Banks: Value Tease or Value Trap?
Updated: Jul 14, 2020
New York | We go into Q2 2020 earnings season with a combination of expectation and dread. On the one hand, we are getting more data on the state of credit inside banks and nonbanks alike, a process of revelation that will make a lot of investors and risk professionals queasy. The discovery process must continue even as many cities remain effectively closed, with plywood covering the windows of businesses.
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For now, the reversal of progress on COVID19 in many states throws any calculus of two weeks ago regarding future credit losses into the waste bin. The longer the US economy remains in lock-down, the more horrific will be the financial and economic cost. This cost will soar into the tens and hundreds of billions, and will be spread across banks and institutional investors.
Tom Michaud, KBW CEO, told CNBC’s “Squawk on the Street” last week he expected to see higher credit loss provisions in Q2 2020 earnings, something we have flagged as an indicator of the degree of comfort inside banks as to the credit outlook for 2020.
Michaud also bravely predicted that Q2 would be the worst quarter in terms of big provision numbers, but that actual losses would remain muted in Q2, a point with which The Institutional Risk Analyst concurs. Note that loss rates were already starting to lift in Q1 2020, an unfortunate trend that we can see going hockey stick in the current quarter due to commercial losses.
In the past couple of weeks, US bank stocks have given up most of the “rebound” from April and May, and are now again in the red for the year – with the notable and ironic example of Deutsche Bank AG (NYSE:DB), the quintessential example of the too big to fail bank.
Despite its latest faux pas regarding transactions for deceased sexual predator Jeffrey Epstein, DB is up 29% this year as of the close on Friday. Morgan Stanley (NYSE:MS), which looked left for dead two months ago, is also up double digits in the past month. The YTD results are less promising for the large bank group.
On CNBC's “Fast Money” last week, we opined that there is still a lack of visibility on credit and earnings for financials, except in residential mortgages, where a record year for volumes and profit per loan is in prospect. A heavy calendar of corporate bond issuance, surging residential loan volumes and fees from risk free government loans may be the bright spots for US banks this quarter.
Also, kudos to the folks on the Federal Open Market Committee for moderating intervention in the REPO and the mortgage backed securities (MBS) markets last week. GNMA 2.5s for August are off from the June highs, this even as the Treasury benchmarks fell in yield last week due to COVID concerns. We note, however, that the VIX has not been much below 30 for long since March.
The flip side of bull markets in residential mortgages is prepayments. The asset shrinkage due to consumer mortgage refinance activity on higher coupon MBS is pronounced and accelerating, which will force the Fed to continue MBS purchases merely to keep the portfolio size stable. But the macro picture of stability remains dependent upon near total monetization of Treasury emissions by the independent central bank.
“The biggest question is whether the Fed will continue to buy enough Treasury and MBS paper to fully fund the issuance of US Treasury debt," writes Lee Adler of The Liquidity Trader. “In other words, will the Fed continue to do enough to monetize the entire Federal Debt? So far, the answer is yes. That could change, but it hasn’t yet.”
The constant prepayment rate (CPR) for the $1.2 trillion in FNMA 4s were running around 40% in June and speeds on GNMA 3.5% MBS were equally high, accordingly to MIAC. With coupon spreads at 2% and the current MBS coupons headed for 2%, this means consumers can get a 3% mortgage or better.
At the present rate of prepayments, on-the-run MBS (which are, in theory, comprised of 30-year mortgages) will basically disappear within a year or so. Properly understood, we think that 30-year mortgages are really 30-day instruments that renew if the home owner/debtor does nothing. The owner of the mortgage note is short a put option, which is given to the debtor at no cost. Is this a great country or what?
The wave of prepayments in June and beyond will likely come as bad news for owners of mortgage assets such as REITs and MBS funds that are not able to lend and create new assets at reasonable cost. The June prepayment numbers on MBS were so high, in fact, that the FOMC can expect the system open market account (SOMA) to take some pretty hefty losses on redemption on its MBS holdings, but that is the point is it not?
Through its various emergency lending activities, the Federal Reserve is taking direct credit risk in ways never anticipated by Congress but mandated, if you’ll forgive the pun, by circumstances. And as we have said before, the circumstances in terms of credit are quite dreadful.
Just as the Fed takes a cash loss on a loan prepayment at par in an MBS, a default on a loan made via any of these emergency credit programs may eventually cause a loss to the central bank. This loss is subtracted from the earnings on the Fed’s portfolio, including the interest earned on MBS and private securities. The Fed is, in fact, operating as a fiscal agency of the US government. Nobody in Congress seems to know or care.
