This week we look at two brief essays for your Outside the Box. The first is my friend Barry Habib talking to us about where mortgage rates are headed. Barry gives us a very simple, but logical analysis on why rates are headed up. Then we jump to Spencer Jakab writing in the Financial Times about the problems in the municipal markets. Seems we may be under funded on our public pensions by about $3.5 trillion. As a tease to his column:
"Taking a page out of Greece's playbook, the peeved treasurer of America's largest state fired off letters this week to the chiefs of Goldman Sachs and other banks questioning their marketing of credit default swaps on California's debt . The instruments, he complained, "wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan."
"Insulting indeed, but who exactly should be insulted?"
It helps if you have seen Borat, or at least a trailer, but the message is the same.
I am off to Phoenix and San Diego, the NYC next week, so I will be writing on the road. Have a great week.
John Mauldin, Editor
Outside the Box
Where Are Rates Headed And Why?
So the Fed stopped buying Mortgage Backed Securities, and people are wondering if this will affect mortgage rates. There's been plenty of whistling past the graveyard, guesswork and denial, where so-called experts have been trying to tell us that there will be minimal - if any - change to rates.
That pipe dream is just nonsense.
Let's look at what we can expect for mortgage rates and the overall Bond market in the months ahead. During the past fifteen months, the Fed purchased $1.25 Trillion in MBS, which represented 80% of the mortgage market. Prior to this program, mortgage rates were above 6%. Now that the Fed program has ended, it's reasonable to assume that mortgage rates will rise back towards those levels.
Just How Much Money is $1.25 Trillion?
In today's financial headlines - the word Trillion is often casually thrown around. So much so, that it's easy to lose perspective on how much money this really represents. Picture a stack of $100 bills. It might surprise you to know that it only takes a stack four inches high to be worth $100,000. So $1,000,000 would be a stack of $100 bills 40 inches tall. How about a Billion? Well, you would have to stack $100 bills up to the top of the Empire State Building...twice...in order to reach a Billion. So to picture $1.25 Trillion represented by a stack of $100 bills - that stack would be 850 miles high. If you could turn that stack on its side and were able to drive alongside it, it would take you longer than 14 hours to reach the end. If you laid those $100 bills down side by side, they would travel around the world 50 times. We're talking about a lot of money here.
What Moves Mortgage Rates?
Mortgage Rates are not pegged to the 10-year Treasury Note, as some have reported in the media. Those in the know do understand that mortgage rates are based on the pricing of Mortgage Backed Securities (MBS)...and these Mortgage Bonds are influenced by many different factors.
They respond quite well to technical signals as well as Stock market volatility, as money can be drawn from or parked into Mortgage Bonds. Certainly, the news and inflation implications also play a heavy role in influencing Mortgage Backed Securities.
And just like the aforementioned influential factors, Treasuries can also play a role in the price direction of Mortgage Bonds. Last year, the 10-year Treasury Note was at approximately 2.2% and has since moved towards 4%. During this time, mortgage rates have been virtually unchanged. But now, Treasuries are offering yields that are close to the current Mortgage Backed Security rates, which are offered to investors.
Let's take a moment to understand the difference between the mortgage rate a borrower pays and the coupon yield on a Mortgage Backed Security that an investor receives. If a borrower pays 5.25% on their loan, only 4.5% of that is passed on as a coupon yield to the investor. This is because the mortgage loan servicer (that's who you make your payment to) takes a piece of the action. Additionally - the aggregators of these loans, like Fannie Mae and Freddie Mac take a piece as well. And let's not forget the folks on Wall Street, who need to get paid for underwriting, securitizing and selling this paper.
We know that Treasuries are backed by the full faith and credit of the US Government and are free from state income tax. And the 10-Year Treasury Note, while clearly not pegged to Mortgage Backed Securities, does offer investors a competitive alternative with a similar maturity period to Mortgage Backed Securities. But because of greater safety and tax advantages, the 10-Year Note will always trade at a lower yield than Mortgage Backed Securities, and therefore put a floor beneath how low Mortgage Backed Security coupon yields and corresponding home loan rates for borrowers can go.
