Rates Rally Financials, But Credit Fears Remain

December 15, 2023 | 溢价| After the past week of market exuberance, we take a look at the banking, mortgage and fintech sectors to see who is on top in terms of the equity markets and who is not. Some of the results may surprise readers of The Institutional Risk Analyst, but that is not remarkable given that the 10-year Treasury has rallied to below 4% yield in a week. Basically, today we are back where the industry stood at the end of Q2 2023. The key term for risk managers and investors in 2024 remains unchanged from this year: Volatility.

Our basic view is that the global equity markets are way ahead of the FOMC and the US Treasury when it comes to long-term interest rates. Those optimistic souls at Goldman Sachs (GS) are telling clients that the first Fed rate cut will come in the first quarter of this year, but we think that the Boys of Broad Street may have the wrong year. With the US economy roaring along with no recession in sight, we suspect that Powell will err on the side of patience. Indeed, the inaction from the FOMC may allow Powell to return to a quarterly media event instead of the current monthly spectacle. 

Here are a few high level takeaways from the past week. 

First, the rally in the bond markets has taken away some of the immediate pressure on banks. Instead of adjusting bank asset prices by more than 20% as we did at the end of Q3 2023 in our fire sale assessment, the adjustment now is close to 12%, reflecting the current prices on corporate debt and Ginnie Mae MBS. GNMA 3s were trading around 89 this AM vs closer to 80 a month ago. 

Second, the enormous volatility evident in the interest rate markets has caused an equally sharp swing in levered positions and hedges at banks and nonbanks alike. Bankers made money on their cash positions, but may have taken significant losses on hedges as the 10-year Treasury moved a point in yield in less than two weeks. 

“MSR holders are seeing a drop in value due to lower credit on escrow balances,” notes one advisor. “The folks that are long standing MSR hedgers have on paper adequate hedge coverage but that coverage is misplaced at the 10 year point versus the point of the curve where escrow credit is earned / applied.”

Third, the sharp drop in LT rates has caused a rally in banks and other financials, but not always in a way that makes sense. Looking at the banks, for example, the group is being led by $22 billion asset Customers Bancorp (CUBI), which is up 96% over the past year and is now trading 1.1x book. 

Why is CUBI outperforming its larger peers?  First and foremost, the bank has astutely managed its balance sheet, selling low coupon assets and redeploying capital into higher yielding loans and securities. GAAP earnings almost doubled between Q2 and Q3 2023, boosted by the bank’s focus on PPP loans. The tangible book value of CUBI has continued to grow over the past several years. 

Bank Surveillance Group

Source: Bloomberg (12/14/23)

Another bank stock that has moved significantly is Citigroup (C), which is up 12% this year and is once again trading above 0.5x book value.  What has caused this remarkable development? Cost cutting by bank management, including aggressive layoffs and a number of business changes, such as winding up the bank’s loss leading muni trading business. It is probably too soon to say whether CEO Jane Fraser will continue to improve the bank’s expense profile vs its peers. As we've noted previously, Citi needs to get its efficiency ratio down into the low 60s to be credible.

UBS Group (UBS) has been one of the better performing names in the group for some time, this even though the bank is now finalizing its merger with Credit Suisse.  We think the merger with CS will continue to be a source of loss for the giant Swiss asset manager, but the bank’s leading position in the advisory business seems to be offsetting any investor concerns about the legacy CS business. It is entirely possible that UBS may write off its US mortgage business, including the biggest remaining subprime mortgage portfolio and a large Ginnie Mae servicing book.

Also in the top-ten performers among banks are CapitalOne Financial (COF) and Ally Financial (ALLY), in both cases benefitting from the broad assumption that the economy is headed for a “soft landing.” We beg to differ with the consensus view and believe that investors buying consumer facing banks based upon the idea that there will be no uptick in credit costs are mistaken.  The question is timing.

"The blunting of the pass-through from higher rates to mortgages has been the game changer for households this cycle," writes Simon White of Bloomberg. He continues:

Our single common stock holding in banks, New York Community Bancorp (NYCB), has also benefited from the happy narrative among stock investors. At 0.8x book, we think NYCB is still good value, but remember that the bank has significant exposure to New York multifamily assets.  As and when the equity crowd wakes up from their pleasant dreams of soft landings for the US economy, we may see NYCB, ALLY and COF trade off due to credit concerns. 

In the world of mortgage issuers, the one year total returns are equally impressive, with Angel Oak Mortgage (AOMR) leading the group. Like many of the stocks we cover, it is important to look at both the short-term and LT charts to gain perspective.  AOMR is an issuer of non-QM mortgages and is up almost 150% over the past year.  That said, the stock is still trading at half of its value in September 2022, when it fell off the edge of the proverbial table, and less than half of the $19 high from June 2021.  Buyers beware. 

BMO Capital Markets strategist Brian Ye says that a Fed rate cut in 2024 will not lead to a refinancing waves. Next year’s anticipated rate cuts are best proxied by cuts in 1995, which were shallow and coincided with lower spread volatility as well as lower overall spreads.

“Those experiences bore some similarity to the current environment”: Ye writes. He says that the cuts came on the heels of an aggressive rate-hike campaign, in 1995. "The Fed fund rates went from 3% to 6% in a hurry but did not trigger a recession," he writes. "As in 1995, next year’s shallow cuts should come as relief and likely accompanied by lower volatility and more range bound MBS spreads."

Next on the list are Fannie Mae and United Wholesale Mortgage (UWMC), two thinly traded nonbank stocks that are not names we would encourage our readers to follow. Next is PennyMac Financial (PFSI), one of the more substantial names in the group which just completed a new $750 million debt offering. 

Mortgage Equity Group

Source: Bloomberg (12/14/23)

Next on the list is LoanDepot (LDI), which is up high double digits for no particular reason other than investor hopes for immediate rate cuts. Given that the bond market rally is unlikely to result in a surge of loan refinance business, we wonder about the motivations of buyers of this stock. LDI has been bleeding cash for two years. We have been in and out of LDI, but at almost 3x nominal book we are definitely not a buyer.

Last but certainly not least, we arrive to the fantastic world of fintech. Leading the way is Affirm Holdings (AFRM), one of our favorite subjects for writing but a stock we have avoided. With a beta of 2.8x the 6 month average market volatility, AFRM is more an option than a stock, mostly recently on option on the “buy-now-pay-later” craze that has captured the minds of many equity managers.

Fintech Surveillance Group

Source: Bloomberg (12/14/23)

To be clear, we view BNPL as another way of saying delayed event of default, but there is a large crowd of speculators that love the AFRM name and are acting accordingly. The 1 year total return on AFRM is over 300%, followed by crypto currency play Coinbase (COIN), consumer lending channel Upstart Holdings (UPST) and SoFi Technologies (SOFI).  

The ranking of these names has not changed in some time, making us wonder how these fintech leaders will look a year from now – especially if consumer credit deteriorates.  In the meantime, flush consumers and businesses are still driving a very positive narrative for consumer lenders. Just remember, don’t fight the Fed. Look at where these stocks were trading a couple of years ago, during the period of hyper-low interest rates and zero credit costs. If you believe that the economy will slow and credit will weaken, then these high flyers may be equally attractive shorts.

Source: Google Finance

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