Extinguishing Fears of a CMO Armageddon with A Bottle of “Clos Médecin” Anjou-Villages Rouge.

My Dear Friends,

While all eyes are presently on the ongoing MBS pools liquidation (SVB/Signature) by the FDIC/BlackRock, I wanted to focus on the CMO portion of these liquidations. At the risk of stating the obvious, while the MBS pools sales are already active, the CMO liquidations are not likely to start until early May, and even this timeline is subject to change. Any scheduling and indications that we currently have, are preliminary at best, with updated guidance expected to be sent in advance of the first CMO list.?

As we have expected, the anticipated weekly CMO “injection” will range between $300 and $500 million of CMOs (in contrast with $1.5-$2 billion per week in pools), mostly likely broken in two segments, ranging from $150 to $250 million each. Given the fact that the average weekly new issues CMO supply has been hovering just under $3 billion, the average size of liquidation blocks is likely to be in the range of 10%-15% of that amount.

Thus, despite the several "media-sponsored" concerns that the liquidation poses a great risk to CMO valuations, I do not see any disastrous dislocations as a result of it. And, as we speak about dislocations, when searching for my vino stories, I always consider dislocations to my personal budget, especially if I fall in love with a given wine, and forced to buy large quantities of it.

Domaine de Brizé,

“Clos Médecin” Anjou-Villages Rouge

Loire Valley, France 2018

Todays wine sits at the crossroads of pedigree, price, and mass appeal. Uncorking a flagship cuvée that’s been consecutively produced for 90+ years usually comes with a whole load of anticipation and pomp, but 18th-century Domaine de Brizé’s “Clos Médecin” is the sort of delicious, no-frills, Cab Franc-Cab Sauv blend I'll want to pop every night of the week. And it comes in at a price that allows me to do just that.

Today’s Anjou-Villages appellation might not carry the same clout of a Chinon or Saumur-Champigny, but I’ve come to learn that in a region as large and diverse as the Loire Valley, wines from these lesser-known areas easily grab my attention. More than once I’ve ordered what I expect will be a simple glass of local wine, only to be thunderstruck by the quality, nuance, and absurd enjoyability of each sip.?That?is exactly what this sleek Cabernet blend reminds me of.

Domaine de Brizé has been run by the Delhumeau family since the mid-1700s. Viticulturally, the estate is an embodiment of the blurred lines in this central portion of the Loire Valley, with plantings of Cabernets Franc and Sauvignon, Gamay, Chenin, and Chardonnay. The soils are a bit of a mashup too, with the clays associated with Muscadet to the west commingling with the schist and sand you’ll find in Saumur and Vouvray. All for the best: these convergences produce a bottle that’s as refreshing and quaffable as any Loire red, without any of the thin fruit or weedy vegetal notes you can sometimes find here.

“Clos Médecin'' is a true flagship wine, not because it comes in an embossed bottle or a wooden crate, but because it’s been produced by the same family from the same small plot of land for nearly a century now. It comes from a single, walled vineyard with Cabernet Franc and Cabernet Sauvignon planted alongside one another, from the domaine’s oldest vines. Roughly 60% Cab Franc, the 40% Sauvignon serves to round out and darken the wine, adding a sensuous quality I don’t often associate with the Loire. A year of aging in stainless steel keeps it in check, retaining vibrancy and structure you might otherwise lose in oak.?

In the glass, “Clos Médecin” is a vibrant purple moving out to a ruby rim. Decant for 15 minutes and pour into a Bordeaux stem, and the nose will exude what seems like every part of a blackberry bush: lush yet tart berries, but also the leaves and the dirt it grows in. Bright, crisp blackcurrants and raspberries follow, with Cab Franc’s sometimes aggressive green pepper notes subdued into a lovely tobacco leaf herbaceousness.

The palate combines ripeness and roundness with deep refreshment, Cab Sauv’s black-fruited body married to the signature snap of Cab Franc. The tannins are moderate and seamlessly integrated into the fruit.

Now, fortified with a glass or two of this magic juice, we can get back to the CMO liquidation business. As I mentioned earlier, contrary to prevailing sentiment, I do not see any disastrous pricing dislocations as a result of it. In fact, I do believe that the terms, pace, and timing of this liquidation are likely to be highly flexible in order to maintain pricing stability.?

