Author: Dwight Cass

Dwight Cass

Mnuchin is Right: the Fed’s Zombie Feast Must End

It seems counterintuitive to shut emergency financial market support programs in the middle of a pandemic and recession. But Treasury boss Steve Mnuchin’s move to force (there’s no other word for it) the Federal Reserve to let its most underused, and economically damaging, special purpose vehicles (SPVs) lapse as scheduled on December 31 is the right thing to do. Indeed, it should have been done sooner, before the programs prompted the most lamentable, economically distorting feeding frenzy for credit zombies and leveraged lenders the world has ever seen.

Mnuchin broke the news to Fed boss Jerome Powell on Thursday, sending markets fluttering. Financial reporters wrung their hands. The usually sensible FT moaned:

The move by Mr Mnuchin jeopardised a very effective partnership with Mr Powell that was crucial to securing a hefty US policy response to the coronavirus crisis early on. The central bank made no secret of the fact that it wanted to preserve the credit facilities being axed by the Treasury secretary as a key weapon in its arsenal to keep markets healthy during the pandemic.

Mnuchin notes that the five SPVs that Treasury wants to shut down (four others, which back short-term lending markets, will be renewed for another 90 days) succeeded. Oddly, they did so despite barely being used. The mere fact that the Fed said it would buy corporate bonds and bond ETFs juiced the lending markets to the point where they shoveled money at even the dodgiest credits. Not bad for jawboning. The Fed bought about $25 billion of securities under the programs (which had a total capacity of $2 trillion). This is a rounding error compared with the other QE programs that have swelled the Fed’s balance sheet to over $7 trillion.

Fed Balance Sheet

Hot air, even in finance, rises. The Fed’s hot air caused the markets to abandon any notion of credit discrimination. Cruise lines and airlines borrowed billions. Every zombie with a working phone could get an investment bank to float its bonds.

Wolf Richter summarizes Mnuchin’s 12 reasons for pulling the plug here. Among the list of ostensible successes are the breathtaking volumes of junk and investment grade corporate bonds, municipal debt and asset backeds, issued since March. The cost of funding meanwhile became uncoupled from any reasonable credit fundamentals. Mnuchin notes that the spread on investment grade corporates has fallen from a peak of 4.06 percent to 1.40 percent, and on junk bonds from 10.78 percent to 4.94 percent.

So, the stated reason for pulling the plug is that jawboning worked, even if it was not backed up with actual purchases, and the SPVs have, according to Mnuchin, “clearly achieved their objective.”

That conclusion is only true if the programs were meant to completely undermine the process for sensible allocation of capital in our economy. The markets are not healthy. They are a farce. The government has been childishly reluctant to allow capitalism to work and to let untenable businesses go bankrupt so that resources can be invested productively. Investment-grade companies borrowing at under 2 percent and junk companies at under 4 percent is not a sign of victory. It is a disaster. If markets ever “normalize” and credit risk once again becomes a factor, the amount of refinancings required by the walking dead will probably require – yup – more government intervention to keep the junk windows open.

Bear in mind, this farce is mainly a bonanza for the economy’s dead weight. Normal financing is available for viable companies. As Mnuchin wrote on Thursday, “Banks have the lending capacity to meet the borrowing needs of their corporate, municipal and nonprofit clients.” The volume of commercial and industrial lending is down, mainly due to weaker demand, according the to Fed’s most recent survey of bank loan officers. But banks are still reasonably well capitalized and able to lend.

So Mnuchin’s move is a welcome one, even if it only keeps the Fed from throwing more gasoline on the credit market conflagration. Best outcome for the economy? The credit markets really freak out this week, bond prices drop like stones and borrowing rates rise to reasonable levels. That would be bloody, but necessary. If it happens, and the markets start to howl, the Greenspan Putters at the Fed will be revving their helicopters. Here’s hoping that Mnuchin keeps his nerve.

Dwight Cass

CRE Finance: From Bad to … Slightly Less Bad

Commercial real estate market participants had some reasons for optimism in the third quarter. Banks continued to avoid large realized losses on CRE lending. Lower infection rates in some large cities allowed them to ease lockdown measures, benefitting the retail, office and lodging sectors. But despite these promising signs, and irrespective of the near-term course of the pandemic, Covid-19’s long-term effects on the CRE market are shaping up to be profound.

