Monday Musings: June 29, 2020

Jun 29, 2020


Public Trust Credit Team
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Houses are selling, but companies are not as COVID comes back into the foreground

Existing home sales in the U.S. recorded their largest increase on record with a shocking 44.3% gain, blowing away all economists’ estimates. Home sales increased on the back of lower interest rates and reopenings across the country, providing positive sentiment amid a tumultuous market by showing that some economic bright spots were beginning to appear. Coupled with the Markit Flash PMIs last week, there are visible signs that the U.S. economy has seen some meaningful impact from the reopening as services and manufacturing move closer and closer to the expansionary “50-level.” 
Things are not as rosy in the M&A market, though. In Q2, the global M&A market had only $199 billion of transactions, the weakest quarter since 1998. So far this year, $87 billion in deals have been abandoned, sent to court, or delayed because of the uncertainty COVID-19 has thrown into companies’ outlooks and the stock market. According to Bloomberg, the deal market has slowed by more than 70% in the U.S. and 55% globally. While economic data appears more encouraging than the M&A market, the rise in COVID-19 cases across the country has halted investors risk-on sentiment. Texas and Florida have had to reclose bars due to the sharp uptick in cases while California issued mandatory bar closures for seven counties, and the E.U. is planning a travel ban for the U.S. New cases recently surpassed the last peak recorded in April and do not seem to be slowing down. It certainly appears that COVID-19 is making its way back to the front of investors’ minds as they try to grapple with increasing cases but also gradually better economic data.

Lack of transparent deferral data makes quantifying consumer risk difficult for lenders

Over the past several months, U.S. lenders have become increasingly conservative regarding their standards for extending consumer credit, remaining extra cautious around consumer loan growth while tightening underwriting requirements considerably. According to an article in the Wall Street Journal, consumer loan originations have fallen by 65% over the past 10 weeks, with originations for autos and credit cards during the same period declining by 32% and 44%, respectively.  The precipitous drop in consumer lending stems from a smaller pool of qualifying applicants given the now tighter underwriting requirements but is also the consequence of lack of transparency in consumer creditworthiness. As estimated by TransUnion, domestic consumers deferred debt payments on more than 100 million accounts in the period between March 1 – May 31, and in most cases, these deferrals are not being reflected in FICO scores, adding to uncertainty around the actual creditworthiness of household borrowers. 
At present, delinquencies on card trusts are still very low as many card lenders offer some form of relief programs (e.g. Discover offers a skip-a-payment relief program) and delinquencies do not advance while in a relief period. Therefore, some of the only signs of COVID-19 related stress for this consumer segment are decreasing payment rates and a decline in yield, mostly attributable to lower spending. However, based on recent data and statistical relationships, JPMorgan expects credit card master trusts (the mechanism by which credit card receivables are securitized) may see charge offs of 6% of total receivables by Q1 2021, assuming unemployment declines to ~9%. 
Auto lenders provide more transparency into loan modifications. According to JPMorgan’s asset-backed security research team, prime auto loan modification rates ranged from 1-4% in May, 2-12% in April, and ~0.5-12.4% in March. In pre-pandemic February, the high end of the range was 1%. The current downward trend in prime auto loan modifications is encouraging, although the figures are substantially higher for nonprime borrowers where losses are expected to be materially higher (Public Trust invests only in securities backed by prime borrowers). Based on current data and estimates, total losses are likely to remain below the level experienced in the global financial crisis. In aggregate, given the competing priorities facing U.S. lenders, banks seem to be exercising prudent caution before extending consumer credit which may help them avoid higher losses down the road.  

U.S. banks have been stressed

Last week, the Fed released the results of its highly anticipated annual bank stress tests. Given the unusual economic environment, the Fed added three new scenarios that examine how the U.S. banking system would fare under different patterns of economic recovery. Positively, the results show that the domestic banking system has sufficient capital to withstand extreme economic turbulence. In aggregate, loan losses for the largest 34 banks would reach up to $700 billion under the worst case scenario. However, the sensitivity analysis did not incorporate the potential impacts of the various government stimulus actions that were put in place in recent months, suggesting it may have been overly punitive. Still, given the high degree of uncertainty regarding the pace of economic recovery, the Fed decided to limit the amount of capital that could leave the banking system. As a result, banks will not be allowed to buy back their shares in the third quarter, and dividends will be calculated based on the average net income over the past four quarters with a cap at second-quarter levels. The Fed also asked banks to reevaluate their longer-term capital distribution plans, and the regulator will conduct additional analysis every quarter to determine if capital levels remain appropriate. 
All comments and discussion presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.

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