The National Securities Clearing Corporation (NSCC) may be gearing up to issue new debt, amid increasing liquidity concerns in the financial services sector as COVID-19 continues to wreak havoc.
Fears about escalating unemployment, household debt, consumer credit exposure, and default rates have generally rattled markets and have compelled some big U.S. banks to materially increase their credit reserves.
As the wreckage from the novel coronavirus pandemic continues to batter the domestic landscape, a debt sale from NSCC could well be a prescient warning of liquidity trouble brewing.
NSCC, a subsidiary of clearinghouse behemoth the Depository Trust and Clearing Corp (DTCC), could announce a new U.S. dollar-denominated bond in a private placement after reportedly holding a series of fixed-income investor calls Wednesday – apparently arranged by Bank of America, J.P. Morgan and Wells Fargo.
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Should NSCC issue new debt to help shore-up liquidity, it could signal larger risks for the nation, given it acts as a central counterparty (CCP) for virtually all U.S. broker-to-broker trades involving equities, corporate and municipal debt, exchange-traded funds (ETFs) and unit investment trusts (UITs).
Through its Continuous Net Settlement (CNS) system, NSCC becomes the contra-party to each compared trade and guarantees settlement, placing it in a vulnerable position should one of its clearing members default with large, unsettled net long positions.
Analysts at S&P Global recently noted that even if a CCP “has sufficient resources to absorb substantial losses arising from the close-out of defaulted members’ portfolios, CCP regulators worldwide are focusing more and more on a CCP’s other vital financial resource: liquidity.”
They continued that “CCPs should demonstrate that they have sufficient liquidity resources to cope with potential large liquidity needs should one or several clearing members default under ‘extreme but plausible’ conditions.”
According to S&P Global, NSCC had pegged proceeds from previous debt deals to supplement liquidity resources. The DTCC-owned CCP had also more than doubled its commercial paper outstanding to US$7.4bn at the end of December 2018 from US$3.2bn in the prior year.
Managing Liquidity Risk
NSCC employs a host of risk management measures to help ensure it can provide liquidity under various stress scenarios.
For instance, if NSCC suffers a loss after liquidating all of its member’s net positions, and all resources available to it are utilized, then it may institute other loss allocation methods, including certain cross-guaranty agreements, retained earnings and the clearing fund itself.
The firm had also maintained an untapped line of credit to support settlement worth US$12.1bn at the end of 2019.
Moreover, NSCC in mid-March filed with the U.S. Securities and Exchange Commission a proposed rule change that addressed changes to the way it identifies and calculates its clearing fund requirements for illiquid securities.
The clearing fund is intended to provide NSCC with liquidity to complete settlement on behalf of its participants in the event they are unable to satisfy their net debit settlement balances.
The company said its proposed rule change would also enhance the calculation of the haircut-based volatility component of the clearing fund formula that it applies to positions in illiquid securities, including ‘sub-penny securities’ and initial public offerings, as well as UITs.
The proposed modification would replace the fixed-percentage charge applied to net unsettled positions in each of these securities.
Banking Sector Exposure
Against this backdrop, some commercial banks – who maintain memberships with NSCC – appear to be grappling with their consumer lending exposure.
J.P. Morgan Chase & Co (NYSE: JPM), for example, committed to shoring-up its anticipated liquidity needs in the face of a tsunami of potential defaults across the firm, including from credit cards, as well as from wholesale activity in the energy, real estate, and consumer and retail industries.
J.P. Morgan CEO Jamie Dimon said that “given the likelihood of a fairly severe recession, it was necessary to build credit reserves” of US$6.8bn, resulting in total credit costs of US$8.3bn for Q1’2020.
The build had mainly been responsible for the bank’s 69% year-over-year plunge in net income to US$2.9bn, as well as its drop in earnings per share to US$0.78 – down 71% from the same year-ago quarter.
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Other financial institutions have also seen their income impaired by increasing credit reserves, including Wells Fargo (NYSE: WFC), which saw its net income shrivel to US$653m, or US$0.01 EPS, in Q1’20 compared to US$5.9bn (US$1.20 EPS) in the same quarter in 2019.
The bank attributed the impact to a US$3.1bn reserve build, reflecting the expected damage to its customers caused by the unprecedented downturn in the economy.
To help support its customers, Wells Fargo CEO Charlie Scharf said the bank will suspend residential property foreclosure sales, offer fee waivers, and provide payment deferrals, among other actions.
Since early March, for example, Wells Fargo claims to have helped more than 1.3m consumer and small business customers by deferring and waiving fees, including deferment on more than 1m payments and providing over 900,000 fee waivers.
In Tuesday’s intraday trading session, shares of both J.P. Morgan and Wells Fargo had each risen about 2.65% before retracing their gains; they had initially been bolstered in large part by their focus on capital and liquidity, as COVID-19 poses further threats to the labor market and broader economy.
