California Pension Fund Goes Green With Muni-Bond Debut (Calstrs Selling $281 Million In Tax-exempt Municipal Green Bonds)

Calstrs, which sounds like a cholesterol-reducing medication, is selling $281 million in green municipal debt to fund expansion of their Sacramento headquarters.

(Bloomberg) — The California State Teachers’ Retirement System may have just missed its investment goal but its debut municipal-bond sale Thursday is right on target.

The public pension, the second-biggest in the nation, is selling $281 million in tax-exempt municipal green bonds at a time when wealthy Californians are snapping up such debt to drive down their tax bills and when buyers are increasingly seeking investments intended to lessen the impact of climate change. The pension, which posted a 6.8% return shy of its 7% expectation for the year that ended in June, is using the bond proceeds for an expansion of its West Sacramento headquarters designed to meet high environmental standards, including the ability to achieve zero net energy consumption.

While investors generally haven’t paid higher prices for assets complying with environmental, social and governance principles, that may change in the future, [famous last words] said Eric Friedland, director of municipal research at Lord Abbett & Co. That makes the Calstrs bonds, which are already linked to a strong state credit because of the financing California provides for the pension system, even more appealing, he said. (or appalling).

“If you believe that there will be more of an ESG focus going forward, and that people will pay a premium for green bonds, then you’re basically getting that for free right now,” Friedland said.

The new building, a 10-story tower, will link to the current headquarters and ultimately encompass 510,000 square feet serving 1,200 employees, according to bond documents. Elements include a child-care center, “irresistible stairwells” to encourage people to take stairs instead of riding an elevator and a cafe offering healthy meals with ingredients from the on-site garden, Calstrs Chief Financial Officer Julie Underwood said during the Environmental Finance conference at the Milken Institute in October.

Vanessa Garcia, a spokeswoman for Calstrs, said in an email that officials wouldn’t make public statements on the bond issuance through the California Infrastructure and Economic Development Bank until after the closing of the sale. The building is expected to open in 2022.

The pension hired Kestrel Verifiers to vouch that the securities meet the standards for green bonds from the Climate Bond Initiative. It makes sense that Calstrs would sell green bonds given how it uses its influence as a shareholder to drive social and environmental change, said Ksenia Koban, a municipal-credit analyst at Payden & Rygel Investment Management in Los Angeles. Calstrs, for example, has pressured Duke Energy to cut carbon emissions and retailers to adopt best practices for firearms sales.

Calstrs officials are “putting money where their mouth is in mainstreaming ESG practices and ideas,” said Koban, who called the bond offering “a great issuance.”

The state, which has booked years of surpluses thanks to its growing economy, plays a large role in the pension’s bottom line: it directly made 36% of all contributions Calstrs received last fiscal year and provides significant aid to school districts, which make their own payments to the pension. California lawmakers in this year’s budget made a supplemental payment to pay down the state’s share of the unfunded liabilities for the organization that represents more than 960,000 educators and their beneficiaries.

The system, which by law has limits on how much it can hike contribution rates, is five years into a plan to reach 100% funded by 2046. It has about 64% of the assets needed to cover its liabilities, according to the latest data.

The new bonds are rated A+ by S&P Global Ratings, which gives the rating a stable outlook because it expects the pension’s funded ratio to improve over the next two years. Moody’s Investors Service ranks the debt A1 and Fitch Ratings grades it AA.

Like many US pension funds, Calstrs is only 67.2% funded

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Note that Calstrs has lowered their private equity investment target to 13% and raised their equity target to 47%.

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Like other pension funds, Calstrs is heavily weighted in the technology sector.

And yes, California munis keep growing (with historic low interest rates and a still growing state economy).

Fannie Mae Takes Lead In Mortgage Risk-Taking (Q3 ’18 LTV And DTI Spike Ahead Of Freddie’s)

Mortgage giant Fannie Mae recently released their Q3 2018 loan acquisition data base. And it revealed that Fannie Mae is seeing a spike in risk-taking.

