Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here
“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.
Financial Times, February 20, 2020
Destructive Unintended Consequences
The Federal Reserve’s response to the Coronavirus crisis is having a significant impact on the mortgage industry. Some industry players believe capital losses within the sector could be on par with the 2008 financial crisis. The epicenter of risk is focused on capital requirements (mortgage lenders need to function) and covenants allowing them to do business. Lets us take a look…
One Loud Backfire
From March 2nd to March 19th, the brain-trusts at the Federal Reserve took the Fed Funds target rate from 1.75% to 0.25%. During the financial crisis, they made a similar move but it was over a 3-month period, NOT 17 days. The unintended consequences of Fed policy are more than significant, the yield on the 30-year mortgage soared. Unintended Consequences: housing, over 20% of US GDP is at risk as MOST of the entire US mortgage ecosystem is currently dysfunctional.
Three Year Break-Even
Mortgage servicers typically pay 1% of the mortgage loan amount for the privilege of typically earning 0.30% of the loan amount and the responsibility for forwarding the mortgage payments to the loan originator or secondary investor, taking care of insurance, taxes, and records. Thus the break-even for the servicer is a little more than three years.
Black Swan Drawdowns
Countless ETFs in the mortgage sector have crushed investors, large and small alike. Since non-bank financial companies now service most mortgages but don’t have access to the funding window at the Fed like banks do, aren’t these companies in for a massive liquidity shock once people start defaulting on mortgages?
Wipe Out
With the recent overnight collapse in interest rates, these mortgage loans will pre-pay rapidly. Thus the loans the servicers paid for vanish and the servicers see a loss from a wipe-out of their performing loan portfolio. Normally changes in interest rates are gradual enough such that pre-pays are gradually replaced with new mortgages. Not this time! On the other hand, unemployed mortgagers will default. When that happens, servicers still have to pay the interest to the secondary owner of the mortgage. And most servicers are levered to boot. In sum, the good loans go away, and the bad loans that remain leave no way to pay interest to secondary owners or their lenders. Most banks don’t own the mortgages. They package them up and sell them to ETFs that are bought by retired people. They sell them to pensions and insurance cos. Banks get paid to originate, not to carry them. A holiday would have minimal if any impact on Wall St., but CRUSH servicers.
“The Federal Reserve and its master (Too Big To Fail
Banks) are trying to thin [knock-out] the nonbank servicer
herd through margin calls. As usual Fed economists are too
theoretical to understand markets. Killing one, in crisis
leads to broad failures.”
Josh Rosner, New York Times Bestselling Author – Reckless Endangerment
Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here
Be Careful
In recent weeks, there is a meaningful amount of well-intentioned discussion about the suspension of payments (mortgage, car, student loans, etc); keep in mind contract rule of law, protection of private property (creditors) is constitutionally protected – a large reason investors flock to the USA.
Forbearance
Furthermore, the government has granted forbearance of mortgage payments. It is not clear that this is constitutional. Back in the depression, the Frazier-Lemke Act forbade banks from foreclosing on farms. The Supreme Court ruled that law unconstitutional. The good news is that a Mortgage Services Facility has been created to bridge mortgage servicers through this difficult period. The bad news is that it’s too little, too late.
Many mortgages were already in pre-payment and replacement just as the homeowners became unemployed. The new facility doesn’t contemplate that challenge. Defaults are not deemed collateral and the servicers are left holding the bag. Additionally, service fees have dropped from 1% to half that. While this means new portfolios may be bought less expensively, the servicers themselves are less creditworthy thus increasing their cost of capital. This loan conduit for the mortgage industry is a shadow of its former self.
Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here
Finally, lenders and servicers alike have hedged their portfolio risk against default by shorting mortgage-backed securities or their derivatives. But the Fed is buying MBS in its new QE program! Thus their portfolios have deteriorated while their hedges have run-up in their faces. The situation is so bad we believe the Fed* is about to reduce the pace of its former announce MBS buying program. The net result of the above is that the Fed’s actions restrain lending, the exact opposite of what the Fed intended. Whether or not the road to hell is paved with good intentions is a matter for debate. But the road to hell is certainly paved with the corpses of mortgage servicers.
*Note:
“The Fed bought $21B today and reduced the plan for the week from $40 to $30B, no more short settlement either. There should be a liquidity facility for the originators especially since the regulators caused this problem. They can’t allow the basis to blow back out though.”
Barry Knapp
“NY Fed task force to help servicers being formed and trying to figure out how to support servicers who will have to province timely interest and principal payments to investors from those who cannot pay their mortgages (forbearance).”
“The ramp-up in MBS TBA prices has led to unprecedented levels of margin calls on mortgage originators who use the TBA market to hedge their loan production and eliminate any interest rate risk. The situation became acute Monday leasing the Fed to announce a reduction in their daily MBS purchase: the pace of its MBS buying program. Housing, over 20% of US GDP is at risk as MOST of the entire US mortgage ecosystem is currently dysfunctional. TBA prices did end the day lower than Friday’s close after being up 1/2 point in the late morning. Independent mbs issuers are over 500 firms, the entire industry with 2 more days of ramped up MBS would have been insolvent. “
Larry McDonald
Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here
We know elephants leave footprints. Looking over the calm seas across markets, from the crow’s nest if a hedge fund manager David Tepper sees something meaningful risk wise, the first thing he does is takes 0.25% of this year’s p/l and deploys it at the cheapest, relative value protection. If David Einhorn joins him, Seth Klarman’s head trader as well, that’s fairly detectable. Of course, we have no idea what hedge funds are leaving the footprints, just using those three veteran investors as an example.
