All METARs who follow world economic news are aware that the U.K. financial market suffered a crisis of confidence last month which caused the new prime minister to fire the finance minister, reverse her policies and will probably get her fired.
Federal Reserve researchers and officials quizzed experts from Wall Street and around the world last week about a pressing question: Could a market meltdown like the one that happened in Britain late last month occur here?
The answer they got back, according to four people at separate institutions who were in such conversations and who spoke on the condition of anonymity to describe private meetings, was that it probably could — though a crash does not appear to be imminent. …
The risk of a financial crisis has grown as central banks have dramatically raised interest rates…
Markets have been choppy for months in the United States and globally as central banks — including the Fed — rapidly raise interest rates to bring inflation under control. That has caused abnormally large price moves in currencies and other assets because their values hinge partly on the level of interest rates and on international rate differences. Stocks have been swinging. It can be hard to quickly find a buyer for U.S. government bonds, although the market is not breaking down. And in corners of finance that involve more complicated investment structures, there’s a concern that volatility could trigger a dangerous chain reaction…It is impossible to know what might break until something does. Markets are large and intertwined, and comprehensive data is hard to come by. …[end quote]
It is concerning that “It can be hard to quickly find a buyer for U.S. government bonds” since normally Treasuries are the most liquid investment in the market. It’s an indication that the ususal buyers are hoarding cash. The largest international buyers of Treasuries are Japan and China. Changes in either one might cause illiquidity in the Treasury market. The Federal Reserve would probably step in to buy if that happened, but that’s opposite to their current strategy of gradually selling Treasuries and mortgage bonds from their bloated portfolio.
The 2008 financial crisis was triggered by the failure of highly-leveraged, opaque financial products that intertwined between companies. When the Fed raised the fed funds rate in 2004 - 2006 from its abnormally low level to a more normal level, mortgage defaults began to rise in 2007, leading to the 2008 financial crisis.
The 30 year mortgage rate is currently rising faster than it did in 2006. Mortgage rates have more than doubled in the past year.
Faltering home prices are hurting investors’ demand for junk-rated mortgage securities sold by housing giants Fannie and Freddie
By Matt Grossman, The Wall Street Journal, Oct. 19, 2022
Investors are unloading securities sold by Fannie Mae FNMA -2.35%▼ and Freddie Mac FMCC -0.96%▼ that shift the risk of mortgage defaults away from taxpayers, a sign of growing concern about defaults if rising interest rates cause a severe recession.
The securities, called credit-risk transfers, could incur losses if rising defaults creep into the massive swaths of mortgage debt backed by the housing-finance giants. The Federal Reserve’s interest-rate increases have shown signs of cooling the pandemic’s roaring real-estate market, and many worry that the central bank’s inflation-fighting may cause a recession that hurts homeowners’ ability to repay their loans…[end quote]
I have never heard of “credit-risk transfers” (CRT) before. Asset managers, pensions and hedge funds all invest in the roughly $60 billion CRT market, which acts as insurance for the two agencies against defaults on slices of roughly $4.5 trillion of mortgages that would otherwise spell losses for U.S. taxpayers. CRT prices have fallen so much that judging by spreads alone, the market looks like it is preparing for a housing crisis as bad as the 2008 recession. (I buy mortgage-backed bonds on the secondary market, but they are AAA rated, not CRTs, and I always hold to maturity.)
Having just read 3 books about interest rates and markets, I’m concerned that higher rates may indeed cause a crisis, although it would take time to work its way through the system.
Zombie companies, which can barely cover their interest payment even when rates are ultra-low, will gradually fail as their debts mature and need to be rolled over. According to the Fed, 10% of listed companies are zombies.
Failures caused by mortgage-backed securities. Outstanding (as of 4Q21) $12,201.6 billion – an enormous amount, equal to about 50% of U.S. GDP. These are often highly leveraged – the trigger of the 2008 financial crisis.
US Mortgage Backed Securities Statistics - SIFMA - US Mortgage Backed Securities Statistics - SIFMA
I would like to call attention to one of the most insightful essays in the financial press, John Mauldin’s “Fingers of Instability,” written in 2006. It may be relevant for our current situation when the sandpile of stressed debt is growing ever higher and put under more stress by rising interest rates. Mauldin has just written a new insight, “Pension Sandpile.”
The trend has decisively shifted from stability to instability. Be careful out there.