Category: Featured

In-depth analysis or commentary on companies, securities, or the economy

How has NVR stock outperformed Microsoft?

NVR stock has absolutely crushed the competition. The company is a homebuilder, which isn’t a very good business, but has a differentiated strategy than its peers. Below is a chart comparing NVR to other builders.

This may surprise some people, but investing in NVR in the 1990s would have outperformed buying Microsoft!

Note, the starting point differs a bit from the chart above, but you get the idea. $10,00 invested in NVR stock would be worth $2.8MM today compared to only $1.1MM in Microsoft stock.

Quick overview of the homebuilding industry

Homebuilding is pretty simple — essentially acquire land and subcontract most parts of the building process out.

Therefore, if you had the capital and time, you could probably enter the industry. That’s probably why most homebuilders do not create much value for shareholders in the long run. There are several other reasons as well.

Trusting them to be good asset managers. Homebuilders want to acquire cheap land, so they acquire in areas outside of where they currently operate – going where they think the growth will be. This land is typically “raw” and needs to be  zoned & entitled, roads paved and sewer installed, etc. Now, builders typically let a land developer handle this, but enter into a contract to purchase that land when it is developed. By the time the land is developed and the builder is prepping to build homes, they are praying that demand will hold in or has moved in their direction, otherwise the investment in the “raw land” may not be fruitful.

In homebuilding, you are rebuilding the factory each year. Builders are constantly acquiring lots for growth. Think about it. What other business are you constantly selling your asset base down? In manufacturing, typically your factory creates products that you sell, but at the end of the year you still have the factor. In farming, I sell the fruits of my labor, but I still have the land for next year.

I liken homebuilding to oil & gas – if I drill one well, it will produce cash but for me to keep my earnings power constant, I’ll need to reinvest that cash into other wells.  Typically this means they are burning cash in the good times, as demand looks good in the future so they continue to acquire future inventory. In bad times, the builders need to generate cash, but do so at the worst time. They have illiquid assets that need to move quickly to generate liquidity so they have to take a haircut.


As you can probably tell, I think homebuilding is a bad business. But as I said when I launched this series, you can have a bad industry, but a great company. Oftentimes investors will write-off sectors and leave gems out like NVR stock.

So what sets NVR apart? NVR actually filed for bankruptcy in the 1990s have a debt-financed merger went sour as the economy went into a recession. They came out of that will a new, safer business model that is quite differentiated.


NVR Options Land

Summing up NVR in one picture: The company takes very limited land risk.

So for an initial deposit, NVR keeps flexibility of whether or not it will buy the lot. This helps it keep flexibility in a downturn so that its not still acquiring things that may be bad investments or it can divert capital elsewhere when needed (in fact, NVR is the only builder right now that can confidently buy stock on the cheap due to its flexible model and strong balance sheet). This also means it keeps very little land on the balance sheet compared to peers because it doesn’t own it.

This is very different than the rest of the industry:

Let’s compare how the cash flows then look for a traditional builder. Pay attention to working capital, which is mostly inventory movements (may need to click on picture to see better):

As you can see, Lennar generated cash in the financial crises, but it came from liquidating inventory. It then needed to replenish as the market came back. It was forced to sell when you’d want to be a buyer and forced to buy when you’d want to be a seller. 

Let’s compare that to NVR’s cash flows. It too sold down inventory, but as a % of earnings, it was much lower and emerged much stronger. It also didn’t need to impair large portions of its book like Lennar did.

NVR Builds Only After the Home is Sold. NVR does not typically take ownership of a lot until it has pre-sold a home and the buyer has qualified for their mortgage and then it begins construction on the unit. This also reduces risk that the company spends capital today for no reason.

NVR ships pre-cut materials to the job site at specified requirements. This speeds up the building process for quick & efficient assembly. The company is one of the few builders to maintain manufacturing facilities for framing products as well as windows & cabinets. This type of vertical integration helps control costs and provide efficiency.

Maintains leading market share on a local level. I shudder whenever a homebuilder acquires another where it doesn’t currently build. Think about it – what benefit does the transaction bring? Yes, it brings lots in a new region. Some would say diversity is good. But M&A is typically done at 1x book value or above. So how does that create value? You won’t get any purchasing scale or scale on labor used unless you expand your market locally. It’d be much better to buy a player where you already operate. Lower competition plus gain regional scale.

