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The guest commentary below was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst

As Stocks Rise, Liquidity Falls - z 0516Long incredulity cartoon 05.25.2016

The Institutional Risk Analyst travels to Chicago this week to participate in the annual conference hosted by Fay Financial, LLC. In addition to agency and non-QM lending, Fay offers mortgage loan acquisition, liquidation, and restructuring services. Click here to downloadour presentation for the event on Tuesday, which includes another version of the striking chart below.  We call it “How the FOMC Failed Housing” under Chairmen Ben Bernanke and Janet Yellen.

As Stocks Rise, Liquidity Falls - zcra1

The chart above compares outstanding mortgage debt as tracked by the Mortgage Bankers Association vs the change in value of residential home equity.  Simply stated, the Federal Open Market Committee did manage to cause home prices to rise by double digit annual rates since 2008, getting home-owners well above the previous 2005 peak and then some in terms of home equity. But the dollar amount of credit deployed in housing finance actually contracted during the years of “extraordinary policy” by the FOMC under Bernanke and Yellen.

Those of you who recall your high school economics know that expanding credit is the Fed’s chief tool in boosting consumption and economic growth -- at least in theory. In the case of housing finance post 2008, the FOMC's policies failed when it comes to boosting mortgage credit as measured by outstanding debt. Indeed, even as the US economy grew and along with it the footings of the US banking system (up 25% since 2008), the amount of capital allocated to housing remained stable or even declined. The chart below shows the landscape of mortgage servicing including bank portfolios of 1-4s, which smaller banks tend to retain. 

As Stocks Rise, Liquidity Falls - zcra2

Not only did the total outstanding stock of mortgage debt fall from 2008 until 2016, but the amount of balance sheet allocated to 1-4 family mortgage credit by US banks also declined even as the servicing book also ran off. Assets serviced for others (AFSO) by banks fell by $2 trillion or 25% from 2008 through the end of last year.  Readers of The IRA will recall that sales of 1-4s by banks into the secondary loan market also have fallen 30% during the same period, evidencing an even larger overall decline of bank support for mortgage finance. 

Where’s the Liquidity Jay?

Meanwhile Federal Reserve Board Chairman Jerome Powell delivered two days of upbeat economic assessment to members of Congress in Washington last week. Powell declared that the economy had received a severe “confidence shock” at the end of 2018 and that full recovery had not yet occurred.  Short version: Only by executing a skillful pirouette and promising an interest rate cut if needed was our hero Chairman Powell able to save the day.  

Measuring something as ephemeral as investor “confidence” is the functional equivalent of herding cats.  Even when measuring liquidity, an equally mystical quantity, at least there are market indicators that resemble hard data.  When Chairman Powell and his colleagues on the FOMC talk about “confidence,” they do so in the context of “surveys” and other anecdotal reports. Is a survey or luncheon discussion really data?  The late great composer Frank Zappa perhaps said it best: 

“Information is not knowledge.
Knowledge is not wisdom.
Wisdom is not truth.
Truth is not beauty.
Beauty is not love.
Love is not music.
Music is THE BEST.”

No, sad to say surveys are not data. They are like measuring “confidence,” complete with biases and error rates a mile wide.  So if you are a data dependent Fed chairman or governor and you justify your actions (or inaction) based upon surveys, are you still data dependent?  Or should we conclude, when you waffle about confidence, that you have no idea what you are saying or doing when it comes to monetary policy? 

Since the entire policy discussion is about “easing” Fed policy or not, we think it is particularly notable that the “data,” shows that markets continue to tighten. Cast your eyes to the link below and consider the two charts from the Depository Trust and Clearing Corp (DTCC). The charts suggest that the rate paid for repurchase agreements on Treasury and agency mortgage collateral in bilateral transactions is climbing while volumes financed are falling sharply:

http://www.dtcc.com/charts/dtcc-gcf-repo-index 

In fact, the bilateral REPO rate on Treasury and agency collateral is up 50bp over the past year, but particularly since the end of June 2019.  This is when a significant amount of liquidity appears to have exited the market and has yet to return.  H/T to Scott Skyrm, who notes on Twitter that REPO rates spiked to 3% at the end of June vs the low 2s in the weeks before. Yet as of Friday, REPO rates were still 50bp above early June levels, with rates again climbing on falling volumes, more evidence that the markets continue to tighten as the FOMC runs off its balance sheet.   

