The fourth stimulus bill was agreed to by the Senate yesterday and the House is expected to vote on the bill Thursday followed by a quick signing by the President. The bill provides another $320 billion for the wildly popular Paycheck Protection Program, $75 billion for emergency hospital funding that will provide monies for additional protective gear, and $25 billion for virus testing. President Trump said that once this bill is signed attention will turn to yet another bill that will provide funding to state/local governments for lost revenue including funds for infrastructure improvements like bridges, tunnels, and broadband. It would also include tax incentives and a payroll tax cut. As possibly the last bill in this phase of the pandemic it’s likely to be subjected to a lot of horse-trading before becoming law.
When the price of the May futures contract for oil dipped into negative territory Monday, getting as low as -$40/barrel, there was some talk that it had more to do with financial shenanigans and the imminent expiration of the contract rather than signaling another step down in oil demand. The action yesterday, however, confirms there’s indeed something amiss in the oil patch and it’s not getting better. On Monday, the June contract fell too but just around 11% which is significant but not the outright collapse seen in the May contract. Yesterday, however, selling accelerated in the June contract as it took center stage in the oil market as the lead contract. It fell from Monday’s close of $20.43/barrel to $11.10/barrel this morning for 46% decline.
The issue is really a simple one of supply and demand combined with limited storage. Before the economic collapse brought on by the virus, the market was operating in near equilibrium with demand of 100 million barrels per day meeting an equivalent supply. Enter the virus and demand has plummeted 30% while supply has more or less continued with Russia and Saudi Arabia keeping the spigots wide open. The issue now is finding sufficient storage space for the aggregate oversupply. Beyond the storage issue and its impact on prices, oil is also telling us that the extent of demand destruction has been broad and deep. The 51,000 oil-related jobs lost in March are just the beginning, not to mention coming loan losses in the oil patch. It looks like it could be years not months before global demand returns to 100 million barrels per day not to mention all those lost jobs.
Preparing for Increased Loan Loss Provisions
While most bankers are in the midst of the SBA PPP loan onslaught, another loan-related onslaught could be just around the corner and that is the expected increase in loan losses and additional provisions for expected losses. At Wells Fargo, the first-quarter provision of $4.01 billion was 3.4 times the bank's average quarterly provision in 2019. At JPMorgan Chase, Bank of America and Citigroup, first-quarter provisions of $4.76 billion to $8.29 billion were 5.3 times to 6.1 times quarterly averages in 2019. All three of those banks recorded large builds for their large credit card portfolios, something most community banks don’t have, but suffice it to say that all banks are likely to experience increased provisioning and loan losses given the scope of the economic devastation.
One part of the balance sheet that might be available to help ameliorate the negative impact of increased loan losses and provisions is the investment portfolio. With rates at, or near, all-time lows most portfolios are brimming with plenty of unrealized gains. Before the market volatility of mid-to-late March our bond accounting group had unrealized gains totaling 2.29% of book as of February. With the Treasury rally continuing since then, and market volatility calming a bit, gains today should easily exceed those earlier levels.
The first question is determining the amount of gain to take. That will be a function of the expected increase in provisions and loan losses, and the extent to which management wants to offset those charges. The next question then becomes how best to harvest gains with as little impact to portfolio performance as possible. In that regard we offer a few thoughts on that matter.
- One approach is to sort the portfolio by book yield and begin selecting bonds that have gains with the smallest book yield making reinvestment less detrimental to performance going forward. The offset to this approach, however, is that it will involve selling more par to reach a given gain thereby negating some of the benefit of selecting the lowest yielders.
- Another approach that we find more efficient is to sort the portfolio by gain as a percent of book value. That gives us the bonds with the largest gains for a given amount of par. This allows us to achieve the desired gain with the least amount of par being sold. This method also helps to uncover those market sectors that are currently being priced rich which again helps to maximize the gain with the smallest amount of par sold.
- In the current market, municipal’s suffered indiscriminate selling in mid-to-late March and while they have recovered from some of the worst levels, prices have yet to fully recover and until more direct relief in upcoming stimulus bills is provided for states and municipalities don’t expect those early March prices to return. We should note, however, yields on maturities inside 10 years are within 20bps of early March levels while the curve beyond 10 years is still lagging by 25bps or more.
- Generally speaking, spreads on MBS product remain wider than 2019 averages but particular pools that are likely to prepay slower in the current environment should retain a solid bid.
- Your CenterState Bank representative can help identify those pools and also provide several bond swap scenarios to consider in meeting your goals to soften an expected increase in loan losses and/or provisions.
Agency Indications — FNMA / FHLMC Callable Rates
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