“Disneyland is over, the children go back to school. It’s not going to be as smooth as it was the last 15 years... All these years, assets were inflating like crazy… It’s like a tumor, I think is the best explanation.”
Nassim Nicholas Taleb
February 3, 2023 | Premium Service | There are two economic narratives in America. The first narrative is obviously false, but largely controls the financial media and the political conversation. This narrative reflects the conflicted, long-only view of the major investment advisory firms and is supported by the Fed and Treasury.
Fed Chairman Jerome Powell says that 2% inflation is the minimum requirement for economic stability. Why? On the assumption that a little inflation will lift all or at least some boats. This leads to the second narrative, the actual story for the vast majority of Americans. These are people who work to live and are being killed by double digit inflation every year.
The Americans in the real narrative have no interest in or knowledge of the financial markets. The tens of thousands of Americans who have been laid off in the past ninety days understand that the US economy is slipping into recession. The credit markets are reacting accordingly. After 12 years of pro-inflation QE, the post-COVID reset is going to hurt, as Nassim Taleb suggests above.
Many emerging companies that we wrote about in 2020-21 as equity plays are now credit stories. In the real economy, households that lose a wage earner must often choose between paying for the car, the house and/or food. The second narrative resides in the world of credit and fixed income securities. No surprise then that the big take away from Q4 2022 earnings is that credit expenses are headed higher and at a brisk pace.
Watching the announcements of layoffs that have blossomed since the New Year, it seems striking that the unemployment rate is at just 3% yet the levels of delinquency visible in low FICO, high loan-to-value (LTV) subprime mortgages (aka “FHA/VA/USDA”) are in the mid-teens and rising back to pre-COVID levels.
DQ rates on sub-600 FICO government loans are rising roughly 1% per month and are now in the mid-teens. This is a stunning statistic that nobody in the first narrative seems to have noticed.
While the average FICO score in the US has risen into the low 700s since 2008, more than one-third of all Americans have scores below 600. Thus when we see that the overall level of delinquency on Ginnie Mae 3.5% MBS is already above the level of gross income on the servicing strip, this begs the question of liquidity. As we discuss below, funding the growing pile of delinquent government loans is becoming more problematic as interest rates rise. The fact of large depositories stepping back from the mortgage market is also not helpful.
Speaking of liquidity, there is growing evidence that the artificial market benchmarks led by the Secured Overnight Funding Rate (SOFR) are starting to become unstable. It seems that the Alternative Reference Rates Committee — the Federal Reserve-backed industry body known as “ARRC” that rubber-stamps the central bank's shaky transition from dollar Libor — has created a potential systemic problem by over-regulating the market for short-term cash.
William Shaw and Alexandra Harris of Bloomberg reported earlier this week that Scott Peng, one of the early voices to call out the scandal-ridden London interbank offered rate (LIBOR) during his time at Citibank, is now sounding the alarm over its successor.
Peng says guidelines designed to limit who can use derivatives tied to the Secured Overnight Financing Rate are inadvertently heaping risk onto banks’ balance sheets, echoing warnings from TD Securities and JPMorgan Chase & Co. Left unchecked, he says, it could pose a significant risk to the smooth functioning of financial markets.
“Banks and issuers are just starting to come to grips with this — we are at beginning of a reckoning,” said Peng, chief investment officer of Advocate Capital Management. “At the present time it’s an annoyance, but as that risk position become bigger and bigger at some point it becomes a systemic issue.”
The rapid decline of market liquidity presents a threat to the economy on multiple levels, yet Fed Chairman Powell does not yet see a problem. Raising interest rates 400 bp in nine months has created huge problems in housing finance, commercial real estate and other sectors, problems that are still not visible to much of the mainstream media.
The bond market rally in Q4 2022 took some short-term pressure off of banks and the credit markets, but a new period of rising yields could literally blow the wheels off of the proverbial wagon a la December 2018. Announcements by Wells Fargo (WFC) and New York Community Bank (NYCB) that they are withdrawing from mortgage lending is a huge blow to the liquidity of the housing market.
Credit Suisse & Ginnie Mae MSRs
As the accelerating reduction in “free” reserves in the banking sector may bring the entire rate hiking process to an end, liquidity is a growing problem in the housing sector. While many observers and media worry that mortgage lenders are preparing to sell government MSRs, in fact the opposite may be the case.
One issuer told The IRA this week that the recent announcement by the Federal Housing Finance Agency (FHFA) that it is considering modeling the valuations for mortgage service rights (MSR) is a defensive reaction.
“Ginnie Mae is sucking all of the capital out of the market,” the issuer laments. “When things get tough later this year, issuers will sell Fannie Mae and Freddie Mac servicing to protect their position in Ginnie Mae assets. There is no choice.”
The issuer worries that the cost of advancing cash on delinquent loans is already above the monthly cash flow from the performing loans behind the MSR, begging the question as to how this delinquency will be financed. As we noted in a research paper in 2020, the FHA/Ginnie Mae market requires issuers to provide liquidity to the government market, especially in times of recession.
The GSEs such as Fannie Mae and Freddie Mac provide liquidity to issuers, but offer inferior execution to the government market and other hazards such as repurchase claims and definitional games. For example, the GSEs are taking the position that COVID was not a “natural disaster” when it comes to sunsetting liability for representations & warranties on conventional loans.