NVR’s strategy is to gain leading market share where it operates and growth areas stem from places its operated before. NVR has a dominant 20%+ share in its core markets — much higher than peers’ typical share of 7-10% when they have a leading position.

Combining the last two points translates into similar margins to peers. NVR did about 35% of the sales that Lennar did in 2019. Yet compare their financials. NVR is lower GMs (which is a byproduct of their business model), but also much more efficient with SG&A, as discussed. This leads to comparable margins to peers.

Land is the most capital intensive part of the business, so they (i) are earning similar margins as peers but also (ii) turning inventory much faster than peers. This translates into much higher ROEs… higher ROE in the long-run helps NVR stock outperform peers.

Breaking this out – look at NVR’s historical ROE!

Why doesn’t everyone operate this way?

  • Not all geographic areas offer options like the ones NVR uses, so it may inhibit NVR in the long-term. But also many builders in other areas simply don’t have this option.
  • In times of growth, NVR’s top line will typically lag peers as its business model acts as a governor. Through cycle though, we can clearly see the benefits
  • Gross margins, in the good times, can also be better because you are selling low cost inventory into higher prices

NVR’s sales and earnings aren’t the largest, but its differentiated strategy aimed at limiting risk has obviously helped in a cyclical industry. As you can see by NVR stock, slow and steady wins the race.

Breaking Down Amazon’s Business Strategy in 6 Points

What better way to open my new Competitive Strategy Series than to focus on Amazon – a company that has had great success the past two decades. But Amazon’s business strategy may surprise people – it got to where it is largely by following the playbook that others laid out before it.

I’ll be starting at the beginning because I hope to show that decisions a company makes compound over time. This compounding of focus and good decisions leads to a competitive advantage that we are seeking. Spotting these moves could help you find investments at the beginning of the curve, which I think will drive to higher returns.

I don’t need to share this, but looking at Amazon’s stock over time shows they’re building tremendous value. Companies don’t do this by accident — they follow a certain business strategy.

AMZN Total Return Price Chart

AMZN Total Return Price data by YCharts

How did it do this?


Amazon gained appropriate scale:

I’m actually not talking about the distribution and warehouses that ship literally everything today. Don’t skip ahead — I’m talking about Amazon’s business strategy, its choice, to focus on books in the beginning. Why books?

  • Books had more items than any other category.
  • At the same time, a hard copy of “A Tale of Two Cities” is basically the same as any other hard copy. So a lot of SKUs, but at the end of the day this was a commodity business.
  • Not manufacturing themselves, so quality assurance wouldn’t be a big issue in the beginning – just get the books in customers’ hands
  • Customers value two things in books from a retailer: availability of the book I want (when I want it) and the best possible price. That is all Amazon really had to focus on in the beginning

Amazon quickly built a catalog of over 2.5 million books, more than what a local bookstore could carry. It would keep inventory of 2,000 bestselling books so it could ship quickly or it would have a relationship with a publisher to print it and ship it as fast as possible.  I went back to Amazon’s 1997 IPO prospectus and decided to clip what it said about the business:

For those interested, I found this old video of Jeff Bezos explaining Amazon in 1997.


Gained Cost Advantage:

A firm can generally control costs in two ways:

  • control the cost drivers (i.e. continually focus on reducing the cost of producing something so you can edge out competitors), and
  • reconfigure the value chain to drive costs lower than competitors

These aren’t mutually exclusive, but the e-commerce space was in itself re-configuring the value chain. Publishers produce books, ship them to a Barnes & Noble distribution center and then shipping them to the stores to sell to customers.

Amazon’s business strategy would sell direct to consumer. This would cut out costs in the long run. Amazon was so focused on reaping advantages from being a First Mover, that it purposely kept its margins low to sell more books.

