Tag: COVID19

Is it Time to Buy Cruise Stocks? Pt 2 $CCL $NCLH $RCL #COVID19

It’s always a pleasure to share these pages with like-minded people. Today’s post was written by a very smart, very diligent guy — who just so happens to be a long-time friend of mine. During COVID-19, he’s scrutinized one of the most “center of the storm” sectors: the cruise line stocks . I was thrilled when he accepted the invitation to share his thoughts and work on the blog. I know you will be, too.


With almost five months of lockdown behind us, logic would tell most that the outlook for the cruise industry has gone from bad to worse. As you’d expect, most cruise lines have spent the last few months pulling together survival dollars for what could be the worst storm to hit while not sailing. But even in the darkest of times, could there be light at the end of this tunnel? Article #Is it Time to Buy Cruise Stocks? Intrinsic Value Impact from Coronavirus identified what I think is a very counterintuitive point – even when some of the most horrific events have hit cruise lines, their demand has been remarkably resilient in the following year(s).

For those who like bottom lines up front – I think CCL probably has best chance of survival, and a lot of assumptions used in this analysis are pretty conservative. This is a big gamble, and I’m not expecting any potential pay off until 2022 at the earliest (although reckless day traders may create some wild ups and downs along the way), but the payoff could be exceptional.

The case for strong demand recovery

So what happened after a massive pandemic hit, confining people to their homes in March and April…see Carnival swamped with cruise bookings after announcing August return or What pandemic? Carnival Cruise bookings soar 600% for August trips. When CCL announced cruise returns in August 2020, bookings shot up, with the spike reflecting a 200% increase in bookings over the same period in the prior year.

Who are these people making these bookings? Will these spikes in demand last? Even if there is strong demand, won’t governmental restriction stymie all chances for recovery here?

All great questions. The first two cannot really be answered definitively. If the past can be used to determine the future, it is fair to say that cruise demand has historically come back strong even after disastrous events. Further, many people seem to be of the mindset that Covid is here to stay, and are accepting its spread while hoping for a low death rate (whether this is an ethically acceptable position is an entirely different discussion and far out of the scope of this article’s analysis).

The last question is probably the most important here – where does governmental restriction fit in all of this? In my opinion, it is the most important final step in the recovery. If demand is there, but governments forbid sailing, then demand becomes irrelevant. Your guess is as good as mine here, but demand assumptions for the rest of this analysis are:

  1. No more cruises will sail in 2020 – only revenue accumulated was Q1’20, with a complete halt to revenue for the remainder of the year.
  2. Demand in 2021 is 50% of what it was in 2019.
  3. 2022 resembles normal operations – EBITDA falls somewhere between the min and max annual EBITDA generated in 2017, 2018, and 2019.

After diving into the financials of CCL, RCL, and NCLH (“The Big 3”), it looks like these three cruise lines have the ability to survive into next summer with no cruise activity. While some of these may be able to last longer, failure to resume sailing in the peak season for cruises (i.e. the North American summer months) would likely be a final dagger for these businesses. CCL looks best poised to survive of the three, so more of the below will focus on them. Note that as of date of this post, cruises in the US will not resume until October for The Big 3; however, some European cruises are still scheduled to go ahead as planned.

Survival – what does liquidity look like over the next year?

Let’s start by getting perspective on what debt looked like on the balance sheet for The Big 3 pre-Covid. Looking at Net Debt to EBITDA and FCF as a % of Debt (avoid using equity in this kind of assessment, as companies can mess with it via share repurchases, dividends, etc):

CCL looks best capitalized coming into this mess, and has traded cheaper in comparison to the other two – EV/EBITDA ratio is ~20% less than the other two at the end of 2019.

As you’d expect, over the last few months The Big 3 have moved quickly to build up liquidity to survive this next year, drawing down revolvers and issuing new debt. Some of the debt issued at CCL and NCLH are convertible notes, so assuming these companies recover I think it’s important to factor dilution into any analysis that you run. NCLH also took in additional equity investment from both the public and via PIPE from L Catterton.

Now let’s put together some pro formas for CCL. What does a projected income statement look like?

As expected, these next couple years look rough, but I’d like to reemphasize that 2020 assumes no additional revenue, and 2021 assumes 50% demand – unless Covid goes from bad to worse than we could have ever expected, these feel conservative. This analysis also does not bake in the benefit of reduced fuel prices that may stick around these next couple years.

