The Contrarian Corner - Author Archives - groditi
The last 3 pieces have been:
- Too much money, not enough paper, redux
- How Leveraged Money Becomes Less Leveraged (and less money)
- The Low Return of High Yield
Given that we are starting with a capital-constrained banking system (even before write-downs or 2013 EBA recommendations), we know this, holding capital levels stable, any government deficit must be matched by foreign capital or by reduced lending to the private sector to maintain leverage ratios stable--of course, due to 0%-RW on SPGBs, the EUR amt need not match centavo for centavo. Now, retained earnings (new capital) are not zero, so banks can either maintain their balance sheet size and increase their capital ratio (delever), or increase balance sheet size (fund the deficit) and maintain their capital ratio, or--most likely--something in between, where purchases of new sovereign bonds against increases in capital and levered via LTRO produce large amounts of carry.
This gives us the illusion that banks may very well be able to earn their way out of this mess (see also: LTRO), however, this all changes if we change the risk weight on SPGBs to something other than its current level of zero. Which is were we ask ourselves: In a country where almost 3/4 of private household wealth (ex expected benefits from government pensions, etc) is held as housing equity which has been borrowed against, what happens to the sovereign if that # is cut in half? After all, the sovereign's creditworthiness is just the aggregate of the households. Its credit backed by its ability to tax and/or confiscate private wealth to pay back creditors. If the households are, collectively, broke, then what is left for the government to take? Which is where I--finally--get to my point. If the government represents the collective households and the collective households are overburdened, then how will they be able to back their sovereign's increasing promises as the banks decimate the private sector through loan attrition? Or, in simpler terms, Is there any difference between extending-and-pretending with the households' mortgages and extending-and-pretending with the sovereign's obligations?
As we continue on our march to binary outcomes, I believe it becomes important to ask ourselves, why do we hate capital so much? What is so wrong about recapitalizing the banks and arresting this self-feedback loop? Is it about crystallizing losses by raising equity at prices below book? If so, why the big deal? If equity were really so under-priced, current shareholders would surely rush to a private offering before letting outsiders dilute them, no?
As a final comment, I think there is a 4th possible solution: Capital injections from the core banks and sovereigns.
Maybe this should actually be 3c, but given that we know there is no way except for "more capital" to resolve this and whether it be through debt-to-equity swaps or lower than normal real rates, Core private savings will ultimately pay for this. It might be nice to skip the whole near-financial-meltdown part that ends in core households recapitalizing their own banks after the D2E swaps and just get it over with so 25% of the worlds 12th largest economy could, you know, get back to work.
|top: spread between mortgage rates and MBS yield|
bottom: spread between CC MBS and 7-year US treasury note
...there is evidence to doubt whether lower MBS spreads will be passed on to customers or whether the banks will keep the windfall. Despite current coupons trading at record tight spreads, the "primary-secondary" spread remains, not only stubbornly high, but near all-time record highs! Proponents of the MBS Twist insist that the Fed can put pressure on the "primary-secondary" spread and push savings to borrowers by increasing (more in a second) their purchases of current coupons, but to me it is clear that the problem lies in the demand, not supply, side of loans. This is why, unless we see further expansion of H.A.R.P. (Home Affordable Refinance Program) which increases the pool of homeowners eligible for refinance, I think the ultimate effect of an "MBS Twist" on aggregate demand will be limited and the ultimate economic beneficiaries will be banks and security holders who see their securities increase in price.Since Chairman Bernanke announced the latest round of open-ended LSAPs, current-coupon MBS has tightened 56bp to Treasuries while the primary-secondary spread widened 31bp to all-time record highs despite 7y Treasury notes trading 10bp wider than pre-FOMC. Meanwhile, earlier today, MBS traded flat to 10y swaps. It is clear who's keeping the windfall for now.
|Top: TIPS & UST curves; Bottom: break-evens|
|5-year, 10-year, and 5-year forward 5-year break-evens (rhs)|
YoY All Urban Consumers CPI (lhs)
While borrowers continue to deleverage, any impact from lower rates will be limited and as mortgage debt outstanding continues to fall, the marginal stimulative power of monetary policy, unfortunately, diminishes.
Additionally,there is evidence to doubt whether lower MBS spreads will be passed on to customers or whether the banks will keep the windfall. Despite current coupons trading at record tight spreads, the "primary-secondary" spread remains, not only stubbornly high, but near all-time record highs! (see lower left). ... This is why, unless we see further expansion of H.A.R.P. (Home Affordable Refinance Program) which increases the pool of homeowners eligible for refinance, I think the ultimate effect of an "MBS Twist" on aggregate demand will be limited and the ultimate economic beneficiaries will be banks and security holders who see their securities increase in price.
|YoY % change in average hourly and weekly earnings|
of private sector employees. (source)
|Purchasing power of a $1,000 monthly payment on a |
30-year fixed-rate mortgage assuming 15% down-payment.
|Fannie Mae current coupon, 10-year US Treasury Note spread|
|Historical % of median household income required to buy|
a median-price existing home at prevailing mortgage rates
|Purchasing power of various payments at a 3.5% interest rate|
|Fannie Mae current coupon minus 10-year US Treasury note|
|Purchasing power of a $1,000 payment at various interest rates|
|Mortgage debt outstanding (source)|
|The "primary-secondary" spread, the difference between the|
yield borrowers pay, and what MBS yield.