Economic Musings

JPM CIO swings, hits home run on UK RMBS

Thu, 16 May 2013 20:45:50 -0400

The embattled CIO unit at JP Morgan which was rocked hard last year by major losses from the “London Whale” saga hasn’t missed on all of their trades. A close look at their holdings in their $360bil plus available for sale (AFS) portfolio reveals pretty substantial bets on UK & Dutch RMBS.

As of year end 2012, JPM held over $70bil in non-US non-agency MBS bonds. This is a sizable stake in the European structured products markets, something that Reuters reported on earlier last year. “Indeed, the CIO almost single-handedly resuscitated European RMBS market in 2009, buying huge chunks of new issues and providing repo agreements on others. As one fixed-income head said, when selling European structured finance, the JP Morgan CIO was “your first call, your second call, your third call and your fourth call.”>

With the dramatic rally in all spread products, non-agency MBS bonds have been big winners, and JP Morgan looks to have began to trim their position during Q1 2013. Their 10-Q provides confirmation of this on Page 37 noting, “Securities decreased largely due to repositioning of the CIO AFS portfolio, which resulted in lower levels of non-U.S. residential mortgage-backed securities (“MBS”)”. Given the ZIRP environment and pressure on bank NIM’s, activity in the bank’s investment portfolio will continue to play a big role going forward. $684bil or 29% of the bank’s total assets are in cash, AFS securities, or secured financing as of 12/31.

Was a stealth tax in Cyprus the better idea?

Tue, 19 Mar 2013 23:34:00 -0400

The idea that the deposits of the average person in Cyprus (in addition to corporations, and Russian organized crime) could be confiscated via a levy has caused a great deal of fear in the financial markets. For instance, to people in the United States it almost seems unfathomable that you could wake up to have JP Morgan/Wells Fargo/Any Local Bank take 7-10% of your deposits.

Yesterday in the Financial Times, James Mackintosh showed a chart of the deposit rates for both Cypriot and German banks. The difference was easy to see, as deposit rates (less than 1 year) in Cyprus have averaged over 4% for the last three years while German deposit rates have hovered around 1-1.5%. As Mackintosh points out, over a three year horizon, a depositor in Cyprus would have earned roughly 13%, or ~10% over an equivalent German account. This difference, as he points out, is ~10% or nearly the exact amount that was originally proposed as the levy on deposits over 100k euros.

Better Idea?

I’m clearly out of my element to discuss bank specifics in Europe (let alone Cyprus!) but I will carry on anyways. US banks are all assessed fees (I’m simplifying the specifics) for FDIC insurance based on the amount of non-interest bearing deposits. So banks in aggregate pay out fees to “fund” FDIC insurance. Ultimately these costs are borne by the depositors as the bank incurs the cost of the insurance.

Instead of a publicly proposed/mandated tax/levy on deposits in Cypriot banks, could the EU/ECB not have accepted a “payment plan” from these banks? The banks could lower the deposit rates (Let’s say from 4% to 1%) and pay the difference as “ECB tax”. The cost of funds would remain the same for the Cypriot banks (all else equal), while the costs would still be borne by the depositors. This would be more like a “stealth tax” as the depositors would not feel this as much, and theoretically confidence would remain in the system.

Now there are obviously valid arguments to this. Would depositors keep their money in these banks at substantially lower interest rates? Isn’t this the return that is needed to entice depositors? How would you assign the tax rates among banks? I agree that this is no slam dunk, but you wonder if the same end game could have been achieved through lower deposit rates and the banks paying the difference in lieu of the levy. Thoughts? Am I crazy?

Pondering Fixed Income in 2013

Mon, 03 Dec 2012 21:02:00 -0500

I recently had a chance to speak with Loomis Sayles’ Matthew Eagan who is co-manager of the famous Loomis Sayles Bond Fund led by Dan Fuss. We covered a number of topics ranging from the Fed, Europe, High Yield, Hedging Tail Risk, and many others. You won’t want to miss it as he’s a very bright PM. It should be posted Wednesday or Thursday on the CFA’s Inside Investor blog found here.
I was honored to participate in Reuters 2013 Investment Summit last week in New York. In Katya Wachtel’s article titled “Chasing yield, investors favor credit again in 2013” I join in the conversation. Chasing yield is no doubt a continuing theme heading into 2013 as institutional investors far and wide are finding a diminishing set of opportunities available. You are starting to see non-agency MBS become almost “too popular” as every HF is suddenly an expert! Everyone thinks its a great play on a housing recover and an “easy way” to earn 4-6% returns. The low hanging fruit has been picked! Funds such as DoubleLine, Ellington, and Elliot have apparently moved more towards CMBS & CLOs versus incremental non-agency investments.
Heading into next year, I’d have to think that the majority of the run in high yield is over. HY spreads and yields are down 111bps and 131bps respectively. Defaults, which have run under 2% (and likely will next year too) really have no room to improve. At the same time you have very positive factors supporting the market. The boom has caused a flood of refinancings, thus debt maturing in the next few years has been dramatically reduced. HY becomes negatively convex as prices rise, so I anticipate little price appreciation, but rather just the “clipping of coupons” for investors which isn’t a terrible thing.
I’d prefer leveraged loans to HY: According to JPM, high yield absolute yields less leveraged loan yields are at only 57bps as of mid-November. Traditionally this spread is a fair degree higher given that loans are higher in the capital structure. As concern about interest rate risk grows, I think the retail sponsorship of leveraged loans will continue to grow as investors seek floating rate alternatives; and LL’s provide that. This along with growing CLO demand could boost LL’s next year. The average investor can gain exposure to LL’s through various mutual funds or a closed end fund such as $VTA.
UST Rate Explosion Unlikely: Sure UST rates could rise. Or they could fall. My prediction for 2013 is that it’s unlikely we see a dramatic rise in UST yields. Overall, there is still a dramatic lack of risk in the financial system. Everyone’s waiting for the next crisis, and in my opinion, that’s not what bubbles look like. While base money continues to explode through the Fed’s QE programs, broad money supply has been kept in check through a lack of bank lending. More or less, the money multiplier is negative at the margin. I find it unlikely we see a large rise in yields without a strong lending led recovery.
Agency Derivatives: Yes, this sounds like somewhat of an obscure asset class but that’s a good thing. The natural pool of buyers for securities such as IO’s, Inverse IO’s, etc is small and as a result option adjusted spreads are extremely attractive. You really can’t buy these on your own, but you can get exposure through closed end funds such as $DBL and $PDI.
Mortgage REITs: No way I was getting through this post without mentioning mortgage REITs. I mentioned at the Reuters summit that I thought mREITs (particularly pure GSE mREITs) would be poor investments going forward. Leveraging a bond that yields 1.5%-2% (same bonds the Fed is buying via QE) over 8x is not a great business proposition. As the Fed keeps their foot down via QE-infinity, prepayments will continue to accelerate causing margin pressures at the mREITs. At the same time prepayments accelerate, they will be forced to redeploy this cash back into lower yielding bonds. This is a bad formula and dividends will be cut more than investors realize. I can’t tell you when, but you’ll see names like AGNC, NLY and others trade a lot lower next year. If you remember, I was actually a HUGE mREIT bull last year into the first half of 2012. Here was my post on Two Harbors written last July. The massive price appreciation in Agency MBS fueled large gains in mREITs, but I think this party is largely over. MBS prices may tread water, but margins are in trouble and that equals lower dividends and subsequently lower share prices.

