No Hazards, Moral or Otherwise

August 23, 2020 – Weekly comment

Prior to the housing crisis, Freddie Mac securitized mortgages as participation certificates (PCs) and sold the interest rate risk to investors. Under this business model, Freddie Mac retained 100% of the associated mortgage credit risk.

In 2013, Freddie Mac engineered the STACR program, making them the first GSE to develop a structure to transfer mortgage credit risk to investors. Since then, Freddie Mac has introduced a suite of innovative CRT offerings that enable investors and (re)insurers to engage in the U.S. housing market. CRT has fundamentally changed the nature of housing finance by transferring credit risk from U.S. taxpayers to the private capital markets.

A Bloomberg article from July 23 by Joe Light notes that because the CARES act allowed mortgage forbearance, owners of the above securities could face losses of up to $2 billion.  At the heart of the issue is Credit Risk Transfer securities.  From the article, “The issue is an unintended side effect of the response to the global health crisis.  As the US economy shut down in March, Congress rushed to pass the $2T CARES Act, which included a provision that allowed forbearance on loans backed by Fannie and Freddie for as long as one year if borrowers were impacted by the pandemic.  The postponed mortgage payments will hurt investors in certain credit-transfer securities even if homeowners resume payments and Fannie and Freddie never suffer losses, a predicament that’s prompted bond holders to lobby lawmakers and federal officials for a fix.  The situation has also soured some investors on CRT securities, a $50 billion market that was created in part to protect taxpayers from ever again having to bail out Fannie and Freddie.”

Man, that’s some pretty dry stuff.  I was pulled into this vortex by a friend of mine who thought it could be important to the markets.  So I continued reading articles about CRTs and mortgage forbearance.  That’s a few hours I’ll never get back.  Sure, $2 billion used to be a lot of money.  But think of it in this context:  Since April, AAPL has doubled in value, adding $1 Trillion to its market cap.  TSLA has doubled in less than two months, adding about $200 billion in market cap.  The quibbling  about Credit Risk Transfers is thus 1% of the increase in market cap of Tesla.  It’s a couple percent of what the Fed buys in MBS every week.  It’s a rounding error.  If you blinked, you’d miss it as an addition to M2.  

However, it’s still important.  Because of the name.  Credit Risk Transfer.  That concept has pretty much flown out the window.  Capitalism used to require judicious weighing of credit risk.  Now, corporate bonds barely have any yield premium.  So… what happens when the government grants relief to the injured parties who willingly bought credit risk transfers and now can’t bear to have their returns impacted by the “risk” clause.   Well, that part will now probably transfer over to the government.  That is, to the taxpayer.  Again.  It seems somewhat unfair… that YOU bought a security that might have a loss associated with it, and WE have to pay for it.  If only there was some clue, if only there was some sort of previous episode that could have alerted us to the stark possibility of loss.  CREDIT RISK TRANSFERS.  Nope, I don’t see anything in the fine print there.  STACR.  That seems innocent enough.  Well, if you re-arrange the last two letters you get something that sort of sounds like “stark” but It looks like these things have a better yield than the other stuff in the portfolio.  “Sounds like a winner boss.  These guys at the agencies want to TRANSFER a few extra basis points to us.”  “Very clever Smithers.  Nice work on the due diligence. Buy everything you can for the endowment portfolio.”

So now it falls to the taxpayer.  But wait a second, what the hell is THAT?  It too has become a meaningless concept.  Stephanie Kelton, the Modern Monetary Theory maven, actually does justice to the taxpayer part of the equation in one of her lectures.  She draws government spending as a series of big circles, let’s just call them poker chips.  Taxes are represented as poker chips as well.  The government spends 10 poker chips, and then takes back 5 poker chips from the economy. It really doesn’t have anything to do with what’s right or fair.  It is about as far from ‘pay-as-you-go’ as one can get.  As the reserve currency, the US government can just print dollars. 

Some people are trying to explain the bid in precious metals.  Others are trying to wrap their heads around bitcoin.  Think about the concepts of “risk” and “the taxpayer” in conjunction with the value of the dollar and the amount of debt.  And then tell me why you don’t want to (anonymously if possible) own silver and gold and bitcoin.

Way back when NationsBank was still around, the chief executive was a guy named Hugh McColl, a former marine who kept a hand grenade on his desk.  The trading desk had lost a large amount of money on some sort of technicality having to do with the bond contract, perhaps a squeeze on the cheapest to deliver.  It was a lot of money, and at the time, it was well publicized.  Other desks had also taken a hit on the trade, and there was talk of litigation to wiggle out.  Not McColl.  He said, “We’re big boys.  We should have known the risks and we’ll eat the loss.”  Semper Fi.

That’s a little different in tone from Stephanie Kelton who put out this tweet and chart over the weekend:

“Debt climbs.  Rates fall.”

It’s not just a lack of taking responsibility.  It’s pretending that nothing has consequences.  For example, last week the New York Fed’s Liberty Street Economics blog featured a post, ‘Market Function Purchases by the Federal Reserve’.  The discussion centered around current Fed heroics and several other historical instances of Fed intervention to restore functioning markets.  The paper ends with this humdinger:

There may be other ways to forestall or mitigate the appearance of a disorderly, illiquid market, such as primary market auction sales of Treasury debt (which in the 1970s replaced the fixed-price offerings at the root of the 1958 and 1970 episodes) or improved clearing and settlement systems (which have been suggested in the wake of the 2020 purchase program), but the infrequency of Federal Reserve intervention suggests that relying on the Fed on those rare occasions when markets are in extremis has not materially exacerbated moral hazard.

Right.  Got that?  Fed intervention is rare and moral hazard is just a figment of our over-active imaginations. 


Fed Chair Jay Powell will give a speech at the virtual Jackson Hole conference on Thursday, Aug 27, at 9:10 am.  The subject: “Monetary Policy Framework Review”

PCE Core Deflator and UofM Inflation survey on Friday.
Auctions of $50 billion 2’s and $22 billion 2yr FRNs on Tuesday, $51 billion 5’s, and $47 billion 7’s next week, beginning on Tuesday. 


Last week I put out a chart which overlaid the yield of the gold euro$ pack on the 30 year bond.  Below, that chart is updated with the spread between the two in the lower panel.  Not quite to the 2012 high, but at 77 bps, only about ¼% away.  By the way, QE3 was Sept to Dec of 2012 and that period also featured strong forward guidance.

UST 2Y14.714.3-0.4
UST 5Y29.826.8-3.0
UST 10Y70.863.3-7.5
UST 30Y144.2134.8-9.4
GERM 2Y-64.7-64.7-63.3
GERM 10Y-42.1-42.1-50.7
JPN 30Y61.561.561.3
EURO$ U0/U1-3.0-3.25-0.3
EURO$ U1/U24.04.00.0
EURO$ U2/U312.010.0-2.0
CRUDE (active)42.3142.340.03

If you’re dying to learn more about CRTs:

Posted on August 23, 2020 at 2:40 pm by alexmanzara · Permalink
In: Eurodollar Options

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