This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
As Q1 2020 ends, the global banking industry faces a world that has been completely changed by the economic impact of the Wuhan virus, COVID19. Financing markets are greatly constrained and banks and government-supported debt markets remain the sole remaining islands of liquidity. Markets for corporate bonds and asset backed securities have taken a substantial hit and credit spreads have more than doubled in the past two weeks for many issuers.
There are two worlds now: securities eligible for repo with the New York Fed and those that are not eligible for liquidity support. While public equity markets have rebounded after days of record selling, the markets for private equity and related debt remain disrupted and are likely to remain so for the foreseeable future.
It is important for investors to understand that the Federal Reserve is going to provide liquidity to many different markets, but it cannot handle the process of restructuring credit defaults. This is one reason why the Fed has hired BlackRock (NYSE:BLK) to act as manager for its bond purchases a la 2008. The CARES Act provides liquidity for advances to cover arrears at mortgage servicers, for example, but no subsidies for actual credit defaults.
In terms of Q1 2020 earnings, here’s what we expect from the banks:
* The good news is that credit provisions generally are likely to rise modestly in Q1, but the big change is going to be delayed until June 2020. We expect to see a modest increase in mortgage loan delinquency in March, for example, but the big numbers are probably not going to be seen until April 25th, when coupon payments are due on most MBS and advances increase proportionately.
* The once benevolent balance between credit costs, income and cash dividends is about to be violated, but probably not in a big way until the June quarter end. This is a blessing and a curse, of sorts, since we have 90 days to ponder the substance as well as the presentation of the coming results, even as new information comes in regarding credit events. Most banks simply lack the data to make changes in credit risk allocations, but it goes without saying that a number of bank credits have slipped into “special mention” in the past two weeks.
* Here’s our best guess of what bank provisions and net income look like over the next two quarters. We double provisions each quarter from the Q4 2019 baseline, hold income and expenses roughly stable in Q1, then start to push down net interest income and increase non-interest expense in Q2.
* Q1 will be relatively quiet for financials compared to what lies ahead for the rest of 2020. As loan payment delinquency starts to accumulate in Q2, however, we expect that the larger banks and nonbanks are going to be forced to provide monthly guidance to investors on default rates and financing.
* We expect, for example, that the increase in residential mortgage loan delinquency and the related advances to pay interest on agency and government MBS will be quite large for banks and nonbanks alike. Thus the Council of State Bank Supervisors wrote a letter requesting that the Federal Reserve Board invoke Section 13 (3) of the Act to directly support advances by nonbank mortgage servicers.
* The financing issue is not merely a nonbank concern. Think about the cost of financing advances when we see significant delinquency on the $1.2 trillion servicing book of Wells Fargo & Co (NYSE:WFC). More than just the credit costs of coming payment disruptions, the US banking and nonbank sector is about to undergo a vast expansion of operations around loan servicing and default mitigation. We are talking about increases in operating costs and decreases in short term fee revenue due to defaults of significant size and at least as large as 2008.
* While the full weight of the credit costs COVID19 crisis will not be reflected in Q1 earnings, there are a lot of marks to bond positions and credit portfolios that will take down marks. Specifically, there are whole classes of corporate securities that have effectively been downgraded. Even things like the credit-risk transfer (CRT) bonds issued by the GSEs have fallen to distressed spreads over Treasuries. Just imagine what would have happened to large nonbank mortgage issuers like Fannie Mae and Freddie Mac last week were they already "privatized?"
As we noted in ZeroHedge this week, the negative marks that must be taken to a variety of hedge and trading positions are going to be brutal in Q1 2020, effectively the precursor for more and continued bad news coming from the corporate and asset backed securities sectors over the balance of the year. Again, if the assets are not eligible for margin or repo, then they are likely to be illiquid. We continue to worry that some platforms in the REIT sector may be forced into a forced liquidation.
The good news is that the market valuations of banks seem to have stabilized and credit spreads are starting to narrow on publicly traded financials. Citigroup (NYSE:C) is trading at half of book and +140bp over the curve in 5-year CDS, while Goldman Sachs (NYSE:GS) is loitering around 0.6x book and +140bp over the curve in CDS. More important, US banks have largely curtailed share repurchases, adding $30-40 billion per quarter to internal cash flow that is now available to absorb credit losses.
Despite these grim figures, we'd strike a positive note. We've been accumulating bank preferreds this past week, in many cases below par. Recall that it was not capital that saw US banks through the 2008 financial crisis, but raw earnings power that was available to fund loan losses without touching capital. With the notable exception of the Citigroup rescue, the US banking industry cleaned up its own mess in 2008, with the active assistance of nonbank mortgage servicers we'd add.
Remember that in Q4 2019, US banks had almost $150 billion in net income, dividends and cash used for share repurchases available to absorb losses. This substantial cash flow is now about to absorb the full weight of the COVID19 virus disruption. Yes, the numbers are large, but in our judgement, more than manageable by the US banking system.
Source: Federal Reserve Form Y-9
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington.
This piece does not necessarily reflect the opinion of Hedgeye.
