The Big Idea
Stock and flow effects of the FDIC liquidations
Steven Abrahams | April 28, 2023
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.
Even though BlackRock has started selling the FDIC’s positions in securities formerly held by Silicon Valley Bank and Signature Bank, some MBS pass-through investors have stepped to the sidelines to wait for wider spreads. It will likely be a long wait. The history of preannounced programs of major buying or selling of debt securities argues that most of the impact gets priced in within days or even hours depending on the liquidity of the sector. And with the unusual level of detail available about the timing and balance of specified pools scheduled for auction, the chances of materially different spreads due to the liquidation itself seem vanishingly low.
Unique liquidation exposure in the agency pass-through market
The MBS and broader debt markets have repriced since Silicon Valley Bank and Signature Bank collapsed, but MBS pass-throughs have unique exposure. Of the $114 billion of securities seized by the FDIC, $56.5 billion or nearly half were in agency pass-throughs. The banks also held significant amounts of agency CMOs and Ginnie Mae project loan REMICs and smaller amounts of non-agency MBS along with corporate, agency and Treasury debt. All of these markets have had to price to some degree for the broad impact of liquidation since the assets arguably are close substitutes. But the pass-through market here is the bellwether.
Sell the rumor, buy the news
High interest rate volatility since the banks collapsed has moved nominal MBS spreads around considerably, so option-adjusted spreads, which strip out the effect of volatility, become a much better measure of the balance between expected supply and expected demand. Those spreads began to widen after Silicon Valley Bank announced a restructuring of its balance sheet on March 8 and continued until the FDIC seized the banks on March 10 (Exhibit 1). At that point, markets could only speculate about whether the FDIC would find a buyer for the banks or would have to liquidate them. MBS spreads continued to fluctuate through March 20, when the FDIC sold Signature Bridge Bank to New York Community Bank, and through March 27, when FDIC sold Silicon Valley Bridge Bank to First Citizens Bank. In both sales, the FDIC retained the held-to-maturity security portfolios. When the FDIC announced on April 5 that BlackRock would help it liquidate the portfolios, spreads widened until BlackRock published a full list of CUSIPs scheduled for sale and announced on April 17 weekly sale targets for pass-throughs. Since then, MBS spreads are marginally tighter.
Exhibit 1: MBS spreads widen until full details of pool liquidation come out
Although noisy, the pattern of MBS spreads since the bank collapse seems to accurately reflect the flow of information into the market about potential liquidation supply. There is still uncertainty around liquidation of big positions in CMOs and Ginnie Mae project loan REMICs, and that uncertainty may keep MBS spreads wide or push them wider if handled poorly. But at this point everything is known about the pool CUSIPs scheduled for sale except for the specific date when each CUSIP will come to market.
Lessons on stock and flow pricing from QE
Based on the level of detail about the pools, history would argue that the impact of liquidation itself is fully priced. Fed QE offers an important example. Some of the best studies of the market impact of QE—D’Amico and King for example—distinguish between the “stock” effects of Fed buying and the “flow” effects:
- Stock effects capture changing market expectations of future available supply. In QE, the market has to price in the total amount of Treasury debt or MBS the Fed intends to absorb. In the early efforts at QE in 2008 and 2009, the Fed announced specific target amounts of MBS and Treasury debt but has since only announced monthly purchase targets and left the ultimate amount unstated. The market may have a general idea of the amount the Fed will absorb, but an unstated target leaves a healthy amount of uncertainty. In later QE, as a result, the amount of supply absorbed by the Fed and the specific securities only become completely clear when QE ends.
- Flow effects capture market reaction to ongoing transactions. In Fed purchases of Treasury debt, the Fed only discloses CUSIPs purchased after each auction. The amount of each specific CUSIP absorbed only becomes clear after the Fed buys.
D’Amico and King estimate that stock effects have nearly ten times the impact of flow effects on Treasury yields, In other words, the market prices in the majority of the impact of QE on the announcement of a Fed target and only uses the actual purchases themselves to modify pricing on specific CUSIPs.
