Adjusting Your Investment Strategy for 2020
In this episode, Tom Fitzgerald sits down with Todd Patrick and Todd Davis from CenterState’s fixed-income group. They unpack how banks should be approaching their investment portfolio during this economic crisis and highlight the ways River Bank & Trust in Prattville, AL is implementing these strategies and winning with their bond portfolio.
Intro: Helping community bankers grow themselves their team and their profits. This is the community bank podcast. Now here are your hosts, Eric Bagwell and Tom Fitzgerald.
Eric Bagwell: Coming to you from Atlanta, Georgia. This is the community bank podcast the show by bankers, for bankers. Thanks for joining in our conversation today. I’m Eric Bagwell, Director of Sales and Marketing for the correspondent division at Center State Bank. And joining me again is Tom Fitzgerald, Director of Strategy and Research here at correspondent division Tom, you doing okay?
Tom Fitzgerald: I’m doing good Eric. And we’ve got a full house in the studio today, which means we probably hopefully have a lot to talk about.
Eric Bagwell: We do. We got a great show today for you. And we’re thrilled. This is our second show, we got a lot of great feedback from our first show. If you did not get a chance to hear that we interviewed Billy, Billy talked about culture, and just working from home in this crazy environment. And we thought it was a neat show got a lot of good comments back from folks across the country. So, if you have not heard that, please tune that one in and listen to it. But today, let’s talk about our show quickly. We’ve got Tom leading a roundtable discussion with a couple of our guys here in the fixed income area at the bank just talking about investment portfolios, and what folks need to be looking at and talking about and I know it has a pretty good municipal flair as well when the economy kind of gets stressed. Everybody wants to talk about municipals and the financing that goes on there. Tom, elaborate a little bit, and then we’ll join that interview.
Tom Fitzgerald: That’s right. We’ve got Todd Patrick and Todd Davis with us today. And they’ve got years of experience and we’re going to kind of tap into that today in our discussions is kind of getting drilling down a little bit into investment portfolio management in this recessionary environment.
Eric Bagwell: Perfect. We’re going to play that interview for you guys right now and I hope you enjoy it.
Tom Fitzgerald: As I mentioned, we got a full house in the studio today I’m joined by two colleagues of mine, Todd Patrick and Todd Davis. Todd Patrick has 25 years of experience in banking and a lot of it the sales and research area of it. So, he’s got a lot of insights that I think he can bring to bear. Todd also is very active in the speaking circuit. So, you have probably seen him or if you haven’t seen him, you’ll see him soon. So, Todd, how are you doing this morning? You got that that beard since the last time I saw you?
Todd Patrick: Yes. My COVID beard. I was telling somebody the other day my colored beard my stash looks like white bogs and my chop looks like white bugs, dad. So, not that I need anything to get my head circumference is large. But I’m going with it for now.
Tom Fitzgerald: What makes you look even smarter than you are?
Todd Patrick: Maybe my old man glasses too. I’ll go look good.
Tom Fitzgerald: You know, I’ve noticed in the last month I’ve had to go-to reading glasses more and more. So, I’m afraid when we come back into the office, I have to finally succumb to that. And also, with us today, Todd Davis and Todd. He has kind of a unique profile. Did he spend how many years on the Muni desk?
Todd Davis: It’s been 13 years trading municipals and spent the last two years covering banks.
Tom Fitzgerald: So, he’s got kind of an experience from a trader’s aspect as well as the salesman aspect. So, he will kind of bring a lot of that to bear in the discussion today. So, Todd, have you been?
Todd Davis: Good? I’m surviving COVID, surviving the quarantine, with five years old and a three-year-old. So, we’re getting there. I’m happy to be out of the house. And thanks for having me. Can you say, longtime listener? The first-time caller on the podcast?
Todd Patrick: And I’ve got in addition to kids in the house, I’ve got a mother-in-law. So, I’m looking forward to this return to work.
Tom Fitzgerald: No wonder why you guys want to do this again, tomorrow.
Todd Davis: This may be the longest podcast in history. We may stretch this out.
Tom Fitzgerald: But anyway, we’ve recorded this just after the Fed meeting. And so, I wanted to kind of touch on that before we get any further. As expected, they didn’t change any monetary policy parameters. They didn’t do anything to the rates, they didn’t mention anything as far as quantitative easing, changing too much. What they did do is kind of come back to start forecasting, again, they had kind of dropped the last forecasting that they did for the economy and rates were back in December. And then when all of the COVID situations came up, they kind of had to put that to the side while they were dealing with the fires that they had to put out. So, they returned to projects, the economic outlook, and also the rating outlook. The economic outlook was I thought fairly reasonable. They looking for about a negative six and a half GDP for this year and then bouncing back to a 5% positive GDP next year and then three and a half the year after that.