CRE property values continue to fall, although data from Moody’s Analytics shows a decrease in the pace of declines in the third quarter. Even so, office sector properties fared badly, with appraised values of troubled assets falling 77% in the second quarter and 60% in the third.

Although banks do not hold much CMBS, their direct loans are worrying. According to a recent Financial Times analysis of the 10 biggest bank CRE lenders, the size of their problem loan holdings had increased 144% since the beginning of the crisis, to $26 billion. These loans are now equivalent to debt with a rating deep in junk territory – CCC or lower.

Other types of lenders are no better off. The rating agency Fitch says that life insurers will see 50% greater losses on their mortgage loans than they did during the Great Financial Crisis. Fitch also expects U.S. CMBS delinquencies to be near their previous peaks of 8.25-8.75% in the fourth quarter of this year.

Luckily, there are signs of life returning to some sectors, even office. Kastle Systems, which provides employee monitoring equipment for 41,000 businesses in 47 states, says its ten-city average occupancy index rose to 25.8% at the end of September, up from its April nadir in the mid-teens. Some cities have done significantly better, such as Dallas and Los Angeles. Even New York, the U.S. epicenter of the pandemic, has seen some improvement, although occupancy still languishes at 15.6%, according to Kastle data. San Francisco is at the bottom of the list, with only 14.5% occupancy.

While financing will eventually struggle back, analysts say Corona-19 dislocations will fundamentally change the CRE landscape. In a recent report, Fitch’s structured finance team wrote, “The effects of the pandemic will accelerate secular trends that were already underway prior to the crisis. The pandemic has also introduced new challenges to social and business transactions that will affect retail, office, lodging, industrial and multifamily housing to varying degrees.”

A forecast by Cushman & Wakefield supports this, as it applies to the future of the office sector. According to the firm’s model, the U.S. office market will shed 145 million square feet of space in the next two years. The firm expects office demand to decrease by 30% more than it did during the Great Financial Crisis. Those changes will not be reversed easily. While signs of progress in fighting the pandemic might be encouraging, CRE market participants should temper their optimism with the understanding that this business is undergoing fundamental change, the full extent of which is only now becoming apparent.

Dwight Cass

The Crypto Casino: Invest Defensively … If at All

In the run-up to the most contentious U.S. presidential election in living memory, cryptocurrency investors who either can’t stay away for psychological or ideological reasons, or who have to maintain exposure due to institutional exigencies, should be focused on ensuring that they have access to one crucial thing: liquidity.

With election season uncertainties, the ongoing economic effects of the Corona-19 pandemic, and longer-term worries like U.S.-China trade clashes, the ability to enter and exit positions without being forced to sell into a falling market is critically important. That means favoring the most liquid cryptocurrencies. Until election-year political risk recedes, the two biggest players, Bitcoin and Ethereum, are where traders looking to maximize their flexibility should be riding out the storm.

Both cryptos have taken a beating this month, with Bitcoin falling $2,000 in early September before recovering some of its loss. While any sensible investor would be loading up on puts given that volatility, trading volumes show the casino is still popular.

Bitcoin Price (Source: CoinGecko)

The importance of liquidity in an uncertain market should put Bitcoin, with a $198 billion market cap, at the top of diehard crypto enthusiasts’ lists. Ethereum’s market cap is less than a quarter of the size of Bitcoin’s, but it still dwarfs most of the other cryptocurrencies.

Bitcoin and Ethereum are defensive plays (if such a term has any meaning in the world of cryptos), but also have some upside potential right now. They should benefit from recent regulatory changes that will open the cryptocurrency market to significant inflows of institutional capital. Most of this capital will go into cryptocurrency “household names” with proven track records.

However, the most compelling reason to favor Bitcoin and Ethereum is simply good risk management. The specter of a contested election has become the second-most pressing concern for global investors, after the coronavirus, according to Bank of America Securities monthly fund manager survey. Until those two risks subside, the volatility they could cause across various markets will affect investors’ risk appetites and therefore their demand for cryptocurrencies. Those cryptocurrencies with small market capitalizations could be subject to sharper swings in price.

