In this issue of the Institutional Risk Analyst, we feature a comment by David Stevens , CEO of Mountain Lake Consulting and former President and CEO of the Mortgage Bankers Association (MBA) . Prior to assuming this position, Dave served as the Assistant Secretary for Housing and Federal Housing Commissioner at the U.S. Department of Housing and Urban Development (HUD) . By David Stevens When America realized that it had to shelter itself and implement safety and distancing measures to respond to COVID19, most public policy makers jumped into high gear. Addressing housing was part of this enormous series of response measures in an effort to cushion the US economy and its people. Almost all sectors of the federal government's apparatus dove in, from the Federal Reserve , to Congress and the White House, HUD, and more rallied to do their parts. But notably absent was was Federal Housing Finance Agency (FHFA) ? With an excess supply of mortgage backed securities ( MBS) in the market as investors repositioned their balance sheets, the Fed began aggressively buying agency MBS removing the excess, creating a short, plunging yields lower and prices higher eliminating the risk of failure to companies holding these bonds. When the Fed realized it had pushed rates down too hard, risking a severe blow to nonbank lenders with short hedge positions on their production pipelines, they quickly slowed the purchases. Rates stayed low but margin calls slowed and the mortgage markets stabilized. But the Fed did not stop its commitment to support liquidity in the agency markets. Beyond simply purchasing Treasuries and MBS at an unprecedented level, Fed Chairman Jerome Powell took to the airwaves to spread a message of their commitment to cushion the economy. To his credit, Powell appeared in multiple interviews including the Today Show , something rare for a Fed Chairman. He understood that supporting the markets, financially and rhetorically, was important. ABC reported last week, Federal Reserve Chairman Jerome Powell pledged Friday that the Fed will “use our tools" to support the economy, an effort to ease fears over the viral outbreak” one of many stories in early March that were followed by rate cuts and more. In came Congress to help pass a sweeping bi-partisan piece of legislation, signed into law by President Donald Trump that provided $1.8 trillion in aid to spread across small business, consumers, housing, and more. It was this piece of Legislation that created a new form of forbearance. Rather than follow the blueprint from the last recession, where one had to prove something called “hardship,” in order to insure that taxpayer dollars only went to those who needed it, this was quite different. First, CARES Act forbearance was made available to all homeowners with a government backed mortgage. That removed any friction in allowing people to get relief from mortgage payment. Yet it also introduced moral hazard by allowing people who were still employed and able to make their payments to skip them anyway. Unlike 2008, consumers need only ask for assistance with no proof of hardship. Second , The CARES Act offered 6 months of forbearance with an option to extend for another 6 months, a term far longer then the four month terms used previously. Third , the legislation stated that loans in forbearance were to be considered “current” and the consumers credit would be reported as such; Forbearance loans would not be considered delinquent mortgages. There were gasps heard across the mortgage industry simply due to the magnitude of the CARES Act forbearance. Estimates of impact showed massive dollars of outlays depending on who would take forbearance. This is also where the FHFA and Director Mark Calabria began to ignore the facts and depart from basic commercial market practice in the world of secured mortgage finance. The Mortgage Bankers Association as well as top economists began looking at potential impact in ranges of $40 billion to $100 billion in skipped payments. Calabria, an economist, made his prediction in public comments that total forbearances would be under 1 million borrowers by May, but the actual number was already more than three times that and rising by the 3rd week of April. The risks were clear to almost all in housing. From mortgage bankers to consumer groups, realtors, and members of Congress, all took aim at Calabria warning of the impact to bank and nonbank servicers, calling for a liquidity facility to be established to help make advances. As noted in an article by Mike Calhoun, Jim Parrott, and Mark Zandi : “Congress hasn't made the repayment obligation disappear, but simply moved it from the borrower to the mortgage servicer.” The Cares Act offered this to all borrowers with a government backed mortgage. Because forbearance lasts 6 months or more, and because these "performing" loans would remain in the securities rather than being repurchased out of pools, there was an open ended funding requirement for all servicers, banks or nonbanks. The amount of advances required looked to wipe out some smaller servicers. This unprecedented liquidity requirement thrust on industry by Congress was in excess of any available source of funds. But Director Calabria not only turned a deaf ear to such real world concerns, he made things worse by making public statements about his willingness to let nonbank mortgage servicers fail. In shocking remarks as reported : Calabria suggested, incredibly, that Fannie Mae and Freddie Mae "could just transfer servicing in a way that's not too disruptive" and give those mortgage servicing rights owned by independent mortgage banks to other entities – either larger nonbank servicers or the banks themselves. He even suggested that some homeowners might be better off dealing with larger banks, a dangerous fiction everyone in the mortgage industry knows to be untrue. His comments set off a chain of events that tightened credit. Rather than calm markets like other Federal regulators and use the tools of government under his authority to step in and support this legislation, Calabria's public comments sent a message to warehouse lenders, MBS investors, broker dealers, and more that they might get caught holding the bag should one of these companies fail. Investors might lose their back stop for reps and warrants made, warehouse lenders might get stuck with a pipeline of forbearance loans, etc. So credit overlays started rolling out and the result is significant tightening in credit terms for 1-4s. Minimum credit scores rose, debt to income ratios dropped, certain programs like bond loans, high balance GSE loans, and more simply began to vanish. What’s most outrageous perhaps is FHFA's view about transferring servicing and consumer experience when the opposite is true. First, no servicer wants to take on a new volume of in-forbearance loans, particularly not in the midst of a rising credit loss cycle. The FHFA's position shifts the advance burden for forbearance and actual loan defaults to the servicers, who must fund and manage the workout process to be done post forbearance. The costs would be significant and the GSE’s would have to essentially pay handsomely for any servicer to take that on. Second, as the FHFA Director knows first hand, the transfer itself is disruptive to the consumer and simply shifting to a “larger” servicer adds no benefit to the experience. Far from providing liquidity, the FHFA aided and abetted a credit tightening event at a time when liquidity is needed most. HUD, in contrast, approached this in a different and far more responsible way. Rather than shake the markets, HUD moved quickly and quietly to calm them. GNMA took a liquidity facility once only used for servicers in technical default and facing collapse and expanded it to all of their issuers thus easing the concern about finding the money to make these advances. In addition, the FHA's tools were already in place to handle the borrower and the servicer once the forbearance period ended. The servicer submits a partial claim to FHA and the balance to be repaid by the borrower is tacked onto the back of the loan in the form of a “secretary’s lien.” The forbearance is to be paid back at minimum when the home is sold or refinanced. In effect, HUD is financing the CARES Act forbearance. After weeks of pressure on Director Calabria, he came back with partial help by capping the forbearance payments to four months. But much of the damage had already been done. Credit had already tightened in the correspondent lending and other channels . And, as of this writing, because these loans will remain in the security there is no reasonable timeline for the servicer to get the advances returned. Keep in mind, all of the $5.5 trillion of conventional servicing is owned by the GSE’s. It’s their legal asset as the owner of the mortgage notes and issuer of the UMBS securities. In the conventional market, the servicer owns the loan level servicing and acts as essentially an agent for the note holder, servicing the loan for the GSEs and, indirectly, the investors in the UMBS securities. The FHFA did not protect these crucial assets owned by the GSE’s It should have authorized a liquidity facility to be established by the GSE’s to make advances and thereby protect the value of this servicing asset. A GSE-led liquidity facility would not impose any risks on the GSEs and, indeed, would have made Director Calabria the hero of this story. Sadly, his lack of understanding of the rules of secured mortgage finance blinded him to this obvious political win. A GSE-led liquidity facility would have alleviated the risk to the massive non bank market that dominates the US mortgage finance system, accounting for over 60% of all mortgages made. The risk, fully secured by 1-4 family mortgages, would be placed it where it should be - in the hands of two companies controlled by the federal government and under the control of this federal regulator. The sort of extremis that is the COVID19 crisis was the reason Congress created Fannie Mae almost a century ago, to provide liquidity to the mortgage market in times of crisis and, more than anything, to buy time. When Congress created Fannie Mae in 1938 it was about buying time. The wave of defaults that are right behind the CARES Act forbearance issue should be the focus of our attention. The complex web of inaction, obfuscation, and belligerence in the midst of a national crisis when all other