MFA Financial and Invesco Mortgage Capital: COME ON DOWN! You’re the next mREITs to succumb to the turmoil in repo markets and beg your counterparties to enter forbearance agreements!
Jokes aside, these are big ones. Invesco and MFA have $17.5B and $9.5B in current financing arrangements, respectively. Both missed posting collateral to cover their margin calls as of close of business yesterday. I don’t see a need to get into details about why this is happening, as you already know the story.
This is a big deal, though. You now have four different companies that need to (i) either convince all of their counterparties to enter into the forbearance agreements or (ii) dump their assets into the open market to raise cash and basically implode the mortgage bond market – simultaneously. I can’t imagine a scenario in which they can all convince their counterparties to lay off, as I’m sure there is overlap between who is providing these companies with financing. Some of these firms will have to go away, and it will be the smallest to liquidate first.
In any event, there is a fire sale looming in the mortgage bond market and it may get pretty ugly.
You always have to think bigger picture. Just yesterday I touched on the mortgage market unraveling and, in my hubris, declared I thought that Cherry Hill Mortgage would likely be the next victim. Obviously, having a direct competitor of MITT and NYMT be the next shoe to drop seemed likely – albeit it predictably boring. Then, out of nowhere, Bloomberg drops this bomb about ED&F Man just to shake things up a bit.
To be clear, ED&F is not in the same business as MITT or NYMT. They’re a traditional broker-dealer, making markets and structuring products in a variety of different assets classes (they’re traditionally an agricultural and commodity-focused merchant). The firm is over 200 years old and much more well capitalized than the mREITS so, were things to get even more dicey, they would likely be able to source liquidity in some way, shape or form to avoid disaster.
Anyway, back to the fun stuff. ED&F transacts in a space known as the TBA (to be announced) market. TBAs are pass-through securities issued by Fannie, Freddie and Ginnie. It’s essentially a contract to purchase a mortgage bond in the future. To be clear, you’re agreeing to buy pools of mortgages in the future but you’re unaware of which pools at the time of the trade. This seems risky at face value, but the securities are issued by government agencies and are normally of the same general quality, so the market runs efficiently and the risk is generally well understood.
It seems that ED&F was long TBAs, essentially taking a long view on the price and performance of U.S. mortgages. The thing you fear when long mortgage bonds (besides non-payment) are falling mortgage rates. When mortgage rates decline, people generally tend to refinance their mortgages. This (i) eats into the interest payments an investor had planned on receiving when they bought the bond and (ii) forces them to invest the recently returned principal into lower-interest mortgages, leading to losses. As prudent risk managers, ED&F hedged against this by shorting 10-year treasurys because normally mortgage rates are inextricably tied to this benchmark. If mortgage rates were dropping, so would the yield on the 10-year, thus mitigating much of the downside risk for ED&F.
Wrong! Times are not normal, adjust your hedging strategy accordingly. The long mortgage / short treasury trade has exploded in the last few weeks, as investors have dumped mortgage bonds over non-payment fears related to COVID-19 and piled their cash into U.S. treasurys as a flight to safety. As a result, ED&f posted $100M in additional collateral just on Friday.If the precipitous fall in mortgage bonds continues, the firm will likely be hit with additional margin calls, further straining their liquidity profile.
Again, I actually do not believe that ED&F Man is in any real trouble. They’re relatively large, liquid and have great counterparty relationships. If they need to tap equity or debt markets to raise additional capital, I don’t doubt they’ll be able to do it. That said, they’re not the only firm with this trade on at the moment, so if they’re feeling the heat, I’d imagine some other firms are, too.
In my last post titled “I’m Back. Markets Are Not.”, I spoke about how repo market liquidity was drying up and why it would impact counterparties that rely on the market for financing. In the post, I used mREITs as an example of how dire the situation had become, as investors began dumping their shares hand over fist in an effort to get ahead of any possible solvency issues:
“The equity market is essentially looking at these companies and saying, “Yeah, we’re gonna wake up one morning and one of these guys won’t be able to open for business” (read: bankruptcy). If the repo market completely dries up, there will be another Bear / Lehman event. The banking business is entirely built upon borrowing short to lend long, so any material interruption in that business model will prove absolutely fatal for some of the more highly-leveraged financial institutions.”
As of 6:30am ET this morning, we received our first look into how bad it had really become. AG Mortgage Investment Trust (NYSE: MITT), a publicly traded hybrid mREIT managed by Angelo Gordon, filed an 8-K stating that they had missed posting collateral Friday evening for their margins calls, and that they do not expect to be able to meet expected margin calls later this week. As a result, they’ve entered into discussions with their financing counterparties on forbearance agreements in order to avoid triggering a technical default under their current financing agreements. MITT’s stock cratered, both common (-38%) and all classes of preferreds (-66%). The only reason the common wasn’t down in tandem is because it had gotten absolutely massacred as of late, but pref investors up until now thought they may be spared from the carnage of dividends cuts / suspensions.
