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May 10, 2023 | Premium Service | Key risk indicators visible in the world of credit are not exactly confirming the rosy scenario coming from Buy Side managers and their enablers in the economics profession. Congress is playing chicken with the debt ceiling, for example, but we think the amount of US debt already demands a credit downgrade. Just the increase in debt service costs is enough reason for a ratings action. When will Moody’s, KBRA et al admit that S&P is right and downgrade the US Congress to “AA+”?
Besides the dysfunctional behavior of the federal government, another reason for a sovereign downgrade of the US is the equally skittish behavior of the central bank. The Fed’s use of “abundant reserves” from 2019 onward looks an awful lot like a subsidy for the Banco de Mexico circa the 1980s. The US Treasury is, after all, the main beneficiary of QE.
Looking at the accumulating ill-effects of this deliberate Fed policy (i.e. QE) of enabling ridiculous fiscal behavior in Washington, we think an explanation is in order. Not only did the Fed monetize trillions of dollars in Treasury debt since 2008 and especially since 2019, but it also taking billions in cash flows from trillions more in mortgage bonds, diverting income from private investors to the benefit of the US Treasury. This is the sort of dissolute behavior that traditionally has been observed among the more decrepit societies of the developing world.
Indebted nations that threaten credit default should be marked accordingly – if the rating agencies have any value to investors. That is, of course, the real question raised by the lack of action by the credit rating agencies. Bill Nelson of Bank Policy Institute notes even more aberrant behavior at the Fed as even more piles of sovereign debt accumulate due to failed banks:
“Yesterday the Fed released its always excellent biannual financial stability report (available here). The report includes an entire section on the Federal Reserve’s actions in response to the recent banking turmoil pp. 53-54. The section discusses regular discount window lending (primary credit) and lending through the Bank Term Funding Program. In the section and in the entire report, there is no mention of Fed lending to bridge banks or to the FDIC as receiver even though such lending currently accounts for 73 percent of Fed lending in response [to] the banking turmoil.”
Essentially, the FDIC now must assess new deposit insurance fees on large banks to take the Fed out of its loan to the three FDIC receiverships created since March. FDIC will also get $50 billion from JPMorgan (JPM) when the financing for the First Republic Bank (FRC) failure matures. The Fed is always an expense to the Treasury, keep in mind, unless the banks pick up the cost of now three large bank failures. That deal Jamie Dimon did buying First Republic Bank from the FDIC does not look so great now, yes?
Meanwhile in the world of credit and banking, the interest rate hikes by the FOMC have left trillions of dollars worth of bonds and bank assets trading at a sharp discount to par. We noted previously that First Republic Bank boasted a gross yield on its loan book of about 3.25% at year end.
The Real Deal reported this week that FRC had been making below market loans to all sorts of borrowers on New York City residential properties below $1.4 million. As the bank neared failure, it tellingly began to run away from this market. “It was clearly First Republic trying to get out of these loans because no one wants them,” Barbara Ann Rogers told The Real Deal about loans approved but never closed. “No one wants to buy a portfolio of 30-year fixed mortgages at 3.25 percent.” Ditto.
We begin to perceive yet another benefit of the Fed’s QE medicine, namely a tendency to underprice risk on a systemic basis. FRC was really a whole bank full of underpriced loans that pretended to manage money. Now, in a “normal” interest rate environment, whole sectors of the world of banking and finance are trading at a sharp discount to book value. When any company trades below 0.7x book value, it suggests that the fair value of the firm is overstated.
Update: Rithm Capital