Tour of the Left Bank Bordeaux & MBS Implications of the SVB/Signature Event

Last few trading sessions were someone reminiscent of those memorable days in April of 2020, even if without the "end of the world" drama. Yet, volatility was bad enough to prompt most of us to consume an “unscheduled” glass (or two ) of vino. Now, as the markets appear to be stabilizing, we all need a vacation. And today, we are going to the Left Bank, where we will talk about many great and legendary Bordeaux names. Before we depart, few words are in order.

Much has been (and even more will be) written about the SVB/Signature events. While we all hope that this list of troubled banks is not going to expand, there is a real possibility for several other names to join it in the near future. Yet, I would still categorize this event as an idiosyncratic occurrence, as most banks remain in good financial standing at the moment.

The purpose of this publication is not to dissect the chain of events that led to the collapse of these two institutions, but to focus on the immediate implications of these events on the mortgage market, either directly, or via the broader economy. Clearly, some elements of my predictions are obvious and nearly certain, while others are arguable and subjective. Yet I will present them all to you.

And now lets get back to a much more pleasant Left Bank Bordeaux business.

This is our third conversation about Bordeaux, so, let's uncork a couple of good bottles and dive even deeper into the world of Left Bank Bordeaux wines. I will explore the sub-regions of the Left Bank in greater depth and highlight some of the most famous wineries in each area. So, grab a glass and let's get started!

The sub-region of Graves, which is located just south of the city of Bordeaux, is an excellent place to start. Graves is known for producing some of the finest dry white wines in Bordeaux, as well as some excellent reds. The name "Graves" comes from the gravelly soil that is characteristic of the area, and this terroir is what gives the wines their unique flavor profile. The red wines of Graves are typically made from a blend of Cabernet Sauvignon and Merlot, with a touch of Cabernet Franc and Petit Verdot. The wines are elegant and structured, with flavors of blackcurrant, tobacco, and earthy notes.

But it's the white wines of Graves that really steal the show. These wines are typically made from a blend of Sauvignon Blanc and Sémillon grapes, and they're known for their vibrant acidity, citrus flavors, and minerality. Some of the most famous wineries in Graves include Chateau Haut-Brion, Chateau Pape Clément, and Chateau Carbonnieux. Chateau Haut-Brion is one of the oldest wineries in Bordeaux, with a history dating back to the 16th century.

Moving on to the Médoc, which is the largest and most famous sub-region of the Left Bank. The Médoc is home to some of the most famous chateaux in the world, including Margaux, Pauillac, Saint-Estèphe, and Saint-Julien. These wineries are known for producing some of the finest red wines in Bordeaux, and they're made from a blend of Cabernet Sauvignon, Merlot, Cabernet Franc, and Petit Verdot.

Margaux is one of the most famous appellations in the Médoc and is known for producing some of the most elegant and refined wines in Bordeaux. Some of the most famous wineries in Margaux include Chateau Margaux, Chateau Palmer, and Chateau Rauzan-Ségla. Chateau Margaux is one of the oldest and most prestigious wineries in Bordeaux, with a history dating back to the 17th century. Their wine is a blend of Cabernet Sauvignon, Merlot, Cabernet Franc, and Petit Verdot, and it's known for its aromas of violets, blackcurrant, and tobacco.

Pauillac is another famous appellation in the Médoc and is known for producing wines that are more full-bodied and muscular than those of Margaux. Some of the most famous wineries in Pauillac include Chateau Lafite Rothschild, Chateau Mouton Rothschild, and Chateau Latour. Chateau Lafite Rothschild is one of the most famous wineries in the world and is known for producing some of the most expensive wines in Bordeaux. Their wine is a blend of Cabernet Sauvignon, Merlot, Cabernet Franc, and Petit Verdot, and it's known for its aromas of blackcurrant, graphite, and cedar.

Saint-Estèphe is another appellation in the Médoc that is known for producing powerful and complex wines. Some of the most famous wineries in Saint-Estèphe include Chateau Cos d'Estournel, Chateau Montrose, and Chateau Calon-Ségur. Chateau Cos d'Estournel is known for its iconic pagodas and oriental-style architecture, and their wine is a blend of Cabernet Sauvignon, Merlot, Cabernet Franc, and Petit Verdot. The wine is known for its intense aromas of blackcurrant, spices, and tobacco.

Last but not least, we have the appellation of Pessac-Léognan, which is located just south of the city of Bordeaux. Pessac-Léognan is known for producing some of the finest red and white wines in Bordeaux, and it's home to some of the most famous wineries in the world. The red wines of Pessac-Léognan are typically made from a blend of Cabernet Sauvignon, Merlot, Cabernet Franc, and Petit Verdot, while the white wines are made from a blend of Sauvignon Blanc and Sémillon.

Some of the most famous wineries in Pessac-Léognan include Chateau Haut-Brion (which we already mentioned earlier as being located in the Graves sub-region), Chateau La Mission Haut-Brion, and Chateau Smith Haut Lafitte. Chateau La Mission Haut-Brion is known for its full-bodied and powerful red wine, which is a blend of Cabernet Sauvignon, Merlot, and Cabernet Franc.