And then with unemployment falling from where it is today in the 1314 range down to about five and a half by the end of 2022, those all seem fairly reasonable, it’s hard to kind of give it a forecast with the volatility and kind of the uncertainty that we’re facing. I think what really kind of took the market and what you saw the risk part of what the risk-off trade that we’ve been seeing in the last day or two is the fact that they didn’t see any change in rates out through 2022. So, leaving rates at zero, through 2022. Only two of the 17 members even thought that we’d see a rate increase, in that last year of 2022. So, that kind of speaks to the level of damage that I think the Fed sees in the economy and the length of time that it’s probably going to take to recover. And that probably gave the least that stock traders a little bit of pause that in the spike and virus cases, which is moved, equities, lower, and treasuries higher in the wake of that. So, with that backdrop, I guess you could kind of summarize it from the fed’s viewpoint, we’re going to be lower for longer. For the next several years, certainly, we’re going to be tied down to the zero-lower bound on the front end for the next few years.
And probably on the long end will be range bound as well with the quantitative easing and possible yield curve control measures taking place if they need them. So, I think we’ll see sort of a range-bound market on the low end and the long end, and so kind of how do we trade that environment? What are some of the risks and pitfalls because of that? And what are some of the opportunities because of that? And so, I thought at this point, I would turn it over to Todd Patrick, and talk about mortgage-backed specifically, that’s when we look at our community banks, the largest typically the largest sector is the mortgage-backed sector, typically 50 60% of the portfolio is in mortgages. So, a key investment area. So, Todd, can you give us some, some of your thoughts on what are some of the risks one of the opportunities in this environment in the mortgage market?
Todd Patrick: Sure, Fitz the mortgage market, is been such a core portfolio holding and one that we believe strongly in is a good fit for community bankers. It’s just the market itself is becoming increasingly challenging in finding and picking the right bonds. Now, we’re in an environment where rates are at historical lows. Mortgage originators are just now starting to drift, mortgage rates down and so people’s ability to refi is increasing, we’re seeing extremely fast prepayments on a lot of products. And then trying to evaluate the space to buy is gotten harder, we’ve been introduced to two different prepayment models, particularly we’ve considered always use the consensus Bloomberg model, which is the dealer-based projections. And Bloomberg in the last several months has released a new prepayment model called bam, and they’re spitting out two very different projections in yield.
And so, when you look at the two, which one has more value than the other, it is coming hard to figure out where you think the value may be based on each model, actually projected yields. And so, what we’re finding is that neither one really may be the best projector, bam itself has not been around long enough to build a say, we know for doubt, this is a more accurate predictor of yields, we can’t lean on that we do think there’s value in bam, over the Bloomberg consensus model when looking at very specific collateral. Things like low loan balance pools are pools that are put together where the max loan size is much lower than what a traditional pool could be. They break these down from an 85-k max to a 110 to 150 to 175 k in history shows that these have a lot of value in slowing down prepayments. I know Davis, you’ve been using this product a good bit lately. What are you seeing in that market?
Todd Davis: We’ve done more of the low loan balance pools. And it’s we’ve kind of arrived at it in two ways. One is, when I looked at the performance of the generic collateral underneath those two, what we found is a 150-k pool with a max load of 150,000 is paying about a third as fast as the generic pool that doesn’t have any sort of Max loan parameter. And then the other thing is, as I talked to banks, that’s what they’re seeing in their mortgage portfolio. That’s what they’re seeing refi they’re seeing the bigger loan balances refi. So, it’s a combination of what we’re seeing in the market, and what our customers are experiencing in their mortgage portfolio.
Todd Patrick: And I think it makes intuitive sense as well. You think about these guys who originated mortgages, they make more money off the bigger refinances, and so they’re likely marketing to the higher balances first. And I think history plays out. I think it’s a great point that a lot of bankers are seeing it in their actual own data what they’re originating in their marketing efforts to get people to refinance. And so, as we look at those, there is a good bit of value there. The problem is, we’re having to pay a pretty good premium right now for that, how much does the pay up you see on that kind of collateral?
Todd Davis: You’re seeing like one to eight handles, which can give you some heartburn and some real indigestion as you start looking at it. At the end of the day, what we’ve come back to as we look at it is, how much certainty is there in that product? And how much certainty is there in the other products? And there’s pay up on everything? And do you feel good about paying 106 handles for something that you have a lot of uncertainty over or 108, or something you feel better about? And that’s just something you have to wrestle to the ground and get your hands around and kind of get comfortable with. But that’s kind of what we’ve done.
