Speaker 1: Hello, and welcome to another episode of the All Thoughts podcast.
Speaker 1: I'm Tracy Alloway and I'm Joe Wisnal. You know, Joe,
Speaker 1: we've been talking a lot about what higher interest rates
Speaker 1: mean for the housing market, and we had that really
Speaker 1: good episode with Morgan Stanley's housing strategist, Jim Egan. He
Speaker 1: walked us through a lot of the technicalities of the
Speaker 1: impact of higher rates on house prices. But I think
Speaker 1: we could get even more detailed. Well, absolutely, because we
Speaker 1: talked about what is the impact of higher rights on housing,
Speaker 1: but we didn't really talk about why have rates gone
Speaker 1: so much higher? And I know, like this is all
Speaker 1: I know about housing finance. I know the government like
Speaker 1: backstops a lot of or implicitly or explicitly actually I'm
Speaker 1: not even sure anymore, but backstops all a lot of
Speaker 1: it does it does even more. It's so like you
Speaker 1: start with like the sort of risk free rate on
Speaker 1: like treasuries because it's government, and then you add some
Speaker 1: spread and that's like the average more and then I
Speaker 1: don't know anything beyond that. Well, that's a fair question
Speaker 1: that where does that spread come from? Why do people
Speaker 1: make additional money or why do they demand an additional
Speaker 1: premium for investing that's in something that has a guarantee
Speaker 1: from the US government. Yeah, exactly right. This is the
Speaker 1: part I don't understand, Like, if the if the asset
Speaker 1: is backed by the US government, why don't we get
Speaker 1: mortgages the same rate as treasuries? But it's not because
Speaker 1: right now, a third year treasury somewhere on four percent
Speaker 1: and a third year mortgage is around seven percent. And
Speaker 1: that's spread various quite a bit from time to time.
Speaker 1: So even as recently is last spring, the gap between
Speaker 1: a mortgage and a treasury had gotten down to less
Speaker 1: than one percent. Now it's around three percent. Where did
Speaker 1: that spread come from? And why does it change over time?
Speaker 1: Or two things? I just don't know the answers right well. Also,
Speaker 1: that three percent spread is like at the highest that
Speaker 1: it's been I think of all times. So like something
Speaker 1: is happening in the mark it right now that is
Speaker 1: different to the way it used to work, and I
Speaker 1: think we need to dig into that. You know, we
Speaker 1: spoke a little bit with Jim about it, but we
Speaker 1: really need an expert. And I got to say I
Speaker 1: was sort of bated by there was a tweet recently
Speaker 1: It started with I'm not about to go on a
Speaker 1: podcast to explain why, but this year has likely broken
Speaker 1: the market for mortgage backed security. That was a dare time.
Speaker 1: It's like if he's like you did now, just like
Speaker 1: I'm not going to go on a podcast, It's like,
Speaker 1: all right, let's try us, let's see, let's see if
Speaker 1: you can resist. Okay, well, here is the podcast to
Speaker 1: explain why the MBS market seems to be broken. We
Speaker 1: are going to be speaking with really the perfect guest.
Speaker 1: We have Guillermo rodit Domingo's He is the managing director
Speaker 1: at New River Investments, and he is going to explain
Speaker 1: all of this to us in detail. One of our
Speaker 1: super fans, I think really, I think so. He's one
Speaker 1: of the first to tweet them often so and we've
Speaker 1: known him a long time. So very excited about this conversation.
Speaker 1: So maybe it wasn't a dare, or maybe it was.
Speaker 1: You know, please pick me for the podcast, Guermo. We
Speaker 1: are delighted to have you on. Really looking forward to
Speaker 1: the conversation. I am very very very happy to be honest.
Speaker 1: A bucket list item for me, and you know I
Speaker 1: do stay up until very late at night. So I
Speaker 1: can listen to you know, odd Lots and tweet out
Speaker 1: my notes before anybody else wakes up. I love that.
Speaker 1: That makes me happy. Okay, So why don't we start
Speaker 1: out with Here's a very simple premise, is the current
Speaker 1: moment in the mortgage market. And you know, when I
Speaker 1: say the mortgage market, I'm kind of talking about mortgage
Speaker 1: back securities a k A m b S. A lot
Speaker 1: of people will think back to you know, pre two
Speaker 1: thousand eight times and think of them in that context.
Speaker 1: But is this particular moment in the mortgage market different
Speaker 1: or remarkable in some way? Like, can you give us
Speaker 1: some historical context around what we're seeing right now? Yes,
Speaker 1: So this moment is special because it's not happening because
Speaker 1: people are afraid people are not going to pay their mortgages.
Speaker 1: Is them because people are afraid house pics it's going
Speaker 1: to go down. It's a common nation of the fact
Speaker 1: that mortgage backed securities went from being effectively short lived
Speaker 1: assets because we went through a pretty epic refinancing boom
Speaker 1: in two all of a sudden, rates going up, very
Speaker 1: very very quickly, faster than anybody expected, pre payments going
Speaker 1: effectively to zero, and a huge train on neutral funds
Speaker 1: from tax payments that we're do for games from counter year.
Speaker 1: That's you know, give or take one and a quarter
Speaker 1: trillion dollars. That's probably the highest compared to GDP that
Speaker 1: we've ever had. This kind of conspired to leave holders
Speaker 1: of mbs holding securities that have a much longer expected
Speaker 1: life than than they ex than they originally expected when
Speaker 1: they purchased them, and you know, the discount rate on
Speaker 1: that longer life going up, which has been pretty disastrous
Speaker 1: to the prices of this product. This gets to an
Speaker 1: important nuance or an important thing. A person buys a
Speaker 1: house and it takes out a thirty year fixed mortgage.
Speaker 1: Let's start really simple. They get a thirty year fixed mortgage.