As you can see above, debt to EBITDA multiples at issuance > 5x have surged dramatically.
In recent years, the Fed has saved the day numerous times. First on ending rate hikes after promising to march on, then on quickly shifting to rate cuts, and finally a colossal capitulation on their beloved balance sheet reductions plans ($2.5T in reduction promises to recent $400B expansion of their balance sheet). There have been runs on leveraged loan funds, but each time the Fed put out the fire with a reversal toward far more accommodation. Even so, with all the Fed love, stresses are NOT going away!
We believe the market is underestimating this liquidity risk should the market face a true, prolonged downdraft.
As the chart above shows, most funds have over 60% invested in single-B and lower-rated assets, yet typically have cash positions at just 5% on average. One fund held only 0.32% in cash and yet had over 70% in single-B and below assets. In a prolonged sell-off, the 5% cash would likely prove grossly inadequate in the face of reduced overall market liquidity, lengthening settle times and a spike in redemptions. In a severe downturn, it’s likely that a significant percentage of the loans would be downgraded to CCC, rendering sale much more difficult and all the while prices likely would be collapsing.
The Blackstone GSO credit fund is loaded with lower quality (B rated) leveraged loans. It’s interesting with stocks ripping to new highs, B rated loans are under meaningful selling pressure as downgrades mount. If credit is weakening at this pace with a U.S. economy near full employment, what will happen when stresses mount?
In an attempt to support the Eurozone economy, since 2014 the European Central Bank has expanded its balance sheet by $2.7T and kept its deposit facility rate between -0.20% and -0.50%, suppressing the Euro currency. If there was a score for cheating on the global trade playing field, ECB chair Mario Draghi has a perfect “10”. Over the same time period, the Fed hiked interest rates 9x and reduced its balance sheet by $600B, per Bloomberg (since this clear policy error, the Fed has recently expanded its balance sheet by $200B and cut the Fed funds rate upper bound from 2.50% to 2.00%). This bizarre policy divergence between the Fed and ECB has empowered the global wrecking ball that has become the U.S. dollar. Trump’s bid to stay in the White House hangs in the balance.
In Q3, the U.S. Dollar’s surge to its October 1st peak of 99.67 (97.28 today) did some serious damage to manufacturing jobs in MI, WI, and PA (see the image below). This places TRUMP in a meaningful risk position, far more than U.S. equities are currently pricing-in. If you do the math, Trump CANNOT win these states in 2020 with a strong dollar. U.S. equities are at grave risk unless the White House / Fed can get the greenback down, and down fast.
Similar to 2015-2016, this year as the dollar soared, U.S. export products to other countries became far more expensive and manufacturing jobs in Michigan, Wisconsin, and Pennsylvania plunged. 
After the 2015-2016 US Dollar surge, manufacturing jobs in the U.S. came under serious pressure. We believe this factor, among others, cost Hillary Clinton the election. Heading into 2020, there are few things Treasury Secretary Steven Mnuchin and of President Donald Trump want more than a weaker Dollar. It’s probably not too much of a stretch to say that the Dollar’s 2014-2016 surge delivered Michigan, Wisconsin, and Pennsylvania to Trump on the back of undermined manufacturing and exports (see the above image, Dead Zone). The President clearly knows this and it’s part of the reason for his regular tweets and comments lamenting Powell’s interest rate 2018 rate hikes and the strong USD. Stay tuned.
Ridesharing companies LYFT, and UBER don’t have a moat in our view. It’s like “Chinese capitalism” (that funnels lots of profits to consumers, thus poor performance in the company’s stock prices). It’s a subsidy of consumers (Uber riders) at the expense of Uber shareholders and Uber Drivers.
The double-edged sword of duration is on stage here. Some investors like ultra-long maturities with low coupons because their prices rise dramatically when their yield falls. In the great race away from negative yields, over the last year, Austria’s long bond has doubled in value, while Silver is 32% higher, and gold up more than 29%.
The junk of the junk, why has CCC-rated paper dramatically underperformed while capital is flying into BB credits in the U.S. In the middle of the ‘everything rally’ – one would expect beta-chasing to drive demand for the highest yield, worst rated high bonds. That’s NOT happening. To us, this is an important signal, we’re very close to the ugly credit saturation point. Even with colossal pressure from central banks to reach for yield, rising default risks are keeping investors away from CCCs. What does this mean for U.S. stocks? Pick up our next report, just click on the link below.
The 2s 10s US yield curve spread inverted for the first time since mid-2007 on Tuesday. Despite many other areas of the curve having inverted earlier this year (3-month / 10-year for example), the widely followed 2s / 10s curve had the media’s attention throughout the day and helped contribute to the significant equity sell-off. When coupled with slowing global growth and rising geopolitical tensions, markets ran-away in fear, from this classic recession indicator.