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Ex-Morningstar Analyst Confirms What We Already Know: Analysis is Lacking

Mon, 03 Dec 2012 20:07:00 -0500

One of my favorite blog pieces that I have written was undoubtedly “Is DBLTX misunderstood? Is the fund victim of faulty analysis & biased research?” No, it wasn’t fun pointing out mistakes made by various individuals. Rather, the enjoyment was found in setting the record clear on an investment management start-up (DoubleLine) that was being unfairly scrutinized by faulty and shallow analysis.

Earlier today a friend forwarded by an article written by a former Morningstar analyst named John Coumarianos who worked at Morningstar for six years. His conclusion was hardly shocking as it lined up nearly exactly with what I had written last December.

Gundlach accuses Morningstar of not understanding his approach to fixed income, and it’s a good bet that Morningstar’s analysts aren’t capable of analyzing a mortgage-backed security to the point of understanding which cash flows are owed to which tranche of a debt security Gundlach might own, what the FICO scores of the underlying borrowers are, what the loan-to-value characteristics of the security or tranch are, etc…Morningstar’s response conveyed by Don Phillips is that it’s “reprehensible” for Gundlach to demand that senior fixed income fund analyst Eric Jacobson be fired for misunderstanding the fund.

There’s an old saying in the bond market: “There are no bad bonds, only bad prices.” That means that some or all of the non-agency mortgages Gundlach owns may be excellent investments purchased at the right price, but it’s not clear that Morningstar knows how to judge the price Gundlach paid versus underlying or intrinsic value of a mortgage-backed security. Certainly Moody’s and S&P couldn’t perform that task adequately prior to the implosion of AAA-rated subprime CDOs. Morningstar, having achieved a largely unblemished reputation for protecting and assisting the individual investor and many advisors who, in turn, serve individual investors, may have to rethink its enterprise if it can’t analyze mutual funds on a security level basis. It’s not as clear that Gundlach’s request is reprehensible as it is that Morningstar is holding itself out as delivering analysis that isn’t worthy of the name.

The team at Morningstar is human, and I am by no means stating that any sort of mistakes are unacceptable. Unfortunately, in the line of business that Morningstar is in, they are perceived to be a trusted source of mutual fund analysis. My analysis from last December clearly showed that Morningstar missed the mark with respect to DoubleLine, and the post from the former Morningstar analyst only appears to confirm this thesis.

The day after Halloween

Thu, 08 Nov 2012 22:44:27 -0500

Halloween was a fun time in our household this year, our four year old was finally old enough to have fun, dress up, and eat a lot of candy! As is probably typical in other offices throughout the country, many of my colleagues brought in leftover Halloween candy and the office collectively made ourselves sick on chocolate.

By the second day the large bowls had largely been picked through and only the least desirable snacks remained. Reese’s Cups & Snickers were long gone. As I stood over the bowl I began to try and convince myself that the remaining “bad snacks” could still be good.

Although it’s a stretch of a comparison, the same type of feeling is now present in the fixed income markets. The low hanging fruit has been picked. Years of income have been pulled forward through rapid capital appreciation. Yields and spreads have come in substantially. We are no longer in the early innings where easy money was made across the credit universe in high yield, non-agency MBS, IG Corps, levered loans, and so on. The relentless buying of Agency MBS has pushed investors into spread products and thus richened almost all areas of the bond market. Smart money has adapted and is now forced to become more selective. A good example is Ellington Financial (run by Mike Vranos) which said the following in their earnings release today:

In the third quarter, the market for non-Agency MBS rallied significantly. As home prices continue to stabilize (and are even trending higher in many regions), and as mortgage default rates continue to decline, investor demand for non-Agency RMBS has continued to increase. Meanwhile, alternatives for higher yielding investments in those other fixed income sectors where investors typically search for higher yields, such as Agency RMBS and investment grade corporate bonds, have become more limited, thereby further increasing the demand for non-Agency MBS. With interest rates currently at historically low levels, many financial institutions (such as pension funds and insurance companies) are finding that they will be unable to fund their long term liabilities without increasing their allocations to higher-yielding asset classes; we believe that this state of affairs will continue to provide support for the non-Agency MBS sector.

Later on Ellington discusses how they became less constructive on non-agency MBS and have found great opportunities within CMBS. Vranos isn’t the only renowned MBS manager to recently take a liking to CMBS. As I discussed in a recent post over at Inside Investing, DoubleLine’s Jeffrey Gundlach has also made a move into CMBS.

"The incredible mispricing of risk"

Tue, 23 Oct 2012 22:32:24 -0400

Earlier this week I published a piece on the CFA Institute’s Inside Investing section titled: Mortgage REITs: Does Doubling the Leverage Make Them a Good Investment? The post was my response to UBS launching an ETN that provides 2x leverage on a basket of already heavily levered mortgage REITs “mREITs”.

In short, I believe it’s a dangerous product as many investors in the underlying REITs have little idea how 10%+ yields are being generated. Moreover, they don’t understand the scenarios that could lead to a significant decline in share prices. To paraphrase the great Howard Marks, “…do not confuse adding leverage to an existing investment with increasing return…if you take a 10% return in a security and lever it up 4x and after financing costs generate 15-20% returns, you haven’t increased your returns, you’ve just increased your leverage and significantly increased your risk, but you’ve also got a 20-25% downside threat”. I think this thinking certainly applies to mortgage REITs today.

