Regulators Add to Rising Market Risk
The meeting of the Federal Open Market Committee last month delivered a lot of unwelcome news to the mortgage market. Fed Chairman Jerome Powell made clear that the FOMC is committed to fighting inflation, but then almost immediately retreated on the question of shrinking the Fed’s $2.7 trillion hoard of mortgage-backed securities.
Truth is, the Fed is uncertain how to unwind the great easing of 2020. In coming days, expect more market volatility, less visibility for issuers, investors and consumers. Powell punted the question of Fed balance sheet reduction for the June FOMC meeting, but the big question facing the mortgage market is whether the Fed will feel compelled to raise interest rates until home prices start to fall.
The uncertainty with respect to interest rates is reflected in the fact that low-coupon MBS issued during the period of massive QE starting in March of 2020 are today trading in the low 80s. The 10-year Treasury note is moving up and down 10-15bps in a day, making loan and MBS hedging operations problematic.
Just as market volatility has picked up, the Federal Housing Finance Agency is preparing to levy a 2% additional margin on too-be-announced (TBA) trades in the forward mortgage market. Normally the province of the Financial Industry Regulatory Authority (FINRA) and the Fed, margin requirements came into sharp focus in March 2020, when the Fed’s enormous market interventional nearly caused several REITs and dealers to fail as record margin calls were seen on securities and even dry loan collateral. When a pool of FHA loans moves enough in price in a period of days to provoke a margin call, then you know that the Fed has got it wrong.
The FHFA’s 2% surcharge on margin for TBA positions makes no sense financially and seems counterproductive in terms of reducing risk. Although the FHFA and other agencies are right to be concerned by market events in April 2020, the fault for this situation lies with the FOMC and not IMBs or the Enterprises that FHFA supervises. Indeed, the performance of IMBs and their liquidity providers in 2020 refutes the underlying premise of the FHFA proposal, namely that there is a problem.
Because of the strong relationship between the IMB community, the TBA dealers, warehouse lender banks and the GSEs, a crisis was averted in April 2020 -- just barely. This experience led to changes in practice for how banks, dealers and IMBs manage margin and netting of exposures during periods of market volatility. Indeed, the IMBs and lender banks and dealers coped admirably with the massive wave of liquidity unleashed by the Fed. By May 2020, the crisis was essentially over.
A hard rule requiring higher levels of restricted cash or capital, however, on top of existing TBA margin requirements from FINRA and the SEC, could unnecessarily trigger an event of default or even bankruptcy for IMBs. The FHFA needs to make a better case as to why the risk management of the TBA dealers and commercial banks, overseen by the Securities and Exchange Commission and FINRA, is inadequate.
One of the industry responses to the market volatility in April 2020 was the expansion of netting agreements between warehouse lender banks, TBA dealers and IMBs. Global netting agreements are now a more common practice between lenders and seller/servicers, especially if the lender also acts as dealer for TBA execution. The value of exposures, once netted, should then be subtracted from the outstanding TBA hedge position for the purpose of the FHFA rule.
If the prospect of a doubling in the effective cost of TBA margins was not enough of a headache for the intrepid mortgage banker in these times of Fed-induced market agitation, there is more dear friends. Unbeknownst to our devoted servants at FHFA and by remarkable coincidence, the folks at FINRA are grinding toward a new rule that requires higher margins for covered transactions such as TBA trades.
For the past seven years, the securities industry has been fighting a protracted battle over whether dealers need to collect margins on trades that are done but not yet settled. Known as Rule 4210, the FINRA margin requirements relate to swings in the value of MBS or whole loans trades between the date of the trade and final settlement.
Historically, dealers have exercised discretion in terms of whether or not to collect valuation margins after the trade date, either from the buyer or seller. The worry for dealers and customers is that posting margin on a final trade that settles regular way in days or even weeks is an unnecessary cost in a business with nonexistent margins. Smaller dealers and customers will be disproportionately impacted by the new FINRA rule, but the larger dealers that are affiliated with banks are indifferent.
FINRA officials rightly point out that the change in Rule 4210 is simply making mandatory a requirement that was never really optional, but over the years became unevenly enforced. Yet as March 2020 teaches us, market volatility has grown dramatically in recent years as the Fed has increase the magnitude of its open market operations.
The Mortgage Bankers Association noted in a March 29, 2020 letter to FINRA CEO Robert Cook:
“The dramatic price volatility in the market for agency mortgage-backed securities (MBS) over the past week is leading to broker-dealer margin calls on mortgage lenders' hedge positions that are unsustainable for many such lenders. We urge, therefore, the Financial Industry Regulatory Authority (FINRA) and the U.S. Securities and Exchange Commission (SEC) to call on their regulated broker-dealers to work constructively with their mortgage lender counterparties in response to the COVID-19 outbreak.”
As with the prospective FHFA rule on TBA margins, the revisions of FINRA Rule 4210 will reduce market participation and liquidity, particularly in the forward market for new MBS. Both the seller and the buyer of an MBS trade will be held strictly liable for posting the full cash margin, a grim example of how regulators think that diminishing market function and free cash is somehow helpful to managing all manner of market risk.
Scott Buchta, Senior Managing Director at Brean Capital in Chicago, told me last week: “Today is a great example of the dangers of Rule 4210 for investors. In addition to facing margin calls on their leveraged trades, investors would also be facing massive margin calls on their unsettled regular way trades as well (ARMS, spec pools, CMO). This would include banks and credit unions who are regular players in the new-issue MBS and CMO markets.”
I asked senior officials at both FINRA and FHFA if they had contacted the other agency to discuss the cumulative effect of their respective impending and potentially dreadful rule changes for margins on TBA, gestation REPO, and other covered transactions. FINRA was not aware of any outreach by the FHFA. The regulator for Fannie Mae and Freddie Mac did not respond to a written request for comment.
Given market conditions and the FOMC’s intention to tighten credit a lot, perhaps FINRA and FHFA, and perhaps also the SEC and Federal Reserve Board which set margin requirements, could talk. All could discuss the shared objectives of the federal government when comes to managing risk and market liquidity in the $12 trillion market for housing finance.
TBAs, never forget, are the foundation of the entire market for Federal Funds, and Treasury and agency securities. We get this wrong and the movie ends in tears.