Josh Youthful is a lecturer at Columbia Legislation College 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 just lately detailed, Taiwan is an attention-grabbing place, having amassed a completely large treasure trove of US {dollars}. We now need to discover what is going on with these {dollars} — and the bizarre phenomena it will possibly trigger.
To rapidly recap the last post, Taiwan has stealthily grow to be the fifth largest overseas creditor on this 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 nations.
Amongst developed nations, solely Hong Kong, which pegs its foreign money to the US greenback, and Norway, with its large oil reserves, come near matching Taiwan in web overseas property relative to the dimensions of their economies.
Taiwan’s overseas property have additionally ended up in an uncommon place — insurance coverage firms. Taiwan has one of many largest life insurance coverage business on this planet in comparison with its economic system and inhabitants. At greater than $1.1tn in complete property as of the top of 2023, that’s greater than 140 per cent of Taiwan’s annual financial output, and works out to $47,000 per particular person.

How did the Taiwanese life insurance coverage business get so monumental? They provided policyholders engaging options to their financial institution deposits — greater yields however most of the similar liquidity options.
Maybe most strikingly, these insurers aren’t solely large but in addition operating an equally large foreign money mismatch. Because the final publish identified, two-thirds of Taiwan’s insurance coverage business property 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 foreign money.
In different phrases, Taiwanese insurers make investments the proceeds of their premium revenue predominantly in overseas foreign money property whereas making guarantees to redeem these insurance policies predominantly in native foreign money. The hole could be bridged utilizing overseas change derivatives or, more and more, by no means.
The consequence of this transformation on a large 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 possibly?
Taiwanese insurers are traditional yield-seekers — searching for the best returns on the longest maturity property they’ll monitor 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 just like extra vanilla devices in most respects however, critically, they provide 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 possibility 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 selection is usually nugatory (who desires to purchase one thing price 90 cents for $1?). However when charges go down, and people bonds are buying and selling at a premium, that possibility can change into fairly invaluable. The investor is in apply brief that possibility, and which means probably substantial losses. To compensate themselves for taking this danger, the patrons of callable debt demand the next yield.
The complexities of modelling and managing the dangers embedded in callable bonds means they not often commerce and are tough to worth. However for all times insurance coverage firms making an attempt to fund costly liabilities, it’s simpler to deal with the upper yield than the relative illiquidity.
These investments grew to become wildly in style in Taiwan, and the business clamour for extra was rewarded with the creation of “Formosa bonds”.
Formosa bonds are listed in Taiwan however issued by overseas firms and denominated in US greenback. Their title — a sixteenth century-vintage Portuguese time period for Taiwan which means “stunning island” — was chosen through public referendum, having edged out options like “Excessive-Tech Island Bond,” “Finest Bond,” and “New Dragon Bond.”
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 loads of company debt held by a couple of giant buyers and in a really illiquid format. However what does all of this should do with mortgages?
it’s vital to recognise that issuing Formosa bonds is usually not likely about borrowing. It’s a commerce. Giant, subtle 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 straight 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 firms made its manner relatively rapidly into the market writ giant.
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 properly. In different phrases, the worth for these choices implied a decrease and decrease stage of volatility over time.

So, what does this should do with mortgages? Effectively, American mortgage debtors are additionally shopping for an possibility — an choice to refinance their debt if charges decline. Similar to Formosa issuers, that ends in a considerably greater price on mortgage debt than different comparable devices.
Mortgage lenders select what price to supply on a brand new mortgage partly by pricing within the worth of the refinancing possibility as inferred from rate of interest spinoff markets. All else equal, the cheaper these choices are as standalone spinoff contracts, the decrease the speed mortgage lenders are keen to supply.
Placing all of it collectively, Taiwanese insurance coverage firms had written loads of insurance policies. However they needed to provide excessive assured charges of return to take action. To hit these hurdles, they appeared offshore and aggressively accumulating us dollar-denominated callable debt. These callable bond issuers in flip used derivatives to carve up their liabilities into their part elements and offered off the embedded choices at a revenue.
That put downward strain on long-dated rate of interest possibility costs which fed via into mortgage charges and, in the end, 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 mainly unchanged over the previous two years.
As the provision of callable bonds was choked off, so too was the provision of volatility. Now 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, basically reversing the influence 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 some extent.
Which may not transfer the needle on a brand new dwelling buy or refinancing by itself. However it’s positively one thing you’d discover when locking a price. And, when seen 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 firms and US homebuyers via the mechanism of derivatives markets is a traditional case of the interconnectedness and complexity that has come to outline fashionable monetary markets.