Will Credit Risk Transfer Save the Banks? Are MSRs Overvalued?

June 12, 2024 | Premium Service | For some time now, we have struggled to understand the net, net picture in commercial credit, on the one hand. The pristine state of residential mortgages and even relatively low defaults on credit cards and auto receivables, is on the other side of the coin. Down a second level, we see the clear deterioration of valuations for commercial real estate and mounting defaults across the wider commercial sector. Yet simultaneously a flood of cash is welling up from the ground in private credit to fund credit risk-transfer transactions and in size.

Banks, REITs and non-bank investors alike are transferring doubtful credits to investors in growing volumes. The acronyms used to describe these transactions are also expanding, a worrisome sign. Will CRT be enough to save the banks from credit Armageddon in 2025?  NPLs for commercial real estate loans owned by banks are already at levels not seen in over 15 years and the crisis in commercial real estate is not nearly begun. US banks just ended disclosure of loss-sharing agreements with the FDIC, but is it time for banks to disclose private credit risk transfer (CRT) transactions? 

Earlier we had written about some of the challenges facing Merchants Bank of Indiana (MBIN). “Eight quarters ago we see almost no NPLs in MBIN's Non Owner CRE portfolio,” writes Bill Moreland at BankRegData in his review of “sentry events.”

“Then over the next seven quarters we have 7 'events'. The $21,753,000 increase to $21,783,000 is what we call an NPL Spike. Most likely this is 1 or 2 CRE loans that have gone on Nonaccrual or are 90+ Days Past still accruing interest.”

What Bill is describing is a significant change in the rate of increase in the losses for MBIN and other lenders. The net loss numbers are still low, but they are moving fast, enough to signal concern for a veteran analyst like Moreland. We have seen similar “motion” in the loss data for other banks, something we attribute to the long period of suppressed default activity from the mid-2010s through COVID.  Has the proverbial rubber band of loss been released?

To us, the big question facing investors in bank equity and debt is whether we are about to see the normalization of credit loss rates after 15 years of artificial life support from the Federal Reserve Board.  You cannot look at the chart for loss given default (LGD) for all bank loans below and not conclude that the past decade and more have been extraordinary. Yet we are nowhere near the volume and rate of LGD seen in 2008.  Notice that loss severity actually fell in Q1 2024.

Source: FDIC/ WGA LLC

In terms of asset quality, banks are showing increased losses in senior credit, but the situation in publicly traded commercial property vehicles that own the equity is becoming increasingly dire. KKR & Co. (KKR) just put $50 million of fresh capital into one of its major property trusts and agreed to a plan to support its valuation as the money manager looks to weather the ongoing turmoil in commercial real estate. Starwood Property Trust, Inc. (STWD) has basically put its funds invested in CRE into “survival mode,” prohibiting redemptions by bond investors and refusing to mark or sell assets into a declining market. 

"Commercial Real Estate Values Continue To Be ‘Slashed’ 60% to 70%," writes Jonathan Miller of Miller Samuel in New York, "But Investors Still Trust The Asset." He continues:

"I’ve been posting commercial office price drops here fairly regularly and the anecdotal drop in value is hovering around two-thirds of the pre-pandemic value (before WFH was super-charged). The most recent commercial office sale in Manhattan was a 67% discount from a 2018 purchase. This building, 321 West 44th Street, ironically houses the headquarters of the Commercial Observer, a widely-read commercial office trade publication."

Yes, investors do still trust the CRE asset. That may change over the next several years, even in rarefied markets such as Dallas and South Florida. Our colleague Nom de Plumber, as usual, had some incisive comments earlier this week about the collapse of private equity and commercial real estate, and the coincident rise of the private credit trade by retail advisors and funds:

“Now that public pension funds and private endowments have been tapped out, and angrily await long-promised capital returns, PE sponsors can ignore them and raise new capital instead from high-net-worth retail investors. A new pigeon is hatched every day.”

While deteriorating asset quality for banks clearly is a problem, the real question that we cannot answer is whether the astute banks can sell enough first loss credit exposure to avoid the reckoning. Trouble in CRE also awaits funds and REITs. Nonbank investors are also utilizing private CRT transactions of various flavors to deal with commercial delinquency. What we and the short-sellers of bank stocks do not know is how much these private credit transactions will impact bank losses, provisions and thus earnings. When you sell the risk, you also sell the income.

Meanwhile, the firms that have been waiting for a Fed rate cut this summer may need to recalibrate their expectations and assumptions above cash flow. Business investments and capital spending are both falling due to the growing prospect that interest rates to remain elevated.  Default rates on loans to small businesses in April hit an annual rate of 3.2%, matching the highest level in at least a decade, according to credit bureau Equifax. All of this will impact loss severities on commercial exposures for banks and credit funds alike.

“It might be the ultimate risky bet,” write Laura Benitez, Allison McNeely and Natasha White of Bloomberg. “Pension funds, insurers and hedge funds are taking on the first losses of loan failures of banks around the world — without even knowing the identities of the borrowers behind those loans.”

