R. Christopher Whalen
May 4, 20225 min
Updated: May 5, 2022
"Without price stability, the economy really doesn't work for anybody."
Jerome Powell
May 4, 2022 | Premium Service | In this issue of The Institutional Risk Analyst, we return to the topic of interest rates, credit and mortgage assets. For the past several years going back to April of 2020, the housing market has been turbo-charged by quantitative easing or QE, pushing interest rates and loss-given default (LGD) down to negative levels. BTW, we just updated our latest paper on Ginnie Mae mortgage servicing assets.
With the increase in interest rates now set in motion by the FOMC, which moved by unanimous vote this month, our assumption is that credit default expenses for banks and bond holders will begin to revert to the mean. This repricing of risk will take time, perhaps several years. But if we assume that the FOMC means to wring the inflation out of the system, then the outlook for short-term rates – and credit over the medium term -- is decidedly bearish.
When LGD on a mortgage loan or secured bond is negative, that means that after a default, the proceeds generated upon liquidation exceed the original amount of indebtedness. In 2009, LGD on the average 1-4 family mortgage was 80-90% vs the 40-year average of 65%. Twenty three years and 5 QEs later, LGD on prime bank owned 1-4s is essentially zero and inflation is in double digits. As the FOMC raises interest rates significantly for the first time since 2008, we see major inflection points coming in credit as well as interest rates.
The chart above from Bloomberg illustrates how strongly the FOMC has been holding down the short end of the curve. This chart also symbolizes the degree of inflation in asset prices that the Fed has facilitated, an important relationship that is now about to change. Since default rates were muted during the entire decade of the 2010s, the mean reversion could be far larger than expected.
As the FOMC raises the target rate, the short-end of the curve will adjust accordingly. But everything from 2-year Treasury notes on out is above 3%. Obviously, the FOMC is behind the curve both figuratively and actually. This is perhaps one reason why St Louis Fed President James Bullard and others on the Committee are calling for faster action by the FOMC. Consistent with his strategy, Chairman Jerome Powell continues to move deliberately.
We interpret Powell’s caution as a recognition that the US market cannot tolerate a very significant upward move in short-term interest rates. This caution is reflected, we believe, in the average structure of the infamous dot plots, which show Fed Funds rising to less than 3.5% through 2024.
Listening to the press conference, it seems pretty clear that the "transitory" view of inflation is alive and well. Powell is slow walking inflation fight to avoid a market meltdown. Even the modest pace of change, however, suggests much higher long-term interest rates and a recession ahead. Even as Powell signals willingness to take interest rate targets higher, he has put off a decision on the Fed's balance sheet until June. That is perhaps one of the most important take-aways from this Fed meeting.
Mortgage Servicing Rights
The table below shows the mortgage servicing rights (MSR) results for JPMorgan (JPM), Wells Fargo (WFC), Mr. Cooper (COOP) and New Residential (NRZ). With the Fed’s 50bp rate hike this week, you would think that the owners of MSRs would be cheering. After all, because MSRs are negative duration assets with cash flow, when interest rates rise and bond and loan prices fall, the value of MSRs goes up. The marks on the MSRs are raising a lot of eyebrows as well, on Wall Street and also in Washington.
Mortgage Servicing Rights
Source: EDGAR
Looking at the strong upward increases in fair value (FV) for MSRs in Q1 2022 earnings the sky seems to be the limit. But not all MSRs are created equal and not all buyers have a good understanding of the risk involved. Over the past several months, officials at Ginnie Mae have actually approached a number of issuers, asking for pricing and methodology details on past MSR purchases. The response reported from issuers universally has been “November Foxtrot Whiskey.”
Why would the folks from Ginnie Mae’s risk function feel the need to make such a request? The short answer is that loan delinquency is rising and regulators are starting to worry that Buy Side investors and smaller independent investment banks are not sufficiently well-capitalized to navigate an increase in loss mitigation activities. While players such as JPM are highly selective in their purchases and prefer conventional or jumbo assets, the same cannot be said for the rest of the industry.
As we noted in the revisions to our Ginnie Mae paper, the factors affecting the value of mortgage loans and MSRs are highly varied and also, thanks to QE, extremely volatile. We note:
During 2020-2021, the embedded option to refinance was one of the chief valuation metrics employed by secondary market participants as MSR prices neared record levels. Some leading issuers were selling MSRs are a premium in 2021, on the one hand, but then paying top prices for other MSRs that were thought to have high potential for loan refinance. The same market factors in 2020-2021 encouraged issuers to buy delinquent loans out of GNMA pools in the hope of remediating the delinquency and selling the modified loan into a new pool, capturing a 3-4 point gain-on-sale.
Another adverse factor that is not always recognized in valuations of MSRs is the probability of default of the underlying loans, an important factor that can quickly change and thereby impact the profitability of an MSR. Valuations for MSRs tend to be overstated (and capitalization rates are therefore too low). Over the past several years or record MSR valuations, the embedded default risk in the asset was understated due to future default risk. Yet it is possible to lose money on one’s investment in a GNMA MSR through the economic cycle.
One way to view the suppression of default risk due to low interest rates is loss given default (LGD) on 1-4 family mortgages. Chart 5 below shows LGD for $2.6 trillion in bank-owned 1-4 family mortgages, a mostly prime population of fully documented, above-average size residential mortgages. Notice that the series skewed deeply negative during the period of the largest quantitative easing by the FOMC vs the long-term average LGD in the 60% loss range.
Source: FDIC/WGA LLC
As interest rates rise and the US economy slows, we expect to see the rate of delinquency in bank portfolios and bonds begin to normalize. In the case of 1-4 family loans, that would put default rates in the 25-50bp range and delinquency in the 2-3% range, but that process of normalization could take months or even years. If we adjust current rates of default and delinquency for the degree of extraordinary ease provided by the FOMC, that could imply credit loss rates that are above the average levels for the past decade.
“Our tools don’t work on supply shocks, they work on demand,” Chairman Powell noted in his press conference. Powell intends to focus on the demand side of inflation and also price expectations, this this suggests to us that interest rates could remain elevated for some time to come.
That said, Powell is in no hurry, looking for no more that 50bp at a time. And perhaps most important, Powell recognized the uncertainty of shrinking the balance sheet. He wants the rate of interest to be the primary tool of policy, thus the FOMC seems to be using the symbolism of rate increases and not the reality of balance sheet shrinkage.
As Michael Pak at TCW summarized: “Given the relative insensitivity to the Fed’s policy rate of the supply side factors impacting inflation, the central bank is left with the uncomfortable choice of weakening the demand side of the economy thus risking recession in the process.”