Speaker 1: Someone owns that asset, but their expectation is not that
Speaker 1: they're going to hold that for thirty years. They're not
Speaker 1: thinking like, Okay, I'm gonna wait thirty years. What is
Speaker 1: the typical length via which that asset exists? How frequently
Speaker 1: in normal times would it either get refinanced by the
Speaker 1: homeowner or sold because the homeowner sells the house and
Speaker 1: the loan gets paid back automatically. On a basic on scenario,
Speaker 1: you would assume that you have a thirty year mortgage
Speaker 1: transit weighted average life of the castles, because it's an
Speaker 1: advertising a loan of about you know, fifteen years, and
Speaker 1: we have some expectation of turnover. You know, people move,
Speaker 1: you know, people sell, sell their houses, or prepay their
Speaker 1: loans for many different reasons, all sorts of life events,
Speaker 1: and you know that shortens the effective life to you know,
Speaker 1: about half of that about seven years. And usually we're
Speaker 1: assuming anywhere between six and eight percent of loans on
Speaker 1: an annual basis transition, not because they are refinanced to
Speaker 1: their being a rave incentive, but from any other number
Speaker 1: of reasons. During one we saw about thirty six percent
Speaker 1: of loan balances being extinguished each year. That's a lot,
Speaker 1: you know, Usually, you know we're expecting about half of
Speaker 1: that sixteen. You'll recall in the first three course of
Speaker 1: the year we had pretty low rates and we got
Speaker 1: up to twenty and that was that was pretty high.
Speaker 1: And you know t n which was a more normal year,
Speaker 1: we were at out seventeen. So you know, this fueled
Speaker 1: a lot of extinguished singing over those balances, and you know,
Speaker 1: you you bought what you thought was a seven year asset,
Speaker 1: and you know, it turned out that it was, you know,
Speaker 1: a five year asset, and then happens and all of
Speaker 1: a sudden, you know, you're holding a ten year asset, right,
Speaker 1: So can we dig into this just a little bit
Speaker 1: more because I seem to remember during the era of
Speaker 1: low interest rates, so you know, after two thousand and eight,
Speaker 1: when rates were just grinding lower and lower and lower,
Speaker 1: the big investors in MBS, the big buyers, and we
Speaker 1: should probably talk about who those actually are. At some point,
Speaker 1: they didn't want MBS to be prepaid because it basically
Speaker 1: meant that they would get like a bunch of money
Speaker 1: that they then had to invest at even lower interest rates.
Speaker 1: Now we're in an environment of higher rates, and it
Speaker 1: feels like MBS is not desirable because suddenly it leaves
Speaker 1: you with an asset that has much longer duration than
Speaker 1: you expected and much more exposure to interest rate volatility.
Speaker 1: Is that right? Yeah, that's correct. I think one way
Speaker 1: to look at it is a mortgage backed security is
Speaker 1: essentially similar to a covered call in equity terms. That
Speaker 1: means that you know you have all of the downside
Speaker 1: and you know very very little of the upside and
Speaker 1: you trade that in for a little bit of extra coupon.
Speaker 1: And you know, when rates were going down, everybody was
Speaker 1: upset about it because you know, treasury bonds were going
Speaker 1: up and frist people are making money there. If you
Speaker 1: have the NBS, you know you've got your money back,
Speaker 1: and then you want to buy new bonds. You know
Speaker 1: you bought them at a lower yield. And right now
Speaker 1: what we're seeing is all of a sudden, bond prices
Speaker 1: are are going down, the yields are going up, and
Speaker 1: you know you're not getting any castles, so you don't
Speaker 1: get to reinvest the money. This is sort of a
Speaker 1: key thing, and I just want to like make it clear.
Speaker 1: You know, everybody knows that a homeowner can always like
Speaker 1: refinance their home, and people talk about like homeowners a
Speaker 1: third year fixed has like a quote like free option
Speaker 1: to refinance their home if rates go down after them.
Speaker 1: But essentially that free option for the homeowner is a
Speaker 1: theoretical source of risk for the holder of the NBS.
Speaker 1: So there's two ways for the MBS holder to lose. It.
Speaker 1: Sounds like one is, Okay, rates go up a lot
Speaker 1: and then you're not getting much payment done those bonds
Speaker 1: or ready to go down and then you have to like,
Speaker 1: you know, eat that repayment. Yeah, and I mean I
Speaker 1: would say that it's not a pre option. It's an
Speaker 1: expensive option. Not always, but right now it is. We're
Speaker 1: talking about why our mortgages at you know, seven plus
Speaker 1: when you know treasuries are at four. You know, just
Speaker 1: a year ago, treasuries were two and fifty basis points lower,
Speaker 1: but mortgages were basis points lower. Maybe this is a
Speaker 1: good moment to sort of step back and talk about
Speaker 1: who the big buyers of mortgage backed securities actually are.
Speaker 1: And one thing I would be curious to hear is
Speaker 1: have they changed from pre two th eight to now?
Speaker 1: Because of course, I mean the big change has been
Speaker 1: the Federal Reserve when it started quantitative easing. You know,
Speaker 1: it bought a whole bunch of different types of bonds,
Speaker 1: but one of those was NBA. Now that they're in
Speaker 1: quantitative tightening mode, they've sort of stepped back from the market.
Speaker 1: So could you maybe talk a little bit about the
Speaker 1: ecosystem of who actually purchases these securities and the kind
Speaker 1: of considerations that they're thinking about as they decide whether
Speaker 1: or not to buy more or less MBS. The answer
Speaker 1: that nobody wants to tell you is that right now
Speaker 1: there's no natural buyers right you know, and that's that's
Speaker 1: the problem. You see these spreads go really wide. The
Speaker 1: problem is that who is the buyer right now? Right now,
Speaker 1: there is no natural buyers. Postal thousand and eight, you
Speaker 1: had you know, banks that had expanding deposits and you know,
Speaker 1: there was not to no loan growth, and so banks
Speaker 1: kind of building that gap with MS. Bonds funds had
Speaker 1: you know, pretty sizable inflows. And when you think about
Speaker 1: bond funds, you know you're thinking about like people goes
Speaker 1: total return fund or you know double lens total return fund.
