April 11, 2022 | The market for too-be-announced (TBA) mortgages closed last week at a discount, something of a change compared to the 3-4 point premiums seen in 2020 and 2021. Winter has come to mortgage land, this according to industry sage Joe Garrett in San Francisco. Below c/o Joe’s firm, Garrett McAuley, are the profit per loan numbers for some of the best and worst years in recent memory in the residential sector. Joe has a great way of reminding readers of The Institutional Risk Analyst of the context in data.
Profit per Mortgage Loan (bp)
When the front contract in TBAs is trading below par, that means that lenders are losing money on every loan they close, a circumstance that will only go on for so long before headline rates and spreads move higher. Yes, the servicing is worth good money, but what TBAs are telling you is that mortgage rates are headed north. MBS are now sporting 4% and 4.5% coupons vs the 2s and 2.5% MBS of 2020. If you add a point in fees to those MBS coupons, that gives you residential mortgage loan APRs in the 5.5% range. TBAs tell us that, barring some unforeseen hiccup, we'll see a 6% residential mortgage by summer if not sooner.
That 5.5% mortgage is what you might call sticker shock, maybe. But in fact, even as mortgage interest rates rise, the purchase market for homes continues at a brisk pace. We wonder if consumers have reached the same conclusion as many institutional investors in rent-to-hold models, namely that the Fed’s inflation of real estate values is not transitory. As a result, the Fed is likely to need to push interest rates much higher before buying activity slows in real estate. We could easily see consumer mortgage rates at 6% by June as all manner of lenders try and restore pricing power. Meanwhile, new issue volumes are falling dramatically in most categories other than US Treasury debt.
We were pleased to be the only dissenting voice in the celebration of the Life of Brian Moynihan, CEO of Bank of America (BAC), published last week by the New York Times. Just for the record, BAC's stock price languished from 2009 through 2017, then galloped when the agony of mortgage crisis woes finally ended. This caused SG&A to drop at BAC from a $70 billion annually expense down into the $50s, yet the bank’s financial performance remains decidedly unexceptional.
Make no mistake, Brian Moynihan avoided more revenue at BAC over the past decade than the $100 billion plus he paid out in fines and losses due to the 2008 mortgage crisis. BAC is down less than some of its peers YTD as financials flee the specter of rising interest rates. Can bank asset returns keep pace with rising market rates? Probably not, suggesting that a 1980s-style margin squeeze may lie ahead as the FOMC seeks to earn back credibility on inflation. We commented in our pre-earnings comment (“Top Five US Banks: USB, JPM, WFC, C & BAC”):
“In terms of net income, Citi is at the bottom of the group followed by BAC, WFC and Peer Group 1. JPM and USB are the best performers in the group. Notice that USB has been the top performer in the top five banks going back five years and maintained that position through COVID. Why do investment managers prefer temples of mediocrity like BAC to USB? Because the former is bigger and a more liquid stock, and relatively cheap. But BAC is cheap for a reason, namely the weak management and lack of focus under CEO Brian Moynihan.”
Some Buy Side managers get testy when we so publicly disrespect Brian Moynihan, but hey, we don’t make up his financial results. If you want to see the definitive view of BAC, pull up the most recent Bank Holding Company Performance Report from the FFIEC. What you find is that BAC is in a race with Citi and Wells Fargo & Co (WFC) for last place among the top five banks. And all of the larger banks look pedestrian vs the smaller names in Peer Group 1.
Watching the Sell Side analysts reducing their estimates and price targets for Q1 2022 bank results, we get the feeling that the Street has figured out that there is a large chunk of bank gross interest revenue missing compared with year-end 2020. With investment banking also looking a tad light and the Street focused on other comprehensive income losses on low-coupon Treasury and MBS, bank earnings season is shaping up to the quite the train wreck.
The table below shows a subset of our bank surveillance group, which illustrates that the leaders of 2020-2021 are now leading the group lower. Some of the stronger names such as American Express (AXP) and Charles Schwab (SCHW) are resisting the increased gravitational pull from rising interest rates. Notice too that Morgan Stanley (MS) is trading at a 50% better book value multiple than Goldman Sachs (GS), which along with CapitalOne (COF) is reverting back to a discount to book. Citigroup (C) continues to suffer from concerns about exposure to the Ukraine War.
Source: Bloomberg, Yahoo Finance
If you like financials, the good news is that common shares and lower risk securities such as preferred equity are getting cheaper by the day. This movement lower is likely to persist until markets get a better handle on just how high and how quickly US interest rates are likely to move. But the more profound question that occurs as rates rise is how quickly will credit expenses normalize and again become an expense drag on bank earnings.
Falling prices for all manner of loan collateral, from plain vanilla 1-4s to complex structured notes tucked inside collateralized loan obligations (CLOs), are weighing on the minds of institutional money managers. When he Fed pushed asset prices higher, visible credit costs also fell. Now that process is reversing across the credit complex, led first and foremost by residential mortgages.
“CLO collateral metrics have stayed resilient despite the recent volatility in markets but more forward-looking market indicators such as asset prices and declining equity NAVs shouldn’t be ignored, says Bank of America’s Alexander Batchvarov. “Defaults remain low, but given the macro picture, their uptick in the foreseeable future cannot be ruled out,” Bloomberg reports.
Asset prices for homes and commercial property are not weakening just yet, but we expect to see a more general softening in asset prices in 2023 and beyond. The quantity of happy juice injected into the US economy by the FOMC's experiment in QE is massive and still enduring, but the end of QE and the move to tightening of policy suggests a correction in asset prices across the board. For every dollar that runs off of the Fed's balance sheet, markets must shoulder $2 in new duration.
The BIG question facing analysts and policy makers is what happens if the FOMC goes for 50bp at the next meeting, then the stock market rolls over and cuts 10% off the value of the national pastime. Will Fed Chairman Jay Powell fold in terms of further rate hikes if the S&P 500 falls 1,000 points in a day?
We continue to believe that the US stock market has limited tolerance for higher interest rates, in part because of what rising interest rates imply for asset prices and credit. Put it all together and we think bank stocks will be a lot cheaper in June than they will be on this Good Friday.