The Treasury Auctions That Nearly Failed

The financial crisis was a truly strange and stressful time to be a trader on Wall Street.  For one thing every firm's stock price was seesawing around like crazy and you never knew for sure how stable your job was.  The other thing was liquidity in the markets shut down.  If you got caught in a bad trade it was nearly impossible to get out of it.  Bid/Ask spreads (the difference between where a market maker was willing to buy and sell a security) were the widest anyone had seen since the advent of electronic trading.  In the midst of all this chaos, the Treasury department was issuing tons of securities to pay for all the bailouts and programs they were unveiling on a near daily basis.  Two of these auctions nearly failed.


The 4 Week Bill Auction That Saved The Street

On Monday September 15, 2008 Lehman Brothers declared bankruptcy after last minute negotiations to sell the firm broke down.  This set off a chain events.  The very next day The Reserve Primary Fund the oldest and one of the most respected money funds in the world announced that it had "broken the buck".  After writing off investments in both Lehman Brothers commercial paper and Lehman Brothers asset backed paper, the fund was now worth 97cents on the dollar.

While not guaranteed, money funds were considered a very safe place to put excess cash.  Corporations and individuals counted on them to generate safe returns.  What many investors didn't realize was, that over the years money funds had become one of the biggest drivers of the subprime bubble.  banks and other investment managers set up conduits to buy low rated mortgage backed securities.  These conduits then issued highly rated asset backed commercial paper to pay for these investments.  The conduits were taking advantage of the large spread between subprime mortgage bonds and where they could issue commercial paper.  Money funds were buying  this asset backed commercial paper to generate higher returns.  It was a vicious cycle that was about to come to a crushing halt.

As investors panicked and dumped their holdings in money funds, money funds were forced to liquidate their investments.  Soon money funds were preemptively selling assets and investing only in treasury bills.  This allowed them to stay ahead of redemptions and be invested only in low yielding liquid securities.  As a result 4 week treasury bill yields plummeted.  Take a look at the auction results for the 2 weeks prior to Lehman Brothers bankruptcy and the 2 weeks afterwards.

9/2/08           1.54%
9/9/08           1.575%
9/16/08         0.30%
9/23/08         0.35%

Besides shocking treasury bill yields lower, this reallocation by the money funds caused huge distortions in the other major money markets (agency discount notes and commercial paper) that I'll talk about at another time.

On 9/30/08 the Treasury department was again set to auction 4 week bills.  The week pior they had auctioned off $28billion at a discount rate of 0.35%.  The week of 9/30/08 they were set to auction $25billion 4 week bills off.  All morning dealers and customers had been trading the WI (when issued security) at yields between 0.30% and 0.40%.  There was every reason to expect that the auction would come at a similar yield as the week before.  I remember selling a customer a few hundred million at about 0.35% and joking with him that he had just cost me my month's pnl on that trade.  Everyone was very punchy and trading was lackluster to say the least.  Myself and most of the street were short the WI security and looking to cover our position in the auction.

On 9/30/08 the Fed Funds Rate, the target rate for where banks would lend each other excess reserves was still at 2%.  There was really no reason for anyone to be excited about a 4 week bill yielding 0.35%.  Yet given the recent auction history, no one expected a very different result.  This is in part due to the primary dealer system that the Federal Reserve has set up.  In order to become a primary dealer and be able to bid on securities in auctions and to use the federal reserve facilities dealers must ensure that no treasury auction fails.  They do this by always bidding in each auction and for large amounts above and beyond what they require to cover any short positions.

The 9/30/08 4 week bill auction arrived at 1.01%.  This was a tail of roughly 61bps.  The largest on record.  The DV01 (dollar value of a bps) on a 4 week bill is roughly $8/million.  So for every million dollars of the 4 week bill that a dealer had sold prior to the auction and then covered at the auction they had generate $488.  This may not sound like a lot, but on a couple $100million short position this quickly adds up to hundreds of thousands of dollars.  On the entire auction the Treasury had just gifted the market $12,200,000.  Dealers having made up 14billion of the 25billion in awarded bids did very well.  For banks and dealers who had been getting kicked around much of the week by the money fund volatility it was a much needed shot in the arm.

The Treasury Learns  A Lesson in Turn Around Time

The closest auction to ever come to a fail was the reopening of 4 1/4% of 5/15/2015.  On October 8, 2008 at 10:30 a.m. the Treasury announced that to help mitigate the fail problems associated with several off the run 10year note securities they would be reopening $10billion of 4 securities  (3.5% of February 15, 2018, 4.25% of August 15, 2015, 4.125% of May 15 2015, and 4.0% of February 15, 2015).  The first security, the 4 1/4% of 5/15/2015 would in fact be auctioned off later that same day.  This was a huge change in Treasury policy.  In the past the Federal Reserve had relied on the markets to cleanup fail problems.  They would often call for a large position report to try and ascertain what the cause of the problem was, but never before had the Treasury been convinced to do a snap reopening of a security.  As it would turn out it was also a huge gamble.

The 2015 sector of the bond curve was trading extremely rich (all in anticipation of the Treasury announcing they would start auctioning off 7 year securities possibly) as much as 10bps rich to fair value and sometimes even more.  On announcement those lucky enough to still be short these securities and not to have capitulated had already made a paper windfall.  What followed in that days auction made them more money than they could have imagined.

As we traders sat around joking about how much money we had made or lost based on this random reopening of the 2015 sector, our head trader received a very strange call.  The Federal Reserve rang him on the desk and berated him for not helping to underwrite the auction.  They reminded our trader that he had an obligation to bid for this auction.  Our trader began frantically writing us notes to sell more 5year and 10year notes into the screens.  This auction was going to be messy.  We upped our bids slightly for the auction at levels we felt were far back from where the auction would stop and we waited.

At 1p.m. when the auctioned closed, there were just $12billion in bids for the $10billion in securities.  The market had been expecting something on the order of a 2.95% yield on the reopening.  Instead it tailed 36bps to 3.31%.  A 7 year note with a DV01 (dollar value of a bps) of roughly $690 translates into a lot more money gifted to the street.  Over $24,800 per million dollars of the security you had been short.  For the entire auction this 36bps tail had cost the Treasury roughly $248,400,000.  The banks and dealers had made a fortune as they were awarded $8billion of the $10billion in securities.  The Treasury had learned a valuable lesson on how quickly they could announce and then auction securities.  Despite incredible demand for this particular security, the 2 1/2 hour turnaround time was insufficient to alert everyone that might have wanted to bid in the auction.  The dealer community had learned to always put in a large bid well back of the expected auction rate just in case.  The rest of the reopenings went off with minor tails.