SVB Collapse: Focus on risk of MBS investing

-Vinod Kothari and Timothy Lopes

finserv@vinodkothari.com

It all started after Silicon Valley Bank (‘SVB’) announced its Q1’23 Mid quarter update^[1], revealing that it intended to raise about USD 2.25 billion of capital owing to the fact that it had sold its USD 21 billion ‘Available for Sale’ (‘AFS’) securities portfolio, which consisted of US treasuries and Mortgage Backed Securities (‘MBS’) and suffered a USD 1.8 billion loss.

This caused a run on its deposits that triggered the quick collapse of SVB just two days after this announcement, which is being called the ‘largest bank failure since the global financial crisis’^[2]. On March 10, 2023, the SVB Financial Group announced^[3] that its wholly owned subsidiary SVB was closed by the California Department of Financial Protection and Innovation and placed under Federal Deposit Insurance Corporation (‘FDIC’) receivership.

Part of the blame is being placed on the investment decisions made by SVB in long term MBS. The Financial Times^[4] talks about how crazy it was that SVB did not hedge its Held-to-Maturity (‘HTM’) portfolio which comprised of very long term agency MBS maturing in 10 years or more.

SVB amassed a large bond investment portfolio of over USD 120 billion at the end of 2022 (USD 26 billion in AFS securities and USD 91 billion in HTM securities as of the end of 2022 as per the financial statements of SVB). Most of this was investment in long term MBS.

With interest rates being raised by the Fed in the US, the value of the long term MBS portfolio fell, being one of the factors that resulted in the collapse of SVB.

Negative convexity of MBS

Investment in MBS is normally associated with higher yields than traditional bond returns. This higher yield makes MBS an attractive investment. Higher yield would have been a motivating factor for SVB to consider when allocating a majority of its portfolio towards investment in MBS.

However, this higher yield is associated with higher risks. The change in the price of a bond on account of interest rate changes is measured by duration. Convexity of a bond measures the sensitivity of changes in duration as interest rates change.

When it comes to MBS, an investment in MBS is associated with negative convexity, meaning that prices suffer a greater decline when interest rates rise and prices witness a smaller rise when interest rates fall^[5].

What is the reason for the negative convexity? Before understanding negative convexity, we may briefly understand convexity itself^[6]. The inverse relation between prices of fixed income securities, that is, prices of fixed income bearing securities drop when interest rates rise, and vice versa, is explained by the duration. The more the duration, the more the sensitivity of the prices. However, this relation is not a straight line – the relation is a convex time, given the nature of present values of future cashflows. Thus, when interest rates increase by, say, a percentage point, the resulting drop on price of the bond is the change of interest rates, multiplied by duration, but a little less, due to convexity, which is called convexity gain.

However, let us consider the case of a callable bond. By definition, a callable bond is one which may be called at the option of the issuer. If interest rates have risen, the motivation on the part of the issuer to call the bond will be lesser, and therefore, there is lesser likelihood of the bond being called. For the fixed coupon bond, with the interest rates having risen, the bond is now likely to remain alive longer, and therefore, with increased discounting rates, the present value of the cashflows will be even lesser. On the contrary, if interest rates decline, while in case of a non-callable bond, the price of the bond would have gone up, the price of a callable bond will not show corresponding increase, because the chance of the bond being called will increase. The simple intuitive reason for this is – call option, which is an option with the issuer, is always exercised against the wishes of the bond investor.

Mortgage-backed securities are similar to callable bonds. Why? The borrower has the option to prepay and close the mortgage loan. Assuming that the mortgage was prepayable without any penalty, a borrower will prepay a loan if the rates of interest have come down, and will have reduced motivation to prepay a loan if the interest rates have gone up. It is important to understand that prepayments in case of mortgage loans happen due to two reasons: (a) interest-rate-triggered prepayment; (b) non-interest-rate related prepayments, mostly connected with people selling their houses. The latter is non-economic, as it is not caused by changes in interest rates. However, the former is an important point, and happens quite frequently. If the rates of interest drop, a borrower who has borrowed on fixed interests will opt to refinance the mortgage loan by prepaying the existing one. However, if the interest rates have gone up, it is important for the borrower to stick to the loan that he has taken as a cheaper rate – so even the turnover-related or non-economic prepayment speeds will come down.

Since mortgage backed securities are pass-through instruments, if the underlying mortgage loans prepay, the MBS will prepay as well, to the investor. As such, the borrower becomes the one who has the prepayment or call option, and the MBS investor becomes the one who has written the prepayment option and is, therefore, exposed to the downsides.

As prepayment is a strong phenomenon in mortgage lending, estimation of prepayment rates is a key part of MBS investing. That is, MBS investors estimate the prepayment rate or prepayment speed, mostly expressed in terms of PSAs (100 PSAs equal 6% prepayment rate per annum).

Now, if interest rates increase, the following are the implications for an MBS investor:

• Prepayment speeds come down. Therefore, if the duration over which the MBS investment was expected to last based on a certain prepayment speed, that duration will get elongated. That is, there is an extension of maturity.
• Rising interest rates will mean the value of all fixed income bonds/securities will drop, but in case of a callable/prepayable investment, the drop will be higher. This is because prepayment speeds will come down and therefore, the mortgages, giving a lower rate of interest, will stay for a longer period.
• Hence, negative convexity will hit the investor, in addition to the drop caused by interest rates.

Are all MBS investments prone to negative convexity?

With SVB collapse, investors may generally start getting apprehensive about MBS investing. However, it is important to understand that not all MBS investments have prepayment risk. The following points are important to note:

• The interest-rate related prepayment risk is a feature of US convention mortgage loans, which are fixed rate loans for a 30 year term, with no prepayment penalty. In most other countries, lenders of fixed rate mortgage loans have the right to charge a mark-to-market penalty for prepayment.
• In countries like India, mortgage lending is done at floating or adjustable rate of interest – hence, the mortgage loan itself will be repriced based on interest rate changes. Hence, the question of interest-rate sensitive prepayments does not arise at all.

However, if an investor invests in long-dated MBS, which has prepayment risk as in case of US mortgages, it would be important for the investor to realise the interest rate risk, and deploy appropriate risk mitigation practices. For example, an investor may use interest rate swaps, or issuing liabilities which float against the market rates, such as inverse floaters.

Investments in prepayable MBS creates an asset liability mismatch, not just as a matter of maturity, but also the interest rate sensitivity.

Conclusion

The jury may keep adjudicating on the reasons for SVB collapse, but as far as the inherent risks of MBS investing are concerned, it is important to understand that an investor has to do appreciation to the inherent prepayment risk. This risk certainly exists in US mortgages, but outside of the USA, the investor should see if the mortgages have the option to prepay without penalty.

---

^[1] https://s201.q4cdn.com/589201576/files/doc_downloads/2023/03/Q1-2023-Mid-Quarter-Update-vFINAL3-030823.pdf

^[2] See- https://www.theguardian.com/business/2023/mar/13/silicon-valley-bank-why-did-it-collapse-and-is-this-the-start-of-a-banking-crisis

^[3] https://d18rn0p25nwr6d.cloudfront.net/CIK-0000719739/bd88776f-cd49-486a-a9b3-56a2f72a3686.pdf

^[4] https://www.ft.com/content/f9a3adce-1559-4f66-b172-cd45a9fa09d6

^[5] More on negative convexity of MBS – https://www.capitaliq.spglobal.com/interactive/lookandfeel/4017464/3.pdf

^[6] See, for detailed discussion on duration and convexity, Vinod Kothari’s article here: http://vinodkothari.com/wp-content/uploads/2014/01/duration-and-conexity.pdf