Tag: coronavirus

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

The mortgage market is actually 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

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!

Will Exxon Need to Cut its Dividend? $XOM

Saudi Arabia and Russia are in a price war — increasing the supply of crude oil at a time when we are seeing an unprecedented collapse in demand due to the coronavirus (COVID-19). Exxon has gotten crushed this year, down 45% YTD with a 9% dividend yield. They’ve consistently paid, and grown, the dividend over the past 37 years. That’s a juicy proposition for a company that is rated investment grade and at a time when the 10 yr treasury yield is <70bps.

But let’s do some quick math to see if the dividend is covered, first by looking at 2019 figures. As shown below, Exxon did $1.5BN in FCF.

This is not good. Exxon spent $14.6BN on dividends in 2019. One thing we could do is look at what bare-bones capex is. In other words, what did the company spend in 2015/2016 when the oil outlook was also bleak? Cutting capex down to those levels would help preserve cash:

So now we have ~$10.5BN of FCF, but that still doesn’t cover the dividend. The other problem is that cutting capex is not what the company wants / intends to do. As stated in their March 5, 2020 investor day, they will actually be spending more than 2019:

Sure, they leave an out to lower capex, but this was the beginning of March so we already could see the demand destruction. I will say, this was a few days before the price war. Even so, cutting capex back doesn’t help. And the bigger problem is that oil was roughly 100%-200% higher in 2019 than it is right now.

Exxon could sell assets to help cover the dividend, or increase its debt load, but is that really what you want in a commodity industry?

I think its a matter of when, not if.

Will Coronavirus Kill the New Media Tech Giants? $FB $GOOG

We’re all locked inside. And that means we’re all watching Netflix, shopping Amazon, and perusing Facebook & Instagram and googling places we wish we could visit. That means all of these companies will benefit from the virus, right?  Facebook and Google must be killing it with advertising revenue.

Facebook just put out this somewhat misleading press release. In a gist, it says app usage is skyrocketing…

But….

“Much of the increased traffic is happening on our messaging services, but we’ve also seen more people using our feed and stories products to get updates from their family and friends. At the same time, our business is being adversely affected like so many others around the world. We don’t monetize many of the services where we’re seeing increased engagement, and we’ve seen a weakening in our ads business in countries taking aggressive actions to reduce the spread of COVID-19.


Both Facebook and Google make money off of small-and-mid-sized businesses. While having a lot of users allowed them to begin charging businesses for ads, it doesn’t necessarily mean they are making money off all the users. More on that later.

The interesting thing about them is that they have been fast growing through the past ten years, but weren’t really around in the past. Therefore, the business model hasn’t really been tested through a real recession.

Advertising is cyclical. This makes some intuitive sense. When business is going well, you have extra funds left over that can be used for generating more sales. Or competition is higher because there is room for it and so you need to maintain market share. YOU may even be the new entrant trying to gain that share.

In a downturn, cuts have to be made. If I am a restaurant, I can’t really sacrifice much on food costs or labor or else my customers may have a bad experience.  If I also have a feeling that consumers don’t really want to spend money right now (e.g. unemployment is going up) then why not cut my advertising spend? It ripples through the chain.

As the saying goes, “Half the money I spend on advertising is wasted; the trouble is I don’t know which half.” This has historically resulted in cuts to spend since CEOs don’t feel like they are getting the bang for the buck.

Here is a snapshot of “old school” advertising companies’ peak-to-trough in the Great Financial Crisis (GFC).

Note, for the TV broadcasters I am using 2-yr average results given election years play a factor in results.

I also use gross profit given incremental margins matter so much in advertising. Quick Segway: If I have an existing network of 10 billboards in a town and 9 of them are on rent, you can see how getting that last billboard on rent would result in meaningful profit to the bottom line. My sales go up ~11%, but my costs barely go up. True in nearly all advertising and very true for Facebook and Google. Ok back to the main points.

What Can We Expect from the Tech Behemoths

I highly doubt many people are truly thinking about Facebook or Google’s earnings declining at all in 2020, but it’s something worth pondering.