Speaker 1: These are these are funds that engage in you know,
Speaker 1: marginal risk ging in a liquid securities in order to
Speaker 1: boost the yield of their fund. And you know, as
Speaker 1: long as you keep that a liquid portion to a
Speaker 1: small percentage of the fundacets, you know, you can enhance
Speaker 1: the yield for for the whole fund. Ever since the
Speaker 1: start of the year, you know, bond funds have been
Speaker 1: seeing weekly outflows, so there are certainly not buyers there.
Speaker 1: You know, the Federal Reserve is not a buyer. Banks
Speaker 1: have demand for loans and managers at banks. You know,
Speaker 1: I thought that they were ready for the risk that
Speaker 1: extension of MBS would entail, and it terms out that
Speaker 1: you know, maybe they don't like it so much, so
Speaker 1: they're not buyers of the product. We used to have
Speaker 1: a pretty healthy demand for some of the cash flows,
Speaker 1: particularly the more longer dated cash flows. There you would
Speaker 1: get into you know, transition, but you'd have some demand
Speaker 1: for that stuff from buyers in Asia, and they're in
Speaker 1: over to be seen. And because of this prepayment risk,
Speaker 1: it's a very poorfeit for people that are in the
Speaker 1: business of matching assets and liabilities because you know, if
Speaker 1: you're in the business and matching assets and liabilities, you
Speaker 1: don't want your asset to get called because the liability
Speaker 1: is not getting called. So you know, it's a nonstarter
Speaker 1: for them, very very few people who want to start.
Speaker 1: Can we just go back on prepayment risk specifically, And
Speaker 1: you made a good point that this option that homeowners
Speaker 1: have to refinance, it's not a free option. They pay
Speaker 1: for it and the spread and that's spread is wide,
Speaker 1: so just you know, seven percent mortgages four percent treasuries,
Speaker 1: you're actually paying a significant amount to borrow that money
Speaker 1: is part of what investors are concerned about, or is
Speaker 1: part of why that option is so expensive right now,
Speaker 1: simply because there is concerned that like, Okay, there's the
Speaker 1: spike rates due to the fight inflation, that's kind of temporary,
Speaker 1: and that rates might you know, reset lower significantly in
Speaker 1: a couple of years, and that we get this huge
Speaker 1: wave of like everyone who can refinances then. So it's
Speaker 1: like if you're you know, if I'm buying a home
Speaker 1: right now, I'm probably thinking, well, I really get I
Speaker 1: really hope this's like inflation fight ends in a couple
Speaker 1: of years and that I can like refinance or something.
Speaker 1: That's exactly right. Nobody wants to take their money at
Speaker 1: this point. You know, if you've had cash up until now,
Speaker 1: you know you've done very well versus the losses that
Speaker 1: you know, everything else has taken. So if you're going
Speaker 1: to put money to work now, why are you going
Speaker 1: to put it into an asset that you know that
Speaker 1: may have capped upside? For most people, it's it either
Speaker 1: doesn't make sense or it's just not something that they're
Speaker 1: willing to consider. You know, if rates go down and
Speaker 1: you buy treasuries, you're gonna make up boatload of money.
Speaker 1: If rates go down and you buy MBS, you might
Speaker 1: not make any money. Can you talk about like whether
Speaker 1: or not there are forced buyers or buyers who have
Speaker 1: to buy MBS. And I'm thinking specifically of, you know,
Speaker 1: situations where you might have a bond fund that's benchmarked
Speaker 1: to a benchmark index, something like the Bloomberg Barkley's AGG
Speaker 1: or something like that. And I seem to recall there
Speaker 1: was some discussion again in the mid two thousands that
Speaker 1: it was unfair that the Barkley's index still included a
Speaker 1: bunch of MBS when there wasn't actually that much MBS
Speaker 1: in the market because the FED was buying it, and
Speaker 1: MBS was a source of duration for a lot of
Speaker 1: the funds, and if they couldn't, you know, buy MBS,
Speaker 1: and they couldn't be as exposed to duration as the
Speaker 1: benchmark index. And so you had people like Pimco actually
Speaker 1: complaining that there wasn't enough MBS in the market. So
Speaker 1: it's kind of ironic that fast forward, you know, seven
Speaker 1: years or something, and a lot of these big buyers
Speaker 1: don't want to touch MBS with a ten foot poll
Speaker 1: after complaining that, you know, they couldn't get enough of it.
Speaker 1: Anybody that tracks an index is not gonna be necessarily
Speaker 1: a forced fire because the funds that track an index
Speaker 1: don't necessarily replicate it down to every single line item.
