October 24, 2023 | Q: Do the Fed's massive open market operations in 2020-2021 mean that rates stay at current levels for years? But no recession? Yup.
The other day Paul Muolo at Inside Mortgage Finance asked if PIMCO and other Buy Side shops are buying mortgage-backed securities (MBS) in anticipation of an eventual refi boom. Well, maybe, but that depends which coupon MBS you are buying. The to-be-announced (TBA) market summary from Bloomberg for mortgage contracts to be delivered in November is below for your reading pleasure.
Source: Bloomberg (10/23/23)
So if you are a cash investor, and have no concerns about funding costs, then you might buy some of those orphaned low coupon MBS for yield. When and if you get a prepayment, you will receive the principal back at par. You paid in the mid-70s for the security. Capital gain, sabe? Those borrowers with 3% mortgages will need to move or die before they prepay those COVID era mortgages.
But if the effective floor of interest rates is now say 4%, those MBS 2s and 3s may not be in the money for refinance for a long time – maybe a lifetime. If you buy the higher coupon MBS at a higher price, say Fannie Mae 5s at 91, you still get a nice discount to par but much shorter duration – maybe. With the Street selling new production mortgages into MBS with 7% or even 7.5% coupons, it will take a few rate cuts for the mortgages inside those 5% MBS to be in the money.
A number of bond market bears have recently called the turn in interest rates, closing out short positions and positioning for the long anticipated Fed pivot. But what if that pivot turns out to be a pause or better, a back to the future, taking us all the way back to the early 2000s when Alan Greenspan was Fed Chairman.
In January of 2000, the effective Fed funds rate was 6.5%. The brief recession of 2001 so spooked Chairman Greenspan and other FOMC members that they took Fed funds down eleven times to 1% by 2004. That was the year that the private label mortgage market peaked and securitization volumes flowing through Countrywide and Washington Mutual started to fall. Two years later, the private mortgage market began to collapse and the Fed lost control over the US economy. By the end of 2007, the Fed funds rate was zero and much of the financial system was insolvent -- as it is today.
Since 2008, the Fed’s answer to just about every contingency has been to supply massive reserves to the system. As we learned in 2019, however, not all reserves are created equal. First in December 2018 and later in mid-2019, the money markets seized up because the models used by the FOMC to predict the required levels of bank reserves were badly wrong. Even though the Fed was paying interest on reserves, these funds were largely frozen, as we discussed with George Selgin in 2019 (“George Selgin on Frozen Money Markets”).
Now Bill Ackman and Bill Gross are touting a drop in market rates by year end, Bloomberg reports. We wonder about their investment thesis because it seems stale and out of touch with the markets. Yes, there is a lot of dry powder on the sidelines, so much that private investors are taking down private loans points below levels where the credit makes sense. But we do not see a lot of investors lining up to buy MBS or Treasury paper. In fact, the smart money is going the other way, buying mortgage servicing rights (MSRs) on 5x cap rates.
With the quality of the stock market clearly in doubt and PE investors taking desperate measures to liquefy sinking private equity portfolios, the notion of going long duration in bonds strikes us as a bit premature. The buoyant economy and job market are basically the result of the fact that the Fed has refused to drain liquidity from the economy for fear of causing, well, another liquidity crisis. But the Fed’s insistence on paying market rates on reserves means the central bank is going to generate $1.6 trillion in losses to the taxpayer.
Because the FOMC fears to unwind the trillions of dollars in Treasury and MBS purchases made in 2020-2021, the US economy is not responding to the policy signals and is unlikely to do so. All sorts of Wall Street managers and gurus have predicted that the US economy is going to roll over soon, in 2024 for example, but we see most of the damage being done in the financial markets.
The few observers on Wall Street who understand that the FOMC has no idea about the direction of the economy or interest rates will benefit. JPMorgan (JPM) CEO Jamie Dimon has excoriated the Fed, criticizing the central bank for getting their prediction about the economy “totally wrong.” Notice that JPM’s astute management of the duration of the bank’s balance sheet has given them an unassailable lead over other large US banks in terms of operating results.
“I don’t think it makes a piece of difference whether rates go up 25 basis points or more,” Dimon said during a panel at the Future investment Initiative summit in Riyadh, Saudi Arabia. And Dimon is 100% correct. The Fed has become irrelevant to the economic outcome, but is an increasing drag on the federal budget. Losses on the Fed system open market account (SOMA) cost taxpayers over $100 billion in FY 2023.
Meanwhile, Katherine Dogherty of Bloomberg confirms our earlier comment that Bank of America (BAC), by being completely insensitive to market conditions, now has a portfolio of mortgages and other paper yielding less than 3% in a world where funding costs are above 5%. For many banks, rising interest rates are an earnings problem. But for large poorly managed banks like BAC, higher for longer could become an existential crisis if as we suspect the FOMC leaves interest rates where they are for years to come.
As we note in our latest comment in National Mortgage News, the Fed was badly wrong about the “transient” nature of inflation. Then they tied their hands by purchasing trillions of dollars in securities that now they cannot sell, locking the US economy into an interest rate trap that may last for years. We don’t see any recession ahead in 2024, but neither do we see a scenario for interest rate cuts in the foreseeable future. We look for modest rate cuts in 2025, followed by an equally modest boom in mortgage lending and then a long-term correction in home prices a la the 1990s.
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