December 27, 2024 | A very happy New Year to all of the readers of The Institutional Risk Analyst. As we close out 2024, the WGA Bank Top 25 is up [36%] and the Invesco KBW Bank ETF (KBWB) is right behind at [39%], but well-off the November highs. The broader WGA Bank Top 50 likewise shows the huge updraft that affected banks stocks in Q4 2024. Consumer lender Synchrony Financial (SYF) leads the group with a 74% total return for the year and a 1.77 price/book ratio.
In our next Premium Service issue, we update the subset of the WGA Bank Top Index that we lovingly refer to as “asset gatherers,” because of the primary focus on investment advisory business lines. Some of the best performing names in the top 100 banks followed by The IRA are asset gatherers, but some of these advisors take significant credit and market risk. Notice in the chart below that Charles Schwab (SCHW) continues to underperform the group, which is led by Stifel Financial (SF), one of Wall Street's oldest investment banks.
Source: Google Finance
The broad market valuation of stocks in many sectors still reflects the strong rally in financials after the November victory of President Donald Trump. As the post-election euphoria wears off, however, the prospect of higher interest rates and bond market volatility, and rising federal debt costs, presents the Trump Administration and markets with some immediate challenges. What are some of the risks facing investors and all Americans in 2025?
Politics
The first risk is politics. The US Congress has lost the will to govern the country. As a result, it important to accept that President Trump does not control the fractious House of Representatives much less the Senate. Even though Republicans outnumber Democrats by a few seats in the lower chamber, the political map of the House is a mosaic. More than 30 conservative Republicans voted against the latest spending stopgap legislation prior to Christmas, meaning that Trump will need Democratic support for many of his agenda items. If that sounds a lot like gridlock during Trump I, you’re right.
“Tonight, we once again found ourselves voting on a temporary spending bill just before Christmas—one that merely delays the inevitable until March,” noted five-term Congressman Alex Mooney (R-WV), who is retiring this year. “I voted NO because we had ample time to pass individual, focused spending bills, yet chose not to. I cannot, in good conscience, continue supporting a cycle of failure that is damaging to the American people.”
There are a growing number of conservative Republicans like Alex Mooney who would rather shut the government down than continue “the cycle of failure” that is the Congressional appropriations process. When Donald Trump shows up on January 20th and wants to cut taxes and increase federal spending, the reaction from conservative Republicans may surprise people and the markets. And there are an infinite number of other political risks, at home and abroad. Don’t assume that anything is a given or impossible in Washington in 2025.
Apathy
The second risk is investor apathy. The growing dysfunction in Washington does have real world consequences. Wall Street very much wants to pretend that everything is fine with the economy, that interest rates are falling and that the trees will grow to the sky. But in fact large portions of the investment world among the G-10 nations are at risk because of growing government debt and related inflation. Is that a global debt restructuring we see on the even horizon for many G-10 members?
Public debt is now “crowding out” all else and generates outsized market volatility and equally destructive monetary policy innovations like QE. The gyrations of US monetary policy seen over the past five years do little to inspire confidence. As credit spreads on government debt continue to widen relative to private credits, what does this suggest for the future of money and debt in America and globally? Can private issuers, for example, have higher debt credit ratings than the sovereign or is it a ceiling? (We suspect the latter BTW.)
Several readers have asked about a possible US debt default scenario. As we’ve noted in past missives the question is not about a sudden default by the US Treasury, but rather the hyperinflation that results when the Fed is forced to resume large scale purchases of government debt. If explicit debt monetization becomes part of the playbook, when is the US compelled to defend the monetary monopoly of the fiat dollar, imitating China by banning crypto currency? Fiat currencies, after all, are an authoritarian model that brook no competition, whether from crypto or gold.
May 2025!
When the US central bank buys government debt, the interest paid is returned to the Treasury (less the Fed’s operating losses), but Americans pay the cost of the debt via inflation. As the Fed buys more and more debt, reserves and bank deposits rise and asset classes like stocks and housing soar. The Washington drama around the debt ceiling misses the key point of inflation and the Fed’s balance sheet, but does provide the illusion of a political contest over spending.
