Bailey Bros. Building and Loan Association

“No, but you … you … you’re thinking of this place all wrong.  As if I had the money back in the safe.  The money’s not here.  Your money’s in Joe’s house … right next to yours.  And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others.  Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can.  Now what are you going to do?  Foreclose on them?”

                                                                                                                     George Bailey.  It’s a Wonderful Life.  1946.

Bailey Bros. Building and Loan Association

Over our 30-plus years, in far too many of our Letters we have found the need to discuss (vent) our fears on the extreme pendulum swings in U.S. monetary policy.  From boom, to bust, to boom, to bust, ad infinitum.  Rinse, Repeat, Scream.  Best intentions duly noted, the sage mandarins (and their literal army of PhDs) in the Eccles Building implicitly assume their collective IQs are more powerful in controlling both the “proper” level and term structure of interest rates rather than a free market of countless participants.  Every teenager also has the best sober intentions the first time behind the wheel of their out-of-town parents’ Corvette.

In describing the Federal Reserve’s less than excellent adventures in monetary policy, we have tortured numerous metaphors.  In our 2018 Letter Hotel California, we opined that small-scale Quantitative Easing (QE), circa-Greenspan, was such a lovely place; however, Fed chairs since Bernanke have checked out any time they like, but QE never leaves.  Successive Fed chairs have become both arsonist and fireman in their collective attempt to employ very blunt, very powerful monetary tools to micromanage ever-evolving macro mandates (The magical, idyllic economic state of sustainable 2% inflation, anyone?)  In addition, the Fed’s obsession with the level of the Federal Funds Rates, instead of the rate of change has demonstrably helped create the current banking crisis.  As dire as it seemed back in 1980, when Fed Chair Paul Volcker raised the Federal Funds Rate from 9% to 19%, that was nothing compared to Jay Powell raising it from 0.05% to 4.83% in twelve short months.

As Colonel Jessup, from A Few Good Men, might opine, the Fed’s historical record of extreme outcomes is clear – crystal clear.  In the end, the Fed typically stays too easy for too long, or too tight for too long.  Easy creates bubbles.  Tight creates busts.  The current folly of the Fed’s obsession with bringing inflation back to their nirvana of 2% has slammed the U.S. banking industry into the windshield.

Specifically, the matter of insured versus uninsured deposits must be addressed in order to mark the end of the crisis.  No easy task for sure.  Changing FDIC insured deposit levels takes an act of Congress.  No best friends across that isle.  One glance at the calendar does not give any banker (or bank shareholder) hope for a quick resolution.  The Congressional Budget Office (CBO) projects that, if the debt limit remains unchanged, the federal government’s ability to borrow using even extraordinary measures will be exhausted between July and September of this year.  Relatedly, the “x date” after which the U.S. Treasury may not be able to pay the federal government’s bills is August 18.  It looks like it will be an unusually hot summer in D.C.  Not to mention, the 2024 election season will be in full swing by this fall too.

In the meantime, starting in just two short weeks, banks will be reporting first quarter earnings.  At the top of every investor’s (and bank CEO’s) mind will be deposit flows.  We already know the initial crush of deposit flows has been a torrent of deposits out of regional and community banks into the biggest, “too-big-to-fail” banks.  The Wall Street Journal reported on March 30 that in the immediate aftermath of the failure of Silicon Valley Bank and Signature Bank, the 25 largest banks captured $120 billion in new deposit flows.  Smaller banks lost $108 billion in deposits.  In addition, more than $220 billion raced into money-market mutual funds.

The Incentive to Deposits Highest in 40 Years

In recent Letters we feared Powell & Co.’s unprecedented tightness could not help but “break something.”  And Powell & Co. did.  Specifically, they broke – severely broke – the mortgage bond securities (MBS) market.  In short, the Fed’s multiyear expansion of its balance sheet to $9 trillion by purchasing both U.S. Treasuries and Federal guaranteed MBS – Fannie Mae, Freddie Mac and Ginnie Mae – via Quantitative Easing (QE) essentially concentrated the coupons on over $13 trillion in MBS between coupons of 2% and 4%.  Once Powell & Co. sharply reversed course and tightened monetary policy (QT) driving interest rates higher, the Fed quickly impose over $1 trillion in unrealized losses on the nation’s commercial banks.  We’ll try to explain.

