Conduit CMBS (Commercial Mortgage Backed Security) debt outstanding is down from $740 billion in 2007 to $400 billion currently according a recent note from Goldman Sachs. The Non-Agency RMBS (Residential Mortgage Backed Security) Market, not backed by the US Government, has been contracting at a rate of 10 percent year, mostly due to prepayments and studious lenders paying off their loans. Agency RMBS (loans backed by the US Government) have been steadily climbing, reaching a level of $200 billion in issuance for the trailing 12 months. When it comes to refinancing, 40% of conventional refinances have involved cash-out transactions according to Goldman’s Marty Young.
Low Rates Have Skewed Lender Incentives
The growth in agency RMBS has overshadowed by the growth in US Treasury debt which is expanding at rate of $1 trillion over the trailing 12 months. This growth has led Mr. Young’s team to forecast the US Fed will “put off shrinking the balance sheet until mid-2018.” DoubleLine’s Jeffery Gundlach warned about 2018 debt bombs, something central bank balance sheets have morphed into, at Charles Schwab’s 2016 Impact conference saying “We’re in the eye of a hurricane for the next three to four years” according to Bloomberg. He added “come 2018, 2019, and 2020, look out!”
If 2016 is not 2008 then 2018 surely will be, although on a much grander scale as global finance has transitioned away from Non-Agency risk (IE: Lehman, AIG) to Agency risk (IE: Fannie, Freddie, and Gennie) so as to more easily allow the Fed to buy toxic paper from the banks since the Fed is literally the only remaining source for any form for finance strength because they can generate money.
Gundlach is right to be concerned. Agency RMBS has just pushed a new four-year high as of September according to Goldman’s Young. Debt issuance has been rising thanks to lower rates and looser mortgage loan standards according to TheMortgageReports.com which noted minimum credit scores required for loan approvals have declined while the maximum threshold for loan-to-values have increased. Makes it pretty darn easy to ramp your national debt 100% with all these easier credit now floating around.
While it is true that the year-over-year percent change in US debt has contracted from the 2008 surge, it still remains around 5 percent using data from the St. Louis Fred:
The US Government (on behave of the citizens) is not the only paper issuer going hogwild either. Societe General’s Andrew Lapthorne showed in a October 21 note that US Corporate debt issuance “is still out of control”, which is exactly what caused valuation metrics to skew, as I previously wrote.
Non-agency RMBS has been shunned relative to Agency likely for two reasons: the first being that Agency loans are backed by the US government and the second being the convoluted environment which Non-Agency paper exists coupled with a lack of demand of home loans due to the shift in demand to rentals:
Non-Agency lenders inherently must account for the risks associated with the various trances embedded in the multiple offerings of non-Agency securities and also worry over the possibility of no repayment. PIMCO wrote back in 2014 that non-Agency paper traders also need very specific analysis to account for the variables involved in making the optimal relative value decision. PIMCO wrote about the need for granular housing analysis required to truely find value in the non-Agency market, saying:
“This means that an investor’s view on the trajectory of home prices needs to be extremely granular. To develop a forecast on national home prices, PIMCO uses macroeconomic conclusions from its quarterly forums, as well as forecasts tailored by zip code, based on key factors including local income and unemployment trends, market dynamics (foreclosure laws, backlog of distressed supply), data and anecdotal information from our non-performing loans business and local market qualitative research (PIMCO “ride-alongs”)”
Ok, so maybe the Non-Agency trading world isn’t for everyone but it does impact us as emotions sway during prosperous times and difficult times.
Rising Rate Environment Bad For Financially Stretched Borrowers
Even as Wall Street tries to predict the next Fed rate hike and while the US 10-year yield slowly creeps higher, home-owners looking to refinance steadily trends higher according to Goldman:
There remains little reason to believe that refis will ramp up before the December rate hike, which has a 50 percent chance of happening but none-the-less has not stopped Wall Street from betting on the percent probability of an event that has a 50-50 outcome. If rates begin to rise, the FRBNY shows that borrowers incentives to refi and prepay decreases:
If anything increases the demand for refis it will be the destressed borrowers still lingering around. The studious borrowers have fallen off record and the remaining paper left to track is essentially the remaining delinquent borrowers, which results in the spikes below for 2005 and 2006 as loans come due:
Weak loans, weak financial dynamics among borrowers, low-rates and a chase for yield have generated a perfect storm again as the world’s efforts to hide-the-debt are beginning to fail. The New York Federal Reserve Bank shared a presentation in May 2016 highlighting the near $9.5 trillion mortgage credit line the US has, which makes up about 24 percent of the country’s total non-financial debt:
The Fed is making it worse as each forgone opportunity to raise rates continues to erode the long-standing base on which financial market trust has historically stood. On October 21 Societe General’s Andrew Lapthorne highlighted the collapsing yield impact on assets. Yield is what gives money value and as it dissipates, fiat currency is seen as what it really is – paper with no intrinsic value. When yields or more specific, returns, are depressed, savers lose incentive to save.
The Takeaway
Macro policy has failed depending on how you want to look at it. In hindsight one could assume things would be better today if the Fed had just allowed the market to establish fair-market prices in an effort to account for the excessive lending fraud the US experienced at the turn of the millennium. Or one could assume if the Fed did nothing we would not have the pleasure of 8 years of manipulated markets because global markets would have spiraled out of control.
Complexity demands trust. If it did not, then the rational understanding we have in the markets would be reflected in the prices. Yet, as economic activity dissipates prices keep rising because the Fed is there to buy up assets and create value through anchored adjustments. Psychology is an age old Fed tool and they’ve recently used it to control inflation as the money supply swelled following the Great Manipulation Recession.
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