The Financial Crisis Is Not Over
The June Monthly Commentary By Annaly Capital Management.
- The Economy: The financial crisis is not over
- The Residential Mortgage Market: The tale of "fails" in the mortgage market
- The Commercial Mortgage Market: Comparing spreads for commercial real estate loans vs. securities
- The Corporate Credit Market: The return of credit risk
- The Markets: Sell in May and go away…for how long?
We begin this month’s commentary with the same sentence we used to close our last one: In case anyone needed a reminder, the financial crisis is not over. The uncertainty over Greece has spread to other corners of Europe and prompted deep soul-searching and grudging action by the central planners of their monetary union. Here in the US, Congress gets down to brass tacks on finalizing a financial regulatory reform bill that was conceived in the middle of a crisis with little apparent regard for potentially negative unintended consequences. (One example: the capital required for 5% risk retention by mortgage originators will likely impede meaningful recovery of the securitization market and won’t help underwriting standards. Another example: the amendment to require banks to spin out their derivatives operations lives on despite the protests of Bair, Bernanke and Volcker, people who presumably know better.) And signs appear that the economic recovery might be built on sand after all, with the housing and job markets flashing yellow and the risk of deflation rising.
Market participants acted rationally in the midst of all this uncertainty. They sold risk and embraced safety. Equity markets were down across the globe. The S&P 500 was down 8% in the month, besting the Nikkei (down over 11%), but trailing the FTSE 100 (down 6.1%) and the Hong Kong exchange (down 5.2%). Volatility picked up significantly, taking the VIX up 45% in May, from 22.05 to 32.07. The 10-year Treasury enjoyed the spoils of a flight to quality bid, sending the yield down to 3.31% at May 31 from near 3.70% a month earlier (at the time of this writing it is down even further, to 3. 17%). The euro dropped precipitously to below 1.20 to the dollar from 1.33 a month ago (and 1.50 late last year). Commodities also lost their bid during May, with the CRB Commodity Index falling 8.25%. Gold, however, managed to rise from $1,179/oz to $1,214/oz (even more in euro terms).
On inflation, it’s hard to be that surprised about the downside in CPI given that the monetary pressures aren’t there. Money supply, as measured by M2 plus institutional money funds, is falling by 4% year-over-year, a pace not seen since the early 1930s. Growth in the monetary base due to excess reserves would be worrisome, if not for the fact that the money multiplier is currently less than one and well below normal levels, meaning that increases in the monetary base aren’t making it out into the money supply. Why is the multiplier so low? New loans, the mechanism by which increases in the monetary base make it out into the money supply, aren’t being made. After a one-time upward adjustment due to the implementation of FAS 166/167, total loans and leases on commercial bank balance sheets have continued their steady decline.
Wage pressures have been absent as well. Both real and nominal personal income have stagnated and remain below pre-recession peaks, particularly when deducting the very large government transfer receipts. Another interesting way of looking at wages is the Bureau of Labor Statistics data series on unit labor costs, which looks at both sides of the labor market coin: the cost of labor (compensation), and the production of labor (output). Unit labor cost is a ratio measuring hourly compensation per hourly output, or how much do we have to pay in labor costs for each unit produced. This ratio incorporates the idea that technological advances can be deflationary, as better production methods enable us to produce the same amount with less labor input.
One of the interesting characteristics of the calculation of unit labor costs is that the ratio uses nominal wages but real (inflation- adjusted) output. This allows the ratio to be interpreted as an output-adjusted measure of wage inflation. As the graph above demonstrates, back in the inflationary 1970s, unit labor costs were growing quickly and the high growth rates were sustained for several years in a row. We are currently experiencing quite the opposite, as unit labor costs are declining at an unprecedented rate. Last Friday’s nonfarm payroll report contains plenty of clues about why this may be, namely the 15 million unemployed workers who make up the pool of available labor to be drawn upon once companies resume hiring.