Facebook on its Q4’19 earnings call stated there are now, “140 million small businesses that use our services to grow.” Google, in its filings, specifically discusses how its targeted ads let small businesses connect with customers.

If the virus ripples through our economy, taking down small restaurants and bars, local gyms, and people pull back on buying cars from their local auto dealer — that could clearly impact Facebook and Google’s results. With most restaurants closed right now, why would I advertise as much?

Unfortunately, it’s impossible to see where Facebook and Google make their money by segment. It’s much easier to know that Yelp generates most of its money from restaurants looking to promote themselves in a competitive field. Not true for the tech behemoths though.

We have some financial history with Google, given its IPO was in 2004. The problem is that it was secularly growing during the GFC. Google does $162BN of revenue today. It did $16.6BN in 2007 at the “market peak”. It kept growing through the GFC, though growth did slow to just 8.5% in 2009 over 2008.

Sell side estimates currently expect 16.7% growth in 2020 for Google… on much larger numbers. Facebook is expected to grow 20%. These may prove aggressive.

Impact from the Virus

I do not think it is out of the realm of possibility that we could see sales growth slow meaningfully for the tech giants. This will lead to a reset of expectations, though admittedly, the two ad tech giants trade for reasonable multiples (believe FB is 12x earnings ex-cash). My larger fear is the reset of investors’ view of the business as whole — they may no longer be bulletproof.

That said, if I am in charge of an ad budget, this may accelerate my shift away from traditional media and to Facebook and Google. People are at home, shopping online, then why not. Plus, its super-high ROI advertising spend. In other words, I don’t pay Google unless someone clicks on the ad, so I’m only paying if the ad works.

This dynamic may finally get rid of the adage I mentioned above – I now know if my ad is working. And because of this we could see more resiliency out of the new advertising names and it could be a bloodbath for traditional names. However, it still holds true that I’m not going to buy an ad, or at least as many, when I’m struggling to pay payroll or rent.

Separate Challenges for Google

Google has been expanding in the travel space, in fact encroaching on ground owned by Booking’s Kayak or Expedia. Booking said in its latest 10-K:

Some of our current and potential competitors, such as Google, Apple, Alibaba, Tencent, Amazon and Facebook, have significantly more customers or users, consumer data and financial and other resources than we do, and they may be able to leverage other aspects of their businesses (e.g., search or mobile device businesses) to enable them to compete more effectively with us. For example, Google has entered various aspects of the online travel market and has grown rapidly in this area, including by offering a flight meta-search product (“Google Flights”), a hotel meta-search product (“Google Hotel Ads”), a vacation rental meta-search product, its “Book on Google” reservation functionality, Google Travel, a planning tool that aggregates its flight, hotel and packages products in one website and by integrating its hotel meta-search product into its Google Maps app.

 This is a problem for Booking and Expedia because they use Google to generate leads for their own sites. While Google may eventually consume these businesses, they also represent non-trivial amounts of their revenue.

Booking stated,

 Our performance marketing expense is primarily related to the use of online search engines (primarily Google), meta-search and travel research services and affiliate marketing to generate traffic to our websites.

How much was “performance marketing” expense?  $4.4BN in 2019 for Booking and $3.5BN for Expedia.

I bring all of this up for a reason: While Google may eventually compete away these businesses, but today they matter. And those businesses are likely being crushed by the lack of travel demand right now, which will mean less spending with Google. These are just two companies, but ~5% of sales for Google. Now imagine every hotel chain, restaurant, airline and so on also pulling back… Now weave in the incremental margin we discussed earlier…


This virus is truly something we haven’t seen before. It permeates everything we touch. Long-term, I think Facebook and Google are amazing businesses to own, but don’t be surprised if 2020 is a hiccup and expectations are reset.

My playbook for “backing up the truck” in this market. Putting my buy-decision thoughts completely out there $SPY

I did a post yesterday on some data points to consider before buying in this market.  I’ve been nibbling on the way down, but looking at some of the data points, I have to agree with what Gavin Baker has said in a recent post: this is a tremendous demand shock that we have not seen the likes of before. It will be very difficult to navigate it this time because its almost like a 9/11 and a 2008 demand shock rolled into one (but not a financial crisis like 2008 was).