A bigger threat is upon us

Last week Annaly Capital’s CEO Wellington Denahan-Norris (who this week replaced the late Michael Farrell who tragically passed away), said some very interesting comments to Bloomberg on the state of the risk markets. After discussing the impact of the Fed buying Agency MBS she said:

“It’s not just at the mortgage REITs where the returns in this market are being put under assault, It’s the general global landscape where you have an incredible mispricing of risk that’s being delivered at the hands of academics at the central banks of the world.”

I could not have said it better myself. I am firmly in the camp that both credit and duration is being dramatically mispriced due to the actions of the Fed. They’ve created a reckless chase for yield that is being driven not so much by greed, but rather by needs based investing. The yield piñata has burst and participants far and wide are scurrying to accumulate what they can across all sectors of the fixed income markets: IG corporates, CMBS, Non-Agency MBS, High Yield, Levered Loans, Munis, and others.

While equity focused investors don’t see the direct impacts of the Fed’s purchases, the spillover is pronounced in fixed income and is causing imbalances far and wide. When I read the article about UBS’ new 2x leverage mREIT product, I couldn’t help but think that we are starting to see signs of these policies backfiring as the chase for yield has reached a more than unhealthy level.

Annaly's Michael Farrell Downplays the USA's Currency Sovereignty

Wed, 17 Oct 2012 23:13:00 -0400

If you’re a regular reader of financial journalism (including blogs such as this) you’ve frequently encountered the argument that the United States is in no way comparable to a country like Greece. This argument, which I generally agree with, states that US is a sovereign currency issuer while Greece does not have control over their currency as they are part of an union. Greece can’t just print their way out of a debt crisis unlike a country who controls their own currency like the US.

Tonight I was reading a commentary (a few months old) by Annaly’s CEO Michael Farrell that goes back to the Civil War time frame and makes an interesting argument that fiscal union alone isn’t everything.

Much has been made about the contrast between the fiscal union in the United States and the lack of one in Europe, but recall that in 1861, eleven southern states decided to dissolve their economic and political ties with the United States of America, leaving the Union with twenty members and five border states.

Thus another lesson of the Civil War is that fiscal union alone is no solution if an economy is facing a drastic change in fiscal circumstances and steep growth in debts and deficits. Today the United States has a unique, historical opportunity to lead the world out of the current mess. But it is my concern that our political system is so polarized that we will be unable to seize the moment and capitalize on it for the benefit of all Americans.

Second Quarter 2012: Fiscal Union, Civil War

Will bonds be "burnt to a crisp"?

Mon, 08 Oct 2012 14:43:17 -0400

That was the question that Bill Gross asked in his latest monthly outlook. For now that’s likely much more of a fear tactic, but as investors we must always understand the risk/return characteristics of our investments.

In my latest for the CFA, I perform some very elementary bond math on the 10yr treasury showing the risk/return for various movements in interest rates. I then look at the holdings of the barclays aggregate index, which many bond funds are based upon, to give investors an idea of what they may be holding.

It’s getting tougher and tougher now to be invested in the fixed income markets. Previously attractive risk/return asset classes such as non-agency MBS, high yield and others do not have nearly the “margin of safety” they had even nine months ago. Central bank balance sheet expansion has changed the economics of the fixed income markets. Everything has rallied and we need to constantly re-assess the attractiveness of such investments.

The premise of his article is that the United States needs to get its fiscal house in order or else the Fed will be stuck printing money to pay the debt deficiencies. Strangely, Gross asserts that the United States will resemble Greece if deficits are not conquered.

That is nonsense because the United States is a currency issuer and can never run out of dollars. Greece, in contrast, is a currency user and cannot issue euros at will. But in any case, investors are coming to the conclusion that economic problems cannot be solved by monetary policy alone. In this, Gross is correct; the United States’ and other countries’ decisions on fiscal policy will be the key determinants of future economic performance.

I am thoroughly convinced that, in the interim, fixed-income asset prices will be largely driven by central bank policy. My earlier post on QE went through the mechanics of QE3 and how it has affected various fixed-income classes. Understanding the capital flows caused by the Fed’s balance sheet expansion is important but not essential to understanding the full fixed-income universe.

Fixed-Income Strategy: Are Bonds Poised to Be “Burnt to a Crisp”?

The QE Aftermath: What it Means and How it’s (not) Different

Tue, 18 Sep 2012 23:17:47 -0400

The latest in my recent posts for the CFA Institute. I think overall I am more bullish on the actual economic impact that QE has had via the refinancing channel (it’s very material), but maybe more skeptical on how perilous of a hole the Fed is digging itself into by buying so much of the Agency MBS market. I obviously think the ramifications and understanding of QE are crucial in the day and age in which we live. I’ll post an excerpt below and read the full version on the CFA’s website. Thanks!

ther risky asset classes as the prices of these bonds rise (yields fall). To put the purchases in perspective, it’s important to understand the monthly production of agency MBS.

At the moment, about $125 billion of agency MBS (mortgages backed by Fannie Mae and Freddie Mac) are produced each month. Through Operation Twist and the reinvestment of previous rounds of QE, the Fed is already purchasing ~$30 billion of bonds per month.

Add in the $40 billion per month that was just announced for the third round of QE (QE3), and the Fed is purchasing ~$70 billion of the ~$125 billion that is produced each month. Purchasing nearly 60% of the gross issuance of MBS obviously has a major impact on the market and forces investors into other asset classes.

The data support the clear benefits that QE has had and will continue to have in certain segments of the economy. Nevertheless, unemployment is persistently high, inflation is relatively tame, and wage growth is anemic. How much will this iteration of QE really be different from QE rounds in the past?

Nomura’s Richard Koo, creator of the balance sheet recession theory, pointed out that monetary policy has lost its effectiveness when the private sector is deleveraging (or minimizing debt), despite near zero interest rates. More and more signs of this deleveraging are appearing in the U.S. economy. While major corporations shrewdly lock in long-term debt at record low rates, average Americans are reducing their mortgage terms. Instead of cutting their term in half and keeping the same monthly payment, they could be investing and spending the savings. Although I’m not saying people should be doing this, the psychology of decision making in the United States promotes deleveraging in many respects.

