This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
Federal Reserve Board Vice Chairman Randal Quarles, who has a specific mandate from Congress for bank supervision and chairs the Financial Stability Board (FSB), last month sounded the alarm regarding the role of non-bank financial institutions in the market swoon in mid-March.
His yowling follows similar protestations by Federal Housing Finance Agency (FHFA) Director Mark Calabria.
Simply stated, Vice Chairman Quarles and his colleagues on the Fed’s Board seems to think that the bad acts of non-banks like hedge funds and REITs caused the extreme run on liquidity in the money markets during the third week in March of this year. In fact, March was a classic systemic event characterized by a sudden onset informational asymmetry.
Like Director Calabria, Governor Quarles seems to be a man looking for a dragon to slay. In fact, the massive response by the Federal Open Market Committee nearly swamped several large funds and REITs that invest in risky things like government-guaranteed mortgage backed securities (MBS).
Volumes in the too-be-announced market are down 20% YOY even as the production of new agency coupons soars.
Former New York Federal Reserve President E. Gerald Corrigan noted many years ago that the definition of a systemic event is when the markets are taken unawares. March 2020 certainly qualifies as a shock.
Financial stocks lost a third or more of their value, thus cutting the national wealth proportionately, and private fixed income securities were likewise crushed.
Unless the bonds were government guaranteed mortgage paper, there was basically no market bid and, more important, no financing available for several weeks in much of the financial world.
Today, the market for non-QM prime loans remains disrupted, as we noted in National Mortgage News (“How the Fed and Treasury are hurting housing”), resulting in the large banks suspending third party purchases of jumbo loans. Spreads for prime jumbos are now 50bp wide of conforming loans instead of inside by the same amount, where they traded for the past several years. The Fed's lack of attention to restoring liquidity to prime private label mortgages, which are predominantly a bank market, is stunning.
In response to the sudden withdrawal of private cash in mid-March, the Fed basically doubled the size of its balance sheet in a matter of weeks, this supposedly to prevent several nonbanks from failing due to the sharp drop in Treasury bond yields caused by the central bank.
Bonds rallied in a way never seen before due to the "go big" strategy followed by Fed economists in Washington, who direct the bond purchases by the Federal Reserve Bank of New York.
Margin calls on short Treasury bond positions nearly sank several large hedge funds and agency REITs in the last weeks of March and first two weeks in April.
Indeed, the intensity and duration of the Fed’s open market purchases of Treasury securities and mortgage paper almost sank a number of funds, lenders and even some small banks.
Quarles places the blame for this latest episode squarely on non-bank financial firms – aka, the private sector – and clearly places no blame for the raging contagion on either the Mnuchin Treasury, the banking system or the central bank itself.
Does Governor Quarles understand, we wonder, that the problem in April 2020 was as much due to COVID-19 as to the Fed’s heavy-handed response? He wrote to the FSB in July outlining his concerns:
|
“Reinforcing resilient non-bank financial intermediation (NBFI). The impact of the COVID Event on credit markets has highlighted vulnerabilities in the NBFI sector related to liquidity mismatches, leverage and interconnectedness, and investor behavior related to certain funds that they may treat as cash equivalents during economic calm but not during crisis. While extraordinary central bank interventions calmed capital markets, which remained open and enabled firms to raise new and longer-term financing, such measures should not be required. Understanding risk, risk transmission, and policy implications for the NBFI sector is more important than ever.” |
When the Fed rode to the rescue with trillions of dollars in liquidity in April and May (we thank them for doing so BTW) it did so less out of concern about the state of the US economy or employment or the solvency of private companies than it was with restoring market access to the US Treasury – the Fed’s first and most important mandate.
Helping calm the Treasury market also helped the market for agency and government MBS. Why does Quarles say that "such measures should not be required?" Isn't this why we have a central bank? Otherwise we'd have to call JPMorgan CEO Jamie Dimon as was the case a century ago.
Quarles, who is nominally considered a conservative on the Fed Board and relatively bank friendly, warns that: "We may be seeing significant pricing disconnects between the market and economic fundamentals, which could result in sudden and sharp repricing. The impacts of these economic strains may be amplified in emerging markets, given the risks to their currency and debt markets from capital outflows."
True enough, the markets have been trading better than the economic fundamentals would suggest, in large part because the Federal Open Market Committee has decided to buy basically every Treasury security and agency mortgage bond in the market.
The FOMC has purchased $1 trillion in agency and government MBS since mid-March.
The US residential mortgage market is booming because of low interest rates. The rate on a 30-year fixed rate mortgage is now below 3 percent. We’ll print at least $320 billion in new Fannie/Freddie/Ginnie MBS in August, a $3.5 trillion run rate for the year. The apparent goal here is to stimulate the housing sector. It worked.
Reading the Quarles letter, it is tempting to ask just what exactly in the problem? Why suggest that the Fed should not act? Would Vice Chairman Quarles merely stand by as hedge fund giant Citadel or giant agency REIT Annaly Capital Management (NLY) collapsed? One hopes not. Since the role of the Fed is to act as the enabler of the mindless fiscal behavior of Washington, it is natural to look for scapegoats at every turn.
In fact, the single biggest threat to the global financial markets is the Treasury’s profligacy and the related strength of the dollar, a trend that is self-reinforcing.
Lower interest rates c/o the Federal Reserve in the US make it possible for offshore investors like the Bank of Japan or postal savings giant Norinchukin Bank to hedge their dollar risk and buy long-dated Treasury bonds and Ginnie Mae mortgage bonds.
The impact of large global investors buying dollar assets tends to push interest rates down even more and, for now at least, pushes the dollar higher. The biggest threat to the United States stems from the fact that the Federal Reserve Board has essentially lost control of its balance sheet.
And nobody on the Fed Board is willing to criticize Congress or the White House for their collective financial idiocy.
Today banks and non-banks alike take less risk, using less leverage than ever before, one reason why the world of private finance is not a problem. The collateralized loan obligations (CLOs) that so vex Senator Elizabeth Warren (D-MA), for example, are not a problem after all. Warren is simply another politician in search of a problem to solve and thereby take the credit.
In 2019 the FSB and its companion agency, the Financial Stability Oversight Council, were fretting about the potential liquidity risk posed by non-bank mortgage firms at the instigation of Director Calabria. Now the targets of regulatory scrutiny in 2020 are hedge funds and REITs that buy mortgage securities. In both cases, the attention is misplaced.
We can think of some far more interesting parts of the market where risk truly does reside.
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington.
This piece does not necessarily reflect the opinion of Hedgeye.
