New York | In this issue of The Institutional Risk Analyst, we ponder how the actions or inaction of policy makers can create systemic events. In the next issue, we’ll dive into Q2 2019 earnings for banks and non-banks. Of interest, the Q2 edition of The IRA Bank Book is now on sale at our online store.
News last week that the leadership of Deutsche Bank AG (DB) is planning to cut one out of six jobs at the bank, this in an effort to regain financial health, drew some positive attention from investors last week. The stock closed up 7% while the SPX was essentially flat for the week.
Does this mean that the troubles at DB are behind us? Only if you believe that the bank can cut its way to profitability. That physical trembling observed afflicting German Chancellor Angela Merkel is, we surmise, a direct result of the prospect of state aid for DB.
While it is certainly good to see the management of DB finally moving to address investor concerns about profitability, the job cuts that impend in the bank’s German retail arm and the US investment bank raise questions in our mind as to whether the $1.3 trillion asset institution is viable as a going concern. When you cut deep enough you get to bone. When the bone is cut, then the patient often dies or is crippled. That seems to be the fate of DB, which is effectively untouchable by all but the most optimistic of hedge fund managers.
Though it is pretty clear that EU political leaders and bank regulators are incapable of winding up the bank, in the US regulators face the possible disruption or even failure of a key part of the world of housing finance. The focal points of the risk are two small, federally insured depository institutions known collectively as Deutsche Bank Trust Corp, the name of the top tier bank holding company of DB in the US. The table below shows the affiliates of Deutsche Bank Trust Corp as reported to the Federal Reserve Board.
This obscure, $42 billion asset bank is a key part of the world of housing and real estate finance in the US, acting as administrator, trustee and custodian for residential and commercial mortgage loans and asset backed securities (ABS). Part of DB’s global back office business, Deutsche Bank Trust Corp provides corporate clients, financial institutions, hedge funds and supranational agencies around the world with trustee, agency, escrow and related services. Three quarters of the bank’s revenue comes from fee income and the risk-adjusted assets are a fraction of the bank's nominal balance sheet.
Are US regulators focusing on finding a new owner for DB’s US trust and custodian business? Were this collection of small, modestly capitalized trust companies and non-bank SPVs to be disturbed, the impact on the world of residential and commercial housing finance and related ABS would be severe. There are obvious suitors, but few banks can or would actually buy the US assets with the tainted European bank. Years of inadequate disclosure and obfuscation have destroyed the credibility of DB with investors and institutional credit professionals.
Top of the list of potential buyers for the DB banking business in the US is Wells Fargo & Co (WFC), the largest commercial servicer in the US and the dominant player in the world of residential and commercial mortgages. But WFC is in the regulatory penalty box due to self-inflicted wounds of various kinds. We don’t expect to see WFC acquiring any significant businesses for years to come and may even sell assets.
Next is $475 billion U.S. Bancorp (USB), one of our favorites (we own the common and preferred stock), which is also a big player in the world of commercial and residential real estate lending and servicing. Our guess is that risk averse USB would not care to take a piece of the DB fiasco and all of the attendant unknowns that accompany “the German bank.”
Next on the list is KeyCorp (KEY), another big player in commercial real estate lending and servicing. The bank certainly has the operational smarts to acquire the DB business. But again, the long list of unknowns probably makes the acquisition impossible for the $141 billion asset KEY, even though the DB US business is relatively small in terms of capital and balance sheet. Notice that we have not even mentioned JPMorgan Chase (JPM), Bank of America (BAC) or Citigroup.
Then there is Goldman Sachs (GS), which is also heavily involved in commercial real estate finance. We like the idea of GS because of all the US banks, CEO David Solomon and his bankers could likely fashion a transaction that would insulate the US firm from the unknown risks that probably lurk inside DB, including the non-bank broker dealer business in the US.
The Asian analog to DB and GS as “narrow” universal banks is Nomura (NMR) of Japan, which has a substantial focus on residential mortgage lending and securitization. But with NMR trading below 50% of book value (compared with 20% for DB after last week’s rebound), acquisitions seem ruled out.
The studied inaction by regulators in the EU and the US with respect to DB is creating a problem and the possibility of a systemic financial event. Alex Pollock notes in his wonderful new book “Finance and Philosophy: Why We’re Always Surprised,” that “the financial future is marked by fundamental uncertainty. This means that we not only do not know the future, but we cannot know it…” But one thing we have learned in the world of bank supervision, is that forbearance by prudential regulators leads to moral hazard and eventual insolvency for the bank in question.
GSE Reform or Release?
Meanwhile in another corner of the world of mortgage finance, we continue to hear rumors of the impending "release" of the government sponsored housing monopolies, Fannie Mae and Freddie Mac, from government conservatorship.
