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January 6, 2022 | In this Premium Edition of The Institutional Risk Analyst, we ponder the world of interest rates, stocks and mortgage servicing rights (MSRs) in the wake of the latest pivot in US monetary policy. In past comments, we have referred to the policy shift of FOMC Chairman Jerome Powell as pirouettes, but the most recent change in FOMC policy seems to be more of a fouetté. If you are Misty Copeland, Gillian Murphy or any of our other friends at American Ballet Theater in New York, you got to be able to do a couple dozen fouettés in a row to be in the big leagues of dance.
News that the FOMC is pondering the schedule for rate hikes and other changes took stock markets unawares this week, creating a level of discomfort with more speculative stocks. As we wrote a while back (“As the Fed Ends QE, Stocks and Crypto Will Retreat”), the degree to which stocks have been pushed higher by QE is not fully appreciated by global investors. There are a long list of MEME stocks, for example, that are at valuations that do not make sense in the absence of QE. We think the chart below from FRED is worth any amount of words on the impact of QE on equity market valuations.
As we noted in our last comment, the published plan from the FOMC is to end additions to the system open market account (SOMA) by March 2022. This means that the Fed’s bond portfolio will continue to grow for three more months. Yet even the prospect of a change has sent waves of selling through the stock market. Imagine what happens if the FOMC decides to curtail reinvestment of redemptions and prepayments and shrink the Fed’s balance sheet a la 2019.
Thus the good news is that the markets ought to be stable through the end of Q1, cushioned by more than ample liquidity, on the one hand, and a robust reverse repurchase (RRP) facility ($1.6 trillion at 12/31/21) to absorb any wayward cash. Lee Adler in Liquidity Trader writes:
“The debt limit has been raised. The Treasury has flooded the market with supply, and will continue to do so for another month or two. But there’s been no disaster in the market. The Fed’s RRP slush fund, designed to absorb the flood of supply, has even grown, thanks to year end window dressing. Even after that window is undressed this week, there will still be around $1.6 trillion in that fund to start. That is overnight liquid money that holders will use to buy new Treasury issuance. The RRPs will gradually be drawn down. But there’s enough there to absorb the ongoing supply bulge that the government needs to issue to rebuild its cash and repay the internal accounts it raided while the debt limit was in place.”
Meanwhile in the MBS markets, falling production and slightly wider spreads are setting the tone for 2022, but as yet market participants are not focusing on the implications for net demand for mortgage paper over the full year, after the FOMC ends additions to the SOMA. Robert W. Baird’s Kirill Krylov and Steven Scheerer see net supply growing to $650 billion as the Fed and banks pull back, suggesting that MBS spreads will widen to clear the markets. They write:
“Add to this another $30 billion of supply produced by GSEs (via portfolio reductions) and the market will have to absorb close to $715 billion in net supply in 2022. On the net basis, the Fed’s contribution in 2022 will decline to only $43 billion compared to the $480 billion purchased in 2021; banks will also lose steam with expected appetite of $315 billion or a $100 billion decrease from last year.”
While stocks and bonds may not benefit from the planned and prospective changes in Fed monetary policy, the negative duration world of MSRs is looking increasingly attractive. In reaction of the latest Fed moves, Alan Boyce told The IRA that the Fed may not appreciate how the change in policy will impact the mortgage market.
“Here comes the extension risk embedded in $12 trillion of 30 year 3% mortgages,” he opined earlier this week. “Nobody is going to prepay. MSRs are going to be worth a bunch. If nobody prepays those cashflows are worth a 6 multiple.”
Source: MIAC
In the same conversation, Boyce notes that real interest rates in the US are now profoundly negative, a big argument of the FOMC doing more sooner. “Real interest rates are negative 9%. The Fed should cease buying bonds and reinvestment right away and raise the federal funds rate by a bunch. The last cut to the funds rate of 0.25% came in March 2020.”
One reason that agency and government MSRs are likely to climb in value is the fact that issuance is falling overall. Even though the Federal Housing Finance Authority increased the conforming limit at the end of 2021, the window for buying loans on second homes and high balance loans in the conventional market has been severely reduced
The FHFA announced targeted increases to the loan-level price adjustments the government-sponsored enterprises charge for second-home mortgages and certain high-balance loans. The LLPA increases will not go into effect until April 1, 2022, to “minimize market and pipeline disruption,” the agency said.
The change by the FHFA is clearly meant to position Acting Director Sandra Thompson for a successful Senate confirmation. But the change is also consistent with her previous comments, namely that the announced changes in the PSPA were not the end of the story in terms of changes to the GSE windows made under former Director Mark Calabria.
FHFA raised the conforming limit because they had to, but have now walked back a significant part of the increase. By adding the LLPAs, FHFA is essentially telling the market that they do not want the high-balance and second home business at all. High-balance loans in CA go above $1.5 million, for example, not a loan that needs government subsidy. Also, because of the existing limits on such paper, the change should not negatively impact the too-be-announced (TBA) market.
Net, net however, the changed by the FHFA will effectively reduce the supply of GSE MBS in 2022, perhaps offsetting the planned sale of portfolio loans. The real question for Thompson and President Joe Biden, however, is when are you going to remove the LLPAs for low-income borrowers who do need help? We applaud Sandra Thompson for raising LLPAs on loans for the wealthy and investors, but it is high time that the FHFA did the right thing and reduced or eliminated the 2008 LLPAs on low-income borrowers.