However, big U.S. banks have a long way to go to recoup recent equity losses.
Year-to-date in 2020, J.P. Morgan has shaved-off nearly 30% of its value; Wells Fargo’s stock has lost over 40.5%; Bank of America (NYSE: BAC) over -30.7%; Citigroup (NYSE: C) nearly -41.3%; Goldman Sachs (NYSE: GS) has fallen around 20.9%, and Morgan Stanley (NYSE: MS) off roughly 20.6%, while the S&P 500 has sunk around 12.7% over the same period.
Holders of high-grade bonds have also generally remained nervous, having recently continued their exodus out of investment-grade corporate funds.
For the week ending April 8, Refinitiv U.S. Lipper Fund Flows reported additional net outflows of US$4.7bn from high-grade corporate funds after a total of around US$46.5bn was withdrawn over the prior two weeks.
As of Thursday, while spreads across major industry sectors tightened almost 23.6 basis points from the prior day, they remained an average of about 224bps wider than their post-2008 crisis lows, according to Ron Quigley, head of fixed income syndicate at Mischler Financial.
Over the past ten trading sessions, bonds from investment-grade rated banks tightened 84bps to 364bps compared to their post-crisis low of 75bps set in early February 2018. Financials also gapped-in by 74bps over the same ten-session period to 218bps – but still a far cry from their post-crisis low of 94bps set in late January 2020.
Escalating Household Debt
Meanwhile, as the U.S. labor market comes under increasing pressure, amid ongoing, virus-induced social distancing and self-quarantines, a host of provisions have been implemented by the federal government and the Federal Reserve to buoy ever-rising levels of household credit.
In fact, the New York Fed’s Center for Microeconomic Data (CMD) highlighted that total household debt balances have been “steadily rising” for five years and, in the fourth quarter of 2019, surpassed their previous peak (Q3’2008) by US$1.5tn.
CMD noted that aggregate household debt surged by US$193bn in Q4’19, a rise of 1.4% quarter-over-quarter to US$14.15tn, with mortgage balances up US$120bn to US$9.56tn, auto loans up US$16bn, credit card balances up US$46bn, and student loans up US$10bn to a stratospheric level of more than US$1.5tn.
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Potential defaults in consumer lending would likely have an adverse impact on the asset-backed securities market, whose total outstanding (ex-mortgages) stood at close to US$1.8tn at the end of Q3’19, according to data compiled by the Securities Industry and Financial Markets Association (SIFMA).
As part of the Fed’s recent actions to support the economy, the central bank said it aims to increase the flow of credit to households and businesses through capital markets. By expanding the size and scope of its Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF), as well as its Term Asset-Backed Securities Loan Facility (TALF), it said it can now support US$850bn in credit backed by US$85bn in credit protection provided by the U.S. Treasury.
Unprecedented Conditions
With the U.S. economy suffering waves of mass unemployment across the supply chain, mainly stemming from closures and restrictions in the service sector, investors have generally become increasingly wary about the extent of defaults in related industries – including airlines, hospitality, retail, and media.
The energy sector has also been in focus as prices of crude oil languish at low levels – the active WTI contract was the last hovering at around US$21.90 intraday Tuesday.
According to Fitch Ratings, the energy sector default rate in 2020 could reach 17% by year-end, closing in on the record 19.7% mark set in January 2017.
Fitch also noted that it anticipates Frontier Communications (Nasdaq: FTR) will enter bankruptcy as early as April 15, while “other troubled companies facing April 15 payment dates” include retailer Neiman Marcus Group (NYSE: NMG), agricultural company Pyxus International (NYSE: PYX) and several energy firms.
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The ratings agency added that many “sizable issuers” had been downgraded over the past two months, including Ford Motor Credit (NYSE: F), Occidental Petroleum (NYSE: OXY) and Kraft Heinz Foods (Nasdaq: KHC).
The U.S. high yield default rate is set to surpass 4% later in April, up from 2.9% at end-March and the highest level in more than three years. Fitch’s outlook for 2020 defaults range between 5%–6%, representing roughly US$70bn of volume before scaling up to 7%-8% in 2021 (about US$100bn).
Fitch added that if the expected “recession becomes prolonged, a double-digit default rate is conceivable, especially for 2021.”
Fixed-income investors will likely be monitoring liquidity levels at clearinghouses such as DTCC to ensure these institutions can continue to ensure the stability of post-trade market infrastructure, as the coronavirus continues to pose a threat to the nation’s economy.
For more insights, use the global bond scanner in the IBKR Trader Workstation to locate corporate bonds that are available to trade in the secondary market, along with U.S. Treasuries, municipal bonds, non-us sovereign debt and more.
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