We told Charlie Gasparino and Lydia Moynihan at Fox Business last week, “Possible Fannie, Freddie IPO whets Wall Street's appetite,” we still see the chances of anything actually happening in Congress as small to none given the conceptual gap between the two sides.
“What Republicans will accept and what Democrats want is very different and there is no way to bridge the gap,” we told Moynihan after a revealing trip to Washington last week. “I can see a scenario where Fannie and Freddie will stay in conservatorship forever.”
There is also a fantasy land quality to the GSE debate, as illustrated by the comments of Senator Mike Crapo (R-ID) back in March:
“It has now been a full decade since the government asserted control of the government-sponsored enterprises, or GSEs, Fannie Mae and Freddie Mac. After ten years of market recovery, these mortgage giants remain stuck in conservatorship, with taxpayers still on the hook in the event of a housing market downturn. It appears that the old, failed status quo is slowly beginning to take hold again, with the government in some ways expanding its reach even further, entering new markets where it has never been before. Today, Fannie and Freddie, along with government-insured mortgages, dominate the mortgage market."
Republicans pretend that the GSE's are a "threat" to taxpayers instead of conduits for middle class subsidies for home ownership. Yet despite this fact, Republicans probably want to see both GSEs just go away, with the responsibility for the guarantee of existing mortgage bonds going to Ginnie Mae. The new unified securitization platform would likely go to the Federal Home Loan Banks and the GSEs would be liquidated.
But none of this matters because bridging the conceptual and ideological gap between progressives and conservatives when it comes to housing is pretty nigh impossible. The increased giveaways and subsidies that Democrats want as the quid pro quo for any housing reform legislation, for example, would make the GSEs barely profitable, even before they emerged from government control.
Could a moderate majority come together in the House on GSE reform and ignore the irrational objections of House Financial Services Committee Chair Maxine Waters (D-CA)? Perhaps, but the more important point is that as the law stands today, the Trump Administration cannot release the GSEs from conservatorship. No matter how much private equity they raise, the GSEs lose their crucial “AAA” credit rating the moment they leave government control.
The good news is that the debt markets are already noticing the discussion of change with the GSEs and have widened the spreads over Ginnie Mae RMBS and US Treasury debt accordingly. Andrew Ackerman of The Wall Street Journal reported last week (“Push to Overhaul Fannie, Freddie Nudges Up Mortgage Costs”), that the mere suggestion of changes in the credit status of the GSEs has investors changing asset allocations. We gave kudos to Dianna Olick at CNBC in National Mortgage News for reporting on this ominous trend.
Just imagine what happens as and when warehouse lenders and REPO dealers must impose larger haircuts on GSE loans and debt when they are no longer “obligations of the United States.” The lack of understanding by members of Congress and also the Treasury and White House as to the fragile nature of the GSE’s credit profile is shocking, even for The IRA. Once the Treasury and the Federal Housing Finance Agency start to even move towards release from conservatorship, spreads on GSE debt will widen and the likelihood of completing an offering of new equity securities will plummet.
Let’s add a little market context. The equity securities of mortgage finance companies, like "narrow" universal banks such as DB and NMR and GS, tend to trade at a discount to book value because of the poor risk/return characteristics. Without an explicit guarantee from the US Treasury, the GSEs and their outstanding debt and equity securities will quickly trade at a discount as well.
The comparable credits for the GSEs will not longer be “AAA” Ginnie Mae and the Federal Home Loan Banks, but Penny Mac (PMT)(1x book), New Residential (NRZ)(0.9x book) and Mr. Cooper (COOP)(50% of book), three names which are among the stronger public issuers in mortgage finance ghetto. Best rating in the housing finance group is “BBB” for PMT. And with Fannie Mae trading on a 4 beta on the OTC bulletin board, as and when it trades, pricing an equity offering on a stand alone basis would be a challenge to say the least.
Under the “catch and release” model being considered by the Mnuchin Treasury, both of the GSEs would quickly collapse. Imagine the disaster if Moody’s, Kroll, Fitch and S&P had to downgrade Fannie Mae and Freddie Mac from “AAA” to say “A” or even “BBB” under the relevant finance company methodology. This would represent a systemic event equal to the failure of the GSEs and Lehman Brothers a decade ago. And once the act of release is done, regaining market confidence in the GSEs as sovereign credits will be impossible -- even were they returned to conservatorship.
Of course, when the GSEs are downgraded the credit agencies would also downgrade $4 trillion in GSE corporate debt securities and RMBS. The whole point of putting the GSEs into conservatorship in the first place was to protect the outstanding bonds, let us recall. The GSEs as corporations themselves don't matter. Just imagine the fiasco of reversing the conservatorship process and downgrading $4 trillion in existing securities. But just this eventuality is being seriously considered in Washington. Ponder that.
National Mortgage News (June 25, 2019)