Updated: Oct 31
October 31, 2023 | This week The Institutional Risk Analyst is in Washington, D.C., for the 12th Annual Housing Conference sponsored by American Enterprise Institute. Tomorrow we’ll be joined by Alex Pollock, Joseph Tracy and our host Ed Pinto to talk about housing, quantitative easing (QE) and modern monetary theory as its is now practiced in Washington. Click below for a copy of our slides.
We want to give the folks at Morgan Stanley (MS) a well-deserved hat tip for a leadership transition that makes sense and seems well considered by the board. There is no childish posturing or hasty departures. No screaming. Just an orderly process that seems like a reprise of the House of Morgan in days past. Our discussion with Rachelle Akuffo is below.
As we’ve noted in our Premium Service, MS is pretty clearly the winner among Sell Side asset gatherers on this side of the Atlantic and is a direct comparable to UBS AG (UBS), the leader among bank asset managers in the EU. But don’t think that MS is low risk or removed from things like equity markets trading and clearing, and investment banking.
MS, of note, is also the largest derivatives dealer in the US, even bigger than the hedge fund known as Goldman Sachs (GS). Gross bank derivatives positions are 90% or more interest rates across the industry and have been trending lower. Centralized clearing of Treasury collateral may put further downward pressure on bank leverage.
Meanwhile, the outlook for interest rates is rapidly turning. Michael Green makes the case for no more rate hikes in his latest comment, but also reminds one and all that “deflation” remains the more fundamental concern of the Fed: “Measures of inflation expectation have normalized, and the term structure suggests the Fed might soon be dealing with deflationary conditions rather than inflation.” And nothing is more deflationary than debt defaults.
Deflation comes when the accumulation of debt makes it impossible for the obligor to refinance or “roll” obligations, forcing a markdown in principal via a debt restructuring. Most of the industrial nations have already reached the tertiary stage of indebtedness, where the bulk of debt is merely rolled and refinanced. Eventually the cost of rolling the debt forces a reduction in principal.
Ponder the possibility of dollarization in Argentina. Imagine the deflation of wealth that will occur in the event, when worthless pesos are exchanged for somewhat more resilient paper greebacks. But a huge deflation has also occurred in the US due to rising interest rates and the negative impact on all manner of assets. Thus it seems pretty easy to call an interest rate peak.
One of the effects of QE has been making many banks and real estate investors insolvent, a precursor to debt defaults. When a debt default occurs, the ostensive owner of the assets is wiped out, but the funding behind the loan is also lost. Remember, double entry accounting. Even if we believe the Fed’s definition of inflation (excluding housing, food and energy) has reached pre-COVID levels, the damage caused in terms of future deflation and credit losses seems kind of excessive.
If the FOMC merely pauses and leaves benchmark rates unchanged for an extended period, which seems to be the consensus narrative at present, then the banking system will need to internalize the losses on asset prices while navigating relatively weak lending volumes. This is a prospective economic scenario unlike that faced by banks since the 1990s. Office loans are facing the highest levels of deliquency in a decade, reports Jeffrey Fuller of Bloomberg, but the real concern is loss severity, because there are so few ready buyers for these assets.
As we noted in our latest edition of The IRA Bank Book for Q3 2023, the US banking industry was deeply insolvent, a fact that will negatively impact earnings for years to come. The 10-year Tresury was still below 4% at the end of June 2023, thus the situation facing the US banking industry was even more extreme at the end of Q3 2023 with the 10-year Treasury note near 5%. The chart below from the most recent earnings report from Penny Mac Financial Services (PFSI) shows the frightening skew in mortgage coupons caused by QE.
Those 3% loans shown above are sitting in a 2% MBS on the books of a bank somewhere. The 2% MBS is trading in the mid-70s today.
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