Tuesday, December 31, 2013

The Return of the Jumbo

Remember those damnable jumbo mortgage loans of the housing bubble?  Well, like the Terminator,  according to Inside Mortgage Finance, "they're back"!

As a bit of background, jumbo mortgages are home loans that exceed the limits imposed by Fannie Mae and Freddie Mac.  In most parts of the United States, these two GSEs limit mortgages to $417,000 with a "conforming limit" of $625,500 in some of the most expensive real estate markets (100 out of the 3300 counties in total) in the United States.  Jumbo loans are generally taken on properties ranging in price from $750,000 to $10 million and a borrower must have a minimum credit score of 700 with a debt-to-income ratio of no more than 45 percent and a 20 to 40 percent downpayment.  Jumbo loan holders also require a higher reserve base than normal loans and, in normal circumstances, have a higher interest rate than conventional mortgages.

Let's start with a bit of history.  Here is a graph showing the conforming limit in dark blue, the average price of an American home in pink, the average sale price of a home financed with a jumbo loan in medium blue and yellow and the average size of a jumbo mortgage taken out on these homes that were priced higher than the conforming limit:

Between 2002 and 2006, banks originated an average of $557 billion annually in jumbo mortgages.  There's your housing bubble!

The volume of jumbo mortgage originations more than tripled between 1993 and 2005 as shown on this bar graph:

Now, let's go back to the present.  Here is a graph showing the interest rate on a 30 year fixed jumbo loan over the past three years:

Here is a graph showing the interest rate on a 15 year fixed jumbo loan over the past three years:

Here is a graph showing the interest rate on a 15 year fixed regular loan over the past three years:

The current rate on a 15 year fixed mortgage is 3.47 percent.  The current rate on a fixed 15 year jumbo is only very slightly higher at 3.50 percent.  In fact, back in September 2013, the rates on jumbo loans were lower than the rates on regular loans, an event that has never happened before.  Normally, the rate on jumbo loans is at least 0.25 percent higher than the rate on regular mortgage loans, in fact, during December 2008, the spread reached 1.8 percentage points.  Why is this historically unprecedented relationship taking place?  There are several reasons:

1.)  Volatile interest rates that have pushed up yields on mortgage bonds issued by Fannie Mae and Freddie Mac which has translated into higher interest rates on "conforming loans".

2.) Higher fees charged on "conforming loans" because Federal officials are reducing the exposure of Fannie and Freddie which have been passed along to consumers.

3.)  Banks are flush with cash on deposit and want to loan that money out.  Jumbo mortgages are kept on bank balance sheets meaning that interest rates are not set by the bond market.  Higher interest rates since late spring have meant that banks are increasingly willing to loan higher amounts of money to their wealthier clientele.  Some banks are offering special discounted mortgage rates for clients that maintain high balances in savings and brokerage accounts in an effort to attract borrowers. 

All of this has led to an increase in total jumbo mortgage originations over the past year.  In the second quarter of 2010, jumbo mortgage lenders originated a tiny $18 billion in loans and that was up 20 percent over the first quarter volume.  In the first three quarters of 2008, only $87 billion of jumbo loans were originated.  If we look at the present situation, we find the following jumbo loan originations by quarter for 2013:

Q1 2013 - $97 billion
Q2 2013 - $105 billion
Q3 2013 - $102 billion 

Jumbo loans have increased by 34 percent on a year-over-year basis, a rather impressive increase.  Obviously, banks and borrowers feel that history will not repeat itself.  Banks feel that their very well-heeled clients are less of a risk than the rest of us.  That said, let's look back at a bit of history that seems to be forgotten already.  During 2008, the number of delinquent jumbo loans skyrocketed as shown on this graph:

Apparently, even America's wealthy are immune from the humbling experience of defaulting on a mortgage.  The large number of jumbo loan defaults led to a massive downgrade of mortgage-backed securities that were held by the two top originators, Chase Home Finance and Washington Mutual.  That was, in large part, responsible for the collapse of WaMu in 2008.

The current low interest rate environment has had a wide range of what could ultimately be very negative impacts on the economy.  The recent resurgence in housing prices has been predicated on low interest rates.  When the Fed ends its unprecedented experiment, we could well see a repeat of history with even wealthy Americans walking away from their jumbo mortgages.

Monday, December 30, 2013

The History of Russian Involvement in Chechnya

 With the possibility that Chechen terrorists are behind the recent bombings in Russia, I thought that it would be interesting to take a look at Chechnya, its history and its link to terrorism over the past two decades.

