Richmond | The 10 year Treasury bond peaked in yield at just shy of 3.25% around Thanksgiving. Since then, the world’s most important interest rate benchmark has rallied, pushing yields back down to just shy of 2.55%. Most of this move is probably due to the exodus of investors from equity markets, but even with a stable dollar and relative market calm the 10 year continues to climb in price/fall in yield. QE and a lot of talk aside, deflation remains the dominant underlying tendency in US markets.
So is now the time to pick up exposure to US financials? Maybe. Will refinance volumes return to the US mortgage sector? Deo volente. Bank OZK? Thinking (see below). Readers of The Institutional Risk Analyst know that credit metrics for all manner of bank real estate exposures are dramatically skewed in the too-good to be true direction. When will the proverbial pendulum swing the other way?
Ralph Delguidice puts the opportunity into sharp focus in a missive this week:
“The banks will present a GENERATIONAL buying opportunity in due time, when the FED has tightened financial conditions to deflate what is clearly a systemic bubble in COMMERCIAL REAL ESTATE (CRE) and, to a lesser extent, corporate loans. CRE and LL fundamentals can be debated to be sure, but the securitization bid is the CORNERSTONE of valuations in credit and it is never easy to ‘make the water fall up these ABS structures.’ Zero loss assumptions have been baked into the equity residual math for almost a decade, and there just isn’t room for ANY error. Like the equities, there is just too much asymmetry of return here. Eventually-- yes to the banks. In the meantime, the flat curve is going to make them too hard to own.”
Ralph’s observations from the credit channel touch on a point we have long noted, namely that the monetary excess of the Federal Open Market Committee has made credit markets flaccid, now grown accustomed to zero or even negative net loss. As and when credit ratings for leveraged loans and related ABS start to slip below investment grade, the whole game will stop and “investment grade” assets that were liquid six months ago will be no bid. That’s what happens when you fall off the edge of the ratings table.
Now if you ask former Fed Chairmen like Ben Bernanke or Janet Yellen, they will tell you that default rate expectations are low because the system is less risky. Yellen said back in 2016:
“One reason that risk premiums may be low is precisely because the environment is less risky... The Fed has long focused on ensuring that banks hold adequate capital and that they carefully monitor and manage risks. As a consequence, banks are well-positioned to weather the financial turmoil.”
The magical mystery tour of self-congratulation featuring Ben and Janet made an appearance last week, joining Fed Chairman Jerome Powell for a round robin session of carefully curated yet mindless nonsense on national television. For the record, Chairman Powell knows better. But their statements are important for investors because they illustrate just how far down the rabbit hole of economics are the internal discussions at the Fed and other agencies. The idiotic “capital will make us safer” view that underlies much of official thinking on the question of market risk sets the stage for a perfect systemic surprise.
Ponder the views of Prerequisite Capital in Australia:
“Ironically, when most investors study the top 15 global banks in the world ‘in isolation’ of the interrelationships and issues that arise when you take a broader look at the complex global system – you will hear them mistakenly talk about the improved ‘capital’ positions of these banks, thereby implying the relative ‘safety’ or strength of the banks globally. However, when you step back and ‘take into account larger and larger numbers of interactions as an issue is being studied. [...You are led to] strikingly different conclusions than those generated by traditional forms of analysis’ ... you start to realize that the banking and financial system globally is more (not less) fragile than it was in 2007.”
The more capital = less risk construct that has become the intellectual foundation of prudential regulation in the US is a perfect analog to the Maginot Line of WWII. After WWI, the French built fixed fortifications along the eastern border with Germany in the hope that these extended castles would protect them from attack. It’s like the French version of China’s Great Wall. But the key failure of the Maginot Line was that it was an incomplete solution to a public problem, both physically and in a technological sense. George Ball wrote in The New York Review of Books in 1984:
"Contrary to myth, the Maginot Line was, as far as it went, quite effective in blocking a German attack. France’s failing was that it had not finished the line and extended it to the sea or modernized its army units on the left flank.”