federal agencies, Congress, and the President dove in is remarkable. Calabria’s ignorance about how the GSEs and the mortgage industry function as well as consumer behavior only adds to the danger. When the FHFA and GSE’s announced a new policy of charging 700 basis points for acquiring first payment forbearance loans and refusing to buy those that were legitimate, agency eligible cash out refinances, this just added to the absurdity of the responsibility that the GSE’s were shirking. And here we sit today with the outcome. Announcements from lenders include things like stopping all cash out refinances, having a 700 minimum FICO score and maximum 80% LTV. The loss of product availability is incredible. According to the Urban Institute these overlays produce an outcome where approximately 64% of all purchase loans fail at least one of these overlays. History will look back at this incredible time that took over the world. The response from the US government will certainly undergo scrutiny about preparedness, response, and subsequent efforts to return to work and the post effects of these moves. For housing the response from the Federal Reserve, Congress, the White House, and HUD was swift and effective. The inept actions taken by the leadership team at FHFA to date are inexcusable. To not use two government controlled and backed companies whose primary mission is to provide liquidity especially in a counter cyclical period is unforgivable. With billions of dollars at stake on assets owned and guaranteed by Fannie and Freddie, this FHFA Director has shirked his responsibility as the Conservator of the GSEs to protect the value of the servicing assets owned by the GSEs and the conventional market that gives the enterprises economic life. The behavior of FHFA these past weeks has been incredible. They are putting confusion and uncertainty into the market. Instead, FHFA should join other federal agencies and leverage these tools of government to help the economy and provide a cushion as they are able to . There is still time to get this right. More stuff National Mortgage News: Why the FHFA's latest move undermines the MBS market https://www.nationalmortgagenews.com/opinion/why-the-fhfas-latest-move-undermines-the-mbs-market Masters in Business: Chris Whalen & Barry Ritholtz on Bloomberg Radio https://www.bloomberg.com/news/audio/2020-04-24/chris-whalen-on-ppp-loans-podcast

In this issue of The Institutional Risk Analyst, we feature a comment from Michael Bright , CEO of the Structured Finance Association . Prior to joining the Structured Finance Association, Michael was the EVP and Chief Operating Officer of the Government National Mortgage Association (Ginnie Mae), which guarantees $2.2 trillion in residential mortgages. The Fannie-Freddie Forbearance Bailout By Michael Bright Forbearance is certainly the new trending word. It’s all over the media. And suddenly everyone is an expert on the once-arcane business of mortgage servicing. Dire predictions are being made about nonbank servicers, although the data is coming in one week at a time. Thus far, the nonbanks are generally holding in, and they are supporting the secondary markets and their borrowers as best they can. Many nonbanks are also taking the lead in addressing COVID19 on behalf of the global investors in mortgage backed securities (MBS) they represent. No one knows the mortgage business better than the servicers, other than perhaps the GSEs – Fannie Mae and Freddie Mac . And right now, the scoreboard is Government Enterprises: 100, Private Servicers: O. That’s not by chance. The servicers appear to face a deliberate strategy designed by the Federal Housing Finance Agency (FHFA) to stick the private market with the cost of dealing with COVID19 in the conventional loan space. T his is not a reluctance to bail out private nonbanks with public funds, as some have argued. Instead, this looks more like the expropriation of private resources of banks, nonbanks and bond investors to shield Fannie Mae and Freddie Mac! The FHFA agenda is tantamount to a bailout for the GSEs at the expense of bank and nonbank servicers, and bond holders. Here’s why. Under normal circumstances, Fannie Mae and Freddie Mac make arrangements with their seller servicers to buy delinquent mortgages out of MBS securities once those mortgages go 120 days delinquent. A servicer will collect and then advance borrowers’ monthly payments to the GSEs. They do this in exchange for a small servicing fee of typically around 25 basis points plus ancillary fees that cover the elevated cost of default servicing Often, a small percentage of borrowers miss their mortgage, and the servicers advance payment of principal and interest for them, then collect the arrears when they either resolve the default or foreclose and sell the house. If, however, a borrower goes from one or two months missing their payment to full 120 days – or four months – delinquent, the delinquent loan shifts from being the servicers’ problem and becomes the problem of Fannie or Freddie. The role of guarantor, and of performing this function, is the essence of the GSEs’ business. Fannie and Freddie take on the credit risk of conventional loans in exchange for a guarantee fee (which is much larger than the servicer fee). All makes sense, right? But then we get back to the kicker - the way the GSE COVID-19 forbearance program is designed, it puts all of the cost of administering it on the servicers. Why? Because this program’s “forbearance” never triggers the clock to when a borrower is 120 days delinquent. Again, that is a private sector bailout of the government in all but name. Adding to the challenge of today’s market, originators are reacting to the FHFA stance by curtailing conventional lending. If the originators (also called “seller-servicer” to the GSEs) are unable to deliver loans into GSE securities because between the time the loan funds and is delivered, the borrower requests a forbearance, then they won’t do conventional loans How many new conventional loans will seek forbearance? No one knows for sure. The numbers from mortgage servicers suggest that participation could be well into double digits. But to protect against this eventuality, lenders are now only originating loans that they have a VERY high degree of certainty will not go to forbearance prior to delivery. The position of the FHFA in refusing to support loan servicers, banks and nonbanks alike, is adding to the restriction of mortgage credit in the economy at this time. The irony of this situation is quite stunning. I like to be positive and look for silver linings in any situation. Clearly, the FHFA has a strong desire to shrink the role of the GSEs in our economy. Fine. But moving forward with this agenda at a time when the alternatives, particularly the market for private label mortgages, has evaporated for now seems short-sighted. The FHFA may have had some thought about re-positioning the GSEs in the private label market, but that option is not viable until investors come back to the table. The FHFA’s position is making that process of restoring investor confidence even more difficult than it need be. At a bare minimum, FHFA should help advocate that the Fed provide liquidity to "AAA" private RMBS the way it is doing for other asset classes such as commercial real estate. That won’t save private label mortgages alone, but it could help limit the damage to an important market that exists alongside the conventional market. It remains to be seen whether we will experience large scale defaults that cause servicers to go bankrupt. And it remains to be seen whether or not the Fed and Treasury will step in to help the conventional market. With 22 million newly unemployed in just a month, surely the delinquency numbers will rise and could force Treasury’s hand. If the Fed does act, remember one thing: the real recipients of this emergency assistance are the firms that took on the credit risk. That is, Fannie and Freddie.

“Because uncertainty about the future is fundamental, financial mistakes will continue to be made. They will be made by entrepreneurs, bankers, borrowers, central bankers, government regulators, politicians, and, notably, by the interaction of all of the above.” “ Boom & Bust: Financial Cycles and Human Prosperity ” Alex Pollock (2010) New York | In this issue of The Institutional Risk Analyst , we consider the practical aspects of systemic risk, something that everyone talks about but nobody seems able to understand or quantify. And we are reminded of the wisdom of our friend Alex Pollock , formerly of R Street Institute and now Principal Deputy Director at the Office of Financial Research . He wrote in his 2010 book which we quote above: “How can you regulate the systemic risk when you are the systemic risk?” Witness the world of nonbank finance. A few months back, we were warned by no less authority than the Financial Stability Oversight Council or “FSOC” that nonbank financial companies were a source of systemic risk. Mark Calabria , who heads that world class regulatory agency known as the Federal Housing Finance Authority or FHFA, apparently encouraged this line of thinking. And Director Calabria and the FSOC turn out to be totally wrong. Instead of nonbanks causing systemic risk, in fact the mounting threat to the US financial system is coming from government sponsored enterprises and the members of the FSOC itself, particularly Mr. Calabria. The FHFA is led by somebody who thinks his job is to “protect the taxpayer” – even if this means standing by as the conventional mortgage market implodes due to a lack of liquidity -- liquidity for obligations that are guaranteed by the United States. Last week, the GSEs Fannie Mae and Freddie Mac had a liquidity facility ready to put in place to support issuers. Meetings were scheduled with members of Congress to discuss the plan. Then suddenly, Mr. Calabria told the GSEs to stand down and shelve plans to support the industry. To say that people in and around the housing industry were flabbergasted is an understatement. Following Calabria’s action to shut down the servicer liquidity facility planned by the GSEs, the FSOC met and decided to take a “wait and see” approach to providing liquidity to mortgage servicers, banks and nonbanks alike. Again, we are told that the FSOC’s decision was largely taken because of erroneous advice from Director Calabria, who has never actually worked in finance much