All Things in Moderation

Vital Statistics:

Stocks are lower this morning after the employment report came in stronger than expected. Bonds and MBS are down.

The economy added 372,000 jobs in June, which was well above the Street estimate of 270k. The unemployment rate remained at 3.6%, and average hourly earnings rose 0.3% MOM and 5.3% YOY. There are 5.7 million long-term unemployed who want a job but were unable to find one, which is still higher than the 5 million pre-pandemic.

Leisure and hospitality, health care and professional / business services added the most jobs. Overall, this report will give the Fed the leeway to raise interest rates 75 basis points at the end of the month as expected.

The demise of First Guaranty and Sprout has people asking if this is the harbinger for another 2008. Given that real estate prices have risen so dramatically over the past two years it is hard to deny the similarities are there. That said, there are big differences. The most important difference is that the products that don’t fit the Fannie / Freddie credit box are still high quality loans. We don’t have the negative amortization (i.e. pick-a-pay) loans that were given to anyone who could fog a mirror. The non-QM loans are often based on rental income, which has been rising at a rapid clip.

Second, the home supply situation is much different today than it was in 2006. In 2006 we were coming off years of overbuilding. For the 10 years prior to the 2006 peak, the US built about 16.8 million units. Over the past 10 years, we have built about 10.5 million. The supply overhang doesn’t exist this time around, homeowners have much more equity and the mortgages that were done since the crisis have been much higher quality than during the bubble years.

Others have pointed out that perhaps the non-QM issue is something more reminiscent of the Russian debt crisis of the late 90s, which blew up hedge fund Long-Term Capital Management. FWIW, I don’t see it – the non-QM market simply isn’t that big. Non-QM issuance is around $20 billion per year, give or take. To put that number in perspective, $20 billion is about half the average daily traded volume of US corporate debt. Year-to-date, corporate bond issuance is about $836 billion. A blow up in the non-QM market won’t even register outside of the mortgage banking space.

My guess is that these firms got stuck with inventory that was depreciating in value as rates rose so rapidly over the past few months. Most of these places hold loans on a sort of warehouse line, and they were being hit with curtailments they couldn’t pay. Don’t forget, there are no products which can hedge the interest rates risk on non-QM. Selling TBAs against non-QM paper is subject to basis risk, which means TBAs and non-QM don’t really correlate all that well. In other words, non-QM paper is basically unhedgeable. This is probably not an issue for lenders who simply buy non-QM for their portfolio, but it is an issue for those who rely on securitization as an exit. Note that this issue doesn’t affect the underlying credit quality at all – NQM securities were falling price due to interest rates, not defaults. This is a huge difference from 2006.

The punch line here is that the non-QM issue is something that isn’t big enough to cause any sort of crisis in the overall economy.

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