Source: FDIC
Q: Isn’t it remarkable that not a single member of the media covering the Fed seems able to ask Chairman Powell about the central bank’s balance sheet? The Fed has lost more than a quarter trillion in taxpayer dollars due to quantitative easing, yet we hear no questions about selling low-coupon debt to reduce the Fed’s interest rate mismatch. But the losses at the Fed’s secret hedge fund are the least of our worries in 2025
As the pricing for sovereign US risk continues to rise compared to corporate issuers, the entire topography of western finance going back a century to the Depression and WWII is threatened. In the 1930s, government was at the apex of credit, but today the US Treasury is gradually seeing its standing decline in the global credit markets. What happens to banks and pension funds when Treasury debt really becomes junk? Will Chairman Powell at the Fed ding banks in future stress tests for owning overmuch long-dated Treasury paper?
Of note, the Bank Policy Institute, along with the American Bankers Association, the U.S. Chamber of Commerce, the Ohio Bankers League and the Ohio Chamber of Commerce announced before Christmas that they are filing litigation against the Federal Reserve, challenging the opaque aspects of the stress testing framework. This confirms our earlier view about the greater likelihood of private challenges to federal regulatory actions (“USSC Kills Chevron | Zombie Banks Pass Stress Tests?”).
Shrinkage
The third risk faced by investors is shrinkage of returns due to inflation, which is both a financial and psychological problem. Shrinkage of the currency was how Americans described inflation a century ago and more. Yet in psychological terms, inflation has not been a serious problem for Americans for half a century and is still not yet top of mind.
There is a tendency to ignore the obvious, even when inflation has become again a large factor in the analysis since 2020. Inflation in financial assets remains a big risk in the world of investing in 2025, but returns often shrink in an inflationary environment. The low double-digit gain on a private fund or credit strategy may seem attractive, but in fact is pretty pathetic when public market indices and even banks are galloping along at mid-double digits.
“Private Credit mutual funds allow retail investors to take more risk, get less liquidity, pay more fees, and earn less than with low-cost, liquid, transparent equity index funds,” notes our friend Nom de Plumber in a pre-Christmas missive. “The manager in a recent Bloomberg article earned 37% over two years in a private credit fund, while the S&P 500 earned over 60%. What is not to like? Thank you.”
The propensity of Wall Street to offer progressively less investment return at a higher price is one of the hallmarks of American capitalism, but it also reflects the wasting effects of inflation on real value. When more fiat dollars chase a given set of opportunities, the price rises and returns fall. The vast sea of dollar liquidity has caused managers to pursue various alternatives from private equity to distressed credit to crypto currencies. All are evidence of persistent inflation. If you're making 15% net of fees on your retail credit fund, you're losing money baby.
As the psychology of inflation becomes more widely shared, however, low return investment strategies will be abandoned in favor of short-term option strategies that promise to stay ahead of inflation. Like the 21% overnight rate i Russia. Markets and even nations will adjust their behavior to factor in inflation, creating a psychology of rising prices that persists and creates opportunities for radical action.
Imagine if China, in desperation to escape from years of deflation, takes a really bad page from FDR in 1933, revalues the yuan and begins to pay $5,000 per ounce for gold. This would be an effective devaluation of the dollar and a direct challenge to dollar supremacy. When your clients call you the next morning, what will be your advice?
Credit
The fourth and final risk factor facing investors and the US economy in 2025 is credit, a danger that has been largely obscured by the Fed’s policy of “going big” with reserves and asset prices. But big is not necessarily free of cost. As we noted in our last comment, in December the Fed finally dropped the rate paid on reverse repurchase agreements (RRPs) to the bottom of the range for fed funds.
When you see the Federal Reserve Board issuing ersatz T-bills in the form of RRPs, that is a pretty good indicator that the FOMC added too much liquidity to the economy earlier in the cycle and asset prices are likely to rise. Keep in mind that the Congress never gave the Fed the legal authority to take deposits from foreign commercial banks, GSEs and money market funds. Indeed, if President Trump wants to be rid of Jerome Powell he can simply impeach him for violations of the Federal Reserve Act going back to 2016. We got a list.
Before Christmas, Bill Nelson of Bank Policy Institute asked:
“As of December 11, the foreign reverse repo pool was $416 billion. Why is fed borrowing over $400 billion from foreign official institutions? Apart from central banks, who are these institutions? The foreign reverse repo pool used to be much smaller, why did it grow in the mid-2010s and then again over the past 3 years? What rate do you pay for the loans? Is a reduction in ON RRP rate meant in part to shrink the pool?”