Amazon realized that if throughput increased, they could drive down their share of fixed costs to serve customers. Keeping all other costs constant, scaling up and taking share clearly would help profitability, especially for a commodity product. Here’s a simple example with made up numbers on how scaling up a low margin business (GMs around 20%) can be profitable when you increase throughput:

Obviously in Amazon’s history, they then used this scaled-up power to push on publishers to drive down their costs. Therefore Amazon’s GMs would increase and fixed costs would also be down as a percent of sales which would increase their dominance even further because customers wanted to pay less.


Increased Buyer Value:

Creating differentiation can’t just be price though. I can enter an industry and just charge less than my competitors and destroy value by earning lower margins and competitors might just follow suit – spoiling it for everyone. Generally, creating true value is raising buyer performance while keeping prices the same as competitors.

Enter two-day shipping – which we all now know and love. This ties back to the last point, but I wanted to bring this up now even though two-day shipping didn’t show up until 2005.

Amazon’s business strategy was a new way of selling products — direct to consumer. This increased satisfaction and kept prices low, increasing total value. It even decreased costs in indirect ways – I no longer need to drive to the bookstore, peruse the aisles, and hope the book I want is there. I go online, point and click to order and it’ll arrive at my doorstep in a couple days.

Many customers looked at the cost of Amazon Prime ($79) and said to themselves, “over the year, I’ll easily make that up in costs I would’ve spent on shipping, I’ll get my goods in two days, and I’ll get those goods at competitive prices.”

This part of Amazon’s business strategy is clearly not unique… This is no different than what Costco did – offer goods at a discounted price, but require a membership fee which can help subsidize the business you while you scale. Hopefully you then create enough incremental demand by the value you provide to consumers that you get scale on an otherwise low margin product.


Shared-logistical system:

“Hey, if we already have a warehouse for books and we’ve figured out online ordering for customers in an efficient way, why don’t we sell more products this way?” This happens in many industries.

For example, in building products distribution, if I am shipping wallboard to a home and the construction team doing the work also needs some fasteners, doors, adhesives etc., why not throw it all on the back of my truck and charge for one order when I show up? I capture more value because I am selling more goods, I can do so at a cheap price because I am going there anyway and making one shipment, and I can pass some of those savings on to the consumer to encourage it.

Amazon’s business strategy has taken this to the extreme by being the “everything store” but you can start to see how the book playbook can just be repeated over and over in each new category.


Focus on Converting Buyers:

Another way to differentiate your company is to change your advertising compared to competitors, educate the buyers on why your product is sophisticated and will reduce their total cost, or get in front of the right buyer at the customer level who understands the value of the product (think the engineer at the company vs. the CEO who doesn’t understand why the company needs to spend more money). Each of these cost money, but will help convert buyers who are on the fence between you and a competitor.

Amazon’s review platform helps solve that problem and actually is a differentiator that builds on itself. A buyer feels comfortable buying from Amazon because thousands have bought the same product from them in the past and had very reliable experience. Or they shared their frustration and helped a buyer not make a mistake. Many other companies have since launched a review section on their site, but none really can match the depth of reviews Amazon maintains.


Share What You Learn.

Ok now we’re getting to things Amazon has done differently, but is extending its lead. Most learning from a first mover is fiercely kept secret. The last thing I want is for a competitor to copy what I am doing and close the gap.

Enter Amazon Web Services. Amazon could share its computing infrastructure, with cloud services, with all companies… and obviously charge for it. This is truly differentiated product which can provide a product & service to companies at a cheaper rate than its customers could themselves – no more buying server equipment for each new business.

The other thing it did to also leverage its existing infrastructure was to become a platform. Now buyers & sellers could connect on Amazon’s site and sellers could leverage Amazon’s fulfillment services. This means that a swath of sellers could offer their products with two-day shipping via Prime, which buyer’s value, and that means these non-Amazon sellers can increase their audience and therefore sales.

In return, Amazon charges inventory storage fees, fulfillment fees, among others. And all the while, it’s leveraging its infrastructure and now not taking inventory risk. You can envision a scenario where Amazon becomes an “infrastructure” company. You want to sell to all these customers we control? You have to pay the toll. In a way it is already charging buyers for access to the platform as well via the Amazon Prime annual membership.


The path forward:

Many of us know Amazon’s history well, but hopefully now you can see its success was meticulously planned to gain a competitive advantage.