This is similar to what happened to the high-flying stocks of the dotcom era. Many of the dotcom superstars rose to the heights they achieved, despite having no revenues, let alone earnings, because of their microscopic floats. Small changes in demand therefore had large effects on their prices. This was all good when everyone was buying, but it caused small-float dotcom stocks to fall faster than their larger, more established technology brethren when investor sentiment turned in March of 2000.

Some might argue that the higher volatility of smaller cryptocurrencies might be an advantage in this environment, since they could pop more if investors crowd into the sector during a flight to quality. But cryptocurrencies have exhibited the same behavior as other assets during periods of risk aversion this year. Witness Bitcoin’s 50% first-quarter plunge and subsequent rebound, which put it firmly in the “risk asset” camp, along with stocks and junk bonds. Cash and sovereigns apparently remain the risk-off assets of choice in a crisis.

The other good reason to back the big cryptocurrencies as the lesser evils is the decision in July by the Office of the Comptroller of the Currency to allow banks to provide custody services for cryptocurrency accounts. The legal uncertainty about this type of custody business that existed before the OCC’s announcement kept a lot of investor capital from reaching the cryptocurrency markets.

That’s because asset managers seeking to invest in cryptocurrencies have been hamstrung by client guidelines that typically require all securities to be held in custody, usually by Federally chartered banks. Now, asset managers can take advantage of their clients’ demand for cryptocurrency exposures to expand their investments in what they see as a profitable asset class. Cryptocurrency hedge funds, for example, have reaped double digit gains this year, and traditional asset managers want in on the action.

Much of the initial funds flowing from these asset managers into cryptocurrencies will go to those that can be traded both in cash and derivatives markets. Bitcoin, in particular, will benefit from its listed derivatives on CME because asset managers can tailor their risk profiles using Bitcoin futures and options on futures – something that will appeal to their more conservative institutional investor clientele. These listed derivatives also give investors a window into market sentiment about future prices. (Futures traders currently anticipate Bitcoin to end the year just shy of $11,000.)

Of course, listed derivatives such as these can increase volatility in some cases, in part because they are leveraged and can be bought on margin. Witness how call options on FANGMAN stocks drove those shares up in the second quarter as option sellers covered their positions in the cash markets. When sentiment reversed and those cash positions were partly unwound, the situation exacerbated the tech plunge in early September.

Nonetheless, the availability of these hedging tools, alongside the market bulk that Bitcoin and Ethereum exhibit, make them the best-positioned of all the cryptos to ride out any serious market volatility in the coming months.

Dwight Cass

Price Discovery a Key Hurdle to Renewed CRE Lending

Commercial real estate companies are facing unprecedented challenges during the Covid-19 pandemic as they attempt to raise financing for new and ongoing projects. Tighter bank lending standards and widespread problems in the commercial mortgage-backed securities market are immediate issues. But CRE debt markets will not stage a significant comeback until assets start changing hands so that price discovery recovers, giving lenders the benchmarks they need to estimate LTVs and risk.

The lack of useful pricing data is reflected in the Green Street Commercial Property Price Index, which showed CRE asset price declines of between 5 and 25 percent in March and April, but which did not move notably between then and August because of the lack of transactions.

“The transaction market is quiet these days—and properties that are trading are ones relatively unaffected by the pandemic—so it’s tough to say with certainty how much pricing of some property types has changed,” said Peter Rothemund, Managing Director at Green Street Advisors. “But it’s pretty clear that the range of outcomes is going to be wide. Record-low interest rates mean properties with a stable top-line outlook will hold up well. Those with some risk, say multitenant office, probably see something like a 10% hit on average. And those with a lot of hair, like lodging and some retail, lose even more.”

Office projects in urban areas are expected to be particularly hard hit. Data from Kastle Systems, which manages employee tracking systems for over 41,000 companies in 47 states, shows that New York City office occupancy is now only 11.7 percent, and Kastle’s 10-city average languishes at 23.3 percent.

