Fitch Downgrades US to AA+; Fintech Stocks Soar on Powell Inflation

August 2, 2023 | Premium Service | As this edition of The Institutional Risk Analyst was going to press last night, Fitch Ratings downgraded the United States from “AAA” to “AA+” in an unexpected move. Given that the US is going to run a deficit of over $2 trillion in 2023, we think the Fitch action is appropriate and long overdue. Among the two remaining agencies with “AAA” ratings, Moody's Corp (MCO) and Kroll Bond Rating Agency, who will be the last to recognize the obvious deterioration in US credit standing?

S&P was the first to call out the growing lack of fiscal discipline in Washington, downgrading Uncle Sam to "AA+" in 2011. Given the trajectory of federal spending, even a resumption of QE may not be sufficient to avoid a US debt default and eventual restructuring. But more important, will the downgrade and rising long-term interest rates be sufficient to push dollar swaps back into a premium market after a decade of fixed/floating swap contracts trading through Treasury yields? The blue line shows US Treasury yields. The green line is dollar swaps out to 50 years.

Source: Bloomberg (08/01/2023)

This past week we saw a lot of decent earnings from banks and nonbanks alike, but nothing spectacular. Yet for reasons known only to the gods and members of the Federal Open Market Committee, a number of stocks have soared by triple digits over the past month. We attribute this upsurge in stocks to the inflation still bouncing around the financial system and expectations for a change in Fed interest rate policy. But when? Our surveillance list for fintech stocks is below.

Source: Bloomberg (08/01/2023)

One way to understand the movements in the markets is that the FOMC has taken $9 trillion worth of duration out of the markets and the position is not hedged. The tweet below from Adam Quinones at Refinitiv gave this concise description. He provides an excellent discussion on LinkedIn of why the inverted yield curve has not led to recession.

Quinones writes:

The artificially surfeit of liquidity created by the FOMC’s lack of selling/hedging of its MBS and Treasury portfolio has helped to fuel a truly ridiculous melt-up in selected financials. Look at Upstart Holdings (UPST) up over 400% YTD and 90% in the past month. The Street is predicting a 40% drop in revenues for Q2 2023, of note.

Another fintech darling that has run during the recent updraft in stocks is SoFi Technologies (SOFI), the student loan refinance platform that became a bank. SOFI was up 27.5% in the past month and 130% YTD. The bank lost $35 million in Q1 2023 and $47 million in Q2 2023. As we’ve noted previously, this business needs to double in size before it makes sense as a bank – and that is before the new Basel capital rules come into play.

SOFI seems to want to hide their actual GAAP financial results behind a lot of non-GAAP measures more appropriate for a technology company. As we’ve noted previously, EBITDA is not especially relevant to a bank, especially when interest rates are rising. SOFI hides its one page of GAAP financials on Page 17 of its investor presentation. The table below is on Page 3 of the SOFI investor presentation.

If you follow the Silicon Valley narrative of the SOFI earnings, shareholder value is a matter of growing users and engagement. At least the Street has a positive earnings growth number for SOFI in 2023. Today SOFI boasts $5 million in assets per employee vs $12 million per employee at JPMorgan (JPM) or $33 million per employee at Goldman Sachs (GS). The big question is this: what is the lifetime value of a customer of SOFI?? Management hints at this question, but provides no answer.

Bottom line for SOFI is that growing customers and particularly non-loan products is the path to greater shareholder value seems to be at odds with the flat revenue and EBITDA. The “financial services productivity loop” looks a lot like the “financial supermarket” of Sandy Weill and Citigroup (C) from three decades ago. We’ll see how SOFI looks after a couple more interest rate increases.

Another surprise is Wise LTD (WISE), the global money exchange service we began to follow several years ago. WISE ran up to over £700 last year, then fell back below £550 before taking off to reach $775 yesterday. The positive in the stock is the higher prospective growth rate which has caught the attention of Sell Side analysts. The negative is that this is still a young firm that generates a lot of noise, like the CEO needing to publicly sell shares to pay UK taxes. We still have a position in WISE and expected continued volatility.

How does one describe market action in fintechs? One prominent hedge fund manager put it like this: “Bouncy, bounce, bounce. AI!! Yippee!!!”

With the yield on the 10-year over 4%, we are seeing more and more evidence that interest rates are starting to put the entire US financial complex in great danger of a systemic break. The definition of a systemic event is when markets are surprised. The downgrade of the US will put renewed pressure on lower investment grade and junk credits in coming weeks. But the big event lies ahead, when Moody's eventually downgrades the US credit.

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