(Note:  We must give proper due recognition and thanks to Christopher Whalen of Institutional Risk Analyst.  He continues to give a master class on current monetary events in his numerous writings and media appearances.  Much of what follows has been our education of his recent work on the Fed’s Quantitative Tightening (QT) breaking the mortgage bond market.)

Long-only equity managers should not be writing about the mechanics and machinations of the MBS market, but here we are.  A bond and MBS primer is in order.  Bear with us; Bond Market 101 will quickly evolve (devolve?) into MBS 401.  Note too, dear reader, those of you who are aficionados of The Big Short and Margin Call,who might just revere those instructive movies more than many of us on Wall Street revere The Godfather Trilogy, Goodfellas and The Sopranos, you might skip this next part.

Ok, Fixed Income 101.  Let’s stick with the very basic elements of the U.S. Treasury market bonds, notes and bills.  Bonds issued at par (100) mature at par (100).  Some are issued, plus those that trade on the secondary market are offered at premiums (say 102) and discounts like U.S. Treasury Bills (98).

Fixed coupons are just that.  Not variable.  Fixed.  Payable to the owners of such bonds twice a year.  Maturity date fixed too. 

When interest rates rise, the price of fixed coupon bonds fall.  When rates fall, prices rise.  Further, bonds with larger coupons fluctuate less given a change in interest rates than bonds with smaller coupons.  Those of you who employ a common asset allocation of say 60% equities and 40% bonds were likely astonished at how quickly and deeply your lower-coupon bond portfolio declined in value last year once the Fed began swiftly raising interest rates.  Bond portfolios built during the Fed’s QE zero-interest rate regime simply, but powerfully lack the buffering, shock-absorbing power of higher coupon bonds.

Duration.  Ok, let’s amp it up a bit.  Anyone reading the financial press over the past few weeks has become versed on the concept of “duration.”  Duration is simply a measure of how sensitive a bond or bond fund is to changes in interest rates.  Us common folk call this interest-rate risk.  Duration, like maturity, is measured in years.  Duration for equity dummies means that for every 1% change in interest rates, a bond’s price will change in the opposite direction by 1% for every year of duration.  Further, a bond with a duration of five years will be more sensitive to changes in interest rates than a bond with a duration of three years but not as sensitive to changes as a bond with a duration of 10 years. 

MBS 401:  Now let’s consider this wild animal called a mortgage-backed security.  Compared to an MBS, a fixed rate bond is positively exacting – and rather boring.  In the history of debt financing, either through regulated financial institutions or unregulated loan sharks, rarely has the asset owner (lender) been more at the mercy of the borrower – and at the mercy of the marketplace than an MBS.  Put simply, the length of coupon payments, the timing of principal prepayments and the ultimate maturity date can be quite variable given changes in interest rates.  When interest rate changes are historic in nature, well, a “risk-free” government-backed MBS can become very risky indeed for MBS owners – and as we have painfully seen of late, very quickly at that.

The dynamism and complexity of the MBS market to us simple equity folks, is, well, mind-numbing.  Mix high IQ, unlimited computer power, untold needs of countless institutions who need to match assets and liabilities, cash flow priorities, Greek-letter hedging, the slicing and dicing of both coupon cash flows and quality-based principal tranches, and leverage, and of course basic interest rate risk within the MBS market (see The Big Short) is a witches’ brew of controlled chaos – most of the time.

Most of our readers have likely had plenty of experience with mortgages.  Unlike Treasuries, and this is a biggie, the debtors (not the owners) of such mortgages have the potential to impart substantial variability in both coupon and principal payments.  Homeowners are expert at this very key feature.  It’s the rare borrower who doesn’t know prevailing mortgage rates better than say the price of gas, eggs, or bread.  And if interest rates fall enough, advertisements from both mortgage banks and mortgage brokers no doubt flood the airways and internet with mortgage refinance offers.  Mortgage holders will refinance at the drop of a basis point if said refinance is remotely economical.  Mortgage refinancing has been part and parcel of the American homeowner financial landscape since 30-year mortgage rates peaked at 18.50% in October 1981.