less in the housing industry. As we note in our comment in National Mortgage News , “ Financial tsunami threatens housing sector ,” the mortgage industry can probably manage to make the April payments of principal and interest due on $11.5 trillion in agency and government insured mortgage backed securities. But by May, the national payments system will be running out of money and the Treasury will face default. The alarm bells are already ringing in Washington and at central banks around the globe. If a government issuer has a deficiency as a result of the Congressionally mandated payment holiday , then they will notify Ginnie Mae and the agency will then call the Treasury to seek financial support to pay the bond holders. If a conventional issuer has a deficiency as a result of the Congressionally mandated payment holiday, then they will notify Fannie Mae and Freddie Mac, which will immediately inform the FHFA. The FHFA, in turn, will call the Treasury seeking financial support. All roads lead back to the Treasury and Secretary Steven Mnuchin . After counseling the FSOC the take a “wait and see” attitude on providing liquidity to nonbanks, including the GSEs it’s important to add, Director Calabria then decided to give an interview to the Financial Times . In the interview, Calabria predicted that the GSEs will run out of money in just six weeks and will then require yet another federal bailout. Mr. Calabria loves talking to the media, you see. Calabria’s ill-considered comments made many people in the mortgage industry question the judgment and state of mind of the FHFA head. For one thing, federal regulators are not supposed to make gratuitous comments in the media about the financial institutions they regulate. His actions seem calculated to undermine confidence in the GSEs and the mortgage market. As one leading mortgage industry CEO told us on Friday: “ No action IS an action. Calabria is turning into the caricature people feared if/when a crisis hit. ” The failure of the FHFA to allow the GSEs to provide liquidity support to servicers of conventional loans is not only threatening the solvency of mortgage firms and smaller banks, but it is also negatively impacting the new issue market for MBS. Years from now, Director Calabria may be remembered for starting the housing industry meltdown of 2020. What investor would want to buy Fannie Mae or Freddie Mac securities if they are uncertain as to whether the inevitable arrears from payment holidays can be financed? The same goes for Ginnie Mae MBS, government guarantee or not. Of course, Director Calabria claims to be concerned about “protecting the taxpayer,” but his actions say quite the opposite. It’s almost as though Calabria was intentionally trying to make things worse in the mortgage finance sector. The collapse of the agency mortgage market is a far greater danger than any short-term losses the GSEs may absorb. Again, Mark, agency securities are guaranteed by the United States. And the irrational and dangerous actions of Director Calabria are also visible with the other GSEs. Witness the experience of prime mortgage issuer Redwood Trust (NYSE:RWT) , which was apparently pushed away last week from the Federal Home Loan Banks and forced to sell a large chunk of agency mortgages at a double-digit loss. JMP Securities wrote last week: “[I]t appears FHLB Chicago made changes to the terms of its lending relationship with Redwood that caused the company to elect to voluntarily and quickly step away from that facility. While there are certainly other significant challenges facing mortgage lenders and investors these days, we believe the souring of this relationship was a major contributor to updated results disclosed on April 2” With the GSEs backing away from the very markets they are meant to support, is there any question that the FHFA is following the wrong policies? Without immediate action to provide liquidity to servicers of both conventional and government loans, the US mortgage market is going to seize up. When the servicers cannot fund their operations, then the new issue market will come to a halt – as it has now. Because of the ill-considered actions of the FHFA, the US Treasury may now be forced to take the GSEs out of conservatorship and take formal control of both Fannie Mae and Freddie Mac by converting the government’s warrant into common equity. By taking active control of the GSEs, the Treasury can push aside Director Calabria and the FHFA, and get the GSEs to work providing liquidity to the conventional market. The current mess in the housing sector is entirely the fault of Washington, a city which is so dysfunctional and so conflicted that it cannot even allow the agencies created to support financial markets in time of stress to operate correctly. Anybody who thinks that the market for US Treasury securities can survive the collapse of the agency and government-insured mortgage markets should think again. President Donald Trump needs to remove Director Calabria from his position at the FHFA forthwith and direct the Treasury to take control of the GSEs. We must get Fannie May and Freddie Mac into the fight to save the conventional mortgage market – and the US financial system – from a serious and unnecessary crisis. And we must act quickly because the opening of trading in the US bond market is likely to be messy on Monday.

New York | In our March 22nd issue (“ What Must Be Done to Support Housing Finance? ”), we talked about what needed to happen in the market for mortgage backed securities last Monday to prevent the apocalypse in the short-term credit markets. The Federal Reserve and the GSEs rode to the rescue, and the markets for existing agency mortgage backed securities (MBS) started to settle down a bit last week. Indeed, some market participants think that the Fed even might have bought a wee too much in the past several weeks. Mortgage Bankers Association President Robert Broeksmit said in a weekend email to MBA board members: "T he Fed’s intervention was so strong that whipsawing mortgage prices threaten to swamp (bankrupt) dozens of IMBs with margin calls on their pipeline hedges. The combination of an industry hitting capacity constraints, unprecedented liquidity demands, and volatile financial markets is leading to severe distress amongst many in our membership." Meanwhile, the carnage in the broader markets continues. This week in The Institutional Risk Analyst , we focus on the new issue market, which has basically ground to a halt in the past several weeks. The chart below from the Securities Market Industry Association (SIFMA) shows issuance through February. The red line represents Treasury borrowing, while the green line just below represents MBS issuance, residential and commercial. Whereas the challenge facing the Fed and particularly the Federal Reserve Bank of New York last Monday was adding liquidity to the money markets, this week the shift focuses to reassuring investors that they should buy new issue Ginnie Mae and GSE MBS. The fate of many lenders, large and small, hangs in the balance based on what is done or not in the next several days. Suffice to say that if MBS prices continue to surge, margin calls could put a number of lenders out of business next week. But restoring confidence among bond investors is equally important. As the chart suggests, there is probably well north of $150 billion in new issue agency loans stuck in lender pipelines as March comes to a close. And this does not include the vast wreckage of non-QM loans, credit risk transfer (CRT) securities and other detritus now clogging the financial arteries. The various fringe markets that were flourishing at the end of February have vanished as an asset class. Last week, investors largely backed away from new issue Ginnie Mae MBS because of uncertainty as to home mortgage servicers would finance the huge advances that must be made on loans that go delinquent through the national payment holiday authorized by Congress. Incredibly, nobody in Congress seems to have considered the financial implications of declaring the Jubilee with respect to consumer loans of all descriptions. The Fed and other agencies are left to clean up the mounting mess. On Friday, Ginnie Mae announced that it was invoking Chapter 34 of the servicing guide that is authorized by the Stafford Act, allowing Ginnie Mae to provide emergency funding assistance for issuers . This is an enormously important development that President Donald Trump , HUD Secretary Ben Carson and other members of the administration should highlight in their public comments on the response to the crisis. Ginnie Mae stated Friday after the close of the markets: “Ginnie Mae fully anticipates implementing within the next two weeks, via an All Participants Memorandum (APM), a Pass-Through Assistance Program (PTAP) through which issuers with a P&I shortfall may request that Ginnie Mae advance the difference between available funds and the scheduled payment to investors. This PTAP will be effective immediately upon publication of the APM for Single Family program issuers, with corresponding changes made to Ginnie Mae’s MBS Guide in due course. We anticipate publishing PTAP terms for HMBS (reverse mortgage) and Multifamily issuers shortly thereafter.” The good news is that Ginnie Mae, backed by the US Treasury, is moving to support the $2.2 trillion market served by government mortgage issuers. This is good. But we’ve not even touched upon the bigger task, namely providing advance funding to issuers in the conventional loan market served by Fannie Mae and Freddie Mac. The conventional market represents half of all US mortgages and some $5.5 trillion in outstanding MBS. Federal Housing Finance Agency head Mark Calabria reportedly does not want the GSEs to provide any extraordinary assistance to the conventional loan market, but this reticence may not last through the end of this week. We’d suggest that instead of telling GSEs not to respond to market pressures “creatively,” being proactive in supporting issuers will pay big returns later. We’d also urge the FHFA to think of creative ways to leverage the Federal Home Loan Banks to finance servicer advances on agency and government loans. Rest assured, we will figure this out. The logic is compelling. Bank and nonbank loan servicers must continue to pay investors who hold Fannie Mae, Freddie Mac and Ginnie Mae securities. In the conventional market, Fannie and