Marathon Asset Management

Lower Rates Brings Hope for New Homeowners, MBS securities & Housing Market As rates decline, homeownership becomes more attainable. Lower rates = greater affordability, existing home resales, new housing starts, and increased volume for mortgage originators. Mortgage rates more than doubled in recent years to >7% from 3.5%, but the mortgage industry is grateful that rates have gradually begun to decline. With the recent rate rally, the 3 largest holders of MBS: banks, Federal Reserve, and insurance companies are seeing improvement in their investment books. The big 3 hold these assets at cost as they don’t incur marked-to-market losses and are exposed to net interest margin or NIM., They take the hit as they hold low coupon MBS vs. higher cost of funding. This hit to NIM should start to dissipate as the Fed reduces the Fed Funds rate next month, bringing down SOFR and cost of funds. This week, mortgage rates fell to its lowest rate in nearly 2 years, but even with this rate decline, only 8% of the residential mortgage universe can currently refi (up from 0% last year) with 92% that remain out-of-the money. What drives 30-year mortgage origination and housing activity is not Fed Funds, not SOFR, since long-duration 30-years MBS is spread relative to 10yr UST rate. The yield curve will matter, but it’s step in the right direction. Ginnie Mae 30YR MBS Balance, by Coupon

BDCs: A Bug or a Feature? Top 30 BDCs: 23 of the top 30 (76%) trade below book value with an average discount to book value of 11%. As these BDC underperform, it’s painful for investors to sell shares less than asset value. The dividend yield for listed BDC that trade at book value or above is ~9%, which is ~250bps less than middle market lending closed-end funds. Bloomberg News ran a feature article providing great insight into the workings of one such BDC, the worst performing BDC of the entire lot, which is trading at ~45% discount to book value, down ~20% y-t-d. Performance is measured by dividend yield, price performance and its discount/premium to book value. For investors allocating to listed BDCs, I prefer the 7 BDCs that trade above book value, but to purchase the shares of these ‘winners’ one must pay an average premium that is often too high relative to the underlying assets. BDC investors assume the risk of selling shares below book value to access liquidity; or contrary, pay too much above book value to invest with the 7 strong performing BDC managers. Many BDC investors measure yield, yet the highest yielding BDCs today are the worst performing representing a bug, not a feature. BDCs investments belong within a diversified public equity portfolio, not as a component of private credit allocation. My recommendation to Capital Allocators investing in Private Credit is to choose private credit closed-end funds (or private BDCs) so that one can avoid the price volatility of the stock market and the discount/premium issue that defines much of the performance metrics for listed BDCs. For long term holders, why be subject to this volatility, especially since middle market private credit funds have generated ~100bps higher yields. Private credit valuations are equivalent to the NAV or book value of the fund. In the case of Private Credit, the price for liquidity should be taken into consideration, but investors should earn a return premium for locking up capital in a longer-term vehicle. I consider this to be a feature, not a bug as it allows the manager to focus on long-term value creation, not the vagaries of the listed markets and structural requirements of BDCs. The best BDCs are down ~5-10% over the last week (average), giving back their entire yearly price gains (y-t-d). From the asset manager’s perspective, it is wonderful to have permanent capital, but from an investor’s perspective, I prefer the performance consistency and yield premium of Private Credit all day, every day. Both invest in the same general asset class, but I believe private credit provides greater performance and consistency. Below is the BDC ETF (BIZD), which is down ~2.7% y-t-d (includes most of the listed BDCs):

