Ukraine & the Return of Credit Risk
April 20, 2022 | Updated | Earnings season for financials ended almost as soon as it began as results for JPMorgan (JPM) on down the list disappointed the rosy expectations of Buy Side managers. As we noted on Monday in our Premium Service edition of The Institutional Risk Analyst, the results for Goldman Sachs (GS) confirm our view that this firm is in trouble long-term.
Funding costs at GS are too high, credit expenses are elevated even now compared with its peers, and the dependence on trading and investment banking sets the firm up for trouble down the road. The proverbial stool at GS has only two legs. Keep in mind that the Fed has been suppressing bank credit costs via QE, thus the poor GS credit experience vs average assets is truly remarkable.
Meanwhile, James Gorman and his team at Morgan Stanley (MS) have created a large, liquid universal bank with three strong legs – investment banking and capital markets, wealth and investment management, and commercial banking. Thanks to half a trillion dollars in core deposits and $1.5 trillion in AUM, the cost of funds for MS is a fraction of that paid by GS. Game over.
All of these thoughts of investing and business models are a pleasant distraction, however, compared to the real human suffering being endured by the people of Ukraine and other nations. The vicious attack on Ukraine by Russian dictator Vladimir Putin positions Europe and much of the developing world for a period of economic depression and political instability for many years to come. And much of the blame for this disaster belongs to officials in Washington and the EU.
The fact that members of the Biden Administration encouraged Ukraine to seek NATO membership eventually will be recognized as a stunning miscalculation by Washington. Russia was falling behind the west economically long before the war began, but the inept actions by US and EU leaders provided Putin with a perfect domestic pretext for war. The inflation and economic costs caused by this horrible conflict in the center of Europe will torment the world for many, many years to come.
With the grain growing regions of Ukraine and Russia consumed by conflict, millions of people in Africa, India and other nations face the prospect of hyper-inflation of prices for basic necessities, eventual starvation and related political upheaval and geopolitical tumult. Industries from technology to transportation to energy will be disrupted for decades. The true economic cost of the ill-considered actions of US and EU officials with respect to NATO membership for Ukraine will take many years to reckon.
The clumsy performance of Russian military forces has also been noticed by Xi Jinping’s China, which like Russia also faces economic malaise due to authoritarian rule. China covets Manchuria as a source of food and other commodities. Never forget that the largest battles of WWII occurred in the Far Eastern regions of Russia and China, between Japanese forces, the Soviet army and the Nationalist Chinese. Thanks to global warming, you can now grow wheat in Manchuria.
As Putin’s Russia fails economically and politically under the weight of western sanctions, the tendency toward military conflict between Russia, the US and China will grow. It is worth recalling that the surprise attack on Pearl Harbor in December of 1941 came about due to Washington’s successful efforts to cut off energy supplies to Japan's military government. Economic sanctions are a weapon just like tanks, missiles and jet aircraft. Just imagine how global markets will react when Putin deploys tactical nuclear weapons in Eastern Ukraine to avoid a conventional military defeat.
Meanwhile back in Washington, there is an almost complete lack of recognition that the global economy is headed for serious trouble due to the Ukraine conflict. Since we now live in the age of the dilletante, appearances naturally trump substance. Celebrity policy makers seem more interested in making television appearances than in truly serving the national interest. The cacophony of voices coming from the FOMC, for example, illustrates this systemic dysfunction.
St Louis Fed President James Bullard leads the hawkish tendency on the Federal Open Market Committee, thundering away on television that the central bank needs to raise interest rates to truly impossible levels to fight inflation. But wasn’t the inflation that so worries Mr. Bullard the result of the reckless policies pursued by the FOMC under Chairman Jerome Powell and former Fed Chair Janet Yellen? Do we hold any of these officials accountable for their actions?
We wonder, do Mr. Bullard and the other members of the FOMC understand that raising interest rates dramatically after two years of artificially low interest rates is perhaps a bad idea? If Bullard’s policy suggestions on television over the past week that we need to get the federal funds rate to 3-4% were actually to become reality, many US banks would see themselves underwater on assets created during 2020-2021.
As we noted during our discussion with Jack Farley on Blockworks earlier this week, the benefit the Fed gave to banks in Q1 2020 may now become an equal burden as the FOMC seeks to reclaim credibility on inflation. Thirty-year mortgage rates are likely to hit 6% by June or double the rate of one year ago. Given the rhetoric from Bullard and other hawks, mortgage rates are likely to move even higher as the year progresses.
Because of the ineptitude and lack of focus we see from many policy makers, our expectation is that the financial markets in the US and globally face a long-period of adjustment and volatility. As market and geopolitical risks surge back into view after years of managed, but artificial, economic stability, investors will be forced to change their risk appetites and time horizons.
Take an example. Thirty-day interest rate locks have disappeared from the residential mortgage industry, forcing borrowers to price loans on the closing date. So too, global investors are being forced into a short-term mindset that is going to add to market volatility and make asset allocation even more difficult.
As we noted this week in National Mortgage News, with TBAs trading at a discount to par, this instead of a four point premium last year, mortgage lenders are losing money on every new loan they close. As this issue of The Institutional Risk Analyst went live, a colleague reported a new pool of conventional mortgages with a weighted average coupon (WAC) of 6.8% and intended delivery into a 6% Fannie Mae MBS in May. This suggests that we could quite easily see a 7% mortgage by June.
With much of Europe and China now off the menu for global investors, the wave of liquidity chasing returns will now focus on a reduced set of opportunities. Many of these remaining investment situations will be distressed due to the economic disruption of the Ukraine war. Look at Citigroup (C) trading at 0.5x book value today and you see the fear of unknown risks in the minds of investors and counterparties. It is not impossible that Citi or another large global bank will need official support due to credit defaults arising from the Russian invasion of Ukraine.
The FOMC managed to suppress credit costs during the past several years, but now as shown by bank earnings, credit costs are becoming very real once again. Over the next twelve months, we look for bank credit costs in the US, Europe and Asia to revert to the mean and then rise to elevated levels that will shock many complacent investment professionals and policy makers. In 2022 and beyond, we are truly headed into the new age of credit and geopolitical risk.