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How debt securitization is fueling tighter lending
+ my strategy.
*I’m not a financial advisor and this is an opinion piece.
Asset Backed Securities ( ABS ) and Mortgage Backed Securities ( MBS ) are two ways that the banks, we love to earn points with, finance their operations. Both of these vehicles finance activities by selling the cash flows of the underlying debt they’ve issued to places like Blackrock, Pimco, Vanguard, etc which then package them. It’s a way for banks to access financing without adding a liability to their balance sheet, and it allows the investors to diversify their portfolio with exposure to cash flows generated on variety of debt instruments. It’s also a major contributing factor as to why credit cards, and loans, will be tightening approvals.
ABS and MBS
ABS is primarily broken up into categories like Auto Loan/Lease, Home Equity, Credit Card Receivables, Student Loan, and Mobile Loans – both home and phone. These are all broken up into tranches from top tier/most reliable to sub-prime/highest rate of default. The cash flows/rate of return expected will be from low to high depending on the risk associated with the cash flow.
MBS – is a pool of home loans broken up into tranches similar to what is described above in ABS where the underlying asset is the mortgage.
Whether an ABS or MBS is the underlying asset it’s sold to a trust who then packages the pools and forms a fund to sell to investors.
If all of this is super confusing, don’t worry, it is…and the veil of confusion and complexity is how many bad players contributed to the financial collapse 10 years ago.
If you remember back to the financial crisis of 08/09 it was the mis-rating of MBS tranches that led to the downfall of institutions like Lehman Brothers and Merrill Lynch. Why? MBS and ABS are broken up into tranches that are filled with loans with comparable default rates. However, during the crisis, it was found that the credit agencies were mis-rating mortgage portfolios sold by banks to bond funds, and sub-prime loans were being packaged into tranches that should have had very low default rates. As you can imagine, expected default rates skyrocketed as the housing market started to collapse, and many of the funds that believed they were buying tranches filled with top tier debt found cash flows drying up as borrowers began missing payments in greater numbers. A cascading effect rocked the market, liquidity quickly dried up, and the system collapsed. This was exacerbated with such creative and complex instruments known at SCDO ( Synthetic Collateralized Debt Obligations ) which allowed leveraged derivative investment on the MBS ( a derivative itself ) and exposed banks balance sheets to margin calls in orders of magnitude to their cash or equivalents. There was a very select group of investors, showcased in The Big Short, that saw this coming and purchased Credit Default Swaps, on these top tier tranches of MBS, and walked away with several 1000% gains – also what lead to the collapse of insurance companies like AIG who were counterparty on the swaps. It was an absolute $#!+ show.
Regulations have been put in place to stymie this behavior – much of this in an attempt to limit the amount of MBS/ABS banks can move off balance sheet, and clean out the corrupt relationship between banks and rating agencies, deter SCDOs ( which have come back – over $200B issued in 2018 ) but what’s been very interesting to me, is the sudden, swift moves by banks to up their loan loss.
But here we are facing another black swan event. They seem to occur every decade now ( tech bubble, housing bubble, covid ) and while many have been warning against a global corona pandemic for quite some time… let’s not split black swan hairs over it.
Since this is a travel, credit card, points and miles based blog, I thought it may be helpful to give some incite into why credit cards and loans are going to become more diffiult in the short term.
Banks uncertain exposure to loan loss affects ABS and MBS demand
With the Covid crisis creating a spike in missed loan payments across the board and a very uncertain landscape unfolding as to unemployment, decreased legitimacy of retail mall space, uncertain return to normal, exodus from city centers, travel plans, etc – it’s creating quite a brewing storm, and no wonder why credit markets absolutely seized in March. Who’s going to buy ABS/MBS, aside from apparently the taxpayer, when cash flows are this uncertain, and odds of default are unknown. It also means that tranches could possess higher than expected rates of default , and the trusts created to service the ABS/MBS still owe the payments even when payments decrease. I wouldn’t be surprised to see these servicers request bailout money once forbearance terms have expired.
Fed Cuts Rates/launches QE again
Back in March, an interesting thing happened. The Fed cut rates twice, ending up at 0%, but the 30 year rate actually went up. Why? There was a mad rush of people looking to refinance at lower rates, and those refinanced mortgages flooded the MBS market, and whenever you have increased supply, prices fall…as they did immediately after. If you’re selling $10M worth of mortgages over 30 years, and the price falls, it implies a lower net present value, and thus higher implied rate of return. This meant the only MBS that banks could sell would be those based off higher interest rates, and thus the 30 year popped, at least until the excess supply was sold off…we’ve seen the 30 year come down since.
