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The Institutional Risk Analyst

© 2003-2024 | Whalen Global Advisors LLC  All Rights Reserved in All Media |  ISSN 2692-1812 

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Big What? Rising Debt Service & Falling Liquidity

Updated: Nov 13, 2023

November 13, 2023 | This week The Institutional Risk Analyst releases our latest Housing Finance Outlook for Q4 2023. The picture is remarkably mixed, with residential default rates still hugging the bottom of the chart but volumes and industry profitability also testing new lows. Multifamily and commercial assets have long since reverted to pre-COVID default rates or higher.

Former FHA Commissioner and past MBA CEO Dave Stevens foresees the "worst winter the industry has ever faced" in 2024. Mortgage bankers at industry events say “Survive till ‘25,” referring to the small probability of an interest rate cut by the Fed in the next year. But of course on Wall Street, where the sun always shines, the Sell Side is already arguing about when and how much the Fed will cut rates. 

The new WGA report will be available to Premium Service subscribers and in our online store on Wednesday AM. We look at how members of our mortgage equity surveillance group have performed over the past five years, going back to before COVID and “go big” ℅ the FOMC and Chairman Jerome Powell.  Who are the best performers in the mortgage sector over the past five years? See our comment about COVID loan forebearance for veterans below in National Mortgage News.

Last week saw two significant systemic events hit the market, almost unnoticed. First we had the cyber hack of Industrial and Commercial Bank of China's U.S. broker-dealer. Reuters reports that the event was so extensive that “corporate email stopped working and employees switched to Gmail, according to two people familiar with the situation.” ICBC was a small dealer, but the problems caused big reverberations in the markets.

“This is a very big deal, even if most people don’t get the joke,” notes one large bank chief risk officer. “This ICBC hack makes me nauseous. Someone is not afraid to play with the big boys!”

As we wrote last week ("ACH: The Bank Deposit Ain't in the Mail"}, there reecently were several significant hacks of financial institutions and the US clearing system. The fact that the Federal Reserve and other players in the clearing system have not put out a more detailed explanation makes us wonder. Is the US financial system under attack via increasingly bold and high profile incursions? 

Even as these latest attacks on the US clearing system were underway, the Treasury had one of the weakest auctions of long bonds in years. The yield on the 30-year US Treasury bond surged to 4.8% last Thursday, raising a lot of eyebrows on and off the trading floor.

Dealers retained 25% of the offering, which is a very weak auction result vs the average of 11% dealer buy in in most auctions. The price volatility reflects the fact that so much of the audience for Treasury debt is hedge funds and highly leveraged traders as opposed to large cash, buy-and-hold investors like central banks.

“New government bond issuance last month was already seeing softer demand, though bond traders were recently encouraged by the Treasury Department's surprise decision to limit the sale of long-dated US debt,” reports Bloomberg regarding the latest Treasury statement.

Did the Treasury “decide” to change the composition of the auction or did indications from primary dealers force Treasury Secretary Janet Yellen’s hand? We continue to worry that the rising cost of servicing the Treasury’s debt, and the equal and steady increase in the Treasury General Account at the Fed, makes a funding crisis inevitable. And yes, the Fed buys Treasury paper to collateralize the growing TGA.

The sale of the remaining rent-controlled multifamily assets of Signature Bank by the Federal Deposit Insuance Corp is also weighing on credit markets. Look for a series of asset write-downs as and when sales are finally announced. "The bidding difference finally provides a mechanism for valuing the effect of rent control on asset values," notes one insider.

The ongoing collapse of the commercial real estate market is largely obscured from the view of consumers and retail markets, but the losses in Q4 and 2024 could be quite startling and not particularly good for liquidity. Konrad Putzier in the WSJ gives you a taste of what is to come:

"The increase in mezzanine-loan foreclosure announcements—while not large in absolute numbers—matters because it offers a more immediate measure of commercial real-estate distress than mortgage foreclosure rates."

But it gets better. The fact that the Biden Administration and the SEC under Chairman Gary Gensler are pressing ahead with plans to require centralized clearing of Treasury debt strikes us as risky right now. The Washington narrative led by the Federal Reserve’s Powell and Treasury Secretary Yellen says that centralized clearing will reduce market volatility and uncertainty. Yellen last October 2022:

“We want to make sure that going forward our Treasury markets remain deep, liquid and well-functioning,” she said at an event in New York City. “We are working actively to try to bolster the functioning of that market to carefully look at what might be appropriate. I think the ability of broker-dealers to intermediate that market — their capacity has not grown in line with the size of the market. So we’re looking at a number of ways to improve resilience.”

