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The Institutional Risk Analyst

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The FOMC Embraces Debt Deflation

August 10, 2022 | One of the goals of The Institutional Risk Analyst is to help our readers see the rocks in the water ahead before we hit the prop on the brand new Yamaha outboard motor. We try to do this by highlighting the exemplars among banks, finance companies and aspiring fintech issuers in our Premium Service. Last year, we helped several readers avoid the downturn in financials, positioning them to go shopping today. We recently featured Block Inc. (SQ) and Guild Mortgage (GHLD), in our last issue (“Update: Guild Mortgage & Block Inc.”).


West Grand Lake August 2022


We also focus on the those increasing instances where the speed of change in the macro markets is adding more noise than signal to the common narrative of investors and risk managers. In that regard, we were more than a little amused when the notorious SoftBank of Japan announced that it was dumping shares of SoFi Technology (SOFI) after reporting a more than $20 billion loss on its portfolio. Bloomberg News reports:


“SoftBank Chairman and Chief Executive Officer Masayoshi Son earlier Monday said he plans widespread cost cutting at his Tokyo-based company and the Vision Fund, following a record 3.16 trillion yen ($23.4 billion) loss. The Vision Fund has been hammered by a selloff in global technology stocks this year, and SoftBank also reported a $6.1 billion foreign exchange loss because of the weaker yen.”


As we predicted last year, SoftBank has been forced to put Fortress Investment Group up for sale. “SoftBank announced its acquisition of Fortress, one of New York real estate’s more active lenders, in February 2017. The deal came out to $8.08 per share, or $3.3 billion overall,” reports The Real Deal. Price talk for FIG is now said to be around $1 billion. Remember, the end of QE means asset price deflation.


Q: If SoftBank needs to take a 70% discount on the sale of FIG and other assets, what does this say about the sustainability of Masayoshi Son?


More than any other global hedge fund, SoftBank represented the one-way trade created by the Federal Open Market Committee during the past decade. Its most radical adventure in quantitative easing or QE was merely the finale of a decade of inflationism. The most recent round of “large scale asset purchases,” as QE is known internally at the Fed, caused stocks and bonds to move higher in a nearly 100% correlation, a fundamental change in how private markets operate.


By nationalizing the short-term money markets, the FOMC created the appearance of control. Just as SoftBank seemed to be minting money with every investment it made over the past decade, the Fed suspended the laws of economic gravity. QE was essentially a free long call option on the equities markets for global investors, especially those fueled by leverage. Now, however, that long-call position has suddenly migrated into a short-put position, with equity managers desperately trying to avoid another down quarter as clients take losses.


As short-term rates rise but medium-duration exposures fall in yield, the FOMC is confronted with one of the more profound aspects of QE: namely that having inflated asset values to a grotesque extent, the central bank is now compelled to embrace and even encourage debt deflation. Not only does this suggests a prolonged period of economic contraction equal to the expansion under QE (read: a recession), but it also suggests that we’ll experience above-average credit defaults after a period of artificially benign credit.


Source: FFIEC


The reality of the construct above is revealed by the decidedly bearish views spilling out of the bank regulatory community. When the Fed directed JPMorgan (JPM) and other banks to raise capital buffers in preparation for the “hard landing” dreaded by economists, what they are really saying is that the conclusion of extraordinary policy may be a significant uptick in bank credit losses. If deflation takes hold and asset prices for stocks and homes weaken, then banks will take a significant hit after two years of negative credit costs.


If you believe that the FOMC is going to stick to its guns and force down prices for residential homes, then you must also believe that all manner of credit investor will also take significant losses in the process. This is not a reference to losses on crypto tokens or other pieces of the financial fringe, but rather a mark-down in the value of real assets with real cash flows. Whereas the 2008 financial crisis was about the excesses of Wall Street in selling private-label residential mortgages, the deflation of 2023 is about marking down all types of real assets to the price level that equates with a non-QE world.


As the FOMC now attempts to reduce the size of its portfolio, it will be a net-seller of Treasury debt and mortgage-backed securities (MBS), putting pressure on the dealer community even as issuance volumes fall. As bank reserves fall, banks and other investors will be forced back into the market for Treasury debt and MBS, pushing interest rates lower in the process. Lower reserves means lower deposits held at banks, eventually pushing down assets for the entire industry. Bank funding costs will remain suppressed for the next 12-18 months, however, giving banks a significant advantage in the money markets.


Source: FFIEC


And as the FOMC raises short-term interest rates and, with it, the cost of borrowing Treasury and MBS from the Fed’s reverse repurchase (RRP) facility, money market funds will be forced to buy Treasury debt and MBS in the open market, again putting downward pressure on medium and long-term interest rates. Banks, meanwhile, will be net sellers of assets as they comply with regulatory edicts to raise capital, putting upward pressure on interest rates as they sell loans and MBS.


For all of you members of the Buy Side community who have been talking about rising bank lending volumes as interest rates rise, forget it. As the FOMC normalizes policy after several years of radical QE, banks will be forced to shrink risk assets and build liquidity, a counter-cyclical aspect to the scenario that is not addressed in most economic models. Banks will be net sellers of risk, putting downward pressure on loan prices and bank earnings for 2022-2023.


Bottom line is that the Fed has created a scenario whereby the central bank and commercial banks are net sellers of risk. The structural aspects of this decidedly Fed market may force rates lower in the near term. As reserves disappear and the bid for Treasury paper and MBS rises in a market with dwindling supply of collateral, medium-term and long-term rates may fall significantly. Chairman Jerome Powell and his colleagues on the FOMC want you to believe that they can manage this complex process without market disruption and without taking the Fed’s balance sheet down below ~ $6 trillion. Sure. Have a great summer.


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