Jumbo Loans seize
Jumbo Loans, up until very recently, have been a bank favorite. High underlying value, usually reliable cash flow, but these loans have become very difficult to acquire. Reports are saying many banks are simply not issuing unless 30% plus is put down, large bank asset holdings, and even then, banks are reticent because JumboLoan MBS market has seized – this means banks will need to keep these loans on balance sheet. Higher balance sheet assets, means less cash on hand to loan, i.e. credit cards, etc. Banks make a lot of money off loan origination, etc – they want to sell those assets to MBS.
Personally, I think this is a bellwether of things to come regarding further restrictions on loans and falling housing prices.
Used Car Market problems
Yesterday, Yahoo published an article hinting at the impending used car market collapse. With auto auction sales ground to a halt, dealerships resorting to virtual tours/test drives, and unemployment skyrocketing, this could significantly impact car manufacturers financing facilities. GM and Ford have $30B and $27B in residual value of leased vehicles as of 12/31/19. This creates a big problem if used car prices fall considerably, since the residual value has been overestimated creating a waive of lease impairments. The supply will get absorbed but at what discount? Auto Loans and leases are packaged and sold as well…
Oil prices drop
The supply glut we’re facing worldwide is creating unprecedented drops in spot oil prices. I am by no means an oil industry expert, but a couple of weeks ago I wrote an article regarding the exposure that Cap1 was facing in the oil market that required them registering as a swap participant. As far as I can gather, banks loan oil companies money to finance their business, but they also sell them insurance to hedge against falling oil prices. Typically oil prices don’t collapse to the degree we’ve recently seen – hell they were paying people to take delivery of crude in May…some at $37 a barrel. Most oil suppliers need $40/barrel to tur a profit. Suppliers were paying people to take their oil. When oil was in the low $20s the exposure Cap1 had to falling oil prices was $1B.
Conceivably, this would mean if a supplier hedged their oil at $40, or breakeven, for every dollar under $40 they’d be on their insurance policy net the premium they’re paying for the policy. In pure economic terms, the external forces at work pushing pil prices down are waging war on not only the domestic oil producers, but also the banks hedging them.
Either way…it doesn’t spell easy capital access to consumers from the bank’s other lending facilities in the near term.
Credit Card restrictions increase
Banks are starting to require assets with them for approval, they’re decreasing lines, and increasing restrictions regarding small business credit cads without an EIN. I don’t see this going away any time soon. Banks are limiting their exposure to loss, but also reacting to a decrease in demand on the ABS market front where they could ordinarily package your payments for securitization.
What does all this mean and how am I strategizing?
To me…it means I’m going to be very, very picky about what cards I choose to apply for going forward. My 5/24 number is 2 right now, so it’s not like I’ve added many to my wallet here recently anyways. I believe banks are going to be increasingly sensitive to new applications, and any hint that you are extending, or plan to extend yourself beyond your means could equate to action from the bank. Banks and clients are in a relationship, and I’m viewing this period as a way to prove my end of the deal. Payments in full and on time, illustrate the credit that has been extended to me is reliable, and to weigh any further cards with a healthy amount of gravity.
I’m going to view this period as a time where I can build up some, for lack of a better analogy, sweat equity with banks. This will be a cycle, and with airlines and hotels requiring massive injections of capital to stay afloat, banks will be sitting on piles of points from discounted purchases they made to help brands, and they’ll want to utilize those points on credit card offers as the cycle unwinds. This all equates to large sign ups bonuses down the road. My strategy is to keep my accounts in great standing with the banks now, so that when the time comes I’m well positioned to capitalize on higher bonuses and hopefully looser restrictions .
My fiancee and I have been shopping for a new home for quite some time. While lending will continue to be tight, I do think that housing prices are going to fall, and I’m advocating a watch and see through 2020. If this is anything other than a V shaped recovery we’ll be in better shape to snag a deal. Personally, I think we’ll see a spike in foreclosures as the forbearance terms close, and saturated markets that have seen outsized price to income appreciation will retract.
If you’re in the market for a used car, especially if you’re a business and looking to optimize the TCJA for 100% bonus depreciation, the next few months could be very good for you. The supply glut is going to create massive incentives for both new and used cars. Just take a look at some of the 84 month 0% interest offers across the market.
Monkey Miles has partnered with CardRatings for our coverage of credit card products. Monkey Miles and CardRatings may receive a commission from card issuers
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