The QE Aftermath: What it Means and How it’s (not) Different

Non-Directional Fixed Income Strategies

Mon, 27 Aug 2012 21:51:43 -0400

The below article is my third contribution for the CFA Institute’s new Inside Investing blog. They are making a strong entry into the blog world, and I’m more than happy to write for such a respectable organization. In the coming weeks I plan to dig into the various funds that I discuss below in greater detail including specific bond holdings.

Despite historically low interest rates and the risk of future rate increases, there are ways to make money in the fixed-income market.

Many investors today wonder whether the “ship has sailed” on investing in bonds. Apart from missing the rally, a number of prominent investors have been vocal about their decision to be short U.S. Treasuries over the last few years. These bond bears are quick to point out that the asset class is in a 30-year bull market and that absolute rate levels leave little room to fall.

The objective here is not to point out short-term market fluctuations but, rather, to highlight the typical fears that reluctant bond investors face. It is not practical to time or predict interest rate movements, but it’s helpful for investors to understand that the success of various fixed income strategies isn’t necessarily predicated on continued falling rates.

A handful of actively managed bond funds have shown significant relative outperformance in the face of a multitude of interest rate outcomes. Certain strategies and combinations of assets can perform well without needing rates to fall further.

Full article: Non-Directional Fixed-Income Investing Strategies

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Fed eyeing a new kind of twist?

Tue, 07 Aug 2012 21:09:25 -0400

To QE or not to QE dominates economic headlines of late. Lost in this debate is a readily available but under the radar tool that the Fed has at its disposal. Slowing global growth, and subsequently lower interest rates, has given credit worthy borrowers an opportunity to continue a now annual tradition of refinancing their mortgage. While many are content, mortgage market participants know that the primary/secondary mortgage spread shows that rates should be even lower!. More specifically, this spread is above 50-70bps higher than the longer term average. Big banks have failed to ramp up capacity, and consequently the rate between what MBS holders earn buying a bond and the rate the borrower pays has expanded.

What does this have to do with the Fed? An astute Credit Suisse analyst pointed out this week that the Fed could perform a “MBS Twist” operation in which they sell up in coupon premium MBS pools and buy lower coupon MBS which could have the affect of lowering mortgage rates to borrowers. In their own words:

“…this policy will specifically target the near par secondary MBS rate, the key driver of the primary rate that is offered to the consumer. Consumers spend “permanent income”, not temporary tax rebates…Operation MBS twist will reduce mortgage payments and redirect consumer cash to increase M-velocity and bump up inflation.”

To put this in perspective, the Fed owns ~$530bil of Fannie 4.5-5.5% pools (purchased during QE1) in which they have an unrealized gain of ~$32bil. 30yr 3.5’s (borrower rates of 4%) still comprise the lions share of origination volume, but 30yr 3.0’s are in production now as well. Pushing down on 3’s and 3.5’s by buying almost all new production could, as CS points out, help compress the primary-secondary spread.

This idea has not just been floated by CS. In a note today, Jefferies told of a recent call in which the Fed mentioned that their systems are now in place for selling mortgages. Like the team at Credit Suisse, the analyst at Jefferies believes this could be a precursor to an event where the Fed sells higher coupon bonds and buys 3’s and 3.5’s. While certainly not the glamor of a multi-hundred billion dollar balance sheet expanding QE program, this could be very effective and something we see Bernanke unveil in September.

HARP: TBTF banks laughing all the way home

Mon, 06 Aug 2012 22:05:29 -0400

The Economics Behind the HARP Program

HARP, The Home Affordable Refinance Program, is a streamline refinance program developed to help borrowers who have continued to make their mortgage payments, but have be unable to refinance due to a decline in their home value. Underwater borrowers have been stuck in a “no-win” situation of sorts, being stuck in a well above market mortgage rate (over 6% in many cases) despite being current on their existing loan and maintaining strong credit. Various fees and a LTV ceiling cause the original HARP program to flame out unsuccessfully. Blame was quick to be cast among the major lenders, the GSE’s, as well as the Government.

The early results of HARP 2.0 are in, and the program’s modifications appear to be spurring strong activity. Are the big bad “too big to fail” banks finally relenting and playing ball? As an investor in the securitized mortgage market, I see aspects of the market that the average borrower or market participant does not. In this post I will walk through the economics of mortgage origination for HARP loans, break down exactly how much these banks are making, and how they are able to do so.

Mechanics of Securitization

Many realize that mortgages are sold into Fannie/Freddie pools but few know the intricacies. If a borrower has a rate of 4% on a 30yr mortgage, the investor of the pool only receives 3.5%. The remaining 0.5% (50bps) is split between the servicing fee and GSE “guarantee fee”. Similar 4% loans will then be aggregated together into a pool. A “30year 3.5” is a pool of 30yr 4% mortgages with a coupon of 3.5%. As of today’s close, a 30yr 3.5% pool trades at a price of ~$105.75. If you tack on the 1% origination fee that most charge, and the servicing rights which are valued at another 1%, the originators (Wells Fargo, JP Morgan, Bank of America) are making almost 8points on a standard plain vanilla conforming mortgage.

Historical spreads of what’s known as the “primary-secondary” spread show that mortgage rates are actually higher than they are supposed to be. The current coupon mortgage rate measures the yield of the hypothetical par mortgage (30yr 3’s trade at almost 104 so there’s no tradable par bond). Today that rate is 2.34%. The average 30yr mortgage rate to borrowers, as measured by Bankrate, is currently 3.61%, or almost 130bps over the current coupon rate. Longer term this primary/secondary spread averages closer to 70bps, not 130bps, so rates are about 50-60bps higher than they should be here.

The Value of HARP Loans

HARP loans are particularly valuable in the eyes of investors due to prepayment friction. A borrower may only “HARP” a loan once. As these borrowers are generally all under water on their loan, it isn’t feasible to finance into a standard loan. As such, these borrower are trapped in these loans. The street, with good reason, projects these mortgages to prepay very slowly going forward. To mortgage investors, the stability of these cash flows due to extremely low prepayments is worth significantly more than the average pool.

Our example above showed that a 4% mortgage rate would trade into a 3.5% pool which is a $5.75 profit to the bank excluding origination. The value of HARP loans can vary, but these typically trade up at least 2-3 points over TBA collateral. ”TBA” is the industry jargon for generic new collateral. So if a 4% HARP loan was originated and quoted at +3, the price would be $105.75 + $3.00, or $108.75. Add on the origination and servicing fees and near 11 point profits are being earned.

