November 4, 2024 | The US bond market rallied for awhile on Friday morning, but the growing size of leveraged short positions in Treasury futures killed any sustained rebound. Brian Meehan of Bloomberg reports that short bets on Treasury yields have risen 50% in the past year to more than $1 trillion notional. These positions are so large that a sudden shift to net long could force the Fed to bail out the Treasury bond market again as in Q1 2020.
Meanwhile, oblivious to the mounting risk in the bond market, global equity managers have piled back into financials with both feet. Like we said. Keep in mind that as the 10-year Treasury note rises in yield, banks become more and more insolvent, as shown in the table below. The average yield on large bank securities was just 3% in Q2 2024, according to the FFIEC. Fannie Mae 3s for delivery in November were trading ~ 86 cents on the dollar Friday.
Source: FDIC/WGA LLC
We rebalanced the WGA Bank Top Indices on Friday with the help of our friends at Thematic and the new group is reflected in the indices. Notice that JPMorgan (JPM) is in the top of the group at number four behind Discover Financial (DFS), Synchrony (SYF) and East West Bancorp (EWBC). Also note that JPM and DFS, the latter of which is awaiting acquisition by CapitalOne Financial (COF), are the only two names that have been in our top ten group all of 2024.
WGA Bank Top 10 Index Constituents
Source: WGA LLC
JPM's position in the index was unchanged vs Q3, but there was a lot of movement in the rest of the group. Wells Fargo (WFC) is back in the top quartile of the test group and Bank of America (BAC) moved from the third quartile to the second, but Citigroup (C), Truist Financial (TFC) and Ally Financial (ALLY) remain in the bottom quartile of our 105 bank test group. Subscribers to the Premium Service have access to the index constituents and the weightings for Q4 2024. The chart below shows the entire test group by market cap, with the highest scoring banks starting on the left.
Source: WGA LLC
Even as hedge funds place huge bets on Treasury yields moving higher, the Fed may be finally considering sales of mortgage-backed securities. The Federal Reserve Board has been reducing the size of its Treasury holdings by $25 billion per month and up to $35 billion in MBS, but in fact the rate of prepayments on the mortgage paper is only a fraction of that amount. Prepayments on late vintage MBS surged in Q3 2024, but the sharp rebound in Treasury yields abruptly ended the September mortgage market rally.
“Speeds in the premium coupons jumped considerably last week, and have been elevated for the past four weeks,” notes Scott Buchta at Brean in a note about actual prepayments in September. “These pay-offs will primarily show up in the October prepayment report as there were a couple of collection days included in the Sept 28th-Oct 4th report…. The biggest w/w increases were in the 6.5% and higher coupons. In general, prepayment activity in the discount coupons remains very low (<=5 CPR) as turnover and cash-out refinancing activity remains muted.”
“It is important to remember that these are the actual pay-offs (end of the process), vs refi applications which are at the beginning stages,” Buchta continues. “These [refi] indices are most likely near their peak, and we expect them to drop considerably as we move through November and into December as the refi indices have fallen 45% from their recent highs.”
Why is this a problem for the Fed? Because the reduction of the system open market account (SOMA) at the Fed is moving asymmetrically, with relatively short duration Treasury paper running off in a very mechanical and predictable fashion. The low coupon MBS, however, is lingering as the few high coupon securities held by the Fed prepay, but the rest of the portfolio of low-coupon MBS is barely moving. More, the effective duration of the SOMA MBS holdings is now larger than the Treasury securities owned by the Fed.
Although the cap under the Fed’s “quantitative tightening” or QT is $35 billion in prepays of MBS from the SOMA each month, the actual prepayments are closer to $15 billion per month. The table below shows the relative increase in the MBS as a percentage of total SOMA securities. Keep in mind that, measured in dollars, the duration of the $2.2 trillion in nominal MBS owned by the Fed is closer to $6-7 trillion, depending on your prepayment assumptions.
Source: FRED
Last week, Bill Nelson at the Bank Policy Institute published an important piece about how the Fed manages (or fails to manage) reserves. He noted, for example, that the model for liquidity used by the Board was designed decades ago (1968 in fact) by Bill Poole to measure liquidity intraday. The model was never intended to predict liquidity needs over time. Nelson:
“There is a flaw at the heart of this conception of monetary policy implementation. The Fed seems to think that when it oversupplies reserve balances, those extra balances just sit idly in each bank’s account at its Reserve Bank, ready to be redeployed easily in pursuit of higher yields. The mistake has arisen because the Fed is drawing intuition from a decades-old model of reserve supply and the federal funds rate that was intended to describe the relationship over a day. The mistake has caused the Fed to incorrectly judge that QE can fairly easily be reversed by QT and to misunderstand the relationship between its balance sheet and repo market resilience.”