Speaker 1: That's you know, incredibly difficult to do. In fix sincom,
Speaker 1: where you know, you're talking about tens of thousands or
Speaker 1: hundreds of thousands of different bonds, and especially in NBS
Speaker 1: where you don't have a fungible product, you know, there's
Speaker 1: you know, thousands of thousands of pools that are packaged
Speaker 1: in different ways, and dealers will often sell you know,
Speaker 1: the entirety of an issuance to a single buyer, and
Speaker 1: so there's no chance for anybody to really replicate It's
Speaker 1: it's impossible to replicate an index, and so you know,
Speaker 1: you have some leeway around that. And sure there's you know,
Speaker 1: there's flows going into index trackers that are going to
Speaker 1: replicate that, but there's also a lot of funds leaving,
Speaker 1: you know, a lot of flows out of different products
Speaker 1: that are more heavily exposed two mbs and I wouldn't
Speaker 1: be thinking about four spires. I'm thinking about four sellers. Sorry,
Speaker 1: Can you expand on that point a little bit more
Speaker 1: like what would trigger a for sale of MBS. Let's
Speaker 1: say you know you have uh total return fund at
Speaker 1: at a large manager, you know, well known large manager,
Speaker 1: and you're participating in the MBS market. Is that way
Speaker 1: you can get some extra spread for your clients and
Speaker 1: you can get them, you know, a little bit of
Speaker 1: a higher return. And all of a sudden, starting this year,
Speaker 1: you start getting massive outflows. And maybe you keep I
Speaker 1: don't know, five or ten percent of your assets in
Speaker 1: super liquid securities and that's going to be bills and
Speaker 1: and one your treasuries or you know, to year notes,
Speaker 1: and all of a sudden, outflows keep coming. You run
Speaker 1: through your bills, you run through your one year notes,
Speaker 1: you know, you run through your two year notes, and
Speaker 1: all of a sudden, you know, you're pre payments, which
Speaker 1: you know, we're coming in every month, and you were
Speaker 1: cash flowing a lot from from those pre payment some nbs,
Speaker 1: all of a sudden they totally stopped. So you you
Speaker 1: have outflows, you have no cash flow coming in, Well,
Speaker 1: you're gonna have to sell something. And you know, unfortunately
Speaker 1: for for many managers, we've been seeing since about March,
Speaker 1: you know, kind of a relentless number of We call
Speaker 1: them be wicks since for bids wanted in competition, it's
Speaker 1: essentially when you option off your bonds to the highest bidder.
Speaker 1: And you know, we've seen that a lot of these
Speaker 1: options bring few or no participants. We have this period
Speaker 1: of high inflation, so of course there's a lot of
Speaker 1: second guessing about all kinds of policies that we're going
Speaker 1: on in one etcetera, fiscal, monetary, etcetera. And one of
Speaker 1: the criticisms of like why was the FED still buying
Speaker 1: you know, mortgage backed securities up until you know, relatively
Speaker 1: recently in your view, can we quantify the degree to
Speaker 1: which that FED buying depressed spreads? Or to put it
Speaker 1: in another way, like, okay, we have this, you know,
Speaker 1: this represent spread between mortgages and treasuries. Can we, like
Speaker 1: I can we decompose, like how much of that can
Speaker 1: just be explained via the FEDS switching from being a
Speaker 1: buyer to a seller of these assets. I can give
Speaker 1: you my best estimate, and so that would be for
Speaker 1: when you're talking about calendar year, I would say about
Speaker 1: to thirty basis points was from you know, QUI continuing
Speaker 1: maybe later than we needed to, we don't have a
Speaker 1: counterfactual of no que to look at. And if we
Speaker 1: look at before their great financial crisis for that kind
Speaker 1: of counter factual, well, the market was a lot, there
Speaker 1: was a lot more private label and bs, the implicit
Speaker 1: guarantees were maybe a little bit less implicit, and there
Speaker 1: was less market share dominated by Jinny May, which is
Speaker 1: obviously an explicit guarantee. But I would say that if
Speaker 1: you wanted to compare to you know, the FED not
Speaker 1: intervening at all, I think fifty basis points is not
Speaker 1: a bad guess, but you know, versus scenario, I would
Speaker 1: say about twenty five basis points. That's that's how much
Speaker 1: the depressive spread. Can you talk a little bit more
Speaker 1: about what's going on with the banks? So they're a
Speaker 1: big buyer of mbs, as you mentioned, and I've seen
Speaker 1: some discussion, you know, for instance, JP Morgan had a
Speaker 1: note a couple of weeks ago talking about how leverage
Speaker 1: and risk capital requirements for the big banks basically makes
Speaker 1: it much more difficult for them to hold onto these assets,
Speaker 1: to hold onto mbs, and so they haven't been buying
Speaker 1: as much of them, and that's one reason why that's
Speaker 1: spread between benchmark rates i e. Treasuries and mortgage rates
Speaker 1: has been going up. Is that a valid analysis or
Speaker 1: is this another excuse for big banks to complain about
Speaker 1: various regulatory requirements. I think it's a valid criticism. I
Speaker 1: think it was just last week or pride of that
Speaker 1: to them and said that, you know, they don't want
Speaker 1: any aret of the conforming mortgage space, but they're not
Speaker 1: participating that at all. Currently. The capital requirements they don't
Speaker 1: make it prohibitive for banks to participate. It just means
Speaker 1: that if they have demand for loans, well that's more
Speaker 1: attractive to them, and so they're not going to participate
Speaker 1: in something that is like relatively less attractive. You know,
Speaker 1: if they can originate a lot of personal loans were
Speaker 1: not conforming loans or credit to their their corporate borrowers,
Speaker 1: they're probably going to focus on those activities instead of
Speaker 1: you know, buying mbs. The other part of it is
Speaker 1: that everybody kind of assumed a certain base level of
Speaker 1: prepayments that in retrospect was not sustainable. I don't want
Speaker 1: to say sustainable, but you know, everybody kind of assumed
Speaker 1: that there will be a flour like that even if
Speaker 1: rates went out pre payments wouldn't decline past a certain point,
Speaker 1: and they did, and maybe you bought a bond and
Speaker 1: you thought, well, worst case scenario, rates go up, and
Speaker 1: then you know the duration of it. You know, it
Speaker 1: goes from from three years to five years, and you know,
Speaker 1: it turns out that now you're looking at six and
Speaker 1: you know, you thought you would be comfortable with five,
Speaker 1: but it turns out that you don't feel so comfortable
Speaker 1: with five, and now you have six on top of it,
Speaker 1: you know, And so there's just a general lack of
Speaker 1: appetite for this. And you see this a lot. I mean,
Speaker 1: you know managers and banks that are just you know,
Speaker 1: normal people, and they have the same biases and reactions
Speaker 1: as all of us. And you know, you get you
Speaker 1: get burned by something you don't want to do it again,
Speaker 1: and they just got burned by the extension risk of them. Yes,
Speaker 1: in the intro, since you mentioned the difference between conforming
Speaker 1: and nonconforming loans, and in the intro, I was like, wait,
Speaker 1: you like Fanny and Freddie still exist because I kind
Speaker 1: of forgot about them and tratically like give me like
Speaker 1: a really like me and look like what it is?