$332M Prime Manhattan Office Building Purchased in 2006 sells for $8.5M; 97.5% Discount to Original Purchase Price The New York Times headline “This 23 Floor Manhattan Office Building Just Sold at a 97.5% Discount” is a bit deceiving, yet intriguing, while providing insight with respect to transactional maturations. With a prime location @ 50th Street in the Rockefeller Center midtown Manhattan office district and nearly 1 million leasable sq. feet, the building is only 35% occupied despite recently undergoing a $76M renovation. The property was purchased in 2006 for $332M as the sponsor put in an additional $76M for renovation. In 2019, the sponsor kept the building but sold the land underneath its property, thus creating a ground lease which it sold to a 3rd party for $285M, allowing the building owner to lower its basis considerably, but in the process agreeing to pay the new landowner monthly land lease payments into the foreseeable future. Last week the building owners sold its equity at auction for $8.5M, losing most of its remaining equity. Not only does the sponsor lose out, but it is has implications for the value of the land, given the lack of equity cushion above it and the little NOI the property generates, after operating expense, ground rent and interest payments. Ground leases are long-term leases, originally up to 99 years, where the landowner retains ownership of the land while allowing the sponsor to own and operate the property sitting on top of the land. At the end of the ground lease, the physical building reverts to the landowner. During the lease period, the building owner (or tenant) pays rent to the landowner for the use of the land. The land rent typically escalates over time by 2% with inflation-capped lookbacks. Some less friendly ground leases are structured with FMV resets or as a percentage of the tenant's revenue from the property. Ground leases provide the property owner with additional leverage to control a property without owning the land. The landowner receives a steady income stream while retaining ownership of the land. If the building owner fails to make ground lease payments, the landlord has the right to terminate the lease and take possession of the property. The pecking order of payments is real estate taxes, then ground lease payment, then interest expense, then operating expenses. Strucutred Credit allows for a bond to be spit into the IO & PO, or a loan that is first-out/last-out or a debt structure that is senior & subordinate. In commercial real estate, a property can be split into the land & the building sitting on top of the land whereby the land holder recieves payment that is senior to the building owner and its creditors. At the end of the day the sponsor took on too much leverage by creating & selling a ground lease, and then taking out a leashold loan on the property above the ground, resulting in little flexibility when performance deteriaoted. 135 West 50th Street, NYC:

Market & Idiosyncratic Risks: Idiosyncratic risk and market risk are two distinct risks for capital allocators to consider. Each has distinct characteristics and implications for investors. Idiosyncratic risk is the risk associated with a specific company or industry, that can further mitigate risk through diversification. Market risk on the other hand, despite portfolio diversification exhibit strong correlation on days like yesterday when the Dow Jones Index & Nasdaq Composite Index dropped 1,000 points intra-day, as dissimilar positions show high correlations with unavoidable market risk. Market risks must be accepted when investing in the financial markets. Allocators who seek to reduce market risk can hedge, however the cost of hedging tends to lower returns over a given period since puts and short positions carry an associated cost. Hedge funds should perform well in this environment, are worth the fees paid, but surprisingly often hedge funds suffer when volatility soars and equity markets decline. Private credit is not subject to daily fluctuations like public equities or liquid bonds are. While one would argue that its price stability is due to the infrequency of transactions and the concept that floating rate debt are inherently stable, the simple fact is that when a company or asset produces strong enough cash flow to comfortably cover debt payments, there is a strong, defensible reason for the debt to maintain its value. Private Credit is not priced continuously on a daily basis, but on a monthly or quarterly basis, reducing the volatility vs. public markets. Capital Allocators investing in private credit appreciate this dynamic, especially given their longer investment horizon. With a willingness to trade off liquidity for more stable absolute returns, capital allocators can generate a strong risk adjusted performance. Further, private credit managers often have an active dialogue with the sponsor or company, exerting influence that is potentially beneficial. Generating alpha or excess return relative to the benchmark is the key to any idiosyncratic investment and is a hallmark for private credit. Fund managers with strong sourcing, rigorous investment teams, structuring and asset management skills are expert in transforming idiosyncratic risk to their advantage. They can uncover investment opportunities and solve complexity that may not be apparent to the broader market and my unbiased view is that private credit will continue to outperform an absolute basis, even more so volatility adjusted.