Lack of Competition is the Driver

One of the quirks with the HARP program is that you’re only allowed to enter into a HARP loan with your original servicer. Noted mortgage analyst Laurie Goodman of Amherst Securities explains, “HARP 2.0, announced in November 2011, introduced significant new benefits to servicers for refinancing their own loans. In contrast, different servicer refinances received at best marginal improvements…This tends to lock a borrower into refinancing with their existing lender, which conveys tremendous pricing power to the banks. A lack of competition has allowed current servicers to charge higher rates to these borrowers, when the economics of origination would suggest lower rates are in order. And borrowers have little choice but to pay the higher rates, as the rules favor same servicer refis to a very strong extent.”

The Menendez/Boxer bill being tossed around Congress proposes to allow borrowers to enter into a HARP loan with different mortgage originators. This would ostensibly create greater competition and lower profits for the three main originators (Wells Fargo, Chase, and B of A). To nobody’s surprise, the big banks are adamantly against this proposal and it’s easy to see why. Not only would their oligopoly on HARP loans be put into jeopardy, but the extra premiums which are able to be extracted would also go down.

Summary

While it is encouraging that more and more underwater homeowners are gaining the benefits of today’s low interest rates, tremendous profits are being made at their expense. Lack of competition is the primary catalyst, but the underlying economics to the large “too big to fail” banks will do nothing but stoke additional anger in the general public. Expect this trend to continue until the dynamics of the program is changed once again, possibly in HARP 3.0. Until then, the cash cow will continue for the TBTF banks.

QE3 feels near but here's two reasons why it's different this time

Tue, 24 Jul 2012 22:09:00 -0400

Late in the afternoon today word came via Bernanke pal Jon Hilsenrath that the Fed could be moving closer to taking additional actions to spur growth. There’s little doubt in my mind that this is indeed the case. In a recent note Bridgewater estimated that in the past few months global growth has slowed from a 3.3% rate down to 1.9%. This lower global growth should inevitably also cause lower inflation, leading developed market central banks to loosen policy via Quantitative Easing while emerging market central banks choose rate cuts. Whether you agree with these policies or not, I believe recent economic developments will cause the Fed to act.

Astute observers have noted that the recent plunge in US Treasury yields has primarily been a decline in real yields. Ten year break-evens, as an example, have declined only ~20bps since May down to 2%. Ten year nominal yields have dropped over 50bps in the same time period falling under 1.40% as of today’s close. Despite Chairman Bernanke profession that “additional tools” remain in play, I believe we will see additional large scale asset purchases “LSAP’s” in the form of Agency Mortgage Backed Securities. What will this accomplish and how is it different than last time?

Just as the repeated usage of an anti-biotic can have diminishing benefits, I believe that the impact of QE too will see a diminished impact. Here’s two reasons why:

1.) Little impact will flow through to mortgage borrowers

Initial QE programs were a large contributing factor in falling mortgage rates. Remember during QE, the Fed removes securities from the system and replaces them with excess reserves held at the Fed. In the earlier versions, the impact to primary mortgage rates (the rates the average borrower receives) was actually fairly substantial. Many borrowers refi’d from a rate over 5% or 6% and into something in the 4% range. This was a direct redistribution from mortgage bondholders to individual borrowers leaving them with higher disposable income.

Today things are dramatically different. Despite mortgage bond prices climbing to new all-time highs, the borrowing rates haven’t moved down as much. The metric used to gauge this called the primary/secondary mortgage spread measures the difference between the 30yr current coupon MBS yield and the average 30yr fixed mortgage rate that borrowers receive. Historically this spread has been in the 75bp range. Today it is sits approximately at 140bps. Thus rates to the average borrower are about 60-70bps HIGHER than they should be based on MBS prices today. Banks are refusing to increase capacity, and the benefits of incrementally lower rates are NOT being shared proportionately with the average borrower.

2.) Other fixed income “risk asset” yields are substantially lower today:

One of the major goals of QE, if not the primary one, is to encourage a “portfolio rebalance” impact by encouraging investors to buy risk assets. The Fed says so themselves! The markets were very different during previous QE programs. For instance, trading in securitized markets such as non-agency mortgages was extremely thin and systemically important financial entities such as banks had large unrealized mark to market losses on these bonds. It wasn’t uncommon to see loss-adjusted yields above 10% for fairly decent collateral. Today non-agency yields are generally in the 5-7% range with cleaner stuff trading in the 3-4% range. 10yr AAA muni yields are in the mid 1.60%’s, substantially lower than a few years ago. Absolute yield levels on high grade corporate bonds hit a record low last week according to JP Morgan. I could go on with examples but the point is clear, there is a massive global hunt for yield and additional QE programs aren’t necessary to accomplish this chase. That being said, an argument can be made that the ultimate risk asset class that the Fed wants investors buying is stocks. Even so, in previous QE iterations, it caused dramatic flows out of “risk free” assets and into distressed markets. Today’s yield starved market is anything but that.

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Shadow Inventory Trends & Projections Show Worst is Behind Us

Wed, 11 Jul 2012 13:21:00 -0400

Some really interesting charts today from JP Morgan showing shadow inventory and bank owned properties among others. It’s clear that we are in the midst of a dramatic fall in both overall shadow inventory as well as REO inventory. The second chart, as evidenced by its title, shows where the remaining shadow inventory exists by location.

These trends are obviously not self-sustaining as the economic recovery is necessary for continued healing in the sector, but those looking for signs of overall improvement can look here for some evidence.

Which banks have felt the greatest impact from ZIRP?

Fri, 06 Jul 2012 13:00:00 -0400

Earlier this week, I wrote about three mega-cap stocks which I believe are cheap. JP Morgan was one of the choices, and I described how I believe banks are no longer given credit for the value of stable deposit bases. It’s really easy to see why - the Federal Reserve’s QE program removes securities from the system and replaces them with excess reserves. By now it should be well understood that the amount of excess reserves has everything to do with the Fed’s bond buying program and nothing to do with bank lending. Banks are flush with cash and ZIRP (zero interest rate policy) seemingly has no end in sight.

A bank’s net interest margin (NIM) is the difference between their cost of funds (liability cost) and their asset yield. Banks with stable core deposit bases previously had lower cost of funds than “hot money” banks which had to compete for deposit based on enticing customers with higher rates. This is GREAT in a non-ZIRP environment and typically lead to large margins.

