December 30, 2022 | As we move into 2023 and nine months since the end of quantitative easing (QE), a few prognostications seem appropriate about the road ahead. We’ll be writing in more detail about these and related issues starting next week. Look for our first focus report on the “Half Ts” – the growing group of US banks in the $500 billion asset category.
Mortgage Finance: Analysts predicting death and destruction in the world of government-insured mortgages and Ginnie Mae may be disappointed in 2023. Sure, we will definitely have some interesting asset sales and even some events of default in the government market. And yes, Uncle Sam does now own the largest government reverse mortgage portfolio in the US (“GNMA, FNMA Seize Assets from Reverse Mortgage Funding Estate”), but the key point is that Treasury has the cash to fix such problems. Right now, cash is king.
It was more than a little amusing to see market-leader SitusAMC complaining about an “Unnamed MSR advisory firm not helping the bulk MSR market” by hitting low bids for servicing assets. The battle between bulls and bears in the loan and MSR channels will intensify in 2023. Look for buyers and sellers to converge in the second week in January. Also look for the dwindling number of lender banks to increase haircuts on both asset classes.
The impending collision between buyers and sellers begs the question, namely what happens to the US banking business and the $20 billion or so in Ginnie Mae MSR exposures at Credit Suisse (CS)? More than any real or perceived risk of contagion in the government space, the fate of this key MSR advisory business will determine how mortgages get through 2023. Note that most of the MSR financing deals brought by CS in the past five years are maturing with no roll in prospect. Forced deleveraging.
Not a word yet from CS, of note, on losses due to the Ginnie Mae seizure of Reverse Mortgage Finance’s loan book. Yet while the government market may seem problematic, the $140 billion in capital behind FHA's insurance fund and the unconditional Treasury backing for Ginnie Mae says no biggie. Instead, we believe that the GSEs – Fannie Mae and Freddie Mac – will actually be a bigger source of potential systemic contagion and political blow-back on the Biden Administration in 2023 and 2024.
Q: How’s it going to look for President Joe Biden’s 2024 re-election campaign if Treasury is forced to rescue Fannie Mae and/or Freddie Mac – again -- in 2023? As we’ve noted previously, the GSEs are going to redeem all of their debt capital over the next several years. Meanwhile, defaulted loans are accumulating on balance sheet of both GSEs supported by limited funding. Will the GSEs be forced to obtain commercial bank advance lines for defaulted assets held on balance sheet?
Source: Bloomberg
Bank Earnings: As 2023 begins, bank stocks are probably near the highs in terms of book value and actual earnings in our view. Buy Side advisors may still decide to buy JPMorgan (JPM) at 1.5x nominal book equity and tell their clients that this represents good value. Although the SOFR-OIS spread is well-off the highs of November and nowhere near 2020 much less 2008 levels, we expect that to change as default events accumulate. As we noted previously ("Is JPMorgan Insolvent"), just what is the book value of JPM anyway?
Since 2008, the swings in the SOFR-OIS spread have lessened with each liquidity crisis, perhaps due to QE. Over the course of the next year and more, as financials spend capital earned in 2021 to deal with mark-to-market losses on available-for-sale assets and credit costs (and loss-leader asset sales) from the retained portfolio, we suspect book multiples will rise as reported capital falls -- and even if stocks tread water at current levels.
Bottom line: Balance-sheet shrinkage from QT and weak loan demand, along with voluntary and involuntary asset sales, will contribute to a significant shrinkage in the size of the capital and assets of the US banking sector in 2023. Banks could easily run off $2 trillion in deposits over the next 24 months as QT continues.
Credit costs are rising and lending volumes are falling, two data points that suggest operating efficiency and headcount reductions will be the dominant themes on Wall Street in 2023. The trading side of the ledger will be especially sparse, one reason why Goldman Sachs (GS) and other traders are in the midst of a serious retrenchment.
Credit Costs: One of the questions we hear most from readers of The Institutional Risk Analyst is when will reported credit losses revert to the LT averages and start to track the level of disruption and volatility that we all see in the real economy?
Our basic answer is that the process will take at least as long as the most intense period of QE between March of 2020 and March of 2022, but we all need to remember that QE started a decade before. Our internal estimates suggest that loss-given-default for bank-owned 1-4s will not really normalize until 2024 or later. This same normalization process will also affect commercial exposures.
Source: FDIC/WGA LLC
Home Prices: Our favorite mortgage banker still does not expect a maxi-housing market reset until 2027. First, once the screams from the asset gatherers reach a crescendo later in 2023, the Fed will drop interest rates modestly. This easing will be followed by a mini-home price rally and lending boom through the election and into 2025.
That late vintage production, however, soon thereafter will be engulfed by a big-time home price capitulation in 2026 or 2027 that takes us down to 2020 price levels. LTVs will soar over 100%. Basically, mortgages made from today through the reset before the end of decade will be underwater for years thereafter.
