May 28, 2024 | Premium Service | Mortgage Bankers Association Chief Economist Michael Fratantoni has one of the hardest jobs in finance. Mike and his colleagues at the MBA manage to accurately forecast purchase and refinance loan volumes in residential mortgage finance. And each quarter, he gets the numbers right without playing favorites or politics with a key sector of the US economy.
Mike asked an important question after our last comment:
“So is it going to be debt deflation or deficit driven excess demand leading to higher inflation? Both arguments make sense, but I think you have to choose one. Unless you’re thinking about different timelines?”
We’d have to say “both” in response. There is a general problem with inflation due to chronic deficit spending, causing the US economy to run “hot.” In fiscal year 2023, the US government spent $6.13 trillion, which was more than it collected in revenue, resulting in a deficit of about $1.7 trillion or $320 billion more than the year before. Deficit for this year will be higher.
Progressives, of course, believe that the economy should always be running at 105% on the reactor. We argued this point with our friend Bill Grieder for many years. But conservatives might be shocked at how the US economy looks and feels with zero federal deficit. Like a heroin junkie stone cold turkey. A quarter of total federal spending is financed with debt instead of taxes, as shown in the chart below from FRED.
Obviously, the budget deficit is a problem. In the world of commercial real estate, however, something also measured in trillions of dollars and altogether ghastly is appearing in the haze, the result of aspirational finance post-2008 and even more since Covid. Imagine the loans made on commercial properties between 2020-2022 at inflated prices and cap rates of between 2-4 that are now being repriced at cap rates of 6-8. Remember the calculus of CRE deflation:
Cap Rate = Net Operating Income / Property Value
There is a large pile of flotsam accumulating in the CRE market, busted bridge loans and other financial detritus created between 2020 and 2022 at absurd loan-to-value ratios that are, to borrow from the Eagles song, already gone. Just imagine the discount rate that should be applied to CRE loans made between Q1 2020 and the end of 2022. Start at 25% and do the diligence.
When we talk of distress in CRE, we are not talking about some "C" property near the interstate between Denver and someplace else. Buyers of the "AAA" portion of a $308 million note backed by the mortgage on the 1740 Broadway building in midtown Manhattan, for example, got less than three-quarters of the original face amount back after the loan was sold at a steep discount. Think about the $2-3 trillion in "value" that appeared in CRE after Q1 2020 that has now disappeared and more.
The troubles in CRE are also reflected in the capital markets. The changes in the world of equity markets issuance certainly tells a tale of woe. We usually focus on the debt securities issuance data from SIFMA, but first let’s first consider the world of initial public offerings and secondaries. When ST interest rates were at zero in 2021, crypto tokens, shares in loss-leading tech firms and freeze-dried soretes – anything really – could be offered to the public in the form of securities. Today, not so much, as shown in the chart below.
Source: SIFMA/WGA LLC
It’s interesting to see that the decrease in new equity offering volumes is roughly proportional to the falloff in new residential mortgage lending. Notice that new IPOs and the issuance of preferred equity is basically nil since 2022. In the world of debt issuance, however, the data shows surging issuance in Treasury debt, agencies and corporates, but flat volumes in ABS, mortgages and municipals. We annualized the first four months of 2024 to estimate the full year. That green hockey stick is the US Treasury.
Source: SIFMA
With a budget deficit projected to be $1.8 trillion in 2024, the odds of the FOMC actually controlling inflation are pretty low. We also think that FOMC Chairman Jerome Powell should be prepared to cut the fed funds rate a quarter point in December, but then lay down a new marker for the next President on his way out the door. No more rate cuts without deficit reduction. This may sound like fanciful speculation, but the deficit numbers are large enough and serious enough that a future Fed chair picked by either party will eventually be forced to say those precise words.
UMB Financial + Heartland Financial
As of the close on Friday, the WGA Bank Top 50 Index (WBXXVW) was up 13.6% vs 9.48% for the Invesco KBW Bank ETF (KBWB). UMB Financial Corporation (UMBF) ranked 34th in the WG. A Bank Top 50 Index in Q2 2024, a mediocre score driven largely by the bank’s 68% efficiency ratio. The average for Peer Group 1 is 62%
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