So where does it go from here? I think we see Amazon’s profitability expand pretty dramatically over the next 5 years.  And I’m not just talking about AWS. In my view, Amazon’s business strategy, its long-term focus, will start to really show itself the next few years.

How does Amazons profitability and return on capital improve?

  • Continued Scale on Resources: So far, Amazon has been reinvesting every dollar back into the business to grow distribution centers and lower shipping times.
    • In the short run, this burdens the income statement as Amazon said they would do:
    • In the long run:
      • more customers come to Amazon
      • they are less likely to switch given Prime and shipping benefits that customer’s value
      • Amazon achieves efficiency, gains route density, improves margins
  • Continues to shift into an “Infrastructure” company: Clearly, we’ve seen the growth of AWS and what that can mean from a profitability standpoint (50% EBITDA margins). We could reach a point where Amazon is selling less goods on its site than other businesses. Instead, it just charges the fee to connect with buyers and sellers.
  • Preemptively Change the Game: I’ve talked a lot about Amazon’s decisions here, but one I glided over was how it consistently changes the rules. From launching on the internet, to moving to two day shipping with Prime, to AWS, and now Alexa, the company has proven itself to be always one step ahead of the curve. What will they do next? As Bezos said in his 2015 Annual Letter:
    • ” Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there. Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a ten percent chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten”
  • Capitalize on Date for Advertising: Sorry to anyone who hates Facebook or Google using their data, but Amazon is now the third largest advertiser in the digital space. And I think they will be huge here:
    • They may not have all the direct data that you entered, like Facebook has, but they probably know whether you are single or married, a family of four, and where you live.
    • If I live in Florida in March, while I am scrolling they can show me an ad for sunscreen. That’s valuable because it helps sellers target their audience rather than shooting dollars into a black hole and hoping it works.
    • Right now, you do a search and a “sponsored ad” appears, promoting a product that is within your search query. It’s only a matter of time before this ads are tangentially related (“looking for an oil filter for your car? Click here to find out how you can save 15% on your car insurance…”)
    • Advertising is high margin and low capital intensity. It also may improve buyers satisfaction if it directs them to things they want.
    • As an aside, they also own Twitch, which is essentially becoming a YouTube competitor
    • I think this will improve Amazon’s return on capital and its free cash flow – more than people realize.

 


I’ll leave this post with another quote, this time from the 2016 shareholder letter,

“Jeff, what does Day 2 look like?”
That’s a question I just got at our most recent all-hands meeting. I’ve been reminding people that it’s Day 1 for a couple of decades. I work in an Amazon building named Day 1, and when I moved buildings, I took the name with me. I spend time thinking about this topic.

“Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1.”

It’s clear to me that Amazon’s business strategy has had focus since day 1.

If you enjoyed this post, please check out my Competitive Strategy home page as well as some of my other posts!

Competitive Strategy – Business Decisions that Strengthened Companies, No Matter the Industry

I’m launching a new, recurring series called: Competitive Strategy – Spotlight on Decisions that Strengthened Companies, No Matter the Industry. Why am I doing this? Frankly, I am tired of hearing “this is a good business” or “this is a bad business” with some blanket statements behind why. How many times have you heard why a certain company is a “good business”?

  • Consolidated industry
  • Leading national market share
  • Asset light
  • High margins
  • Stable demand
  • Of course, saying a business has a “moat” doesn’t hurt

A company that has some of these features isn’t necessarily great. If you want to learn why (or disagree and would like to hear differing thoughts) stay tuned. I am actually launching the first in the series today – and what better way than to start with a company like Amazon.


A company’s competitive strategy outlines what decisions it will follow every day.

Where it will compete, what segments of the market it will target, where it will choose to scale, how it will use its balance sheet, and what will customers value?

These decisions can result the metrics I mentioned above, but the metrics themselves do not make the business good, or differentiated.

I will go through the competitive strategy of a wide array of companies.  Decisions companies have made / are making to show how those decisions upgraded them from good to great.

I hope to surprise some folks by discussing names that are in “bad” or cyclical industries. Sometimes you can have a bad industry, but a great company within that industry – and sometimes the stars align for a great investment opportunity.

