I probably own your house without you even
knowing it…….
By Melvin J. Howard
MBS mortgage-backed
securities fund residential investment and are used by a wide variety of market
participants for investment and collateral purposes. A key feature of MBS is
that the market is "liquid". Specifically, market participants
perceive that they are typically able to buy and sell significant quantities of
MBS without difficulty and face relatively low transaction costs. Accordingly,
many MBS investors hold these securities as a liquid investment that they
expect can be quickly converted to cash at low cost when the need arises while
earning a positive rate of return. This draws the heavy-gun shelling away from
Manhattan and onto consumers – first in the way their home loans are funded,
and then in the investments made by their pension and insurance fund managers. The
United States had $7.5 trillion in these mortgage-backed securities (MBS) at
last count, nearly a quarter of the entire U.S. bond market and 50% larger than
the U.S. government's own Treasury debt issue. Appetite amongst professional
investors in Europe was so great, Sampo Bank now Danske Bank and ABN both
flooded their MBS into the market in the very same week. Britain was late to
the party, but it got $9.4bn from one lender plus another $15bn from HSBC, the
world's third largest bank.
You have to remember why
banks were doing this. Selling a bond backed by mortgage debt means the banks
can lend that much money again, doubling their assets per $Dollar of deposits.
In Britain alone, this little scheme helped the major banks lend nearly $1
trillion more than they took in from savers between 2002 and 2005. Money from
nowhere means money for nothing, and the banks love that!
But
"mortgage-related debt differs from most other categories of debt,"
notes a 2003 paper for the U.S. Federal Reserve, "in that it is subject to
the risk of prepayment." You might think the risk of early repayment
hardly worth fretting about. Not compared with, say, the risk of never getting
your money back at all. But when interest rates slip, homeowners refinance. So
the MBS backed by the first loan now gets repaid...and that leaves MBS buyers
holding cash instead of income. This is why for a period of time some had a
hard time refinancing their mortgages investors didn’t want the cash they
wanted the income from the mortgages instead. Your banker won’t tell you that
but I will.
So what do pension fund
manager do for yield? Buy bonds of course, preferably long-dated
Treasuries...thus pushing all bond prices higher...sending bond yields
lower...and causing more mortgage re-fi that then repays more MBS! "The
market rallies, mortgages prepay, and all of a sudden people have to buy,"
says one MBS strategist. "It can turn into something that snowballs and
causes the [bond] market to rally for a significant period of time."
The MBS market seeps into
the wider financial universe via another leaky pipe, too. "When mortgages,
or other debt instruments, are chopped up for securitization," explains
John Dizard in the Financial Times, "the riskier slices may go to high
yield mutual funds and people who think they're sophisticated investors. The
'residual risk', 'first loss' or 'equity' slices go either to hedge funds or
are retained by the dealers or banks who package the securitizations."
These dealers and banks don't use the Treasury market to offset the prepayment
risk of MBS bonds, says Dizard. They go instead to the market for interest-rate
swaps, where they can exchange one stream of income for another stream of
yield, tweaking their earnings without selling their assets. The interest rate
swaps market constitutes the largest and most liquid part of the global
derivatives market. At the end of June 2014, the total notional amount of
outstanding contracts was $563 trillion, representing 81% of the
over-the-counter global derivatives market, and the gross market value of interest
rate derivatives totaled $13 trillion.
"It's big, invisible
plumbing," says Dizard, "like water mains, of little interest most of
the time until there's a gurgling and nothing comes out of the pipe."
Remember, the interest-rate swaps market is worth 5 times the United States'
annual economy. And maybe those cheap swaps between bankers – their little-seen
deals that pump credit from the mortgage market into the bond market into the
profits of banks, insurance managers and hedge funds – are gone.
The money's got to go
somewhere, remember. Professional investors abhor cash. But "there are not
enough quality assets to go round, so what do you do? Despite the wide
popularity of MBS among investors and the importance that investors place on
market liquidity; until recently there has been remarkably little public
information that can be used to assess the state of MBS liquidity. This is not
the case in other important financial markets. In the case of exchange traded
equities, for example, both transaction volumes and bid-ask spreads can be
obtained at a daily frequency from a number of publicly available data sources
including popular financial websites such as finance.yahoo.com. Such data is
less widely available in fixed income markets, including the MBS market, which
is not typically exchange traded but are dealer intermediated. The lack of
similar data in the MBS market is problematic for systematically monitoring and
evaluating the overall state of market liquidity.
Recently, new data has
become available that can be used to assess market liquidity in the MBS market
through the Financial Industry Regulatory Authority's (FINRA) TRACE reporting
system. The TRACE system was developed in 2002 to increase transparency in the
corporate bond market by providing data on the size and price of corporate bond
transactions that are conducted by FINRA registered securities dealers. In May
2011, these reporting requirements were extended to MBS transactions as well.
These data can be used for a variety of purposes including systematic
measurement and monitoring of market liquidity.