Freddie are the issuers and pay the bondholders. In the Ginnie Mae market, the individual banks and nonbanks are the issuers and pay the bondholders directly. If the banks/nonbanks cannot pay the GSEs, then Fannie and Freddie will very quickly hit a wall and require liquidity assistance from Fed and/or Treasury. In the government market, in the event of nonpayment by a bank/nonbank issuer, Ginnie Mae would immediately require Treasury to step in to make the payments. The next pay date for most mortgage backed securities is April 25th. Again, as we’ve noted previously, the Federal Reserve Board continues to protect the franchise of the primary dealers at the expense of other market participants in providing liquidity. The obvious solution to a lot of the liquidity problems facing the secondary mortgage market is to simply create a standing repo facility that can transact in a broad range of securities and loans backed by the US government. With the passage of the rescue legislation and the legal moratorium on agency loan payments, bank and nonbank mortgage servicers must scale up their operations dramatically to handle the load of customers who need help. Servicers are already buried in incoming calls from consumer seeking loan payment abatements. Call volumes are running an order of magnitude about February levels and dropped calls are soaring, a measure of building volumes. Now that missing consumer loan payments is authorized by government fiat, the US mortgage industry faces a massive servicing task that may exceed the 2008-2012 period. At the same time, investors must focus on some urgent details, specifically how the payment holiday for mortgages and other consumer/business loans is going to impact banks, nonbanks and the Treasury. In short-term, Fed needs to widen the specs of the TALF program to allow banks/nonbanks to pledge payment holiday advances on agency and government loans w/o a credit rating and directly with the Fed. The current spec is basically either to get a Fed loan 1) through a primary dealer or 2) directly for AAA securities. An advance backed by a GSE/FHA guaranteed loan should have the same eligibility for TALF as a "AAA" bond. Another small detail. Should HUD/FHA stick with their current post-forbearance plan and rely on loan modification that requires the servicer to buy out the loan early from the pool?  If, as many issuers anticipate, over 25% of all Ginnie Mae loans take advantage of the forbearance program, prepay speeds will accelerate dramatically. This will be followed by a slew of new issuance of seasoned loans recently off forbearance programs.  This is a lot of paperwork for nothing. If we follow the current HUD/FHFA plan, the US government would need to step in to support this down the road and may require even more significant Fed purchases.  Better to create a program that will leave the loans in the Ginnie Mae security (in other words, not modify the loan) and a partial claims process that would work without the need for modification, recording of lien, and secured financing.  Even better, a process that would help solve servicer T&I responsibility, would be leaving the loans in the pool and allow partial claims to be filed at the beginning of forbearance. This provides advance liquidity to issuers beyond the Ginnie Mae PTAP program. Servicers can handle this as a customer receivable advance that will be owed by the customer at loan payoff and will not cause further significant disruption in the Ginnie Mae securities market. We have great confidence that Secretary Steven Mnuchin and Fed Chairman Jay Powell will figure it out, but time is of the essence. There are a lot of lenders with fully locked mortgage production pipelines that may not survive through the end of next week. We need to see decisive action by the Fed and Treasury to reassure the concerns of large institutional investors in MBS – preferably before the opening on Monday in New York. Action needed now to support borrowers that IMBs serve Scott Olson National Mortgage News Financial tsunami threatens housing sector Chris Whalen National Mortgage News

As Q1 2020 ends, the global banking industry faces a world that has been completely changed by the economic impact of the Wuhan virus, COVID19. Financing markets are greatly constrained and banks and government-supported debt markets remain the sole remaining islands of liquidity. Markets for corporate bonds and asset backed securities have taken a substantial hit and credit spreads have more than doubled in the past two weeks for many issuers. There are two worlds now: securities eligible for repo with the New York Fed and those that are not eligible for liquidity support. While public equity markets have rebounded after days of record selling, the markets for private equity and related debt remain disrupted and are likely to remain so for the foreseeable future. It is important for investors to understand that the Federal Reserve is going to provide liquidity to many different markets, but it cannot handle the process of restructuring credit defaults. This is one reason why the Fed has hired BlackRock (NYSE:BLK) to act as manager for its bond purchases a la 2008. The CARES Act provides liquidity for advances to cover arrears at mortgage servicers, for example, but no subsidies for actual credit defaults. In terms of Q1 2020 earnings, here’s what we expect from the banks: * The good news is that actual credit losses in general are likely to rise modestly in Q1, but the big change is going to be delayed until June 2020. We expect to see a modest increase in mortgage loan delinquency in March, for example, but the big numbers are probably not going to be seen until April 25th, when coupon payments are due on most MBS and advances increase proportionately. * The once benevolent balance between credit costs, income and cash dividends is about to be violated, but probably not in a big way until the June quarter end. This is a blessing and a curse, of sorts, since we have 90 days to ponder the substance as well as the presentation of the coming results, even as new information comes in regarding credit events. Most banks simply lack the data to make changes in credit risk allocations, but it goes without saying that a number of bank credits have slipped into “special mention” in the past two weeks. * Here’s our best guess of what bank provisions and net income look like over the next two quarters. We double provisions each quarter from the Q4 2019 baseline, hold income and expenses roughly stable in Q1, then start to push down net interest income and increase non-interest expense in Q2. Source: FDIC/WGA LLC * Q1 will be relatively quiet for financials compared to what lies ahead for the rest of 2020. As loan payment delinquency starts to accumulate in Q2, however, we expect that the larger banks and nonbanks are going to be forced to provide monthly guidance to investors on default rates and financing. * We expect, for example, that the increase in residential mortgage loan delinquency and the related advances to pay interest on agency and government MBS will be quite large for banks and nonbanks alike. Thus the Council of State Bank Supervisors wrote a letter requesting that the Federal Reserve Board invoke Section 13 (3) of the Act to directly support advances by nonbank mortgage servicers. * The financing issue is not merely a nonbank concern. Think about the cost of financing advances when we see significant delinquency on the $1.2 trillion servicing book of Wells Fargo & Co (NYSE:WFC) . More than just the credit costs of coming payment disruptions, the US banking and nonbank sector is about to undergo a vast expansion of operations around loan servicing and default mitigation. We are talking about increases in operating costs and decreases in short term fee revenue due to defaults of significant size and at least as large as 2008. * While the full weight of the credit costs COVID19 crisis will not be reflected in Q1 earnings, there are a lot of marks to bond positions and credit portfolios that will take down marks. Specifically, there are whole classes of corporate securities that have effectively been downgraded. Even things like the credit-risk transfer (CRT) bonds issued by the GSEs have fallen to distressed spreads over Treasuries. Just imagine what would have happened to large nonbank mortgage issuers like Fannie Mae and Freddie Mac last week were they already "privatized?" As we noted in ZeroHedge this week, the negative marks that must be taken to a variety of hedge and trading positions are going to be brutal in Q1 2020, effectively the precursor for more and continued bad news coming from the corporate and asset backed securities sectors over the balance of the year. Again, if the assets are not eligible for margin or repo, then they are likely to be illiquid. We continue to worry that some platforms in the REIT sector may be forced into a forced liquidation. The good news is that the market valuations of banks seem to have stabilized and credit spreads are starting to narrow on publicly traded financials. Citigroup (NYSE:C) is trading at half of book and +140bp over the curve in 5-year CDS, while Goldman Sachs (NYSE:GS) is loitering around 0.6x book and +140bp over the curve in CDS. More important, US banks have largely curtailed share repurchases, adding $30-40 billion per quarter to internal cash flow that is now available to absorb credit losses. Despite these grim figures, we'd strike a positive note. We've been accumulating bank preferreds this past week, in many cases below par. Recall that it was not capital that saw US banks through the 2008 financial crisis, but raw earnings power that was available to fund loan losses without touching capital. With the notable exception of the Citigroup rescue, the US banking industry cleaned up its own mess in 2008, with the active assistance of nonbank mortgage servicers we'd add. Remember that in Q4 2019, US banks had almost $150 billion in net income, dividends and cash used for share repurchases available to absorb losses . This substantial cash flow is now about to absorb the full weight of the COVID19 virus disruption. Yes, the numbers are large, but in our judgement, more than manageable by the US banking system. Source: Federal Reserve Form Y-9 We’ll be taking a look at the top-10 US banks and the outlook for financials in our next credit report which will be available in The IRA online store Monday.