After writing a few of these, knowledge will build and I probably will refer back to previous posts for examples on different company tactics (e.g. hard to not say Amazon Prime is similar to the Costco Membership strategy)


Here is a preliminary timeline of companies and industries I will examine (subject to change). If there are any companies you’d like for me to add, reach out to me in the comments or on twitter and I’ll add it to the queue. Some names may jump to the top if there is enough demand.

Here’s the one’s published so far:

The Timeshare Stocks Look Attractive… as Does Their Debt

Timeshare stocks look attractive… as does their debt. I know what you are thinking – time shares are the last place I want to be investing right now. Just look at hotels – demand has evaporated. Just look at the google search history:

But there may be some things you don’t know about the timeshare business model that may show they are more resilient than you think.

Out of the timeshare stocks, I’ll use Wyndham Destinations (WYND) as the example.  WYND generates revenue through two ways:

I’ll briefly explain “ownership” as I think most people are familiar with it. The company sells VOIs and in exchange the purchaser can use a specific unit in a property for a week or so. Or they can use allotted points to go to another property.

Typically, WYND and the other players either sell the VOI and get paid upfront or have financing options for the customer. (Note: yours truly recently attended a timeshare pitch – it was around $15k to buy the unit showed to me and they offered financing around ~14-15%).

After the purchase though, the purchaser must continue to pay an annual maintenance fee, which is the share of costs and expenses of operating and maintaining the property. So here we have a major difference between hotels. Hotels have to cover opex and maintenance of the property through its sales revenue (i.e. selling nights). Timeshares already have a book of business that they collect maintenance fees to cover costs. Timeshare costs cover:

“housekeeping, landscaping, taxes, insurance, resort labor, a management fee payable to the management company, and an assessment to fund a reserve account used to renovate, refurbish and replace furnishings, appliances, common areas and other assets, such as structural elements and equipment, as needed over time”

A lot of these costs a hotel must cover even if revenues are zero. Sure they can cut costs, but some of these (taxes and insurance) don’t go to zero just because sales are. Plus, the timeshare is clearly receiving a management fee here as well.

There is a risk that people stop paying these maintenance fees, but that really happened in the last recession because the timeshare managers weren’t maintaining the properties well.

How are timeshare stocks different than 2008/2009? Timeshare companies are different now in a few ways:

  • They are mostly all independent – VAC used to be a part of Marriott and Starwood, Hilton Grand Vacations is now independent from Hilton.
  • No longer sell high-end products – prior to the financial crisis, the timeshare companies got into “high end” time shares in residential units, which collapsed. They no longer focus on this.
  • No longer sell to sub-prime – as shown later, WYND’s credit book has an average FICO of ~720 compared to sub-prime, low-FICO borrowers in the prior downturn

Before I dive more thoroughly into the company, I want to explain really quickly why I am focused on WYND and keep this in mind for the remainder of the post:

Why WYND? There are other Timeshare stocks with good names like Hilton and Marriott…

  • Roughly 1/3 of WYND’s exchange business comes from membership fees, balance is from members swapping timeshares. Cash is actually received when they book, not at the time of stay. So any timeshare opportunists out there may be swapping for 2021 as we speak… and WYND will be collecting cash.
  • Another 17% from WYND come from HOA and property maintenance fees. This is very stable.
  • Solid liquidity: WYND put out a press release that it has $1.3BN of cash and $883MM of receivables it can finance. It therefore has plenty of liquidity to weather the storm.

The one benefit in favor of Hilton (HGV) and Marriott (VAC) is that they charge annual membership fees at the beginning of the year and have already collected the cash. WYND automatically deducts on a monthly basis. I’d prefer to have the cash in the door day one, but beggers cant be choosers.


Sources of Revenue:

Vacation Ownership

  • Timeshare sales (pretty intuitive)
  • Consumer Financing:
    • Finance the purchases noted above. Average customer FICO was 727, 727, 726 for 2019,2018, and 2017 respectively
    • During 2019, the company generated $1.5BN of receivables on $2.3BN of gross VOI sales – timeshare companies typically securitize this, which WYND does, so that they create capacity on the balance sheet to sell more VOIs.
  • Property Management:
    • Company has 3-5 year property management agreements, which typically renew automatically

Vacation Exchange

  • This essentially means that you can use your time share as currency for an “exchange” on another platform. RCI is a popular company for this. The tour that I did was in Florida for example, but I could exchange my points to go to a Disney vacation club or Aspen.
  • The vast majority of revenue here is driven by annual membership dues and fees for facilitating exchanges.
  • OK – if there aren’t many exchanges this year due to a slowdown in travel, that will get hit, but annual membership fees should be very stable

Now that we’ve gone through the revenues side, we should look at the major expenses. I.e. Let’s stress test WYND.