Risk Off, Massive Market Move: - VIX up to 40-50, global equities down sharply - Japan is having its worst 3-days in history (-20%), largest single day move lower since US stock market crashed Oct ’87 - US Treasuries are ripping higher Employment weaker, Sahm rule triggered suggesting recession (softening in economy-yes, but recession unlikely at this juncture) - Carry trades unwound (Yen and EM) BTC getting crushed, other digital assets (ETH ) down more, margin calls and liquidations - Commodities falling, oil in low-70’s Iran threatening Israel, expect the Middle East war to expand - Trump trades unwind, equities re-price outcome as Harris rallies in the polls (election- too close to call) - Credit Spreads wider 50-100bps, this move is not about credit, its about speculation, unwind of crowded trades; credit is solid - Markets now pricing soft landing from no-landing - Markets pricing in 50bp Fed cut in September, possibility of emergency cut prior (I don’t expect cut prior to September) Real economy is okay - Earnings are okay, but earnings multiplies were too high, this move takes the froth out of the market What we are seeing is a massive risk unwind, opportunity galore, calm minds prevail.

The SAHM Rule Triggered Today Today’s employment data triggered the rule, a strong data point that The Fed watches closely. The SAHM Rule, developed by a Fed economist calculates the 3-month moving average for the unemployment rate stating half a percentage point rise in unemployment rate from its low point of the past year results in a high likelihood of recession. This leading indicator not only is an input for future economic activity, but it is also a precursor for the Federal Reserve monetary policy.

Tick-Tock, Tick-Tock, Here is the Debt Clock. When does the alarm go off? UST debt rose above $35T this week, a stunning sum, driven by ~$7T annual government spending that drives fiscal deficit of $1,865,992,497,437. With debt issuance soaring and Debt-to-GDP at a record 122% there seems no end in sight to the lack of fiscal discipline. What is so impressive is that despite increased issuance of UST, the 10-year fell below 4% as the entire yield curve shifted lower. The market is looking forward to the Fed cutting rates, but the rally in UST is in response to a reduction in inflationary expectations, and a slowdown in economic activity as job market cools and commodity prices soften. Despite the yield curves continued inversion, I do not believe there will be a recession this coming year, just a softening in growth.

Despite CRE Problems, KRE Has Ripped: The Fed, as expected left rates on hold yesterday as did the ECB, but when these Central Banks meet again in (September 18 & September 12, respectively), the high probability base case is that they will both lower rates. Powell teased a September cut that recent data (inflation, slowing job market) justifies a rate reduction. We will hear more about his stance later this month when central bankers around the globe meet in Jackson Hole. After making real progress on inflations, this will be the first time the Fed lowers its Funds rate since its lowering of the rate to 0.00% during the early days of 2020 (Covid). "The job is not done on inflation, but nonetheless, we can afford to begin to dial back the restriction in our policy rate,” Jerome Powell stated. What makes this time different from others is that the economy is strong, with the most recent Q2 GDP print of 2.8%. The Fed typically lowers rates when recessionary signs appear, which is not the case, so this time is different. Chairman Powell stated: "the economy is moving closer to the point at which it will be appropriate to reduce our policy rate; If that test is met, the reduction in our policy rate could be on the table as soon as the next meeting in September." While the Fed and ECB are expected to cut rates by 25bps in September, the BoJ raised rates for a second time ending its negative rate policy earlier this year. Yesterday, the BoJ raised its target policy rate from 0.0% to 0.25% and reduced its JGBs purchases as the Yen rallied from ¥153/US$ to ¥150/US$ in step with its equities markets as the Nikkei 225 rose +1.5%, led by banks/financials. The BoJ guided 2024 year-end policy rate forecast to 0.50%, with further expectation that March and June 2025 are on the horizon with a 1.0% policy rate target. So, while, most developed markets are on a guide path to lower rates, Japan is raising rates to normalize its rates and end a generation of financial repression which has proved so punishing for the private sector. CRE has been the windfall, but overall, the economy suffered during recent decade(s) Central Banks moving towards normalization is healthy for the economy, bringing balance to lenders and borrowers, alike. Banks should thrive in this environment, a condition we should all welcome. Federal Reserve stimulus through lower rates and a normalized yield curve should be beneficial for equities. Regional banks have performed well as of late, despite too much exposure to duration and CRE, as lower rates help with both. In addition, the yield curve will dis-invert in the coming months, and regional banks will capitalize from improving NIMs. Regional banks have been actively managing their balance sheet with savvy banks arbitraging regulatory capital requirements by executing SRT transactions that enables them to improve risk-based capital, Tier 1 capital ratios. KRE ETF: S&P Regional Banks +51% from Oct. ’23 lows