New York | As the US financial markets get ready for another volatile week, leaders in the mortgage finance sector spent the weekend in meetings with regulators trying to fashion a way forward. In the $12 trillion marketplace for mortgage finance, liquidity is rapidly disappearing. Banks and even the GSEs are said to be backing away from the mortgage markets with potentially disastrous results. As one dealer noted on Friday: “The specified pool market is dead... there is no spec anymore, it is all TBA. The Fed action this morning did nothing. There are no buyers in the market. The refi rate is between 4.75-5.00%. There has been a massive widening of the Primary rate to swaps & Treasuries.” Another veteran mortgage manager tells The Institutional Risk Analyst : "You need to get them to buy $1 trillion of agency now.  They need to suspend the Volcker rule.  Banks are our only chance to not go into a depression.  They have to fix the system to let banks add liquidity. We also need a PPIP.  Get the mortgage market working.   ABS is totally shut down.  DoubleLines of the world are panicking.  This is worse than 2008 for the system.   If they don’t act soon we are in real trouble." Despite the efforts so far from the Federal Reserve, the mortgage finance markets are increasingly dysfunctional and the risk of a significant financial failure is growing. For example: * Liquidity is drying up in the short-term mortgage financing market for loans, mortgage backed securities (MBS) and servicing advances. There are no bids for specified pools in either the government or conventional markets. Primary dealers reportedly are forcing REITs and other levered investors to liquidate MBS positions, adding further pressure to the markets. Prior to the crisis, 20% of the government FHA/VA/USDA loan market was financed in specified pools. Also, the lack of a specified pool market in conventional and government loans hurts the low-income borrowers that pay the highest fees and need help the most. * The large banks and GSEs are stepping back from the MBS market and are withdrawing financing for warehouse and advance lines, putting further pressure on independent mortgage banks (IMBs). Fannie Mae and Freddie Mac reportedly are stepping away from bidding on specified pools in the conventional market, claiming that they have “balance sheet issues.” The Trump Administration is wasting what could be a valuable liquidity tool by not using the GSEs, including the FHLBs, to provide liquidity to the markets in tandem with the Federal Reserve . What must be done to avert a liquidity crisis in the housing market? * Liquidity : First, the Federal Reserve and other agencies must increase their support for the housing market. Specifically, the Fed needs to increase its purchases of MBS to alleviate strong selling pressure across the market. Add a zero to last week’s daily allocations by the New York Fed. The single biggest thing the Fed can do to help the market is to announce BIG MBS purchase numbers on Monday and keep buying until yields start to fall . The street is extremely fragile; with commercial banks and IMBs hoarding cash. The Fed in the government market and GSEs in conventional loan market should bid directly for specified pools, again until MBS yields start to fall and especially for discount coupons. The Fed’s explicit public policy goal should be to push consumer mortgage rates down to 3% or below . The Fed should use continuous MBS purchases to drive down yields on MBS until it is economic for the industry to originate government and conventional mortgages with 3% coupons. By putting a 103 bid for Ginnie Mae 2s in market and allowing issuers to deliver the pools directly to the FRBNY, the Fed could finance trillions in streamline mortgage refinance transactions and add balance sheet assets to the system open market account (SOMA). * Financing : Second, the Federal Reserve and other agencies, including Fannie Mae and Freddie Mac, should aggressively provide financing for loans, MBS and servicing advances on market terms. The Fed in particular should set up a standing repo facility (SRF) to provide financing directly to all market participants, including banks, nonbanks, dealers, REITs and the GSEs themselves, which will need financing support. As MBS spreads over government yields grow, so too do the funding costs to the GSEs increase. The government should give the GSEs balance sheet support, perhaps including exercise of the Treasury warrant to convert the government’s preferred equity position in the GSEs into common equity, and increase the GSE portfolio limits to allow them to create market liquidity in loans, MBs and servicing assets as well. * Third and also needing immediate attention, the Federal Reserve, Treasury/GSEs and other agencies must provide a liquidity backstop to help finance forbearance on mortgage payments for millions of consumers. Specifically, Congress needs to pass the “Section 13(3) Directive,” which is legislation prepared at the request of Chairman Mike Crapo (R-ID) to provide legal support for using the Federal Reserve’s 13(3) authority and Ginnie Mae’s Chapter 34 emergency authority to provide the needed liquidity to the housing sector. Importantly, this language would fix an impediment in the National Housing Act that effectively precludes financing servicer advances in the Ginnie Mae segment. Markets need this fixed to have collateral for any national liquidity program involving Ginnie Mae loans. Legislative action would greatly speed the administrative efforts on this long-debated topic. Bottom line is that the mortgage finance market, the second largest securities market in the world after the Treasury market, is dysfunctional and in need of government support. The Federal Reserve and the three GSEs, supported by the Treasury, need to provide strong support to the markets on Monday morning , including the provision of liquidity to prevent a disorderly liquidation in the MBS markets and potential contagion among banks, dealers, IMBs and REITs. Just as civil authorities are trying to get ahead of the threat from COVID19 , financial authorities in the US need to act decisively to protect the housing sector and then support the growth of refinance volumes to help drive economic recovery. By protecting the housing finance sector from liquidity-related disruptions, the Federal Reserve, GSEs and Treasury can ensure that this key part of the US economy is functional and able to support economic growth in the months and years ahead.

New York | Officials in Washington are looking for ways to quickly put money into the US economy to counteract the recession looming due to COVID19. One immediate way that the Federal Reserve can very directly add liquidity to the domestic scene is to initiate a massive program to purchase agency and government mortgage backed securities (MBS) directly from issuers, bypassing the too-be-announced (TBA) market and the large bank dealers, and focusing exclusively on refinance transactions at lower rates. Alan Boyce , retired mortgage banker and CA agribusiness executive, argues that the Federal Reserve should begin to immediately purchase pools of Fannie Mae , Freddie Mac and Ginnie Mae refinance mortgages directly from lenders. The former executive of Countrywide argues that given that the Fed’s existing $1.5 trillion portfolio in agency MBS is likely to prepay rapidly in the next few months, the Fed should be an aggressive buyer. He argues that the Federal Open Market Committee is actually adding duration pressure on dealers by allowing the SOMA portfolio to shrink. “Housing is the ultimate domestic market, argues Boyce in a conversation yesterday with The Institutional Risk Analyst . “Cutting the fed funds rate to zero and expanding QE4 is a very indirect and inefficient way to get liquidity into the US economy. With the 10-year Treasury yielding 75bp, it is outrageous to see Americans originating 3.5% mortgages. The Fed should create a market for agency MBS with 2% coupons at a premium in order to guarantee mortgage bankers a profit if they refinance homeowners into 3% mortgages or lower.” Boyce continues: “The Fed should be buying GNMA and UBMS 2 percent coupon (2s) MBS……lots of them and directly from mortgage bankers. Issue an open order to buy $5 trillion of UMBS 2s and GNMA 2s at a price of 103! Let mortgage bankers focus on the paperwork instead of the market volatility. The refi wave is already burning though a huge part of the Fed’s existing MBS portfolio. The runoff of MBS from the Fed’s system open market account (SOMA) is like the Fed selling bonds into the market. Instead, the Fed should start buying back the duration/balance sheet exposure and selling the gamma/vega back to the bond market ASAP. Specifically, Powell should not wait for the actual prepays to hit the SOMA in two months. Buy TBAs now! Drive the prepays and help out homeowners by going directly to the mortgage bankers.” “Below is an example of loan pricing below with better Fannie Mae 2 coupon pricing via the Fed. This approach gets the borrower into a 3% 30yr fixed rate mortgage. We need to direct the GSEs to buy the excess interest only strip at a reasonable price from the lender. More, we can reduce borrower rates by another 29bps with the elimination of the appraisal and loan level pricing adjustments (LLPAs) required from the GSEs. This gets the borrower into a 2.75% mortgage and allows the lender a profit. The FHFA Board of Directors is made up of bank regulators and Fed. They can push Mark Calabria and FHFA to tell GSEs to waive appraisal and LLPAs to make for a more streamlined refinancing process. Remember we were pushing this for HARP 2 back in 2011?” Boyce argues that the lenders can simply create conventional agency and government insured pools comprised entirely of mortgage refinance loans to drive the process and could add several hundred billion in liquidity to US households in the next year. And his larger point about the impact of the runoff of the Fed’s MBS portfolio is crucial and alone makes the argument for direct Fed purchases of securities with refinance loans. Finally, Boyce notes that most of the Street is short duration thanks to the sudden rally in bonds, thus having the Fed act directly may be the only way to get mortgage rates to actually fall without bankrupting a lot of lenders. Boyce argues that mortgage bankers will let their current pipeline of mortgage loans float down to the Fed bid of 103, especially if it comes with no appraisal, no LLPAS and a lower guarantee fee. The resultant MSR will be worth a 5x multiple, that adds to the mortgage banker profits. “All of the mortgage banker pipelines are short duration due to the rally in Treasuries,” Boyce notes. “If the Fed comes in and simply pumps up the price of GNMA 2's to 103, it will put the vast majority of independent mortgaage lenders out of business due to margin calls they cannot meet, not to mention massive pipeline fallout. This is a systemic risk that needs to be addressed. If instead the Fed bids directly for $5 trillion of refis and guarantees a risk free takeout of 103, then the mortgage bankers can originate loans without worrying about market volatility. Mortgage bankers will have a chance to help the economy and make money at the same time. Win-win.”