Chechnya is located in the northern part of Russia's Caucasus region, midway between the Black Sea and the Caspian Sea as shown on this map (coloured in beige):

If you look at the map carefully, you will see why Chechnya is of great strategic importance to Russia.  It is along the pathway to Caspian Sea oil and is located along the key land bridge that connects Russia to the Middle East, particularly Iran and Iraq, as shown here:

Chechnya has a two century history of being governed by Moscow and, after the fall of the USSR, Chechen separatists launched a campaign for independence.  This campaign led to two wars and an ongoing militant-led insurgency.

Who are the Chechens?  They are a largely Muslim ethnic group that has had a long history of conflict with their Russian masters.  After the Russians reconquered the Chechen territory that had been occupied by the German army during the Second World War, Stalin accused the Chechen people of collaborating with the Nazis.  On February 23, 1944, the Chechens were forcibly scattered throughout the entire Soviet Union.  Over an eight-day period, between 350,000 and 400,000 Chechens were deported after men from each village were lured to take part in Red Army Day celebrations.  They were detained at gunpoint and Red Army soldiers undertook a program which rounded up Chechen women and children, giving them only minutes to gather basic belongings in preparation for deportation.  On February 29, 1944, 159 convoys were underway, mainly consisting of cattle trucks or freight cars ferrying people from their homes.  After twenty to thirty days, deportees arrived at their destinations, often in Kazakhstan and Far Eastern Siberia.  Those who resisted were either shot or arrested and then expelled to Central Asia.  For thirteen years, the Chechen people endured hardship, living in villages that they were not allowed to leave and working in factories where they were very poorly paid.  Chechen children were not allowed to use their mother-tongue and were educated in Russian.  Finally, in 1957, Nikita Khrushchev allowed the Chechens to return to their homeland.

Following the collapse of the Soviet Union in the 1990s, separatists in the new Russian Federation Republic of Chechnya formed an independence movement called the Chechen All-National Congress and, in 1993, declared full independence under the leadership of Dzhokar Dudayev, pictured here:

This move to independence was strongly opposed by then-Russian President Boris Yeltsin.  After accusations of corruption by Russia, on November 26, 1994, domestic opposition forces aided by Russian Army units, attempted to overthrow Dudayev in what became a two year long battle known as the First Chechnya War.  This attempted coup was followed two weeks later by three divisions of Russian armour and pro-Russian Chechen infantry.

A massive aerial bombing campaign of Groznyy, the Chechen capital, followed, killing many civilians and resulting in hundreds of thousands of internally displaced persons.   During 1995 and 1996, a long and bloody guerrilla war was fought; Chechen fighters were forced to use terrorist tactics in their attempts to rid Chechnya of its Russian invaders.  In late 1995, Russia called for elections to replace the Moscow-backed government that had replaced Dudayev after Groznyy was levelled.  In April 1996, Dudayev was likely killed by a Russian ground-launched rocket while he was talking on a satellite phone.  Russia withdrew from Chechnya when it became apparent that the cost of the war was too high and that the ongoing conflict was very unpopular among Russians.

The time for Chechen retaliation had begun.  In September 1999, a series of apartment block bombings in Russia led to the killing of over 300 people; 90 in one blast in Moscow and 130 in another four days later.  These bombings ushered in the reign of newly minted Prime Minister Vladimir Putin who used the bombings as a reason to launch another major military campaign in Chechnya.  To this day, the actual parties behind the bombings remain unconfirmed and Chechen rebels have repeatedly denied involvement.  Some experts have even suggested that the Federal Security Service (FSB) the successor to the KGB (headed by Mr. Putin), was responsible either overtly or by not acting on their knowledge that may have prevented the bombings.

The Second Chechnya War began when Russia stated that it intended to subdue bands of bandits hiding in Chechnya's mountains.  When the Russians withdrew from Chechnya in 1996, a wave of kidnappings and other crime took place in the Caucasus region with many hostages being Russian Army conscripts.  In March 1999, Russia's Interior Minister was kidnapped from the airport in Groznyy and was later executed.  A Chechen militant group led by Shamil Basayev and Doku Umarov took action against the Russian forces in Chechnya, resulting in the deaths of over 1100 Russian troops between August 1999 and early 2000 and the deaths of an estimated 10,000 rebels.  Nearly a quarter of a million Chechen civilians were once again displaced internally.  Both sides accused each other of using chemical weapons.  As time passed, the militants decided to change their tactics, moving away from the idea of creating an independent Chechnya and heading towards the creation of an autonomous Islamic region that encompassed the entire Caucasus region.