It’s hard to say what exactly is happening at MITT, but I think I have a pretty good idea so I’ll take a stab at it. MITT has an investment portfolio of $4.3B, but only $3.4B is comprised of relatively liquid mortgage securities. The rest of their portfolio is made up of illiquid whole loans, commercial loans and investments in affiliate entities (and very, very little cash). Alongside those investment assets, MITT has $3.5B in current financing arrangements. In and of itself, this isn’t a problem – MITT’s business model is to utilize leverage in order to juice returns for their investors. The problem is that the market for mortgage securities is, to put it nicely, in a state of uncertainty. Investors are worried that in light of the COVID-19 pandemic, mortgages will not be getting paid – which would impair the mortgage bonds that MITT owns and effectively eliminate the bid for the bonds in the open market. As a result, investors are dumping the bonds and as the value of the bonds decline, MITT’s financing counterparties are demanding they post more collateral to support their positions.
Enter the negative feedback loop. What I believe is likely happening to MITT is simple: (i) the value of the bonds they own decline; (ii) they’re required to post additional collateral; (iii) they become a forced seller of the bonds to raise cash at whatever respectable bid they can find; (iv) forced selling at buyer-friendly prices leads to larger bond price declines; and (v) MITT is now required to post more collateral. Trying to sell securities into a down market that’s experiencing liquidity issues in an effort to cover margin calls will usually result in one thing: insolvency. If they can’t convince a large majority of their counterparties to enter forbearance agreements, it will likely be impossible for MITT to liquidate assets in an orderly manner to fulfill immediate repayment obligations. Barring some sort of miracle, MITT is essentially toast.
I don’t want to pick on MITT though, because they’re not the only one going through this (and they won’t be the last). This evening, New York Mortgage Trust (NYSE: NYMT) issued a press release stating that they too were unable to meet margin calls issued for today. As a result, they’ve preemptively suspended all dividends on common and preferred shares, likely diverting that cash to help shore up their collateral position. I suspect we’ll see more actions like these from competitors and, as a betting man, I’d put my money on Cherry Hill Mortgage Investment Corporation (NYSE: CHMI) to be the next shoe to drop.
The regrettable part about this mess is that to a large extent, these firms didn’t really do anything wrong. They acted within the manner they told investors they would, using leverage to finance the U.S. mortgage market. The bonds they hold aren’t dogshit like they were during the GFC, they’re just being adversely impacted by some black swan virus that threatens to decimate the global economy. That won’t matter, though, people will still peg them as reckless when shit hits the fan:
In any event, I think this whole thing is just getting started. The credit markets remain strained despite all of the help pledged by the Fed. The government is amazingly repeating the mistakes they made during the GFC by bitching and moaning about fiscal stimulus. Markets will likely continue to decline and the real economy will continue to bare the brunt of everything. As I see this all unfolding, I’m reminded of a great quote from everyone’s favorite Marxist, Lenin:
“There are decades where nothing happens, and there are weeks where decades happen.”
There is a chance we’re living through a few weeks that will define the next decade and beyond. The bankruptcies of some obscure mortgage funds won’t cause the next great financial upheaval, but they’re sure as hell trying to let you know that one is lurking around the corner.
The bull market is dead, LONG LIVE THE BULL MARKET!
This fucking virus, man.
I’m not an epidemiologist or virologist, so I’m just going to focus on the market impact here. Cities around the world are effectively shutting down in an effort to contain COVID-19. Aside from the loss of life, these measures are also presenting real challenges to the short-to-medium term viability of the global economy. Credit is freezing up, equity investors are getting hosed and the real economy is suffering from reduced spending. So, what’s going on here?
The credit markets are shutting down, a la ’08-’09.Anyone that lived and/or worked through the GFC knows this all too well.
The first major problem is the commercial paper market. At a high level, this is where corporations come to finance their payroll, accounts payable and other short term costs. Essentially, a company will issue a short term note (usually for a few days but no longer than 9 months), issued at a discount to the par value of the note, in exchange for cash now. The notes are issued at a discount to par which then becomes the investors’ return upon repayment. Since we’re talking unsecured notes, the credit quality of the companies issuing commercial paper is relatively high quality. This is a very mature market that normally functions incredibly well.
Enter COVID-19. As citizens around the world hunker down to “flatten the curve” of new virus cases, the obvious concern for investors has become the implications of what it means to shut down the global economy and how that impacts the liquidity profile of companies. We should even be discussing whether certain companies will be able to operate as a going concern in the future. Worries about liquidity have forced the hand of commercial paper investors: if they’re not sure whether you’ll be generating enough free cash flow through ordinary operations to pay back the notes, then they’re also not sure they’ll lend you the money.
Were the entire market to seize up like it did in the GFC, the effects on both the real and financial economy would be devastating. You’ll see companies struggle to make payroll and pay their bills, which will lead to lay offs and plummeting share prices as equity investors try to assess what it all means for profitability.