Todd Patrick: It was funny, I want to wait for sounds kind of attractive. Now. I was looking at Yvonne yesterday. It was a three and a half coupon, 30-year bond that had 10 years of seasoning on a 150-k max loan. And the premium came in just under 111 handles. It was like 1010 and $28 price, but it was been spitting up 2.4% yield. What else is yielding 240 right now?
Todd Davis: Well, and the other thing is like you look at that premium, but then you think, I feel like I can count on that performance. And so, in this environment, Tom talked about it. In the lower longer type environment. What’s important is what you can count on and in certainty in your portfolio.
Todd Patrick: The negative that gave me a pause as a bond from a yield perspective, I would jump all over. But the part that gives me a pause is that you look at that in for that seasoning. And for that low loan collateral, the pay up on that over conventional similar cloud was about five points. And so, if the rate spike at all, that premium no longer is needed that protection for the prepayments gone. And so not only do my market value declines but also, I lose that spread I just paid. So, I’m underwater, pretty significant, pretty quick. So, the question then falls back, like the fits, with the Fed rates been down low for longer if we’ve got an extended runway, where rates are down, that premiums likely worth it. If we fear that rates are going to go up anytime soon, then it’s probably not, so I agree with Fitz on that, that we’d likely don’t see a rate change for some time. So, it’s likely worth paying up for a premium on that.
Tom Fitzgerald: Right. And also, to I had thought I’d written a little bit about the forbearance programs that are coming out, through the cares act, and I thought that would kind of slow down some of the prepayment activity, but we really, it may be too early to kind of expect that. But we haven’t seen that the last month’s numbers were just fractionally lower than the month before as far as prepays go. And I thought the number I saw was about eight and a half percent of borrowers had elected to kind of at least enrolled in the forbearance program, it doesn’t mean they’re not making their payments, but they can if they elect to not do that, and just to kind of step for, for those that don’t know what we’re talking about them as part of the cares act, they came out with a forbearance program where borrowers who are struggling, they’ve lost some income through the recession. They can apply for forbearance were really, they can just kind of defer their payments for six months. And then they can apply again for the following six months. So totally, you can have about a 12-month forbearance of your payment. The investor still gets his money, the servicer remits, that principal interest to the pool owner. So, they’re not out any money, but the fact that you could forbear and kind of just kind of put aside that mortgage payment for six to 12 months, to me, was saying, I was thinking we were going to see some slowdown and prepays because we won’t see these involuntary prepays through foreclosures and so forth. At least early that the first month, then we haven’t seen that I don’t, Todd do you expect it that may
Todd Patrick: No, it’s a great point, because you think about the prepayment models are capturing truly that prepayment. So, somebody is in forbearance, and the servicer is having to make the minimum payment that is essentially zero CPR. And so, if we do have roughly, growing towards 10% of all mortgages in forbearance, thus, all the mortgage payments, were at zero CPR, it should drop that down some, but we’re not seeing it quite yet. And in the amount of refinancing that’s taking place when people, in theory, can’t get out. Much now when we’re like the crowd gates swing fully open, maybe hopefully in the near term, and people may have more access to refinancing, what are they going to spike to, which kind of comes up in the process of managing what you have right in the environment like this? Six months ago, we’re still in three and a half and four keep on 20-year paper because it looked great.
We had no idea that a pandemic was coming, and the rates are dropping to zero. Now that 4% keeps on 20-year poles are getting hammered. Not for anything is a bad structure just because the rate has significantly changed them something weren’t prepared for So I think a lot of bankers should actively manage to cherry-pick out certain bonds that will underperform in this environment. I mean, we’re seeing negative yields. And so, the ability to make that back up over an extended period is challenging. I think if I thought that this was a three month or less, just kind of get in the fetal position, take somebody blows, no deal with it and move on. But as you said, this doesn’t look like it’s going to end anytime soon. And that prepays likely to stay elevated. And so, I think Davis, you’ve been selling some of that and going back into the low loan balance pools you’ve talked about?
Todd Davis: To your point. One thing we’ve done with a lot of clients is we rotate out of faster paying 20, year three and a half that was originated, first half last year into these low loan balances. And effectively, what you’re doing is your kind of taking away a prepayment, a big prepayment risk, and assuming a premium risk. And so, at that point, what’s more, likely to happen pre payments likely to stay high stay elevated? Or are we likely to see a spike in rates that would create some sort of market loss like you were talking about on a big premium? And I think most of our clients are comfortable with kind of believing that prepayments are going to stay high. They believe that people haven’t flipped the switch on some of the refunds that they can do.
