Once upon a time, with interest rates high and declining, variable-rate and adjustable-rate mortgages were dominant in the market. Variable-rate mortgages were cheaper than fixed-rate mortgages and had prospects of getting even cheaper as interest rates declined. Homeowners naturally turned a blind eye to the risk involved should rates increase, but in the end they were right: interest rates continued to decline. Variable rate home mortgages were the right call.
We were delighted to learn that variable-rate mortgages have lost their popularity. Variable-rate mortgages as a percent of total mortgage originations have declined from about 40% twenty years ago to about 5% in recent years. The vast majority of home mortgages originated in recent years carry fixed interest rates for at least some duration of time; many of those are locked in for 30 years. Nice work U.S. consumer.
While we believe inflation will continue to erode consumer purchasing power in the months and years ahead (see: Consumer Squeeze), we don’t think rising debt service costs on existing mortgages will contribute materially to that degradation in purchasing power. Mortgages represent about 70% of all U.S. consumer debt in the U.S. but homeowners by all indications have done a decent job of protecting themselves from the threat of rising interest rates.
That of course raises the question of who provided all this cheap fixed-rate financing to the U.S. homeowner.
There are two sides to every loan – the borrower and the lender. Fixed-rate loans in a rising interest rate environment shift value from the lender to the borrower. The lender has what turns out to be a low-yielding financial instrument. The borrower has a cheap source of funds. The lender takes a hit. The borrower gets a windfall.
The borrower in this case is the U.S. homeowner. Who then is the lender?
Commercial banks originate most home mortgages in the U.S., but they don’t keep many of the loans they originate. They combine them into pools, chop up the pools into securities with various characteristics, and sell those securities into the marketplace. Those securities are called mortgage-backed securities, or MBSs.
The MBS market has allowed commercial banks to offload the mortgages they originate. Some commercial banks might keep some exposure to fixed-rate mortgages on their balance sheets, but we believe the vast majority of commercial banks have kept their exposure to these instruments low by effectively selling the cash flows from the mortgages in the MBS market. That has allowed them to originate far more fixed-rate mortgages than they otherwise would have originated.
The MBS market has also obscured the identity of the ultimate lender. You might have originated your mortgage through a traditional commercial bank, but your monthly mortgage payment gets dumped into a pool, divided up, and sent out to various holders of MBSs. Billions of dollars of MBSs are bought and sold in the marketplace every day. Nobody really knows who holds them.
What we do know is the MBS market is big, very big. The MBS market, at $11 trillion, is second in size only to the U.S. government debt market. It is big enough to cause widespread problems if something goes wrong.
An $11 trillion market can find its way into lots of nooks and crannies of the economy. We know the U.S. Federal Reserve owns a trillion dollars of them. They report that to the market. We suspect most of us are exposed to them through fixed-income allocations in our pensions or 401K plans. Those who have financial advisors that allocate accounts between fixed income and equities are likely exposed to MBSs on the fixed income side of the allocation.
A decent portion of the $11 trillion in MBS assets outstanding most likely resides in the so-called shadow banking system. The shadow banking system is comprised of financial institutions that create credit and liquidity outside of the global regulatory system. Who knows what they do with mortgaged backed securities or how much they hold.
In Safe Haven Silliness, we showed how the U.S. Federal Government is at risk of significant stress as interest rates rise. It has a growing mountain of debt that will ultimately need refinancing at much higher rates. The government meanwhile continues to spend far in excess of revenues. As debt grows and interest rates rise, debt servicing costs as a percentage of GDP could double or triple or quadruple in the coming years. Ouch.
Mortgage-backed securities could represent a second area of stress, in our view, not due to the creditworthiness of the borrower (although that too is a risk), but due to the value migration from lenders to borrowers of fixed-income securities as interest rates rise.
There are two ways MBSs could cause stress as interest rates rise. The first is directly through the degradation of value. Any individual or institution holding a mortgage-backed security with a fixed rate of return has seen its value decline sharply. That could be in a pension plan, a 401K plan, or in the shadow banking system. That decline will be especially stressful for those holders that used leverage to help finance their purchase.
The second and far more interesting way MBSs could cause stress is through asset-liability mismatches. The two asset-liability mismatches that traditionally cause problems are: 1) borrowing short-term and lending long-term and 2) borrowing at variable rates and lending at fixed rates. The former causes “bank-run” dynamics when the provider of short-term funds wants its money back and the holder of the MBS can’t liquidate assets fast enough to provide it. The latter causes outright bankruptcies when funding costs increase as a result of increasing interest rates and the income from fixed-rate assets stays the same.
Asset-liability mismatches create crises, especially if done at scale.
One sure fire way of determining who owns the $11 trillion of MBSs and whether the owners of those securities have asset-liability mismatches is to start raising interest rates. Problems will start bubbling to the surface. Br’er Rabbit will be forced out of the thicket.
