A Trip To Sicily, "Burdened" By My Thoughts on the Impact of Potential Bank Regulations on MBS Demand

My Dear Wine-Consuming Friends,

Today, I have decided to deviate from my traditional template, whereby I review a specific wine that I found to be outstanding in its category, while attempting to (awkwardly, at time) merge in a topic du jour in the area of MBS, fixed income portfolio management, housing market, and macroeconomics. Today, I will forego a review of a specific wine in an effort to step back, and offer an overview of an often-overlooked, incredibly historic, diverse, and remarkably delicious wine region: Sicily.

To be sure, we will talk about a very important non-wine related topic – a Potential Impact of Regulatory Changes on MBS Valuations (though, while writing on this subject, an ample amount of fantastic Sicilian vino has indeed been consumed by yours truly, and I adamantly suggest you to do the same, in order to make reading of my regulatory section infinitely more palatable).

We will begin with a somewhat comprehensive review of the Wines of Sicily. According to legend, Dionysus (ancient Greek god of wine, winemaking, grape cultivation, fertility, ritual madness, theatre, and religious ecstasy) brought joy and wine to Sicily at the same time. Legend aside, it is a fact that wine has been produced in Sicily for thousands of years.

There is evidence that Mycenaean traders were already active in Sicily around 1,500 BC. cultivating grapes in the Aeolian Islands. When the Greeks settled in Sicily in the 8th century, they could not be without "oinos", their favorite libation, and so they introduced different varieties of grapevines. Just as it was historically the case with most Italian wine regions, Sicily has clung tightly to its traditional grape varieties. While international grapes are becoming increasingly prominent, for critics, sommeliers, and importers, it indigenous wines are the focus of their pre-occupation.

To be sure, over the last 20 years, Sicily's wine culture has seen tremendous transformed, as confirmed by many of the international awards won by Sicilian producers - some of?Italy's best wines come from Sicily. A new generation of producers is exploiting the full potential of the enviable island climate, local grape varieties, and fertile soil. With now 112,700 hectares of vineyards, the island of Sicily (which also includes the volcanic island of Pantelleria in the southwest and the northeastern Aeolian Islands), is the largest wine region in Italy.

Sicily has been investing in sustainable production methods for more than 20 years, converting the island into the "most organic producer" in Italy. In some areas of Sicily, organic production accounts for almost all output. For example 83% of the vineyards processed by Assovini producers are now organic.

There are three key red grapes: Nero d’Avola, Frappato and Nerello Mascalese.

Nero d’Avola?is the most widely planted and celebrated red grape. If you find a Sicilian wine in your wine retailer, it will likely be Nero d’Avola. It yields wines of deep color and flavor, with moderate structure, juicy acidity and soft-to-medium tannins. Flavors of dark, brambly fruit and spice are common. Stylistically, the wines can range from youthful and easygoing to serious and contemplative, with the latter requiring time in bottle for best enjoyment. Nero d’Avola is the primary grape in the Cerasuolo di Vittoria?Denominazione di Origine Controllata e Garantita?(DOCG), an appellation in the south, where it’s partnered with Frappato.

Frappato, though usually seen as apart of a blend, can also be bottled on its own. Once relatively obscure to American wine lovers, the grape has gained fans among sommeliers who wax poetic over its captivating floral perfume. These lean toward easy-drinking wines with supple tannins, though earnest examples exist.

Nerello Mascalese?may rank second in volume and value to Nero d’Avola, but this elegant red has engendered a passionate following over the last 20 years. The grape thrives in the volcanic soils of Mount Etna, and it’s often blended with Nerello Cappuccio, a rustic, spicy grape.

For white wines,?Catarratto?is the most planted grape in Sicily. Catarratto makes delicious soft, dry wines, but it’s often treated as a volume variety, with much of it sent to the mainland or exported as concentrated must.

In addition to Catarratto,?Grillo?and?Inzolia?are used in the base blend for Marsala, which forms a large percentage of the island’s white wine production. Grillo, on its own, is a medium-bodied, dry white accented with a white peach flavor. It makes charming, easy wines throughout the island.

On Mount Etna,?Carricante?is the primary variety behind the white wines that are sometimes referred to as Etna Bianco. It’s dry and medium-bodied with zippy acidity. In the international camp, Chardonnay, Syrah and Cabernet Sauvignon are the most successful grapes.

Sicily’s Key Wine Regions

Sicily has 23?Denominazioni di Origine?(DOC), and one DOCG and can be divided broadly into four geographical regions. But core grapes overlap across the all the areas, including the region-wide?Terre Siciliane?Indicazione Geografica Tipica?(IGT) and catchall Sicilia DOC categories. Here are the four major regions to be aware of.

Sicilia DOC

Sicilia DOC?is a broad, island-wide appellation. It launched in 2011 by a consortium of wine producers who promoted the Sicilia IGT to a DOC. The dozens of wineries participating in the appellation agreed to work in tandem to promote Sicily’s native grapes like Grillo, Nero d’Avola, Frappato and Catarratto as well as the lesser known Inzolia,?Grecanico?and?Perricone. Though, international varieties like Chardonnay and Cabernet Sauvignon, are, in fact, allowed.