Todd Patrick: I would agree. And so, looking at that, and simply been kind of going through portfolios and helping clients, pull some of those out. And I get asked often, and there’s the greatest part about it is pulling out bonds that have negative yields, and yet the banks are booking large gains. You’re like why in the world would somebody pay me again, for a band that I can’t wait to get rid of? It’s a great goes back this period like this really highlight that I think the core philosophy of ours is that we tend to stay more in the past three markets then the structure CMO market, and I think this is a perfect example where this benefits bankers in an environment like this where rates bottom and it’s really what causes the prepaid to explode in on earth somewhat was previously performing bonds. With the past three markets, what you have, you are tethered to the TBA market, you have a known entity that you can point to that when rates fall bond prices rise, and even on performing mortgage-backed bond will still be tied to that TBA market. And so, its price is lifted.
Whereas a CMO is untethered to the street, it is worth what somebody will pay for it. And what we consistently find is, is that when you have a CMO that begins to underperform, even the rates have fallen, that it will bid at a usually a fairly large loss, where passers because it’s tied to the TBA market is anchored to the street and just the Treasury curve, it produces gains. And then of the day, a lot of times people are buying that faster collateral, and they’re using it to create more CMOS, where they can carve out those cash flows and hide the faster prepay. So that’s where the bonds essentially are going. And so, for us, it this is kind of in my opinion reinforces it’s a safer place to be is in the past to market versus to see on the market. And that sad, we do think there it can be some value in the CMA market. So maybe on some very short up front, fronting sequential short packs.
That market seems to hold up, okay, but I found another product that functions like that, but think is better. On the front-end packs as quintals in short packs. What I’m seeing even in the right spike, you’re seeing them move out four and five, six years and the 300. But what I’ve been selling a lot of and looking at is finding a 15-year mortgage back paper, pastors that have 678 years of seasoning. And so, the stated Fondo is short, is got about a three year of his life, it can extend and we can even kind of the seasoning itself kind of avoids prepayments from coming in. But we also can apply that theory. Dave has talked about the low loan balance fools on top of that as well. And just recently spoke to a banker about that, and he’s finding some via that as well.
Tom Fitzgerald: And we’ll play that clip for you right now.
Todd Patrick: Today we have with us Ken Givens is the CFO at the river bank, and trust is based in Prattville, Alabama, the bank is approaching about 1.7 billion in assets and the bond portfolio is on its way to closer to about 400 million. And it’s grown some here in these recent months as we’ve been kind of the world has changed on us. And I want to hear from Ken, you guys have had kind of a liquidity problem going on, haven’t you?
Ken Givens: We certainly have. We’ve seen a tremendous influx of deposits since the end of the year and especially over the last few months. And we kept watching it and working to determine where the deposits were coming from and trying to figure out what we needed to do with those deposits. So Yes, that’s been an issue for?
Todd Patrick: Well, I think you were, were somewhat surprised, kind of like most bankers seem to have been that, you know, cash flow, it hasn’t been an issue, it’s been too much of it.
Ken Givens: That’s exactly right. With the growth in the deposits, and we’ve done, we’ve done quite a bit in the payroll Protection Program loans. And those deposits course went into the bank. And we’re around for a while to show that we’re adding to it. But as we’ve watched, those have begun to form out, as we expected, but deposits continue to grow. And, there’s just an awful lot of liquidity out there and an awful lot of movement into bank deposits.
Todd Patrick: Well, it’s kind of funny, I was thinking back is probably a month or two ago, we know we were talking about this and seeing the cash build up. And he kind of, to me kind of called one day and kind of had an epiphany about the cash that was building. He described that.
Ken Givens: I did I kept watching it. And again, I was concerned about how sticky those deposits would be. But no doubt, we’ve seen some good growth, and some of it was a growth that we got, by being able to get some non-customers into the PPP program. And, so they brought in some deposits. So anyway, I kept looking at it and finally realized, I can’t keep sitting here earning seven basis points on this money. It’s going to be around a while, I believe and so you just can’t continue to do that. So, that’s when I gave you a call.
Todd Patrick: It seems like you’ve kind of bought into the idea that REITs won’t be moving anywhere too quickly.
Ken Givens: I did, I just don’t think that’s going to be the case. I think that most everything points toward a bit of a slower climb out from this whole issue that was brought on by the pandemic. And I do believe they had, I think that they had certainly confirmed that here the other day and saying that they see rates being low, from their perspective for a while. And so, I felt that it was time to do something. But I was a little wary about, where do we go? What do we do so that they again, that’s when I gave you a call?
Todd Patrick: Well, and that seems to be a common reoccurring problem we have with banking, right, is that when rates are at their worst, from the bond perspective, it’s exactly when you’ve got way too much cash, and your kind of forced into the market at a time that its long term feels very, I guess, disadvantaged from the bank long term. And so, from the market value perspective, is that something that you’re worried about that someday that what we had here will be an issue down the road?
