Subprime By Any Other Name Is Back

Housing a lone bright spot, but will we kill the golden goose?

Weekly market view from NewOak Financial

The recovery in housing has been the bright spot of an otherwise anemic economic recovery. Relying heavily on their mortgage machines, banks managed to put up good earnings as a result. However, with mortgage rates rising off their lows, and with the refinancing of the most qualified borrowers essentially exhausted, the golden goose that was the mortgage business coming out of the financial crisis is in need of a new strategy. That strategy is the return of subprime lending. What once was old is new again.

Given the understandable sensitivity around the word “subprime,” a rebranding strategy is clearly in order. With a little creativity, a few major banks, as well as non-bank lenders, are coming to market with the catchy “another chance mortgage” or “alternative mortgage programs”. Sounds like a recipe for disaster, right? Don’t bet on it.

Consider subprime lending the non-investment-grade sector of the mortgage market. In the world of corporate debt, non-investment-grade or high-yield debt witnessed a tremendous rally as investors went looking for yield as a result of tightness in investment-grade securities. The banks and other non-bank mortgage lenders are all looking at non-prime borrowers the same way: a place to pick-up spread.

All subprime lending wasn’t bad, just as all non-investment-grade lending isn’t bad. It simply comes down to credit risk. The banks offering loans to subprime borrowers are following criteria that show the ability of the loan to be paid back, combined with the associated fees, exceed the risk of loss. Underwriting, due diligence and proper documentation are all things that will contribute to a successful subprime lending market.

So don’t fear the first phase of subprime lending’s return, but be wary of the second phase. The second phase is where too many players chase a dwindling supply of borrowers and exceptions to what otherwise would be considered solid and fundamental underwriting standards are ignored. Memories may be short, but don’t expect the banks to reach phase two anytime soon.

Bank Ring-Fencing Rules: Corralling the Global Banking System?

Separate banking regulatory initiatives in progress in the United States and several major European markets are beginning to impact banks’ decisions on the size and type of operations they maintain away from their domestic markets. These rules create complex challenges around capital requirements, OTC derivatives clearing/reporting, proprietary trading, separation of investment and retail banking and capitalization in individual countries.

For three decades, the rising flow of capital fueled global growth. According to a 2013 McKinsey study, cross-border capital flows fell to 60 percent below their 2007 peak. Ring-fencing rules are expected to further exacerbate this trend – i.e. slowing cross-border capital flow.

On February 18, 2014, the Federal Reserve finalized a set of rules to regulate the U.S. operations of foreign banks (Foreign Bank Organization or FBO Rule) that had been in the making since 2012. The FBO rule will require foreign banks to organize virtually all of their non-branch operations under an “intermediate” holding company (IHC) subject to the U.S. Basel III capital and liquidity rules. The final rule applies the IHC requirement to fewer foreign banks than initially thought and provides more time to comply.

The U.S. FOB rule doesn’t affect asset management and wealth management activities of foreign banks, such as UBS and Deutsche Bank. These activities are expected to continue to increase as they are perceived to be high margin, not requiring a capital reserve.

We are already starting to see the impact of the new rules. Deutsche bank has said it will reduce its U.S. balance sheet by 25% and raise additional capital. This will be partly achieved by moving its Latin American business and its lower margin repo operations to Europe. Furthermore, the bank intends to increase its U.S. capital by reassigning some debt to the parent company.

The sheer number of different proposals with different possible outcomes is making it difficult for the banks to devise a comprehensive plan. It is our view that, at least for now, prospects for freer cross-border capital flows will be dim during the transition period.