Where does this get my cashflows?

Using rough numbers here, analysis projects that $7.3bn of financing is needed over next couple years ($3bn in 2020 and $4.3bn in 2021). The good news (depending on how you look at it) is CCL pulled $3bn from revolvers in March and issued $5.75bn of new debt in April (some of which is convertible, and should be assumed converted if CCL recovers), meaning they’ve already achieved the financing needed based on these projections. My above cashflow projections also assumes all treasury shares are reissued at approx. 80% loss, and per the below, 62.5m of the 190m shares have already been reissued.

Other comments on cashflow:

  • 2020 sales of shipsCCL plans to sell 13 ships in 2020 (approx. 10% of its fleet). I assumed $150m sale price per ship in my above cashflow estimates. I don’t think this is actually that alarming, as (1) these ships are probably older, and needed to go at some point anyway (who wants to ride an old cruise ship), and (2) 10% of fleet isn’t that bad given that they are the biggest cruise operator with ~45% market share. Competitors have also done and/or will probably do the same.
  • Cash outlays for ship orders- I’ve assumed that commitments for new ships will be wiped out over next few years. I think it’s fair to assume that CCL is probably under contract to take them, but in this environment they’ll probably tell the shipbuilders to pound sand the next couple years. It’s probably in the interest of the shipbuilders to suck it up as well if they do think CCL can recover – way worse trying to get paid if CCL gets forced into bankruptcy.
  • Credit vs cash refunds- so far, approx. 60% of customers have elected a to receive a future cruise credit rather than cash refund for their postponed cruises – definitely a positive sign for pent up demand

  • Breakeven point- the CCL Q220 earnings call transcript may be worth a read. David Bernstein (CCL CFO and CAO) notes that the breakeven point on an individual ship basis is generally 30-50% of capacity. He estimates that they’d need to run approx. 25 ships for cashflow to breakeven (approx. 25% of fleet). I view this as validation that my analysis is conservative, as I’m anticipating a cash shortfall in 2021 with 50% demand.
  • Debt covenants- I found some of the debt covenant specifics for RCL (net debt to capital ratio, fixed charge coverage ratio, min networth, etc); wasn’t able to find these for CCL and NCLH, but it looks pretty clear that The Big 3 will struggle to meet these. But similar to view on new ship orders, creditors will probably be willing to grant leniency if there is a light at the end of the tunnel – most lenders want to avoid seizure of assets and bankruptcy proceedings.

Other Considerations

  • Bankruptcy- while I definitely see potential upside in an investment in CCL, it is definitely risky. If Covid continues to unfold in a horrific way into 2021, The Big 3 could be pushed into bankruptcies. But important to consider impact to CCL if RCL and/or NCLH go down while it stays afloat. RCL is the 2nd biggest behind CCL – if it files Chapter 11 and is relieved of some of its debt payments, it could suddenly have the opportunity to compete more aggressively. If RCL drives its prices down, it could force CCL to follow, driving CCL into bankruptcy. Takeaway here is that bad news for the other two could ironically lead to bad news for CCL.
  • NCLH differentiation- while NCLH’s balance sheet looked bad going into Covid, two points that I think help its survival case:
    • (1) It historically focused on cruise routes that the other two were not focused on. See snipit from 2019 10-k:

    • (2) its ships are significantly smaller (~30+%) than RCL and CCL. This could come in handy if governments put official caps on the number of people that can be on a cruise at a given time (regardless of ship size).
  • Cruises sailing in 2020analysis assumes no cruises again until 2021, but if some of these carry on (unlikely in the US, but maybe more likely in Europe), it will be very important to track the outcomes and potential regulatory responses.

Bottom line

If betting on the survival and recovery of cruise lines is something that you’re interested in, I think CCL is the best bet. Back in March the market priced death into the Big 3 stock prices, and stock prices of these at the time of this post are not far from those March prices. Applying the lowest PE ratio from the last 10 years (excluding Covid) to this analysis’ EPS estimate shows a sizable ROI is in the cards. By no means should you view this as a real way to project the stock price, but point is that there’s a lot of potential upside here if you can handle the risk.

Caveat emptor. Hope you find this helpful!

Why did oil prices go negative?

Why did oil prices turn negative? How is that even possible? Typically, instead of paying someone to take a product away from you, you would just stop making that product and wait for another day so you can make a profit. Well, it is very difficult to just stop oil production and wait. It’s very costly to shut-in production and then restart.