Ken Givens: Well, I am so wanted to be very careful, we didn’t want to take on a lot of risks, I just needed to move well away from seven basis points of earnings on it. And so that there Again, really, I didn’t want to take on too much risk, but I knew I couldn’t stay there.
Todd Patrick: So where did you land? What kind of products have you been looking at that’s kind of found that balance for you?
Ken Givens: Well, we’ve looked at a lot of 15 years super season mortgage backs, and have been very willing to, take a little less yield to try to also find some with low loan balances so that we could get some, some very predictable cash flows, I didn’t want to have a long product that had the potential to extend that real long illness and didn’t want a product that is going to be throwing the cashback at me. In the next few months, we’ve got enough of that going on with the existing mortgage-backed portfolio that we had coming into this market. So that’s what we were looking for. And we’ve been pretty successful finding that. And again, I’m willing to give up 10 basis points, 15 basis points or so to buy that protection in there. I think it makes an awful lot of sense for us, we’ve moved the money on up, in most cases in the 1% range at least, and being able to be pretty successful with it.
Todd Patrick: And so, what kind of average life are you kind of targeting I have in mind that products going to work out to be?
Ken Givens: We’ll am having been trying to target somewhere around three to three and a half years for a fairly short, and we’ve been pretty successful that also I think we’re certainly less than four, and with very little extension risk. So, I’m very comfortable with that. And again, I think that we’re going to see rates down low for the next year or two. And, therefore I don’t by the time we get through that period these things will have paid down in that I won’t have a tremendous amount of price volatility left on this thing. So, I feel very good about what we’ve done.
Todd Patrick: Well, I think it’s thinking the price fall. That is a great point. As we look at these today, because of the seasoning in the short final, I think the up 300 price falls is only about 8%. And I don’t think either of us worries about rates going up 300 basis points anytime soon. But [inaudible 25:19] writes, do get back, I think you will be left with a smaller balance on those pools, and they will have worked successfully. And I think you’ve been wise and looking at that product, just because of the seasoning aspect of it, it feels like that will mute a great deal of the potential refi the probability that’s been taking place in so many other mortgage-backed schools if you beginning a good bit of cash flow of the other your mortgage backs already in an existing portfolio.
Ken Givens: We have certainly seen it pick up quite a bit, we saw a large increase in the cash flows in May, I’m expecting that to continue to pick on up a little bit over the next few months and then hopefully begin to settle back down. We’ve been pretty careful over the years as we build that portfolio again, to try to stay away from products that would have a tremendous amount of volatility. And so, I feel like we’ll settle back down within a few months. But I think we’ve got a little bit of time left to go on that.
Todd Patrick: Well, have you been looking at other areas outside of the super season 15-year pools to add to the portfolio today since someone’s cashless coming back in?
Ken Givens: I have one of the things, that in looking at our balance sheet and our interest rate risk, we’ve had a photo referred to as a very short balance sheet overall. And we’ve had the ability, to reach out and extend on that a little bit with some of the purchases. So, we have bought some municipals this year, again, coming through the year. And I know that then you don’t know exactly what I would like for them to be but I feel very good with them. And we’ve been able to find some higher coupon issues and get into those that and fairly short calls. And so, we’ve got some pretty good cushion in those, although I quite honestly do expect most of them are called but that’s fine. I think that given our interest rate risk and balance sheet position that it that’s been a good move.
Todd Patrick: Well, I think that to that I think you have used in some of the shorter mortgages backed paper does leave you open some of the flexibility to some longer duration and just chase a little bit of yield on the media side. But I think most people on the first question would ask me news right now a little bit nervous about maybe the credit because misspell is more stressed because of the economy and where it may be headed. What is your take on that?
Ken Givens: Well, I’m a bit nervous about it. We’ve been looking very carefully at the communities we’ve been buying. I will tell you that, one of my great preferences and Moonies or the Texas public scooupon bonds. And so, we bought some of those but the others, we’ve looked at them very carefully, very concerned about pension liabilities, given these low rates, again, what’s been going on there. So, tried to watch very closely for any potential problems with those but, there are some good credits out there, some very good bands out there. We’ve even bought some of the revenue bonds with the central purpose bonds, and I feel like those are okay, so, it’s finding the barn where things have been managed? Well, the finance has been handled well, I’m not afraid to go in and get into some of those engineering, we’re going to have to continue to have water and sewage.
Todd Patrick: People do tend to have running water in their homes. Thank you so much today for sharing your wisdom with us. We do appreciate all your insights. And thank you for your time.