Data Don’t Lie The table below is important for credit investors to evaluate, here are my take-a-ways: Direct Lending PE Sponsor-backed deals are your safest investments in terms of default rates and more importantly loss rates, since credit performance for PE Sponsor deals perform substantially better than non-PE Sponsor: 1.4% default rate, 50% recovery rate and 70 bp of loss vs. 3.3% default rate and 1.3% loss rate for non-PE Sponsor deals. PE Sponsors bring a lot to the table. Strategic oversight by PE sponsors who establish a highly qualified management team, their extensive diligence before making investments, alignment of interest as PE writes a ~50% equity check and the ongoing improvement in operational efficiency, profitability, growth, active monitoring reduces the probability of default. This data set below also demonstrates the value proposition of PE-sponsor private credit loans vs. public market comps. TTM default rates for BSL and HY bonds are 4.4% and 2.2%, respectively also drives home the point that PC Sponsor deals have favorable credit metrics. There is one very important distinction that active management plays in the public market since BSL and bonds are liquid and can be actively managed. For instance, talented CLO managers cut this default rate in half as they avoid CCC credits and manage to a higher quality portfolio than the Index. This active management helps drive CLO equity returns and gives comfort and protection to the investment grade tranches of a CLO deal. In the coming months, I believe default rates will begin to gradually decline, presenting a favorable back drop for credit. Investors should remain cautious when investing in BDCs and other open-ended fund structures since they are buying into a pool of older loans that were likely originated in a lower rate environment and often with higher leverage than deals closing in the current market. Manager selection is so critical when capital allocators invest in Private Credit and CLO managers, alike. Ask your manager: What is the portfolio cash-on-cash yield? What’s the default/loss rate? What efforts do you take to maximize recovery, mitigate loss? The data doesn’t lie.

Losses Up, Premiums Up More U.S. home insurers experienced their most significant underwriting loss this century, driven by severe weather events, greater reimbursements driven by higher replacement costs, and greater property development that occurred in high-risk areas. The home insurance industry faced a staggering $15.2 billion underwriting loss in 2023, according to insurance rating agency AM Best. Last year’s loss was more than double the losses seen in the previous year as flooding became problematic, despite fewer hurricaines reaching landfall. Home insurance in flood zones is hard to obtain, making FEMA the default option for most homeowners, even though FEMA caps its payout to be much less than full replacement cost. Additionally, changes in reinsurance practices, driven by higher attachment points, meant that primary insurers bore a larger share of the losses. Primary insurers vulnerable to high risk areas such as Florida coastal homes have seen premiums soar as population migration to these regions increase, yet insurance costs soar. California fire risk creates an equally dire dynamic for homeowners. Less competition means higher insurance premiums. Home insurance premium increases nationwide rose 12.4% in 2023, much faster than CPI, rents, or home price sales. Homeownership has never been more expensive; insurance is just one of the reasons why. I expect mortgage rates to decline marginally in the coming year which implies that home ownership might be more affordable, but all lenders require homeowners to secure insurance, and home insurance will become more expensive as inlfation adjustements and weather patterns warrant. Marathon Asset Management has adjusted its financial models to reflect higher home insurance premiums which translates to greater cash flow advances when a speical servicer is advances payments in the event of foreclosure, so this dynamic has little/no impact to our evaluation results. Escrow balances, which covers taxes and insurance has soared and no surprise Florida leads the way.