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Participant ○○○

Commentary by Lou Barnes — 9/11/20

Written each week by Lou Barnes in Boulder, CO. Inconsistently available online. Reprinted with permission. Lou typically provides background and context to what's happening in the credit/bond world along with commentary on topical events that some readers appreciate.

    My apologies for the delay, but our email send system had some technical difficulties last week. Please see below for what you should have received on Friday afternoon.


     The world is supposed to come alive in September each year, vacations over, weather cooler and exhilarating, youth back to school, grownups back to work.
     The economy is unchanged -- can’t change, a steady 30,000,000 Americans shut out of indoor or close contact work. The Fed holds interest rates unchanged. The stock market wanders but can’t go far. The economy is vulnerable to spreading layoffs, especially those at state and local government and schools of all kinds, but there is just enough re-opening elsewhere to offset.
     The election is 53 days away. Just seems longer -- although more voters than ever will cast mail-in ballots as soon as they receive them. The outcome is likely already decided, although we have to wait to know what it is. The only large variable remaining is the three presidential debates (September 29, and October 15 and 22), a variable only because of the range of possible performances by these two guys, without a teleprompter anything from catastrophic to comic.
     We have a few distractions. Football! And the discovery by dwellers of cities and suburbs located in semi-desert: jeepers, a lot of stuff burns around here! Each and every overage stand has not ignited because of climate change. Smokey became the champion of fire deferral 70 years ago. A ponderosa pine may live 300 years, a lodgepole half of that (if uncrowded, and most are crowded), and a spruce half of that.
     The virus is unchanged, except for the dramatic fall in deaths everywhere, and trying to get college students to behave. A Harvard professor recommended that if having sex outside their social bubble, students should “wear masks and avoid kissing.” One would think that A would lead to B, but this is Harvard. An Oberlin health official took a more human, if defeatist attitude: “I think any advice regarding masks during sex probably isn’t going to fly.”
     So, in this vacuum filled only with intangible anxiety, I must do my part to provide a distraction. Eastern monks advise resetting the mind by concentrating on breathing through one nostril only, which is impossible but the effort frees the mind of whatever was bothering it. In the financial world, the same benefit can be had by focusing on a topic so dull, so technical and historic that the mind may stop altogether.
     Here we go... in a fit of tidiness, US authorities decided in 2017 that LIBOR as an index in financial transactions including all US adjustable-rate mortgages (ARMs) and some $350 trillion in derivatives contracts would be dropped in favor of SOFR within the next year, and by the end of 2021 LIBOR will no longer published at all.
     The change is at best ill-considered, may not work at all in some markets, and at the moment has shut down most ARM lending in the US.
     Going into the Great Depression, all US mortgages were adjustable or short term or renewable or callable -- features which made the depression Great. The FHA and Fannie (FNMA) in 1934 and 1938 facilitated the 30-year fixed mortgage, which stopped the waves of foreclosures and bank failures. There were no US ARMs until 1980, when Paul Volcker unnecessarily destroyed the S&L industry via stratospheric and unstable interest rates.
     The first modern ARMs were -- and are -- designed to protect investors from a hyperactive Fed (although none has been since). The Fed directly controls the overnight cost of money to the financial system, and all ARMs are designed to mirror changes in that cost. (The Fed controlled long-term rates briefly during and after WW II, and again in upsets 2008-present). ARM design always involves a periodic adjustment in the borrower’s payment interest rate computed by adding a life-of-loan contractual “margin” (spread) to the new value of a Fed-following index.
     Early after 1980, several indices were in play: 3-, 6- and 12-month T-bills, or “COFI” for the cost of funds at west coast S&Ls, or the rate on recently closed loans, or LIBOR. For a variety of reasons, by 2009 all but LIBOR had fallen away.
      LIBOR is the acronym for London Inter-Bank Offered Rate, which began in the early 1970s. By then the world had dollarized, the US cost of money set by the Fed, the cost “offshore” dollars (aka “eurodollars”) set by a committee of the British Bankers Association. The ocean of offshore dollars had been filled by US trade deficits after WW II which revived the global economy, and then became the most secure and reliable means of global exchange.
     Humanity being human, the LIBOR committee became corrupted early on, although not discovered until 2012. (“I am shocked, shocked!!” -- the same response which Captain Renault would give to sex without masks.) Nevertheless the daily LIBOR fixing had worked very well, buffering and smoothing sudden technical upsets.
     No matter. We Americans prefer mechanical precision, free of interventions involving the exercise of good subjective judgment. And so six years ago the Fed empaneled the Alternative Rates Reference Committee (ARRC) to find a LIBOR substitute, which it did, the Secured Overnight Financing Rate -- repurchase agreements (repos... again). Pleased with its work, the Fed announced the end of LIBOR and the dawn of SOFR, but before testing actual workings.
     SOFR may not work at all. SOFR will have an exact value based on verifiable transactions, but neither transition to it nor future operations are clear. Transition is especially sensitive to mortgage consumers, roughly $1 trillion in existing mortgages tied to LIBOR. Every ARM promissory note (the contract establishing loan terms) I’ve seen since 1980 allows the lender to adopt a new index if the original becomes unavailable; but none has said that the lender can change the margin, which in nearly all LIBOR ARMs is 2.25% over LIBOR. If SOFR fails to track LIBOR’s relationship to the economy or the Fed, the margin will mechanically pass through the ill or good and unpredictable effect to consumers and investors.
     In ARMology, the maturity of the index must match the frequency of adjustment. Common ARMs today adjust annually (after initial fixed intervals from three to fifteen years) and are tied to one-year LIBOR. There is no SOFR maturity beyond six months. Freddie says helpfully that new ARMs will adjust at six-month intervals, and new margins must be somewhere, anywhere between 1.00% and 3.00%.
     Other than to distract you from anxiety, this public service: any consumer with an ARM, or any lender who made one should brace for the arrival of deeply confusing mail.


Some good news! The longstanding monthly survey by the small-business association NFIB in August found remarkable recovery in both morale and operations:



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Explorer ○○

Re: Commentary by Lou Barnes — 9/11/20

Thanks for posting, Wayoutwest.

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