MORTGAGE CREDIT NEWS BY LOUIS S BARNES - March 20, 2020

The missions this week: describe credit market events obscured by virus concerns, and grapple with the timing of the recovery ahead.

Many people feel that we’ve never seen an economic event like this one, but we have. The most unusual aspect today is the full-stop in some sectors as we avoid social contact.

My Okie family had several strange behaviors, some of them in public. My mom’s aunt, Mrs. Pinkney -- “Aunt Pink” -- had an especially unruly son, Hugh Bob. His misbehavior was so inventive that she found it impossible to anticipate and tell him all the things he shouldn’t do. So, at random moments each day Aunt Pink stepped outside to shout, “Hugh Bob, whatever you’re doing, STOP IT!!”

Have we ever just... stopped... before? Sure: spring 1980, chart below. In October 1979 Paul Volcker announced that he would take rates as high as necessary to stop 18% annual inflation, and the economy slid toward recession. However, just as we got there, president Carter added his unfortunate help over Volcker’s objection and in March 1980 announced credit controls and asked the nation to stop borrowing. We did. No credit, no spending, and GDP in the next 90 days contracted at an 8.2% annual rate.

To prevent a desired recession from becoming a depression, Volcker slashed rates, 90-day T-bills from 15.2% in March to 7.0% by June. GDP recovered completely in three months. Bizarre footnote: in six months Volcker restarted his campaign and an epic, two year recession followed, the one and only bust-bust recession in history.

How quickly can our economy revive? FAST. Some spending and consumption will be lost, but several insuppressible desires will return quickly and magnified: the urge to travel, shop, socialize, eat out, get to the physical therapist, dentist, and beauty parlor. To work overtime at jobs to catch up. And when Covid-19 comes under control, to party as never before.

The only thing bigger than caring for the infected and limiting contagion, and helping the people worst hurt by economic stoppage: this virus has mutated into a financial crisis. Everybody knows about the stock market, but stocks will bottom as soon as we can fix the credit panic. “We” is the Fed.

The classic financial crisis was a run on banks, old folks lined up around the block to get their money out before the bank failed. During the Great Depression we learned how to stop those runs and have not had one since.

But another form of run will be with us forever: when afraid, our need to sell things to raise cash just to feel safe, the startled mole’s insuppressible need to dig. Worse: when forced to sell at a loss, typically to pay off a loan. Forced selling is bad for a family, but infinitely worse for markets, where non-economic fire sales feed on themselves, forcing those who thought they were safe -- and were -- to sell at even lower prices. “Leverage,” borrowing to acquire an asset, is more forceful in reverse because it can wreck both the borrower and the lender.

Forced selling began in 2007 and continued through the Lehman collapse in 2008, and stopped only when Ben Bernanke’s genius went all-in with quantitative easing. Today, despite this Hugh Bob full-stop, we are in vastly better shape in two ways. First, our banks have never been in better shape -- never better capitalized, liquid, or insulated against each other -- and the Fed has all of the 2008 tools, practice and willingness to use them, and households are in the best debt condition in generations. Second, in 2007 the wild credit bubble had created on the order of $7 trillion in IOUs which could not perform, panic or no panic -- as one trader said at the time, “Underwritten by cows.”

Nevertheless, Buffett’s Law is in action: “You never know who is swimming naked until the tide goes out.” Add a corollary: you may be wearing a perfectly good suit, but a big enough wave can leave you naked.

The markets exposed by the viral panic? Corporate debt has been overloaded. Two issues: stocks have been supported by stock buy-backs funded by borrowing, and so a full stop in one market hurts another. Second, the derivatizers new experiment has been iffy corporates, “leveraged loans” sliced and diced into CLOs, their underlying math now blown to flinders, S&P loss projections once again bovine. But the volume at risk is trivial compared to 2007.

In the strangest aspect of this Covid panic, mortgages are the worst-exposed. Not because of bad credit! We are exposed by panic itself, and the sheer volume of sellers trying to get through the same door at the same time.

Easily the most perplexed Americans are those wanting to refinance a mortgage, and by last week getting mumbles from lenders about rates rising or unable to lock at all.

The first shock to the credit system was the all-time wave of refinancing rate locks in early February. At 3.50% and then below, it was suddenly economic to refi at least 20% of the nation’s $10 trillion in first mortgages. Every refinancing consumer is the seller of a loan. Yes, the old one will be extinguished, but the owner of the old loan may not want or be able to buy the new one.

As this cascade of selling intensified at the end of February, the reaction caused strange companion damage. No investor (bank, pension fund, life company, mutual fund, dealer, REIT...) had imagined payoffs in such mass. Many were hedged against payoff, necessary if carrying mortgages with borrowed money (banks, REITs, and so on), but the hedges were either inadequate or had tipped over to loss.

An REIT is a Real Estate Investment Trust. One variety invests in mortgages, which hold about 7% of all US residential loans -- $700 billion. These REITs hold with leverage, not crazy, but almost $600 billion borrowed. Detail at the Fed’s Z-1, L.129.m, page 107. Of those borrowings... remember the little plumbing problem involving “repurchase agreements,” a recurrent cyclical weak spot? 60% of REIT funding is by repo. Margin calls force REITs to sell anything they can, thus consuming mortgage credit and not providing.

Meanwhile, other frightened parties are drawing on their standby lines of credit at banks. “Standbys” are there for emergencies, good banking and borrowing unless everyone needs to borrow at once and bank balance sheets become overcrowded. And when those who must borrow cannot, they must sell something else, if necessary at a loss, including US Treasurys whose firesales in the last weeks have driven rates UP, not down.

Enough. I have great faith that the Fed will un-clog the system. It will take a week or two to get to something resembling normal, but credit will flow sooner. Probably not to all-time lows until all of the forced selling concludes, but the credit panic will stop contributing to economic slowdown.

Back to swimming naked. Among the exposed: Fed haters. The idiots chanting “No bailouts!” We’re bailing out the nation, including you. Nikki Haley resigning from Boeing’s board because of “philosophical opposition to its bailout.” Those in either party taking political advantage of stimulus, senator Warren the worst offender. The Intel Committee senators using inside knowledge to sell their stock holdings. And the president who did not believe the virus intel.

Freddie’s weekly mortgage survey posting on Thursday, data collected early this week. The survey suffers from that collection lag, and from the assumption that everyone charges and pays “.7% fees/points”, so add about .25% to rate to get a reasonable no-point rate. But the survey has picked up part of the rising-rate dysfunction, actually closer to a shut-down:


The US 10-year T-note is even trickier. The Fed is all-out to beat down the yield, absorb forced selling, and will succeed. Normality is not far below today’s 0.92%, but liquidity has a ways to go. As the economy recovers, maybe just two months away, 10s will jump in a sign of health!


The GDP crash and instant recovery of spring-summer 1980, chart from fall 1979 into winter 1981:


90-day T-bill yield, same interval: