QT & Powell's Liquidity Trap
Updated: Mar 10
February 27, 2023 | Watching the debate over interest rates and the economy, it is a point of fascination to The Institutional Risk Analyst that virtually nobody in the economic profession or media talks about the Fed’s balance sheet. Indeed, by expanding its balance sheet via quantitative easing or QE, the Federal Open Market Committee arguably lost control of monetary policy and has placed America's banks in grave risk.
Since the start of the Fed’s tightening, the nominal size of the system open market account or SOMA has declined, but the duration-adjusted value of the portfolio and the entire mortgage finance complex has exploded several-fold. Mortgage-backed securities (MBS) with sub-5% coupons have seen loan prepayments slow to low single digits, extending the effective maturity of the Fed's mortgage hedge fund by 3-4x. The chart below from FRED shows Treasury debt and MBS on the left scale and reverse RPs on the right.
By facilitating the mortgage lending boom in 2020-2021 during the Fed’s most extreme period of open market operations, the Fed has captured and effectively sequestered more than $12 trillion in duration represented by the $2.8 trillion notional in MBS held by the SOMA portfolio. The chart below shows the distribution of Ginnie Mae MBS by coupon:
The effective duration of all outstanding MBS from 2020-21 is roughly 3x the original duration when these securities were created. This upward surge in duration represents the extension in the average life from low single-digit years to more like 12-15 years. And the duration of the entire mortgage market, including whole loans owned by banks, also expanded by a similar amount. The fact that 75% of all MBS are now between 2% and 4.5% coupons shows how the Fed’s actions have concentrated risk on the balance sheets of banks.
Since the Fed does not hedge the market risk on its vast securities portfolio, the long MBS position is essentially isolated from the market. Selling pressure on 10-15 year Treasury paper and swaps is reduced. Likewise the Volcker Rule prohibits trading by large banks around their massive Treasury, MBS and corporate bond positions, thus selling pressure on long-term yields is reduced.
In effect, the long-MBS position in the SOMA is in direct conflict with the FOMC’s desire to raise the cost of credit, especially long-term interest rates. But does the Fed really want long-term rates to go up and stay up?
The lack of selling pressure from the MBS owned by the Fed also tends to impact the swaps market and the dollar. Thus we come to the real question: Would the negative spread in dollar swaps that has existed since 2008 remain if the Fed were to start actively selling its long MBS position?
In June of 2022, we asked whether it wasn’t time for the Fed to engage the Federal Housing Finance Agency (FHFA) under Director Sandra Thompson to fix the growing duration trap facing the Fed, the GSEs (all three, btw), many REITs and the banking industry (“The Fed and Housing”). Thompson, who has extensive experience at FDIC and Resolution Trust Corp dealing with bad assets and troubled depositories, understands why time is the most precious aspect of managing risk.
In simple terms, the financial world has been massively long bonds (a/k/a duration) in a rising rate environment, a troubling scenario that has left many banks insolvent on a mark-to-market basis. Note that nonbanks and broker-dealers like Goldman Sachs (GS) don’t have this problem. We urgently need to find a way for banks to sell this low-coupon paper, reinvest at a higher rate and buy the time needed to repair the damage to bank capital done by QE and now QT.
Last week, the Financial Times profiled Silicon Valley Bank (SIVB), one of our favorite specialty lenders focused on the technology space. When we worked years ago banking some of the suppliers in the world of semiconductor capital equipment, SIVB was the key relationship for startups and venture investors. But what the bank has in credit sense for lending to early-stage companies it lacks in capital markets expertise.
The FT notes that the bank’s market capitalization has been cut in half over the past year: “But some analysts, shareholders and short sellers point to another problem of its making: a move to put $91bn of its assets into a poorly performing bond portfolio that has since amassed an unrealized $15bn loss.”
At year-end SVB had negative accumulated other comprehensive income (AOCI) of only $1.8 billion, representing available for sale (AFS) loans and securities, and the net mark-to-market on hedges and other market facing exposures. Yet like the Fed, the GSEs and the banking system, the negative mark-to-market on the retained portfolio at SVB are 10x the AFS book and now threatens to wipe out the bank's actual capital.
Remember, the agency and government MBS with 2% and 3% coupons are trading in the low 80s today or 20 points below where they were valued 18 months ago. And these securities are far-beyond the point of being underwater in terms of net carrying cost. Nobody wants to own a Ginnie Mae 2% MBS. This cash negative reality affects most of the banking industry and represents a ticking time bomb that Chairman Powell need defuse pronto.
Under GAAP, if a bank buys an MBS and marks it as “held to maturity” or HTM, it can account for the security at cost. However, when an investor loses the 1) ability and/or 2) intention to hold an asset to maturity, it is forced to mark all such HTM securities to market. This is the danger that is approaching the GSEs and many banks, which may eventually be forced by rising short-term interest rates to sell assets that were once meant to be held to maturity. The FHLBs hold hundreds of billions in seasoned low-coupon loans that are underwater vs the 5% coupons on new system debt.
The Fed, the prudential regulators, the FHFA and the GSEs need to sit down together and fashion a comprehensive program that will allow banks, REITs and the GSEs themselves to repackage low-coupon loans and MBS into CMOs and sell this paper into the market. The FHFA needs to re-open the doors of the GSEs to securities and seasoned loans older than six months. Once the selling process begins, prudential regulators will need to give banks forbearance in terms of the recognition of losses and the impact on capital.
We need to buy time so that banks and the GSEs are not forced into involuntary sales. The good news is that by using the power of the GSEs as underwriters, we can restructure the cash flows from the existing MBS and create attractive “AAA” rated income producing securities and deep-discount zero coupon securities. Banks and other investment grade investors can buy the relatively short-duration front tranches of these CMOs, while long-term investors and insurers will find the longer-duration paper attractive.
Since new issue activity in the bond market is dropping, the Fed and banks should create some new duration to offset the market shortfall. If we take a page from the playbook of Jesse Jones, Chairman of the Reconstruction Finance Corp in the 1930s, we should use the superior credit of the federal government to solve a massive duration problem created by the FOMC via QE. The solution to the problem, as it was a century ago, is to buy time. If you don’t have time, then there is no liquidity and no deliberate action possible. Deflation then ensues.
Federal Reserve Board Chairman Jerome Powell needs to lead a process to help banks and the GSEs extend maturities and timelines for loss realization. We need to do this before banks are forced to explain to investors later this year why they are reporting gigantic losses on assets they once intended to hold to maturity. And after we get the process started, the Fed itself should engage the GSEs to help slowly sell the SOMA MBS and return this duration to private hands. The GSEs need the business. Once the Fed sells its MBS portfolio, it will once again have control over the size of its balance sheet.
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