The Residential Mortgage Market
Prepayment speeds in May (June release), increased as expected across all 6% Fannie Mae product classes as the company completed the second stage of its three stage buyout program of loans that are delinquent by 120 days or greater. The vintage that experienced the largest month over month increases was 30-year 6s originated in 2007 which spiked to 78.6 constant prepayment rate (CPR) from the previous 35.4 CPR, followed by 2006, 2005 and 2008 vintage 30-year 6s which printed 74.5, 74.3 and 66.6 CPR, respectively. As Barclays Capital analysts wrote: "For lower coupons, a 1.5-day drop in day count and an abatement in buyouts offset a seasonal uptick in housing turnover. As a result, Freddie and Fannie 4.5s through 5.5s decelerated 0.5 to 2 CPR, and Freddie 6s and 6.5s slowed 3 to 4 CPR." Interestingly, the data in this month provided the first post-buyout comparison for a Fannie and Freddie coupon, the 6.5s. The Fannie 2007 6.5% coupon prepaid 2.9 CPR faster than its Freddie counterparts, likely due to higher delinquencies in the Fannie cohort. In the same report Barclays provided its prepayment estimate for the immediate future: "For the next prepayment report, a 1.5-day drop in day count, diminished refinancing activity, and a lower buyout pipeline should push down Freddie paydowns by 15 to 20%. While there should be a similar slowdown for Fannie voluntary prepays, this should be more than offset by a pick-up in buyouts. As a result, we expect Fannie paydowns to increase about 5%, with 2007 5s and 5.5s reaching 53 and 63 CPR, respectively."
As we suggested in our previous month’s commentary, just because the Federal Reserve’s agency MBS purchase program is complete does not mean that its market impact is over. We continue to see a problem with "fails" in the system, because there is not enough collateral to fill the bid from the Federal Reserve’s MBS purchase program in the to-be-announced (TBA) market. This will likely continue to be a driver of performance going forward. Nomura Securities recently put out a research piece that quantifies the extent of the problem. "Gross fails by primary dealers have spiked up from $100 billion in the first half of 2009 to $600 to $700 billion in the first quarter of 2010," they write. "What is even more interesting is that gross fails by primary dealers have suddenly spiked up over the week ending on May 19th to $1.058 trillion versus $665 billion over the TBA settlement week in April. Essentially, dealers (and indirectly investors sometimes), are choosing to provide 0% financing rather than delivering mortgage pools on TBA settlement days." Nomura further elaborates that "the volume of fails in the system is expected to be high because the MBS purchase programs of the Federal Reserve and the Treasury have caused a significant reduction in the float available in 30-year [Fannie and Freddie] passthroughs." As a result of these "fails" from the Federal Reserve’s mortgage-backed security purchase program, agency mortgage-backed securities are likely to remain well bid for the foreseeable future due to light daily origination activity.
The Commercial Mortgage Market
Commercial mortgage-backed securities (CMBS) followed the spread movements of corporate securities in May. This spread volatility makes it problematic for the Street to re-engage commercial mortgage conduit lending programs. As a result, the life insurance companies have stepped in to become the primary, if not the only, significant source of debt capital to the commercial real estate market. How does the pricing for commercial mortgage loans compare to CMBS and investment grade corporate bonds? Stated another way, does commercial mortgage pricing reflect the same spread movements of its securities counterparts? To tackle that question, we reviewed commercial mortgage data produced by the American Council of Life Insurers (ACLI).
The ACLI releases its Commercial Mortgage Commitments survey approximately 45 days after the close of the calendar quarter (60 days or longer following year end). Participation in the survey is voluntary, but it covers approximately 75% of the market. The scope and methodology of the survey ".. .includes long-term (over one year) mortgage commitments on commercial properties in the U.S. and its possessions, including maturing balloon mortgages, which have been financed for more than one year at current terms. It excludes standby loans, loans secured by land only, social responsibility loans, tax-exempt loans, and purchases of existing mortgages and acquisitions of mortgage-backed securities."
While the survey consists of typical aggregated mortgage loan data including loan-to-value ratios, loan per unit, property type, geography and maturity, we focused on the commitment amounts, interest rates and spreads. Given that the commercial debt markets began to resuscitate after September 2009, we examined mortgage commitment activity for the six month period ending March 31, 2010 and compared the spreads on commercial mortgage loans to super-senior CMBS and investment grade corporate bonds. While spreads on CMBS have generally rallied since October 2009 thanks to superior liquidity as well as other technical factors, commercial mortgage loan spreads have been stickier. That is caused by the fact that mortgage origination was just starting to revive and originators wanted to be more conservative with their pricing. This market was also a lender’s market where lenders could push pricing. A second reason is that many of these life companies were completing ‘forced economic extensions’ or ‘extending and pretending’ their maturing mortgages during this period. All cash flow from the properties was captured and allocated by the lender to optimize the return on and return of capital. Their desire was to generate as high an earned rate (i.e. spread or coupon) as possible on these assets to maintain performance on their commercial mortgage portfolio.