The writers disclose a world that promises retail investors double-digit returns on blind pools of loans.  What could go wrong? Could there be a problem, to recall 2008, with this private unregistered collateral being pledged to more than one private credit fund?

Some type of CRT transactions are approved for banks, but the exotic repo-style transactions are more risky and include copious amounts of leverage. As the crowd of investors chasing private credit grows, the unlevered returns are being pushed down to mid-single digits.

"Investors poured about $200 billion into private credit funds between January 2021 and the start of 2024, swelling the coffers of general partners (GPs)," wrote S&P Global in May of this year. "This saw the size and market penetration of credit funds shift, with ticket sizes growing and the breadth of limited partners (LPs) investing into funds widening. The steep take-off in rates, which has more than doubled the yields of many private credit assets, has further propelled the growth of these funds."

How much in synthetic CRT transactions will be done in 2024? Our best guess is many hundreds of billions globally including institutional and retail HNW offerings. Add to this inflow of funds to banks the proceeds of ABS transactions, whereby banks are dumping all manner of consumer credits, auto loans and other assets into securities for investors. Huntington Bancshares (HBAN) just priced a $345 million ABS containing auto loans that was rated by Moody’s.

Banks are not the only sellers of assets in a feeding frenzy of private credit that is unfolding in 2024. Many private equity firms manage funds that are hopelessly underwater vs five years ago. The debt tied to these “private equity” deals with leverage was typically +500-600 over the 7-year Treasury at inception, but now the prospect of high single-digit or double digit coupons makes refinancing problematic. But the wave of private credit will accommodate these impaired assets as well.

As with the banks, losses will be mitigated by selling some of the risk exposure via instruments such as credit-linked notes. Both funds and banks are using these instruments to offload tens of billions worth of credit risk. The market for synthetic credit is actually more developed in Europe. Mayer Brown wrote an good primer on credit-linked notes last year:

"Many banking organizations have sought to use synthetic securitization to transfer credit risk and to reduce the amount of RWAs against which they must hold capital. This is because synthetic securitization allows the banking organization to retain the entire asset on its balance sheet and avoid realizing a loss on sale of the asset or foregoing the revenue stream provided by the interest-generating assets. In Europe and other jurisdictions, synthetic securitizations are common, with over $189 billion worth of synthetic securitizations being completed in Europe in 2023. However, only a few synthetic securitizations which include capital relief have been executed in the United States in recent years."

The pace of synthetic credit trades has accelerated. Yet the unspoken truth in the financial markets regarding this trend is that now two years into the tightening by the FOMC, the drop in new securities issuance that we outlined last month (“Inflation & CRE Deflation Too? UMB Financial + Heartland = ?”) has created a dearth of supply for every asset class except US Treasury bills. Nowhere is the scarcity of duration more pronounced than in residential mortgage assets, where loans with servicing are fetching record multiples.

Last week, for example, one Ginnie Mae issuer told The IRA that a recent vintage pool of mortgage servicing rights (MSRs) traded at 7x annual cash flows in a contested auction. The buyer, a large private issuer with close to $700 billion in unpaid principal balance of servicing, has never sold a single basis point of servicing income to finance loss-making operations. They got the cash, plain and simple. But as we note in our upcoming biography of Stan Middleman, founder of Freedom Mortgage, MSRs traded for 9x cash flow in the late 1990s.

The handful of public and private servicers that retain their servicing strip may now use their vast internal cash flow to buy market share and, ultimately, LT survival in a market where 90% of the residential mortgages are out of the money for refinance. And since 90% of the residential mortgage market is now controlled by nonbank issuers of conventional and Ginnie Mae mortgage securities, the fact that these firms continue to access the capital markets for debt finance further enables their hunger for MSRs.

The chart below shows bank owned MSRs, which remarkably still includes a representative portion of Ginnie Mae servicing in the $44 billion portfolio. Our estimate of fair value for the bank MSR portfolio is 1.71bp, but the current average mark reported by the banking industry is 30% higher at 2.21bp. Are the banks and their valuation agents wrong? Not necessarily.

Source: FDIC/WGA LLC

In a market where the issuance of new securities has been muted by the historic change in interest rates, everything is relative. The move in the 10-year Treasury from 2020 through to today is enormous in relative terms, making non-performing commercial assets trade at deep discounts and negative duration mortgage servicing assets trade at what seems a significant premium.

We think that the same logic that makes savvy investors in MSRs pay what seems like astronomical multiples for cash flows from servicing assets is going to literally rip the credit problems out of the banking industry through this year and next. The fact is that the banks need to raise cash and sell credit, and the growing army of private funds want to do just the opposite and in size. The two parties are going to come together and solve their mutual problems: mitigating credit losses for funds and banks, and a lack of easily acquired duration for investors. Whether investors like the actual returns is another matter.

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