Since wines within this denomination can be made all over the island, the DOC is more a marketing tool to promote Sicily abroad and help familiarize consumers with the range of wines. To earn the designation, viticulture and winemaking must adhere to quality control practices laid out by the DOC’s regulations.

Etna DOC

“Mama Etna,” the snow-capped, smoking behemoth in the northeast, earned its nickname for the bounty it provides local communities. Fluorescent-green pistachios, ruby-red strawberries and wine comprise much of the farming income here. More than any other swath of Sicily, Mount Etna’s wines have earned lavish attention over the last few years.

The region’s climate is quite different from elsewhere. It’s practically alpine with intense sunlight, yet it receives twice the rainfall of other regions. The mountain’s unique wines earned DOC recognition in 1968. Producers now seek DOCG status, but they’ve yet to receive it.

Etna’s?main grapes are Nerello Mascalese for red and Carricante for white. The former has been compared to both Barolo (Nebbiolo) and red Burgundy (Pinot Noir) for its transmission of terroir, depending where it’s grown on the mountain.

At warmer, lower altitudes, Nerello manifests as burly and tannic. As elevations climb up to 3,600 feet, where acidity increases and temperatures fall, wines turn taut and ethereal. Soil variation further alters flavor, concentration and texture. It’s a wine for those who appreciate singularity and vintage variation over consistency.

Nerello Cappuccio?is treated as a blending partner with Nerello Mascalese, though varietal bottlings show off the grape’s fascinating spiced pepper character. Blends from the DOC must contain at least 80% Nerello Mascalese, with a maximum of 20% Nerello Cappuccio.

Carricante is a dry, bracing, mineral-laced white. It provides an accessible counterpoint, both in taste and price, to the mountain’s moodier, brooding reds. Many producers make textured wines through different techniques in the cellar, from barrel-aging to lees stirring, in addition to the clean bright wines gleaned from stainless steel.

Carricante may be blended with other local white gapes like Catarratto, but it’s often bottled by itself. Examples often display notes of citrus, anise and honey, with a swirl of saline found throughout.

Etna’s unusual grapes are only part of the story. Another piece is the stone terraces that follow old lava flows to create?contrade,?or crus. The system is likened to the fastidiously delineated vineyards of Burgundy, which are organized by landscape and whose soil composition creates nuances in the final wines.

Cerasuolo di Vittoria DOCG

Compared to Etna, Sicily’s southeast corner offers lower elevation and higher temperatures. That makes it prime red wine country and the source of Sicily’s only DOCG,?Cerasuolo di Vittoria.

Cerasuolo di Vittoria is a red wine blend that earned DOCG status in 2005. Nero d’Avola must comprise between 50%–70% of the base, with the balance filled by Frappato. The Nero d’Avola brings color, structure and depth to the final blend, while Frappato offers aromatics and freshness. Wines brim with red berries like strawberry and cherry (cerasuolo?means cherry), underscored by hints of licorice and leather. Overall, Cerasuolo di Vittoria is a wine of finesse. Cellar-worthy versions tend to have more Nero d’Avola.

There are two quality categories of Cerasuolo di Vittoria: regular, known as?rosso, and?classico. The former must be aged approximately eight months, while the latter, which must be made from grapes grown in the traditional zone, needs to be aged at least 18 months.

Marsala DOC

The city of?Marsala?sits in Sicily’s southwest corner and has suffered a half-century’s worth of quality problems, but this historic port has clawed its way back to wine prominence. The base grapes of its famous fortified wines have moved away from Inzolia and Catarratto in favor of better quality and more traditional Grillo. Made in a method similar to Sherry, the key to great Marsala is time in the blending system known as a?solera.

Not all Marsalas are overly sweet, see extended aging or are made with white grapes. In fact, 10 varieties are permitted, which include the red grapes of Nerello Mascalese and Nero d’Avola.

Like Sherry, Marsala has several age-related categories. The five include?fine?(one year),?superiore?(two years),?superiore riserva?(four years),?vergine/soleras?(five years) and?vergine/solera stravecchio?(10 years).

Color and residual sugar are also noted on the bottle. Hues are split into?oro?(gold),?ambra?(amber) and?rubino?(ruby), while for sugar content, categories are?secco?(dry at 40g/L, or grams per liter),?semisecco?(semi-sweet at 40–100g/L) and?dolce?(sweet at more than 100g/L).

Marsala makes a great cooking wine, as it lends nutty richness to sauces. But only use wines you’d be happy to sip.

What Makes Wines from Etna Special?

