Josh Youthful is a lecturer at Columbia Regulation Faculty and a former JPMorgan analyst. Brad Setser is a senior fellow on the Council on Overseas Relations, and a former US Treasury official.
As FT Alphaville not too long ago detailed, Taiwan is an fascinating place, having amassed a completely large treasure trove of US {dollars}. We now wish to discover what is going on with these {dollars} — and the bizarre phenomena it may trigger.
To shortly recap the last post, Taiwan has stealthily turn out to be the fifth largest overseas creditor on the planet, with a web worldwide funding place (exterior claims minus liabilities) of $1.7tn. That places it in league with China, Germany, and Japan, regardless of being an financial minnow in comparison with these international locations.
Amongst developed international locations, solely Hong Kong, which pegs its forex to the US greenback, and Norway, with its large oil reserves, come near matching Taiwan in web overseas belongings relative to the scale of their economies.
Taiwan’s overseas belongings have additionally ended up in an uncommon place — insurance coverage corporations. Taiwan has one of many largest life insurance coverage trade on the planet in comparison with its economic system and inhabitants. At greater than $1.1tn in whole belongings as of the tip of 2023, that’s greater than 140 per cent of Taiwan’s annual financial output, and works out to $47,000 per individual.
How did the Taiwanese life insurance coverage trade get so huge? They provided policyholders engaging options to their financial institution deposits — greater yields however lots of the similar liquidity options.
Maybe most strikingly, these insurers usually are not solely large but in addition operating an equally large forex mismatch. Because the final publish identified, two-thirds of Taiwan’s insurance coverage trade belongings are abroad, and predominantly denominated in {dollars}, whereas the alternative is true for his or her liabilities, roughly 80 per cent of that are denominated in native forex.
In different phrases, Taiwanese insurers make investments the proceeds of their premium revenue predominantly in overseas forex belongings whereas making guarantees to redeem these insurance policies predominantly in native forex. The hole might be bridged utilizing overseas trade derivatives or, more and more, under no circumstances.
The consequence of this transformation on an enormous scale are vital. We talk about them within the post referenced above. However the query we’re after right here is: what precisely are they doing with these {dollars}?
Name me perhaps?
Taiwanese insurers are traditional yield-seekers — in search of the very best returns on the longest maturity belongings they’ll observe down. Within the years main as much as the 2008 disaster, they went after subprime mortgage-related securitisations and other complex financial products. After these blew up, they went to city on callable bonds.
Callable bonds are much like extra vanilla devices in most respects however, critically, they offer the issuer the correct to name the bond at face worth previous to its authorized maturity. That’s the equal of issuers borrowing cash and shopping for a name choice on their very own debt on the similar time.
When charges go up, and the bonds in query are buying and selling at a reduction to their face worth, this feature is usually nugatory (who desires to purchase one thing value 90 cents for $1?). However when charges go down, and people bonds are buying and selling at a premium, that choice can change into fairly helpful. The investor is in apply brief that choice, and meaning probably substantial losses. To compensate themselves for taking this danger, the patrons of callable debt demand a better yield.
The complexities of modelling and managing the dangers embedded in callable bonds means they not often commerce and are troublesome to worth. However for all times insurance coverage corporations making an attempt to fund costly liabilities, it’s simpler to concentrate on the upper yield than the relative illiquidity.
These investments turned wildly common in Taiwan, and the trade clamour for extra was rewarded with the creation of “Formosa bonds”.
Formosa bonds are listed in Taiwan however issued by overseas corporations and denominated in US greenback. Their identify — a sixteenth century-vintage Portuguese time period for Taiwan which means “lovely island” — was chosen through public referendum, having edged out options like “Excessive-Tech Island Bond,” “Greatest Bond,” and “New Dragon Bond.” Formosa bonds are similar to offshore US greenback callable bonds in most respects, besides that they got preferential remedy by Taiwanese regulators as a result of they’re listed domestically.
At this level there are greater than $100bn such bonds excellent, the overwhelming majority of which have been issued between 2014 and 2018.
That’s a whole lot of company debt held by just a few massive traders and in a really illiquid format. However what does all of this need to do with mortgages?
it’s vital to recognise that issuing Formosa bonds is usually probably not about borrowing. It’s a commerce. Massive, refined worldwide banks and different monetary establishments recognised that captive demand for Formosa bonds led them to commerce at elevated costs; that’s, the issuer was capable of purchase name choices through issuance of Formosa bonds for lower than the associated fee to take action instantly through derivatives.
Every time such a wedge seems, it’s worthwhile to purchase the precise name by issuing Formosa bonds and promote a artificial name constructed with choices on rates of interest. And that’s exactly what many sellers did. Consequently, the options-selling by Taiwanese life insurance coverage corporations made its means reasonably shortly into the market writ massive.
That commerce was initially fairly worthwhile. However, as sellers competed with one another for market share, the ensuing flood of choices promoting depressed costs for artificial calls as nicely. In different phrases, the worth for these choices implied a decrease and decrease stage of volatility over time.
So, what does this need to do with mortgages? Nicely, American mortgage debtors are additionally shopping for an choice — an choice to refinance their debt if charges decline. Identical to Formosa issuers, that leads to a considerably greater price on mortgage debt than different comparable devices.
Mortgage lenders select what price to supply on a brand new mortgage partially by pricing within the worth of the refinancing choice as inferred from rate of interest by-product markets. All else equal, the cheaper these choices are as standalone by-product contracts, the decrease the speed mortgage lenders are prepared to supply.
Placing all of it collectively, Taiwanese insurance coverage corporations had written a whole lot of insurance policies. However they needed to provide excessive assured charges of return to take action. To hit these hurdles, they seemed offshore and aggressively accumulating us dollar-denominated callable debt. These callable bond issuers in flip used derivatives to carve up their liabilities into their element elements and bought off the embedded choices at a revenue.
That put downward strain on long-dated rate of interest choice costs which fed by into mortgage charges and, finally, to us owners.
When Taiwan sneezes, US homebuyers catch a chilly
What occurs when this vol faucet is turned off? That’s exactly what occurred in 2022.
As charges rose quickly, callable bond costs declined. Taiwanese life insurers — which by this level have been nursing substantial losses — misplaced their urge for food for callable debt. Though there’s been a trickle of issuance, the inventory of such debt excellent is principally unchanged over the previous two years.
As the provision of callable bonds was choked off, so too was the provision of volatility. Not did sellers “rinse and repeat” by issuing Formosa bonds and promoting them for scrap. That led costs on long-dated rate of interest choices to rise steadily, primarily reversing the impression on mortgage charges of artificially low costs.
Relying on the way you measure it, the rise in implied volatility seemingly raised American mortgage charges by between one-quarter to three-eighths of a degree.
That may not transfer the needle on a brand new residence buy or refinancing by itself. Nevertheless it’s positively one thing you’d discover when locking a price. And, when considered within the context of the $14tn marketplace for US residential mortgages, the sums concerned are removed from trivial.
Maybe extra importantly, the commingling of the pursuits of Taiwanese insurance coverage corporations and US homebuyers by the mechanism of derivatives markets is a traditional case of the interconnectedness and complexity that has come to outline fashionable monetary markets.
