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“Stock prices have reached what looks like a permanently high plateau."
Irving Fisher
October 1929
This Thursday The IRA’s Christopher Whalen will be in Washington to participate in an event at Cato Institute, “Financial Crisis and Reform," We'll talk with Cato's Ike Brannon about whether enough has been done to “fix” the problem, real or imagined, with Fannie Mae and Freddie Mac. The question posed by the title of the Cato Institute panel suggests that Washington has the slightest idea about the “problem” in the mortgage business much less a solution.
You can be sure that nobody actually working in the US mortgage market is losing any sleep over the fate of these troublesome government sponsored enterprises. Whether you’re lending, servicing loans or managing interest rate risk, you’ve got bigger issues than the fate of the GSEs. Excessive regulation and fickle benchmark interest rates top the list. More on Mortgage Finance in the Age of Trump in our next comment.
And that same evening also at Cato, we’ll be speaking to The Prosperity Caucus about the new book “Ford Men: From Inspiration to Enterprise” and talk about the brave new world of “mobility.” And we’ll have some good stories to tell about John Carbaugh, Robert Novak and other former members of the Prosperity Caucus.
The past eight months since the election of Donald Trump has been anything but stable, either for investors, lenders or consumers. Coming off of the Brexit vote in the United Kingdom last summer, the events that followed the Eighth of November have seen markets soar on waves of optimism, only to be thrown down in bitter disappointment. And the economic indicators are no more clear than they were before the US election.
Wall Street desperately wants to believe that interest rates are headed higher, part of a larger need to confirm that the current market and economic situation is returning to normal. Yet fact is, after eight years of monetary experimentation by Bernanke, Yellen & Co, interest rates are falling, debt markets are at record levels of issuance and the new-issue equity markets are largely barren of value.
It is notable that despite the downward movement in Treasury yields, there are still analysts willing to make public arguments about the benefit to banks of rising interest rates. While net interest margins for all US banks did rise about 10bp in 2017, this was largely due to the upward move in rates after the surprise electoral win by President Trump, as shown in the chart below.
Since the end of the year, however, the twin pillars of the bull trade in financials – rising interest rates and deregulation – have been eroded to the point of disappearing entirely. We spoke about the prospects for legislation helping the banks with our friends on CNBC’s “Squawk Box” on Friday. The fact that there are still analysts willing to tout the positive aspects of rising interest rates when the 10-year T-bond is sinking towards 2% yield illustrates the indomitable optimism of Wall Street – and the degree to which forward risk indicators are diverging.
We called for a 2% yield on the ten year T-bond at the end of last year, a viewpoint that is confirmed by the mounting evidence of credit problems in asset classes from credit-cards to commercial real estate to auto paper. By embracing the modern equivalent of “trickle down” economics via asset price manipulation, the Federal Open Market Committee has succeeded only in adding a new layer of speculative debt atop the financial carcass as it stood around 2010. As this latest vintage of debt issuance ripens, we may be surprised at the rate of change in terms of credit losses at banks and inside ABS.
"Although card standards were extremely tight in the years following the financial crisis, if underwriting then loosened materially, as the rise in charge-offs suggests, asset quality could continue to deteriorate rapidly going forward, especially in the event of a recession," notes our colleague Warren Kornfeld at Moody's.
As we opined in earlier missives, the key relationship to watch when it comes to bank earnings is not interest rates or even net interest margin, but provisions for credit losses vs operating income. This is an especially important topic because the folks at the FASB are currently negotiating with the banking industry about changes in estimated future loss rates on loans that could add 10% or so to the cost of bank provisions for credit losses.
Our friends in the bank credit channel say that the impact of the rule change by FASB will be for banks to over-report likely loan losses, which will then lead to larger recoveries after the defaulted loan is fully resolved. The standard is expected to take effect in 2020, although FASB has indicated that it may revise the rule to address industry concerns.
It is more than a little amusing to see the FASB advocating a change in presentation to bank loan loss provisions that will effectively result in over-reserving for credit losses. This was traditionally the position taken by prudential regulators, while the SEC always tended to want to see loan loss provisions kept to a minimum so as not to artificially understate earnings. Shareholders will, eventually, see the cash returned to the bottom line via recoveries, but seeing this reversal of roles is a rather delicious irony.
Changes in accounting rules, however, will not change the underlying economic reality of excessive debt. We worry about the fact that the latest period of exuberance engineered by the FOMC has embedded significant future losses in the financial system. While the US may be a good bit healthier than the EU or China when it comes to absolute debt levels and credit quality, the fact remains that the predominant tendency in the US credit markets remains deflation.
The 20th Century US economist Irving Fisher worried about the decline of income in the event of a debt deflation, yet today we face a different problem. A combination of technology, innovation and the aging demographics of the key industrial economies is limiting income growth even as asset prices are goosed ever higher by monetary policy and structural constraints.
One reason we expect that the widely anticipated rate hike by the Fed this week will be the last is that members of the FOMC seem to at least understand that the US economy is slowing. Rising credit losses in a variety of asset classes will force the central bank to pause on the road to normalization and prepare to battle another bout of old fashioned debt deflation.
Irving Fisher noted in 1933 “that great depressions are curable and preventable through reflation and stabilization,” but it remains questionable whether the FOMC has in fact achieved either of these blissful ends over the past eight years. Fisher worried that “when over-indebtedness is so great as to depress prices faster than liquidation, the mass effort to get out of debt sinks us more deeply into debt,” but in 2017 the problem is different.
In the 1930s, the debt markets were allowed to clear without government manipulation or support, resulting in catastrophic debt deflation. Today the Fed artificially supports elevated asset prices in the vain hope that a “wealth effect” of some sort will “trickle down” and boost incomes. Memo to Chair Yellen: There is no wealth effect, there is no wealth effect.
What is clear is that the Fed has added to the collective credit bubble, begging the question as to when asset prices will readjust downward again to match flat income levels. Not only has US public debt almost doubled since 2008, but private debt has likewise risen by mid-double digit rates. The slowly rising cost of credit visible in banks and the bond market may herald the start of a new type of debt deflation cycle.
Thus we expect June to be the last rate hike by the Fed in 2017 and perhaps for years to come. As with January/February 2016, our friend Nouriel Rubini writes, concerns about faltering US growth could put further rate hikes on hold. Just imagine how Wall Street will greet that happy news. The real question for investors is when will the Fed be forced to publicly reverse course on rate increases, then cut rates and maybe even resume asset purchases to keep debt deflation at bay for a while longer.