To illustrate the extreme borrower joy (and lender angst), let’s say you bought a house or refinanced your mortgage between 2020 and 2021, at rates never before imagined.  On an inflation adjusted level, such mortgages are literally “free” money.  Fast forward to the present.  Inflation-fighting warriors at Powell & Co. have rapidly raised short-term rates from near zero to 5.00% – the fastest pace in over 40 years.  30-year mortgage peaked back in last November to almost 7.5%.  The likelihood of your current mortgage ever being refinanced again, unless mortgage rates collapse to under 1.5%, is nil.  If you are a homeowner over 50 years of age, you may never move again given your current mortgage rate has essentially locked you into your current dwelling.  If mortgage holders lock in low rates, it’s no surprise that refinances dry up.  Mortgage prepayments dry up too.  And why too make early principal payments on “free” money?  On an actuarial basis, if you are over the age of 60, your 30-year mortgage will likely outlive you.  Said another way in the nomenclature of the MBS market, the “liquidity” of your mortgage won’t reenter the marketplace for two generations.

Pre-pandemic, 30-year mortgage rates almost reached decade highs of 5% in November 2018.  Before the pandemic hit, 30-year mortgage rates fell below 4%.  30-year mortgage rates collapsed to 2.65% in December 2020, with the pandemic raging.  Such rates would stay below 4% until March of 2022.  The vast majority of the housing stock in the U.S. has locked in mortgage rates unimaginable in the history of home finance.  Those of us (debtors) who locked in mortgages from 2020 to 2021 cheer our good fortune, courtesy of the Fed’s zero-interest rate QE.

That was then.  Since then, the Powell & Co. have channeled their collective inner-Paul Volcker to bring inflation back down to 2%.  To do so, the Fed has raised rates from levels (near zero) never before experienced and at a velocity of increase more rapid than any tightening period in over 50 years.

Now let’s look at the brutal owner’s side of your mortgage, as the Fed – first slowly, then suddenly – slammed the banking industry into the windshield.  Because most mortgage lending institutions don’t hold your specific mortgage on their respective balance sheets (like Bailey Savings & Loan and First Republic Bank), your 2.75% mortgage has likely been repackaged as a 3% couponed Fannie Mae MBS.  Your mortgage, and like kind of mortgages, ultimately do find their way back on the asset side of bank balance sheets as an MBS.  Consider the dramatic and swift changes in said MBS in twelve short months.  MBS issued at par (100) now likely trades in the high 80’s.  (Fannie Mae 2s, which purchased at 103 in 2021 were trading in the high 70’s late last year.  The “duration-adjusted” effective maturity has exploded upward, likely doubling (or even tripling) from assumptions when issued.  This “duration” volatility caused the meltdown of Kidder Peabody in 1994 and Long Term Capital Management in 1998.  In addition, the cost to hedge such a security takes into account the coupon rate, prevailing interest rates, assumptions of maturity and cash flows and the volatility of the price of said MBS in the marketplace.  All of these variables make hedging very expensive.  Perhaps 2X-3X over the cost of the coupon.  In short, nobody in the marketplace wants to buy this piece of paper; hence the collapse in MBS price.

Now let’s now try to put it altogether in a macro sense.  Per Whalen:

“Today, sadly, the Federal Reserve Board seems to forgotten that monetary policy is executed through and with banks in the bond market.  By doubling the Fed’s balance sheet between 2020-2021, from over $4 trillion to now $9 trillion in nominal dollars, the Federal Open Market Committee (FOMC) has injected vast amounts of market risk into the U.S. banking system.

“What few members of the FOMC seem to appreciate is that in duration-adjusted dollars, that $3 trillion in mortgage-backed securities (MBS) owned by the System Open Market Account (SOMA), is today more like $12 to $15 trillion in terms of risk to U.S. banks and the Fed itself that own these low-coupon securities.

“As we’ve noted in earlier comments, the massive amount of refinancing that occurred in 2020-2021 has concentrated the coupons of about three-quarters of the $13 trillion market for mortgage securities between 2% and 4.5%.  The average coupon is about 3%, which today is trading at a 10-point discount to par.  Most of the production in that period is found in 2s and 2.5% MBS, a ghetto of high volatile securities that are now points under water vs. SOFR (Secured Overnight Financing Rate) funding costs.

“Simply stated, U.S. banks are caught in a vice between rising short-term interest rates and the Fed’s $16 trillion effective long duration position in Treasury debt and MBS.  How can SOMA be approaching $20 trillion in effective, duration adjusted size when the Fed’s own data show a nominal value just shy of $9 trillion today?  Because of the extension risk of the MBS, risk that now resides inside every mortgage portfolio in the U.S.

