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The Institutional Risk Analyst

© 2003-2024 | Whalen Global Advisors LLC  All Rights Reserved in All Media |  ISSN 2692-1812 

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The Return of Credit Risk

February 23, 2023 | God does have a sense of humor. President Joe Biden is campaigning for a second term. He moved Fed Vice Chair Lael Brainard to the White House to beef up the economic team. This is not so much a sign of strength as profound weakness, running scared, in fact. As the US economy heads into the worst period of credit loss since 2008, the primary victims will be lower income Americans, the core constituents of the Democratic Party.

The Federal Open Market Committee minutes released Wednesday state that the “credit quality of households also remained strong, on balance.” Well, not all households and not all businesses. The lower-income households that got the worst of COVID are about to be clobbered by the Powell FOMC, along with much of the world of secured finance. Most people think first about residential mortgages, the largest sector in secured finance. But this time around commercial assets play a starring role.

Because of the sharp increase in short-term interest rates, nonbank lenders from mortgage companies to commercial real estate conduits are facing negative carry on their assets. Many firms are simply choosing to liquidate positions and shut-down. This hardship is a direct result of the fact that the Federal Open Market Committee models monetary policy vs GDP, and not based upon the impact of the Fed's actions on the private economy. Dr. Brainard participated in and endorsed this policy by the FOMC.

In the world of dynamic stochastic general equilibrium (DSGE) models, where FOMC members spend most of their time, the real world is an abstraction. It may seem reasonable to FOMC members to move short-term rates 500 basis points in 12 months, but in the world of secured finance, which is governed by short-term interest rates, such a magnitude change implies a disaster.

Bloomberg recently reported, for example, that issuance of commercial mortgage-backed securities (CMBS) is down 80% YOY, an indication of mounting liquidity problems. Fed bank stress tests don't assume a swing in credit expenses of several standard deviations. When you see new, non-Treasury and agency debt issuance come to a halt in Q1 2023, that is the signal the sun-dried credit soretes are about to hit the economic fan blades.

“A Brookfield fund delivered a small shock to the US CMBS market last week after it defaulted on two top-tier office towers in Los Angeles,” IFR reported. There are many more actual and maturity defaults coming in CMBS as issuers are unable to roll maturing debt. The decline in new asset-backed securities (ABS) issuance shown in the chart below includes all types of asset-based financing other than mortgages. The MBS series includes residential and CMBS.

Source: SIFMA

Across the world of credit from commercial real estate, delinquency in auto loans and credit cards is climbing back to pre-COVID levels, a function of the interest rate shock that the FOMC has administered to the US economy over the past year. Loss given default on bank credit cards has been rising since the end of 2021. We expect to see this key indicator back to pre-COVID levels by June. Delinquency on the $1 trillion in bank credit cards is likewise rising, especially among younger consumers.


Across town from the Federal Reserve Board, the Federal Housing Administration has just announced a cut in the insurance premium for government loans. This is an amusing development since it harkens back to similar late-stage efforts to pump up housing going back to the Presidency of Bill Clinton. But of course, President Clinton long ago left the building in favor of woke socialism and foreign wars under Joe Biden.

The good news is that the default rate on FHA loans was back into double digits in December. The bad news for President Biden and his team is that the default rates on the bottom 20% of borrowers in the subprime FHA market are in the mid-teens and climbing. Neither the big media nor their economist brethren know of what we speak, but a bad credit tsunami is heading for the Biden White House. The table below is from the MBA and the FDIC.

Notice that the average delinquency of FHA loans jumped 200bp in Q4 2022. Extra credit question: If FHA defaults are over 10% today, where will they be in June of 2023? December 2023?

From a top-level perspective of an economist working for the Board of Governors in Washington, the housing industry looks OK, but if we sift into the different strata of loans, the picture quickly starts to darken. Ponder the world of 1-4 family loans from the perspective of one wizened industry veteran, who spoke to The IRA after the servicing conference in Orlando, FL.

Source: MBA, FDIC

The top $10 trillion in terms of credit quality is basically the bank portfolio and the upper distribution of GSE loans. On the surface, credit is still good and loss-given default for bank owned 1-4s is still negative. Credit costs are increasing, however, as home prices fall.

The top half of the $2 trillion government market features default rates about 3x the GSE market and growing, but still no crisis – yet. In the bottom $1 trillion of the Ginnie Mae market, however, default rates are soaring into the teens and new low-FICO loan product is being added every day. Figure that loans made since 2020 will be underwater in the next downturn, notes the veteran operator and lender. And, of note, the period of ultra-low interest rates allowed hundreds of thousands of FHA borrowers to migrate into the conventional loan market.

When the default rate on a Ginnie Mae MBS portfolio goes above 6%, the cost of loss mitigation generally consumes 100% of the servicing income on the portfolio. We are there now. By the end of the year, the Biden Administration is likely to be facing a growing financial crisis in the government mortgage market focused on lower-income households.

Unlike 2008, there is no bank capital or subordinate debt in private MBS to stabilize sagging credit markets. Thanks to Senator Elizabeth Warren (D-MA) and the other woke socialists in Congress, the largest banks led by JPMorgan (JPM) and Wells Fargo (WFC) have largely withdrawn from direct exposure to the government market.

As we have discussed in the Premium Service, Credit Suisse (CS), is headed for the door, leaving the government market financed by a shrinking group of lenders. So far, JPM and WFC remain committed to the mortgage sector even though they have largely withdrawn from purchasing loans from correspondents. The table below shows the warehouse lenders to PennyMac Financial (PFSI) from the new 10-K.

Ask yourself a question: How many of these banks shown above will even be doing warehouse lending on government assets at the end of 2023? And if CS exits the mortgage sector, who will pick up the slack with Citibank, N.A. on the PFSI warehouse line? Hmm? We will be describing the latest doings in the world of wholesale mortgage finance in a future issue of The IRA.

Even as financing capacity falls, the backlog of defaulted loans is growing inside government guaranteed MBS. Many servicers cannot afford to buy the delinquent loans out of the pools. Unlike two years ago, when early buyouts of defaulted government loans were a source of industry profits, today these same loans are a growing burden on limited liquidity.

The portion of FHA loans below 650 FICO is becoming a serious problem in the industry, with no sign of support or financing for loss mitigation coming from the Biden Administration or the Fed. Some industry leaders, in a meeting this week with Ginnie Mae President Alanna McCargo, reportedly suggested government-guarantees on financing for defaulted, government insured loans. This is a good idea but impossible given current law.

Today delinquent government loans must be financed privately and usually at a significant cash loss to the servicer. Residential loan servicers are paying SOFR plus two for default advance funding. The liquidity crisis in housing will only get worse so long as the FOMC keeps rates at or above current levels. McCargo and her team at Ginnie Mae will need a lot more attention from the Biden White House and the Powell Fed if disaster is to be averted.

Once Dr Brainard is in the saddle at the White House, you can bet that she will talk about how well the economy is doing despite the substantial increase in interest rates -- an increase that she supported over the past several years. Fact is, Dr. Brainard has primary culpability in the growing economic pain being felt around the country. When all is said and done, Joe Biden might have done better to pick an economic champion who was not one of the architects of our shared misery.

The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

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