First, the average credit (FICO) score. Both Fannie Mae and Freddie Mac are taking on less risk than before 2008 and are moving together.

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But in terms of loan-to-value (LTV) ratio, Fannie Mae (orange line) just spiked above Freddie Mac. Both are now above pre-2008 (crisis) levels.

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Fannie Mae also saw a surge in average debt-to-income (DTI) in Q3 2018. Their average acquisition DTI is now about the same as 2005.

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Let’s see how Fannie and Freddie cut expenses in preparation for being released from conservatorship with their regulator, FHFA.

Here are Fannie Mae and Freddie Mac arguing over market share before being turned loose.

Little Wing? US Rate Increases Alter Treasury And MBS Hedging

As the US Treasury 10-year yield approaches 2% … again, we begin to worry about issues such as extension risk and convexity risk (collectively known as “The Wings”) given their propensity to drive hedging.

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Extension Risk
Historically, the risk of sudden yield curve movements has greatly affected the market for MBS, which represent claims on a pool of underlying residential mortgages. The interest rate risk of MBS differs from the interest rate risk of Treasury securities because of the embedded prepayment option in conventional residential mortgages that allows homeowners to refinance their mortgages when it is economical to do so: When interest rates fall, homeowners tend to refinance their existing loans into new lower-rate mortgages, thereby increasing prepayments and depriving MBS investors of the higher coupon income. However, when rates rise, refinancing activity tends to decline and prepayments fall, thereby extending the period of time MBS investors receive below-market rate returns on their investment. This is commonly known as “extension risk” in MBS markets.

Duration and Convexity
The effect of the prepayment option can be seen in the chart below, which displays the relationship between yield changes (x-axis) and changes in the value of an MBS (black) and a non-prepayable ten-year Treasury note (red). The sensitivity of each instrument to small changes in yields (essentially the slope of each yield-price relationship at the point at which the MBS was last hedged, indicated by the dashed line) is known as the effective duration, while the rate at which duration changes as yields change (the curvature of the price-yield relationship) is known as its convexity. In the example shown below, the MBS and Treasury security are duration matched in the sense that they will tend to move one-to-one for small changes in yields.

When interest rates increase, the price of an MBS tends to fall at an increasing rate and much faster than a comparable Treasury security due to duration extension, a feature known as the negative convexity of MBS. Managing the interest rate risk exposure of MBS relative to Treasury securities requires dynamic hedging to maintain a desired exposure of the position to movements in yields, as the duration of the MBS changes with changes in the yield curve. This practice is known as duration hedging. The amount and required frequency of hedging depends on the degree of convexity of the MBS, the volatility of rates, and investors’ objectives and risk tolerances.

Duration hedging of MBS can be done with interest rate swaps or Treasury bonds and notes. When rates decline, hedgers will seek to increase the duration of their positions. This can be achieved by buying Treasury notes or bonds, or by receiving fixed payments in an interest rate swap. Conversely, MBS holders will find the duration of their MBS extending when rates increase, which they may choose to offset by selling Treasury notes or bonds, or by paying fixed in swaps. If sufficiently strong, this hedging activity can itself cause interest rates to rise further, and further increase duration for MBS holders, inducing another round of selling of Treasuries.

A Convexity Event Averted
A sudden initial rise in medium- to long-term rates can therefore trigger a self-reinforcing sell-off in Treasury yields and related fixed income markets, fueled by MBS hedging—a phenomenon known as a convexity event. During a convexity event, MBS hedgers collectively attempt to decrease duration risk by selling Treasury securities or paying fixed in swaps. The two most important factors that determine the likelihood of a convexity event are the size of the MBS portfolio held by duration hedgers and the convexity of that portfolio. The large-scale purchases of MBS initiated by the Federal Reserve in November 2008 as part of the post-crisis LSAPs have had a profound impact on both these determinants.