That being said, this task will be more challenging to accomplish in the CMO space, with some temporary dislocations arising from these sales likely to pop up. To minimize them, the FDIC/BlackRock are likely to be creative with respect to the nature of this liquidation, possibly combining auctioning them with a reverse inquiry process.

In addition, the CMO market is a curious one, with the new issue creation capable of acting like a buffer, reducing the amount of new issue deals that are set to hit the market. That being said, we do not want to place too much hope in this "buffering ability" of the new issue creators, since they produce what the market desires, and low coupon CMOs off of low coupon (mostly conventional) collateral is not what the market wishes at the present time.

Thus, the reduction in the New Issue creation is not likely to “re-direct” investors' interest towards deep discount low coupon CMOs. And the overall CMO interest has been weak to begin with, with only $34 billion in NI CMOs printed this year, putting us on a very troubling trajectory of hitting the lowest level of CMO supply during this century and millennium (sorry; I simply could not resist a bit of a drama here).

In several other asset classes, the reduction in supply could be greeted with some optimism (assuming constancy of demand), due to a potentially positive impact on spreads. Given the reverse inquiry nature of the new issue CMO market, a weaker NI creation is yet another indication of inactivity of the main CMO buyer - banks.

While we do believe that the sales will indeed be “orderly and gradual”, I expect that the short-term dislocations are likely to occur in this space. After all, the total CMO portfolio from both banks (Signature & SVB) is a non-trivial $22 billion, most of which are lower coupons. It is curious to note that stripdown pass-though structures represent ~31% of the total (with all PT structures representing almost, with WAL concentrating in the 7-9 years territory.

This portion of the CMO portfolio does not exactly lend itself naturally into Bank buying “zone" and thus will have to be?sufficiently attractive?to entice those depositories who are willing to bid.?

The good news here is that many of these PT structures can be easily converted to collateral, thus inviting participation of Money Managers, who might otherwise stay away from time-tranched CMOs. It’s also highly likely that the strip down PTs, will be combined with their "soulmates" (IO tranches) and, (possibly) exchanged for pools.

Unfortunately, approximately half of the CMOs (the half that is coming from the SVB’s portfolio) is a very homogeneous, created in larger blocks (~$50 million) during the last 30 or so months (the period of extremely low rates - needless to say) off of new production (and mostly very generic collateral). Thus, investors will be hard pressed to find many stories there.

On the bright side, this homogeneity offers an opportunity to combine several line items created off of similar collateral (which will be easier due precisely to the generic nature of the underlying collateral).

On the "not-so-good news” front, floating rate CMO buyers will not find much to play with since 96% of the CMO deals in question are fixed rate. Similarly, Ginnie Mae buyers will have a limited playground, since only 19% of all CMOs are created off of GNMA collateral (note that this is what investors have been looking for as of late, as evident by the fact that Ginnie collateral accounted for almost 3/4 of all CMOs created this year).?

* So, where does it leave us?

The CMOs spreads (especially those off of lower coupon collateral have already widened in a more aggressive fashion, (when compared to collateral price action) in an anticipation of these liquidations. And given all of the above-mentioned procedural controls pertaining to the upcoming sales, we do not expect any life-changing price actions. In fact, we already find this sector attractive, and suggest investors (both depository and TROR) to monitor pricing developments very closely to seize the opportunity on any additional widening.

While predicting the future is a thankless task, I would venture a guess that all the items that will be liquidated are being well-researched as we speak, with any unexpected weakness likely showing up in the secondary market. I also expect that any trouble in the valuation department due to upcoming liquidations is likely to decrease the pricing gap between “good” CMOs and not so good ones (we could think of this process as a reverse of a “tide that lifts all the boats").

Thus, I expect that any pricing disconnect is likely to occur off the beaten path of the 1,400-line items formally residing in the SVB/Signature portfolios. And while I cannot predict the timing of these potential dislocations, I would bet that it is more likely to occur after several rounds of weekly sales, when initially enthusiastic investors have been “satisfied”, and the low hanging fruits of a strip/down CMO + IO reconstitution have been plucked.

I do expect that any of the above-mentioned dislocations will be short-lived, as the money managers are likely to be surprisingly active in monitoring this process.?

Thanks and take Care!

Kirill A. Krylov, CFA, PhD