"BLACK WEDNESDAY". A day when "rate
sheet influential" MBS were sold by accounts of all types. Banks,
Servicers, Pension Funds, Money Managers, and Hedge Funds...Real Money and Levered
Accounts alike. After all was said and done, over $10bn in "current
coupon" MBS was dumped by mortgage market participants. An amount not even
the Federal Reserve could stand up to...
The broad based shift in coupon bias pushed the MBS current coupon up over 50bps forcing
lenders to reprice two, and even three times, consequently increasing mortgage
rates into the 5.25% to 5.50%
range....the highest levels of the year . This all occurred in one trading
session...."Black Wednesday" seems to be a very appropriate designation
It wasn't just mortgaged-backs that got
massacred though. Treasuries took their lumps as well. 10-year yields
skyrocketed over 18 bps to almost 3.75%, 2s/10s were steeper by 11 bps to 275
bps, and the 30-year bond rose to 4.65%. Equity investors could not ignore the bloodbath
either, the biggest sentiment indicator in the world, the Dow, closed down 173
points after spending most of the morning 200 points higher.
happened? Why the Broad Based Sell Off in Treasuries and Mortgages?
As Matt eloquently explained in Part I
of this Special Report...MBS/Treasury yields spreads were simply too tight (rich). But
this has been an event in the making....
Since March 18 the yield on the 10 year
Treasury note has increased from 2.54 to 3.75...121 basis points in a little
over 2 months.
All while the MBS current coupon has held
stable near 4.00%. (We call this Par-nertia)
As we have informed, this exhibits the degree to
which the Federal Reserve has been "propping up" the mortgage
markets. The below chart further illustrates
the extent to which the Federal Reserve has intervened in the MBS market in an
effort to keep mortgage rates low (all while battling a steepening yield
curve). Notice the majority of purchases are in "rate sheet influential" coupons like the FN 4.0 and FN 4.5...
The Fed's buying over the past month has
indeed offset a large amount of yield curve steepening. MBS yields have
outperformed benchmark Treasury yields.... repetitively....that is until the
previously illustrated "tightness" reached a point where the MBS market
said "enough is enough". During
this period the Fed's intervention in the MBS market sheltered and distorted the
value of mortgage related bonds (made them rich) from several fundamentally negative
income news events....fundamentals that the remainder of the fixed income market
priced into the yield curve.
But What Caused Treasuries and MBS to Collide in Such a Way That Would Cause an Implosion?
Simple: Duration Shedding and Convexity
Hedging. It was all Mortgageland's fault.
If an investor buys "current
coupon" MBS and benchmark interest rates move higher...those investors either
have to sell those coupons for a much cheaper price (function of negative
convexity and embedded call option in MBS) OR that investor must hold the MBS
coupon and hope that borrowers find some reason to pay off their mortgage early
so those prepaid funds can be reinvested at current market. The latter is
unlikely as the borrowers backing those "rate sheet influential" MBS
pools will have no reason to refinance if their mortgage rate is below current
market (adding duration). These market participants are said to be exposed to a
high amount of EXTENSION RISK.
Simple: If market benchmark interest
rates (Treasuries) move higher, non-invested funds then have the opportunity to
be invested at current market for a higher yield and more return (dollarwise,
not necessarily yield spread wise). If an investor buys MBS and benchmark rates
move higher, because the holder of MBS
coupon can't call the debt due (only a
borrower has call option on their mortgage) that investor will be stuck in an underperforming
Yesterday the MBS market came to grips with the
duration of their portfolios...and they decided it was time to shed it.
The market had pushed Treasury yields to the point where extension risk was no
longer a "could be"...it had become a reality. So holders of
"rate sheet influential" MBS coupons dumped it all and repositioned
themselves in a manner that would protect their remaining holdings from the
possibility of underperforming benchmarks (by shorting similar duration
Treasuries and paying fixed in interest rate swap agreements). This hedging
(protective) action initiated a broad based selloff in the fixed income
marketplace...selling beget more selling as the market realized a "great
shift" in sentiment had indeed arrived. It was a snowballing within the snowballing. Yesterday the market was shedding
avoid any extension risk related...including longer dated Treasury securities
and especially embedded call option securities that exhibit increasing negative
convexity as prices move from a premium (over 100-00) into the discount (MBS!).
But Why Now?
What Event Caused Such a Broad based (and Brisk) Eye Opening Selloff?
It wasn't one event...it was a snowballing of
The steepening yield curve is the first to
If you're looking for the underlying
psychological rationale as to why the yield curve has been steadily steepening
(snowballing)....there are several. The ballooning budget deficit combined with
recurring record US government debt issuances. The weakening dollar, rising oil
prices, and the perception of hyperinflation. The market's perception that the
worst is behind us (because of some better than expected economic reports...Consumer
Credit? Come on...see housing data) which has lead to investors moving money from
risk inverse fixed income assets to higher risk/higher return investments (explosion
of corporate bond and new equity issuances). Oh...and there was that message
from the "bond king" last week...remember last Thursday when the
integrity of the United States' AAA credit rating was called into question? China
wouldn't like if we couldn't pay them back...what would the United States do
without a financial backer like China? It wasn't just one event...it was a
recurring theme of fundamentally bad fixed income news culminating with MBS/TSY yield spreads reaching their "too rich" zone (re events: some of which are bad
news for equities too...can you imagine what would happen to the global
marketplace if the US credit rating was cut...currency collapse and Armageddon
come to mind)
The yield curve steadily steepening since
March 18 is something most MBS investors haven't been ignoring though.... as
demonstrated by the majority of the MBS market meddling "up in coupon" (6.0 and 6.5 MBS coupons).