“It is not learning, grace nor gear Nor easy meat nor drink But bitter pinch of pain and fear That makes creation think” They Told Barron: The Notes of Clarence W. Barron (1930) New York | Just how low is the lower bound in US mortgage rates? We may have found out over the past few months. The benchmark 10-year Treasury bond fell to almost zero this past couple weeks, but the companion 30-year mortgage has actually gone up in yield. Now with the Fed dropping the target for fed funds to zero and restarting quantitative easing, will mortgage rates comply with the Fed's guidance? Our bet is maybe. But why are mortgage rates not falling? One word: convexity . When a mortgage bond goes down in price when everything else is rising, that is called convexity. To quote “ Fabozzi Bond Markets and Strategies Sixth Edition, ” “The key point is that measures (such as yield, duration, or convexity) reveal little about performance over some investment horizon because performance depends on the magnitude of the change in yields and how the yield curve shifts. Therefore, when a manager wants to position a portfolio based on expectations as to how the yield curve is expected to shift, it is essential to perform total return analysis.” We are seeing one of those rare events, like a lunar eclipse, where unseen market forces actually thwart the intentions of central bankers and the hopes of a lot of mortgage lenders. We hear many complaints from the secondary mortgage channel about rising primary rates. Now the Federal Open Market Committee has overtly resumed quantitative easing and again includes mortgage backed securities on the shopping list. But will mortgage rates fall below 3%? The Chart of the Week from March 6th posted by the Mortgage Bankers Association tells the convexity story with the rising spread between the 10-year Treasury note and the 30-year mortgage. Today the federal funds rate is a government managed number. Are mortgage bonds next in terms of explicit government manipulation? Probably too big a lift, even for the Fed. What does this say about the efficacy of monetary policy and, in particular, the choice by the FOMC several decades ago to target the overnight rate for federal funds as its monetary tool of choice? Prior to WWI, the benchmarks for the fixed income were high grade corporate bonds and even the bonds issued by Great Britain and other European nations. Government finance was barely considered. Indeed, prior to the creation of the Fed in 1913, where the Treasury deposited its cash balances was the big question on the minds of financiers. But in the 1980s, the FOMC began using the rate for overnight lending between banks as its benchmark for policy. For decades, the FOMC could drop the target for fed funds and the housing market would respond. But now that relationship is in doubt. The private markets for debt and equity in the US remain quite large and provide an effective check on Fed efforts at outright manipulation of markets. Witness the housing market. The nearly $12 trillion in outstanding mortgage debt in the US is the result of originating a couple trillion annually in new mortgages. The average 30-year mortgage actually prepays within 8-10 years, at least in theory. These loans are originated by brokers, financed by large finance companies, banks and REITs, and ultimately sold to investors in the global bond markets. About half the market is conventional mortgages guaranteed by Fannie Mae and Freddie Mac, a bit more than 20% resides in government insured loans that are financed via Ginnie Mae securities, and the rest is held directly in portfolio by commercial banks. The second largest market in the world is the forward or “TBA” market in mortgage securities. Because of the assumed 8 to 10-year average life of a residential mortgage, the markets tend to price these assets against the 10-year Treasury. But in fact, thanks to the extreme volatility of interest rates, the agency and government RMBS markets have seen prepayments accelerate, thereby making the effective life of these securities more like 4-5 years. Markets try to value agency RMBS against the 10-year Treasury, but in fact the 5-year Treasury note is probably a better bet. Yet in either event, the spread between government bond yields has widened in recent months, directly challenging the Fed’s continued use of federal funds as the benchmark for policy. The chart below shows the 10-year Treasury bond and the 30-year fixed mortgage average from Freddie Mac. Much like the Vatican in Rome, the Federal Reserve Board is reluctant to make changes to canon law. First among these rules is the idea that the Fed can effectively execute monetary policy through the few large banks – aka “primary dealers” – that directly face the Fed as counterparties. Second, the Fed’s changes in policy, once transmitted via the primary dealers, will influence the US economy and particularly housing finance and related sectors such as home building. The dealer-centric world of the FOMC not only creates liquidity problems for markets but now seems less and less effective in terms of influencing housing. Since housing broadly defined is one of the biggest parts of the US economy, whether the FOMC can use interest rate targets to influence credit availability in housing is kind of a big deal. But we also need to raise another issue in this regard and that is the growing inventories of unsold Treasury debt on the books of large, primary dealer banks. With a nod to our friend Marshall Auerbach at Levy Economics Institute , we hereby rehabilitate the long discredited economic notion of “crowding out.” The combination of liquidity and capital rules for big banks, crazy levels of volatility, and massive Treasury issuance of new securities has sapped the Street’s ability to efficiently finance debt – all debt. Add to this the natural reluctance of investment managers to lose money and we have today’s situation: massive liquidity coming to the dealers from the FOMC, but ebbing liquidity in the rest of the global money markets. While the yield on the US Treasury 10-year bond came close to the zero bound last week, the forward market for mortgages rates actually backed up in yield, further widening the secondary market spread. Investors suspect that prepayments will accelerate, thus they discount the premium coupons still left in the market and yields rise. New production GNMA 3s are being priced around 3.5X cash flow multiple, according to SitusAMC. We have it on good authority from several large mortgage issuers in New Jersey that a GNMA 2% coupon was briefly quoted offscreen in the TBA market last week, but by the close on Friday, GNMA 2.5s were the lowest coupon offered in TBA. With the Fed's rate action and QE resumed, will the housing market’s response to the latest Fed action remain muted? Look for GNMA 2s to reappear on dealer TBA screens next week, but will they actually trade in significant volumes? Only if mortgage rates fall. The Fed has the ability to influence markets, but the private debt and equity markets in the US are still too large for the FOMC to overtly manipulate. Should the FOMC decide, in its arrogance, to buy existing 3.5% and 4% coupons in RMBS in an effort to force mortgage interest rates down, the Committee should not be surprised that they will take significant losses due to prepayments. The FOMC also may find itself the among a dwindling number of buyers of agency and government RMBS if 30-year mortgage rates actually go below 3% annual rates and RMBS coupons fall accordingly. For now, at least, there remains a limit on the ability of the central bank to intimidate private investors into taking losses on mortgage securities. The way out of this monetary cul-de-sac is for the FOMC to gradually shift away from explicit targeting of the federal funds rate and towards a regime focused on the legal mandates of employment and prices, two relevant yet fuzzy concepts that provide better political cover for the Fed. The downside risk of sticking with the current regime is considerable. With the disappearance of LIBOR, for one thing, federal funds and the TBA market becomes the de facto benchmark for private finance in the US. Does the FOMC propose to manage the federal funds and TBA markets after LIBOR actually disappears? Imagine how different market conditions might be if the FOMC ceased providing guidance on federal funds entirely and simply provided the volume of liquidity necessary to clear the markets? To us, continuing to beat the proverbial dead horse by targeting federal funds seems only to be creating excess volatility in the markets and little else in terms of public policy. For one thing, without the Fed’s clumsy effort to manage fed funds higher in 2018, the level of prepayments in the world of residential mortgages would be a good bit lower. We suspect also that the level of volatility in the global equity markets would be less as well. And Chairman Jay Powell and other FOMC members could take themselves out of the media crosshairs. Ending the FOMC’s targeting of fed funds might be a big win for all concerned. See below our comments to Barron’s last week as carried by Fox Business .