Speaker 1: What I mean, I just roll my eyes. She was
Speaker 1: she was surprised that her co host could say something
Speaker 1: so stupid, like do Fanny and Freddy? But I actually
Speaker 1: don't know what's going on with them because I just
Speaker 1: they're like penny stocks now and I don't really know
Speaker 1: what happened. So could you talk a little bit about
Speaker 1: like what they do now? Like what is their role?
Speaker 1: How big is the difference between the conforming versus nonconforming?
Speaker 1: Like where do things stand with the g c s. Well,
Speaker 1: they're a huge part of the market. I can't tell
Speaker 1: you the exact percentage right now. I actually don't have
Speaker 1: the number in front of me. Jenny May has been
Speaker 1: growing their share over the last decade, but you know,
Speaker 1: Fannie and Freddy are still huge players. And you know
Speaker 1: their role is that DIVII loans from from originators and
Speaker 1: then they know they package someone to two MBS and
Speaker 1: saw them at the market, and they're not in the
Speaker 1: business of, you know, speculating on racist spread. You know,
Speaker 1: they basically just facilitate moving those loans from loan originators
Speaker 1: to the the private buyers in the in the market,
Speaker 1: and as part of that, they guarantee the credit of
Speaker 1: the loans and that's about fifty five basis points effectively.
Speaker 1: There's you know, there's gonna be some variation there because
Speaker 1: you know, some borrowers or more credit worthy than other borrowers,
Speaker 1: and and certain types of loans are penalized. But I've
Speaker 1: ruled that. I think that people don't really consider is
Speaker 1: that you know, they do have certain policies. They act
Speaker 1: to an excellent sort of policy, right, you know, earlier
Speaker 1: this year, at the end of January, I believe NIM
Speaker 1: came out and said, hey, we're gonna restrict credit and
Speaker 1: increase the price of credit for borrowers that are borrowing
Speaker 1: for an investment property or a vacation home. And especially
Speaker 1: if you know, if that vacation if you're trying to
Speaker 1: refinance that vacation home, and especially so if you're trying
Speaker 1: to take cash out you know, on on every finance,
Speaker 1: and especially so if the loan to value ratio is high.
Speaker 1: They kind of saw that there was a little bit
Speaker 1: of frath going on, you know, with with people trying
Speaker 1: to build you know, many real estate empires and you know,
Speaker 1: buy a bunch of properties to airbnb them, and and
Speaker 1: they said, hey, no, no, no, this is this is
Speaker 1: not what these institutions are for. We don't want to
Speaker 1: encourage this. So we're gonna we're gonna actually restrict how
Speaker 1: much money you know, we're gonna give you. We're gonna
Speaker 1: make that money more expensive. But they can't, you know,
Speaker 1: just change the price from like one day to another.
Speaker 1: They have to give you a certain amount of notice.
Speaker 1: And there's customs in this market. And so they said,
Speaker 1: you know, any loan that is, you know, delivered to
Speaker 1: us after a certain date, like you know, we're gonna
Speaker 1: pay less for if it has any of these characteristics.
Speaker 1: And you know what happened was that, you know, originators
Speaker 1: talked to their perspective borrows and said, hey, you know,
Speaker 1: let's get these loans done right now, because they're gonna
Speaker 1: they're gonna shut the faucet off. And sure enough, as
Speaker 1: we saw in April numbers and we saw the origination
Speaker 1: and balanced. So the Feds out of the market because
Speaker 1: it's winding down its balance sheet and we probably wouldn't
Speaker 1: expect it to start buying up nbs anytime soon. Probably
Speaker 1: the banks are out of the market for the various
Speaker 1: reasons that you describe duration, risk, interest rate volatility, A
Speaker 1: lot of them are in the process of rebuilding up
Speaker 1: their capital levels, especially potentially ahead of a recession and
Speaker 1: some loan losses going up. What's the trigger for the
Speaker 1: big buyers to come back and start buying mbs again
Speaker 1: and maybe start to bring that spread down or is
Speaker 1: that just not going to happen anytime soon and we're gonna, yeah,
Speaker 1: we're gonna be stuck with a new normal of higher
Speaker 1: interest rates or higher mortgage rates, I should say. So,
Speaker 1: let me just fill in this one buyer that we
Speaker 1: haven't talked about yet, and that is going to be
Speaker 1: your highly leveraged balunce sheets. And this this is essentially
Speaker 1: hedge funds and mortgage reads. And I guess what, you know,
Speaker 1: we could call shadow banks. I hate using that term
Speaker 1: because it's kind of, you know, become associated with. Yeah,
Speaker 1: it has connotations that that I don't particularly agree with.