MBS investors, broadly speaking, fall into two categories: those holding MBS on an unhedged or infrequently hedged basis and those that actively hedge the interest rate risk exposure. Unhedged or infrequently hedged investors include the Federal Reserve, foreign sovereign wealth funds, banks, and mutual funds benchmarked against an MBS index. MBS holders who actively hedge include real estate investment trusts (REITs), mortgage servicers, and the government-sponsored enterprises (GSEs).

Mortgage bonds are often held by large investors such as money managers and banks. They tend to prefer stable returns and constant duration as a means to reduce risk in their portfolios. So when interest rates drop, and mortgage bond duration starts to shorten, the investors will scramble to compensate by adding duration to their holdings, in a phenomenon known as convexity hedging. A hedge is basically investing in something that tends to go up when the first thing goes down (or vice versa). To add duration, so as to extend payments into a longer period, investors could buy U.S. Treasuries, which would further push down yields in the market. Or they could use interest-rate swaps, which are a contract between two parties to exchange one stream of interest payments for another.

Here are the dollar swaps and US Treasury actives curves today and from December 2005 to illustrate the decline in both curves of around 300 basis points at the ten year tenor.

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Today’s US Treasury curve upward sloping … again having retreated from the inverted curve.

Here is a snap shot of MBS hedge ratios by coupon.

Of course, interest rates are influenced by the Voodoo Children themselves, the Central Banks like The Federal Reserve.

Risky Mortgage Bonds Are Back and Delinquencies Are Piling Up (Bubble Alert??)

Subprime mortgages (that is, loans made to subprime borrowers) are like the dinosaur — extinct. But as Ian Malcolm said in the movie Jurassic Park … life finds a way. They simply morphed into a less-threatening sounding product: the non-qualified mortgage (NQF).

(Bloomberg) The subprime mortgage-backed bond may be dead in America a decade after it helped trigger the global financial crisis, but a security with some of the same high-risk characteristics is starting to take off.

It’s called the non-qualified mortgage — basically a loan granted to borrowers whose checkered financial record made them ineligible for conventional mortgages. Lenders have bundled more than $18 billion worth of these loans into bonds this year that they then sold to investors, a 44% increase from 2018 and the most for any year since the securities became common post-crisis.

This surge in issuance of non-QM bonds, as they’re called, comes just as some initial indications of delinquency rates on the loans are starting to emerge. The short answer: They’re high. About 3% to 5% in some bonds, according to Barclays Plc. That’s multiples of the current 0.7% delinquency rate on Fannie Mae loans.

And while no one is saying these bonds are in danger of defaulting any time soon, their newfound popularity does reflect the growing risk that yield-starved investors are taking to boost returns at a time when the U.S. economy is slowing. It’s similar to the way demand for junk bonds and securities backed by fast-food franchises and private credit have all surged this year. In the case of non-QM bonds, coupons on the debt can be north of 5%. A typical Fannie Mae mortgage bond sold nowadays has a coupon closer to 3.5%.

“It’s obviously disturbing this late in the cycle to see originations for these loans at the kind of level they’ve kicked up to,” said Daniel Alpert, managing partner at Westwood Capital. “The housing market is not quite ready for a big infusion of this product.

The non-QM bond market is for now, at least, way too small to cause the kind of broader disruptions that subprime bonds did when they soured en masse a decade ago. (That’s what she said!) Moreover, the bonds are built to withstand tougher housing downturns than they used to be, and the borrowers aren’t as risky. The securities may face some sort of hit if the housing market weakens, but it won’t be severe, Alpert said.

“It’s not the subprime we remember from 2006 to 2007,” said Mario Rivera, managing director of the Fortress Credit Funds business, which has bought non-QM bonds. “It’s more of a second or third inning of non-QM. We’re getting the best collateral before the more aggressive lending comes in.”

