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Change and opportunity

| April 24, 2020

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.

Of the major balance sheets that largely make up markets and the economy, most will likely show effects of coronavirus that will last for years. The government balance sheet, largely led by the Fed, will likely become bigger and more influential than ever. The consumer balance sheet, strong before coronavirus but now faced with historic levels of unemployment, should leave a substantial new population of subprime borrowers. The corporate balance sheet, mainly its small or highly leveraged parts, looks likely to require years of repair. That leaves the financial balance sheet, which was and should remain strong. In change there is opportunity.

The government balance sheet

The Fed has already pushed its balance sheet to $6.5 trillion, according to the most recent H.4.1 report, and that’s before some of its biggest programs have ramped up. Since early March, the Fed has launched 14 separate efforts to respond to the coronavirus crisis. The Fed’s Main Street lending facilities, launched in partnership with Treasury, have some significant practical challenges to getting off the ground. But if the Main Street programs do get started and fully deployed, they could add $4.5 trillion to the Fed balance sheet. The Fed also launched a program in April to finance loans made through the Small Business Administration’s Payroll Protection Program, and that could add $670 billion to the balance sheet. The Fed balance sheet could rise to between $10 trillion and $12 trillion.

This will make the Fed a significant player across a wide range of markets including money markets, Treasury debt, agency MBS and CMBS, a range of ABS markets, investment grade and some high yield corporate debt, municipal debt, commercial paper and loans to small and large businesses. Fed policy will become a major systemic factor in each one of these markets on par with factors like interest rates, volatility, credit and prepayments.

Unlike like most systemic influences that get determined by the interaction of multiple thousands or even millions of portfolios, Fed policy largely gets determined by a group small to fit around one Federal Open Market Committee table. The FOMC will have extraordinary market impact for years.

There will also be government policy impact outside of the Fed, most visibly so far coming from the agencies that oversee US mortgage finance. The decision to offer mortgage forbearance and the terms for borrowers, lenders and servicers have had significant impact on the value of MBS and CMBS, mortgage servicing rights and the value of all business involved in mortgage finance.

In mortgage finance, systemic policy decisions largely get made in the circles around the Federal Housing Finance Agency, Fannie Mae, Freddie Mac, the Federal Housing Administration and the US Department of Veterans Affairs.

Congress will also almost certainly continue to make decisions in response to coronavirus that have market impact, likely by directing money through the Fed or banks or directly to different parts of the economy or the market.

For now, the Fed, the mortgage finance agencies and Congress are on their way into the markets, making investments or developing policies to address immediate issues. At a certain point, the efforts will reach a plateau before eventually receding. The markets over the next few years will price each inflection point.

With this amount of government impact on markets, investors will need to follow policy as closely as any other systemic source of risk and reward. The portfolios that anticipate policy well win, and everyone else just becomes beta.

The consumer balance sheet

An unemployment wave of historic proportion is in the process of crashing on a consumer balance sheet that seemed in good shape a few months ago. Unemployment was near a 50-year low and debt service as a share of disposable income at the lowest level on record. Household net worth had reached a record, too, although that disguised a majority of households with little savings and just a few paychecks away from insolvency.

If unemployment reaches the 15% to 30% range projected by a number of economists in the next few months and then glides back to single digits over the next year, the damage, even with government help, could linger for years. The consumer credit bureau Experian estimates that roughly a third of Americans have subprime credit scores between 580 and 699. Those consumers could use up a large part of their savings and go delinquent on a range of consumer debt. Consumer financial flexibility is likely to go down, not up.

The changing consumer balance sheet should affect the demand for and credit quality of credit cards, auto loans and leases, payday loans, installment loans, multifamily and single-family rental cash flows, among others, and the financial needs of the companies that serve those consumers.

The opportunity should come in knowing the relative value of existing cash flows backed by these consumers and anticipating the need for new credit from emerging subprime borrowers. As consumers come out of the pending wave of unemployment, many will likely need credit to adapt to rebuild their balance sheet and adapt to changes in the economy. Investors that follow the consumer closely through the current crisis should be in a good position to provide needed credit and build winning portfolios.

The corporate balance sheet

The sudden stop in the economy has meant a sudden stop in earnings for most of the global corporate balance sheet. The largest of those balance sheets, the public and the investment grade balance sheets, have plenty of funding available to help them bridge the gap to some kind of return to a new normal. Investment grade corporations have raised record amounts of debt since the Fed announced it would buy eventually buy it in primary and secondary markets. But small and highly leveraged balance sheets have had a much tougher time. The SBA’s PPP program should help small businesses for eight weeks. The Fed’s Main Street programs could help for longer, although it’s unclear that the Fed will be able to get the money easily to those borrowers.

Small and highly leveraged corporations likely have little room in earnings or liquidity to cover debt for too long, and many of those businesses will reemerge into a changed economy where the new stream of earnings will be thinner than before. A piece of the corporate balance sheet will likely liquidate, a piece will transition to new ownership and new pieces will emerge to take advantage of a new normal.

The opportunities on the corporate balance sheet range from distressed to stressed debt, existing and new CLOs and other forms of lending against leveraged loans, whole business securitizations, securitizations of business equipment, transitional commercial real estate and more. Investor here will need to deeply understand the markets served by these balance sheets and the strength of the balance sheets themselves. Much of the territory will be relatively new with no well-established incumbent. The investment opportunity goes to the fast learners.

Investors’ competitive advantage

Crisis tends to upend the usual state of markets, making investors competitive strengths and weaknesses important in taking advantage of opportunity. Some portfolios will have liquidity, other will not. Some will be able to take mark-to-market risk, others will not. But perhaps most importantly, some will have comparative advantage in information and others will not. There’s a lot of new information in the process of unfolding.

* * *

The view in rates

The current 0.60% rate on 10-year Treasury debt implies an average real rate of -51 bp and inflation of 111 bp. Implied inflation continues to rise, consistent with past episodes of QE. Futures continue to imply policy rates at the zero-bound into the middle of 2022. QE along with other monetary and fiscal interventions of historic magnitude should keep concerns about inflation on the market agenda and keep the yield curve biased to steepen.

The view in spreads

Spreads markets with Fed or fiscal support should continue tightening, and the impact of scarcity, broad liquidity, falling default and prepayment premia should tighten other debt sectors, too. Those markets now include Treasury and agency MBS, agency CMBS and investment grade corporate debt, a wide range of ABS, legacy CMBS and ‘AAA’ static CLOs.

The view in credit

The immediate risk in credit is from companies with high fixed costs and a sharp drop in revenue from current efforts to avoid coronavirus infection. Rating agencies have started downgrading companies and related structured products, CLOs in particular, at a record pace. Companies with the highest leverage are first in line. Until the arrival of pandemic, the consumer balance sheet has been extremely strong. The coming sharp rise in unemployment should change that, although the CARES Act could help cushion the blow. Nevertheless, delinquencies and defaults on mortgage and consumer loans have already started to climb quickly.

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jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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