in the space.

As for "why now" the TMPG has this laughable reason:

Reducing uncompleted trades is necessary because for individual companies, “fails can increase operational costs and counterparty credit risk, absorb scarce capital through regulatory charges, and damage customer relations,” the TMPG said in a paper released today.

“More generally,” the group added, “the prospect of persistent settlement fails at a high level can cause market participants to temporarily withdraw from the market, or even exit the market, adversely affecting market liquidity and stability.”

Uh, we have had record fails for an unprecedented amount of time, but yes, "customer relations" could be impaired. Especially if these are the same customers who listen to PIMCO and dump their securities.

And the most ironic thing is that at its core, this "customer relations" problem  again the fault of none other than the Fed.

The Fed’s decision to hold its target for the federal funds rate in a range of 0 percent to 0.25 percent since 2008 has helped encourage fails because it lowers the cost of not receiving cash in exchange for the promised securities. In a higher-rate environment, dealers would lose more because that cash could be invested at higher yields.

Lower rates boost the incentives for investors or dealers that want to “short,” or bet against, mortgage-bond prices to delay delivering bonds into sales contracts, according to the group’s paper.

Most transactions in the mortgage-bond market are conducted through so-called To Be Announced trading, which also adds incentives to fail on those contracts. TBA contracts can be filled through delivery of securities with a range of characteristics, rather than specific bonds

So while it is somewhat amusing that now according to the Fed's two way sock puppets, the market which is now beyond manipulated by the Fed, needs to promptly eradicate this one side effect of its endless meddling, a far more exciting possibility is that the Treasury has now taken a direct jab at PIMCO, which is certainly Tim Geithner's way of telling Gross to shut up with his endless Ponzi scheme references about the US economy, and satanic comparisons for Ben Bernanke. We expect to have the leaked data of PIMCO's April TRF holdings within the week. We will inform readers then if this tactic of unprecedented bullying by Tiny Tim has worked. But far more importantly, if this action was indeed taken with PIMCO (and an appropriate warning) in mind, it means that things are really starting to unravel.