But fund managers’ willingness to plow money into these securities shows how the intense suspicion that met mortgage bonds after the housing bubble burst last decade is starting to slowly fade. The subprime mortgage crisis triggered hundreds of billions of dollars of losses for investors.

There are more than $27 billion of outstanding bonds backed by non-qualified mortgages now, a small fraction of the approximately $10 trillion mortgage-bond market. In 2007, there were around $1.8 trillion of bonds backed by loans to non-prime borrowers.

The “non-qualified” moniker refers to any mortgages that don’t meet rules from the Consumer Financial Protection Bureau that went into effect in 2014. Many investors and issuers expect the market for non-QM bonds to grow. A temporary rule that lets Fannie Mae and Freddie Mac buy some home loans that don’t meet all the qualified-mortgage rules is set to expire in 2021. That will result in more debt being available to be bundled into non-QM bonds. Redwood Trust Inc., which issues mortgage securities, estimated in May that some $185 billion of home loans bought by the government-backed agencies annually would be considered non-QM.

JPMorgan, Angel Oak

A handful of lenders, including JPMorgan Chase & Co., Angel Oak Capital Advisors and Caliber Home Loans have been making the non-qualified mortgages and bundling them into bonds.

Borrowers’ scores in non-QM bonds are typically lower than what’s seen in other mortgage securities without government backing, like credit-risk transfer securities. But the consumers typically have relatively small debt loads compared with their incomes and the value of their homes. In many recent deals, non-QM borrowers have average credit scores in the low to mid 700s, a level credit reporting groups generally deem “good” to “very good.” Subprime borrowers typically have scores of 660 or less.

The bonds themselves also have more safeguards for investors than they used to. According to a Fitch Ratings analysis, an average of 36% of principal would have to be lost before the top-rated slice took a hit. The cushion in crisis-era “alt-A” bonds with the same rating was just 6%.

“There’s a lot more cushion, as there should be,” said John Kerschner, head of U.S. securitized products at Janus Henderson Group Plc, which manages $360 billion. “You can get some comfort that even if defaults inch up, the losses from those defaults aren’t going to be egregious.”

Real Risk

But even if non-QM bonds aren’t toxic, they have real risks. Many borrowers with non-qualified mortgages offer lenders bank statements to verify income instead of more stringent tax returns. Fitch says such documentation may offer only partial verification, and these borrowers could have unstable income because, for example, they own small businesses.

Making non-qualified mortgages can be legally riskier for lenders. If a borrower misses payments, and it turns out they shouldn’t have received the loan in the first place, they can sue the lender or even the securitization trust that owns the loan. Qualified mortgages have more legal protections for lenders and bondholders.

The strength of the housing market has helped support the bonds for now. Home-price appreciation has slowed over the past year, but the average U.S. house value still rose more than 2% in August from a year earlier, according to S&P CoreLogic Case-Shiller data. In a downturn similar to the financial crisis, when home prices contracted around 34% between 2006 and 2012, Barclays expects only the riskiest, lowest-rated portions of most non-QM bonds to lose money.

Home price growth is flattening after a rapid rise

That’s partly why Barclays says the top-rated portions of non-QM bonds are a good buy at current prices. (Famous last words!) The notes tend to pay down quickly, because borrowers refinance into more conventional mortgages when they can. And the securities offer higher yield relative to alternatives like credit-risk transfer bonds.

“At least for now, credit concerns for most non-QM deals should be modest for investors who purchase the investment grade-rated classes,” Barclays strategist Dennis Lee wrote in a note in September.

That is, as long as there isn’t a home price bubble that bursts like in 2008. Like the stock market could.

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Fed Will Purchase $4.65 Billion 3-7 Year Treasury Coupons Next Week (These Rates Were Made For Dropping)

These rates were made for dropping.

