This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst. This piece does not necessarily reflect the opinion of Hedgeye.
Today in The Institutional Risk Analyst, we ponder the good and bad aspects of extreme Fed monetary policy, including the massive purchase of securities or “quantitative easing” in the Orwellian newspeak used by the central bank.
As we’ve told our readers for many years, ignore what the Fed says and instead watch their actions in the money markets.
One of the clear benefits of Fed monetary policy is seen in the housing channel, where those smart enough to own or buy a house have received a vast windfall, literally trillions of dollars in paper gains thanks to the surge of home prices in the past several years.
Empty nesters are selling. Even American families who own a home and are experiencing financial stress are being floated on a sea of cheap credit c/o the Federal Open Market Committee (FOMC) under Chairman Jay Powell.
The once daunting pile of loans, millions in fact, that opted for CARES Act forbearance in 2020 are curing at a rapid pace, dashing the hopes of progressive activists for a train wreck in terms of low-income households.
The train wreck we saw forming last April for Ginnie Mae issuers was literally averted by the Fed’s cheap money. Meanwhile in the rental channel, there is chaos.
One leading loan servicer and warehouse lender told The IRA this week that while the rental forbearance process is a complete fiasco, the resolution of loan forbearance for home owners is moving quickly. Improved waterfalls used by loan servicers to guide the assistance process help a lot, but the big positive provided by the FOMC is home price appreciations (HPA), aka asset price “inflation.”
The fact of strong HPA has enabled loan servicers to address the issue of COVID forbearance and also unemployment when it comes to defaults on 1-4 family mortgages.
The increase in the value of the assets gives servicers home equity that can be used to assist distressed home owners going through medical or employment related disruptions.
A troubled borrower that cannot get back on track in terms of repaying the mortgage can simply sell the house and walk away with the net proceeds. We maintain that one of the reasons that loss-given-default for prime bank-owned 1-4s has been negative for the past several years is strong HPA and the related decline in loan-to-value ratios. Think of the chart below showing negative net defaults for the $2.2 trillion portfolio of bank-owned mortgages as the inverse of HPA.
Source: FDIC/WGA LLC
We recall the prediction of Stan Middleman, founder and CEO of Freedom Mortgage, that 2019 would be the floor of the next home price correction. Stan told us last summer that the correction might not come until 2025 or years later.
Yesterday in New York City we caught up with Laurie Goodman of Urban Institute, who confirmed her long held view that home prices are likely to stay at current levels due to a lack of supply.
But if the impact of QE has been salubrious for troubled consumer debtors, it has been a disaster for holders of many debt and even equity securities. Investors in mortgage-backed securities (MBS) have been suffering with negative returns on their cash for years due to the tidal wave of FOMC-engineered loan prepayments. Every new MBS that comes to market is immediately in the money for refinance thanks to QE. Mortgage lenders are happy to oblige.
But in the US equity markets, the Fed’s open market purchases have reduced the amount of duration available to investors, forcing buyers to climb up the risk curve in search of positive returns or any assets at all.
We have seen waves of offerings from decidedly inferior issuers that, in different times, might have been viewed as outright acts of fraud. The silence from the SEC is deafening.
The advent of crytpo as retail asset class illustrates the damage done by the Fed in terms of the shifting the quality of the risk-reward equation against investors. Think of securities fraud as another cost of the financial repression by the FOMC. "Crypto Is ‘95% Fraud, Hype, Noise, and Confusion," says the Federal Reserve Bank of Minneapolis President Neel Kashkari. Ditto.
In the mortgage sector, for example, even some of the stronger issuers have failed to create any value for shareholders. As we wrote in our latest note for subscribers to our Premium Service (“Update: Rocket Companies and United Wholesale Mortgage”), falling volumes in Q2 2021 hurt industry profits and, most important, gain-on-sale (GoS) spreads.
The big question: will mortgage sector profits rebound in Q3? Will GoS spreads recover to 2020 levels? How does the impending tapering of QE by the Fed impact the primary-secondary market spread, which has been hovering around 125bp for much of 2021. For the growing number of investors burned by mortgage stocks in the past six months, the answers to those questions no longer matter.
Source: Edgar
In the broader equity markets, the investor carnage caused by the FOMC is even more mind-boggling.
Tens of billions of dollars in investors’ funds have been deployed in various frauds and schemes ranging from crypto currencies to supposed “emerging growth” companies. One of our favorites is RobinHood (NASDAQ:HOOD), which brings new meaning to stealing from retail to enhance insider returns.
HOOD combines the daunting operational risks of running a FINRA-regulated, retail-focused broker dealer with trading in crypto currency, a rancid enchilada of unknowable risks that we cannot imagine being suitable for most investors. Indeed, crypto trading seems to be the most interesting part of the HOOD model.
“Robinhood gained popularity as a brokerage app offering commission-free stock trading,” writes Sam Ro in Axios. “But the company's recent performance suggests the current crop of retail traders are more interested in cryptocurrencies than stocks.” Ditto Sam. This is all about a lot of retail investors chasing the shiny object.
HOOD reported a “surge” in revenue in Q2 2021, but operating expenses kept pace with the increased volumes, resulting in a $501 million loss in Q2 and a $1.9 billion accumulated loss YTD. Notice that like United Wholesale Mortgage (NASDAQ:UWMC), HOOD engages in a great deal of accounting legerdemain in terms of changes to the fair value of assets and liabilities. HOOD states in the IPO prospectus:
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“We intend to use a portion of the net proceeds we receive in this offering to repay approximately $325.0 million that we expect to borrow, shortly prior to the completion of this offering, under our revolving credit facilities to fund our anticipated tax withholding and remittance obligations of approximately $325.0 million related to the IPO-Vesting Time-Based RSU Settlement and IPO-Vesting Market-Based RSU Settlement (assuming the effectiveness of this offering on March 31, 2021 for purposes of any applicable time-based vesting conditions; the initial public offering price of our Class A common stock of $38.00 per share; and an assumed 45% tax withholding rate).” |
After sticking HOOD shareholders with a $325 million tax bill from the vesting of founder shares in the IPO, roughly half of the proceeds from the offering BTW, HOOD then goes on to report another operating loss.
But it gets better.
In Q2 2021, HOOD launched another surprise on shareholders by increasing the “fair value” of convertible notes and warrant liability to the tune of $528 million or a total of $2.1 billion YTD. Remember, this is double entry GAAP accounting here. See table below from HOOD’s Form 10-Q.
HOOD’s capital structure is supported by $5.1 billion in convertible debt, $2.1 billion in redeemable preferred equity and an accumulated deficit of $2.1 billion. Roughly half of the $3.9 billion increase in “cash” reported by HOOD in Q2 2021 is attributable to the change in fair value of convertible notes and warrant liability. Don’t you just love GAAP accounting?
The moral of the story is that for every problem fixed by the FOMC by embracing radical monetary policy, more problems are created. For every consumer debtor in the mortgage market floated by QE and radical monetary policy, an investor is fleeced by the latest fraud to come down the rails of the great Wall Street sausage factory.
There is, after all, no free lunch for investors when the Fed is serving the thin meal of Financial Repression.
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. Currently, he serves as the editor of The Institutional Risk Analyst.