Ken Givens: Absolutely. Thank you very much.
Tom Fitzgerald: Those are some really interesting thoughts and comments from Ken, a banker who’s in the trenches trying to get, make the best decisions for his bank in this environment. And so, we appreciate him participating in that today. And that’s a good segue into the other sector that we wanted to talk about today. And that’s the Muni sector. When you look at a community bank portfolio, typically mortgage banks lead the way. But in a lot of cases, the mutinies are right there behind them as another key component, and typically a key and earnings driver for the portfolio. So, I want to turn to Todd Davis on this one he taught spent several years as a Muni trader and he kind of went through the trenches during the last recession. So, he saw Kind how the Muni market behaved in that environment. And I think everybody who’s been in the business for a while recalls Meredith Whitney, kind of made a name for herself in that environment in that recession and talked about waves of defaults coming through the Muni market because of the recession. And it turned out to be not the case, you just sort of had these off instances that were pretty well telegraphed. And that’s kind of how I want to lead off with you, Todd is, do you see what this different type of recession than we had back then? If someone were to come out to, make another name for themselves and say, we’re going to see the waves of defaults, how do you see that? And again, just given the environment that we have, where do you see the risks? There are probably some more risks than we had through two or three months ago. But also, are there some opportunities out there as a result of this?
Todd Davis: Tom, we’ve had more questions from clients. And one of the things I’ll always say is, at every downturn in the economy, or every slowdown in the economy, there’s no shortage of obituaries written about the municipal market. You mentioned, Meredith Whitney, in 2010, she went on 60 minutes, and said, she expected there to be waves of defaults in the municipal market, it just didn’t materialize. As we look back at that, what caused her to miss that, and she wasn’t alone in that. Warren Buffett over that same period described pensions as a financial tapeworm. And the reason it hasn’t played out, we haven’t seen these waves of defaults in the core municipal market is it’s a very resilient market. And it’s perpetual, these municipalities really can’t cease to exist. So, they have to clean it up, they have to continue to exist. The other thing to think about is, there is an element of headline risk, that’s real, you’re going to see stories about municipal bankruptcy. But it’s important to keep in mind what those are, in my mind, just because a nursing home issues bonds, tax-free in default, that’s not what I would call a core municipal.
And that’s not something that we would put a bank in. So, understand that when you see a headline about waves of municipal defaults coming, that’s the corner of the market they’re talking about. And that’s really where Meredith Whitney, we go back to that call. That’s where she missed, she missed that the core issuers in this market, they come to market to fund operation, they fund their operation, they’re not over-leveraged, and they just kind of use it for cash flow, and they have a specific service. Anytime we have a slowdown, there’s all this fear about the municipal market. And with good reason, people are concerned. But I think it’s worth going back and kind of talking about what we’ve seen happen this year. And the first thing is what happened in March, you had sold off all assets you had sold the stock at the selling of anything that could raise cash, that’s what you saw happen. In the municipal market, we had a liquidity event, it wasn’t a credit event. So, you saw a major move back in yields. We saw it was as violent of a move as I can remember, you saw front end rates whipsaw up 150 200 basis points.
What happened in that is that there was for selling by some funds. The municipal market is made up of various investors, one of the investors in it is a tender option, bond program. And I’ll spare you the details of the plumbing of how that works. But effectively, it’s a fund that they borrow short, invest long, and hedge it out and hedge out the difference. They just make money on a positively sloped yield curve. And what happened in March is that funding rates got out of line. And it was a funding issue. So, all of a sudden, all of these funds were underwater, so all of them sold at the same time. And so, you had this mass sell-off. And it’s important to know what has resolved itself. The Fed is put plenty of liquidity in the system. So, we’ve kind of gotten through that part of it. And we’ve seen rates rally back, we’re back to the lows on the year in the municipal market. I talked about municipals being perpetual. On the whole, the majority of municipal issuers are well positioned, they’ve got rainy day funds. They’re not over-leveraged. I said that earlier. But, to illustrate the point, if you go back and look at 2008, the municipal market was roughly $3.7 trillion. It’s still not even $4 trillion today. And over that same period, we’ve seen Treasury debt go from 6 trillion to 16 trillion. And that was as a You’re in. So, what we’ve done this year is not even included in that number. So, we haven’t seen people rushing to that market to take on unnecessary projects. Infrastructure is been behind. That’s something that probably needs to be invested in. But it hasn’t been.
Tom Fitzgerald: Yeah, it’s a case of almost you could have faulted them for being so reticent to issue, for infrastructure and those kinds of items. You were thinking, Okay, you’re several years out of that last recession, you’ve sort of recovered, but as you said, they just had this real reluctance.
