Housing market needs SOFR alternative — now
For the past year and more, we've been focused on the growing level of dysfunction in the U.S. money markets caused by the open market intervention by the Federal Open Market Committee. In particular, the FOMC's focus on manipulating the price for overnight federal funds has caused a lot of mischief along with undoubted and considerable benefits.
One of the big issues lurking in the background of the money markets is the 2017 decision by the Alternate Reference Rates Committee to make the Secured Overnight Financing Rate, or SOFR, the replacement for Libor.
According to the Fed, SOFR is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities. In fact, SOFR is an imaginary, backward-looking benchmark dreamed up by the economists at the Fed with no discernable market.
There is no actual trading activity in SOFR. While the Fed party line claims that SOFR is built upon "a deeply liquid market in U.S. Treasury securities," in fact the Fed's economists missed that very opportunity entirely and instead had to create a new benchmark of their own design.
Imagine our amusement, therefore, when last week a strange comment from former congressman Barney Frank and J. Christopher Giancarlo surfaced in Barron's. The Barron's comment worries rightly about having a sufficiently "robust" replacement for Libor.
The comment co-authored by former House Financial Services Committee Chairman Frank seems a gentle rebuke to the Fed and carries a message. Who, we wonder, among the top banks wants to send a soft but forceful nudge to Fed Chairman Jerome Powell on the SOFR mess?
Remember, the first and most important financing tool in the mortgage banker toolkit is warehouse lending. While many parts of the market are starting the transition from Libor to SOFR, the bank-funded markets for 30-day securities repo and collateral financial markets are not changing. Not even close.
In particular, the money center banks active in repo for agency mortgage-backed securities and loan financing have made clear that they are not changing anytime soon. "Given the lack of depth and breadth, currently existing within SOFR itself, the warehouse lending market has not even hinted towards the potential for a migration away from Libor," one leading mortgage banker tells National Mortgage News.
And why is SOFR being shunned by the most important, most conservative bond market after U.S. Treasurys? Because the banks don't see an alternative to Libor for pricing both sides of a 30-day repo trade for MBS and dry FHA-guaranteed loans. For those of us who appreciate that forward to-be-announced contracts for Ginnie Mae MBS are the foundation of the hedging market for Treasury securities, nothing more need be said.
Today one-month Libor is trading around 18 basis points, but there is no comparable 30-day rate in the magical land of SOFR, which is about 10 basis points for overnight. The takeaway? It was easy for the Washington economists who staff the FOMC to confiscate a true, working market benchmark like federal funds decades ago. It is less easy to create a functioning market rate out of an economic fantasy like SOFR.
By pushing SOFR, Chairman Powell has created a conflict for the Fed's Board of Governors in terms of bank supervision and regulation. On the one hand, the Fed led and inspired ARRC, has voted to transition away from Libor to SOFR. But these same federally insured depositories cannot do so because making the change to the nonexistent SOFR would increase risk to the banks and their customers, and create other bizarre regulatory problems and risks.
Many cash providers to the repo markets for AAA-rated government-insured MBS and loans, like community banks, for example, will not accept SOFR pricing.
"The demise of Libor was never meant to result in its replacement with a singular benchmark," argue Frank and Giancarlo. "There are alternatives to Libor used increasingly by America's regional, community, and minority-owned banks. They have spoken out about their need for a broad-based, unsecured interest-rate benchmark that tracks lending and borrowing activity in the real economy. For many banks big and small, an unsecured index can play a crucial role in ensuring fair pricing on credit and increasing transparency and liquidity in unsecured debt."
Indeed, there is a solution that satisfies these concerns and also comports with the Fed's existing position. The change simply involves pricing agency and government repo against the TBA market, which is where mortgage firms, REITs and funds hedge interest rate risk in government and agency MBS. Hint to Powell: Traders often sell TBAs to manage rate risk in repo of government insured loans.
Pricing MBS repo off TBAs would be quickly and gladly accepted by market participants and, indeed, would broaden the application of TBA pricing to all U.S. collateral. Neat idea, eh? Since TBAs are the second largest fixed income market in the world after the cash market for U.S. Treasury debt, this would provide a robust and transparent solution to a problem that really need not exist.
There are several sources for TBA pricing benchmarks and even some independent sources, such as MIAC's IOSCO-compliant Mortgage Secondary Market benchmark, which many market participants would readily accept for pricing and back-testing of risk models.
Using the TBA market as an alternative to SOFR has several advantages. First, the pricing is asset on an extant futures market (the TBA market) with long history and economic justification. Second, it represents a true market price and cost-of-funds alternative for many depositories and is compliant with prudential law and regulation. And third, TBA represents an asset yield rather than a financing rate, aligning it with Treasury bills, MBS and other industry products.
So let us lift a cold August beverage to the death of Libor. Let us also drink another to the simultaneous demise of SOFR, which in truth was never really extant as a living market price. And let us cheer the arrival of the obvious solution, the solution with just three letters — T-B-A — that is staring Chairman Powell and the members of ARRC dead in the face. Let's price secured money market transactions in the United States against the risk-free TBA market and have one less problem to solve. Happy Labor Day.