Meanwhile across the world in China, the Chinese Communist Party led by dictator Xi Jinping has apparently mandated an economic reflation of huge proportions. This includes a bubble in stocks fueled by higher margin lending, the Financial Times reports. The mandate from on high is that China is recovering, thus all of the proverbial levers of stimulus are being pulled.
The renminbi has rebounded to a three-month high, reflecting the strong government intervention that began around the end of June. The iShares China Index (FXI) is ahead of the S&P 500 over the past 30 days and for the year. But the recovery of the real Chinese economy lags far behind the manufactured reality visible in the financial markets.
The stampeded of Chinese investors into shares, in many cases using illegal margin loans, is the latest evolution of economic thinking by Beijing, a development that does not exactly instill great confidence about the future. Recall 2015. Securities margin lending is the exclusive business of licensed brokerages, Caixin reminds us. Margin lending is illegal for other institutions or individuals, yet the activity is grows rapidly as available liquidity overwhelms the regulatory constraints.
While there are many examples of resurgent financial markets, we remain concerned that the predominant global tendency is and will be deflation, one reason why a number of policy makers believe that additional credit support for the economy will be required in coming months. We agree. Look for a surge of equity issuance in coming months as financials look to maximize liquidity and capital.
For Q2 2020 earnings of banks and financials, we can say that the process of data gathering and disclosure will be ongoing and intensive. We are still trying to understand the scope of a problem that is outside of recent experience and the silly media narrative of a “V” shaped recovery. Our friend Professor Edward Kane at Boston College sums up the approaching loss horizon for commercial real estate and related corporate risk exposures:
“When payments are not made as due, delinquencies are not immediately registered. Often, the grace period is 60 days. But when grace periods expire, lenders and landlords have only two options: taking possession of the property (or collateral) or easing contract terms. Exercising these options generates uncertainty, takes additional time, and reduces the cash flows that existing contracts and properties can generate going forward.”
“In the wake of the indelible economic damage the pandemic is causing, a lasting contracting equilibrium in the real-estate sector requires the rents and mortgage payments implied by pre-existing contracts to be renegotiated sharply downward. The long-lasting effects of the virus on opportunities to travel and work from home will eventually make it clear that the equilibrium value and size of various commercial real-estate holdings have been permanently reduced. The glut of commercial properties (especially hotels and shopping centers) will reduce land values all around. Agreeing to tear down commercial buildings and repurposing the land on which they sit is a time-consuming business. Far from undergoing a V-shaped recovery, travel, real estate and real-estate finance will remain depressed sectors for whatever time the recontracting and loss-allocation processes take.”
“Sooner or later, direct and indirect mortgage lenders and tax collectors at every level of government must face the pain of these adjustments. State and local governments are deeply vulnerable. Targeting an increased flow of liquidity from the taxpayer-owned Federal Reserve System to benefit selected firms and investors in the travel, real-estate and state-and-local sector can delay and redistribute some of this pain across the population. But the pain can be postponed for only so long. We should not kid ourselves. It is going to take a good deal of time for the pain to go away.”
To Melissa Lee's question last week on CNBC, bank stocks are a value trap for now. Look for markets to sell into the news on earnings for financials as a combination of frightful credit provisions and commensurately low earnings will kill the party that has kept even some blue-chip names well above book value since March end. And remember Lee Adler’s point, namely that we got effective MMT right now through FOMC monetization of the US fiscal deficit.
The bank group we track actually closed up mid-single digits on Friday because, stated frankly, the Street wants to own these stocks, plain and simple. JPMorgan (NYSE:JPM) and U.S. Bancorp (NYSE:USB) led the way, but neither of these stocks is especially cheap at 1.3x book or so and given the magnitude of credit losses in prospect.
Even as the banks take a licking on their CRE and commercial exposures in coming quarters, look for the nonbank residential mortgage sector to remain buoyant as swelling volumes and earnings contrast with the carnage elsewhere. The impending IPO by Rocket Companies, owner of Quicken Loans, will be cause for joyful fascination by long suffering mortgage folk even if the big media barely cares.
The first version of the Rocket Companies S-1 was filed last week. The Street is hoping for a multiple on earnings in the teens or better for the IPO, which is led by Goldman Sachs (NYSE:GS). In the event Quicken founder Dan Gilbert gets such a rousing reception from investors, the members of the mortgage finance ghetto all will be very pleased indeed.
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