The second major problem we have on the funding side is the repo market. This is where banks and financial institutions come for short term financing (similarly to the commercial paper market for companies). A borrower will sell high grade paper (usually government bonds or agency-backed paper) to investors, with a contractual agreement to repurchase the collateral from the investors at a slightly higher price in the future. The repo market is massive, trading anywhere between $2 trillion – $4 trillion EVERY. DAY.
There is an immense amount of friction within the repo markets at the moment. Banks see that a recession (possibly depression) is now inevitable, and there will absolutely be some corporate casualties. They’re becoming more and more skeptical of lending to each other and any market analyst worth their salt knows this is always the kiss of death. The Fed has implemented a handful of programs in excess of $2 trillion to keep the repo market open, but the impact of even those efforts has so far been, muted. If you need just one example of how exacerbated the issue has become, look no further than the mREIT space.
While most people are familiar with the equity REIT space (buying properties and profiting from rents and/or capital appreciation), mortgage REITs (or mREIT) are a bit more opaque. Their business model is to borrow in the repo market at 4-5x leverage in order to finance the acquisition of mortgage-backed securities or originate whole loans themselves. Here’s a one month look at what happens to a highly-leveraged repo participant’s share price when the market starts to freeze up:
That’s not great! The equity market is essentially looking at these companies and saying, “Yeah, we’re gonna wake up one morning and one of these guys won’t be able to open for business” (read: bankruptcy). If the repo market completely dries up, there will be another Bear / Lehman event. The banking business is entirely built upon borrowing short to lend long, so any material interruption in that business model will prove absolutely fatal for some of the more highly-leveraged financial institutions.
But here’s my number, so call me maybe…
Equity markets are plummeting. Gold was rallying but then fell off a cliff. Bonds rally and sink every other day. Oil isn’t remotely putting up a fight. Even fucking bitcoin looks like shit. Everything is selling off. How can that be? Where are the safe havens? Oh, that’s right:
SELL IT ALL! The ultimate feedback loop. Markets spiral > PMs sell to cover margin calls > forced selling tanks markets further > PMs sell more to cover more calls.
The stock market has been on an 11 year tear. The economy has been on fire, juiced (perhaps irresponsibly) by the Trump tax cuts. Credit has been pretty loose in a post-GFC era. It’s not difficult to imagine why portfolio managers around the world borrowed money to buy stocks and, to be fair, I don’t think you can ask a PM to hedge for pandemic-related exposures, either. After all, they don’t make a derivative for that (paging all structured products desks).
That said, none of that matters in this moment. The leverage in the system has exacerbated the equity sell off we’re seeing now, and it’s impact is going to be felt not just by fund managers, but by anyone with a 401-k, IRA or brokerage account. Those are real losses that are going to trickle up into the economy via reduction in consumer discretionary spending.
C.R.E.A.M.
The dollar is absolutely ripping, no surprise. There are a few reasons for this outside of the traditional safe haven trade.
The first is that since the U.S. capital markets are so dominant in the global economy, international investors have a lot of U.S. exposure. Typically, they’ll hedge their FX risk by selling USD and buying their local currency in their portfolios. The problem is that when U.S. markets start collapsing or fund managers begin selling, they’re left with hedges that are notionally too large for their overall U.S. equity exposure. This leads the international fund managers to scramble for the dollars needed to pare down their USD shorts in their portfolios.
The other reason, which hasn’t been in the headlines yet, will end up being the Eurodollar market. A Eurodollar is essentially a USD-denominated bank deposit that lives outside the U.S. financial system. The purpose of this market is avoiding U.S. capital requirements. In a Eurodollar transaction, an international bank will issue a short term deposit instrument to investors that will be denominated in USD. The deposits immediately become a USD-denominated liability on the bank’s balance sheet. This is all well and good in prosperous times. However, the rapid ascent in the value of onshore dollars during a crisis has a devastatingly deflationary effect on the international bank’s USD-denominated liabilities. Every time the USD increases in value, it costs more money for the international bank to repay the deposit instrument (their liability). This will likely force the international banks to go to market and purchase dollars as quickly as possible to avoid any more losses, akin to a short squeeze:
Combine the traditional safe haven trade, a general unwind of FX hedges and a Eurodollar squeeze, and you’ve got the recipe for a global dollar funding shortage – better known as a good ol’ fashioned liquidity crisis.
Where do we go from here?
The pain is likely to just be getting started. As quarantines become more prevalent, so will their impact in the economy. Institutions will continue to have difficulty funding their operations and share prices will continue to fall. Aside from markets imploding, however, there will be real human costs to this crisis.
There are thousands of restaurants and bars across the country (and millions across the world) that will never open again. Those people will lose everything and so will their employees. The supply chain is going to become increasingly strained as borders shut, likely inducing shortages of some goods. People are going to lose their savings, and that will take an indescribable toll on some.
Who knows what the next 12-18 months holds in store for everyone. All I know is that it’s getting weird out there and I’m not sure I have enough wine stockpiled. All we can do is sit back, go cash and enjoy the show.
Waiting for the coming recession is going to be like ordering an UberX: you know it’s going to be a terrible ride, but you won’t really know just how bad until that black Camry with seat protectors pulls up.
