Scottsdale | In this issue of The Institutional Risk Analyst, Ralph Delguidice expounds on the world of leveraged investing in the post-QT markets. Suffice to say that we expect the world of leveraged loans and CLOs to be the catalyst for a larger reset in the world of fixed income. Sure there is equity underneath these deals, but with over 60% of all CLO collateral comprised of intangibles, so what? We heartily endorse those few brave souls in the ratings community who believe that post default recovery rates in late vintage corporate exposures will be far lower than the historical norms. As Tracy Alloway noted on Twitter: "CLOs are just repackaged intangible assets like goodwill & trademarks, which are tough to price, verify and sell to someone else when the company's in trouble."
THE CARRY TRADE IS DEAD
The companies know it.
The analysts covering the industry and working for the bankers who underwrite the deals know it.
The institutions that buy the offerings on the dip, hold for a dividend and wait for retail to bid the stock back up to near book value (AKA the "zone of issuance") know it.
And even the hapless dividend obsessed retail investor is starting to smell something bad in the refrigerator.
The pace of the issuance is simply torrid. Mortgage REIT New Residential Investment (NRZ) has raised $1.3 billion plus with 90 Million new shares issued in just 3 months. Meanwhile little if any guidance is given on the deal calls regarding any use of proceeds, aside from vague hints about “looking to add revenue away from the portfolio of investments” and" bigger pieces of the pie" (whatever that means). And where is that next trade?
It is obvious what is happening here. The likes of NRZ are raising capital BECAUSE THEY CAN, and because they know the market access window can close suddenly—and finally—at any second. The “core” business—that is the basic carry trade and NOT the way they practice non-GAAP accounting using so called “core earnings”—is in trouble. It is in trouble for the same reason banks in general are in trouble, namely a flat yield curve.
The real cost of QE —a decade of FED controlled "price discovery" in the credit markets—is always visited worst on the financials when all is said and done. Inevitably it is as a totally flat “Japan-style” yield curve that offers little or no real carry, risk adjusted or otherwise. Last time the FED “paused” in the hiking cycle, in late 2015, the 2-10 spread was 250 basis points (bps). Today it is 15 bps. So much for maturity transformation.
Mortgage REITs can and will try as hard as they can to throw asset mix, accounting and hedge pixie-dust complexity at the model, but at the end of the day it is matter of simple subtraction; and nothing can change the fact that there is just no there-there anymore. The carry trade described last week in The Institutional Risk Analyst in terms of cheap funding for banks is also gone.
Start with the plain Agency REITs. They buy GSE paper and finance it in the REPO markets, using swaps and US Treasury hedges to minimize the duration gap between assets and funding. There are a few moving parts here, but the return—to a REIT company that is running a legacy portfolio of existing assets and swaps built over the last decade—has collapsed almost entirely. This is regardless of how “tasty” the next trade (done with incremental capital of course) is said to be.
Case in point: Last year AGNC Investment Corp (AGNC) lost almost $3 per share in book value while the 10 year US Treasury —and the corresponding agency pass through securities—moved less than 15 BP. "It’s the VOLATILITY, STUPID.”
Adding credit exposure to the mix (like Annaly (NLY) and others) and/or negatively convex IO’s in the form of crazy scary MSRs (like NRZ, Two Harbors (TWO) and Cherry Hill Mortgage CHMI) are REITs that “self hedge” the portfolio, which serves only to increase the raw complexity of the accounting. And while it may change the timing and recognition of the state of the basic trade, it will do little to offer any real diversity or protection in the long run given current curve environments. At the end of the day these companies were all really just a longer term trade, and not a business.
The almost insatiable retail yield hunger—courtesy of the same FED that crushed their effective yield curve—has attracted too much attention; and too much capital has flowed in to these trades that are (much like getting married too young) easy to get into but incredibly hard to live with. Non REIT investors such as BlackRock (BLK) and PIMCO—who need not pay out taxable earnings—or dividends at all for that matter—and that are now happy to accept HALF the indicated returns (especially on the more esoteric asset classes) have crashed the party.
MSRs are a good case in point. They have DOUBLED in price over past three years, and most of the demand has been SINCE rates peaked and began to fall again—actually undermining their hedge value. The same is true with all kinds of commercial real estate credit. As the FED-blown bubbles have exploded, cap-rates have collapsed—and of course leverage has increased to fill the holes.
We have reached the point of economic no return. This is what tops look like. The story is an old one, and like every other time we have told it the end of cycle dynamics are always the same. “Yes," we hear, "the party will end someday—badly we know—but not today, right?” So let’s keep dancing.
But that said, right there at the top of the long and growing list of reasons to expect the credit market eschaton in 2019 should be this insane capital raising behavior we are seeing here. It is like they teach pilots. “Climb, conserve, confess.” Have enough capital to meet the inevitable margin calls and then hunker down to wait for the OTHER GUYS FIRE SALE.