(Bloomberg Intelligence) — The New York Federal Reserve will purchase T-bills twice next week. Besides bills, it will buy the 3-4.5 year and 4.5-7 year coupons using MBS runoff proceeds. In this note, we look at the bonds the Fed is unlikely to purchase, given its self-imposed buying criteria; for T-bills, the Fed avoids those with four weeks or less to maturity.

The Fed has several criteria for adding bonds to its portfolio. The trading desk will limit System Open Market Account (SOMA) holdings to a maximum of 70% of the total outstanding amount of any security. It also won’t purchase securities trading special in the repo market for specific collateral, newly issued nominal-coupon securities and those that are cheapest to deliver into an active Treasury futures contract. Exclusions also include securities that mature in four weeks or less.

The exhibit shows bonds the Fed likely won’t purchase, based on these conditions.

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Here is a snapshot of the 3-7-year sector of Treasury coupons outstanding and their spread relative to a theoretical relative-value spline curve. The Fed will look to purchase securities that are cheap to its own relative-value model.

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The US Treasury curve slope (10Y-3M) has creeped into positive territory.

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And mortgage rates continue to rise again.

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Yes, these rates were made for droppin’. And that’s just what they’ll do.

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Wipeout! Will Fannie Mae And Freddie Mac Adopt A Good Bank/Bad Bank Model? (FHFA Director Calabria Open To Wiping Out Shareholders)

As FHFA Director Mark Calabria ponders putting Fannie Mae and Freddie Mac back in the “private” sector, one model that is being considered is the “good bank-bad bank” model.

Under the good bank-bad bank model, legacy assets would be transferred to the “bad bank” (rather than purely troubled assets).

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Fannie Mae has $3 trillion in loans on its books, much of it acquired after Fannie Mae was placed into conservatorship in Q4 2018.

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Freddie Mac is similar, but smaller.

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Legacy assets could be loan acquired prior to Q1 2009 that have not been refinanced or in default. Or sell off the stressed assets (orange and red) and keep the low risk loans (green).

Will there be an appetite for Fannie and Freddie legacy assets? Other than from The Federal government?

Good bank-bad bank. You know we’ve had our share.

And then we have FHFA Director Mark Calabria saying that he is open to wiping out existing Fannie Mae and Freddie Mac shareholders

WASHINGTON — At the second of two hearings to examine the Trump administration’s housing finance reform blueprint, key officials charged with implementing the plan made clear they are abundantly focused on Fannie Mae and Freddie Mac’s capital levels.

Members of the House Financial Services Committee were mostly concerned with issues that the administration proposal did not discuss. But Treasury Secretary Steven Mnuchin, Federal Housing Finance Agency Director Mark Calabria, and Housing and Urban Development Secretary Ben Carson offered additional insight on the process to end Fannie and Freddie’s conservatorships.

Calabria told the committee that he is open to wiping out shareholders of the government-sponsored enterprises, but he cautioned that “no decision has yet been made on moving forward.” He also hinted at a future rulemaking intended to shrink Fannie and Freddie’s footprints.

Shareholder Wipeout?

Natural Born (Volatility) Killers! ECB’s Draghi’s Low Volatility Legacy (Fed Also Kills Bond Volatility AND Term Premium)

The ECB under Draghi has been effective a depressing bond volatility and yields as he passes the torch to Christine Lagarde.

(Bloomberg) — Looking through the lens of rates market volatility, Mario Draghi has performed a masterclass in the art of keeping it very low. Incoming European Central Bank President Christine Lagarde will have a challenge to achieve the same effect as monetary policy nears its limits.

A successful central bank will aim to keep market volatility controlled by the predictability of its policy. Draghi has been in the business of keeping euro rates volatility suppressed, by communicating policy shifts effectively and deploying large-scale monetary easing.

Lagarde may find it harder to achieve a consensus on easing, inheriting a divided Governing Council. Policy makers disagree on whether more monetary stimulus is needed, and have voiced louder calls for fiscal policy to do more.

