After a long-awaited vacation, the Weekend Reading is back. Last week I headed down to Florida with my family to enjoy the sun and the beach. Logging into FactSet and seeing all these quotes in red, I think I need another vacation.
Anyways, we flew back on Saturday so we could get to a ballet recital on Sunday. Yes, as a father of two girls, ballet recitals are now the center of my social calendar.
Naturally, Sunday was an absolutely beautiful spring day. Sunny, 60’s, light breeze… the kind of day that should be spent on a golf course.
My friend texted me to see if I could play. I texted him back from the dark, depressing, windowless auditorium and then put my phone on silent. As I later found out, to add insult to injury my phone autocorrected to “baller recital.” Not only did I spend the day at a ballet recital but I am far from cool enough to attend a “baller recital.” If anyone knows how to update an iPhone’s default settings to Suburban Dad please let me know.
Small businesses are the engine of the US economy.
Politicians fall all over themselves to provide headline-grabbing subsidies for large companies. In truth, small businesses (fewer than 500 employees) account for almost half of US jobs. More importantly, these dynamic businesses account for almost 2/3 of all job growth. Understanding what is happening with small businesses is key for understanding the direction of the US economy. (NFIB Monthly Economic Report- April)
- Inflation concerns are high and rising. Inflation concerns are at their highest since 1Q81 and displaced “labor quality” as the top problem facing small businesses.
- Owners expecting better business conditions over the next six months decreased 14 points to a net-negative 49%. The lowest level recorded in the 48-year-old survey.
- 72% of owners raised prices over the past three months, a 48-year record high reading.
- Inflation is hot. Duh. No surprise here. But does this suggest a peak in inflation or does this suggest stagflation?
- With the Fed currently hiking, I’m hopeful we can avoid stagflation but the negative outlook of small business owners worries me.
Quantitative Tightening and the Mortgage Market
Reminder: Discussion of securities does not constitute a recommendation to buy. Please review full disclosure below.
Raising the Fed Funds rate is just one way the Federal Reserve impacts financial markets. The other way the Fed influences interest rates is by purchasing other securities on the market. To provide liquidity and manage rates, the Fed has been engaging in Quantitative Easing (QE) where it buys up Treasury bonds and mortgage securities. By bidding up the prices, the Fed holds down the yields. If the Fed wasn’t there as a buyer, bond prices might fall and interest rates rise to levels that could harm the economy.
The Fed is an enormous buyer of Treasury bonds AND mortgage-backed securities. The US national debt is about $30T and the Federal reserve owns about 20%. Additionally, the Fed owns about 1/3 of all outstanding mortgage-backed securities (MBS) guaranteed by Fannie Mae and Freddie Mac.
In addition to raising the Fed Funds rate 50bps, the Federal Reserve also stopped Quantitative Easing (QE) and is starting Quantitative Tightening (QT). This means that the Fed will NOT be buying treasuries and mortgages but will be letting these securities ‘run off’ as they mature. Today, I want to focus on the mortgage market specifically.
Mortgage rates tend to track the US 10-year treasury bond. Today, the 10 year is at about 3% and a 30-year mortgage is at about 5.4%. The difference or “spread” is about 2.4%. This spread is an important indicator of financial market health.
Issues arise when the spread between the 10 year and mortgages rise. If this gets too high (ie ‘spreads blow-out’) it can signal liquidity issues in financial markets. For instance, something might be happening that makes investors badly want to buy treasury bonds but too scared to buy mortgages. You can see in the below chart that this happened in the Global Financial Crisis in 08/09. It also happened in March of 2020 thanks to COVID-19. Both times, investors who owned MBS found themselves unable to sell these securities. There simply were not enough buyers. During normal times, MBS are some of the most liquid securities (second only to treasuries). MBS are often used as collateral in financial transactions because they are so liquid. In 08/09 and 2020, when investors found themselves suddenly unable to sell their MBS, the follow-on effect was profound. In fact, the below char showing spreads go from 1.7%-2.7% in 2020 does not do it justice because transactions were not happening. In both cases, the Federal Reserve had to step in and support financial markets by buying up these securities.
