Fed Asymmetry Threatens Credit Crisis
Updated: May 16
May 15, 2023 | Last week we participated in the Thirteenth Annual Bank Dinner sponsored by Nomura Securities (NMR). The event focused on the commercial banking, credit and mortgage sectors and featured some important discussions. Former FDIC Chairman Sheila Bair discussed the three major bank failures so far this year and made perhaps the key observation: the FOMC should have sold bonds over the past year rather than simply raise the level of short-term funds over 5%.
As readers of The Institutional Risk Analyst know, the excessive interest rate increases by the FOMC have left many banks and nonbanks insolvent. The lack of balance in Fed monetary policy is strange on a number of levels, but not surprising. By lowering interest rates and manipulating the bond market through massive open market purchases of securities, the FOMC pushed interest rates down to zero and pushed asset prices up dramatically. Now we are going the other way, with asset prices falling and credit costs rising fast.
The FOMC pushed the effective duration of mortgage securities to near-impossible low levels in 2020-2021, creating the circumstances for the failure of Silicon Valley Bank two years later. As we told the Nomura audience, SIVB was dead by the end of 2021 because of the massive position in mortgage backed securities (MBS).
The Fed's rapid interest rate hikes in 2022 ensured that SIVB would fail. When the FOMC began to unwind this policy of "abundant reserves," however, the Fed hastily raised the target for fed funds without any active sales of bonds. This asymmetrical policy choice not only caused three large banks to fail, but left the Treasury yield curve looking like an inverted salad bowl, with short-term interest rates well-above long-term rates.
By avoiding bond sales, the Fed is trying to conceal a major policy error -- without great success. Today, like the banks, many bond investors are also insolvent because of the Fed's insensitivity to how its policy actions would impact markets. Had the Fed raised fed funds to say 3.5% and aggressively sold bonds from the portfolio, longer-term interest rates would be higher and the banking industry would not be under attack by short-sellers armed with various types of exotic derivatives.
“The deposit flight dynamic is not a ‘bank run’ out of fear—it is a totally logical one which the Fed continued to perpetuate last week,” noted veteran Nomura analyst Charlie McElligott. “It’s a rational decision from depositors everywhere who are now even more aware that instead of sitting in bank savings account at 0.1%, that they should continue reallocating instead into Money Market Funds or Treasury Direct Account in T-Bills and earning ~5.0%”
In the asymmetrical world of Fed Chairman Jerome Powell and the FOMC, banks with a market beta > 1.5 are targets. Banks with a price to book value (p/b) below 0.5x are targets. PacWest (PACW) and Western Alliance (WAL) just happen to be the relatively small stocks where the short trade was able to get traction. The folks doing the short-trade are big institutional firms.
It’s not merely short-selling of regional bank stocks that is causing bank failures, but a deliberately orchestrated assault designed by some of the biggest Wall Street derivatives houses. As the market beta for names such as PACW rises, the swings in stock price, up and down, grow and eventually the beta is over 2x the 6m SP500. The growing pendulum swings of the stock flow into the credit-default swaps models, the institutional counterparties back away and then the bank is doomed.
The only limit to the short regional bank trade is the lack of short-side liquidity. The long mega banks/short regional banks trade described by McElligott last week is getting very crowded. As regionals fall, the exotics desks of the major dealers are taking on huge technical/market risk to maintain the spread positions, essentially equal weight long big banks, short regional banks. Since the regional banks are far smaller than the largest depositories, dealers are using derivatives to force down the price of regional banks even more.
In order to maintain the equal weight of the trade, desks are adding lots of “vega” as prices fall for regionals. This is all done vs KRE index, which is not really liquid enough to take the massive institutional flow into this short regional bank trade.
McElligott notes that “Deeply underwater long-duration Treasury and mortgage securities portfolios along with outsized CRE exposure which means awful marks for potential acquirers” of regional banks. The price volatility injected into markets by the Fed is a primary reason why the FDIC cannot easily find buyers for smaller banks. What is the fair value of a bank that has zero tangible capital, falling earnings and an indefinite price for its assets?
As we wrote this week, net interest margin (NIM) for US banks in Q2 2023 will get crushed as banks double or treble deposit rates in order to retain liquidity. As noted above, all banks are competing with 90-day bills and Fed RRPs. After PACW and WAL get annihilated, perhaps then we'll then move on to Ally Financial (ALLY) and Capital One (COF)? Think that will get the Fed's attention?
We assume that bank interest expense/average assets will be north of 3% in Q2 vs ~ 1% at 12/31/22. But even if the better managed regionals reprice deposits and otherwise restructure, many banks will still fail because of the excessive rate hikes by the FOMC. And all of this is unnecessary. The Fed’s lack of sensitivity to how policy will impact banks and markets is stunning and it is about to get a lot worse.
The impact of the Fed’s asymmetrical policy is being felt in the broader world of credit beyond banks. Howard Marks, founder of Private Equity Giant Oaktree Capital Management, told the FT last week that “The worst of deals were made during the best of times.” When rates were near-zero during the 2020-2021 period of QE, private credit was extended with fierce competition which meant that the rates offered were low and the terms often relaxed (e.g. covenant lite).
Today the world of credit is strewn with dozens of busted issuers that cannot function at prime rates approaching 10%. Think of selling that $90 billion whole loan portfolio of First Republic Bank with a 3.25% average coupon in today’s market. The same price analysis is applicable to commercial loans originated in 2020-2021.
While everyone is distracted with the troubles facing regional banks and credit investors, there is a lot of value being created in the process of restructuring housing from the COVID boom. Roughly half the people who worked in housing finance in 2021 will lose their jobs in 2023. The process of down sizing from QE is painful for the victims and profitable for the winners.
Mr. Cooper (COOP) just bought what was left of HomePoint for a 20% discount from fair value just a quarter before. The HomePoint MSR, which was booked at 6x cash flow at year-end, went for just shy of 5x last week. COOP looks to be rolling up the residential mortgage space on its way to $1 trillion in mortgage servicing AUM.
Meanwhile, as we wrote for our Premium Service readers last week (“Update: Rithm Capital”), Softbank/Fortress spawn Rithm Capital (RITM) is about to jettison its mortgage business to focus on commercial restructuring. By no coincidence, a lot of the smart money on Wall Street is focusing on the world of credit and commercial loan restructuring. When Oak Tree’s Howard Marks and RITM CEO Mike Nierenberg are both calling the bear trade in commercial credit, that is called a big hint.
If all of this is not enough worry on your risk dashboard, the folks at the Fed have managed to screw up the Treasury bond market so that the cash and the futures are no longer tracking. TBAs and MSR hedges are not performing as expected. Or in plain English, the off-the-run Treasury bonds are now the cheapest to deliver against your short position. Send your thank you notes to Jerome Powell c/o the Board of Governors of the Federal Reserve System in Washington.
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