R. Christopher Whalen
Nov 17, 20236 min
November 17, 2023 | Premium Service | This past week The Institutional Risk Analyst was in Dallas for client meetings. While we toured the Texas miracle, the thundering herd in the US equity markets decided that the Fed’s battle with inflation is done.
The outburst of exhuberance drove yields on the long end down sharply. Intense speculation followed about when and how much the FOMC will cut short term rates. Only days earlier, of note, the Treasury had trouble selling long-dated debt at yields half a point higher than Friday’s close. But hold that thought.
On Thursday we attended the annual Garrett McAuley client dinner in downtown Dallas and got to hear Doug Duncan from Fannie Mae talk about interest rates and related questions. He noted that the Fed remains the largest holder of MBS in the US and the GSEs are not available to support the market.
Duncan also noted that the market seems disinclined to support issuance of MBS at even today’s current low volumes ~ $1.5 trillion. Meanwhile, demand for agency eligible loans in private label MBS is growing as investors hunt for yield. Divergent data points make the road ahead less than clear.
We had an opportunity to hear Stan Middleman, founder and CEO of Freedom Mortgage, talk about the markets and mortgage servicing rights (MSRs) at the Garrett McAuley event. His simple rules: 1) Make loans that you expect to pay you and your investors back and the rest will follow. 2) If you want good MSRs, make good loans. Simple. Stan makes no secret of being an aggressive buyer of mortgage servicing assets. What does that say about forward interest rates?
The mood in the Dallas mortgage community is subdued, much like the atmosphere after an especially good summer party. The housing finance sector did five years worth of business between 2019 and 2021, leaving the pipeline a tad light, both today and looking forward over the next several years. More to the point, retail establishments in the affluent regions of Dallas are showing visible signs of a pullback by consuers and a related slump in commercial property rents and valuations.
What you see in Dallas and many other communities is massive overbuilding of office and retail venues, almost on a scale of the malinvestment seen in communist China. In effect, many developers in Northern states moved south and contrbuted to massive construction of real property. The related financial assets may now be headed for years of deflation. As Robert Shiller wrote in the New York Times last year, the period before October 1929 was good for stocks:
"Great as that was, the stock market in most of the Roaring Twenties was even better: It was the biggest bull stock market in U.S. history, when you factor in inflation. I calculate that the real total return for the Standard & Poor’s Composite Index (an S&P 500 predecessor), including dividends, from September 1919 to September 1929 averaged 20 percent a year. That implies a sixfold increase in real value over the decade."
If you ponder the recent meeting between President Joe Biden and Chinese leader Xi Jinping, and various western business executives, the scale of the misallocation of investment resources represented in that the audience is mind boggling. Ultra-low interest rates created a vast amount of investment in public and private equity, commercial real estate and various cash consuming innovations like housing, electric-vehicles or even “artificial intelligence.”
The Biden Administration has given away hundreds of billions in federal debt proceeds over the past three years, everythings from housing assistance to debt forgiveness to subsidies for producing lithium batteries. The White House just decided to subsidize the manufacture of heat pumps, another act of hubris on par with the economic edicts of the Xi regime. As domestic subsidies for EV’s fade, of note, the sales of electric vehicles fall.
In the US we call it “industrial policy.” In China it is called “Belt & Road” or “high quality consumption,” but note that the managers are always wrong in their economic decisions. The “business leaders” who feted Xi Jinping at dinner in San Francisco are almost entirely managers, not business owners, the perfect companions for Chinese cadres.
In both the US and China, the result of growing government involvement with the economy is largely a disaster in financial terms. Increased levels of spending in both nations created a lot of public debt that cannot be repaid, banks and corporate issuers that are deeply insolvent, and late vintage commercial assets that are underutilized at best.
The amount of vacant office and residential space in Texas, for example, is unprecedented in a strong economy, but problematic in a slowdown. The notion that a “soft landing” is possible after such a frenetic period of asset allocation decisions is really laughable. But the approaching pain will be visible first and foremost in commercial assets, with consumer following as much as a year behind.
In China, the mark-to-market on the property sector represents a significant threat to the country’s financial stability and social peace. Efforts by Beijing to support the several insolvent property developers have been inconsistent, resulting in falling public confidence and even lower prices for housing. Published indices of home prices in China are down roughly 20% from the 2021 peak values.
In the US, whole swaths of the commercial real estate sector are being marked down by lenders in major cities. Commercial assets in downtown Dallas or Atlanta are just as empty as are sections of New York or Chicago. We note that this week’s auction by the FDIC of the rent stabilized multifamily assets of Signature Bank was essentially a bust.
The good news of sorts is there is not yet any sign of a consumer led recession, the scenario that the Street economist narrative is seeking. Credit losses have normalized to pre-COVID levels but the rate of change is slowing. Kevin Barker at Piper Sandler notes:
“Industry-wide net charge-offs (NCOs) increased to 3.85% from 2.41% in October 2022, a +59% Y/Y increase compared to +62% in September. Industry-wide 30D+ delinquencies (DQs) increased +36% Y/Y in October after increasing +31% in September and +34% in August. Consolidate NCO rates surpassed pre-pandemic levels in October by ~11%, which we expect to continue given the elevated DQ growth rates. That being said, the rate of growth in DQs has moderated to ~35% Y/Y the last three quarters from running 40%+ in the preceding five quarters. DFS continues to see outsized growth in DQs, now +103 bps above 2019 levels. SYF continues to outperform peers with DQ rates only +2% above pre-pandemic levels, while COF has seen a slowdown in the rate of growth over the past six months.”
The bad news is we are going to see a slowdown next year and eventually that reduction in consumption will be visible in credit and employment. The year will start and continue along with increasingly bad news in commercial assets and exposures, but the default rates on consumer assets will slowly rise during the course of the year. This change will come at the same time that the US Treasury will be funding progressively larger amounts of cash to fund government operations, putting upward pressure on longer Treasury maturities.
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