Centralized clearing of Treasuries is Yellen's "big" idea. Of course, no mention of the FOMC or QE is ever made when discussing recent Treasury market volatility. The Yellen Treasury, of note, is still planning to buy back low coupon debt in 2024, an amusing prospect given the current narrative regarding Treasury market liquidity.

We think one near certainty is that centralized clearing will reduce the number of buyers for Treasury debt and the leverage available for such purchases. The volatility in Treasury debt comes from low coupons and even lower capital behind a lot of interest rate arb trades. 

We also observe through our conversations with traders and back office professionals that the impending transition to T+1 settlement of US Treasury debt could throw another spanner into the proverbial gearbox of market liquidity.

The SEC adopted the rule to shorten the settlement cycle to T+1, effective May 28, 2024, for all U.S. securities transactions that settle through DTC. Canada has adopted a parallel rule covering their markets, however, given the three-day Memorial Day holiday in the United States, Canadian securities will begin trading using a T+1 settlement date on May 27th, one day before U.S. securities. 

What impact will this change to T-1 clearing of Treasuries have on the post-trade processing of securities transactions?  The short answer is that the initial transition to T-1 is going to be a gloal train wreck, especially for smaller firms. Throw in the possibility of a hack affecting a large bank primary dealer and we’re off to the races. Ponder this encouraging message from DTCC:

“With the shortened settlement cycle, allocation and confirmation must happen on trade date, impacting all institutional trades that clear and settle through DTCC’s various services. The new guideline of 7:00 PM ET for allocations and 9:00 PM ET cutoff for straight through processing of affirmations on trade date puts added pressure on global investors to ensure the proper processes are in place. Firms — investment managers, broker-dealers, custodians — will need to consider their target operating model. Asia now has one day to reconcile, but after the move, that will be reduced to as little as two hours, depending on the market.”

What could go wrong? Bill Meenaghan at S&P Global notes

“T+1 will remove some market risks, but risk doesn't go away, it simply moves to another area and, right now, it looks like that area will be back-office operations…. Compressing the settlement cycle to T+1 will demand that operational risk is mitigated. Any manual processes will immediately come under pressure, as automation is a prerequisite for a T+1 environment to ensure exception management is limited and there is as little risk as possible. US banks, brokers and investors need to initiate an assessment of their current post-trade technologies and processes, from the front-office to back- to ensure that they are ready both from a technology and an operational standpoint for T+1.”

For the longest time, regulators have equated faster processing times and increased regulation of financial institutions as operative goals of public policy to benefit investors. As with the Volcker Rule for banks, the move to centralized clearing of Treasuries and next-day settlement seems destined to reduce market liquidity. We wonder if the focus on technological improvement (a/k/a "speed") does not lead to qualitative degradation of markets and the people they represent.

The move to T+1 for US Settlements, which will likely start in the first half of 2024, is great news from a market and counterparty risk perspective. The leap for great efficiency may be really, really bad news for the markets from an operational risk and liquidity perspective.

Op-risk because a lot of back office clearing is still manual and cannot transition to T-1. Maybe it will just go away. Liquidity risk because T-1 will of necessity force buyers (aka small dealers) out of the market. T-1 clearing is basically an invitation to leave for small counterparties who can’t or won’t pay the freight to upgrade systems to support 100% automated clearing. That's part of the same authomated clearing mechanism that broke down last week, of note.

So just to summarize, at the moment when US debt service costs are rising and support for Treasury auctions is largely in the hands of indirect bidders, we are going to move to centralized clearing and T-1 settlement of all securities trades. This process will reduce the number of bidders in Treasury auctions and reduce the effective leverage counterparts can put under Treasury and agency debt. 

And at the same time, we are going to be increasing capital requirements on banks, effectively pushing down effective leverage in the financial system. These same large commercial banks, keep in mind, are arguably insolvent and, that is to say, illiquid, forcing them to be net sellers of Treasury and agency debt and MBS. What could go wrong?

The big "what" is that long-term yields rise and the Fed is unable to control the long end of the yield curve. The Report to the Secretary of the Treasury from the Treasury Borrowing Advisory Committee stated in August: 

“Based on the marketable borrowing estimates published on July 31, Treasury currently expects privately-held net marketable borrowing of $1.007 trillion in Q4 FY 2023 (Q3 CY 2023), with an assumed end-of-September cash balance of $650 billion. The borrowing estimate is higher than at the May refunding, primarily due to a lower starting cash balance, a higher assumed end of quarter cash balance, and projections of lower receipts and higher outlays. For Q1 FY 2024 (Q4 CY 2023), privately-held net marketable borrowing is expected to be $852 billion, with a cash balance of $750 billion assumed at the end of December. Primary dealer projections for issuance have increased for FY 2023 and FY 2024, with uncertainty driven by economic growth expectations and the duration of SOMA run-off.” 

The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.  


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