Watching the fun of earnings this week, we feel a certain feeling of déjà vu, a sensation that brings a chill to the back of the neck.
The GSEs have just made the largest upward adjustment in the maximum price of a conforming loan in many years, reflecting the fact that home prices are galloping along at double-digit rates of increase. Investors are pushing prices on assets to truly silly levels. But there are still a few people in Washington who think that inflation is not a problem.
Meanwhile there are signs that the one-way trade in US interest rates is also coming to an end. The 30-year mortgage rate has backed up nearly half a point since the lows of February, when we priced a 30-year jumbo mortgage at 3%.
Today that loan would be a 3.5% coupon. And yet the inflation already baked into the system will keep the party in 1-4 family housing going for years to come. The only question is when, not if, the latest financial bubble will burst.
For banks, the end of the bull trade in interest rates comes as the Federal Open Market Committee prepares to end its reckless purchases of securities. QE, as massive securities purchases are known in the Orwellian newspeak of the central bank, is one of the key drivers of asset inflation and also a big generator of future risk for banks and investors.
By shifting the credit risk curve a couple clicks in favor of debtors, the FOMC has embedded massive future credit risk in the system. Whether we speak of home prices, stocks or crypto, all asset classes are inflated by the manic behavior of the FOMC.
Because the Fed and Washington have decided to spare the financial markets the usual cleansing correction after a period of monetary excess, the degree of myopia visible in the financial markets today is more absurd than ever before. Investment managers, of course, will not warn their clients of the impending correction.
After all, as one veteran trader reminded us on a recent plane ride, “the two is often more important than the twenty.” So true.
Edward Chancellor writes in The New York Review of Books:
“[P]rofessional investors, who fear that clients will leave them if they underperform, may be forced to buy overpriced stocks to preserve their jobs—that is, they rationally choose to make seemingly irrational decisions. This problem becomes acute when investment performance is measured over the short term; as Keynes observed in his General Theory, most money managers are concerned ‘not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.’ Such behavior makes markets inherently unstable.”
JPMorgan (JPM) illustrates the risks ahead. While the bank managed to deliver a respectable performance in Q3 2021, the pain of rising interest rates was clearly visible.
Not only did the bank’s cost of funds rise 3% sequentially, but the bank took losses across its securities book and also on its hedge for mortgage servicing rights (MSRs). JPM's cost of funds is still half of what it was a year ago, but that will change soon enough. Sadly asset returns are unlikely to keep pace as interest rates rise.
The good news for JPM is that its servicing book grew above $500 billion after several quarters of declines. More important, the gain-on-sale margin for JPM’s considerable non-agency loan business also widened as benchmark rates rose over the past three months.
Spreads not interest rates are what matter for bank profits. But how much credit risk is embedded in those loans being purchased by JPM and other banks from third-party originators?
“Mortgage fee and related income totaled $596 million in the third quarter compared to $548 million the prior period. But the year ago was more impressive at $1.08 billion,” notes Paul Muolo at Inside Mortgage Finance. As we noted in our recent column in National Mortgage News, winter has come in the world of housing finance.
Yesterday we commented to Stephanie Link and our friends on Twitter that big banks don’t make loans so much as they buy loans. When Wells Fargo & Co (WFC) reported a decline in loan originations, this means that the bank was not buying loans in the secondary market. And WFC’s third-party servicing book continues to decline rapidly, part of a broader run-off strategy by the bank to shrink its balance sheet.
Note to investors in WFC: As loans on the bank's balance sheet prepay, they are not being replaced 1:1. Not even close.
Again Muolo: “Wells’ third-party MSRs declined by $29.9 billion in the July-September period and now total $739.5 3 billion. The decline comes as servicing rights are continuing to increase in value.”
Likewise, Bank of America (BAC) reported a modest increase in 1-4 family loan production, but again keep in mind that organically making a loan and buying/funding a third-party loan are two different things. Loans made through traditional retail systems are very expensive, while correspondent and wholesale channels offer aggregators better value. Of note, banks do not split-out each loan channel separately in their public disclosure.