Speaker 1: But you know, these are institutions or you know, operators
Speaker 1: that want to behave like banks in terms of you know,
Speaker 1: participating in having a maturity mismatch and a liquidity mismatch
Speaker 1: and earning that spread and using a lot of leverage
Speaker 1: to achieve it. But they also don't want like the
Speaker 1: regulation that comes with like being a bank and the
Speaker 1: costs associated with being a bank. I think the one
Speaker 1: that is most visible in the market is mortgage rates, right,
Speaker 1: and and they basically borrow a bunch of money by
Speaker 1: a bunch of mbs, do some hedgen they can't be
Speaker 1: like completely unhedged, and then whatever the spread is, you know,
Speaker 1: to take a big fee for themselves and then they
Speaker 1: pay the rest of the villain. And these instruments are
Speaker 1: you know, pretty popular with current yield focused investors and
Speaker 1: like income focused investors, and they've been a sizeable participant,
Speaker 1: right And so as long as repo is reasonably easy
Speaker 1: to get and it's not too expensive, and there's a
Speaker 1: decent spread between where you borrow and the yield you get,
Speaker 1: they're out there. You know, they're participating in this market
Speaker 1: buying those bonds. Some of these rates are you know,
Speaker 1: effectively captive to loan originators. I'm not going to name
Speaker 1: names because I don't want to make anybody mad, but
Speaker 1: you know a lot of these originators are in the
Speaker 1: business of originating these loans and immediately selling them to
Speaker 1: a read that is associated with the same management. And
Speaker 1: as long as you know the book value was underneath
Speaker 1: the share price. They were very active in issuing you
Speaker 1: know who shares, thereby raising more capital and thereby, you know,
Speaker 1: being able to increase how many bonds they bought. And
Speaker 1: that trade is broken. Now there's not you know, there's
Speaker 1: not enough yield left. Repos is harder to get and
Speaker 1: it's one of the reasons that things are very difficult
Speaker 1: for this product is because using mbs as collateral for
Speaker 1: a loan is a lot harder and more expensive than
Speaker 1: using investment grade credit level of treasuries. I was going
Speaker 1: to ask just on this point, I mean, why can't
Speaker 1: you do what every major financial player seems to do
Speaker 1: when it comes with a liquid bonds and just put
Speaker 1: it in like an E t F wrapper and improve
Speaker 1: margins on it that way. That is the question that
Speaker 1: I was hoping you would ask. E t F s
Speaker 1: need to track a reference basket. And as we've mentioned,
Speaker 1: and you know we talked about earlier, this is a
Speaker 1: market that is full of individual securities that are not
Speaker 1: funcible and they're not liquid. A lot of times a
Speaker 1: particular bond will only have one owner for its entire life.
Speaker 1: That makes it particularly unsuited for wrapping around you know,
Speaker 1: wrapping it in an e t F. The other part
Speaker 1: of it is that, you know, we do have some
Speaker 1: ets that folks some mortage backed securities. They don't really
Speaker 1: get a lot of flows. Whoever the end user is
Speaker 1: of e t F s seems to want either investment
Speaker 1: grade credit or government bonds. There's really very little appetite
Speaker 1: for mbs wrapped in an e t F product. I
Speaker 1: can speak as to why, but you know, I do
Speaker 1: monitor the flows pretty closely, and we just don't see that.
Speaker 1: So I just have one last question. And you know,
Speaker 1: one of the things that's going on right now that
Speaker 1: we talked about on our last housing episode is there's
Speaker 1: been this big affordability shock and so you know, no
Speaker 1: one wants to buy homes at these levels. Probably not
Speaker 1: a lot of people want to sell. Expectations that you
Speaker 1: just have this like very frozen dormant market. The monthly
Speaker 1: payments at these prices, and these mortgage rates are just
Speaker 1: like way too high. Do you see finance innovating beyond here?
Speaker 1: Like could we see a fifty year mortgage, could we
Speaker 1: see a hundred year mortgage? Or other things? Or maybe
Speaker 1: the return of like you know, non fixed rate mortgages
Speaker 1: come back in popularity after a long time dormation. Yeah,
Speaker 1: like we'll be talking about like are we going to
Speaker 1: see the return of like finance finding ways to lower
Speaker 1: that monthly cost for perspect of home buyers. Unfortunately, not
Speaker 1: an adjustable rate product works when you have a steep
Speaker 1: yield curve. But you know, right now we're we have
Speaker 1: a pretty flat yield curve, and so you know, if
Speaker 1: you're paying you a rate based on the short rate,
Speaker 1: that's not going to be great. The market might be
Speaker 1: a little bit reduced because people are less worried about
Speaker 1: the duration, but it's not going to help that much
Speaker 1: past thirty years. Increasing the immortization time doesn't really reduce
Speaker 1: the monthly payment. We've we've had attempts at you know,
Speaker 1: doing forty years pretty recently, and it just doesn't help
Speaker 1: lower the monthly payment. The thing that helps lower the
Speaker 1: monthly payment is bringing the spread down, and you know,
Speaker 1: having rates at a lower level. And I just want
Speaker 1: to clarify when I talk about the NBS spread, you know,
Speaker 1: I'm talking about the spread between uh, you know, a
Speaker 1: generic mortgage backed security and by generic, I know I
Speaker 1: just said that this product is not fungible, but you know,
Speaker 1: we're talking about the products. It's called t b A
Speaker 1: stands for to be announced. It essentially product that hasn't
Speaker 1: been delivered to the market yet. You can think of
Speaker 1: it as like futures for nbs, and that is you know,
Speaker 1: at the highest level, and you know, probably about twelve years.
Speaker 1: You know, if we use the you know, last week's
Speaker 1: rates it was about one it's about the same today.
Speaker 1: That's really really high. A year ago that rate would
Speaker 1: have been you know, about eight basis points. And so
Speaker 1: you know, we've seen about you know, one percent added
Speaker 1: to a borrowers page just from that spread. But apart
Speaker 1: from that spread, you know, we also have the spread
Speaker 1: that is captured by the g c s and that's increased,
Speaker 1: not much, but it's increased by about five basis points.
Speaker 1: And there's also originators, right, Originators have to make money,
Speaker 1: and part of you know, what they make is that
Speaker 1: the difference between what borrowers pay and at what level
Speaker 1: they sell the loan to Fannie Freddie. And you know,
Speaker 1: we've seen that go up, you know, depending on the week.