“The mortgage bonds owned by the Fed, which has an effective average life of 2-3 years at the time of issuance during QE, are now closer to 20 years when measured against actual prepayment rates.  CMBS (Commercial Mortgage Backed Securities), which are generally interest-only affairs, where principal is rarely prepaid and refinancing is assumed, are also extremely sensitive to changes in interest rates.

“Given the market distortions of QE, how much can the Fed raise interest rates from 2021 levels before holders of those 2 and 2.5% MBS are insolvent?  About 300 bps or 3%.  But the FOMC has already moved the Federal Funds Rate (FF) nearly 6% in 18 months.  Likewise with bank deposits, the Fed’s 600 bps move in FF rates has destabilized those heretofore stable business deposits at banks, large and small.

“’ Banks often assume that retail term deposits (CDs) are stable, because individuals would forego all the accrued interest as penalty for early redemption,’ our (blogger) friend Nom de Plumber observed overnight.  ‘However, for example, if a seasoned one-year deposit has been paying only 0.25%, but money-market mutual funds, short-maturity Treasuries, or new deposits are paying 4% or more, the customer will readily terminate that seasoned deposit and roll the funds to elsewhere.  Hence, banks have been losing huge amounts of ‘stable’ funding as the Fed quickly raised interest rates.’”

Those lending institutions (owners) who locked in mortgages during the same time period curse the Fed’s new higher-interest-rate Quantitative Tightening (QT) policy.  Extending beyond mortgages, most fixed-rate debt in the trillions issued before the Fed embarked on QT is dramatically in the red.  It’s not too difficult to forecast that even if the current banking crisis has seen (suffered?) its nadir, we suspect that banking woes will still be part and parcel of financial headlines for the foreseeable future.  Indeed, a Stanford University finance professor estimates that approximately 500 banks (11% of the U.S. banking stock) have suffered percentage losses on their respective assets worse than Silicon Valley Bank.

This new bolder banking world of ours where we are all bank tellers on our smartphones, will soon become even more bold still in a couple months when the Federal Reserve rolls out their new payment system.  Little remarked to date, the Fed’s FedNow Service will allow bank customers (both individuals and businesses) at over 10,000 financial institutions to send instant payments and transfers in real-time, 24-7,365, 24-hours a day, including weekends and holidays.

So, what’s the “fix?”  Here, once again, the informed opinion of Whalen:

“While the Federal Reserve Board is busy trying to balance its various active interventions in the markets, we think that the time may have come for Congress to tell the FOMC to reduce its balance sheet.  The losses to the Fed (and, indirectly the Treasury) will mount, but unless we force the Fed to reduce the scale and range of its market intervention, we may never emerge from “quantitative easing.”

“For example, while the Fed has rightly taken steps to provide cash to banks, it has not yet addressed the hundreds of billions or more in cash flow losses facing banks that own securities issued during 2020-2021.  Even if the Fed does not raise the target for federal funds (FF) above current levels, these losses will threaten the existence of dozens more banks, large and small, later this year.

“So, what is to be done?  The FOMC needs to gently push money market funds out of the RRP (Reverse Repo Agreements) facility and into private markets.  At the same time, the FOMC should sell MBS from the system open market account (SOMA) with the goal of keeping the 10-year bond above 3.5% yield.  Don’t worry in Fed Funds trades on the floor, we want to keep LT (long-term) rates positive and stable.

“Give the Street back the duration that is sitting, passive and sterilized, inside the SOMA.  Market rates will start to stabilize and volatility will decrease.  While the Fed does not hedge the SOMA portfolio, private investors will and this shift in duration and related hedging activity will help stabilize markets.  The Street will start to repackage this low-coupon MBS into interest-only and principal-only bonds.  Problem solved.

“But even as the FOMC forces investors off of the public teat and back to the market, it must shoulder another burden, namely helping banks to deal with the funding mismatch between the Treasury and MBS issued in 2020-2021 and the current production issued today.  Just by way of comparison, the average coupon for all $13 trillion in outstanding MBS is a 3% coupon.  Ginnie Mae 3s were trading around 90 cents on the dollar this AM (March 30).

