October 25, 2021 | After a blissful week immersed in the world of housing finance at the Mortgage Bankers Association annual meeting in San Diego, we thought to return to ground zero of monetary policy. Below are three questions we’d ask Federal Reserve Board Chairman Jerome Powell if the opportunity arose. Suffice to say, we’d like some guidance on the size of the System Open Market Account or SOMA over the next three years. But hold that thought.
On Wednesday in NYC, we dive back into the world of mortgage loans and related servicing assets at an event sponsored by IMN in New York City. We’ll be talking with some industry leaders about the political and regulatory threats to the market for residential mortgage servicing rights or “MSRs,” one of the most attractive and also most treacherous assets in the financial world. Just imagine an investment with negative duration, cash flow and a tendency to disappear at a 30% annual rate!
A while back in The Institutional Risk Analyst, we noted that the 50-50 split in the US Senate allowed for binary outcomes in terms of policy. The fact of an equal division makes every vote a super vote, and makes the holder of that vote the arbiter of every issue that comes before the Sentae. That man, of course, is Senator Joe Manchin (D-WV), who refuses to support the progressive agenda for trillions more in political giveaways.
Mother Jones, of note, reports that Manchin is considering a move to “independent” status and would caucus with Republicans. This would deprive President Joe Biden of a Senate majority and thereby put the final torpedo into his decidedly bizarre fiscal agenda. Since there is little visibility on fiscal policy, here's our first question for Chairman Powell:
Q: How do you plan future monetary policy given the uncertain future of the Biden spending plan? How does Treasury plan for future cash outlays?
Fred Hickey, author of The High-Tech Strategist, describes the increasingly absurd fiscal scene in his latest letter:
“When the COVID pandemic hit, that was the excuse for politicians (both Democrats and Republicans) to start with the massive hand-outs. Since then, we’ve had one trillion-dollar program after another – almost too many to remember… The National Debt is now $28.8 trillion and will approach $30 trillion once the so-called debt ‘ceiling” is lifted, as has always been done in the past…”
All of this new federal debt has been accumulated during a period of radical open-market operations by the Federal Reserve, a departure from previous governance in Washington that has seen the central bank’s balance sheet double over the past two years. The Federal Open Market Committee has discussed tapering purchases of mortgage-backed securities (MBS), but purchases of Treasury debt likely will continue in order to maintain liquidity in the system. Thus our next question for Chairman Powell:
Q: If the FOMC tapers purchases of MBS, will they allow the SOMA to shrink as the mortgage bonds run off? Agency and government MBS are prepaying at 25-30% annual rates or CPR. So figure net shrinkage of $600-700 billion annually?
In the past, when the FOMC attempted to reduce the size of the SOMA, liquidity disappeared from the money markets and then an equity market tantrum occurred soon thereafter. The chart below shows the $8 trillion SOMA and reverse repurchase agreements (RRP), which drain cash out of the markets and peaked around $1.6 trillion on September 30th. Note that RRPs were also significant in the 2017-2018 period.
The investors holding $1.6 trillion in RRPs with the FRBNY will presumably be willing to purchase similar securities as and when the COVID cash wave dissipates and the Treasury resumes debt issuance. The multi-trillion cash pile that the Treasury accumulated last year is now visible in RRPs, thus, if anything, there continues to be a surfeit of demand for risk-free assets. The question is how can the FOMC rebalance the supply-demand equation without spilling the proverbial punch bowl onto the floor, as happened at the end of 2018 and in September 2019?
Where would US interest rates go if the Fed stops at ~ $8 trillion in SOMA assets and simply replaces Treasury securities as they mature on the central bank’s balance sheet? We suspect that benchmark interest rates would fall, but with much greater volatility. And since the Treasury is now the largest issuer in the US bond market, we may yet test the limit of investors’ appetite. If the Fed tapers MBS purchases and Biden's spending plans are greatly reduced, for example, there may yet be an imbalance between demand and supply.
For the same reason that bitcoin is surging towards $100k, the “silent majority” of investors, to borrow a Nixonian phraseology, seems willing and indeed anxious to purchase the IOUs of Uncle Sam. The same can be said of agency and government MBS, as well as whole loans and even MSRs. Note too that corporate (aka "junk") debt issuance has gone vertical over the last three months, driven by strong Buy Side demand. Meanwhile, issuance of federal agency securities, municipals and ABS continue to be weak.
During our trip to San Diego last week, we heard tales of JPMorganChase (JPM), PennyMac (PFSI), and other large depositories and IMBs, buying conventional MSRs at 5-6x annual cash flow or 125-150bps. The buyers are looking to replace assets that are running off their servicing books at a brisk 25% of total assets each year. One downside of financial repression via low or zero interest rates is that the duration of securities eventually goes to zero as well.
This relatively high runoff rate for financial assets is seen not just in residential MBS, but is visible in all manner of commercial loans and housing assets. Even with the backup of the Treasury yield curve over the past month, rates remain very low by historical standards. Even government MSRs guaranteed by Ginnie Mae are going at levels well above fair value, suggesting to some that the irrational exuberance has gotten a bit silly.
The strategy operating for a bank or nonbank to pay 150bp for a conventional MSR includes the value of the option to refinance the mortgage, an obvious consideration that strangely is not recognized by GAAP. The folks at the Securities & Exchange Commission and the Financial Accounting Standards Board don’t recognize the optionality of in-the-money loans within an MSR. Go figure.
But more to the point, the MSR is a negative duration asset with cash flow. The option to create new duration in terms of a new mortgage loan seems a contradiction, but a good one. The old MSR disappears, two new assets are created and, let us recall, a gain on sale occurs for the new mortgage note. Send regrets to the MBS investor who receives a prepayment at par.
What seems apparent, however, is that there is still a large crowd of banks and nonbanks willing to pay premium prices for MSRs or loans on the basis that there are going to be opportunities to refinance those loans at lower rates. This is not to say that everyone is a buyer of mortgage assets today. But there remains a large crowd of investors willing to play interest rate roulette with the FOMC.
There are a number of notable exceptions, including Texas Capital Bancshares (TCBI), which has recently sold much of its MSR book. A growing crowd of independent mortgage banks, large and small, are sellers as well as they seek to raise operating cash. Even with a rising tide of sellers, however, supply is unlikely to meet demand for mortgage assets anytime soon.
The global crowd chasing returns in fixed income assets is big and unlikely to be satiated in the near term, thus we continue to see lower rather than higher rates ahead. Sure, the FOMC is going to pay lip service to inflation for a while. Yet when the economy slows and the ratio of job seekers begins to equal job openings – currently 1:1.5 today -- look for bond prices to rally, interest rate benchmarks to fall and stocks to swoon, including our favorite ersatz equity play, bitcoin. Then we'll want to hear an answer to our last question for Chairman Powell:
Q: What is the target size for the SOMA over the next 36 months?
The dynamic created between the Treasury's fiscal operations and the size of the SOMA is imponderable and a likely source of future market volatility. If the FOMC allows the SOMA to shrink, then reserves will fall along with bank deposits. That's why we think the FOMC needs to provide guidance to the markets as to the expected size of the SOMA over the next several years and especially if the FOMC ceases purchases of MBS.
Rates may even rise in the near term if market liquidity comes into question. But look for the FOMC to act early and go big in terms of forward repurchase agreements, to add cash to the markets through or by going around JPM and the other zombie banks, at the first sign of liquidity stress. After all, the last thing that the debt or equity markets need at the present time is another Fed-induced tantrum.