The US is spending at an unprecedented rate - and its spending money it doesn't have. This means that more and more Treasuries will continuously need to be auctioned off. And in order to entice buyers to keep absorbing this supply, yields will very likely need to continue higher, just as they have for over the past year.
Additionally - sovereign debt has come into question. Downgrades in the sovereign debt of both Greece and Portugal are a warning to the US that the same can happen here, which would drive the cost of borrowing much higher. Our government currently spends $1.49 for each $1.00 it brings in. Our debt is now 57% of GDP...and rising. Does anyone really believe that Treasury yields are headed lower? As Treasury yields move higher from their current levels, mortgage backed security coupon yields will also need to move higher in order for investors to want to purchase them.
The Ever-Important Carry Trade
While the Fed's end of the MBS purchase program and eventual selling of MBS - along with an almost certain move higher in Treasury yields - all tell us that mortgage rates are headed higher, there is another important element that could have an even greater influence in moving yields higher and prices lower throughout the Bond market. It's called an unwinding of the "carry trade." The low interest rate environment in the US has provided fertile ground for the carry trade, where large investors can borrow at very low rates, and leverage into higher yields, resulting in huge returns.
Let's take an example: An investor wishes to purchase $1M in Mortgage Bonds yielding 4.5%. This would provide $45,000 as an annual return. In order to make the purchase, the investor puts up only 10% of $1M, or $100,000 in cash - and borrows the other $900,000 at the Fed Funds Rate + 2%, for example - which would be a borrowing cost of 2.25% or $20,250. This investor receives a $45,000 return, but subtracts a $20,250 cost to borrow $900,000 - leaving them with a net return of $24,750. Remember, the investor needed only to invest 10% of the $1M purchase - or $100,000 in cash. This gives the investor a whopping 24.75% return on their investment in a boring little old Mortgage Bond. And of course, this "carry trade" can be used in other securities as well.
While the investor understands that there are always market risks at play - the juicy 24.75% yield cushion gives them much added comfort to stay in the trade. But the biggest risk for the investor is if their borrowing costs - which are based on the Fed Funds Rate - were to rise.
When the Fed starts to hike rates, it will signal the beginning of a tightening cycle. A few Fed hikes can cause the yield cushion to quickly evaporate...and the decline in Bond values from overall higher yields could turn the trade from highly profitable to highly costly in a very short period of time. So why do these carry trade investors have such a care free attitude and confident air? It's because Ben Bernanke and the Fed have assured them that there is nothing to fear. How did the Fed do that?
Via "Fed Speak," these carry trade investors hear that "conditions warrant exceptionally low rates for an extended period of time." Translation: your biggest fear - that a hike in the Fed Funds Rate, which increases your borrowing costs and wipes out your gains - won't happen anytime soon. It's this "extended period" verbiage that is keeping the carry trade in place. When the Fed removes the "extended period" language, this will signal that hikes will begin in the near future, and that risk will prompt investors to begin to "unwind" their carry trade holdings. This will include the selling of Mortgage Backed Securities, which will assuredly push yields higher still.
When will the Fed remove the "extended period" language? It may happen sooner than you think. Kansas City Fed President Thomas Hoenig has officially dissented to the "extended period" language at the last two Fed meetings. And recently, St. Louis Fed President James Bullard, while yet to officially dissent, has stated that he feels "extended period" is inappropriate language and should be replaced by "data dependent." And there have been grumblings from other Fed members, who are growing more concerned that leaving rates too low for too long can spawn asset bubbles or inflation down the road.
