Josh Young is a lecturer at Columbia Roaster and a former JP Morgan analyst. Brad Cesser is an advanced fellow of the Diplomatic Council and a former US Treasury official.
As FT ALPHAVILLE recently explained in detail, Taiwan was an interesting place and gathered a huge treasure trove of US dollars. We want to explore what is happening in those dollars now -and a strange phenomenon that can cause it.
Quickly summarize the last post, Taiwan became the fifth foreign creditor in the world, and had a pure international investment position (deducted from external claims) to 1.7 TN. It is in the league with China, Germany, and Japan, despite being an economic minnow compared to those countries.
Among developed countries, only Hong Kong, which fixes currencies to US dollars, is approaching Taiwan with a pure country assets compared to the scale of the economy.
Taiwanese foreign assets have become an unusual insurance company. One of the world’s largest life insurance industry is one of the world’s largest life insurance industry, compared to the economy and population in Taiwan. As of the end of 2023, it is more than 1.1TN, which is more than 1.1TN, Taiwan’s annual economic production, and is $ 47,000 per person.
How did the Taiwanese life insurance industry get so big? They provided an attractive alternative to the bank deposit to the insurance policyholders.
Probably surprisingly, these insurance companies are not only large, but also performing large -scale currency mismatch. As the last post pointed out, two -thirds of Taiwan’s insurance industry assets are overseas, mainly derived in dollars, but the opposition is true, and about 80 % of them are truth. Is derived in local currency.
In other words, the Taiwanese insurance company mainly invests in foreign currency income in foreign currency assets, promises to redeem these policies in local currencies. This gap can be bridged using foreign exchange derivatives and using things that are not even more and more likely.
The result of this large -scale conversion is important. I will explain in the above post. But what we remain here is what they are doing accurately in those dollars.
call me maybe?
Taiwanese insurance companies are those who seek classical yields. We are looking for the best return to the longest maturity assets that can be tracked. For several years before the 2008 crisis, they followed subprime mortgage -related securitization and other complex financial products. After they exploded, they went to the town with bonds called.
Bonds that can be called are similar to more vanilla instruments in most points, but importantly, they give the publisher the right to call bonds before legally mature. This is equivalent to the issuer borrowing money and at the same time purchasing a call option with his debt.
If the price rises and the bonds in question are discounted, this option is almost valuable (do you want to buy a 90 cent equivalent for $ 1?). However, if the price is reduced and those bonds are trading at a premium, the options may be very valuable. Investors actually shorten their options, which means a potentially large loss. In order to make up for this risk, buyers of the possible debt require higher yields.
The complexity of the modeling and management of the risk embedded in the possible bonds means that they are rarely traded and are difficult to evaluate. However, it is easier for a life insurance company that is trying to supply expensive liabilities to focus on yields higher than relative non -fluid.
These investments were very popular in Taiwan, and the shouts of the industry for more were rewarded in the founding of “Formosa Bonds.”
Formosa bonds are listed in Taiwan, but are issued by foreign companies and derived in US dollars. From the 16th century in Taiwan, which means “beautiful island”, the Vintage Portuguese term- is the people of the Portuguese language, such as “High Tech Island Bond”, “Best Bond”, and “New Dragon Bond”. It was selected via a referendum.
At this point, such bonds were over 100 million unpaid, most of which were issued between 2014 and 2018.
It is a large number of corporate debt held by a small large number of investors and a very irritating format. But what is this relationship with a mortgage?
It is important to be aware that issuing Formosa bonds is often not related to borrowing. It is trade. Large -scale and sophisticated international banks and other financial institutions have recognized that the demand for POL for the Formosa bond has derived them at high prices. In other words, the publisher was less than the cost of performing directly via DerivativeS, so it was possible to purchase a call option through the issuance of Formosa bonds.
Every time such rust appears, it is useful to issue a Formosa bond to buy an actual phone and sell a synthetic call built with options related to interest rates. And that’s exactly what many dealers did. As a result, optional rising by Taiwanese life insurance companies has been quite promptly attached to the market.
The transaction was very useful at first. However, the floods of the options that occur as a result are also selling the depression price of synthetic calls because the dealers were competing with each other for market share. In other words, the price of these options implies low -level volatility over time.
So what is this relationship with a mortgage? Well, I also buy options for American mortgages. This is an option to refinance debt when the price decreases. Like the Formosa publisher, the rates of mortgages are slightly higher than other equivalent equipment.
Mortgage lenders select a part of the new loan provided by pricing refinancing options, as estimated by the interest rate derivative market. The more they are equal and their options are cheaper, the more they want to provide a rates mortgage lender as a derivative contract for standalone.
All of the Taiwanese insurance companies wrote a lot of insurance. However, they had to provide a highly guaranteed profital rate to do so. In order to hit these hurdles, they seemed offshore and positively accumulated debt that the US dollar could call religiously. These bond issuer who can call us the derivatives to open their liabilities into component parts and sell options embedded by profits.
This will be supplied to mortgages and ultimately under pressure on the many years of interest rate options supplied to U.S. housing owners.
When Taiwan sneezes, US housing buyers catch a cold
What happens when this VOL tap is turned off? That was exactly what happened in 2022.
As the rate rose rapidly, the bond price that could be called was reduced. Taiwanese life insurance companies had been nursing significantly by this point, but lost their desire for their debt. There was a published trickle, but such unpaid debt shares have not been basically changed in the past two years.
Volatility supplies were suffocated because the supply of callable bonds was suffocated. By issuing Formosa bonds and selling for scraps, dealers no longer “rinse, repeat”. As a result, the prices of long -term interest rate options have steadily increased, and the effects of essentially artificially affect the mortgage ratio of mortgages.
Depending on the measurement method, the implicit volatility may increase the US mortgage rate of one -quarter to three -eighth points.
It may not move the needle by purchasing or refinancing a new house. But that’s definitely something you notice when you lock the rate. And in the context of the 14 -ton market for US mortgages, the relevant amount is far from trivial things.
Probably more important is that mixing the interests of Taiwanese insurance companies and US housing buyers through the mechanism of the derivative market is a classic of interconnection and complexity that has defined modern financial markets. It is a case.
