One of the most interesting and rewarding specialist income funds has been the diminutive and low profile EJF. This little known London listed fund invests in CDOs issued by small or community banks as well as insurance companies. These static pools of loans involve less leverage than traditional CLOs and seem, on initial inspection, to be a smarter bet especially given the wave of M&A activity in the sector. It’s also worth noting that EJF Capital has a pretty good track record in picking those loans. Of the nine transactions since 2015, Numis reports that one transaction has already been refinanced and subsequently called, and another two have already been called due to strong performance. $1bn out of the $3bn of financial debt assets securitized by EJF Capital has already been redeemed early. The remaining securitizations continue to perform strongly and provide attractive risk-adjusted returns. Since launch, EJF has provided NAV total returns of 17.1% pa since April 2017.
EJF argues that the sector is still looking good as balance sheets have been strengthened and the smaller banks have cut their reliance on wholesale markets. Net margins are also up and defaults look OK. EJF argues, via Numis, that “ during an economic slowdown or in a recessionary environment, debt issued by banks and insurance companies may withstand and perform better than leveraged loans and high yield instruments, largely due to the highly regulated financial institutions, the reduction of leverage on the banks’ balance sheet and the improved bond covenants and bond investor protections”.
I tend to agree and would rate EJF a strong HOLD myself on a current 8.8% discount, which seems a bit excessive to me given the track record. But those worries about a future recession aren’t going away, and the impact is clear from the share price of lending funds which continue to slide south.
Cynics can always find plenty of evidence to back up these recession/default worries – the latest is from analysts at DWS asset management. They observe that default rates delinquency rates are ticking up for credit-card-loan balances of thousands of smaller U.S. commercial banks.
“Since the fall of 2016, the share of delinquent loans (defined as having payments overdue for thirty days or more and still accruing interest) among these smaller banks has more than doubled, to about 6%. This is above the levels seen during the financial crisis of 2008. By contrast, the picture looks far healthier for credit-card-loan books of the 100 largest banks, as our Chart of the Week shows. “The main explanation for the divergence appears to be growing customer segmentation in the market for credit cards,” explains Christian Scherrmann, U.S. Economist at DWS. Larger U.S. banks can offer some of the most sophisticated incentives and marketing. As a result, they tend to attract customers having some of the best credit ratings allowing them to pick and choose which subprime customers to accept. Overall, larger banks have most of the customers and most of the credit-card balances. But, partly as a result of regulatory changes, subprime clients now only account for a tiny fraction of their credit-card business.”
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