What led to this issue? Supply is greater than demand right now. Given the impacts of COVID-19 means the largest consumers of oil have halted (jets and cars). At the same time, we’ve been building supply in Cushing, OK which is America’s key storage and delivery point.

Negative prices may seem attractive when you’re getting paid to take product, but aren’t so great when you realize if you were to take delivery (i.e. receive physical oil) you’d have to pay high prices to store it, which could eliminate all your profits.

Why didn’t the energy ETF sell-off more? If you look at Exxon or Shell or any of the majors on April 20th, their stocks were down maybe 3-4%. In fact, if you looked at Brent futures, the benchmark for Europe, it was selling for $25 / barrel. WTI contract for June delivery was $20 / barrel. Huh?

It all has to do with the futures market. Matt Levine also has a great post on this.  In essence, if you want exposure to oil, but didn’t want to actually take barrels of oil, you could buy a futures contract that gives you paper exposure to the commodity until it expires at which point you can either roll the contract (maintain paper exposure) or take physical delivery. If you go to the CME website, you’ll see you can buy oil in 1,000 barrel increments and it is settled “physically” – not financially – so you’d actually have to find a place to store it if you didn’t roll the contract.

When the June oil futures contract price is higher than May, that means the market is in contango. The June cost being higher than May partially reflects “the cost of carry” or storage costs for you to pay someone to hold the oil for you until the contract is settled. In this case, oil went into super contango because the cost of carry went to extreme levels.

This is also why energy companies didn’t sell off more. The “real” price of oil wasn’t actually negative. It was a panic to not settle physically. In fact, if energy companies hedge, they were likely the ones selling futures contracts before this point…

So this caused oil to turn negative?  Yes. As traders looked at their May contracts, they realized they couldn’t take physical delivery without paying huge prices. Also, panic probably settled in.

Was this predictable? Yes, actually. Here is a link to an article published on Bloomberg about 1 month before oil actually turned negative essentially predicting it could happen.

Could it happen again? Yes. And it might given investors decided to buy $USO, the oil ETF, to gain exposure. $1.5BN flooded into the ETF.  The problem is that investors bought this fund, which had to create shares and buying underlying, front-end futures contracts. So what did they buy? They forced it to buy June expiry contracts. So now they have exposure to the June contract in a vehicle that cannot take physical delivery and has no choice but to roll contracts. That may very well lead to this issue happening again in a month.

Oil prices outside of futures contracts remain very low. Could we see the majors like Exxon cutting more dividends?

Another incredible black swan event for 2020!

Cash on Cash Return of Real Estate – Will #COVID19 Create Opportunities?

COVID-19 has already produced some interesting investment opportunities in the stock market. Fortunately or unfortunately, part of investing is being prepared to buy an asset that others NEED to sell. Perhaps the cash on cash return of real estate will improve

This happens in the stock market all the time, but I think real estate could again become attractive given unemployment is rising, there has been disruption in the mortgage market, and a cease in travel may pressure liquidity of those who bought short-term rental properties (think airbnb). Since I am seeking investment opportunities for myself, I figured I would share. My wife & I already own one investment property purchased in 2010 and I can clearly see the benefits.


Here are a few positives of buying real estate:

Cheap leverage:

You can finance around 75%+ of the purchase price with very cheap, 30 yr debt. Our property is an investment, so interest rates are around 50-75bps higher than the national average, and we are paying 4.25% over 30 years.

Compare that to buying a cash flow producing business and you’re likely going to have to pay 8% and carry risk that the business fails, whereas you can generally have decent protections in real estate (location, location, location)

Asset is then paid for by tenants:

The next best thing is that you have that rate locked-in for the tenor of the loan, but rent typically rises each year or over a long period of time. So you’re typically getting “more profitable” each year. Also, you’re not the one paying for it – the tenant is!

Rinse & Repeat – Taxes are favorable:

Thanks to 1031 like-kind exchange rules, when you sell a property (hopefully for a gain) you can roll your original investment & gain into another property and avoid paying capital gains. In other words, it’s akin to a deferred tax account.

You can buy a property on the cheap, realize gains & maybe move rent up to a market rate, sell for a profit & repeat. Also, mortgage interest is tax deductible.

