Outlook 2021: Financials & Credit Markets

Central Park South

December 2020

New York | As we begin 2021 after a decidedly forgettable 2020, many of the challenges and opportunities that characterized the past nine months will continue, albeit with the caveat that this economic recession is very different from 2008 in terms of the risk hot spots and, most important, the fiscal posture of the US Treasury.

Whereas a decade ago private label securities backed by home mortgages were the source of market contagion, this time around the problem lies in now moribund private commercial assets mostly owned by REITs and bond and ABS investors.

There is a huge opportunity in acquiring and restructuring distressed commercial assets, but few investors are able to participate directly in this institutional process. The secondary impact of restructuring trillions in commercial real estate over the next decade will be enormous and is largely ignored by mainstream economists.

The conventional view of the US economy expressed by many analysts remains largely focused on domestic, consumer-focused economic factors. These assessments overlook a number of significant systemic changes, in particular 1) the size of the Treasury’s huge debt pile, 2) the impending markdown of trillions in commercial property, and 3) the deliberate asset scarcity engineered by the Federal Open Market Committee. A quarter of the Fed's balance sheet is now financing Treasury cash balances, which are part of the exploding US fiscal deficit.

The chart below shows three-month LIBOR for dollars, yen and euro from FRED. Notice that euro LIBOR is half a point negative, but offshore demand for dollars has supported dollar LIBOR through year-end. This tranquil picture may not carry through the first quarter of 2021, however, depending on whether Congress agrees on a substantial spending package.

Financials & Earnings

With authorities in the US and EU lifting limits on quarterly share repurchases by banks, the signal coming from regulators is that commercial lenders have sufficient capital and loss reserves to handle the cost of remediating COVID related credit expenses -- at least for now. These signals confirm the positive Q3 2020 guidance from several banks and suggest that the worst-case scenarios for consumer portfolios have not been realized.

Even as regulators allow the resumption of share repurchases by banks, we still expect to see higher net charge-offs in Q4 due to troubled commercial exposures. New loan loss reserves should continue to be well below peak levels seen in Q2 2020. This will drive a rebound in earnings across the industry, although perhaps not quite to 2019 levels. It is important to note that we may not see bank dividends restored to normal levels for several more quarters since bank income is falling under the pressure of FOMC policies.

Source: FDIC

Stronger lenders such as Truist Financial (NYSE:TFC) have already set new share repurchase programs for 2021. Look for a wave to positive share repurchase announcements to goose interest in financials. Most of the market leaders in our bank surveillance group already trade well-above par in terms of equity market valuations and at five-year lows in terms of debt spreads and credit default swaps (CDS).

With Charles Schwab (NASDAQ:SCHW) trading at 2.5x book and below 50bp in five-year CDS, it is hard to get terribly constructive on the name based upon fundamentals like value or earnings. But we do believe that the scarcity of investable assets and the growing pile of low-quality offerings in the IPO market will drive investor interest further into high-quality financials regardless of the current yield.

Consistent with the theme of asset scarcity, we expect to see another record year in 1-4 family mortgages, with shrinking secondary market spreads and gain-on-sale profits. We are now well-into the FOMC interest rate cycle, thus this is not the time to be increasing exposure to mortgage lenders or hybrid REITs. With 30-year conventional mortgage rates closing in on 2.5% APR and the FOMC buying 1.5% MBS coupons as part of quantitative easing, this is a good time to take cash off the table in IMBs and REITs, and go buy a well-located residential home.

We own Annaly (NYSE:NLY) at 0.6x book value. It now trades just shy of 1x book. Tempting to sell it, but we wonder whether the periodic volatility tantrums will afford us another opportunity to buy a leveraged pile of agency MBS at half of par. Of note, despite the strong push from the FOMC, we do not expect to see the remaining nonbank mortgage IPOs pending to come to market in 2021.

Home price appreciation will be driven by the bottle-neck in terms of new housing construction, which lags badly behind population growth and obsolescence of existing housing stocks. This means that net-loss rates on bank owned and conventional 1-4s are likely to remain depressed for several more years, but double-digit delinquency rates on FHA loans are a source of future concern. The tale of credit losses due to COVID is a barbell, with some asset classes impaired and others rising in value on a cushion of FOMC credit.

As we noted in our earlier reports (“Nonbank Update: PennyMac Financial Services”), the funding overhang in government mortgage servicing is a particular worry as 2021 begins. So long as low interest rates drive mortgage lending volumes, the situation will be manageable. Once volumes begin to fall, however, then the funding situation with respect to Cares Act forbearance will become critical very quickly as bank lines are drawn.

The top independent mortgage banks (IMBs) are offering conventional 30-year mortgages at 2.625% this week, while high-priced jumbos are just inside 3%. This is powerful economic stimulus that will propel mortgage debt issuance in 2021, but this is a banquet that will benefit nonbanks primarily even as commercial banks continue to back away from consumer exposures.

