Think the OTC derivatives market will be allowed to fail without more bailouts and rules changes by the Fed, US Treasury and big banks?
It is interesting to note, so long as we are focused on market dysfunction, that while many parts of the market are starting the transition from LIBOR to the secured overnight funding rate (SOFR), the bank funded markets for 30-day securities repo and collateral financial markets are not changing. Not even close.
And why is SOFR being shunned by the most important, most conservative MBS market after US Treasuries? 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. And for those of us who appreciate that forward TBA contracts for GNMAs are the foundation of the hedging market for Treasury securities, nothing more need be said.
You see, 1 month LIBOR is presently trading around 17bp but there is no comparable 30-day rate in the magical land of SOFR, which is about 9bp for overnight.
The lesson? It was easy for the Washington economists who staff the FOMC to several decades ago confiscate a market benchmark like federal funds. Today, however, its is less easy to create a functioning market rate out of an economic fantasy like SOFR.
Since SOFR is an artificial overnight rate and does not yet have a true market following (aka “markets, people”), including a term structure out even 30 days, warehouse lenders and other providers of cash to the markets are not moving as yet. Memo to Chair Powell: How can a federally insured depository use a nonexistent benchmark like SOFR to price assets and liabilities?
It is worth noting that the administration of LIBOR was shifted to the Intercontinental Exchange (ICE) in 2014. In the event that the Federal Reserve is unsuccessful in breathing life into SOFR, as close to a monetary Frankenstein’s Monster as you’ll ever see, we suspect that the Fed may be forced to either (1) fix LIBOR under ICE’s administration or (2) fashion a new indicator based upon the TBA market. Haven’t heard that one? Wait for it.
Why not simply fix the existing LIBOR? Well, that would require the folks at the Fed and other central banks to admit that they were wrong to kill the benchmark in the first place. Probably not a good idea. But fashioning a new, functioning market benchmark is not easy.
For one thing, it probably never occurred to the economists at the Fed to base the replacement for LIBOR on a functioning, secured marketplace like TBA.
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