The market clearly priced some of this in. The chart below shows the Russell 2000 drawdowns in the past. We’ve already surpassed the drawdown of 2001-2002 and did so much more swiftly. If anything, this drawdown is looking like 2008 just from the slope of the line (its steep).

IWM Chart

IWM data by YCharts

The Fed has acted quickly, congress knows it needs to get its act together, Trump views the stock market as the best polls, proposals are coming together to give every American $1,000 to bridge the gap, and there is plenty of talk of bail outs. Seems like some lessons were learned from 2008… act fast.

But is that enough? Is everything “priced in”? How will the market react to new information of cases vs. stimulus? That’s a billion dollar question. Personally, I think we have further to go before I can say we all need to “back up the truck“. Yes, I view this as temporary and there will be pent up demand, but as I think through what happens over the coming months, it goes something like this:

  1. Markets have tanked, fear is palpable, there have been runs on grocery stores. Consumers are literally quarantined so the only thing they can think about is the pandemic which drives more fear
  2. Congress and Fed act quickly, but this also tells people that things are serious. Congress puts together a bill to give $1,000 to every American; agrees to provide some loans to essential industries
  3. Just like GM – I don’t see why Congress would give a subordinated loan to these industries. In other words, it primes (or comes in front of) existing lenders plus equity holders. It’s hard for me to see how equity holders get out scot-free here, as well as bond holders. Haircuts will be taken.
  4. Even with Congress taking action, if I work in the restaurant, bar, travel, event hosting, leisure, or any service industry remotely attached to that, I’m thankful for $1,000, but I am worried about my job. I pull back spending considerably. As a consumer, thanks for the grand, but I still am not spending much.
  5. This ripples through the economy. First pullbacks on major purchases (vacations clearly cut, but also autos and home buying) and that continues through everything else.
  6. All the while, US count of the virus will likely grow considerably. We likely reach 100,000+ cases as more tests come out. This will cause the market to freak out and people will go from thinking this is a four week thing to a 12 week thing… maybe longer. The market always assumes the bad things will last much longer than they do.
  7. Media headlines will run rampant.
  8. You will also see bankruptcies of small and large businesses. BDCs and middle market private equity that invested (& levered up) companies with major customer risk and exposure to small business? See ya later.
  9. Elsewhere, cases will begin to decline. Markets will take a deep breath that the measures are working, even if they continue to climb in the US. The market is forward looking so they will see hopes for the US.

So what does that mean for equity prices? I think we have further to fall, unfortunately. Don’t get me wrong – I fundamentally do not believe you can time these things (“Well gee, you sure did waste a lot of text writing about what you think will happen…”) and I have bought many names throughout this bear market. As I noted in my cruise lines post, which was really clickbait for readers to see that long-term intrinsic values of businesses will be fine,  I think this creates a good opportunity to buy high quality businesses.

At the same time, I look at the market and it is just below / slightly above Dec 2018 lows depending on which market you’re looking at. As a quick barometer or sanity check, that doesn’t seem low enough for truly pricing in a destruction to GDP in Q2 this year and people worrying about systemic issues.

Backing it up to a P/E ratio: If we did $164 in EPS for 2019. There’s probably 0% chance we’re up from that number. We can haircut it though and multiple to see where things could shake out this year.  You can argue that because these are depressed earnings and we all likely expect a rebound, that the market should trade at a premium multiple. However, I rarely see that play out in real life. Panic causes people to over shoot. And again, this is a cheapness indicator, not an intrinsic value indicator because one year of bad earnings does little to impact your DCF.

This essentially tells me that my “back up the truck” moment for S&P500 is somewhere around 2,000 and below and I’ll still be a buyer at around 2,300 because I believe the storm clouds will eventually pass and this shows if we go back to 18x $164 in earnings, that is very solid upside.

Ok – I put my thoughts out there. I open myself to being wrong in the future and this post won’t be deleted. Where do you think we shake out? Why?