EVs, Crypto & Meme Stocks: One thing that most people still cannot see is the connection between the crypto craze and mania-related, stocks most notably Tesla Motors (TSLA). The US markets are still recovering from 2008, yet we are unable to articulate this reality for fear of violating the progressive narrative. Stock prices don't care about narratives, so now TSLA is trading at 25% of its value a year ago, a little better than bitcoin.
Now that the leading EV stock has fallen to earth and its CEO is busily destroying his latest acquisition, Twitter (TWTR), the cost of financing EV production and infrastructure is likewise going to normalize. Progressive zealots are about to get a lesson in economics, cold-weather physics and power grid management. Fact is, without QE the EV revolution is out of gas.
As we never tire of reminding our readers, 120 years ago Thomas Edison told Henry Ford to use gasoline for his cars for a very good reason. Both men wanted to build electric cars and both realized that the technology of their era made electric cars with batteries impractical. In a century since that time, nothing has changed except the efficiency of modern motors and electronics. The physics of using batteries for propulsion still sucks and EVs with lithium batteries are even worse.
Without huge and continuing subsidies, it is difficult to see how the EV sector will survive – especially with electricity costs now making conventional vehicles in Europe and elsewhere more practical. We were especially delighted to see Toyota Corp (TMC) CEO Akio Toyoda reject the reckless EV narrative and reaffirm “his strategy to continue investing in a range of electrified vehicles instead of going all-in on all-electric cars and trucks,” reports CNBC.
“Just like the fully autonomous cars that we are all supposed to be driving by now, EVs are just going to take longer to become mainstream than media would like us to believe,” Toyoda said in remarks to dealers. “In the meantime, you have many options for customers.” Toyoda then continued, illustrating the authoritarian nature of the progressive EV agenda on the environment:
“People involved in the auto industry are largely a silent majority. That silent majority is wondering whether EVs are really OK to have as a single option. But they think it’s the trend so they can’t speak out loudly.”
What is becoming clear about EVs is that governments around the world lack the financial commitment to even begin to make battery vehicles practical and reliable for consumers. Like TSLA stock, the EV industry is going to become the ward of China and other regimes willing to subsidize it.
This chart of TSLA is a perfect visual representation of QE and its extraordinary effects on markets. It does not seem unreasonable to say that TSLA could retrace all the way down to pre-2020, pre-COVID craze levels. At that level, will TSLA be able to survive in the global auto industry?
Tesla Motors
Source: Bloomberg
Interest Rates & the Dollar: Even as the Federal Open Market Committee talks about fighting inflation and further increases in short-term interest rates in 2023, the Treasury yield curve and the related market for dollar swaps is rallying. The FOMC is seeking to tighten a market that is awash in cash, thus the yield curve looks like an inverted salad bowl.
What does a negative swap rate mean? Counterparties are willing to exchange fixed dollar payments for floating rate payments at yields below Treasury yields beyond about five years. You can buy a Treasury bond, swap away most of the coupon payment and pocket a profit. The Fed is holding up short-interest rates, but the swaps curve beyond five years is headed lower in yield. There is, as yet, no sign of pressure on US interest rates or the dollar. The blue line below is the Treasury yield curve, while the green line shows dollar swaps.
Source: Bloomberg
In the near term, we are not impressed by arguments from Zoltan Pozsar and others predicting the demise of the dollar in favor of a commodity-led cartel comprised of failed police states such as Russia, China, Iran and the OPEC nations. In fact, demand for dollars from “mainstream” nations around the world, places where investors would actually domicile assets, is growing. Nobody wants to domicile assets in China, Russia or Iran unless they are subject to US sanctions.
We do, however, look forward to the day when some special act of fiscal idiocy coming from Washington will force the dollar swaps market back to a premium over Treasury yields. Timothy Geithner and Janet Yellen think that limiting access to the Treasury debt market helps boost liquidity, but in fact limiting federal deficits is more important. A change back to the pre-2008 market situation in dollar swaps will be a sign that the world is tiring of the inability of Congress to eliminate fiscal deficits and otherwise behave seriously.
To paraphrase the cuckolded movie mogul in The Godfather, on that day when US swaps spreads again turn positive, that is the day that we can no longer afford to look ridiculous. On that day when US risk spreads are again positive, America will start to slide toward the status of troubled debtor nation. Yet it must be said that a US debt default, not the actions of dictators in China or Russia, will destroy the dollar system for international trade and finance.
The aftermath of a US default will be something that looks like global finance prior to WWI with the added functionality of the internet and attack drones. In the event of a US sovereign debt default, the world would fall back into the dystopian world described by Poszar and many other analysts in the dollar doom community. This would be a world with zero leverage and commodity barter as the basis for global commerce. America would revisit the horrors of debt deflation of the early 1930s but with social media.
Since most analysts never ponder the offshore aspects of dollar finance, the doom scenarios flourish amid a sea of sensational ignorance. Contrary to the doom crowd, in fact the dollar has become even more dominant since the 2008 financial crisis. Thus the inverted swaps market. We fancy that the market power of the private US economy and the freedom of its people will survive even the future acts of foreign dictators or bipartisan stupidity coming from Washington, and thereby preserve the dollar system a little while longer. Happy New Year.
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