Speaker 1: It's pretty volatile, but you know between fifty basis points there,
Speaker 1: which brings you to something that I think you guys
Speaker 1: will find interesting. And I don't think enough people are
Speaker 1: paying attention to Originators make money based on how many
Speaker 1: dollars of volume they put through, right, so their costs
Speaker 1: are tied to the number of loans that they process.
Speaker 1: Loan originators their main costs as out of like you know,
Speaker 1: like office space and whatever is that they have, you know,
Speaker 1: these loan officers and you know, and their assistance, you know,
Speaker 1: chase borrowers, making sure that they have all the paperwork,
Speaker 1: making sure that you know, they're getting everything in before
Speaker 1: the deadlines. It's a very call centered type of job,
Speaker 1: making sure that you know everything is according to the rules.
Speaker 1: And those costs are kind of like on a per
Speaker 1: loan basis, but the money that they make really is
Speaker 1: based on like how much dollar volume they do, and
Speaker 1: so you know, bigger loans mean more profits. And last
Speaker 1: year and the year before that, they were you know,
Speaker 1: they were doing many many loans, but they were also
Speaker 1: doing like bigger loans, right, and you know, because they
Speaker 1: have this incentive to write you a bigger loans so
Speaker 1: they can make more money, they would remind you, hey,
Speaker 1: you know you're doing every finance I see that you know,
Speaker 1: you're you know, dropping the rate that you're paying from
Speaker 1: you know, three point five to two point seven five.
Speaker 1: You know, you new lower payment that turncome drops and
Speaker 1: you know, would you like to borrow against your existing
Speaker 1: home equity? And a lot of people said, you know yeah,
Speaker 1: And we had an incredible amount of equity withdrawn from housing,
Speaker 1: you know, about a trillion dollars last year. We had
Speaker 1: a decent sized chunk this year. That's also you know,
Speaker 1: when you think about like wise inflation so high, you know,
Speaker 1: where's all this money coming from? All trillion came out
Speaker 1: from that way. So they were employing a lot of
Speaker 1: people doing this, right, And now you know, we've had
Speaker 1: the amount of dollars that flow through these originators declined
Speaker 1: by more than half. You know, we were seeing in
Speaker 1: some months two d and fifty billion dollars you know,
Speaker 1: being originated and now we're closer to a hundred and
Speaker 1: well there's just not that much work too, and and
Speaker 1: you know, you want to keep people around because like, well,
Speaker 1: what if the business comes back, right, you want to
Speaker 1: be able to ramp up. But you know, one of
Speaker 1: the things that we are likely to see is, you know,
Speaker 1: this is a commission based business. And so as the
Speaker 1: flow drives up and the commissioner's dry up, there's gonna
Speaker 1: be some attrition and staffing. And then what you're gonna
Speaker 1: see is something similar to what we saw in where
Speaker 1: in the second half when everybody was rushing to refinance
Speaker 1: and mortgage, originators said, you know, we don't have enough
Speaker 1: people to handle this loan pack line. So they, you know,
Speaker 1: they did what anybody else in that situation does, and
Speaker 1: they raised their prices and they you know, they kept
Speaker 1: a larger amount of you know, the the coupon that
Speaker 1: the borrower is paid. And so as we go through
Speaker 1: this slowdown lending, we're likely to see attrition to this
Speaker 1: quote unquote supply chain of lenders. And if pressure rates
Speaker 1: were to come down again, that doesn't necessarily mean that,
Speaker 1: you know, the rates available to borrowers are going to
Speaker 1: come down, because in that case, originators are going to
Speaker 1: have enough pricing power to defend their unit economics and
Speaker 1: keep a larger portion of that coupon. You know, I
Speaker 1: love it when guests come on the show and talk
Speaker 1: about incentives, because there are a bunch of incentives at
Speaker 1: play here. There's the incentives of banks like choosing exactly
Speaker 1: what to put in their portfolio, or big investors making
Speaker 1: the choice between treasuries versus mbs, but the loner senators
Speaker 1: as well. Well, I was just gonna say, this is
Speaker 1: a supply chain episode, because what you're describing, or what
Speaker 1: you described, is the physical like literally not even a
Speaker 1: financial but the physical capacity to process all this paperwork.
Speaker 1: And I remember when it was really constrained in early
Speaker 1: because rates collapsed, but you know, there was just this flood,
Speaker 1: and so there was like this sort of like physical
Speaker 1: constrained like a supply chain. Anyway, I think that's like
Speaker 1: a fascinating point that and now as you say, it's
Speaker 1: gonna ripple and we're gonna have like hollowed out supply
Speaker 1: chains that will keep mortgage rates even higher if rights
Speaker 1: come down, and it doesn't just happen in originators. Everybody
Speaker 1: loved complaining about prepayments, but prepainments keep this industry allowed.
Speaker 1: It kept massive amounts of flow going through the system.
Speaker 1: It keep you know, originators employed, It kept appraisers employed,
Speaker 1: It kept people on the south side employed. It meant
Speaker 1: that you know, if you were on the buy side,
Speaker 1: and you know you were buying all these billions of
Speaker 1: dollars worth of products and it's like rapidly prepaying and
Speaker 1: you have to you know, kind of recycle that money
Speaker 1: and kept those traders employed. Generally, more flow is good,
Speaker 1: there's more to do. People in this business love to
Speaker 1: be big accounts. It helped and helped with that. You know,
Speaker 1: you were saying, hey, you know, I'm doing like X
Speaker 1: amount of business with you, and that X was like
Speaker 1: a very big number that kept doing. The good graces
Speaker 1: of the South Side kept your coverage happy, you know,
Speaker 1: salesman for for bonds, especially on the primary market where
Speaker 1: you know, they always had lots of products and there
Speaker 1: was always buyers for that product. So everybody got said
Speaker 1: by this refinancing and pre payments flow and that disappeared,
Speaker 1: you guys reported Bloomberg reported recently that you know, BMO
Speaker 1: cut of their staff, and Wells Fargo has been cutting
Speaker 1: the people that they have associated with this, and I
Speaker 1: can tell you from from talking to people that have
Speaker 1: known for for ten or fifteen years, it's it's tough
Speaker 1: out there. People used to have a steady source of clients.