But a portion of the marketplace had a need, either for balance sheet or
charter reasons, to continue to invest in "rate sheet influential"
MBS coupons. These MBS investors had been ignoring the short term fundamental
reactions of the market because the Federal Reserve was providing enough
support to justify holding current coupon MBS.
What those MBS investors didn't count on was
a "snowballing" and culmination of fundamentally negative fixed
income events...those MBS investors had not priced in the fact that market was
now beginning to worry about the "intended" and "unintended"
LONG TERM consequences of the US government printing money to stabilize the
economy in the short run. Those investors had not priced in the marketplace's nerve
to question the long term consequences of a ballooning budget deficit, a
weakening US dollar, hyperinflation, and the possibility of the crowding out
effect destroying private investment. Those MBS investors were not convinced
that the marketplace was ready to flee "risk averse" investments like
Treasury bonds and MBS coupons. Those MBS investors were caught off guard by
the marketplace's willingness to believe that recovery was in effect.
Simple: MBS investors were ignoring the short term
reactions of "crisis exhausted" market participants. All of these fundamental reactions collided
with super rich MBS valuations yesterday (MBS/Treasury yield spreads way too
tight) triggering a mass exodus from longer duration MBS coupons (rate sheet
As appropriately explained in Part I.
Current Coupon MBS spreads can't get much tighter than they already are....this
implies we need a rally in the Treasury market (notes specifically) to make room
for MBS prices to appreciate and for mortgage rates to fall below 5.00% again. Unfortunately
the market's attention will have to be diverted
from the previously discussed "intended" and "unintended" long
term consequences (back to the slow and steady recovery) before it (the herd) decides
to move back into longer dated US Treasury notes.
It appears that only economically
bearish news headlines will have the power to push investor's perspectives back
into the short term though (like the bankruptcy of General Motors?). Then again
the Fed could always step onto their bully pulpit and scare the market away
from the "light at the end of the tunnel" (economic recovery)...but
even then they must still overcome the fact that the market thinks it is always
Wait..isn't the market always right? Allegedly...unless
you consider that "crisis exhaustion" (swine flu) has altered the
market's perception in such a way that the opinion of right and wrong is skewed
(no foundation for good or bad at this point). "Better than expected"
has become a means for celebration lately...maybe this "loss of
perception" has put the market in a place where rational vs. irrational psychological behavior is no longer discernible. After all, "better than
expected" doesn't always mean long term recovery...especially when the
relative comparison is record economic weakness. Do you
think the market can come to grips with the fact that the Fed is so deeply
intertwined in the credit markets (entire banking system) that investors have
no choice but to play along with the Fed's every aspiration?
If the market does indeed believe that the
worst is behind us...then "better than expected" data releases should
only move money if the market's expectations are for noticeable growth and
recovery. Either way the market must make up its mind whether or not it is
ready to deal with the long term "intended" and
"unintended" consequences....if participants are jumping the
gun and the economy is only just stabilizing (meaning avoiding a currency collapse and all-out
Great Depression)....then upcoming economic data
should illustrate this and the yield curve will flatten out allowing mortgage
rates to stabilize as the Fed restores liquidity to lenders looking to sell
their pipeline of newly originated mortgage loans.
Simple: The Fed's recent balance sheet
expansion has served its purpose...to stabilize the economy in the short run. The
calming efforts of the Fed appears to have led the market to believe that the economy is on
the road to recovery (V-shaped). If the market perception is distorted and
investors are overestimating the timing of such a recovery... the recent
steepening of the yield curve will be corrected (oversold) as the herd flows
funds back into risk averse assets.
When making an argument for the flip-side...as
in the possibility that we are stuck with the 10 year note yield at 3.75 and
mortgage rates above 5.0%...one must assume that the economy can escape
recession without the help of a housing recovery. NOT POSSIBLE. So we will keep this short and sweet...we do
not believe the market is behaving rationally at the moment. There will be a
correction. The timing of such a correction depends on the economic data to
come and the psychological reactions of market participants.
Simple: The recent run up in rates and
massive MBS sell off was a function of a
snowballing of financial market's irrational/"crisis exhausted" reactions
to fundamental data. The Fed's interaction in financial markets and whirlwind of
contradictory economic data has altered the market's perception of economic reality. We believe the market's perception of recovery is overagressive...what we are witnessing is economic stabilization...the economy has avoided the worst case scenario. Reality must be restored if we are to avoid the market "biting the hand
that feeds them" (going against the Fed's policies that are intended to save the banking system), inadvertently pushing the global economy into
depression. Now that short term stability has been restored the focus must now be placed on the
building blocks of recovery...the biggest of which are restoring jobs (aggregate demand)
and rebuilding credit within the banking system. Without this strong economic
foundation the housing market will not recover and the United States will lead
the world into a global depression.
So yes...Matt and I think mortgage rates will
improve in the process. To what extent and when...well that is a crapshoot. Lots more debt to be issued by the US government though....
Join Now or Login to Post Comments