QT Means Short Credit Risk
May 30, 2022 | Over Memorial Day weekend, we released the latest edition of The IRA Bank Book with our review and outlook of the banking sector for Q2 2022. As we analyze the ebb and flow of earnings in the financials, in many respects the patterns visible in bank results are also visible elsewhere. We all have the same problem: rapidly repricing asset values under the weight of threatened Fed tightening. Market risk realized today becomes credit risk tomorrow.
Look at ad revenue for Twitter (TWTR), Snap (SNAP) and the company formally known as Facebook, Meta (FB) (h/t to Variety), and you see the same manic pattern as is visible in financials. Sadly we cannot share the really cool chart in VIP+ earlier this month. Suffice to say that Q2 of 2021 was a good time to sell online ads. But the more important point is that the asset value of all of these companies has been cut in half or more.
A sharp spike in online advertising activity was caused by COVID and followed by the latest episode of social engineering from the Federal Reserve Board. Now that the COVID contagion has seemingly (but not in fact) moderated, we see an equally rapid collapse in demand in many sectors. The JPM index of global developing debt is down 15% so far this year. Will the FOMC come back to the rescue if the patient begins to flatline?
Like most potions conveying unnatural life, the side effects of ending the Fed’s purchases of securities via QE is an equally powerful snap in the other direction. People are no longer cloistered at home staring at their cell phones, thus no surprise that ad revenues have fallen back to pre-COVID levels at TWTR and FB. When you pull tomorrow’s sale into today, tomorrow ends up being light.
The power of the Dark Side of inflation wielded by the Fed is most felt in the leveraged world of finance. The 120% increase in the ad revenue for SNAP, for example, is as nothing compared to the three-fold rise in operating income orchestrated by the Fed for banks, this as net interest revenue was falling rapidly. The FOMC ultimately sliced $40 billion per quarter out of bank interest earnings, a loss that may never be restored.
Source: Quarterly Banking Profile
If you examine the price movements of TWTR, SNAP and FB, all began to crater as ad revenues fell at the end of Q3 2021. Likewise, banks started to roll over as investors started to understand that the 340% spike in operating income seen in 2021 was an anomaly. Market risk realized today becomes credit risk tomorrow.
Let’s consider another example c/o Joe Garrett at Garrett McAuley & Co in San Francisco and the Mortgage Bankers Association. When lending profits were 1.5%, mortgage companies actually seemed investable. What a difference a few months makes. Suffice to say that we’ll test the lows of 2018 in terms of lending profits during this up cycle in interest rates.
No matter how many times we explain to investors that the earnings surfeit at banks was a mirage caused by GAAP, many refused to accept the data. More did not sell bank stocks at record levels and rode them down. And many today are sitting with low coupon loan exposures that are likely to move lower in the near term as the downward sloping trend in bank earnings unfolds. Likewise mortgage lenders dependent upon fat gain-on-sale margins are now fighting the Fed. But perhaps the largest banks face the most risk in the near term.
Consider, as we noted in The IRA Bank Book, that the gross yield on the loan portfolios of the large banks in Peer Group 1 averages 4% as of Q1 2022. Some of the larger, more profoundly mediocre names such as Bank of America (BAC) are closer to 3% gross yield, according to the FFIEC. Figure BAC's gross yield at year-end was 3.25%, minus overhead of 2% of total assets and funding cost of 0.16%. What remains is net operating income.
Notice that we did not include credit provisions in the analysis in the previously paragraph, not meaning to upset the more impressionable members of the reading audience. Provisions for loan losses were still negative in Q4 2021. Add 15-20bp vs average assets for normalized loan loss provisions in 2022. So the hypothetical reckoning for BAC's loan book looks like this:
Gross yield: 3.4%
Funding costs: 20bp
Provisions expense: 15bp
Net income ~ 1%
It does not take an astrophysicist to see that a small increase in funding costs and/or credit expenses will be enough to drive many banks into loss. If our fishing pal Danielle DiMartino-Booth is correct about a Paul Volcker style rate increase regime this year, say 50bp per meeting, then many banks could find themselves underwater a la the 1980s and the S&L crisis.
But of course, Chairman Volcker moved faster and bigger than this crowd on the FOMC today. He not only attacked inflation, but also called out fiscal dishonesty in Washington. Volcker destroyed a lot of banks, home builders and investors by fighting inflation in those politically difficult years.
As all manner of companies struggle with the increase in interest rates this year, many investors find themselves holding paper that was created during 2020-2021 that is now profoundly under water. The secret of QE is that the Fed’s machinations embedded big losses on the balance sheets of banks, pensions and other savers, the latest and largest manifestation of Financial Repression in this cycle.
“The Fed’s May meeting minutes contained few revelations, leaving our Fed Minutes Sentiment Indicator little changed and remaining relatively hawkish,” Bloomberg Intelligence strategists Ira Jersey and Angelo Manolatos wrote in a note. They continued that a “number” of FOMC members thought sales of agency MBS could be necessary after runoff was “well underway,” according to the minutes
“We wouldn’t be surprised if the Fed were to embark on sales in 1H23 after getting some feedback from market participants and allowing about six months of full runoff to occur before making a final decision,” the analysts wrote. We certainly hope so because any attempt to sell large portions of the Fed portfolio will badly distort interest rates and especially mortgage rates.
As we’ve noted, the mark-to-market on the Fed’s $2.7 trillion portfolio of mortgage backed securities is easily minus $500 billion, a sum that is actually a loss to the taxpayer. When we said a while back that the Fed’s actions with QE are illegal, we refer directly to the fact that the Federal Reserve Board is spending money in a market speculation without authority from Congress.
Robert Eisenbeis of Cumberland Advisors told The IRA back in December of 2017 (“The Interview: Bob Eisenbeis on Seeking Normal at the Fed.”
“The Fed almost by definition cannot make a profit. It baffles me how people inside the system can fail to see the accounting reality here. The Fed issues short term liabilities to buy Treasuries taking duration out of the market. The Treasury makes interest payments to the Fed who takes out its operating costs, including interest payments on reserves and returns the remainder to the Treasury. If this intra governmental transfer were settled on a net basis like interest rate swaps, there would always be a net payment from the Treasury to the Fed.”
And the Fed now also stands to lose money for the Treasury on QE, a fact we think is rather remarkable. Since the national Congress has chosen to treat the remittances from the Fed as a “profit” for the purposes on the federal budget, perhaps it does not matter in Washington. It certainly matters for lenders, investors and risk managers around the world.
As our friend Alan Boyce opined previously, the MBS that the Fed purchased for 102 with a duration of 4 now trade in the low 80s with a duration of at least 12. As interest rates rise, the duration of the Fed’s MBS portfolio will extend further, increasing taxpayer losses and creating a vast obstacle to normalizing policy because these low-coupon mortgage bonds are essentially unsalable.
To understand the scope of the problem, instead of $2.7 trillion in MBS, imagine that the Fed actually owns $10-12 trillion in MBS that is lengthening in duration and falling in price as interest rates rise. Welcome to the risk of negative mortgage convexity, BTW. But as private investors see large portions of the gains they thought were real over the past several years eviscerated, they can take some comfort in the fact that Fed Chairman Jerome Powell feels their pain, sort of. And again, market risk realized today becomes credit risk tomorrow.