How far the Fed’s facility is prone to go in stopping financial institution MBS woes
The effectiveness of the borrowing facility now available to address the mortgage-backed securities risk that contributed to Silicon Valley Bank’s failure remains to be seen, as it has been tapped for at least $12 billion but institutions are leaning more heavily on other funding sources. But experts are hopeful about its usage.
“I think that the immediate problem has been sufficiently addressed. I don’t think that that facility is going to be a panacea,” said Nicholas Gunther, co-founder and chief product officer at Infima Technologies, a Stanford University-affiliated data and analytics firm that specializes in predicting the behavior of borrowers, securities and markets.
The Federal Reserve’s Bank Term Funding Program (BTFP) targets the central concern, which is that other banks also are likely to have MBS underwater compared to their original value because those bonds were issued prior to a run-up in rates and generate far less than more recent vintages. If a need for funds arises, rather than selling them and recording a loss based on the change in value, institutions can borrow against the securities at par, or their at-issuance value, instead.
The facility “will be effective for what it’s designed to do, which is to avoid banks having to liquidate securities at a discount that are trading at a discount because of interest rate movements,” said Jon Van Gorp, chair at law firm Mayer Brown.
Some may be hesitating to utilize the facility and are using the Federal Home Loan Bank System or the traditional Fed discount window instead. Borrowing through the discount window last week exceeded the previous record set during the Great Recession, according to a Moody’s Investors Service report.
Van Gorp said there can be a stigma to using what may be perceived to be emergency facilities provided by the government “that somehow, if you draw on them, you must be in a position of peril.” But he added that while that may be the perception, use of the new one doesn’t necessarily reflect desperation for funding.
Borrowing through the discount window last week exceeded the previous record set during the Great Recession, according to a Moody’s Investors Service report.
“It just seems like good and prudent measures as a bank manager to use the credit available, and the rate on the facility is competitive. It’s a competitive interest rate, you don’t pay an extremely high interest rate,” Van Gorp said. “The government’s lending against, basically, their own obligations, Treasuries and mortgage backed securities that are issued by the GSEs, so they’re not taking a lot of risk here.”
The financial system may’ve been even healthier if the new facility had been available earlier and prevented Silicon Valley Bank’s problems regarding MBS. (Regulators also are covering the bank’s uninsured deposits.)
The BTFP does allow banks to “access liquidity at the par value of their securities without being forced to sell the collateral, with the goal of stopping any deposit runs before they can start,” said Walter Schmidt, senior vice president, mortgage strategies at FHN Financial, in a report Thursday.
Silicon Valley Bank had an unusually large portfolio of government-related mortgage-backed securities, and was in the top 10 of institutions holding these types of bonds as ranked by this publication. MBS made up a relatively higher percentage of its assets than at other institutions. But even banks still holding this type of MBS as an average share of their assets could feel some pain from the Fed’s decision to rapidly hike rates if they still have those kinds of securities, so a broader need for the facility does exist.
That said, it would be surprising if much of the surge in bank borrowing relates directly to MBS management rather than broader ripple effects from recent institutional failures, which may explain the facility’s relatively more limited use.
Large banks more typically manage the kind of risks SVB experienced with hedging instruments that, albeit sometimes imperfectly, aim to offset the impact on rate movements on mortgage-backed securities. Large banks also are considered better at managing developments like differences in the shape of the curve formed by yields of short and long-term bonds. That was inverted to the detriment of long-term assets and thus it was tougher for SVB to match them with liabilities.
Smaller, specialized institutions like SVB that might be strong in their area of expertise, but not necessarily outside it, are seen as more likely to have problems managing MBS rate risk.
“In the case of the banks that have been most in the news, management was very focused on their core line of work, which in the case of SVB, was providing services to seasoned startups. That may have distracted them from critical risk management,” Gunther said.
While there’s a negative outlook for the U.S. banking sector, the type of discount window borrowings tapped so far indicate that the overall financials for banks are generally bearing up.
“None of the discount window borrowings were secondary credit, which indicates that U.S. bank supervisors consider the banks that needed support ‘healthy’ and not at risk of imminent failure,” Moody’s Investors Service said in a recent report.
But the whole industry went through an exceptionally long period without significant Fed hikes. That may have left many out of practice in managing rate risk, particularly given government-related MBS are often thought of as “safe” bonds.
Those less familiar with MBS need to understand that while the bonds have government-related backing that would indeed protect them from the kind of delinquency concerns experienced during the Great Recession, they still have rate exposures. And those rate exposures are somewhat different from those of other government bonds.
Unlike Treasury bonds, MBS have negative convexity. That’s when a bank, for example, has a bond backed by mortgages that lenders originated at 2%, moves into a market where rates are much higher, such that the borrower can’t refinance. That means the now lower-valued security stays on the books longer than it might’ve otherwise.
“The issue is that not only does it carry a fixed return for a significant period, but that period can extend dramatically exactly when you don’t want it to,” Gunther said.
To some extent, the Fed facility’s par pricing eliminates how these distinctions drive valuations while it’s used. But it is not, as Gunther notes, a cure-all. Banks may still need to account for fluctuation in market values when it’s not using the facility, as bonds transfer in and out of borrowings, depending on how the investments are categorized in terms of being available for sale or held to maturity. How accounting works in conjunction with the facility at deadline was a topic at least one expert contacted by this publication was reluctant to weigh in on due to scrutiny the industry is experiencing in conjunction with Silicon Valley Bank.
While questions have come up about how mortgage-backed securities used in the facility get treated for reporting and other purposes may be a hindrance now, if answers come and more comfort with it follows, use could grow further.
For now, that may be enough for the facility to fulfill its aim of preventing problems like SVB’s, although it comes too late for the bank itself to benefit from it the way others could.
Even if usage of the BTFP specifically remains relatively low, it could be effective. Government mortgage-bond insurer Ginnie Mae’s pandemic-era Pass-Through Assistance Program, a liquidity facility for servicers, did not get a lot of actual use, but it nevertheless helped stabilize a mortgage market at the time.
If banks aren’t going to use the new facility, Gunther said he hopes they also beef up or maintain strong interest rate risk controls around their MBS and don’t get complacent.
“We hope it’s going to be a wake-up call to other banks and investors who hold similar securities and haven’t suffered the same dramatic events that we’ve seen with publicized bank failures, but nonetheless are facing similar issues,” he said.