Bloomberg – ED&F Man Capital Markets Inc. has been hit with growing demands to post more capital to cover souring hedges in its mortgage division, according to people with knowledge of the matter. The requests are coming from central clearinghouses and exchanges, forcing the firm to put up almost $100 million on Friday alone, the people said, asking not to be identified because the information isn’t public.
You always have to think bigger picture. Just yesterday I touched on the mortgage market unraveling and, in my hubris, declared I thought that Cherry Hill Mortgage would likely be the next victim. Obviously, having a direct competitor of MITT and NYMT be the next shoe to drop seemed likely – albeit it predictably boring. Then, out of nowhere, Bloomberg drops this bomb about ED&F Man just to shake things up a bit.
To be clear, ED&F is not in the same business as MITT or NYMT. They’re a traditional broker-dealer, making markets and structuring products in a variety of different assets classes (they’re traditionally an agricultural and commodity-focused merchant). The firm is over 200 years old and much more well capitalized than the mREITS so, were things to get even more dicey, they would likely be able to source liquidity in some way, shape or form to avoid disaster.
Anyway, back to the fun stuff. ED&F transacts in a space known as the TBA (to be announced) market. TBAs are pass-through securities issued by Fannie, Freddie and Ginnie. It’s essentially a contract to purchase a mortgage bond in the future. To be clear, you’re agreeing to buy pools of mortgages in the future but you’re unaware of which pools at the time of the trade. This seems risky at face value, but the securities are issued by government agencies and are normally of the same general quality, so the market runs efficiently and the risk is generally well understood.
It seems that ED&F was long TBAs, essentially taking a long view on the price and performance of U.S. mortgages. The thing you fear when long mortgage bonds (besides non-payment) are falling mortgage rates. When mortgage rates decline, people generally tend to refinance their mortgages. This (i) eats into the interest payments an investor had planned on receiving when they bought the bond and (ii) forces them to invest the recently returned principal into lower-interest mortgages, leading to losses. As prudent risk managers, ED&F hedged against this by shorting 10-year treasurys because normally mortgage rates are inextricably tied to this benchmark. If mortgage rates were dropping, so would the yield on the 10-year, thus mitigating much of the downside risk for ED&F.
Wrong! Times are not normal, adjust your hedging strategy accordingly. The long mortgage / short treasury trade has exploded in the last few weeks, as investors have dumped mortgage bonds over non-payment fears related to COVID-19 and piled their cash into U.S. treasurys as a flight to safety. As a result, ED&f posted $100M in additional collateral just on Friday.If the precipitous fall in mortgage bonds continues, the firm will likely be hit with additional margin calls, further straining their liquidity profile.
Again, I actually do not believe that ED&F Man is in any real trouble. They’re relatively large, liquid and have great counterparty relationships. If they need to tap equity or debt markets to raise additional capital, I don’t doubt they’ll be able to do it. That said, they’re not the only firm with this trade on at the moment, so if they’re feeling the heat, I’d imagine some other firms are, too.