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Weighing the impact of politics

| September 6, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Politics has always shaped US markets, but usually through policies that affect the economy. These days, the delivery is often more direct. Most recently, new administration proposals to reform mortgage finance could directly affect markets for MBS and CMBS, among others. There’s only one way to invest in markets buffeted directly by politics: get inside the beltway.

The US mortgage market has arguably been the most politicized market in US finance for decades. Since the 1930s, housing crises driven by either credit or interest rates have steady increased government involvement. Out of the Great Depression came the Federal Home Loan Bank System, the Federal Housing Administration, the original incarnation of Fannie Mae and, after World War II, mortgages guaranteed by the Veterans Administration. Problems funding mortgage loans in the 1960s brought an updated version of Fannie Mae along with newly created Ginnie Mae and Freddie Mac. The interest rate volatility of the 1980s drove mortgage financing out of banks and into the capital markets. And the 2008 financial crisis has pushed nominal control of mortgage finance largely into the hands of regulators including the Federal Housing Finance Agency, the Consumer Financial Protection Bureau and the US Treasury.

The entanglement of government with mortgage finance in the US makes handicapping real policy change an insider’s game. US housing, like housing in many countries, is a product partially subsidized by the government. And every member of Congress has a healthy share of constituents that get tangible benefits from this. Beyond voters, entire parts of the economy run under the assumption that mortgage finance policy continues. Those parts are represented by the Mortgage Bankers Association, the American Bankers Association, the National Association of Realtors, the National Association of Home Builders and a host of organizations lobbying for affordable housing, just to name a few. These organizations represent businesses in almost every congressional district. Those businesses have money. And they have lobbyists.

So, here’s the calculus: if a policy proposal creates any winners or losers, who lines up on either side, how much political currency can they and their allies bring to the fight and will that be enough to influence the process. All of these are answerable questions, but not by most investors just reading the newspapers. The people and organizations involved in the fight will have a sense of where the chips may fall.

The most investable parts of the new mortgage finance reform proposal all revolve around decisions that the Federal Housing Finance Agency, the Consumer Financial Protection Bureau and the US Treasury could make alone or in concert. The FHFA and the CFPB are both insulated from political pressure. The FHFA, for example, gets annual funding not from Congress but from assessments on Fannie Mae, Freddie Mac and the FHLBanks.. And the agency director can only be fired by a sitting president for cause.  The CFPB gets funding from Federal Reserve banks, and its director, too, can only be fired for cause. That insulates but does not eliminate political pressure. Both organizations rely in some part on other parts of government to get things done.

The FHFA could unilaterally decide to reign in Fannie Mae and Freddie Mac guarantees on loans with high debt-to-income ratios, or tighten the underwriting of cash-out refinancing. It could try to cap the enterprises’ share of the multi-family housing market. It could allow REITs to come into the FHLBank system through captive insurers. These decisions would affect the supply and pricing of agency and private MBS and CMBS, and the size and profitability of US REITs. The potential market impacts are clear.

There’s the impact, and then there’s the probability of the event. Sketching the impact is easy. Figuring out the probability is hard. That’s where getting inside the beltway and seeing the constituencies involved makes the difference. For investors thinking about positioning against the latest proposals for mortgage finance reform, the hard part starts now.

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The view in rates

The value of convexity for the rest of 2019 has not diminished. Implied US rate volatility came off as expected after Jackson Hole but still stands near the highest levels since early 2016. Trade tensions give volatility plenty of room to run. It is hard to predict the next twist in trade and, consequently, shifts in potential Fed policy and rates. Good investors should only take risks they can understand and manage, and prudence argues for being neutral on rates. Convexity should continue to perform well. Long positions in volatility should pay.

It is intriguing to think that the bullish flattening and inversion that has been in motion since January could continue. Longer US rates are moving far faster than the Fed. The Fed is focused on the US economy, the long end may be more focused on the global economy. QE and foreign flows into US debt have also distorted the curve and could continue distorting it. The 10-year point on the curve is currently priced for nearly 0% real rates and 156 bp of inflation. Real rates are poised to go negative on rising trade tensions, and nominal rates would likely track lower, too.

Exhibit 1: The market is pricing for 0% 10-year real rates and 156 bp of inflation

Source: Bloomberg as of 8/20/19, Amherst Pierpont Securities

The view in spreads

All spread products show sensitivity to market volatility, making directional calls on spreads more difficult than usual. Corporate spreads look the most vulnerable, consumer ABS and private MBS the next in line and agency MBS the least vulnerable. Agency MBS is likely to see a wave of prepayments, putting supply pressure on TBA benchmarks. Investors in spread products have to be able to ride out the likely higher spread volatility ahead for the balance of the year.

The view in credit

Fundamental credit could be vulnerable in parts of the corporate market sensitive to trade such as technology and communication, energy and commodities. Industries with a domestic US focus look better. Households look even better. Low interest rates have spurred mortgage refinancing, which should further reduce household debt burden. Low rates should also give some support to home prices, which should help homeowners continue to build equity.

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