Mount Etna?is an active volcano that has erupted from time to time. The wines of Mount Etna are considered the stars by many experts and connoisseurs. And what exactly makes Etna wines so special is the?terroir?and soil. Vines are cultivated on terraces and at high elevations which makes it difficult to use mechanical equipment and most of the work is done by hand. Also, Etna?soils?are rich with volcanic nutrients that give special qualities and minerals to wines. In particular, white wines thrive on the fertile mountain slopes up to almost 1000 meters in height, which, in contrast to the boiling interior, have large temperature differences between day and night.

Well, sorry if I got carried away a bit. This turned out a bit longer that I have initially intended. And, it is time to talk about the upcoming changes in a regulatory environment for Banks, and its impact on MBS valuations.

The SVB/Signature crisis created an impetus for a regulatory overhaul for banks, and while the changes are likely to impact many aspects of depository existence, we focus on those that have a potential to impact demand and supply for mortgages.

Before we begin, we want to state that this proposal, titled “amendments to bank capital rules” and originally released in July of last year, is still in the “comment” stage, and we have no clear idea as to the final shape of the regulations that will follow. Some of them, however, are easier to predict than others, and we do believe that after everything is said and done, capital requirements will end up being more “painful” vs. the current framework. (particularly for banks with assets >$100 billion).

That being said, given the pushback from the banking industry, as well as parties concerned about the impact on home affordability, the final version is likely to be considerably more "mild" than what we saw in July.

These institutions (with assets >$100 billion) are likely to see a 16% increase in aggregate CET1 capital requirements (at least if the changes materialize in accordance to July amendments). To deal with the new requirements, banks could rely exclusively on retaining more dollars of capital, but we emphatically do not see it as a viable way to resolve this issue. Instead, Banks are very likely to engage in a comprehensive RWA optimization. And they are unlikely to wait until these new rules become effective.

Overall, we see the long term impact of these changes on government guaranteed MBS securities as positive, especially for zero risk-weighted Ginnie Mae pools and CMOs.

Among several important implications of the proposed amendments is their impact on LTVs. Specifically, regulators proposed to change the risk weights for residential mortgages from the current 50% risk weight that applies uniformly, to a system of risk weights that vary based on LTV. And if this is not enough, regulators further stratified LTVs by the type of the underlying real estate: owner-occupied and vacation (where property does not rely on income generation) and Investor/Vacation properties (that do rely on income production).

For loans that do rely on generating income from the underlying property, risk weights would range from 50% to 125%, as a function of LTV. These higher risk weight will compel banks to securitize more of these loans, thus potentially increasing the share of investor/vacation loans in the MBS pools.

As a reminder, we do like investor loans as a means of achieving a moderate call protection, and vacation loans as a solid extension protection story. We also know that many vacation loans are essentially "hybrids" (the owner uses it as a pure vacation property some of the time, while renting it out as well). We would suspect that as banks will be much more likely to securitize these hybrid vacation loans, the extension protection of future vacation story pools will improve even more.

For loans backed by non-income producing properties, these new risk weights will also vary with LTVs. Loans with LTVs >80% would face the largest increase (potentially as much as 40%). We do not expect much of a difference between the proposed and existing regimes for loans with LTVs between 60-80%.

To be fair, the proposed framework is not indiscriminately harsh to all loans, and it does like loans with current LTVs <60%, though the benefits of this “love” will be felt only by super-seasoned loans, or those very few newer low LTV ones.

In summary, we do expect an increased “favoritism” towards 0% risk weight securities, and a moderately stronger preference for securities vs. loans (holding all else equal). Treasuries and Ginnie pools, Ginnie CMOs, and, (to a lesser extent) Ginnie Mae Project loans are likely to be the biggest beneficiaries of their change in preferences. To be sure, conventional MBS will benefit as well (20% risk weight), especially if the final outcome that follows this “comment period” will prove harsher than what we currently expect.

More importantly, we expect the retention ratio to decrease, while the securitization ratio increases. The decrease in retention ratio would suggest that banks will have more $$ for MBS purchases, which is clearly positive. We will note that this increase in potential appetite for MBS due to a drop in loan retention will be partially offset by an increase in securitization of loans, translating into a higher agency MBS supply.

We also expect an increase in mortgage rates (on a relative basis) for high LTV loans, which is likely to enhance their call protection. Net supply of high LTV pools is also likely to increase, since banks are likely to securitize a higher share of these high LTV loans. On the margin, these higher mortgage rates will be detrimental for housing affordability, thus reducing the inflow of first time buyers, and pressuring HPA downwards.

Investor and vacation call protection is also likely to improve, while relative supply should increase. A higher debt burden on investor and hybrid vacation loans could also translate into slightly higher delinquencies, although we do not expect this increase to be material.

Lastly, there is a question of classification of HTM securities as high quality liquid assets (HQLA). Since HTM-classified securities are “locked-up”, and really unable to do much to help manage liquidity, we do see a possibility of their exclusion from the "HQLA club". In this case, the broader focus on liquidity is likely to push banks towards MBS pools, while avoiding less liquid investment alternatives.

I sincerely thank you for you patience in reading this unusually long article. I trust you found at least parts of it helpful and interesting.

Take Care,

Kirill A Krylov, PhD CFA