New York | The great sucking sound heard last week was the release of accumulated froth in the global equity markets. The FOMC’s decision to act with a 50bp cut in the target for Fed funds had little effect on real markets for real counterparties. Meanwhile, the panic in the media is having outsized effects on people, companies and society. Below we ponder the effects and consequences. The unfolding impact of COVID19 changed the effective ratings for dozens of corporate issuers, resulting in an increase in the effective cost of equity finance for everyone from American Airlines (NYSE:AAL) to Amazon (NASDAQ:AMZN) . And the fact that the Fed dropped the target for federal funds is nice, but does nothing really to help these and other companies. Assets move for ratings, a fact we learned long ago from Bob Salvaggio at AMBAC in the world of RMBS. John Dizard writes in the Financial Times on the topic of Fed interest rate announcements: “The actual rates at which even most institutions can borrow against Treasuries or government backed securities have not been cut by any 50bp. On Tuesday, the widely used DTCC GCF Repo index quickly rose from 1.6 per cent at the open to 1.85 per cent, and only came briefly down to 1.5 per cent before creeping up again. The index settled at a 1.72 percent average for the day. By that evening, “ease” or no ease, the Fed was turning down some of the record $111bn of bids for repo from within its own select circle of counterparties.” Because so much of the world of monetary policy is predicated upon maintaining consumer confidence, and since the availability of credit impacts same very directly, times of market stress are costly to the economy. The Fed now faces a sudden, twin crisis of both liquidity constraint and sharply discounted credit profiles for some major corporate and public sector names. The Fed’s 50bp was thought to be a way to reinforce confidence, but instead it signaled that the worst is yet to come. Treasury Secretary Hank Paulson’s suggestion that the government had to buy bad assets from Citigroup (NYSE:C) over a decade ago had a similar effect. Robert Eisenbeis at Cumberland Advisors asks whether the Fed wasted 50bps last week. Our thought is probably yes. Nobody in the mortgage industry is going to agree with you on that count, however, with secondary market spreads north of two and one half points and widening. He writes: “The Fed’s move was clearly intended as insurance designed to convince participants that the Fed will do what it takes to support the economy in the face of the coronavirus threat. As the day proceeded, however, the realization set in that rate cuts aren’t medicine when it comes to the threat of a pandemic. It can’t get consumers out of their homes to spend and it can’t fix supply chain bottlenecks.” The first question, of course, is whether the virus panic now being fanned in the global media and also in the political sphere is going to cause a global credit crisis and recession. Specifically, and to the questions about the efficacy of last week’s Fed rate cut, is merely adjusting the target for Fed funds sufficient to meet the growing demand for the volume of credit? Specifically, will the hit to the supply chain also cause crippled corporate credits to lean hard on bank lines and other sources of liquidity. “Just cutting funds and IOER without backstopping liquidity is going to make USD funding offshore a nightmare in coming days as the global supply chain (which is a payments chain in reverse, thanks Zoltan) clogs and backs up like bad plumbing,” says Ralph Delguidice of Pavilion Global Markets . “Companies not shipping high value-added goods (chips, etc) will draw down USDs to make payments to fill the gap (resulting in a temporary surfeit of liquidity). This will become a global scramble for dollars among those banks seeing deposits flee and credit lines drawn the longer the chain stays disrupted.” Source: FDIC/Whalen Global Advisors LLC As the chart above suggests, the FOMC has managed to throttle bank deposit growth since December 2018. Strangely, this is when the central bank stopped raising rates and started to become aware of ST liquidity risk. With the shock to the global supply chain will also come a shock to commercial banks, first in terms of increased volatility in once stable corporate deposits from longtime customers. Later these same customers may come under financial stress or even be forced into default and restructuring due to the disruption of COVID19. Liquidity, like confidence, is something that economists discuss endlessly but cannot define or measure. We constrain bank liquidity with rules and regulations, but then lament when funding is insufficient to meet market demand. And cash liquidity available to the broad market, not the target rate for Fed funds, is what gets stuff to happen in the economy such as loan growth. In fact, the volume of liquidity flowing through GCF repo for Treasury collateral has been falling for the past year even as interest rates have fallen – or rather have been pushed down by the Fed. GCF RMBS repo volumes have been strong, of note, even as new loan origination volumes climbed 20% year-over-year. As with this past September and December 2018, when we took large cap stocks off by a third in value, the forward concern seems to be liquidity risk resulting from numerous examples of falling corporate cash balances and deteriorating credit conditions. We cannot see whole industries such as airlines, lodging and hospitality grappling with sharp cuts in revenue and not expect a substantial reaction in terms of reducing costs and raising liquidity in those sectors. Another worry when it comes to liquidity is the new issue market, which was going great guns in January but may have slowed significantly in February with the notable exception of mortgage securities. At $158 billion in January, RMBS volumes were up 25% YOY according to SIFMA. But more worrisome is the fact that corporate and ABS bond issuance has fallen dramatically since September of 2019. This may have been the early sell signal from the world of credit in this cycle. We’re struck by the fact that corporate debt issuance started to dive five months ago, but the equity markets did not respond until the arrival of COVID19. In fact, after a small pop in high yield (HY) spreads in the September 2019 time frame, HY credit spreads actually rallied 50bp in yield down to the mid-300s over the curve by early 2020. With the arrival of COVID19, however, HY spreads have widened to plus 500bp over, dangerous territory that can be a predictor of an impending credit risk reset event. Fred Feldkamp’s First Rule states simply that when HY spreads go much about 400bp over the swaps curve, financing activity on the fringes of the consumer economy slows as counterparties start to demand wider spreads on risk transactions. Get to plus 500bp as we are today and the economy is in danger of an outright stall. An economy is an airplane that never actually takes off but must always be at least at sufficient autorotation speed necessary for flight. Falling volumes in the GCF repo market, stagnant bank deposit growth and a sharp drop in corporate bond and ABS issuance don’t sound like a particularly positive combination to us. Add a likely spike in cash demands by a range of public and private obligors whose effective credit ratings changed over the past week and we see a variety of immediate and long-term problems facing the Fed and the Trump Administration. For starts, we think the Fed should worry less about targeting interest rate price and more about understanding, intimately, what is happening in terms of apparent and real liquidity in the credit markets. Like we said, assets move for ratings. There is a huge, sudden and somewhat hysterical asset allocation shift underway out of equities and into safe assets due to uncertainty arising from COVID19. At some point, however, the lack of yield in bonds will drive investors back into equities.

New York | Is the Federal Reserve Board killing America’s banks, pension funds and anybody else that saves with low interest rates? The answer we provide in the latest issue of The IRA Bank Book Q1 2020 is a resounding yes! Points: * Bank interest expenses fell in Q4 as lower market interest rates and ample liquidity provided by the Fed ended the steady increase in bank funding costs since 2016. The drop in yields, however, hurt asset returns as well. Earnings are down several quarters in a row. As bank earnings fell in Q4, revenue decreased faster than funding costs. * Despite increasing credit provisions at most banks, overall credit continues to be a distant worry. Banks are preparing for another very strong year in residential mortgage lending, a notable bright spot in terms of volume growth. * In particular, Q4 2019 actually saw sales of mortgage notes into RMBS with servicing retained rise for the first time in almost a decade, again signaling a renewed interest in correspondent lending on the part of several large mortgage banks including JPMorganChase (NYSEJPM) , Quicken Loans, Freedom Mortgage, Amerihome, a unit of Athene (NYSE:ATH) and Mr. Cooper (NYSE:COOP) . Copies of The IRA Bank Book Q1 2020 may be purchased at The IRA online store. To say thank you to readers of The Institutional Risk Analyst , copies of The IRA Bank Book Q1 2020 are on sale, 50% off through COB Friday, March 6, 2020 . Just how is the @federalreserve killing America's banks? Read and learn about the true cost of Financial Repression. Source: FDIC/Whalen Global Advisors LLC

New York | Last week, financial markets wiped out about a quarter of the market value of large US banks and nonbank companies. One of our core holdings, U.S. Bancorp (NYSE:USB) , closed Friday just shy of 1.6x book vs over 2x only a couple of weeks back. When USB goes below 1.5x book, we’ll be nibbling again. In a funny way, as we said on Twitter last week , the coronavirus or COVID19, took some excess air out of the obvious bubble in US equities. This market wanted to go down, but did not know how. Thanks to Uncle Xi Jinping and COVID19, Federal Reserve Board Chairman Jay Powell’s problem is fixed for now. Yet the low level of interest rates remain both an immediate opportunity and also the most important long-term problem facing the US banks and the broader financial sector. First the good news. Last year, thanks to lower interest rates, was the best year in mortgage lending and secondary market sales in half a decade with over $2 trillion in production. Refinance volumes actually exceeded purchase loans in Q4 2019. And 2020 is looking to be another record year in terms of both volumes and profitability, this even as loan loss rates continue to be muted due to low interest rates. JPMorganChase (NYSE:JPM) , for example, reported strong results in mortgage banking for the past several quarters. But with the rising volumes comes risk in terms of home price appreciation. The chart below shows loss given default (LGD) skewing sharply negative for bank owned multifamily loans, a pattern that is shared with LGDs for residential loans, construction and development loans, and home equity loans (HELOCS). These outlier indications of negative credit costs harken back to 2005. Then as now, negative LGDs for residential real estate suggest that monetary policy is too accommodative and that home price inflation is actually quite high. Source: FDIC/Whalen Global Advisors LLC “JPMorgan Chase & Co. is shifting workers to handle an expected surge in demand for home loans as the American housing market looks forward to its strongest spring in at least a decade and the coronavirus sends mortgage rates lower,” reports National Mortgage News . Indeed, the entire industry is gearing up for a big year in terms of both purchase and refinance transactions, with a bumper crop of new mortgage servicing assets awaiting financial investors. Indeed, as we reported earlier in The Institutional Risk Analyst , both JPM and Citigroup (NYSE:C) are said to be keen on re-entering the correspondent channel in a serious way, part of a larger trend that is seeing commercial banks regaining market share in residential mortgage aggregation and servicing. As we prepare The IRA Bank Book Q1 2020 for publication later this week, there are a couple of key takeaways regarding the mortgage sector from the Q4 2019 data from the FDIC. In particular, Q4 2019 actually saw bank sales of mortgage notes with servicing retained rise above $6 trillion for the first time in almost a decade, again signaling a renewed interest in correspondent lending and servicing on the part of several large banks including JPM, C and others . Of note, the unlevered yield on the $38 billion in bank owned mortgage servicing assets in Q4 2019 was over 9%, as shown in the chart below. Source: FDIC/Whalen Global Advisors LLC Another positive data point for bank mortgage banking: The nonbank share in mortgage servicing actually grew modestly as well in Q4 2019, this as bank sales of residential mortgage backed securities (RMBS) surged. In particular, Q4 2019 actually saw sales of mortgage notes with servicing retained rise $20 billion, the first time in almost a decade bank RMBS securitization volumes have risen . Source: FDIC While the banks are re-entering the market as aggregators and sellers of correspondent loans into the agency and government RMBS market, the nonbanks remain the predominant originators of loans. And with the surge in lending volume driven by falling interest rates will also come a surge in loan prepayments on existing mortgage securities. Last month, our friends at SitusAMC had capitalization rates for new production conventional 3.5% coupons indicated at 5x annual cash flow, a valuation that now is rendered stale by February’s frantic equity selloff and interest rate rally. Maybe 3-4x? As with the MBA production volume estimates for 2020 and beyond, we expect to see significant revisions to prepayment rates for premium coupons in coming days. Now the bad news, of sorts. Even as volumes for residential mortgage loans surge in 2020 and beyond, the rest of the bank loan book is being squeezed. Yes, the wild rise in bank interest expense has stopped and reversed down below $40 billion per quarter. The trouble is, interest earnings are falling faster, and thus net income for US banks fell again in Q4 2019. Returns on earning assets, one of the most basic measures of aggregate bank profitability, are again falling under the dead weight of quantitative easing (QE) and panic buying of risk-free assets. We’ll discuss this troubling trend in detail in the new edition of The IRA Bank Book . The forward scenario for residential mortgage risk kinda looks like this. Falling rates cause a surge in residential mortgage production in 2020, but the disruption due to COVID19 is so pronounced that the US economy slips into recession. The FOMC responds with even lower interest rates, causing yet another manic surge in mortgage refinance and purchase loan production in 2021-22. RMBS coupons will fall into the low 2s, but then comes the punch line after 2022: a larger than expected upsurge in credit costs. After almost a decade of FOMC-suppressed credit default activity, the LGDs in the $11 trillion portfolio of residential mortgages will skew in the other direction. We suspect the rate of change in visible default rates will be considerably faster than in past cycles. Defaults will occur at both ends of the mortgage credit stack, including the high-end, prime jumbo production that is now trading well through the TBA curve. And with the industry and many large institutional investors in the residential asset class leveraged to the rafters, the cost of distressed servicing will come as a very unpleasant surprise to some investors. Large Buy Side players who think that they own cash flows attributable to specific mortgage servicing assets via participations may also be surprised, in the event of servicer default or forced sales. Read the fine print. And the mortgage industry will see another wrenching process of distressed loan resolution and also consolidation among nonbank mortgage companies and REITs. The nonbank servicers will clean up the mess as the commercial banks happily provide the financing. And life will go on. But the next couple of years in residential mortgage lending and servicing could be a very profitable and also quite volatile ride indeed.