You might say, “so what, the Fed steps in when they need to and life goes on right? The system works fine.” Again, the follow-on effects of this can be profound. For example, consider Invesco Mortgage Capital (IVR). Prior to 2020, this was a sleepy mortgage real estate investment trust (mortgage REIT). A mortgage REIT works this way: say each MBS security pays interest of 6%. If you can borrow at 4%, there is a 2% profit spread to be made. This 2% profit margin is nice but to justify the use of capital, equity holders will need to earn more than 2%. So a mortgage REIT like IVR levers up its equity by borrowing short-term debt. With the proceeds from this debt, IVR buys MBS. IVR was levered up about 6x meaning that for each $1 of equity, it had $6 of debt. Suddenly, that 2% spread becomes a 12% return on equity. This might sound reminiscent of overleveraged and complicated derivative bets on the housing market from the global financial crisis. A key difference here is that the credit quality is much higher and the leverage is much less. Securitized Fannie Mae and Freddie Mac mortgages, known as Agency MBS, are backed by the US government. In terms of liquidity, Agency MBS rank second only to US treasuries. The point is, 6x leverage with such as safe asset is not a ridiculous risk. But if liquidity dries up and banks demand payment of the loans (as happened in March 2020), things can get dicey. On the below price chart of IVR, it’s pretty easy to find March 2020. The Fed DID step in to help in 2020 and still IVR’s capital was permanently impaired. I believe that if the Fed waited just 2-3 days, IVR would have declared bankruptcy (along with a slew of other mortgage REITS).
Liquidity problems are no joke!
**You might be wondering, “why does a vehicle like IVR even exist?!” more on that at the bottom of the post.**
So, back to the chart showing 30 year mortgage rate versus the 10 year. Recently, this spread has increased. Nothing problematic but if this continues it might signal trouble. What gives me cause for concern is that the Federal Reserve was still buying MBS up until early March when the spread crossed 2%. After March, the Fed was still maintaining its position by replacing maturing MBS. As a huge purchaser of MBS, the Fed is bidding up MBS and hold down interest rates on mortgages. When the Fed backs away, will spreads widen further? No one knows but as a huge buyer exits the market, it makes sense that MBS prices might fall (and MBS yields rise). Lower MBS prices >> Higher MBS yields >> higher mortgage rates for borrowers.
The Federal Reserve has come to account for about 1/3 of the entire mortgage market. Tapering does NOT mean that they will suddenly sell everything, but the shift from net-buyer to net-seller is significant. Not only are mortgage rates higher but mortgage rates are also higher relative to US treasury bonds. While the financial press is laser focused on the 50bp hike in the Fed Funds rate, the Federal Reserve’s actions in the mortgage market could have much more profound effects on the economy. After all, housing drives about 15-18% of the US economy and home prices also contribute to consumer sentiment.
As the Fed steps away, what market actors will step in as buyers of MBS?
How high will the Fed allow spreads to climb before stepping in or reversing course?
**Mortgage REITs have been around since the 1970s and can serve a few purposes. First, as a buyer of MBS, mortgage REITs help add liquidity to this market. When a market is very liquid and has lots of buyers, costs decrease. In other words, it helps the cost of a 30 year mortgage decrease. Mortgage REITs are also unique investment vehicles. For individual investors, buying MBS is relatively difficult and not that profitable. By buying shares in a mortgage REIT, investors can get levered exposure to the mortgage market and earn dividend yields 8-11%. If you need income or if you think interest rates are going to drop, mREITs can be a terrific investment. Finally, regarding my example, I chose IVR specifically because it was a horror-story. AGNC, PMT, MFA are examples of mREITs that did not implode.
**Mortgage REITs have been around since the 1970s and can serve a few purposes. First, as a buyer of MBS, mortgage REITs help add liquidity to this market. When a market is very liquid and has lots of buyers, costs decrease. In other words, it helps the cost of a 30 year mortgage decrease. Mortgage REITs are also unique investment vehicles. For individual investors, buying MBS is relatively difficult and not that profitable. By buying shares in a mortgage REIT, investors can get levered exposure to the mortgage market and earn dividend yields 8-11%. If you need income or if you think interest rates are going to drop, mREITs can be a terrific investment.
Finally, regarding my example, I chose IVR specifically because it was a horror-story. AGNC, PMT, MFA are examples of mREITs that did not implode.