Speaker 1: You know that we're pretty reliable buyers of new issues
Speaker 1: every month, and suddenly they're just not there. They're not present.
Speaker 1: There's more supply on the secondary market from you know,
Speaker 1: these fund out flows that we talked about, and from
Speaker 1: level balance sheets that have to reduce their leverage because
Speaker 1: higher interest rates and less favorable borrowing conditions have made
Speaker 1: it on economic for them to hold this paper. It's
Speaker 1: not good for for anybody. And so we're going to
Speaker 1: see attrition in the origination space. But we're also going
Speaker 1: to see attrition on the cell side, you know, whether
Speaker 1: that involves sales or structuring or trading. You know, by structuring,
Speaker 1: I mean the trenching of these securities into into different
Speaker 1: risk profiles. All right, Germa, we tease this episode by
Speaker 1: saying we were going to go into detail on what's
Speaker 1: going on with the MBS market, and you definitely delivered
Speaker 1: on that promise. So thank you so much. Really appreciate
Speaker 1: you coming on odd lots, even though you said on
Speaker 1: Twitter that you would never do at Yeah, you weren't
Speaker 1: going to go on a podcast. I meant that. I
Speaker 1: meant that, but then but then you DM me and
Speaker 1: you know, and I talked to I talked to Power
Speaker 1: Sin and I was like, I don't really love doing media,
Speaker 1: and he's like, but it's OK, you can't say no,
Speaker 1: and I said, I know, I can't. I can't say no.
Speaker 1: We got to leave this part, and no one shouldn't
Speaker 1: say no. That was so good I learned. That was
Speaker 1: so helpful. Now I actually understand your tweets. All right,
Speaker 1: thank you, Thank you guys. So Joe, well, first of all,
Speaker 1: I would never give you a mean look. I rolled
Speaker 1: my eyes with love. Okay, thank you that. It makes
Speaker 1: me feel better. Feeling pretty down for the first few minutes. Sorry,
Speaker 1: but I thought that was a really interesting conversation. And
Speaker 1: so first of all, you know, it's not it doesn't
Speaker 1: happen that often that someone comes on and says a
Speaker 1: market is essentially broken, or it used to happen a
Speaker 1: lot more when the FED was in various markets and
Speaker 1: everyone would come in and say, oh, it's broken or distorted,
Speaker 1: But then the FED left, and now people don't seem
Speaker 1: to be talking about that as much. It was so good.
Speaker 1: That answered so many questions. I mean just started like
Speaker 1: I told you, you know, I did not always understand
Speaker 1: like why if we have Fannie and Freddie or Jinnia
Speaker 1: may backing mortgages, like why can't we just get mortgages
Speaker 1: at four percent, like the treasury if they're if they
Speaker 1: has the government guarantee. So that was just really helpful
Speaker 1: understanding like why now in particular, the spread is so
Speaker 1: high in part but there are obviously many reasons because
Speaker 1: of like sort of the cost of that option going up,
Speaker 1: because of course everyone wants to refinance. The question do
Speaker 1: you asked about the natural bus so much good stuff there. Well,
Speaker 1: the other thing I would say, I know, everyone's interested
Speaker 1: in the mortgage market because it's house and people are
Speaker 1: interested in housing. But the other reason I find this
Speaker 1: so interesting is it's sort of a microcosm of some
Speaker 1: of the more like structural critiques that you're starting to
Speaker 1: hear about about who's going to be the natural buyer
Speaker 1: for all types of bonds, so not just mbs, but
Speaker 1: also things like treasuries, other government bonds. I mean, we
Speaker 1: just had a massive kerfuffle with guilts in the UK.
Speaker 1: And so if you think that because of all these changes,
Speaker 1: because we were in this new era of higher interest rates,
Speaker 1: higher interest rate volatility, that's going to lead to structurally
Speaker 1: higher spreads, then that basically means like that's kind of
Speaker 1: a drag on growth and a dragon returns potentially. I
Speaker 1: was looking while we were talking. I was like looking
Speaker 1: at some like mortgage reads on the term or just
Speaker 1: the price. I just don't do it so brutal, if
Speaker 1: you know. Also, I love that last point, and I
Speaker 1: remember that from like early because right, like rates collapse
Speaker 1: and so if you have a house, you're like, yeah,
Speaker 1: I want to refight, right, but everyone to doing it,
Speaker 1: So then you know they lacked the capacity, and so
Speaker 1: then they charge more because they're like, well, if you
Speaker 1: want to get through, if you want to have our
Speaker 1: workers do the paperwork, you're gonna have to pay more.
Speaker 1: And then they hire a bunch of people and then
Speaker 1: it's like okay, then you're late when the spread collapses
Speaker 1: because they have no pricing power anymore. So it really
Speaker 1: like this idea that like there is this like finance
Speaker 1: supply chain where it's going to say, by people, So fascinating.
Speaker 1: We managed to turn a highly technical financial markets episode
Speaker 1: into basically a supply episode as a quintessential odd lots episode.
Speaker 1: All right, shall we leave it there, Let's leave it there. Okay.
Speaker 1: This has been another episode of the All Thoughts podcast.
Speaker 1: I'm Tracy Alloway. You can follow me on Twitter at
Speaker 1: Tracy Alloway and I'm Joe Wisn't all. You can follow
Speaker 1: me on Twitter at the Stalwart, follow our producer Carmen
Speaker 1: Rodriguez at Carmen armand also check out the odd Lots
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Speaker 1: Tracy and I we write every week. We don't talk
Speaker 1: about it enough, do we, Tracy, No, we actually write
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