In the ZIRP environment, there is a floor to a bank’s liability cost - zero. Banks with a strong core deposit base cannot lower their cost of liabilities much more. Who can? Banks which rely/relied heavily on wholesale funding (brokered CD’s etc) and now have a large amount of liabilities which are repricing downward. The consequences of the Fed’s low interest rate policy have done an interesting thing; disproportionately benefit banks which relied on non-stable sources of funding.

This thought led me to dig into the data a little deeper. In the universe of banks, how have the stocks performed which have a high cost of funds? How have the banks performed which have a low cost of funds? My test led me to screen in Bloomberg for all US listed banks which have a market cap of greater than $20mil. My cost of funds measure was “Interest Exp/Avg Int Bearing Liabilities”. Now banks have both interest & non-interest bearing liabilities, so this metric isn’t perfect, however if an institution is reliant on wholesale funding it will show up here. Performance was measured by YTD total return.

The median and average 1 year total return’s for banks with a cost of funds over 1% have been 17% and 25.7% respectively. This compares to banks with a cost of funds under 1% of 12.6% and 17.2% respectively. Now each bank has other factors which obviously drive stock performance, but there is clearly something here. Should we continue to be a prolonged low interest rate environment, we should see this trend continue. It makes sense that banks which are disproportionately benefiting from low interest rates would outperform. Time will tell whether this will continue.

5 charts that tell it all on student loans

Thu, 05 Jul 2012 15:42:00 -0400

A great report was put out today by Neal Soss and Dana Saporta of Credit Suisse on the Student Loan situation in the US. Here are five charts that stood out:

Three mega-caps with big value to be unlocked

Mon, 02 Jul 2012 09:16:20 -0400

The ups and downs of the post credit crisis markets are enough to drive the average market participant crazy, and certainly enough to push the average American largely out of stocks. Billions of dollars has continued to flow into bonds, and material inflows to equities haven’t been seen in years. I have written fairly extensively on bonds the past year, and this post will be a break from that topic. I can’t tell you whether or not today is a good time to buy equities versus tomorrow, next week, next month or next year.

The purpose of this post is to assume that someone wants to own equities “long term”, and can withstand a moderate/high amount of volatility along the way. I would preface volatility to mean systematic risk (risk inherent to the whole market), and not unsystematic risk - risk particular to an individual company etc. Now I’ll undoubtedly get people who say, “buy and hold is dead”, and “how long is long term?”. Those are valid comments and questions, but again the purpose is to identify a handful of equities that look cheap due to unlocked value (legal&regulatory overhang, management risk, macro-environment etc) but which value I believe will be realized in the medium/long term.

JP Morgan ($JPM)

I am very comfortable holding JP Morgan, but first here are two assumptions I have regarding their future. 1. Future “Big Whale” type events while still possible are unlikely. 2. The US yield curve, which has materially flattened over the past few years, will not stay as flat as it is long term. The current and obvious overhand on the stock is the trading loss, which while not material to capital or P&L levels, has impaired JPM’s reputation as a rock solid “conservative” bank. Here is what I believe are where the Street is getting it wrong:

1. Value of core deposit base: Longer term, JPM has substantial advantages that people often forget living in this ZIRP environment. JPM has a very sizable and stable deposit base. This is overlooked as ZIRP has caused the cost of funds on most banks to come down substantially. In other words, banks (including JPM) are already paying people near nothing on their deposits - and they can’t lower this expense any further. Conversely, as assets reprice in today’s environment, may are repricing lower. Liquidity is so plentiful right now, that the value of a stable deposit base is not what it once was.

If/when short rates move up, JPM will have a substantial advantage as they will maintain a deposit base that won’t reprice up as fast as competitors. The implications to this are obvious, assets will likely reprice faster than liabilities and NIM will expand. Nobody knows how long we will stay in this interest rate environment, but my bet is that it won’t be forever. Liquidity will, at some point, leave the banking system, and banks with a stable deposit franchise will trade at a premium once again.

2. Valuation: The combination of the ZIRP environment, the recent multi-billion dollar trading loss, and general disdain for large banks has caused JPM’s valuation to fall close to 1x P/TBV. Valuing JPM which is still generating a very respectable ROE (and nice dividend yield), like it will perpetually be unable to monetize on its valuable deposit base is unreasonable and a bad bet in my opinion. A more likely scenario is JPM growing its equity and seeing a multiple which reverts close to 1.5x P/TBV. On a 2-3yr horizon, I see a very skewed return distribution ($5 of downside versus $15-20 of upside) to the upside as the aforementioned headwinds are pricing JPM like ZIRP is forever & it will have a perpetual risk management problem.

Novartis ($NVS)-

Some of the reasons for choosing this stock are very generic and common. For one, big pharma is “cheap” and very defensive to various economic cycles. Next, the stock (and sector) throws off a ton of income with the dividend yield in the 4.5% range. Now after this, I think there are some compelling reasons for owning NVS versus other large pharma stocks that provide a better risk/reward profile. The stock has admittedly had a lot of headwinds with manufacturing problems and patent expirations. As a comparison, has underperformed virtually the whole the peer group as well as Swiss competitor Roche by over 11% during the TTM.

The major catalyst that Novartis can eventually realize is the embedded value of the Alcon business, an eye care products company gradually acquired over the past five years. This unit, which should be a long-term beneficiary of an aging population, is projected by management to grow top line in the double digit range over the coming years- an estimate significantly higher than the Street saw. As far as the patent expirations go, skepticism is ripe whether NVS can replace the looming lost revenue of Diovan - but this may be overblown. Though I’m not a huge fan of sell-side research, I believe the analysts at Morgan Stanley have a realistic view of NVS: “Novartis shares are pricing in a near worst case scenario post recent headwinds. 2012 represents the trough year and we see potential for pipeline surprises, cost saving opportunities and improved shareholder returns. Risk-reward is attractive and valuation is underpinned by a ~5% dividend yield and 10% FCF yield.”

Now admittedly, part of the reason I like $NVS is wanting a piece of a mega-cap pharma in general. These companies in general are very defensive, and I believe lowers the overall risk to a portfolio. That being said, it is debatable whether NVS is the best way to gain exposure within this sector.

