The Fed cutting cycle began in November 2022. You just missed it. While you’ll hear a bunch of debate about whether the Fed will raise rates “25bps at the next meeting”, or “they’ll pause!”, or “25bps now and 25bps again at the next one!”…. It all misses the point.
Yes, the Fed isn’t actually cutting rates (yet). But if you are confused by market reaction right now (equities are well off the bottom and credit markets are thawing each day), it is because the market is forward looking and already started to price cuts in. In fact, no matter how hawkish Fed officials have been, rates even at the short-end refuse to budge.
October CPI came in weak. Weak enough to piece together inflation had clearly peaked.
In turn, we had a massive move in the market. The S&P closed up 5.5% that day, but more importantly, look at the yield curve:
The 10 year tightened nearly 30bps, as did the 3, 5 and 7 yr. Since then it has continued to be a dramatic difference, with the 10yr now 70bps inside.
But how else can we see this view changed exactly on that day?
The US Dollar also peaked:
Homebuilders have ripped:
Here are 3 month SOFR Spreads, which is a way to look at market expectations of future Fed policy. Big change around November, huh?
It is no different when the Fed says it will, “likely raise rates 50-75bps at a meeting” like it did in 2022. The market priced that in largely at announcement. The Fed didn’t actually have to start raising rates yet for financial conditions to tighten to that level.
We all like to believe the market is inefficient, and I have seen inefficiencies first hand. In some cases though, it is pretty good at sniffing out the truth. It’s pieced out inflation has peaked and now is time to focus on the second mandate, employment.
When a lender provides a loan for you to buy a house, odds are that lender will originate that loan, package it along with other loans into a mortgage-back security and effectively sell the risk on to investors. They will retain some mortgages on their books, but they do this so that they can continue to originate loans, possibly generate a gain on sale, and generate fees.
Typically, when a homeowner is paying interest and principal, another company called the “servicer” handles the payments and divvies it up to investors, tax authorities, etc. In exchange, they receive a small, fixed fee as a % of the principal balance they manage. This is how the mortgage market typically functions.
The problem: Mortgage servicers are required to pay principal & interest to holders of the mortgages, even if there are missed payments.
Mortgage servicers are not huge companies raking in tons of money off of this service they provide. Banks would be much better prepared to fund this gap.
Therefore, if 5, 10, 15% of people with mortgages decide to defer payment, this could bankrupt the servicers and cause turmoil in the function of the mortgage market.
If 10% of GSE loans are delinquent for 3 months, that would be roughly $6BN in cost – something the servicers don’t have lying around (assumed based on $4trn GSE loans @ 4% WAC). This also doesn’t include taxes and insurance.
Lastly, if Ginnie borrowers can’t be brough back to current on their loans, then the servicers need to fund the buyout of those loans while modifying and re-pooling the loans.
Investors may not receive payment in securities they thought were very safe (remember, backed by government sponsored enterprises like Fannie & Freddie & Ginnie). These investors may also be levered to juice their returns on the securities which may throw them into bankruptcy as well.
Investors were trying to shore up liquidity ahead of some of these unforeseen and unknowable outcomes (i.e. they are selling securities). Agency MBS spreads over treasuries widened to ~140bps compared to ~30bps from Dec 2019 through February 2020. Then the Fed unleashed unlimited QE on agency MBS, so that helped calm the market a bit.
Still, if this is the way we are going to operate, the Fed or the servicers should come up with a liquidity facility for the servicers. Ginnie Mae announced it will launch a liquidity facility in the weeks to come (details TBD) but we need a much more encompassing rule.
Another issue here is in the originators warehouse. Let’s say you are a bank with a “warehouse”, which is like a revolving loan in which you ramp up loans before you sell them off. In a simple example, let’s say in normal times you can originate 2 loans in your warehouse per month, sell them off to investors, and start the process over with capacity in the warehouse for 2 more loans next month. If you originated a loan that isn’t performing, you cannot sell that to investors… that freezes credit. Now the originator is stuck with a bad loan and his capacity to make new loans is drastically reduced. This has me worried about the flow of credit when it is needed.
Take what you know from above and apply it here: widening spreads on previously high quality assets can have negative impacts on levered vehicles.
The agency MBS spreads widened materially and since interest rates and prices move in opposite directions, that causes agency MBS to fall. Mortgage REITs (mREITs) use agency MBS as collateral to back their short-term financing in the repo market. The falling bond prices triggered margin calls on them and we saw many names were unable to meet their margin calls.
After the Fed announced it would buy unlimited agency MBS and treasuries, this helped calm the market, but clearly a lot of damage has been done. The Fed buying mortgages actually helped trigger margin calls. This is because mortgage originators protect their loan pipelines with interest rate hedges to buffer the impact of market rates moving higher than “locked in” rates. These hedges are profitable when MBS prices fall, but the Fed’s massive purchases pushed rates lower. Therefore, broker-dealers put out margin calls and stressed lenders’ liquidity positions.
This also still leaves the non-agency resi and non-agency CMBS space in turmoil, which we’ll discuss next, as names like Annaly is down 62% from the peak in late February. REM, the mREIT etf is down 70% as is MORT.
Third Mortgage Issue: Little bit of both
Fannie and Freddie have allowed multifamily landlords whose properties are financed with performing loans to defer payments by 90 days if they’ve had hardship due to COVID-19. In return, they can’t evict someone who isn’t payment. However, this is just multifamily and just agency-backed names… that leaves 75% of the commercial real estate mortgage market in trouble.
Many other landlords won’t be able to service debt if their tenants enter forbearance or cant pay interest. I’m not sure the system can handle that (i) wave of requests and (ii) that many missed payments. Ultimately, what we will and probably already are seeing is a freeze in the CRE lending market. This too, is causing margin calls on the CRE mREITs.
Its fine to think “ok well, we can get past this. People understand the credit crunch and can forgive a missed payment here and there.” But you have to remember credit drives this economy. The credit cycle = the business cycle, which is why the Fed has gone through great lengths post-2009 to keep rates low and lending on the rise. This system is more connected than ever before. What happens now when maturities come due? There are many questions still left unanswered and this is a truly unprecedented time!