We can think of capital in major global banks as a Maginot Line type of linear, static defense. But what was needed to counter the blitzkrieg warfare of the Nazi armies was a mobile, flexible defense comprised of tanks, infantry, and mobile artillery combined with close air support. The Allies did not have these tools or tactics and early on almost lost the war. In rare cases such as General George Patton, a horse cavalry soldier who became one of the fathers of modern mobile warfare, there was understanding, but not yet broad acceptance among US military leaders.
Because the Maginot Line ended at the Luxembourg border, the Germans simply drove their Panzers around it via Belgium and the Ardennes Forrest. To apply the metaphor to finance, capital is fine, but regulators and officials responsible for monetary policy need to think about risk dynamically, especially when that market risk is the result of extreme forms of monetary policy. As curves flatten and funding costs soar, the possibility of contagion rises exponentially and regardless of capital – because liquidity ultimately is about confidence.
Think about the fact that the 10 year T-bond has rallied three quarters of a point since November at a time when the Treasury is borrowing record amounts. The unwind of the Fed’s extraordinary policy is causing asset classes to correlate and other distortions in both demand for duration and funding. Any pretense at making rational investment decisions in such a muddled environment seems to stretch credulity to the breaking point. But life continues, in defiance of the apocalyptic.
Let’s take a case in point, Bank OZK (formerly known as Bank of the Ozarks). Long one of the performance darlings in the US banking industry, OZK was known for being a well-run regional bank from Little Rock that had a big footprint in CRE lending nationwide. The common is off 50% over the past year, a reflection of some credit write downs that we not well handled with investors and an expensive name change and corporate name change and restructuring effort that leaves many puzzled.
When you look at the available disclosure on OZK, which is greatly reduced since the bank dissolved its parent holding company and became a unitary state-chartered non-member bank, the numbers look fine. Strong capital, low credit losses. BTW, a great resource when you need to follow the growing number of publicly traded unitary banks is the TBS Bank Monitor (see below), which scored OZK an “A+” in Q3 2018. Ping Dennis Santiago at TBS for more information.
After cratering to down 60% YOY on Christmas Eve, OZK rebounded 10% in the past month. Do you go in and start to increase exposure to this tainted dove, this one time exemplar of the CRE syndication world that now trades at a discount to subprime players like Citigroup (C) at 0.75 x book value? Not to mention U.S. Bancorp (USB) at 1.75 x book? The answer to that question depends on your view of risk and particularly unexpected risk.
We could spend a fine evening debating where that floor, that average equity market volatility rate, really ought to be for OZK given the perceived embedded risk. But looking at larger comps, the market swings of the past six weeks confirm that change is underway.
The high volatility players such as Goldman Sachs (GS), Deutsche Bank (DB) and Citi all trade at a discount to book because of the potential for large operational risk events. You could argue that GS wishes for a higher beta. All of these stocks reflect a lack of visibility on future risks, something the folks at Wells Fargo (WFC) also learned about over the past several years.
OZK with a beta of 1.8 is twice as volatile as GS at about 1 beta or roughly in line with market volatility. OZK at 0.89 book value is down 50% from a year ago, but since the unexpected credit write downs and the other fumbling around, the bank has lost that special bond with investors.
Based on the historical performance, we want and expect to see OZK deliver solid earnings and strong credit, quarter after quarter. But once you start to lose confidence in bank management and start to think about unexpected risk events, then that premium valuation goes out the window. The fact that OZK is head-to-head in CRE lending with some of the largest banks in major metros is not exactly a cause for confidence given loan pricing.
The point of the story is that consistency pays big dividends, but once you introduce the risk of uncertainty into the equation, investors quickly forget past performance and start to discount the promised outcome no matter the historical track record. Will the once premier names of WFC and OZK return to that premium pricing band above 1.5x book value? Yes, but it may take years to happen.
Credit spreads have widened considerably and given the softening of collateral values in residential and commercial real estate, worry about the unknown is certainly going to dominate financials going forward. The key question for the future is when will actual default rates follow spreads and how rapidly.
The National Interest
The Institutional Risk Analyst