BP ($BP)

Like JPM above, BP is largely viewed as a very cheap stock that lacks visible catalysts that would unlock the value. The TNK-BP situation has been a disaster and it’s uncertain what the outcome will be. Despite the political drama of the venture, the operational performance of TNK-BP has been strong. In 2011, according to JPM analysts, the BP share of TNK-BP dividends accounted for 13% of BP’s cash flow,19% of BP’s earnings, and 29% of their production. After investing over $8.3bil in the entity in 2003, BP’s has recovered over $9.7bil in cumulative cash flows - a 12% IRR since 2003. The current equity market value of ~$19bil would imply a yield based on 2011 dividends of over 20%. Analysts speculate the 50% stake could sell for a 25%-75% premium, with a 50% premium around $30bil.

The other obvious overhang with BP is the lack of a settlement with the Gulf oil spill. A resolution would obviously remove the uncertainty associated with this large liability. BP has a laundry list of famous value investors as holders of their stock including Seth Klarman’s Baupost fund. On almost any metric you look at (P/E, Dividend Yield, P/B, EV/EBITDA), BP screens very cheaply on an absolute and relative basis. Various analysts have sum of the parts valuations for BP to have anywhere from 30% to 100% upside. Its my view that too many positive potential catalysts are present for BP to continue to trade at these levels. As a bonus, the stock theoretically has decent positive carry with a dividend yield of ~5%. Any combination of strong global growth, a positive TNK resolution, and/or the gulf settlement could lead BP to trade closer to its estimated intrinsic/SOTP valuation.

Heavy Hitter Leaves TCW, Tips Hat to Gundlach

Thu, 28 Jun 2012 23:22:08 -0400

Remember the coup of December 4th 2009? TCW CEO Marc Stern announced the ouster of Jeffrey Gundlach and, to replace him, not the hiring of a new chief investment officer but the acquisition of an entire company, Metropolitan West. Remember the aftermath? Clients cutting bait, outflows of assets, more than 40 TCW professionals quitting to join Gundlach, and recent the explosive growth of their new firm, DoubleLine Capital.

Within weeks of the DoubleLine/TCW trial jury verdicts, financial media in New York and Paris, all quoting anonymous sources, began reporting efforts by SocIete Generale (the parent of TCW/MetWest) to auction off the Los Angeles-based firm. In late 2011 Mutual Fund Wire , Bloomerg News and in France the financial daily La Tribune published articles to the effect that SocGen was shopping TCW/MetWest to other asset managers.

La Tribune reported the bids were disappointing, and after that, news of a possible sale. Of TCW/MetWest went quiet.

But recently, fresh reports by Reuters and Pensions & Investments say that TCW/MetWest management, with the help of private equity financing, is trying to pull off a management buyout. However this would-be MBO has an ironic twist.

Whereas TCW was the acquirer of MetWest, a report this week in Pensions &Investments suggests that the tables have turned; it appears that yesterday’s acquisition target (MetWest) is seeking to become today’s acquirer. According to Pensions & Investments, citing anonymous sources, a handful of MetWest executives — David Lippman, Tad Rivelle, Laird Landmann — are working with private equity firms to buy control of TCW/MetWest. Quoting the P&I report:

“Although Marc Stern is the CEO (in name), David Lippman is really the virtual CEO,” said a source who asked not to be named. “In many ways, MetWest engineered a reverse takeover, assuming much control over the investment management and operations of TCW,” the source added.

So it’s probably safe to say the TCW/MetWest merger hasn’t materialized as some at TCW and SocGen had hoped. When the TCW/MetWest merger was announced on December 4th, 2009 it was reported that cumulative AUM was $140bil. The MetWest merger was made with the intent of taking some of the sting out a Jeffrey Gundlach-less organization, the superstar portfolio manager of the TCW Total Return fund who was controversially fired. By the time the deal closed in late February 2010, that total had dropped to $115 billion. So the transaction caused an outflow of $25 billion, some of it no doubt attributable to Gundlach’s departure. TCW reports total AUM of $128bil as of 3/31/2012. While some of the MetWest & TCW funds have performed well, the combined entity still has not gotten back to the combined AUM reported on the day of the acquisition.

“Heavy Hitter Leaves TCW”

A friend recently sent me an interesting academic paper (I highly recommend you read it) titled “The Golden Dilemma” by Claude Erb and Campbell Harvey in which the authors discuss the current merits of gold as an inflation hedge. I knew the name Claude Erb sounded familiar and a quick Google search reminded me of his past.

First, Erb and Harvey authored an academic paper on commodities and diversification/rebalancing that won them the prestigious Graham-Dodd award. Second, Erb was previously a managing director at TCW under Gundlach and, shortly after the coup of December 4th, 2009, initially made the decision to join the DoubleLine team only to return back to TCW days later.

Erb’s change of heart soon made its way to the media. Morningstar Director of Fixed Income Research Eric Jacobson, no stranger to readers of Economic Musings, broke the news in a December 18th, 2009 article under the headline: “Big Hitter Leaves Gundlach, Returning to TCW”. The Morningstar Fund Times article also included a tagline that emphasized Erb’s decision might spell more trouble for Gundlach’s start-up firm, the tagline reading, “Decision raises question of whether others might follow.” Near the end of the article, Jacobson speculated, “This decision does call into question, however, the unity with which Gundlach’s team acted so immediately after his firing. Moreover, it suggests the possibility that others who committed to joining him could eventually come to decisions similar to Erb’s.”

Erb was certainly a valuable catch for TCW, and now its fair to wonder what caused the Graham-Dodd award winner to leave. One of two commodity portfolio managers left for DoubleLine, so getting one of them back would seem to have been a rational priority for TCW. But contrary to Jacobson’s speculation that others “could eventually come to similar decision’s as Erb’s,” no one else at DoubleLine went back to TCW.

I don’t know what motivated Erb’s decision to return to TCW. Stories in the press indicate that TCW tried desperately with offers of enhanced compensation to lure a number of former TCW employees back from DoubleLine A BusinessWeek article published last month recalled that TCW CEO Marc Stern personally drove to the home of Gundlach’s co-portfolio manager, Philip Barach, to offer Barach $10mil a year over six years to come back to TCW.

The departure of Erb in at a time of open sale speculation around TCW/MetWest leads to more questions than answers. But let me refer back to Pension & Investments article:

“Another issue for both TCW executives and any potential private equity backer would be the willingness of star performers from the TCW side of the business to work under a MetWest triumvirate.”

