Setting up outside the banks’ front door
admin | September 21, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The 2008 financial crisis left its mark on a lot of things, including lending. Bank standards tightened sharply on most loans in the years after the crisis and have only modestly loosened since. Slowly into the breach has stepped private capital willing to take risk just beyond the banks’ front door. And as it has in the past, the mortgage market is providing some of the clearest examples.
As Chris Helwig points out in his note this week, the private securitization market has increasingly left the legacy of 2008 behind and has started bringing a new generation of loans to market. The new loans show a clear divide between the type of lending that banks seem to prefer and the type other investors seem to like. In general, bank standards are narrow. Standards at money managers, REITs, finance companies and hedge funds—the new lenders—are broader.
This is not the only market where private capital has set up shop right outside the bank door, but it is increasingly visible. Anecdotally it’s happening in corporate lending and commercial real estate, in student and consumer loans. Other markets, too. The mortgage market, where data just seems much more readily available, is only where the light shines the brightest.
Helwig points out that a new set of loans has started to come out in sufficient volume to need financing and risk transfer through private securitization, and the pace has picked up this year. The securitization shelves sponsored by banks, however, seem to focus only on the loans with the most pristine credit, including a healthy set of loans that otherwise would go into Fannie Mae or Freddie Mac securitization. The shelves sponsored by private equity, finance companies and asset managers seem more comfortable with broader risks. The list of attributes that constitutes risk beyond the comfort zone of banks is interesting:
- Expanded prime: FICO credit scores of 660 to 750 with small variances in loan-to-value, debt-to-income or payment history
- Prior credit event (PCE): A recent foreclosure, bankruptcy, deed-in-lieu or short sale that occurred too soon for GSE securitization, which could be anywhere from two to seven years ago
- Alternative documentation: Income and asset verification that varies from strict Qualified Mortgage standards, often involving bank statements in lieu of tax returns
- Business purpose: Loans for 1-4 family rental properties outside the purview of GSE lending
- Foreign nationals: Borrowers without a FICO score or credit report due to a lack of permanent US residence
These are the mortgage lending niches apparently left behind by banks, and they bear a striking resemblance to the types of loans that showed up in private securitizations in the late 1990s, well before the lending excesses that lit the fuse on the 2008 crisis. The lenders presumably consider these niches as ripe with creditworthy borrowers, and post-crisis requirements that securitization sponsors retain risk gives the lenders incentives to get the lending process right. From 1995 through mid-1998, when the Long-Term Capital Management crisis blew up the market, B and C lending made up between 10% to 14% of total mortgage originations, well above the current expanded credit share of less than 3%.
The lenders standing outside the bank door already have started shifting the possibilities for fixed income managers. Some of the loans will likely make their way into private MBS and ABS. Others will go into the portfolios of direct investors. Other portfolios that end up holding loans will need financing secured by the loans, financing that is roughly equivalent to a position in a securitization.
Banks, surely at the urging of their regulators, look unlikely to ease lending standards anytime soon. The opportunity for money managers, REITs, finance companies, hedge funds and other platforms looks likely to grow.
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The view in rates
The forward market says the 10s30s part of the Treasury curve will nominally invert before the end of this year—dead on, according to some of my colleagues. That timeline seems eminently reasonable. The 2s10s part nominally inverts a year from now, according to forwards, but that seems too slow. Strong growth and low unemployment give the Fed good reason to keep raising policy rates faster than forwards imply. The 2s10s curve should beat the timing and magnitude implied by forwards.
Next week the FOMC should lift the curtain on its expectations for fed funds through 2021 and show its projections for growth and unemployment. The projections for fed funds should give the market some indication of the potential peak in policy. It should also indicate whether the neutral rate has moved up or not. Growth projections may show some glide toward long-run potential. And unemployment projections should likely show when and by how much the Fed expects unemployment to dip below NAIRU and then drift higher. Historically the Fed has had a tough time pushing unemployment up without triggering a recession, so the market should be watching the unemployment projections closely.
The view in spreads
Spreads have marginally tightened in the last few weeks, with investment grade corporate, high yield and emerging markets debt slightly tighter in September and agency MBS slightly wider. Puzzling. Strong US growth might make a bullish case for spreads for now, but longer trends run in the other direction. The Fed is draining liquidity, the risk profile of investment grade credit keeps rising with corporate leverage and growth in ‘BBB’ debt outstanding. Anecdotal evidence suggests that investors are starting to reallocate away from investment grade credit and into other things. Although agency MBS is likely to do better than credit, the gravitational pull on spreads generally should be wider.
The view in credit
A good economy solves a lot of problems, and a strong equity market helps, too. Near-term risk in most credit seems benign, but the risk from any softening in the economy keeps rising. Leverage has kept rising in investment grade debt, higher LIBOR has kept the pressure on interest rate coverage in leveraged loans and a stronger US dollar has softened prospects for emerging markets. Household balance sheets look strong by comparison. The fundamentals would argue for reallocation from corporate into consumer debt.