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Trading on household credit

| August 7, 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.

Clues to changing bank investment demand and securities performance rarely show up in the New York Fed’s quarterly snapshot of consumer credit, but the latest report had a couple. Big shifts in credit card usage and a sharp rise in the credit score needed to get a new mortgage have investment implications for some banks and prepayment and credit implications for MBS. It is also clear that big parts of the consumer balance sheet depend these days on government support.

The New York Fed’s Quarterly Report on Household Debt and Credit provides a detailed picture of the consumer balance sheet, and that balance sheet shifted in the second quarter as the world changed with coronavirus.

Look for rising securities demand for credit card bank investment portfolios

Credit card balances plunged in the second quarter, likely adding to earnings pressure at banks such as Bank of America, Capital One, Discover, JPMorganChase, US Bank and Wells Fargo that hold large credit card loan portfolios. Card balances declined by $76 billion, the largest quarterly decline since the New York Fed began collecting the data in 2000. Most other loan balances—autos, home equity lines of credit, student loans—came in flat with mortgage balances up $63 billion. Sharply tighter bank underwriting on commercial and industrial, commercial real estate, mortgages and other consumer loans (see Fed’s Senior Loan Officer Opinion Survey released this week) and lower borrower demand has limited the ability of loan portfolio to lift banks out of a growing profit hole (see Bank strategies: Returns to duration, prepayment and credit risk). Banks have responded by adding securities. Demand at banks with big credit card portfolios may be particularly sharp.

Look for a falling supply of floating-rate ABS

Declining credit card spending and demand to keep loans on balance sheet contributed to a free fall in issuance of credit card ABS. Credit card issuance year-to-date in 2019 was $13.7 billion while this year it is $2.5 billion. Although modest in the context of the broader market, it is a decline in the supply of shorter floating-rate ABS.

Look for higher prepayment risk and lower credit risk in the newest mortgages

The median credit score of newly originated mortgages ran up in the second quarter to 784, the highest in the New York Fed’s records since 2003, likely leaving prepayment risk higher in the new loans and credit risk lower. Of course, the shift in risk profile assumes all other features of the new loans match past standards. The new highwater mark echoes the tighter mortgage underwriting standards reflected in this week’s Senior Loan Officer Opinion Survey. The strongest borrowers find it easier to refinance as originators crowd around borrowers that need the money the least, adding negative convexity to MBS. But the faster prepayments deleverage the security, and the borrower credit is stronger to start. Easier access to credit have already started shaping parts of the FSMT, GSMBS, JPMMT, WFMBS securitization shelves (see Smaller loans drive speeds and valuations in prime MBS). Look for securities backed by newer loans to show more negative convexity, better credit.

Of course, the flip side of tighter credit is that weaker borrowers may face more frictions, such as originators overlays, in getting new credit or refinancing old.

A cloudy outlook for consumer credit overall

Foreclosure moratoriums, forbearance and fiscal support from unemployment benefits and other programs have had dramatic effects on the consumer balance sheet, clouding the picture of credit should these policies lapse. Foreclosures, for example, dropped from more than 35,000 in March to less than 10,000 in June. The CARES Act automatically rolled all federal direct student loans into forbearance and waived interest, leaving an estimated 88% of private and federal student loans at the end of July with a scheduled payment of $0. This leaves securities most leveraged to the consumer balance sheet—speculative grade MBS and ABS—also leveraged to fiscal policy.

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