“The FOMC should order the FRBNY (Federal Reserve Bank of New York) to offer term repurchase agreements to banks and dealers for any Treasury note or bond, or agency/govt MBS, that was issued during 2020-2021, at par.  The rate charged should be <= the debenture rate on the security.  This facility should be rolled every 30-days until the bond price reaches 5 points from par.

“If the Fed helps banks to avoid most of the cost of QE/QT, the savings in terms of bank failures avoided will be considerable.  The cost of this operation to the Fed will be enormous, swelling the negative equity position of the central bank.  The political cost of this operation of revealing this colossal expenditure of public funds will also be enormous, but the time for hiding the losses incurred by the Fed as a result of QE is at an end.”

Inverted yield curves have typically presaged near-future economic weakness at best and recession at worst – particularly if the yield curve inverts deep as it stands as deep as it has been over the past 40 years.  More pertinent to the current banking crisis, it’s not just a matter of deposit flows out of banks, but the crisis has morphed into concerns ranging from cost of deposit funding and sharp reductions in loan growth to loan loss provisions and hits to capital. As such, the bond market is screaming for the Fed to cut rates now.  Not during their next meeting in May.  Nor June.  Now!

Remember, much of consumer finance is priced off short-term rates.  When benchmark rates raise 500 basis points (5%) in 12 swift months, secured consumer finance literally shuts down.  Banks were already sharply tightening lending standards before the banking crisis.  Indeed, Bloomberg reports that bank lending through March fell $105 billion – the largest two-week drop in Federal Reserve data since 1973.

The Kobeissi Letter reports that auto loan rates and credit card interest rates have just hit new record highs.  Credit cards: 24.5%. Used cars: 14.0%.  New cars: 9.0%.

Our friend Whalen chimes in on the recent seismic changes on the auto loan market:

“The final thought is credit, the one thing that nobody has needed to worry about over the past decade because of QE.  The Fed’s purchase and sequestration of trillions in duration forced asset prices up and net loss rates down, resulting in negative credit loss rates for much of secured finance.  Now everything from auto loans to CMBS and C&I loans and residential MBS are rapidly reverting to long-term average loss rates.  The illusion that credit had no cost, created in 2020-2021, is now fading from view.  Note in the chart below that net-charge off expenses for prime auto loan owned by banks bottomed out at zero in Q2 2021.”

In addition, the tightening of mortgage rates has already hit the housing markets.  According to Califia Beach Pundit: 

“In normal circumstances, 30-yr fixed mortgage rates tend to be about a point and a half (150 bps) above the yield on 10-yr Treasuries. (Think of 10-yr Treasuries as the North Star of the world bond market: the standard against which all other interest rates trade.)  If the current spread were 150 bps instead of today’s 344 bps, 30-yr fixed mortgage rates would be 4.8% instead of today’s 6.7%.  Mortgage rates today are hugely inflated relative to where they should be, and that has a powerful and negative impact on the housing market.”

Powell & Co. are in a box of their own design.  The banking crisis has presaged higher risks of harder economic landing, plus headwinds for corporate earnings.  We look forward to fatter pitches served up by the stock market as the Fed tries to check out of its too-long stay at the Hotel California.                       

                                                                                                                                                   April 2023

David A. Rolfe, CFA                       Michael X. Quigley, CFA                    Christopher T. Jersan, CFA

Chief Investment Officer            Senior Portfolio Manager                Portfolio Manager

The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness.  We do not undertake to advise you as to any change in figures or our views. This is not a solicitation of any order to buy or sell.  We, our affiliates and any officer, director or stockholder or any member of their families, may have a position in and may from time to time purchase or sell any of the above mentioned or related securities.  Past results are no guarantee of future results.

This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct.  These comments may also include the expression of opinions that are speculative in nature and should not be relied on as statements of fact.

Wedgewood Partners is committed to communicating with our investment partners as candidly as possible because we believe our investors benefit from understanding our investment philosophy, investment process, stock selection methodology and investor temperament.  Our views and opinions include “forward-looking statements” which may or may not be accurate over the long term.  Forward-looking statements can be identified by words like “believe,” “think,” “expect,” “anticipate,” or similar expressions.  You should not place undue reliance on forward-looking statements, which are current as of the date of this report.  We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise.  While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate.

The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security.