After SVB's Collapse, Anxiety Grips $8 Trillion Of Mortgage Debt

A deteriorating banking sector is wreaking havoc on a roughly $8 trillion bond market considered nearly as risk-free as government bonds issued by the government of the United States.

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Banks, insurers, and bond funds are often the holders of agency mortgage bonds because they are backed by government-owned lenders like Fannie Mae and Freddie Mac, which are backed by mortgage loans. This is one of the major reasons Silicon Valley Bank made its biggest investment before it foundered, as bonds have a much lower default rate than most debt and are quite easy to buy and sell, making them Silicon Valley Bank's biggest investment at the time. 

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A mortgage-backed security from an agency is, however, vulnerable to interest rate rises, as all long-term bonds are. Rising interest rates last year pushed the prices of agency mortgage-backed bonds down and left banks such as SVB SIVB 0.00%increase; green up pointing triangle with unrealized losses. Having taken over SVB, investors are expecting that the bonds will be sold off in the near future, adding further supply to a weak market and pushing prices down as investors expect the bonds to be sold off. 

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A widely followed index of agency mortgage-backed securities hit a high last week as interest rates rose, turning global markets upside down. Bond-fund managers said the move was a reflection of fears that other regional banks would have to sell their holdings.

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The market is deep enough to absorb even large liquidations as cheaper valuations draw in new buyers as the market absorbs liquidations when they occur. However, Varunok still expects the market to be volatile if any more turmoil surfaces at the banks in the near future. 

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As we hear more and more stories about other banks likely putting supply in the market, there are a lot of fits and starts that we are likely to see going forward," he added.

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In the event of a rise in benchmark rates, bonds that were sold previously at lower rates will lose value. Prices of such agency MBS, which use the term "low coupon", began falling about a year ago, when the Federal Reserve raised interest rates in order to combat inflation and indicated it might potentially start taking on new MBS. 

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The prices of some of these bonds dropped as low as 80 cents on the dollar in just a few months after the loss of 15% or more by some of these bonds.

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Most of the low-coupon MBS managers sold them at a loss because they must mark their investments at market value. However, banks largely held on. In contrast to "available-for-sale" securities, which can be marked at above-market prices because they are intended to be held until repayment, most of the debt was classified as "hold-to-maturity."

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Bank analysts and MBS investors alike fear that other midsize banks will suffer the same fate soon and through a wave of withdrawals, their deposits will go down alongside SVB. Now bank analysts and MBS investors alike are conducting investigations into the holdings of other midsize banks to ensure that their depositors continue to be confident in their banks.

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In response to the news of the sale, T. Rowe Price Group Inc. immediately analyzed the company's mortgage-bond holdings, explains Ramon de Castro, T. Rowe Price's mortgage-bond portfolio manager. “You take a page from the [2008] great financial collapse and use it to your benefit.”

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I fear that a similar scenario will occur when a larger institution submits a report to regulators that must be complied with. In the meantime, First Republic Bank, which is in free fall and has been taken over by regulators, owns far less agency MBS than SVB's roughly $78 billion as of December 31.

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The Securities and Exchange Commission has released filings with the U.S. Securities and Exchange Commission that show that Charles Schwab Corp., Truist Financial Corp., and U.S. Bancorp hold the largest amount of agency mortgage bonds among midsize U.S. banks. In terms of securities, the lion's share is accounted for by brokerage giant Schwab, with $237 billion in holdings. The companies claim they have enough capital to meet withdrawals. Since March 1, shares have plummeted by 27% to 35%.

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Charles Schwab spokeswoman said that given that the company has immediate access to liquidity, there are almost no chances that we would need to sell our portfolio prior to maturity, given that we have immediate access to liquidity.

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The paring of such a large portfolio would negatively impact the prices of the low-coupon bonds most banks hold, but U.S. regulators could prevent a fire sale by taking measures. According to Ankur Mehta, Citicorp's global head of securitized products research, the Fed's lending facility and other initiatives would prevent banks from forcing out forced sales.

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As a result of the run on SVB, investors' demand for an index containing agency MBS bonds increased by 27%, or 0.20 percentage points, after the yield premium between U.S. Treasury yields and agency MBS yields jumped, based on Trade Algo data. 

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There were a number of buyers last week, including Franklin. 

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When I walked in at the start of the week [Monday], [risk premiums] shot higher at a rate that we have not seen since the high volatility levels reached in mid-October. We used that differential to optimize the portfolio,” Mr. Varunok explained.