The hospitality and retail sectors are equally troubled. Fifty-four percent of CMBS loans transferred to special servicing entities due to delinquencies since March are backed by hotels, according to ratings firm Fitch. Another 32 percent are backed by retail properties, including malls.

Banks have responded to the CRE meltdown by becoming significantly more conservative. In the second quarter, two-thirds of banks surveyed by the Federal Reserve tightened standards for CRE loans. The remainder left them unchanged. Over a third made their lending standards tighter than at any time in the last 15 years.

The CMBS market, meanwhile, is being roiled by near-defaults, avoiding outright ones through special servicing, extend-to-pretend refinancings (also a favorite tool of banks for the CRE mortgage assets they retain), and forbearance measures. According to Fitch, $35.5 billion of U.S. CMBS was pushed into special servicing in the second quarter, up from $4.6 billion in the first. That’s up from a total of $9.1 billion at year-end 2019. The first half total represents 7 percent of the entire CMBS market.

Even with these discouraging signs, pressure is growing to get the CRE financing markets rolling again. As Ethan Penner of Mosaic Real Estate Partners recently told the Financial Times Odd Lots podcast, asset managers are piling up uninvested cash that they sorely want to put to work in order to be able to charge fees. Penner, credited with inventing the CMBS market in the early 1990s, cautioned that government policies like forbearance and the Fed’s ZIRP subsidy for refinancings reduce the pressure on owners of troubled assets to sell. This deprives the market of the data points it needs to establish prices on comparable assets. Without those, banks cannot feel confident generating LTVs and risk assessments, and asset managers will continue to fear buying assets for more than they are worth.

Dwight Cass

Uh Oh: Banks Turning to “Mark to Myth” Accounting for Massive CLO Market

​Dominoes are falling in the financial sector according to the pattern set in 2008. Only then it was mortgages driving the mayhem. Now it is zombie corporate credits, kept alive for years on cheap junk-rated loans bundled into collateralized loan obligations (CLOs), which investors were forced to buy because central banks kept returns on everything else artificially low. 

Once the belle of the ball, since the Covid-19 crisis there are evidently too few buyers to provide prices for the banks that peddled the CLOs to value them accurately. According to a piece today in Risk, German lender Commerzbank is in trouble, having been forced to categorize $5.2 billion of its CLOs as Level 3 assets in the first quarter,  meaning they are unable to be marked to market (valued using market prices) and requiring Commerz to use a “mark to model” approach.

That means it more or less makes educated guesses, none of which anyone else believes. In 2008, this was referred to as “mark to myth” accounting when applied to the toxic mortgage securities that torpedoed many banks and brought down Lehman Brothers.

According to the FT, which wondered aloud today if CLOs were “ground zero” for the next stage of the financial crisis, JP Morgan estimates that US CLOs alone totaled some $691 billion at the end of last year, double the amount from two years earlier. In the same time, the market for the junk loans backing the CLOs doubled to $1.2 trillion.

The FT article showed that the Covid-19 crisis has since sent investors fleeing: Yields (which move inversely to prices) on the junkiest BB tranches shot up from around 9 percent to over 16 percent when the crisis hit.

All the investors stuck with this dreck can’t sell it without big losses, meaning they’ll have to sell more liquid assets to meet redemptions, spreading the misery to other markets, if the events of 2008 are any guide. But hey, perhaps the Fed and its counterparts will snap them all up, leaving the banks to repeat their mistakes yet again, and setting the stage for the next crisis. Third time’s a charm.

hen structured credit markets froze up in March, Commerzbank could not find enough real quotes to accurately price its collateralised loan obligations (CLOs). The dearth forced it to shift €4.8 billion worth ($5.2 billion) into the mark-to-model category –reserved for complex, illiquid assets

When structured credit markets froze up in March, Commerzbank could not find enough real quotes to accurately price its collateralised loan obligations (CLOs). The dearth forced it to shift €4.8 billion worth ($5.2 billion) into the mark-to-model category –reserved for complex, illiquid assets.The move increased the German lender’s stock of Level 3 assets by 69% quarter-on-quarter to €9.8 billion. As of end-March, they made up 7.2% of all fair value assets, up from 5% at end-2019.