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Of course, The Federal Reserve is not too shabby about killing bond volatility.

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Treasury note term premium (the amount by which the yield-to-maturity of a long-term bond exceeds that of a short-term bond) has been reduced to negative territory.

Yes, the ECB and Fed are natural born volatility killers.

US Average Hourly Earnings (3 Mo Avg) Highest Since President GWBush, Home Price Growth Lowest Since 2012 (Housing Bubble Redux?)

Unlike the housing bubble and “The Big Short” years of 2005-2007, when home price growth was greater than average hourly earnings growth, we are now in the opposite situation: slowing 2% YoY home price growth and the highest average hourly earnings growth rate since 2008 and President George W. Bush.

Home price growth is slowing …

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As average hourly earnings growth rises to its highest level since 2008 and George “Dubya” Bush.

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Using a different home price growth index (FHFA Purchase Only) and an average hourly earnings for the majority of Americans, you can see where home price growth exceeds average hourly earnings growth starting in 1998 and ending in 2006 (the “Big Short” bubble) and the QE3-induced home price bubble starting in 2012 to today.

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Between HUD’s National Homeownership Strategy of 1995 and The Fed’s quantitative easing (particularly QE3). the US Federal government is doing the “housing bubble dance.”

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Regulatory Arbitrage Alert! FHFA’s Calabria Ends G-Fee Discounts For High-volume Lenders Like Quicken

Recently Federal Housing Finance Agency Director Mark Calabria issued a directive ordering the end of the GSEs’ practice of guarantee fee discounts for high-volume lenders.

The Temporary Payroll Tax Cut Continuation Act of 2011 required the FHFA director, in setting guaranty fees, to:

“provide for uniform pricing among lenders;” and
“provide for adjustments in pricing based on risk levels.

From my FNAN 432 class at George Mason University using Python to analyze Freddie Mac’s Q4 2017 online mortgage data,

All Data	Average	St. Deviation
FICO	748	110
LTV	74	16
DTI	35	10

Count of Quicken loans: 18,261 (about 6% of all the loans)

Quicken	Average	St. Deviation
FICO	730	50
LTV	71	15
DTI	36	10

Quicken has the lowest FICO (credit) scores of lenders selling loans to Freddie Mac and lower LTV and higher DTI than the rest of the pack.

Yes, as lenders try to avoid regulatory burdens, lenders like Quicken originate loans and sell to Fannie Mae and Freddie Mac, we may see a change in Fannie and Freddie’s loan purchases from non-bank, high volume lenders.

My students will have an update on Fannie Mae loan purchases by Monday.

It’s Always Sunny at GMU School of Business using Python in my class!

Rollercoaster! Mortgage Refi Wave Seems Over As Refi Apps Decline 15% WoW

Refi rollercoaster!

US home mortgage rates fell from almost 5% in November 2018 to 3.5% in September 2019 before rising a bit. This spurred a “refi wave” since late November 2018.

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But the refi party seems to have ended (for the moment).

Mortgage applications decreased 10.1 percent from one week earlier, according to data from the Mortgage Bankers Association’s (MBA) Weekly Mortgage Applications Survey for the week ending September 20, 2019.

The Refinance Index decreased 15 percent from the previous week and was 104 percent higher than the same week one year ago.

Yes, the “refi wave” seems over as

The seasonally adjusted Purchase Index decreased 3 percent from one week earlier. The unadjusted Purchase Index decreased 4 percent compared with the previous week and was 9 percent higher than the same week one year ago.

Now, as Democrats in the US House of Representatives undertake their impeachment of President Trump in part for not releasing the transcript of his call with the Ukrainian President Zelenskyy (that has been released), it will likely lead to an increase in Treasury Note 10y prices and a decline in yields (and mortgage rates) as Democrats focus on impeachment and stonewall any attempts at a trade agreement with China.

Jerome?

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