Now, let's look at the terrorist groups that are active in Chechnya.  According to the U.S. State Department, the Islamic International Peacekeeping Brigade is the primary channel for Islamic funding of the Chechen guerrillas through links to al-Qaeda financiers on the Arabia Peninsula.  Chechyna's long history of guerrilla warfare has attracted Arab fighters that may also be linked to al-Qaeda.  Shamil Basayev who was killed in July 2006, was an Islamic militant and was responsible for the 2004 attack on a school in Beslan, North Ossetia (a southern Russian republic) where 186 children and 148 adults were killed in a two day hostage taking with an additional 810 people being.

Chechen rebels are also responsible for these attacks:

1.) A bomb blast in May 2002 in Kaspiisk during a military parade that killed 41 people including 17 children.

2.) The October 2002 seizure of Moscow's Dubrovka Theater that ended up killing over 120 theater patrons when the gas used by Russia's Special Forces to disable the hostage-takers overcame many of the hostages.

3.) A December 2002 dual suicide bombing that attacked a building housing Chechnya's government, killing 83 people.

4.) A bomb attack on the Nevsky Express high speed train travelling between Moscow and St. Petersburg caused a derailment that killed 27 people and injured 95.  The bomb is believed to have been triggered by a cell phone.

5.) In March 2010, two female suicide bombers detonated bombs in Moscow's metro subway killing 39 people.

As we can see, Chechnya has a long and painful history, particularly in its fractious relationship with its Russian masters.  The involvement of Russia and the U.S.S.R. in Chechnya’s internal affairs are once again bearing a very bitter fruit.

What Did the 113th Congress Really Accomplish?

It's now apparent that the First Session of the 113th Congress was the least productive in the last 25 years.  According to the Library of Congress, a total of 65 Bills were passed into law, 28 percent of the 25 year average of 230.  While more laws are not necessarily a positive thing, I thought that it would be prudent to take a detailed look at what was really accomplished by the House and Senate.

Here is a list of some of the critical laws that have been passed during the First Session of the 113th Congress:

1.)  H.R. 1071 - To specify the size of the precious metal blanks that will be used in the production of the National Baseball Hall of Fame commemorative coins.  This new law modifies the requirements for the production of silver and gold coins commemorating the National Baseball Hall of Fame, requiring that such coins be struck on planchets of specified diameters.  This bill was introduced in the House on March 12, 2013 and was passed by the House on April 24, 2013, the Senate on May 7, 2013 (unanimously) and signed into law by the President on May 17th, 2013, just over two months after it was introduced by Rep. Richard Hanna of New York.  See, the House and the Senate can get things done at light speed when they are really important to the ongoing business of the nation!

2.) H.R. 475 - To amend the Internal Revenue Code of 1986 to include vaccines against seasonal influenza within the definition of taxable vaccines.  This new law amends the Internal Revenue Code adding influenza vaccines to the list of vaccines that are subject to the excise tax on taxable vaccines. This bill was introduced in the House on February 4, 2013, passed by the House on June 18, 2013, the Senate on June 19, 2013 and signed into law by the President on June 25, 2013.  Again, legislative light speed was invoked!

3.) H.R. 258 - The Stolen Valor Act of 2013.  This new law amends the Federal Criminal Code, making it illegal to fraudulently hold oneself to be the recipient of a Congressional Medal of Honor, a Navy Cross, a Purple Heart, an Air Force Cross and other honours if that individual intends to use the claim to obtain money, property or other tangible benefit.  Those guilty would be subjected to a fine, imprisonment for not more than one year or both.  This bill was introduced in the House on January 15, 2013, referred to the Subcommittee on Crime, Terrorism, Homeland Security and Investigations on January 25, 2013 passed by the House on May 20, 2013 (390 yeas and 3 nays), the Senate on May 22, 2013 (unanimously) and signed into law by the President on June 3, 2013.  While this law is obviously very important to the country's legitimate veterans, it impacts relatively few Americans. 

4.) H.R. 1092 - This law designates the air route traffic control centre located in Nashua, New Hampshire as the "Patricia Clark Boson Air Route Traffic Control Centre".  This bill was sponsored by Rep. Ann Kuster of New Hampshire (no surprise there) and was introduced to the House on March 12, 2013 and referred to the Subcommittee on Aviation on March 13, 2013.  After 40 minutes of debate on June 25, 2013, the House passed the bill and the Senate unanimously passed the bill on July 24, 2013.  The President signed the bill into law on August 9, 2013.