hen structured credit markets froze up in March, Commerzbank could not find enough real quotes to accurately price its collateralised loan obligations (CLOs). The dearth forced it to shift €4.8 billion worth ($5.2 billion) into the mark-to-model category –reserved for complex, illiquid assets

Dwight Cass

Let’s Kill Off The “Banks Are All Fine” Meme

This morning I heard some joker on an Intelligence Squared podcast call the heightened risk based capital requirements set by the Basel Committee and Dodd Frank as “dead capital”. It’s part of this “The Banks Are Fine” meme that has spread through the business media. It has to stop. The banks are screwed.

Admittedly, not yet. But how do they make money? What assets do they hold? Mortgages? Dead. Derivatives? Good luck. Bonds? Good thing they slashed their inventories. But not to zero.

Those living wills give you comfort? The worst case scenario they’re stress tested against is already in the rear view mirror. Market structure changes? I just spoke to a risk manager at one of those clearinghouses that Dodd Frank tapped as a panacea for OTC counterparty risk. He’s worried about his credit reserves being swamped. That’s just one catastrophic risk.

Don’t even think about what eurodollar futures are predicting about negative interest rates. What would that do to bank earnings?

The term “Greenspan Put,” once a snarky dig at Fed machinations, is now mainstream policy. The basic job of banks – allocating capital – is now seen as some quaint artifact of yesteryear.

No, the banks are not alright. Stop pretending they are. Shoes might not drop until the second half, but they’re already in the air.

Dwight Cass

The Fed’s Credit Head Fake Imperils Yield Curve Policy Prospects

The Fed has still not acted on its promise in February to purchase essentially unlimited amounts of investment grade and junk corporate debt and ETFs. While a yield chasing frenzy has allowed marginally investment grade issuers – including Walking Dead extras Carnival and Boeing – to raise stonking amounts of debt without the central bank’s help, the Fed risks losing credibility. Given its hopes to manage its balance sheet bloat through a yield curve control (YCC) policy, its timing couldn’t be worse.

The Fed’s empty jawboning has not gone unnoticed. On Friday, Bank of America credit analysts wrote:

Note to Fed: a lot of investors (including non-credit ones) have bought IG corporate bonds the past two months. . . on the expectation they can sell to you. So would be helpful if you soon began buying broadly and in size. (H/T Grant’s Almost Daily)

On April 23, Wolf Richter wrote:

So over the past four weeks, the Fed has not done any of the things with these SPVs and Primary Dealers that the markets were raving about it would do. It didn’t buy junk bonds, it didn’t buy ETFs, it didn’t buy stocks, it didn’t buy old bicycles. But Wall Street sure loved raving about it.

The situation hadn’t changed as of last week’s Fed balance sheet report.

The Fed’s credibility, always crucial, is particularly important now, with central bank grandees considering using a YCC policy to control rates without further ballooning its balance sheet. In essence, this involves telling the market that it will buy Treasuries at a given price. No one sells lower than that, knowing they can sell to the Fed, so rates stay at the target level, even if the Fed doesn’t actually buy much. But for that to work, as it did during World War II, the market has to believe the Fed will support the peg.

Hence the need for credibility, which the Fed is now frittering away.

Dwight Cass

Fed Brings Knife to Gunfight

The Fed is not only no longer a credible player, it’s actually causing measurable harm. Investors, hoping for something useful to come out of the G-7 conference call this morning, reacted to the central bank’s 50 basis point rate cut by driving the Dow and S&P down 3.5 percent by early afternoon. It would have been wiser for Powell and Friends to keep silent, sequestering their dwindling monetary ammunition for another day, when it might have done some good.

Even stock market investors understand that the Fed is making a category error. The Fed boss may have a hammer, but this crisis isn’t a nail. Specifically, unlike the Global Financial Crisis, when rate cuts helped ease pressure on bank balance sheets, Wall Street just isn’t the problem this time around. The industry’s solipsism makes it hard for bankers, and by extension, the Fed, to understand this. But this time, the trouble stems from events outside their purview. As Wolf Richter put it in a post earlier today, “Disappointed the Fed didn’t print antibodies?”