What It All Comes Down To
It brings to mind the closing scene of the movie "Dumb and Dumber," where two good-hearted but incredibly stupid heroes Lloyd and Harry are hitch-hiking, when along pulls up a bus full of beautiful Hawaiian Tropic models in bikinis. The models tell Lloyd and Harry that they are looking for two "oil boys" to lube them up before each of their photo shoots on the tour. Lloyd and Harry explain that there is a town down the road, where they should be able to find two lucky guys to help them out. As the bus pulls away, Lloyd and Harry look at each other and declare that one day their opportunity will come - they just have to keep their eyes open.
Here's hoping you have your eyes wide open to take advantage of this fleeting opportunity...before it's gone.
California ire over Borat bonds
Maybe Bill Lockyer not make benefit glorious state California?
Taking a page out of Greece's playbook, the peeved treasurer of America's largest state fired off letters this week to the chiefs of Goldman Sachs and other banks questioning their marketing of credit default swaps on California's debt . The instruments, he complained, "wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan."
Insulting indeed, but who exactly should be insulted? Home to Hollywood, Californians may derive their hazy image of Kazakhstan from Sacha Baron Cohen's satirical take on a country where he claims the main forms of entertainment include the "running of the Jew", the sport shurik "where we take dogs, shoot them in a field and then have a party", and where the favourite plonk is made of fermented horse urine. The real Kazakhstan, though not problem-free, looks fairly solid compared to California and many other states - a fact that should worry investors in America's $2,800bn municipal bond market.
On paper, California's debt of $85bn supported by 37m citizens and the world's eighth largest economy looks more manageable than Kazakhstan's nearly $100bn heaped on its poorer population of 16m. Go beyond headline figures though and Kazakhstan, with the world's 11th largest oil reserves, an economy that grew more than 8 per cent annually from 2002 through 2007 and unemployment of just 6.7 per cent looks positively vibrant next to the Golden State's joblessness of 12.4 per cent.
Meanwhile, Kazakhstan's modest budget deficit and $25bn rainy day fund make it a paragon of fiscal virtue compared to a state forced to pay bills with IOUs last year and possibly again this summer. Unlike US states, Kazakhstan has its own currency and central bank. If it were to raise taxes or cut public services, wealthy Kazakhs could hardly defect to Kyrgyzstan the way Californians, already facing some of the highest levies and worst schools in the nation, might decamp to, say, Utah.
But such head-to-head comparisons do not even begin to spell out the relative woes of American states compared to many developing nations. In addition to their headline borrowings, equal to almost a quarter of national output, states and cities have made trillions more dollars in promises to current and future retirees. Pensions are nominally underfunded by an already scary $1,000bn according to the Pew Center for the States, but that uses their own rosy actuarial assumptions. Former Social Security administrator Andrew Biggs reckons the shortfall would be up to $3,500bn if calculated using a more conservative private sector methodology. Tack on another trillion or so for unfunded health benefits and America's states appear to have dug a hole so deep no amount of austerity can fill.
Demographics, too, favour developing countries. Even with a relatively restrained birth rate, the median Kazakh is four years younger than the median American and will live ten years less, cutting down the country's dependency ratio. And while California's innovators may or may not crank out future iPods, Kazakhstan will soon export even more oil as its giant Kashagan field and pipelines to booming China come on stream.
States' borrowing costs are supported by a minuscule historical default rate on traditional municipal debt but also by the distortion of being tax-exempt. Lacking this feature, taxable California "Build America Bonds" given a direct federal subsidy yield 6.3 per cent for a 2022 maturity, some 2.4 percentage points above comparable US Treasuries. A more modest spread than Greek bonds over Germany's, to be sure, but then Greek credit protection is also pricier.
After resorting to Hellenic-style fiscal sleight-of-hand to plug this year's budget hole, it is alarming to hear California's officials blame the messenger in similar style. They must grasp that markets don't lie and creditworthiness is unrelated to superficial wealth. For example, Californians who illegally employ Mexican migrants as maids or gardeners might be surprised to learn that swaps traders consider its poor southern neighbour about half as risky a borrower as their state. Jagzhemash!