You can essentially conduct a dividend recap on the property:

Also known as a cash-out refi, we did this with our rental property. The lender will appraise your property and allow you to re-lever back up to 75% LTV. So a new mortgage is created against the higher property value, the old mortgage is paid off, and the bank cuts you a check for the difference.

This is a great feature because you can buy a place that needs to be rehabbed on the cheap, fix it up, rent it, and then go and refinance the property on likely a higher value and take out all of your original equity! This has also been called the “BRRR” strategy, Buy, Rehab, Rent, Refinance, Repeat.


I do, however, have a few complaints.

Not quite passive investing:

I can go out tomorrow and buy a bond fund that pays interest and pay the manager a few basis points for their trouble. Real estate though is tough. If you’re managing it yourself, you need to find tenants (a challenge) and be prepared to find someone to fix an issue at any time. A property manager can ease this concern, but there still is generally some back-and-forth here.

Are the returns really that great?

This is what I plan on investing in this post. My wife & I just hired a property manager, but there have been times while we were self managing the property where we asked ourselves if it was all worth it in the end.

Liability:

You can finance properties in an LLC, but typically that interest rate won’t be nearly as good. You can instead get insurance to help cover some of the liabilities involved with renting properties, but will you lose sleep wondering if its enough? (biggest fear for me is a party where someone falls off a roof railing or something like that – personally I should be covered in several ways there, but still a concern in the back of my mind).


Understanding Cash-on-cash returns vs. IRR vs. Cap Rate in real estate

There’s a lot of jargon thrown around in investing, particularly real estate. First is probably cap rate, which is your NOI (net operating income) over the asset value (or purchase price). NOI is just the annual rental revenue less the operating expenses (such as ongoing maintenance costs, utilities, property taxes), but does NOT include financing costs. It’s just a rough proxy for what the return on the property will be unlevered. So it’s likely a lower rate of return given you probably will finance your purchase.

I sometimes look at cap rates, but only as a quick proxy for value, similar to EV/EBITDA — in fact, a cap rate is really just EBIT/EV. So clearly, it is missing financing costs (interest) as well as any capex needs and I prefer to know what my cash returns are as an equity holder.

Cash on cash return removes what we just discussed. This takes out financing costs and any recurring annual capex to find out what a real cash on cash return is.

Note, by financing, I just mean interest cost. That’s because a pay down of principal is paying down debt permanently and therefore building your equity (as I’ve said before, when a company pays down $1 of debt, this is a $1 to the equity). Some investors add the principal amount to cash flow, but I don’t do that because I’m not actually benefiting from that cash flow in the period. Doesn’t make intuitive sense to me.

Example:

I wanted to share some math that I’ve been looking at so, here is a spreedsheet snapshot I’m working on (perhaps this is a legible picture…). Hopefully the assumptions are clear enough. This assumes purchasing the property at a ~6% cap rate and a 8% cash on cash return, which I would say is somewhat typical.

I also highlighted when you could expect to refi out around ~95%+ of your original equity. Not bad – I can cash out my equity by year 8 and still own the asset. I could probably then go buy another property with that cash.  Unfortunately, as of right now, the areas I am comfortable investing in are more like 4-5% cap rates… not that great.

One thing that should be somewhat obvious is that the more equity you put down, the closer your cash-on-cash return will be to cap rate.

What does this mean from an IRR perspective?

The IRR in this example was around 9%, including closing costs on both sides of the transaction. Clearly that is much closer to the cash on cash return. The problem with IRR is it basically assumes you can reinvest each dollar you receive back at the project rate, which may not be realistic.

That brings me to another thing to focus on: total return. Just add up all the costs in vs. costs out. This ratio is called the multiple of money. I like to use it to compare returns. Subtract 1 from it and you have the % total return as well.

All-in-all, these returns aren’t bad. Especially for a “stable” asset class. That said, I have to think about the balance between buying this asset, some of the headaches that come with it, and not have much liquidity. I’d need to either find a way to put less equity down (to juice returns) or find properties at a steeper discount.

If you want to look at some properties yourself and run the math, you can check out this company called Roofstock, which to me seems like its trying to make long distance relationships & real estate a thing. Its an interesting concept and I have to commend them on their tools as well. You can even buy fractional shares in a home on their site (not sure how the financing and taxes works though… I’ll have to give them a call), though inventory seems limited. I’m not getting a kickback from them or anything, but I do monitor their site so thought I’d share.

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!