Todd Patrick: I saw a stat that said that just last year, did revenue return to pre-recession levels at most municipalities. So, it took that long in the previous recession, just to get back? Yeah, here they are wallet again, as soon as they kind of get back to ground zero.
Todd Davis: In the majority of issuers in the market. And as we talk about the market, we’re talking about core city, county, essential service type issuers, they’ve been reluctant to ramp back up after the recession. And they’ve managed their books pretty well outside of a couple of areas. As we talk about kind of a path forward in the municipal market, and we look back at where we’ve been, I always tell people, it’s a bifurcated market, meaning it’s kind of haves and have nots, we’ve seen people come out of the recession and clean up their books buttoned down. And then we’ve seen other people just other issuers just get worse. They haven’t been able to close pension gaps, they haven’t been able to close funding gaps. So, you have to pay attention to, is this trending the right way? Is this a municipality that’s done the right thing in terms of rebuilding balances over the last 10 years? I would expect, just like we did, coming out of the Great Recession, we saw a lot of austerity from these municipalities. They cut services, and last time in the Great Recession, that gave them cover to pass-through taxes that they had wanted to pass anyway. So, it’s kind of gave them that ability to do that. It’s important to remember that local governments make up 10% of GDP and 13% of employment. And if that fails to recover that has an impact on the bigger picture.
Todd Patrick: Well, they just cut what 600,000 jobs thus far with more coming.
Tom Fitzgerald: That was the one area in the jobs report where you had a negative.
Todd Davis: They’re going to be slow to bring that back. We get a ton of questions on pensions, and pensions are a real issue. But it’s important to remember the context of pensions. Municipals don’t declare bankruptcy over three months because of pensions. It is a slow-moving, long term issue that creeps up on people, we always like to say that municipal bankruptcies and municipal problems or slow-moving car crashes, whether it was Detroit, Puerto Rico, Jefferson County, none of those sneaking up on anybody.
Todd Patrick: And I think that’s a perfect example for now. I think the Fairfield Alabama’s hit that national headlines lightly because, again, what sells is that the COVID in the quarantine is going to cause municipal to stress in Fairfield, Alabama, filed a guess a couple of weeks ago, and I saw it in the headlines is going here’s the COVID, casually on that. And so, we went back just I was curious, looking at so we went back and ran, we found an old bond issue. We ran the pre-purchase, post-purchase analysis on it, which we do for all of our municipal holdings for our clients. And this is something you wouldn’t have touched with a 10-foot pole years ago. It is years of mismanagement. We wouldn’t ever sell it be at your doing your post credit work, you would have gotten rid of it long ago. They don’t manage city finances. Well, but they’re pretty good marketers because they felt bankrupt at the right time. So, the storyline read COVID casually versus mismanagement of city finances.
Todd Davis: The credit was listed as distressed in 2016. So, I’m not sure.
Todd Patrick: But it was even like a bit as it was really bad. It was a three-year graph where they even released financials. If you’re looking for red flags, so you can spot these things coming. And the thing I think we know with municipalities is they can’t just go away. Last I checked, Detroit was still on the map.
Todd Davis: That’s right. And that’s a really good point about COVID in bankruptcy, and if you view COVID as a nationwide hurricane, as just like a hurricane impacts a certain area of where it hits if you just view this as it’s like the entire nation get hit by a hurricane. What does that look like in municipal credit? There’s never been a city municipality default because of a natural disaster. Now, you could point to Puerto Rico, just like we did Fairfield, the hurricane was the catalyst. But Puerto Rico was on the road to bankruptcy before the hurricane hit. So, there will be bankruptcies or there will be people who file a certain, threatened to out of there will be events that happen under the cover of COVID. But I don’t know that necessarily as you dig into that, I’m not sure that’s the driver of it.
Todd Patrick: I’ll take optimistic bankruptcies. We have strategic defaults in a recession, those will be optimistic bankruptcies.
Todd Davis: So, as we talk about where we go from here in the municipal market, what we’re telling people is a be prepared, you’re going to get asked about your minister portfolio in an exam, you’re going to be asked by regulators about what you own, get ahead of that, you’re going to look so much more prepared. If your examiner shows up and you have that information, you’ve reviewed it, and you can hand them something that says, I’m aware of what’s going on. The other thing is to focus on how essential the project is. Just like we as an economy deem certain people, essential employees, and non-essential employees. Projects are essential and non-essential. A waterpark probably is not as essential as, say, plumbing, just be aware of that.
Todd Patrick: So, I should sell my airport rental car bonds?
