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July 5, 2023 | As is customary over the period leading up to long holidays, a good bit of interesting news and commentary emerged last week. The big news globally is the slowdown of the Chinese economy. Witness the frantic efforts by Beijing to address a deflation led by a collapsing real estate market. Much of China's malinvestment in housing, as well as the "belt & road" boondoggle, was funded in cheap dollars. But overinvestment in housing is not a situation unique to communist China.
If China has created too much housing stock, the US has too little, resulting in rising prices for existing homes. As we noted in our last issue, prices for existing homes started to rise again in 2023, defying efforts by the FOMC to calm inflation by crushing the US housing market. Rising home prices, however, may not be your only problem if you own a home in Florida.
Last week our friend John Dizard, formerly of the Financial Times and now a free man in Paris, described the building train wreck involving residential property insurance in Florida and GOP Governor Ron Desantis (“RON DESANTIS AND THE FLORIDA HOME INSURANCE UPRISING”). John writes:
“A fair number of homeowners will have extreme difficulty finding affordable property insurance. No home-owners insurance means no access to mortgage financing supported by the US government’s housing agencies. This is a real wake-up from the Florida Dream. Reasonable people might say this set of problems was not created by Governor DeSantis, but he happens to be Governor right now, this year and next year, when the reckoning is coming due.”
So say, for example, that a homeowner gets subsidized homeowner's insurance from the State of Florida, but the insurance lapses after six months and the homeowner cannot afford market rates. What happens to the loan? This is a question you can be sure is attracting the attention of Sandra Thompson, Director of the Federal Housing Finance Agency and regulator of Fannie Mae and Freddie Mac.
A conventional loan with lapsed property insurance on a home in Florida is a perfect candidate for a putback claim to the issuer. But will those conventional issuers still be answering the phone a year from now? As we’ll be discussing in our next Premium Service issue of The IRA, there are a few names in the world of housing finance that have run up double digits in the past year but may disappear in the next twelve months.
“Mortgage fintech Better.com — which still clings to the hope of becoming a public company — lost $89.9 million in the first quarter of 2023, according to updated financials filed with the Securities and Exchange Commission,” Inside Mortgage Finance reported on July 3rd. “In 1Q22, the New York-based lender lost $328.9 million and spilled (combined) red ink of $1.19 billion in 2021 and 2022, the amended S-4 filing states.”
The world of secured finance is still coming to grips with the idea of several more increases in the federal funds rate this year. Higher for longer seems to be the consensus in the world of mortgage finance and the market for US Treasury paper. Accordingly, MUFG Securities is revising its 30-year current coupon basis target for the end of 2023 upward to 120-130 basis points from an original December 2022 forecast of 100 basis points,” Bloomberg reports.
“[T]he FDIC liquidations of the failed banks’ agency MBS portfolios has gone well leading us to conclude an underlying strength in the demand for agency MBS relative to anemic net supply,” wrote Glenn Schultz, head of mortgage prepayment & strategy at MUFG, in a June 22 report. This suggests that the Federal Open Market Committee has ample room to sell mortgage backed securities (MBS) into market strength. But what about deflating China?
Even as the Fed and other global central banks fret about inflation, a collective problem created by years of sovereign bond purchases, few in the analyst community have noticed that higher interest rates are creating a largish recession in secured finance. Driven by the short end of the yield curve, secured finance is the part of the economic complex where jobs are created and economic growth occurs.
One hint of a growing problem is securities issuance. Private new issuance levels are falling as banks ratchet-up the sale of loans and securities, and build piles of cash, a dangerous recipe for global deflation in 2024. If you take out the Treasury (green) and agency (yellow) issuance from the SIFMA chart below, the remaining mortgage, corporate and ABS issuance is weak.
Source: SIFMA
US bond issuance is falling due to rising interest rates. Chinese demand for dollars is falling due to deflation in housing and inflation in US interest rates. Bloomberg reports that “Chinese firms’ dollar-bond issuance hit the lowest level in a decade during the second quarter, and there are few near-term catalysts to reverse the trend as cheap onshore borrowing costs and economic uncertainty persist.” Fewer bonds in the offshore dollar market means less demand for dollars?
Specifically, Bloomberg claims that dollar debt issuance by Chinese firms has fallen almost 80% year-over-year as Beijing cuts borrowing rates to counteract a severe deflation in the property sector. Since peaking near ¥6.6 per dollar, the Chinese currency has depreciated rapidly as shown below. If Beijing supports internal demand with further domestic monetary emissions, will the dollar strengthen further, hurting Chinese imports from nations around the world?
Even as bond yields in the US are struggling higher, and expected cap rates are extending accordingly, the bid for private assets is weakening. Investors will seek shelter in risk free Treasury and agency exposures, forcing yields even lower, but a larger opportunity beckons to institutional investors, both short and long. As banks and even the GSEs regurgitate low-coupon assets, will prices fall further?
The Buy Side crowd is talking bank stocks up on the belief that this time is like last time, but maybe not. Maybe stagflation is the next leg for the global economy, led downward by China. President Xi has indicated that bolstering domestic demand is the priority for China in 2023 and beyond, but China’s leadership is still reeling from the policy errors during COVID and demand shows little signs of recovery.
“If Chinese consumers stay home and the property rebound stalls,” China Beige Book notes, “Beijing will probably support the economy through policy, still giving investors what they have long wished for.” Such happy sentiments may please the vanity of Buy Side global equity managers, but underestimate China’s capacity to choose very badly when it comes to economic policy. Robert Shapiro writes in The International Economy:
“Apart from the unknown, there is one clear, potential threat to China’s growth and progress: President Xi’s determination to concentrate all important decisions in himself and a loyal coterie while building an advanced surveillance state to identify and eliminate any nascent challenge. The combination deprives Xi and his government of the broad array of information and analysis that prudence and experience require for cogent decision making… Xi’s irrational approach to the pandemic suggests that he is not immune from terrible decisions that would imperil China’s economic prospects.”
During the period of low interest rates in the US, China used dollar financing to fund the absurd belt & road demand creation initiative, Xi Jinping's version of Mao's Great Leap Forward. Now with higher dollar interest rates, China is stalling. Can lower costs for local currency financing catch the falling knife in the Chinese property sector? And if the FOMC keeps interest rates at or above current levels, will prices for US residential housing fall?
In the next Premium Edition issue of The Institutional Risk Analyst, we’ll review the world of mortgage lenders and servicers as the markets get comfortable with the idea of higher interest rates for longer than just 2023.
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