Whatever Erb’s feelings toward the “MetWest triumvirate,” he no longer is a potential subject of their governance. As for Erb, he still apparently thinks well of Gundlach with a complimentary attribution of him in the “Golden Dilemma” paper.

Meanwhile, DoubleLine has achieved some of the fastest growth in mutual fund with assets growing to over $35bil today from inception in April 2010. After Erb, no one from the DoubleLine investment team went back to TCW, despite reported efforts by TCW to buy back the rebels and Eric Jacobson’s public doubts about the unity of the DoubleLine team.

Two bonds that DoubleLine bought over $1.7bil of last month

Fri, 22 Jun 2012 12:55:35 -0400

While people tend to flock to the DoubleLine Capital conference calls, I’ve always been more interested in tracking the bonds that they buy from month to month. After all, with AUM in the Total Return Fund now exceeding $27bil, they need to be buying a TON of bonds. Where do they see value? How does that fit in with housing and macro views?

In retrospect, the fund has changed a lot over the past two plus years. When the fund opened in March of 2010 the 10yr was over 3.5%, and non-agency MBS prices were generally much lower across the board. With rivals fretting about “who will buy all of those treasuries”, DoubleLine prudently bought a large amount of duration in the form of last cash flow Z CMO’s at deep discounts. The key rate duration of these type of bonds were tied to the 10-30yr part of the UST curve, and they obviously rallied tremendously as the 10 & 30yr now sit at 1.66% and 2.75% respectively. Today’s rate environment is very different and so are the opportunities in fixed income.

The relatively stable loss-adjusted yields produced by non-agency MBS are still available, but they’ve come in with the overall yield chase. Furthermore, with billions going into the total return fund each month it becomes more difficult to source as attractive bonds as it was when the asset base was a fraction of today’s size.

What are they buying today with these massive inflows?

After reviewing the fund holdings of DBLTX as of May 31st, 2012, a few purchases were notable. DoubleLine added over $1bil of newly issued 20yr 3.5% pools and nearly $700mil of 30yr 4% jumbo pools. The 3.5% pools are borrowers with a rate of ~4%. Looking at total issuance for May, it appears DoubleLine bought about 1/3rd of the total issuance of these bonds. This collateral has been pretty slow with prepays generally under 10c. Not a super sexy bond, as it will likely yield somewhere in the 2.30%-2.60% range with a spread of ~1.35% over USTs, but the bond would be a strong performer if rates continue to fall and/or QE3 comes around.

Blame Ben not Jamie

Sun, 13 May 2012 22:01:00 -0400

I could write a whole post on whether this whole JP Morgan trading loss is being under or overstated but I won’t. For the record, I think given that the $2bil loss, which is ~0.5% of JPM’s total capital, shows that the magnitude is being a bit overstated. Nevertheless, the concerns of the critics are reasonable. Does Dimon even know what risks JPM is taking? How can the banking industry keep any semblance of credibility when the most conservative of the TBTF’s had a massive risk failure? I digress to my main point.

Wealth effect & impact of QE

It is well established that Ben Bernanke is a big proponent of the “wealth effect”. That is, if the stock market is higher people “feel wealthier” and thus react accordingly. The mechanism of this is also clear and straight-forward. The Fed has purchased trillions of dollars worth of US Treasuries, Agency Debt, and Agency MBS. How does it work mechanically? The Fed sends newly created reserves to banks and in return receives the securities. So while no new “net financial assets” are created, fewer securities are in the financial system and a whole lot more reserves. This is what many refer to as “printing money”.

As I’ve talked about here and here QE has undeniably pushed up asset prices. We have 30yr current coupon Agency MBS with a yield under 3%, IG spreads at ~200bps, and higher grade non-agency MBS yields pushed down to 4-5% in some cases. Let’s not forget covenant lite deals returning in the levered loan space. Mortgage REITs have quintupled in asset size as investors salivate over 15% yields. (Hint: levering up 8x on a 2.75% asset which is hedged using swaptions is no slam dunk. These will blow up at some point). No need to go on any further. As my friend likes to say, this is the “great incredible paper chase”.

Amount of excess reserves is NOT caused by lack of lending

As we have gone over so many times, the quantity of bank reserves are determined entirely by the size of the Federal Reserve’s policy initiatives and in NO way reflects bank lending. The moral of the story is these reserves will be at SOME bank, only selling securities would “drain” these reserves.

Banks are in a pickle

Are there any negative implications of the QE policies? The quantity of risk free securities is down (Fed owns ~15% of Agency MBS as well as USTs etc). Banks and other institutions can continue to bid up the prices of these “risk free” assets but eventually they can also opt instead to earn IOER of 25bps at the Fed.

Why do banks need to follow suit with this yield chase? The are attempting to save any sort of profitability as measured by ROA and/or NIM. One major reason that NIM (net interest margin) is under pressure is that banks have already lowered the cost of their liabilities as much as possible. You probably realize your bank pays you little/nothing on your deposits. Now that they already pay little on deposits, lowering their cost of funds/liabilities any further is no longer material.

The obvious next step to saving NIM is making it up on the asset side. Assuming growing loans/increasing pricing isn’t feasible today, banks are attempting to save margin in their investment portfolio. With the Fed pricing many banks out of the Agency MBS & Treasury market, they are forced to either take on greater duration (interest rate risk) or go down in the credit spectrum (credit risk).

Ben, you had to know this was coming

Some institutions are buying longer bonds, and others are returning to structured products such as non-agency MBS and CMBS. Other banks afraid of taking on credit risk are buying long duration bonds which exposes them to great amounts of interest rate risk in a rising rate environment.

Banks are starving for interest income due to the ZIRP environment. The Fed has fundamentally propped up these markets and forced banks among others to either invest at inflated prices or go chase credit. Guess what Bernanke wanted and guess what is happening?

Bernanke is not responsible for risk failures at JP Morgan or any other TBTF bank. BUT, he certainly has fostered an environment that has encouraged investors (which includes banks) to take on risk due to their meager alternatives. Risk has crept into an area that is typically conservative on many levels.

It is said that the job of a central bank is to pull away the punch bowl before it gets out of hand. While the Fed pays close attention to inflation, it has left the punch bowl out in the chase for risk assets and is contemplating spiking it even further (QE3).

How will this end? Should we expect that revelations such as the JP Morgan trading losses will not occur given such policies? A chase for risk is what the Fed wanted, only the intention was not for it to occur at banks.

This one’s on you Ben.