New York | The rally in risk-free bonds is quickly rendering irrelevant the policy direction of the Federal Open Market Committee . We’ve talked in past comments in The Institutional Risk Analyst about the structural shortage of risk-free collateral, even with bond yields down 50% from the November 2018 peak. As fear of the economic effects of the COVID-19 virus grow, investors are seeking liquidity and high-grade credit. Many of the financial and risk decisions that were made even six months ago now look questionable in view of the unfolding flu epidemic from China. But as we noted earlier, the risk to the US markets was always meant to come from offshore. At present the forward risk is that the combination of QE by central banks and fear driven purchases of US Treasury paper may drive US interest rates to zero, further inflating the US bubbles in housing and financial assets. The chart below shows the now negative cost of default for 1-4 family loans held by US banks, another way of saying home prices have risen strongly. Source: FDIC Some analysts continue to point to a future increase in unemployment or an economic slowdown as the likely pretext for lower interest rates. But the market already has discounted a slowdown. And lower market rates provide the impetus for another spasmodic surge in valuations for stocks, bonds and real estate – and all at the same time. Traditional correlations are dead and gone, thus the question is only the timing of the next upward surge in dollar asset prices. A sustained drop in interest rates may actually forestall an economic slowdown, again dashing the hope and expectations of many forecasting economists. Even as the fear trade drives dollar interest rates down, estimates for forward loan origination volumes are rising. Indications of growing froth in the housing markets such as the LGD chart above go largely unheeded by investors, but regulators are concerned. Such is the level of consternation among regulators over the visible level of inflation in housing assets that lenders are being told to step back from certain housing markets, particularly in overheated coastal cities. Worries that a sharp decline in home prices will occur as and when the next recession begins are driving the increasingly frantic directives coming from the Federal Housing Administration and the Federal Housing Finance Agency regarding capital levels in a stressed economic scenario. Across the mall in Washington, however, no less a luminary than Fed Governor Lael Brainard is pushing for an even higher inflation target. Why? The Fed Board does not really say. Perhaps to goose asset prices ever higher? Referring to the policy as “flexible inflation averaging,” Governor Brainard believes that the US central bank needs to set temporary inflation targets above its current goal of 2 per cent, to make up for periods when inflation runs below “target.” But what exactly is the target? The fact that the Fed’s governing statute refers to “price stability” as the Fed’s policy target does not seem to bother Governor Brainard. Neither the former MD bank regulator nor the rest of the FOMC seem to have noticed that asset inflation in housing, stocks and bonds and other asset classes are presently running at low- to mid-double-digit rates of increase. Another surge in the value of housing assets impends. Were US home prices rising at say 25 or even 50 percent annually, do you think Governor Brainard and other FOMC members would take notice? Would such a circumstance constitute inflation or at least a rise in consumer living expenses that warranted recognition? That depends. The Debt Avalanche The fixation of the FOMC and other world central banks with statistical “inflation” stems less from a concern about weak employment, consumer price inflation and economic activity than from the growing pile of debt held by public sector obligors. Unless global central banks lean against the potential debt deflation by monetizing a certain amount of public obligations each year via QE, the situation will very soon become problematic. The new update of the IMF’s Global Debt Database shows that total global debt (public plus private) reached US$188 trillion at the end of 2018, up by US$3 trillion when compared to 2017. Ponder how these figures will look at the end of 2020 after a year of dealing with the coronavirus. “The global average debt-to-GDP ratio (weighted by each country’s GDP) edged up to 226 percent in 2018, 1½ percentage points above the previous year,” the IMF notes. “Although this was the smallest annual increase in the global debt ratio since 2004, a closer look at the country-by-country data reveals rising vulnerabilities, suggesting that many countries may be ill-prepared for the next downturn.” China, of note, has seen the fastest growth in its debt load, this as the Chinese Communist Party has turned to ever larger and more ridiculous types of public spending to keep the nation’s 1.4 billion citizens cowed and under control. We are now into year five of the great debt deflation in China, which was signaled by the collapse of HNA Group and Anbang Insurance and the growing red ink in China’s overall payment flows. Again, ponder China's debt numbers in 2020. Source: IMF We wrote in The American Conservative last week that much of China’s pile of debt is really just deficit spending in disguise: “The collapse of heavily indebted Chinese companies such as HNA and Anbang Insurance Group several years ago illustrated the growing pressure on the Chinese economy caused by hundreds of billions of dollars in subsidies to state companies and local governments that are treated as ‘debt.’” Yet even with the consternation over China, any correction in equity markets as a result of reduced expectations for growth due to COVID-19 will be quickly overwhelmed by the rising demand for dollar assets. The world already had a propensity to hold dollar assets before the start of the year, but as 2020 progresses, the downward pressure on US interest rates will become intense. Should the US central bank, as well as the European Central Bank and Bank of Japan , be buying dollar assets via QE when the rest of the world is piling into risk free securities as well? You can be sure that Governor Lael Brainard and the rest of the FOMC will never ask that question – at least not in public. That would involve an open admission of policy error, something that Federal Reserve is unable to accept. But to be fair, the concept of delegated infallibility is well established in Washington agencies, most notably Defense, Treasury and particularly FiNCEN. We have long maintained that the decision first by the BOJ, then the Fed and ECB, to force interest rates negative via public asset purchases was inevitably deflationary. The diversion of interest payments from private investors to governments, and the reduction in carry on assets generally, reduces private leverage on capital and also current income. We suspect that the deflationary effects of QE cause consumers and investors alike to become ever more cautious. The good news, of sorts, is that inhabitants of the dollar zone will continue to benefit from the spreading deflation in China and the rest of the world as the dollar soars. So long as the dollar remains the global means of exchange, the US under Donald Trump can seemingly issue infinite amounts of debt in competition with profligate communist China, which of course will hyperinflate endlessly to forestall political unrest. The bad news, again in relative terms, is that real inflation on a personal level in the US will remain brisk, with prices for housing and financial assets continuing to rise and with it the true cost of living in dollars. Even in the event of a global debt crisis and restructuring, perhaps by Italy and/or China in several years’ time, we suspect that the demand for fiat dollars will only grow. Global central banks are deliberately engineering a shrinkage of the stock of risk-free assets via asset purchases or QE. This continued manipulation of credit spreads is perhaps the single biggest risk to the market in 2020. We wonder when the FOMC will realize that it is easier to be a price setter rather than trying to physically manipulate the short-term money markets.