As fund managers at the life companies seek the best relative value for their funds during 2010, commercial mortgages on stabilized properties (tenanted, in-place cash flows) continue to attract attention. As a result, life companies have become more competitive in lending against certain properties and accept less of a pricing premium relative to other investments. With transaction volumes not matching the capital available, commercial mortgages have been reported to price in the area of 5% or approximately 200-225 basis points over the applicable Treasury since the last ACLI survey date of March 31, 2010. Therefore, as we show in the graph below, when the 2nd quarter 2010 ACLI survey is published in mid-August, it will show commercial mortgage loan spreads have moved towards their corporate investment grade securities counterparts.
The Corporate Credit Market
Risk aversion has emerged in full force in the corporate credit market. European sovereign woes serve as a reminder of a familiar theme: the concentration of positions and corresponding de-risking of portfolios can drive correlations across asset classes. How many of us can forget the initial consensus view of a little, and presumably isolated, problem called subprime a couple years back? It’s hard to argue that U.S. corporations and countries like Greece have anything fundamental in common. Yet, the painful lesson that "technicals" can morph into "fundamentals" is fresh. The root problem dragging down the weakest link can be more widespread than casual observation suggests. As we discuss above, policy shock is a risk that presents itself from both the financial regulatory reform germinating in the U.S. and European bailout packages. Risky asset prices are falling, in part, in anticipation of another round of financial deleveraging.
May was the worst month for credit performance since the post-credit crisis rally commenced. High yield cash bonds lost 3.5% of their value as spreads crossed back above the 700 basis point mark based on Bank of America Merrill Lynch’s bond index. Cumulative mutual fund outflows for the past five weeks are the weakest since 2002. We suspect some of these sales reflect profit-taking from high double-digit yield entry points and will not find their way back into the high yield market anytime soon. The spectacular performance of loans was also thwarted in May as the loan market lost 2.5%. These two markets are cousins if not sisters: a critical driver of loan performance has been the refinance trade into the high yield market. As the chart below shows, the breakneck pace of bond issuance has come to a halt. A large portion of prior new issue is under water by 3 to 4 points.
Moving up in quality to investment grade, total returns were a small negative, buffered by the drop in Treasury yields. However, thanks to a 47 basis point rise in option adjusted spreads, their returns fell short of Treasuries by 2.7%, the worst showing of this measure since October of 2008. Furthermore, many "crowded" trades —overweight financials, long credit curves, short Treasuries, down in quality, and underweight agency mortgages— have been correlated with each other.
"Interventionist government" is a global secular theme de jour. Thus, Congress is working to have a financial regulatory reform bill for President Obama’s signature by the July 4th holiday. The specifics of the Senate bill, in particular, have weighed on U.S. financial spreads. Most notably, a "Resolution Authority" would be charged with conducting liquidations of distressed financial institutions. "Bailouts" are expressly prohibited. Since the rating agencies give large cap banks "credit" for governmental support, the long-term rating outlook for these institutions is clouded by presumed deleveraging (e.g. utility-like model) on the one hand, and the removal of the too-big-to-fail (e.g. lower rating) option on the other. The rating agencies are taking their time, but removing the support of too-big-to-fail would likely mean a downgrade in the short term rating for many to A2/P2, thereby limiting access to the short-term debt markets. Furthermore, given the heavy weighting of financial bonds in the cash bond index and their high float, they are high beta when investors are quick to sell, thereby contributing to their underperformance compared to industrial bonds in down markets.
Both the sovereign crisis and U.S. regulatory reform will result in deleveraging of financial institutions in Europe and the United States. The aggressive liability management that has transpired over the past several months should keep default risk at bay in 2010. However, longer term a more regulated banking system could reduce the availability of credit to the most risky firms. One unknown is the degree to which other types of institutions or financial vehicles fill the gaps. One known, in contrast, is that policy uncertainty is currently feeding risk aversion.
May was a good month to own bonds, gold and the dollar. It was a bad month to own stocks, credit risk and most commodities, including oil. Welcome to the summer of market exhaustion, volatility and uncertainty. Sell in May and go away? Apparently so, but for how long?