Cost breakdown

I’m doing this to see how much is variable vs. fixed and what they can cut to preserve cash. Note, I pulled these breakdowns from Hilton Grand Vacations because they do a great job breaking it out line by line whereas WYND brackets a lot of it together:

  • Cost of VOI sales – represents the costs attributable to the sales of owned VOIs recognized, as well as charges incurred related to granting credit to customers for their existing ownership when upgrading into fee-for-service projects. If you’re not selling new VOIs or acquiring new inventory and customers aren’t exchanging, this probably can flex considerably lower.
  • Sales & marketing – relatively obvious. But if you know you’ll have no sales in the next few months, you could cut this back tremendously. Perhaps 90%.
  • Rental and ancillary services expense – These expenses include personnel costs, rent, property taxes, insurance and utilities. These costs are partially covered through maintenance fees of unsold timeshare slots and by subsidizing the costs of HOAs not covered by maintenance fees collected. These are relatively fixed, however.
  • Resort & club management fees – payroll and other admin costs associated with running the clubs. I think this could be cut back drastically, but maybe will say 50%.
  • Financing – financing charges for securizations, but is offset by financing income
  • General & Administrative – back office costs in general. I assume this could be cut somewhat, but might be 75% fixed.

All in, I would say not super variable cost structure, but also not terrible.


Financial Summary

Here is my breakdown of what I expect could happen to WYND for the balance of 2020. Yes, it looks brutal, but at the same time, with a complete halt of travel its not really as bad as you think. They actually remain EBITDA positive throughout this year. If you look at the price of Timeshare stocks too, I can’t help but think this is priced in.

How does this translate into FCF? Believe it or not, I think the co could be FCF positive this year:

Therefore, if I think the business isn’t permanently impaired, we could be scooping it up for a great discount. This actually will build the company’s liquidity position as well.


Valuation

Looking out to 2022, WYND is trading at <3.5x EPS and ~4.5x EBITDA. That seems way too cheap to me.

Finally, why is the debt interesting?

If the company maintains over a $1bn of liquidity this year, they will have no problem addressing their next maturity, a $250MM tranche in 2021. Right now, that bond trades at around 90 for a YTW of 17.6%. I’ll take that all day. Frankly, the company may want to scoop some bonds up on the open market. Buying the bonds at even 95 cents would save the company ~$12.5MM in principal plus additional savings from interest expense.

COVID-19 Throws the Mortgage Market into Turmoil #COVID19 $REM $OCN $MORT $NLY

The mortgage market is in turmoil right now. While congress passed the “CARES Act” to provide relief to families impacted by COVID-19, there were clearly some unintended consequences.

First Mortgage Market Issue: Possible Bankruptcies in the Servicer Space

The CARES Act allows homeowners and renters can stay in their homes in the case they can’t pay their monthly dues during this crisis. This establishes a 120-day mortgage payment moratorium option for borrowers with agency-backed mortgages (i.e. those loans backed by Fannie, Freddie, and Ginnie which constitute about 60% of the entire mortgage market). This created significant uncertainty in the mortgage market that I hope to walk through.

How the mortgage process works:

When a lender provides a loan for you to buy a house, odds are that lender will originate that loan, package it along with other loans into a mortgage-back security and effectively sell the risk on to investors. They will retain some mortgages on their books, but they do this so that they can continue to originate loans, possibly generate a gain on sale, and generate fees.

Typically, when a homeowner is paying interest and principal, another company called the “servicer” handles the payments and divvies it up to investors, tax authorities, etc. In exchange, they receive a small, fixed fee as a % of the principal balance they manage. This is how the mortgage market typically functions.