All that said, most of the issuers we work with are increasingly sellers of loans and servicing, while credulous Buy Side investors are clamoring to buy loan assets and MSRs at ever increasing prices. Duh. Normally, in a rising rate environment, lower coupon securities tend to fall faster in price than similar securities with higher coupons. In the inflationary asset bubble environment created by the FOMC, however, lower coupon MBS are well bid due to the optionality embedded in the residential mortgage loan.
Prices for new issue conventional loans are trading at 4.5-5x annual cash flow, or roughly 125bps (25bps x 5). Prices for seasoned assets are appreciably higher. At this price, the asset is unlikely to be profitable through the cycle and may even be cash negative later in the life of the asset.
Duration starved investors are indifferent to such concerns, however, as witnessed by the fact that government assets guaranteed by the FHA are trading well-above fair value. Again, the two is more important than the twenty for most investment managers.
The logic of buying a government MSR asset at say 4x annual servicing income or ~ 125 bps (32bps x4) is fairly straight forward for an issuer. The FHA loan of say 2017 vintage has seen the price of the collateral rise in value so that the mortgage may now be refinanced into a conventional loan to be purchased by Fannie Mae or Freddie Mac. But what will happen to that conventional loan several years hence?
The credit of the borrower probably has not changed, but the loan-to-value (LTV) ratio of the house has fallen 10-15 points thanks to Chairman Jay Powell and his pals on the FOMC. Today, the new conventional loan looks great.
But in a couple of years, when home prices correct down to the floor of this credit cycle – say ~ 2019 prices – then the true credit characteristics of the asset will surge back into view. The conventional MBS issued by Fannie Mae or Freddie Mac will start to evidence default and loss rate characteristics normally found in a Ginnie Mae MBS. This is called "credit migration."
The moral of the story is that as the Fed solves today’s problems, it also creates a new, bigger problem for the future. Since the socialist mandate in the 1978 Humphrey-Hawkins law is “full employment,” the bias to the US dollar system is always inflationary.
The pursuit of political stability in the US because of the full employment prime directive and because the US targets fed funds as its main policy tool, carries with it the seeds of our eventual destruction.
Now it is considered gospel in the crypto community that bitcoin, Ethereum, and other new age tokens are somehow immune to the eventual collapse or correction of the US dollar system. Arthur Hayes writes in BitMEX:
“The cryptocurrency complex – led by Bitcoin – is the best hedge against hyperinflation because it resides outside of the mainstream financial system. Even the best performing traditional asset will never eclipse the returns of the crypto complex during a period of inflation, simply because all assets in the mainstream financial system are manipulated by central banks so that they do not output the correct inflationary warnings signals.”
Well, no. The crypto system depends fundamentally on confidence.
Back in March 2020, when bitcoin essentially traded down to zero, the positive correlation between the fiat world and the ethereal world was laid bare.
Perhaps Elon Musk and Mark Cuban have a big enough pile of chips to pretend that the global poker game known as crypto is somehow disconnected from the rest of the financial world manipulated by central banks. Yes, the “tape” says bitcoin touched $5k at the low in March 2020. In fact, it was no-bid.
We are all staring at computers or handsets, all of which are connected to the internet. The hard-wired herd mentality of human beings does not recognize the distinction between bank stocks or embedded options or crypto assets. When one market goes south, the rush for the door means that any and all financial assets will be suspect and therefore become illiquid. That’s why the better crypto traders all have contingency plans to liquidate their holdings and run back to the safety of fiat at the first signs of contagion.
Bottom line: We all live in the same bubble regardless of the financial asset of choice. Again, Chancellor:
“[M]ore accurate historical accounts of speculative manias and advances in the psychology of decision-making have failed to produce any noticeable improvement in financial behavior. On the contrary, over the past quarter-century, we have witnessed a succession of speculative bubbles, from dot-com stocks to the current craze for new technologies such as electric vehicles and cryptocurrencies."
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.