5.) H.R. 185 - This law designates the United States courthouse located at 101 East Pecan Street in Sherman, Texas as the "Paul Brown United States Courthouse".  This bill was sponsored by Rep. Ralph Hall of Texas (again, no surprise there) and was introduced to the House on January 4, 2013 and referred to the Committee on Transportation and Infrastructure on September 27, 2013.  After 40 minutes of debate, the House passed the bill on October 22, 2013 and the Senate unanimously passed the bill on December 17, 2013.  The President signed the bill into law on December 20, 2013.

Of the 65 new laws that passed through the House and Senate in the First Session of the 113th Congress, seven or nearly 11 percent of the total new laws created involved naming something with six involving the naming of buildings or other federal infrastructure and one involved naming a section of the Internal Revenue Code with an individual's name.   

It is reassuring to see that, in light of the fact that they accomplished relatively little over the past year, at least the 113th Congress concentrated their efforts on matters that were urgent to the national well-being given that they could have been spending their time on other issues like the national debt and changes to the nation's gun laws.  It's also interesting to note that, when the issue is critical to the ongoing viability of the United States, the House and Senate can actually pass laws at legislative light speed.

Friday, December 27, 2013

The Bond Volatility Haircut

The Federal Reserve's long experiment with its zero interest rate policy is looking like it is going to wind down over the coming months.  As the Fed withdraws its support from the bond markets, the price of Treasuries is likely to fall and, since interest rates move in the opposite direction to bond prices, the rates on government bonds will rise.  We're already seeing some evidence of that in the fixed income market as shown here:

One year ago, yields on a ten year Treasury note was 1.74 percent.  This has risen to just under 3.0 percent, a rise of 1.26 percentage points or 72.4 percent, a very significant increase on a year-over-year basis.  This is obviously a reflection of the market anticipation of the coming tapering.  On the price side of the equation, if we look back to December 27, 2012, the price for a ten year Treasury note closed at 132.74.  By December 26th, 2013, the price had dropped to 122.98, a decline of 9.76 or 7.4 percent.  That means that holders of ten year Treasuries saw the value of their holdings drop by $9.76 for every $100 worth of Treasuries that they held, a rather significant "haircut" also known as a capital loss.  This is where the problem will lie for those who have invested in market-traded fixed income products whether they hold them in kind or through a bond fund.  What is particularly concerning is the impact on the price of Treasuries down the road as tapering becomes more than just talk.

How bad could the fixed income haircut be?  Thanks to the American Association of Individual Investors, we can get a precise idea of how bond investments will be affected by changes in interest rates in both a rising and a falling interest rate environment.  Here is a chart showing what will generally happen to the price of both a 4 percent and 6 percent coupon bond for bonds with maturities of one, five, ten, twenty and thirty years when interest rates rise and fall by both one and two percentage points:

Here's a brief example showing how the table works.  Assume that you have a bond with a 30-year maturity and a 4 percent coupon.  If interest rates rise by a mere one percentage point, the value of the bond will drop by 15.5 percent, pushing the value of a $1000 bond down to $845.  If interest rates fall by one percentage point, the value of the 30 year bond rises by 19.7 percent to $1197.  If the interest rate rises by 2 percentage points, the value of a 30 year bond with a 4 percent coupon will drop by a very painful 27.7 percent, leaving the holder of a $1000 bond with only $723.  You can see that the longer the bond duration, the bigger the capital gain and capital loss experienced as interest rates fall and rise and the higher the coupon on the bond, the smaller the capital gain and loss since the change in interest rates makes up a smaller proportion of the coupon.  This means that the best way that bond holders can reduce the volatility of their bond holdings in a rising interest rate environment is to reduce the maturity length and increase the coupon interest rate.  You will also notice that the gains are always larger than the losses for the same interest rate change.  That's the mathematics of the relative change in interest rates.  It is this mechanism that has made investors that held bonds during the drop in interest rates since the Great Recession very happy.

The chart above gives us a rough idea of what will happen to the value of our bond holdings as interest rates change in the post-ultra-low interest rate environment.  While the trading price of low-rated (i.e. high yield or junk bonds) will likely be much more volatile (i.e they will fall far faster) than those bonds that are issued by more secure issuers, it is quite apparent that, in any case, there will be rather significant post-taper bond market "haircuts" for many investors, particularly since the impact of even a small interest rate increase on a the price of a low coupon bond is very significant.