The fragile mortgage market

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Good morning. It’s Jenn Hughes here as Rob enjoys his escape from markets’ endless Debt Ceiling Watch. Away from the Washington wrangling, stocks appreciated the strong numbers from Nvidia but bonds weakened on a surprise upwards revision to first-quarter growth. That prompted investors to factor in a 50 per cent chance of a July interest rate rise by the Federal Reserve. It was only a month ago that rate cut talk was all the rage. Whiplashed and/or worried? Email me:

Home moans

The US debt ceiling discussions make it hard for other markets to get a look-in. So strains in the $12tn mortgage market aren’t necessarily front-of-mind but they’re very real and Thursday’s gross domestic product revisions and rate rise chatter only add to them.

Mortgage borrowing costs have hit a two-month high of 6.57 per cent, according to a Thursday survey from mortgage finance giant Freddie Mac. That’s painful enough for would-be buyers, but more significantly, spreads, or the premium demanded to hold mortgage-backed securities over straight Treasury yields, on Thursday reached 1.89 per cent, surpassing their March 2020 market panic peak.

October’s 1.79 per cent high came when investors panicked that rates would be higher for longer and worried too that the Fed might begin selling its $2.5tn holdings. Instead, it chose only to stop reinvesting proceeds from maturing bonds — a far more gradual process.

That leaves the current spreads level-pegging with a peak in September 2011 (the aftermath of a debt ceiling fight), though short of their 2008-era high of almost 3 per cent.

Fear is not the only factor dictating spreads, of course. Supply is tight, which is helping keep yields in check. That’s to be expected when refinancing demand is virtually non-existent at these rates, as people cling tight to their low-rate home loans. Something like 95 per cent of outstanding mortgages charge less than 4 per cent, per data cited by Bank of America in February.

Demand is trickier. The market has coped well with BlackRock’s steady selling of the $114bn in MBS and other assets inherited by the Federal Deposit Insurance Corporation from the collapses of Silicon Valley Bank and Signature Bank. Until recently, good investor interest in the FDIC’s holdings was buoying market sentiment and producing analyst recommendations that investors switch out of investment-grade corporate bonds into MBS.

But banks are historically a big buyer of mortgage-backed securities. They’re not out of the woods yet — as shown by, and also because of, MBS prices. Banks have pledged $91.9bn of MBS and Treasuries at the Federal Reserve as of Wednesday under the Bank Term Funding Program introduced after SVB’s collapse to stave off fears about wider forced selling. That’s up just less than $3bn in a week, the third consecutive weekly rise:

Column chart of Loans outstanding under the Federal Reserve's Bank Term Funding Program ($bn) showing The rising cost (to the Fed) of a weak MBS market

Unless the MBS market rallies, that number is likely to keep rising as banks, stuck with underwater holdings, must either realise those losses or take advantage of the BTFP if they need to raise cash.

The great hope was that the MBS market would be boosted by rate cut expectations. Fresh investment lured by that cheerier outlook would push up prices and bring down spreads as well as absolute yields, spark new homebuying interest and bolster the wider economy. The current rate rise talk might be based on stronger data, but it’s unlikely to produce a stronger economy if the mortgage market is any guide.

Japan activism and its discontents

Some 10 years ago a large Japanese company replied to my offer to discuss their overpaying, in my opinion, for a consumer brand (I was the FT’s Lex columnist in Hong Kong at the time). “We do not think we overpaid,” they said, “because we have lots of cash.”

That frustrating attitude to valuation is worth bearing in mind as recent activist victories are spurring fresh hope that the cash hoarded by Japan Inc could at last be freed for investor benefit, as Ethan discussed earlier this week. But a decade reporting on Asia makes me wary of believing in a wider shift beyond some very dogged work at specific companies by activists such as Elliott and Oasis. Here are two cautionary tales.

1) Toshiba Remember in 2017 when a group of western funds backed a desperate cash raising by the scandal-wracked titan? Six years and several further scandals later — including signs of collusion between executives and government officials to see off foreigners’ proposals — the pushy outsiders did win two board seats. But the storied group is currently being taken private for a price far short of those investors’ hopes.

2) Bank of Kyoto The $3.7bn regional lender is one well-known example of Japan’s infamous cross-shareholdings, where companies cement business and regional ties by buying each other’s shares. The bank has 146 “strategic equity” stakes worth $1.1bn as of March 2022. It is moving gradually in the right direction but last year committed only to reducing the holdings by 10 per cent by 2025. And it just rejected, again, a request by longtime shareholder Silchester to pay out all its investments’ dividends. At $279mn in the year to March 2022, they dwarfed its $168mn net profit.

I’m generalising here, but a rule of thumb for stockpickers seeking likely activist targets might be to focus on the names with western sensitivities, be those shareholders or their product markets. Be careful around those with government links of any sort, such as Toshiba. And steer clear of hoping those with domestically focused businesses and seemingly easy solutions will do the logical thing.

Don’t forget to adjust for inflation

Ethan here. I made a dumb error in yesterday’s piece about R-star, the natural rate of interest. The offending part was: “Policy rates are some 380bp above the estimated natural rate.”

To recap, monetary policy is “tight” insofar as the policy rate is above the natural rate. However, this is only true of the real policy and natural rates, and yesterday I neglected to adjust the policy rate for inflation. That 380bp figure compares a real rate, R-star, to a nominal one, the fed funds rate, so it makes no sense.

I’ve redone the maths, this time putting the fed funds rate into real terms. The chart below uses a few different gauges of inflation expectations: 10-year break-evens give the market’s view, the University of Michigan survey gives the view of consumers, and the Philadelphia Fed survey captures that of professional forecasters. The real fed funds rate is then shown as a spread over the New York Fed’s recently updated R-star estimates:

Line chart of Real fed funds rate spread over R-star, using different inflation adjustments, % showing Policy is tight

So it’s more accurate to say that policy rates are about 130bp above the estimated natural rate. That is still tight, but not 380bp tight. Thanks to all those who caught my mistake. (Ethan Wu)

One good read

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