At the end of his piece, Nelson suggests that the Fed may be considering sales of MBS. Why? Because the portion of the SOMA portfolio that is in MBS is now rising as Treasury paper runs off. This is contrary to the public statements by Chairman Jerome Powell and other FOMC members that the Committee would like to return to owning primarily Treasury securities. In technical terms, moreover, it would be desirable to put away this huge block of duration with investors and invest the proceeds in higher coupon Treasury securities. A big reason for Powell to do the CMO trade is to narrow the Fed's negative net interest margin and eventually get it positive.
Nelson notes that while the Fed is shrinking only by allowing securities to mature without replacement, it could also gradually sell securities. The Fed originally planned to sell securities to normalize its balance sheet as discussed in the June 2011 FOMC meeting. He concludes:
“It would be doubly useful if the Fed sold MBS as opposed to Treasuries. The Fed’s current normalization principles state When QT started, 32 percent of its portfolio was MBS. Now, 34 percent is MBS. No one is refinancing the mortgages made at ultra-low rates that are bundled into the Fed’s MBS, so the securities are maturing very slowly. In a recent speech, Lorie Logan, President of the Dallas Fed, reminded the audience that the FOMC said in May 2022 that the FOMC might sell MBS and that they haven’t rescinded that possibility. Maybe it is not a coincidence that Roberto Perli, the recently hired head of the open markets desk at the New York Fed, is an expert on mortgage markets.”
In June of 2022, we asked whether it wasn’t time for the Fed to engage the Federal Housing Finance Agency (FHFA) under Director Sandra Thompson to fix the growing duration trap facing the Fed, the GSEs, many REITs and the banking industry (“The Fed and Housing”). Thompson, who has extensive experience at FDIC and Resolution Trust Corp dealing with bad assets and troubled depositories, understands why time is the most precious aspect of managing risk. And time may be against us all when it comes to LT interest rates.
Obviously with residential mortgage rates near 7% again, nobody in Washington or on Wall Street wants to see the Fed making outright sales of MBS into a retreating secondary market. But the Fed can use the power of wide spreads, which have boosted issuance of collateralized mortgage obligations (CMOs) and other structured securities, to shed low-coupon MBS on the books of the Fed and also banks and other financial institutions. The goal is to normalize net interest margin for the Fed and banks within say two years. We wrote in March of 2023:
“The Fed, the prudential regulators, the FHFA and the GSEs need to sit down together and fashion a comprehensive program that will allow [the Fed], banks, REITs and the GSEs themselves to repackage low-coupon loans and MBS into CMOs and sell this paper into the market. The FHFA needs to re-open the doors of the GSEs to securities and seasoned loans older than six months. Once the selling process begins, prudential regulators will need to give banks forbearance in terms of the recognition of losses and the impact on capital.”
Given the fact that LT interest rates may, in fact, continue to rise, we need to buy time so that banks are not forced into involuntary sales. The good news is that by using the power of the GSEs as underwriters, we can restructure the cash flows from the existing MBS and create attractive “AAA” rated income producing securities and deep-discount zero coupon securities. Banks and other investment grade investors can buy the relatively short-duration front tranches of these CMOs, while funds and insurers will find the longer-duration paper attractive.
The Fed ought to aggressively sell the short-duration tranches of deals created with SOMA MBS by the GSEs, but retain the volatile, longer duration (and higher return) tail pieces to reduce the impact on markets (and possibly generate a nice return for the Fed and taxpayers in the future). The FOMC should authorize the FRBNY to contract with the GSEs to issue CMOs starting with the lowest coupon paper, the 2s and 1.5s that the SOMA now holds.
The same dynamic that has caused the duration of COVID-era MBS to quadruple or more since 2021 also affords the Fed an opportunity to get back some of the billions of tax dollars they have spent via QE. Unlike banks and other private financial institutions, the Fed has the ability to sequester long-duration, deep discount tranches of CMOs that can be problematic for private issuers. It’s time for the Fed to get smart on managing duration risk and help itself and the banks before circumstances create another money market crisis.
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