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The Institutional Risk Analyst

© 2003-2024 | Whalen Global Advisors LLC  All Rights Reserved in All Media |  ISSN 2692-1812 

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Hard Landings & Systemic Crypto

July 4, 2022 | Today America celebrates its liberation from British tyranny two and a half centuries ago. Then as now, we face new threats at home and abroad, but these hazards spring largely from hubris. As the winner of WWII and the Cold War, American became entirely assured in all respects.

Jeffrey Sachs describes the American surrogate war in Ukraine as a success for the neo-conservative movement going back decades, long before Presidents George W. Bush and Barack Obama:

“The war in Ukraine is the culmination of a 30-year project of the American neoconservative movement. The Biden administration is packed with the same neocons who championed the U.S. wars of choice in Serbia (1999), Afghanistan (2001), Iraq (2003), Syria (2011), Libya (2011), and who did so much to provoke Russia’s invasion of Ukraine. The neocon track record is one of unmitigated disaster, yet Biden has staffed his team with neocons. As a result, Biden is steering Ukraine, the U.S. and the European Union towards yet another geopolitical debacle.”

The Federal Reserve Board, for its part, pretended to be in control of the US economy up until the end of last year. With the shattering of the low-inflation illusion, however, the pretense of managed stability of markets that goes back 50 years also is discarded. The Fed now has seemingly set up the US markets for a very hard landing.

Think of a hard landing for the US economy as the Fed deliberately inducing a recession sufficient to lower equity valuations and home prices 20%. For those not familiar, this is like an autorotation in a dead helicopter from about 5,000 feet. You shut the engine down and land using the rotor as a wing. The great video from YouTube provides step-by-step instructions. Please don’t try this at home.

By manipulating the $12 trillion mortgage market via QE, the Fed not only disrupted the enormous housing sector, but has also clotheslined (h/t Tim Rood) the entire financial community and bond market, and thereby caused corporate credit spreads to blow out. Leverage is now the enemy instead of your friend. The result is a growing list of distressed financial companies and investments. Banks are hoping for higher loan yields, but with the yield will come sharply higher credit defaults.

Q: Do we all still believe that “QE” is a form of economic stimulus?

The collapse of First Guaranty Mortgage last week probably was not a surprise to readers of The Institutional Risk Analyst. The PIMCO-controlled nonbank lender was mostly third-party origination, which in this market is an excuse to lose money in large chunks. But the rapid move in interest rates is what killed this independent mortgage bank and will kill many more.

Lenders are often down cash when they close your mortgage loan, but losing money selling the loan into the bond market is fatal. When the on-the-run TBA contract is trading at a discount, that means that you lose money on the sale of the loan. The 400bp increase in US mortgage rates over the past six months is the proximate cause of the failure of FGMC and huge capital losses in the secondary loan market.

The Friday-close screenshot from Bloomberg last week shows that the on-the-run contract for loans deliverable into a FNMA MBS for July is 5.5%, but the TBA 5s have rallied back to a premium in the past several weeks with the rebound of the 10-year Treasury note. In particular, notice that the 10-year Treasury moved 21bp in yield on just Friday, a direct result of volatility caused by the FOMC’s market manipulation.

Source: Bloomberg

The fault for the failure of FGMC lies directly with the Fed, so let’s all please dispense with the handwringing about the risk of nonbank finance. The Fed and its’ increasingly reckless open market intervention are the chief risks to all forms of financial intermediation. Indeed, the social phenomenon called crypto is the result of QE and, despite the happy talk from US officials led by Federal Reserve Chairman Jerome Powell, is a threat to the US financial markets.

It takes one pebble to start an avalanche. Notice that the financial media finally has taken note of some infamous names very familiar to our readers (“Profile: Silvergate Capital Corp (SI)”). Signature Bank (SBNY) and Silvergate Capital (SI) are perhaps the most visible examples of real banks diving into the surreal world of crypto tokens – we won’t call them “currencies.”

These FDIC-insured banks (as well as many others) got caught in the trap of “lending” on crypto as “collateral,” a clear act of idiocy that fully deserves federal prosecution. When you as the officer or director of a federally insured bank cause a capital loss by lending against nonexistent collateral, that is called bank fraud. And there are some very interesting names from Wall Street, sports and celebrity behind some of these bank crypto projects. Stay tuned.

“Signature Bank uses an Ethereum based payments application to serve its customers,” noted Damian Mark on SeekingAlpha in February. “The bank is materially growing its crypto deposits and has been recognized by Forbes as a top 50 blockchain company (2021).” Obviously, this would not be a flattering description in July 2022.

Q: Is Ethereum an asset or a receipt for cash?

Both SNBY and SI have deep roots in the world of secured lending, but this legacy has not prevented the managers of these institutions from risking their depositories on what seems a pretty clear example of “unsafe and unsound” banking practices, to borrow the language from 12 CFR Part 337. Few of the players in the world of crypto even know that transactions that disadvantage a bank can be construed as felonies under federal law.

Fortunately for the crypto community, federal bank regulators are still largely clueless about the risks of crypto to US banks. It’s not the sheer size of the crypto Ponzi that matters, but instead the potential for surprise, that key ingredient for a systemic event. Like if SBF, founder of Alameda Research and Bahamian crypto exchange FTX, backed away from rescuing foundering crypto ventures. That would be a surprise for many, but not for all.

Putting dollar leverage under crypto tokens – that is to say, under nothing – makes for infinite dollar risk. Yet as we noted on Twitter last week, there are actually some fools in the global bank regulatory community that think allowing banks to invest 1% of total assets in crypto is acceptable. After a few months of QT from Chairman Powell, people talking seriously about crypto will be laughed from the room.

Meanwhile, the wreckage in the world of private equity is building into a mountain of disappointment that could easily rival the crypto bust. “Over 140 VC-backed companies that went public in the US since 2020 had market capitalizations as of mid-June that are less than the amount of venture funding they raised,” according to PitchBook News. Add some leverage to that analysis and the PE market is yet another surprise waiting to happen.

When the Fed gunned the bond market in April 2020, they set in motion an upward shift in short-term credit ratings and a related move in the equity markets, perhaps best illustrated by the flourishing of the market for special purpose acquisition corps or SPACs. Since the duration of QE was obviously finite, the SPAC offered an accelerated pathway to the public markets. Or put another way, when SPACs are popular, FOMC members should worry.

But of course, we’ve seen this movie before. If we harken back to January 2021 (“A Tale of Two Frauds: Bitcoin & GSE Shares“), via QE the Fed increased the bezzel to gigantic size, allowing all manner of frauds like crypto tokens and NFTs to blossom in the name of full employment. In the 1920s, investors traded fractional shares in FL real estate. In 2020, they traded pretend real estate visualized on a screen. Go figure.

Now with the threat of QT, the “bezzle,” what John Kenneth Galbraith described as the “inventory of undiscovered embezzlement,” is contracting – this even as the cash flow from financial assets has been reduced via QE. It would be difficult to imagine a risk management situation in the global capital markets more likely to generate anomalies and surprises. Happy holiday.

Next in the Premium Service of The Institutional Risk Analyst, we look at some of the top-performing banks in our surveillance group and position our subscribers for the upcoming Q2 2022 earnings reports for financials.


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