Worse, the Fed’s move could contribute to trouble in bank-land. In a note out yesterday, Fitch analysts warned that a rate cut could hurt bank profitability. With historic levels of marginal investment-grade debt about to slide off the cliff, and the leveraged markets looking increasingly parlous, banks don’t need this kind of trouble:

Fitch sees near-term downside to profitability due to asset yield compression while the yield curve falls at a historical pace, with the 30-year rate hitting an all-time low, as the Fed indicated that it would use necessary tools to support the economy. While we expect that banks will attempt to be quick in their response to cut deposit and other funding costs accordingly, these actions will not likely be to the same degree that asset yields compress, resulting in lower margins and reducing overall profitability, at least in the near term. Fitch notes the 30-day LIBOR forward curve dropped 25 bps during February, which could significantly affect loan yields during 1Q20.

That’s not apocalyptic, but it’s not great news, either, especially as the biggest US bank dealers – the eight so-called systemically important ones – boosted their equity holdings by 20 percent last year, to $454.5 billion, according to Risk. Luckily, they increased their stock of Treasuries by 28 percent, to $345.4 billion. The latter are rallying.

It is almost a relief to see the Fed out of the game, like a tennis star who has missed an easy volley staring dumbly at his racket, looking for the hole. The invective spewed at the Fed by Trump and his Tammany-on-the-Potamac enablers was dispiriting before; now it is a policy-ossifying distraction. On to the next bad option.

Dwight Cass

Banks’ Corona Response Lives Down to Worst Expectations

Hard to argue with nonprofit Better Markets’ scathing take on banks’ grotesque attempt yesterday to use the Corona Crisis to slip their regulatory leash. From Better Markets:

Wall Street Biggest Banks Shamelessly Trying to Use Coronavirus to Get Federal Reserve to Weaken Rules

March 2, 2020

FOR IMMEDIATE RELEASE
March 2, 2020
Contact:  Christopher Elliott, 202-618-6433, press@bettermarkets.com

Washington, D.C.  –  Dennis M. Kelleher, President and Chief Executive Officer of Better Markets, issued the following statement in response to the Bank Policy Institute’s request for “Actions the Fed Could Take in Response to COVID-19”:

“It is shameless but not surprising, that Wall Street’s biggest banks would use the coronavirus to attack the financial rules they have been trying to weaken for a decade, including weakening critically important capital and liquidity requirements.  It is even less surprising that they would direct their request to their favorite regulators at the Federal Reserve, which secretly doled out trillions of dollars bailing out Wall Street in 2008-2009 with virtually no public transparency, oversight or accountability.  That was great for Wall Street’s biggest banks, but a disaster for Main Street and should not be repeated now.

“As the coronavirus-created uncertainty mounts and the possibly of financial deterioration increases, the worst thing anyone could do is reduce the biggest banks’ ability to withstand a downturn or shock, which is exactly what Wall Street’s biggest bank lobby group is arguing.  Reducing capital and liquidity while preemptively taking action under Section 13(3) just tees up more taxpayer bailouts and makes them more likely. 

“Most importantly, current conditions relate to the entire economy and financial system, not just Wall Street’s biggest banks.  Rather than one-off reactions to the importuning of a subgroup of self-interested financial actors, the Financial Stability Oversight Council (FSOC) should be meeting and planning daily to be prepared for a comprehensive response if economic activity decreases dramatically and financial conditions deteriorate.  The FSOC was created for these very circumstances:  to provide a coordinated response for the entire financial system in the best interests of the country, not just the best interests of Wall Street’s biggest banks.

“Finally, to the extent Wall Street’s biggest banks are genuinely concerned about having enough capital and liquidity to support the real economy, then they should immediately stop making any additional distributions of capital via dividends or buybacks until there is certainty regarding the threat posed by the coronavirus.  If Wall Street’s biggest banks are unwilling to take that action immediately, then their real motives will be clear, and their deregulatory requests should be seen for what they are: part of their ongoing, years-long attack on the rules.”

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