The wine is known for its intense aromas of blackcurrant, tobacco, and leather. Chateau Smith Haut Lafitte, on the other hand, is known for its red and white wines, which are both highly regarded in the wine world. Their white wine is a blend of 90% Sauvignon Blanc and 10% Sémillon, and it's known for its vibrant acidity and flavors of citrus and white peach.

So there you have it, a brief tour of the sub-regions of the Left Bank and some of the most famous wineries in each area. Of course, this is just the tip of the iceberg - there are many more wineries and appellations to explore in this amazing region. But one thing is for sure, if you're a wine lover, then the Left Bank of Bordeaux is a must-visit destination. So, pour yourself a glass, sit back, and enjoy the delicious flavors and aromas of this amazing wine region!

And now, it is time to go back to the implications of the Bank crises on MBS.

During the first 23 years of this century, only one bank failure (that of Washington Mutual @ ~$307 billion) eclipsed that of the SVB ($209 billion) & Signature ($110 billion), creating a somewhat chilling effect on economic activity. While these events will have a negative economic impact on many levels, the decline in availability of bank lending is of direct importance to MBS investors.

At the risk of oversimplification, the problem is that the entire depository world is now facing the drought of deposits, which resulted from the Fed “withdrawal” from buying MBS, which was re-enforced by the dangerously tempting short-end yield that lured away funds from deposits and into money markets. In the case of SVB, where the number of depositors was relatively low, the decline in deposits ended up being lethal.

While few institutions are in such a dire position, all share similar concerns. Thus, we expect that banks will attempt to “synchronize” the growth of deposits and loans, as best they are able to. And since deposits are not likely to turn on a dime and start growing, it is the loan side of this equation that will have to give.

The decline in lending (as well as the increased competition and cost of deposits) will mean lower NIMs. It will also push our already miserably low supply estimates even lower. Here it is worth pausing to discuss a very important issue – securitization rates. When we mentioned a decline in lending, we really mean loans that are retained on the balance sheet.

Loans that are sent into the securitization are not part of this equation. Thus, in order to decrease loan growth, more loans will be sent towards securitization (of which GSE loans represent a vast majority). This will increase the securitization rate and is likely to offset the decline in supply due to the overall slower loan growth.

While it is too early to tell which if these opposing forces will dominate, we can comfort those investors, who were fearing an element of illiquidity in the MBS market due to a supply shock. This is unlikely to occur, since the securitization rates will likely offset at least some of this decline. Yet, it is important to note, that the recent turbulence in the Banks space is likely to reduce net supply below the previously expected levels, which is a net positive to MBS valuations.

This decline is likely to be particularly acute in the 15-year sector. In fact, we estimate that the share of the 2022 cohort, who might become refinancible in a rally and choose to opt for a 15-year, is ~35% lower than in the previous refi waves. The reasons for this phenomenon are multiple.

* First, there is growing awareness that unless the rate advantage of 15-year vs 30-year loans is dramatic enough, investors are forgoing a valuable “option” to pay less on the monthly basis, should they run into financial trouble. ?

* Second, many of the borrowers, who have entered 2022 cohort have meaningfully higher DTI and therefore are more payment-sensitive. Thus, 15-year net supply is likely to remain very negative, even in a rally.

Yes, Banks will put the brakes on lending until the rate of deposit growth, equalizes (more or less) with that of loans, but until they do so, we are not out-of-the-woods. The future risk lies in banks with a high share of business deposits, or large investment portfolios as a percentage of the bank's assets. We also see some danger for banks with long-duration exposure.

Many banks have large MBS portfolios that are not hedged. The rising rates of 2022 have led to a profound increase in the duration and yield gap between their assets and their liabilities. If these institutions will be unable to stabilize their deposit situation, they might be forced to sell bonds at a loss.

I think that, structurally, this is a very different bond market than most have encountered in the recent past. While the flight to quality might favor duration now, this "romance" will not last long. There exists a conflict between fighting inflation on the one hand, while guaranteeing all the deposits of the U.S. banking system on the other.

The very facilities that are being put in place to backstop depositors will likely make the Fed's job of reaching its 2% target more difficult. Besides, if it is a recession we are talking about, the short end is likely to rally more than the long end, thus making shorter assets, essentially longer. And we are back to the need of staying short in duration.

And that is what many depository (as well as TROR) investors are likely to be biased towards. Investors may still be concerned with short duration positions due to the uncertainty of further increases to terminal Fed funds, but the desire for short duration could come back with a vengeance in a recession scenario (even a mild one), where the Fed is likely to cease (or pause) the quantitative tightening.

I will note here that Fed powers are more limited than in the past: the Fed has historically cut interest rates following every major negative financial event over the past 40 years. This time, the inflationary pressure will make this option very problematic. In this case, performance of the short end of the curve (both carry, and principal return if the short end were to normalize) will be too tempting to ignore.

More thoughts to follow. For now, take advantage of a small MBS widening.

Take Care & Thanks for Reading

Kirill A Krylov, CFA, PhD