The problem: Mortgage servicers are required to pay principal & interest to holders of the mortgages, even if there are missed payments.

Mortgage servicers are not huge companies raking in tons of money off of this service they provide. Banks would be much better prepared to fund this gap.

Therefore, if 5, 10, 15% of people with mortgages decide to defer payment, this could bankrupt the servicers and cause turmoil in the function of the mortgage market.

If 10% of GSE loans are delinquent for 3 months, that would be roughly $6BN in cost – something the servicers don’t have lying around (assumed based on $4trn GSE loans @ 4% WAC). This also doesn’t include taxes and insurance.

Lastly, if Ginnie borrowers can’t be brough back to current on their loans, then the servicers need to fund the buyout of those loans while modifying and re-pooling the loans.

Investors may not receive payment in securities they thought were very safe (remember, backed by government sponsored enterprises like Fannie & Freddie & Ginnie). These investors may also be levered to juice their returns on the securities which may throw them into bankruptcy as well.

Investors were trying to shore up liquidity ahead of some of these unforeseen and unknowable outcomes (i.e. they are selling securities). Agency MBS spreads over treasuries widened to ~140bps compared to ~30bps from Dec 2019 through February 2020. Then the Fed unleashed unlimited QE on agency MBS, so that helped calm the market a bit.

Still, if this is the way we are going to operate, the Fed or the servicers should come up with a liquidity facility for the servicers. Ginnie Mae announced it will launch a liquidity facility in the weeks to come (details TBD) but we need a much more encompassing rule.

Another issue here is in the originators warehouse. Let’s say you are a bank with a “warehouse”, which is like a revolving loan in which you ramp up loans before you sell them off. In a simple example, let’s say in normal times you can originate 2 loans in your warehouse per month, sell them off to investors, and start the process over with capacity in the warehouse for 2 more loans next month. If you originated a loan that isn’t performing, you cannot sell that to investors… that freezes credit. Now the originator is stuck with a bad loan and his capacity to make new loans is drastically reduced. This has me worried about the flow of credit when it is needed.

Second Mortgage Issue: Margin Calls on Mortgage REITs

Take what you know from above and apply it here: widening spreads on previously high quality assets can have negative impacts on levered vehicles.

The agency MBS spreads widened materially and since interest rates and prices move in opposite directions, that causes agency MBS to fall. Mortgage REITs (mREITs) use agency MBS as collateral to back their short-term financing in the repo market. The falling bond prices triggered margin calls on them and we saw many names were unable to meet their margin calls.

After the Fed announced it would buy unlimited agency MBS and treasuries, this helped calm the market, but clearly a lot of damage has been done. The Fed buying mortgages actually helped trigger margin calls. This is because mortgage originators protect their loan pipelines with interest rate hedges to buffer the impact of market rates moving higher than “locked in” rates. These hedges are profitable when MBS prices fall, but the Fed’s massive purchases pushed rates lower. Therefore, broker-dealers put out margin calls and stressed lenders’ liquidity positions.

This also still leaves the non-agency resi and non-agency CMBS space in turmoil, which we’ll discuss next, as names like Annaly is down 62% from the peak in late February. REM, the mREIT etf is down 70% as is MORT.

Third Mortgage Issue: Little bit of both

Fannie and Freddie have allowed multifamily landlords whose properties are financed with performing loans to defer payments by 90 days if they’ve had hardship due to COVID-19. In return, they can’t evict someone who isn’t payment. However, this is just multifamily and just agency-backed names… that leaves 75% of the commercial real estate mortgage market in trouble.

Many other landlords won’t be able to service debt if their tenants enter forbearance or cant pay interest. I’m not sure the system can handle that (i) wave of requests and (ii) that many missed payments. Ultimately, what we will and probably already are seeing is a freeze in the CRE lending market. This too, is causing margin calls on the CRE mREITs.


Its fine to think “ok well, we can get past this. People understand the credit crunch and can forgive a missed payment here and there.” But you have to remember credit drives this economy. The credit cycle = the business cycle, which is why the Fed has gone through great lengths post-2009 to keep rates low and lending on the rise. This system is more connected than ever before. What happens now when maturities come due? There are many questions still left unanswered and this is a truly unprecedented time!