Look for JPMorgan Chase (NYSE:JPM) to repeat good performance in terms of mortgage banking in Q4. The numbers could be much higher if JPM and other large banks were still buying third party production. Once large banks have better visibility on credit in 2021, we may see JPM, Wells Fargo & Co (NYSE:WFC) and other money centers jump back into the mortgage market. The lion’s share of the profits in 1-4s this cycle, however, have already been gathered by the likes of PennyMac (NASDAQ: PFSI), Rocket Companies (NYSE:RKT), AmeriHome and Freedom.

Credit Markets

The size of the $900 billion spending package signed last night by President Donald Trump eliminates much of the uncertainty behind our earlier warning regarding the possibility of a taper or outright cessation of T-bill issuance by the US Treasury. (“Wag the Fed: Will the TGA force Rates Negative?”). Ralph Delguidice at Pavilion Global Markets described the situation last week:

“There are dynamics in the US money market complex pushing short rates down to (and perhaps through) the zero bound. The response of the Fed and the U.S. Treasury will likely flatten the curve once again, but not in the way, most investors are prepared for.”

Most economists and even many bond market strategists do not consider the financial relationship between the Federal Reserve and Treasury, a duality that has changed radically with the increase in the US budget deficit. We expect to see rates move steadily lower due to the FOMC’s policy mix of massive asset purchases and other measures, but the action or inaction of the Treasury is decisive. How quickly Treasury is able to spend its cash cushion will determine any market impact in terms of changes in new debt issuance.

The chart below shows issuance data from the Securities Industry and Financial Markets Association (SIFMA) suggesting that mortgage issuance is slowing while Treasury issuance surged through November as the cash hoard in the TGA neared $2 trillion.

The first obvious observation to make about the SIFMA data is that while mortgage debt issuance was still running $400 billion per month in November or a $4 trillion annual run rate, volumes are starting to slow. Although the immediate impact of the TGA issue may be to force the yield curve negative, the response that PavilionGM refers to in terms of an eventual yield curve flattener to rescue the money market funds may be a negative factor for financials.

Second and more significantly, new issue volumes in all of the major securities asset classes other than Treasury debt are trending lower as 2021 begins. This is an ominous sign since a large part of the demand for equities has been driven by corporate debt issuance and related share repurchase activity. Issuance of asset backed and agency securities is also slowing, again suggesting another datapoint that the US economy will underperform in at least the first half of 2021.

Here are several imponderables to consider in the next year:

• Will the desire of equity managers to own large cap bank stocks outweigh the negative impact of a flat yield curve on all financials, banks, REITs and also nonbanks?

• Will the shrinking net interest income of major banks due to the impact of QE dissuade investors from increasing exposures?

• If the FOMC is forced to put an artificial floor under short-term interest rates to rescue MM funds from disaster, will this force the FDIC to seek a similar subsidy for banks?

Readers of The IRA will recall that when the Treasury extended a credit guarantee to MM funds in September of 2008, the FDIC responded and extended emergency federal deposit insurance coverage to non-interest-bearing bank transaction accounts. If the Fed rides to the rescue of MM funds in Q1 2021 (many of which are sponsored by banks, BTW) will the FDIC seek a quid pro quo to protect banks from the negative impact of NIRP?

In terms of the price of risk, the markets seem so compelled by the Fed to accept inferior risk/return opportunities that the question of short-term pricing seems to be answered as asked. We fully expect to see the markets take financial debt and equity up in price in the near term, but we again think that a flattening yield curve could well spook some of the more simplistic perspectives in the bank credit market.

Seeing Goldman Sachs Group (NYSE:GS) equity trading above book value and the bank's five-year CDS inside of 90bp, we think that risk is not accurately or adequately compensated – but that it precisely what the financial engineers on the FOMC want us to think. The better part of valor may be to surf the asset inflation wave, the very same wave of ersatz credit that is causing 1-4 family loan volumes to go ballistic. The fact that monthly mortgage issuance volumes hit $600 billion in October illustrates the magnitude of FOMC market manipulation.

The chart below from FRED shows corporate bond spreads for the past year. While corporate default rates are rising, the spread relationships in the new issue market have barely moved. In this sense, at least, we can say that FOMC policy of massive open market purchases of securities perhaps kept corporate credit spreads from widening.

The only problem with this thesis, of course, is that falling new issue volumes addressed earlier may suggest that these carefully curated risk benchmarks shown above may be wrong. Investors may not be willing to take on exposures at these apparently benign credit spreads. After all, it takes a market. Happy New Year.

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Mortgage Group: ACGL, AGNC, AI, BKI, BXMT, CIM, CLGX, COOP, ESNT, FAF, FBC, FMCC, FNF, FNMA, IMH, LADR, MFA, NLY, NRZ, NYMT, OCN, PFSI, PMT, RKT, RWT, STWD, TWO

Bank Group: ALLY, AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC

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