When the Fed adds overmuch liquidity to the US financial system, there are a number of pernicious effects, mostly notably artificially higher asset prices and lower short-run credit costs. When the apparent cost of credit is muted by inflationary monetary policies, the financial system looks better in terms of the cost of default, even if the obligors are suffering from severe economic stress. Instead of foreclosure and evictions, we see a growing flow of involuntary home sales, usually after one of more unsuccessful loan modifications.
The net loss rates on $2.7 trillion prime bank owned 1-4 family mortgages are still negative while delinquency on FHA mortgages is in double digits. We estimate that delinquency rates on subprime 1-4s that typically go into Ginnie Mae securities are actually in the mid-teens if you adjust for the positive effect of soaring home prices on the cost of default. But the cost of reduced affordability of housing is also massive, leading to negative economic and also political results. Donald Trump won over Kamala Harris in 2024 in large part due to inflated housing costs.
Source: MBA, FDIC
In 2025, we expect to see loan delinquency rates for mortgage loans, auto financing and credit cards continue to rise, whether or not the Fed drops interest rates further. Loan forbearance and other progressive schemes are likely to end, meaning that the visible rate of delinquency will rise substantially. In 2025, for example, Ginnie Mae issuers will no longer be able to modify delinquent loans multiple times and recoup cash advanced via partial claims. Do you think anybody on the FOMC knows what a "partial claim" means?
Eventually the economy will slow and the FOMC will deliver lower short-term interest rates sometime in 2025, which will boost home lending volumes. It will also boost home prices even further. Short-term interest rates will boost production profits for lenders, but mortgage rates for home buyers may still be in the 7% range due to the federal deficit and widening credit spreads.
As credit costs rise, President Trump may be releasing Fannie Mae and Freddie Mac from conservatorship around 2027. Downgrading the GSEs during a rising credit default cycle could impact the liquidity of behind $8 trillion in conventional loans severely.
Before Christmas, Fitch Ratings wrote that an end to GSE conservatorship would have a direct negative impact on the GSEs, which it currently rates the same as the US government due to its “implicit” guarantee. “If taking the GSEs out of conservatorship would, in fact, result in meaningful downgrades, that could have knock-on effects for money managers,” Fitch warns.
We’ve noted in the past that the GSE MBS aren’t rated, but most firms treat MBS with the same rating as the unsecured GSE issuer rating. “Significant downgrades could possibly cause concentration limit issues for some funds. Since money managers are currently the key marginal buyer of mortgages, disrupting their holdings could have a pronounced impact on mortgage rates,” Fitch concludes.
While the quality of the conventional loan portfolios of the GSEs are currently very solid, we worry that the large multifamily books will be a drag on profits for years to come. We also worry that the home price inflation caused by the FOMC during and after 2020 may disappear in a future correction. That big uptick in home prices is great today and, in fact, makes the cost of credit in 1-4s seem negative. But what happens to lenders and investors when home prices do eventually correct?
“Using the rule of ‘the eights,’ history suggests that 2028 will be the year of the correction—at least until COVID-19 arrived on the scene,” Freedom Mortgage founder Stan Middleman observes in “Seeing Around Corners,” his biography that was published by Forbes Books earlier this year.
“Things change—sometimes without any warning. COVID-19 is the biggest single and most sudden change in my professional life. It brought huge changes in consumer preferences and behavior. As always, we must be very attentive to credit as always as we go forward. But strong home prices give us a lot of confidence that today’s home loans will be money good.”
Of course, today's mark-to-market problem becomes tomorrow's credit expense. If home prices retrace in 2027 down to say 2021 levels, that will be bad but not necessarily an extinction level event such as 2008. But it needs to be said that the gross yield on securities held by the largest US banks was just 3.16% in Q3 2024 and the yield on MBS averaged just 2.89%. At yesterday's close, the 10-year Treasury note yielded 4.6% and Fannie Mae 2.5% MBS were trading at 81-04 for January delivery, according to Bloomberg, meaning that the US banking system will be insolvent by a couple of trillion dollars at year-end 2024.
Like we said, don't ignore the obvious and have a very safe and prosperous New Year!
Source: FFIEC
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