For smaller players, the game may be just beginning
by James Frischling, President, and Ron D’Vari, CEO, NewOakWeekly market view from NewOak
The mortgage litigation fight facing banks is in the late innings, is the general market perception, but that didn’t stop America’s biggest banks from spending billions in the last quarter to defend themselves. So if the good news for the largest banks is that the end of these massive litigation and financial dispute expenses is near, the bad news for the banking sector is that for mid-sized and smaller banks the fight may just be beginning.
The Federal Housing Administration (FHA), which has been leading the charge against the largest banks, has expanded its probe into other financial institutions for their role in the mortgage crisis. Some of the mid-sized banks undergoing federal investigations include SunTrust, Fifth Third, Regions and US Bancorp. The FHA’s investigations related to the mortgage practices of these institutions highlight how, even years after the crisis, the government is continuing to work through the rubble that was left by the collapse in housing in an effort to recoup losses at the agency.
The potential damages and fines associated with these regional banks may be smaller, but the issues are very much the same—the packaging of residential loans into securities. Similar to some of the investigations into the largest banks, the probes into the regional firms involve officials at the Department of Housing and Urban Development (HUD) along with HUD’s inspector general office and the Department of Justice (DOJ). From the government’s perspective, this combination has proven successful in securing settlements with large banks. The agencies will now use this combination to investigate and try to reach agreements with the regional banks.
So while the mortgage fight may be nearing the end for the largest banks, the investigative resources of the FHA and DOJ are taking the lessons learned to the next rung on the ladder. If the fight is assumed to be late in the game, then this one is going into extra innings.
Municipal Bonds: Junk is King?
Municipal bonds (munis) have outperformed Treasuries, corporates and equities so far this year as demand for tax-exempt bonds revived while supply has declined.
Returns for high-yield munis such as Puerto Rico have risen over 10% while higher-quality munis have returned nearly 5.75%.
Overall muni outperformance has been attributed purely to demand and supply drivers. Traditional muni buyers have jumped back to avoid higher taxes as prospects for economic growth have cooled. As a result, treasury rates have fallen and muni spreads have tightened. Bond prices rise when yields fall and spreads to Treasuries narrow.
These moves came after one of the largest muni fund redemptions in the last half of 2013 (over $39 billion). The supply of new issue munis has also been anemic this year due to municipalities’ belt tightening while demand has recovered.
The extraordinary performance of high-yield (junk) muni bonds has been driven by alternative and opportunistic buyers while retail investment advisers have been recommending individuals stay away from them. Advisers have favored safety and stable income while alternative investors have sought higher absolute returns in junk munis.
The more risk-tolerant investors are betting municipalities with bad finances will get their houses in order to regain badly needed access to the public finance markets. The theory is that higher demanded yields force politicians to push through unpopular legislative measures to increase taxes and cut budget deficits by lowering employee benefits. Municipalities are trying to avoid getting into downward spiral situations like Detroit. One may view the Detroit bankruptcy as a catalyst that has pushed public finance management in the right direction. While a positive sign, most are far from having their houses in order.
So far, the bet by alternative investors in “junkier” munis has paid off despite the cooling off of the housing sector and more economic uncertainties. Junk is king until it is dethroned by its next of kin.
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