Todd Davis: Those may struggle. With what hertz has done lately, maybe you should ride. Pay attention to the pledge behind it. We always tell people the municipal market is nuanced. There are no two credits are the same. Don’t abandon everything. I would be worried about stadium bonds. But we’re recording this looking at the Braves Stadium, which is backed by Cobb County, it has a triple a pledge behind it. So, if they don’t play a game in that stadium this year, Cobb County’s on the hook for it. So that looks different than a minor league ballpark.
Todd Patrick: So, you’re saying I should sell my Cobb County bond?
Todd Davis: I think you are okay with those that look different than some, the Braves. A league minor league team in Biloxi, Mississippi, or wherever that’s paid for with parking. That looks completely different. So, you have to dig into these credits, be aware of them know what’s going on. Don’t buy your minimum credit. If you’re trying to stay in an A rating, I wouldn’t buy a minus rated bonds right now. Because just prepare for everything to be downgraded. It’s strained, they will have some stress, they can work through that long term. But, expect everything to kind of migrate lower in terms of rating and watch for opportunities. The baby will be thrown out with the bathwater. We’ve seen this happen whenever Detroit declared bankruptcy. The entire state of Michigan got cheaper.
Everything that they issued was what came with more yield. The market penalized the entire state. There wasn’t credit that the Detroit bankruptcy didn’t spread to other credits. And know this, there are school programs that offer great support. I talked about Michigan, one thing that we’ve seen happen is these school programs offer great protection. Michigan I just mentioned, they have a school program that’s backed by the geo of the state. So, if the city if the school program has issues, the state is on the hook for that debt. That makes you feel really good about that. I always tell people; this is a really neat story about the municipal market. To me. The PSLF program is probably the most famous school program. It’s triple-A-rated, it’s never been drawn upon. So, it’s kind of like an insurance policy from the mafia. Are you going to file a claim from these people? That’s kind of what you’re seeing happen.
Todd Patrick: Well, last time I read too, they had 34 billion in assets that haven’t been touched.
Todd Davis: So, there’s some real reluctance to kind of make the statement. Yeah, make the state man you get a ton of funding from the state. And finally, this is a stat of always finish with a talked about pay attention to credits tip pay attention to pledges, various forms of credit come. Bank’s initial reaction in these environments is to, I don’t want to buy revenues, only one about Geos. Certain revenues offer a ton of protection. They’re entities that operate, they operate in good coverage. And, into Detroit bankruptcy, that’s a history we have the Geos of Detroit recovered 74 cents on the dollar, the limited Geos, which had a limited pledge recovered 41 cents on the dollar. These COPs or general pledge of the city recovered 13 cents on the dollar. Detroit’s water and sewer bonds were made whole, they recovered every dollar that they were, they had 100% recovery. So, these are entities that they’ve kind of segmented out. They’ve kind of pulled them away, and said, you guys can operate on your own some of the city’s pension problems aren’t yours.
Todd Patrick: Ken mentioned, that he’s looked at that kind of paper for that very reason. So that’s a great point.
Todd Davis: So, be aware of that. And that’s kind of what we’re seeing.
Tom Fitzgerald: Well, guys, thanks a lot. So, a lot of information here today. And I hope the listeners have taken something away from this discussion. If we’ve hit on something that interests you, certainly, get in touch with us. And we can kind of expound on it further. But really, thanks again, guys for coming and taking some time and sharing your insights with us today.
Todd Davis: Absolutely.
Tom Fitzgerald: That was a lot of good information today show and very relevant. I think, as we moved, the investment portfolio, like I said earlier, come from more of a liquidity vehicle to an earnings vehicle. And so, it again, just really good information today. And we thank Todd and Todd for taking part. We also want to thank Ken Givens from the river bank and trust for participating as well and, really appreciated his insights and what he’s doing out there in the field, so to speak. So anyway, Eric, what do we have teed up for the next show?
Eric Bagwell: Tom the next show? We’re going to kind of turn the tables just a little bit and talk about what’s going on digitally in banking. We’re going to have a couple of folks on from Quantic bank they are down in Midtown Manhattan. And we’re going to have a couple of other folks on they are a kind of a frontline cutting edge kind of innovator when it comes to technology for banks. So, we’ll have a few of their folks. We’re also going to have Jason Hendricks from alloy labs and alloy labs. They help banks that don’t have large IT budgets, they help them just kind of be on the cutting edge as well with trying to get up to speed technology-wise with the larger banks. So, we’ll have those two folks on and like Tom said, we had Ken on today, we want to try to feature a couple of bankers in every show, so that for the banks out there listening, we don’t want to just talk about stuff. We want to tell you how other banks are doing stuff so that you can kind of hear what people are implementing. And hopefully, it will bring you some value to hear what other folks are doing. So, we look forward to that. And thanks again for listening today.
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