For the current round of bank portfolio liquidation, the market gradually priced in the stock effect between the FDIC seizure of Silicon Valley Bank and Signature Bank and the BlackRock announcement of pool CUSIPs and auction schedule. But at this point, the pass-through market knows exactly what is coming. And that should be fully priced in general and in specific coupons and corners of the specified pool market.
As for flow effects of liquidation, those apply to the degree the market is uncertain about exactly what is coming out. In this liquidation, the market knows all the CUSIPs in advance although timing is uncertain. A particular CUSIP could show up on the BlackRock auction list in a day, a week or months from now. It is possible that some investors could simply miss a CUSIP, but flow effects in the pass-through liquidation should be minor.
The case of MBS sales by the US Treasury
Some investors have looked to sales of MBS by the US Treasury starting in 2011 as a possible source of insight on the impact of the current bank liquidations. Treasury announced on September 5, 2008, as it took Fannie Mae and Freddie Mac into receivership, that it intended to buy agency MBS with the amount and timing of purchases left open (Exhibit 2). It finished buying on December 31, 2009, holding a $225 billion MBS portfolio. On March 21, 2011, it announced plans to sell up to $10 billion a month. And selling of the last balances finished on March 19, 2012.
Exhibit 2: MBS spreads tightened during Treasury selling in 2011 and 2012
The few studies of the Treasury’s MBS buying and selling get clouded by the Fed programs going on at the same times and in much bigger size, so no useful guidance comes out of the Treasury episode. MBS spreads tightened while the Treasury bought, held relatively steady while the Treasury paused, and tightened again while the Treasury sold. And while the Treasury sold, the QE2 allowed Fed MBS balances to decline. Something bigger was going on.
For MBS investor that have stepped to the sidelines, it seems worthwhile to take another hard look at the bank liquidations. All else equal, the spreads on the scheduled assets today are likely to be the same spreads months from now when the selling eventually winds down.
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The view in rates
OIS forward rates continue to price one more Fed hike in May and cuts of 50 bp through December. The market has moved closer to the Fed’s own projected path in the last few weeks. But the market is clearly assigning more weight to the possibility that tighter bank credit will magnify the impact of cumulative Fed hikes and drive cuts later this year.
Fed RRP balances continue to climb and closed Friday at $2.32 trillion, up $35 billion from a week ago and nearing the highest balances of the RRP outside of dates marking the end of a quarter or the end of the year. Money market funds continue to get net inflows, and that is flowing into RRP.
Settings on 3-month LIBOR have closed Friday at 530 bp, up 5 bp from a week ago. Setting on 3-month term SOFR closed Friday at 508 bp, up 1 bp from a week ago.
Further out the curve, the 2-year note closed Friday at 4.01%, down 17 bp over the last week. The 10-year note closed at 3.42%, down 15 bp over the last week.
The Treasury yield curve has finished its most recent session with 2s10s at -58, steeper by 2 bp. The 5s30s finished the most recent session at 1 bp, 8 bp steeper on the week.
Breakeven 10-year inflation finished the week at 221 bp, down 8 bp in the last week. The 10-year real rate finished the week at 121 bp, down 8 bp in the last week.
The view in spreads
Volatility has slowed in its return to earth after the MOVE index rocketed to levels last seen in 2008 and 2009. Lower volatility should keep helping risk assets, credit especially. The Bloomberg investment grade cash corporate bond index OAS widened over the last week to 161 bp. MBS is weighed down by the liquidation of $114 billion in securities formerly held by Silicon Valley Bank and Signature Bank. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields closed Friday at 169 bp, wider by 6 bp from a week ago. Par 30-year MBS TOAS has closed Friday at 60 bp, wider by 4 bp on the week.
Investors short volatility should note that the Treasury market has started to reflect concerns about a debt ceiling showdown in late July and early August.. Volatility should rise if the standoff goes down to the wire.
The view in credit
Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market are funded with floating debt. Leveraged and middle market balance sheets are vulnerable, especially with the sharp tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. Some commercial real estate funded with floating-rate mortgages have started to show some stress, too.