Specifically, Freddie Mac is stating that COVID does not meet its definition of a disaster and so forbearance offers made to customers for COVID will NOT be considered as having made on time payments. Despite the fact that the government and both Fannie and Freddie required servicers to offer the forbearance plans, they are now changing the rules after-the-fact.
When a large issuer confronted Freddie Mac over this policy decision, the officials seemed almost embarrassed to admit that they weren’t following the same protocol for COVID as in other natural disasters. Of note, FHFA has yet to put out a public statement on this position. If this is in fact the stance taken by the GSEs, the next time servicers are requested to offer up solutions for events similar to the COVID pandemic, they are going to say “No Thanks.”
A more serious situation is festering over at Credit Suisse (CS), where the bank has been struggling to sells its Structured Products Group (SPG) since the middle of last year. CS most recently announced plans to move its asset management arm into a revived First Boston spinout, an ironic end to the banks earlier efforts to build its investment banking business.
CS had previously indicated that a deal to sell SPG and its unit, Select Portfolio Services (SPS), to APO would be finalized in Q4 2022 but there was no announcement. Credit Suisse announced in early November an exclusivity agreement to transfer “a significant portion” of SPG to an investor group led by Apollo Global Management (APO), reports Inside Mortgage Finance.
Apollo and PIMCO were said to be negotiating to acquire most of the securitization group’s assets and “hire the SPG team to the new platform.” No close was ever announced and the remaining bankers at CS are not talking.
SPS serviced about $166 billion in unpaid principal balance (UPB) of loans at the end of 2022, mostly non-agency exposures. More important, there reportedly are advance and warehouse credit exposures related to Ginnie Mae MBS and MSRs that APO and PIMCO were not willing to purchase. APO was reportedly willing to manage these assets on behalf of CS, but there has been no further mention of these assets nor confirmation of the transaction closing this year.
To give you some idea of the complexity involved in breaking up the CS business in the US, the link below downloads an CSV file from The National Information Center that contains the full hierarchy of Credit Suisse Holdings (USA) Inc., the top-tier parent for CS in the US. Under Basel, CS is required to maintain the capital of its US business on a stand-alone basis, thus shifting the Ginnie Mae exposures as part of the SPG sale is essential.
CS has been a key advisor to a number of the larger Ginnie Mae issuers and the architect of the several MSR financial transactions issued for Penny Mac Investment Trust (PMIT), Rithm Capital (RITM), Freedom Mortgage and other GNMA issuers. If a stable and liquid new home cannot be found for the Ginnie Mae exposures inside the CS SPG unit, then it is hard to construct a scenario for 2024 where these MSRs deals are refinanced. More likely, we believe, is that these deals will be extended or redeemed.
In the PMIT Series 2017-GT1 financing for Ginnie Mae MSRs, for example, the Cayman Islands branch of Credit Suisse AG provided the variable funding notes (VFN) and separately provided an uncommitted MBS Advance VFN to get these deals done five years ago. Is there a lender today that would step into the shoes of CS to roll these deals for another five years? Given the reaction of APO and other Buy Side shops to the opportunity to acquire the CS Ginnie Mae book, we think the answer is no.
Of note, RITM moved much of its warehouse and Ginnie Mae MSR financing business to Goldman Sachs (GS) last year, seemingly anticipating the dysfunction at CS. Citi reportedly has also been willing to provide VFN financing for MSR financings, but it remains to be seen whether these banks or other mortgage-focused shops such as Morgan Stanley (MS) will pick up the slack.
With the demise of the financing market for Ginnie MSRs, we may see a renewed emphasis on bank lines and excess servicing sales as a means of financing for Ginnie Mae servicing assets. That said, it is hard to think of a likely buyer for the CS mortgage exposures to Ginnie Mae assets. Requests for comment to APO and CS were not answered by press time, but we will update this report in the event.
The irony of course is that Ginnie Mae’s leadership had been leaning toward the capital markets execution and away from bank lines and excess servicing sales (ESS) as a way to finance the MSR. With the apparent demise of CS as a factor in the mortgage finance market, we think that the leadership of Ginnie Mae and FHFA need to become more open to and encouraging of creative means to raise equity capital.
We recently asked Ginnie Mae if they have come to a view of using ESS in the risk-based capital framework finalized last year. No response yet, but we have a feeling that the Ginnie Mae leadership will be looking for multiple ways to get Buy Side money into the world of mortgage finance. The only difficulty is that QE not only pulled many loans from tomorrow into today, but it left precious few loans for mortgage bankers to make in the future.
The table below shown the distribution of $2.2 trillion in GNMA loans by coupon. Notice that 75% of all GNMA MBS have coupons between 2% and 4% thanks to QE and the FOMC. The 10.8 million loans inside these MBS may not be in the money for refinance for many years to come.
Source: Ginnie Mae
The incentive to put capital behind a Ginnie Mae portfolio in tough times was always the prospect of making money on new loans when interest rates fall and the sun begins to shine. Now thanks to the Fed, the future earnings potential for mortgage lenders may be significantly curtailed for many years to come because three quarters of the mortgage market is out of the money.
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