R. Christopher Whalen
May 18, 20226 min
May 18, 2022 | Premium Service | As the Federal Open Market Committee raises interest rates and ends the massive purchases of securities under quantitative easing or QE, the liquidity is running out of the global capital markets. Readers of The Institutional Risk Analyst know how this movie ends. Bond spreads are widening and new issue volumes are falling like a rock. The vast output gap in global GDP caused by the Ukraine War is being exacerbated by the FOMC’s actions, only confirming our view that deflation remains the key risk to the US economy as 2022 progresses.
Even as new bond issuance volumes are falling, spreads on high-yield securities are rising, a danger sign for the US economy and also the equity markets. Once HY credit spreads rise above 500bp over the Treasury curve, this indicates that the capital markets are not functioning properly. The sharp increase in credit spreads since January 2022 has resulted in a decline in equity valuations, wiping out trillions of dollars in aggregate paper wealth.
The 3.5 trillion yen (about $27 billion) loss by the Softbank (SFTBY) Vision Fund illustrates the losses being taken by many investors that foolishly deployed cash into various crypto frauds and aspirational stocks, both public and private. Below we discuss how these negative trends are likely to affect specific sectors as the year progresses.
Crypto Assets
We will dispense with any analysis of specific crypto assets. The key thing for investors to appreciate is that crypto made sense as a tactical speculation only so long as interest rates were at or near zero. Due to the actions of the FOMC and global central banks, rising interest rates are again creating competition for short-term assets. Both crypto and speculative stocks will now suffer.
“Crypto’s an innovation that seems likely to be dead before FASB can determine their proper accounting procedure,” notes Fred Feldkamp. “As mortgage derivatives were the mass destruction devices of 1985-2008, crypto looks like the candidate for that distinction in the decades of a 0-bound Fed.”
Once interest rates began to rise, the zero carry crypto schemes began to collapse like any Ponzi-type speculation. The illusion that bitcoin and/or the various other coins could serve as a payments medium has also evaporated once Ether's stable coin fraud broke down. Incredibly, some members of the crypto crowd are now looking for a federal bailout. The post below from Twitter pretty much summarizes the situation.
Fintech
Our general thesis about the process of QT and reducing liquidity in the financial system is that the stocks and assets that benefitted the most from QE and the investor mania it caused will now see similar price reductions. The mark-to-market on the Softbank (SFTBY) portfolio, to take an example, begins to approximate the mark-down required in similar pools of assets.
Q: What do Elon Musk and Masayoshi Son have in common? Gigantic margin loans tied the the equity of their respective firms.
SFTBY bottomed at a 52-week low, but bounced to finish the week just below $20. Given that the FOMC has only just started the tightening process, we’d be reluctant to add this name to our portfolio at this stage. The same dynamic that made SFTBY soar in past years is now dragging the heavily leveraged firm down as the value of it’s portfolio falls.
“The risk was magnified in mid-March when shares in Jack Ma’s company dropped to $73, the lowest level since 2016. On that day, SoftBank came ‘insanely close’ to a $6bn margin call on the loan borrowed against Alibaba’s shares, according to one person familiar with the situation,” reported the FT last week.
It is interesting to note that the Chinese authorities rescued Son and SFTBY, illustrating the close ties between Son and Beijing. This illustrates one big reason why the US government does not trust this organization.
In that regard, we continue to wonder whether Masayoshi Son will be forced to sell Fortress Investment Group, which is the manager of mortgage giant New Residential Investment (NRZ). As we noted earlier, the Committee for Foreign Investment in the US (CFIUS) blocked SFTBY from integrating FIG when it was acquired in 2017.
Founder Wes Edens has effectively retired from FIG, making any sale a difficult proposition given the slowdown in the mortgage sector. We just spent the past four days at the Mortgage Bankers Association Secondary Market Conference in New York City.
Suffice to say that much of the industry is for sale, but there is no obvious candidate to roll up the sector. Aspirational mortgage tech names such as Blend (BLND) and Better.com are literally dead in the water with no practical acquiror in evidence. Market leaders like Rocket Companies (RKT) have lost any pretense of a tech valuation and the entire sector is under intense operating pressure.
There is a growing problem in the mortgage industry with depositories, mortgage banks and funds choking on loans and servicing assets that are mispriced. Loans produced in Q4 2021 and Q1 2022 are now trading at steep discount. We continue to hear troubling reports of buyers and third-party valuations shops using "cross-sell" opportunities to justify sky-high valuations for mortgage servicing rights (MSRs).
Servicing assets likewise are trading at a discount to the official valuations seen in Q1, with several bulk deals now languishing in the secondary market. Names such as PennFed credit union are frequently named as among the more aggressive buyers of 1-4 family loans, including high-risk loans for solar conversions in residential properties.
JPMorgan (JPM) has been among the most aggressive buyers of MSRs, but from a very selective perspective in terms of price and composition. Most of the assets are either jumbos or large balance conventionals. TIAA has been among the most aggressive sellers. A host of foreign and regional banks have recently entered the sector to finance MSRs, never an encouraging sign.
We sold our position in REIT Annaly (NLY) last week and have been adding to our position in Nvidia (NVDA) as well as some of our bank preferred positions, since many of these names are now trading below par. Our view of the tech world is that companies with real profits and revenues are going to weather this storm far better than the aspirational names.
The situation with Twitter (TWTR) is a case in point since the stock peaked three times in the past six weeks, apparently as discussions with Tesla Motors (TSLA) founder Elon Musk began to leak out, as suggested by the movement of the stock.
We continue to wonder as to Musk’s true motivation in launching a bid for TWTR, which like most acquisitions announced in the past several weeks is mispriced. Could be simply be attacking TWTR and the large population of bots in the user base? And we agree with Jim Cramer on CNBC that Musk may be compelled to follow through on his agreement with TWTR unless he can demonstrate fraud regarding the number of bots in the social media’s firm’s user base.
Our surveillance group for the fintech financials is shown below. We are pondering re-entering names like payments providers like Block (SQ) and Fiserve (FISV), but we believe that the macro downdraft in terms of the reality of and fears regarding the Fed’s future actions is likely to make all of these names cheaper in the near term. We are going to be patient as the crowd comes back to earth in terms of valuations and earnings expectations.
Fintech Group
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Disclosure: L: EFC, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC
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