David Kotok, Chairman of Cumberland Advisors, opined to us last week: 

“I’ve encountered several folks who see the intraday liquidity pinch which never appears in spreads using markets closing price,” The big NYC folks are complaining about REPO collateral shortage intraday. The hourly metric is a penalty for failure so it is driving portfolio behavior.  Treasury responds by issuing more and more bills. Austria sells a 100-year bond. Lunatics at Treasury could sell 100-year tips.  Instead they sell bills.  This ends badly. It becomes visible in credit spreads way too late.  Watch when IOER is not the cap. Watch when a big bank pays above IOER intraday and you know that bank seeks to avoid stigma by paying up.” 

We continue to be concerned about how tightening money market conditions are affecting financial institutions and particularly non-banks.  Let’s make a short list of the non-bank default events that have occurred since June, when we had a great conversation with Mike Mayo, bank analyst at Wells Fargo & Co (WFC) and our friends at CNBC’s “Fast Money.” 

  • Reverse mortgage lender Live Well Financial shut down abruptly in May and subsequently filed bankruptcy, reportedly leaving behind a double-digit loss for warehouse lender Flagstar Bank (FBC) on a “secured” credit line. A Live Well official blamed the “reduction in credit availability combined with challenging conditions in the markets for mortgage loans” for the event of default, reports Housing Wire.

  • French investment bank Natixis was forced to suspend redemptions from its $35 billion open-ended H2O fund. After Morningstar put one of the funds under review, citing concerns over liquidity and governance, demands for redemptions surged. Here an adverse rating actions caused a cascade of market and liquidity risk to hit the H2O fund.

  • The £3.5 billion Woodford Equity Income Fund in the UK suspended redemptions at the start of June when it could not meet requests from several large customers. An equally large chunk of its assets cannot be sold quickly, leaving thousands of investors trapped in this illiquid investment scheme, Reuters reports. Lazlo Hollo at MSCI asks: “Is there another Woodford waiting to happen?”  Yes indeed.  Just thank the folks on the FOMC for shifting the risk curve. 

  • “Stearns Holdings, the parent company of residential mortgage lender Stearns Lending, filed for Chapter 11 protection [in early July] after agreeing on a debt-restructuring plan with majority owner Blackstone Group (BX),” reports The Real Deal. Stearns previously sold its servicing portfolio to Freedom Mortgage to raise cash.  Blackstone is trying to wipe out almost $200 million in bond debt in the bankruptcy but preserve its equity control. PIMCO owns most of the Stearns debt, making it unclear who is going to end up with the assets and the Stearns lending business.  Note that PIMCO owns First Guarantee Mortgage and could easily merge what’s left of Stearns into its portfolio company in a liquidation.

These default events are relatively small and have certainly not yet bothered participants in the equity markets as the S&P 500 and other indices hit new all-time highs. But we feel obliged to remind our readers that the crisis of 2008 began in 2005, with the decline in home prices, a drop in lending volumes and the accumulation of small defaults by non-bank lenders such as New Century, Longbeach and eventually a hedge fund sponsored by a firm formerly known as Bear, Stearns & Co.   

Is the exodus of liquidity from sectors such as collateralized loan obligations (CLOs) and even risk-free assets such as Treasury and agency REPO a sign of approaching systemic risk?  We noted last week that the credit fundamentals in CLOs remain quite solid, but what about confidence? The CEO of a large non-bank said last week after the Stearns bankruptcy filing: “One bad event will send the lemmings off the cliff.”  Case in point: Will Tesla CEO Elon Musk default on the Solar City convertible senior notes due later this year?  

The lemming off the cliff metaphor is apt since the biggest share of investment grade debt is just barely investment grade. But the vast amount of non-investment grade, illiquid paper currently held by global investment funds is perhaps an even bigger worry.  

EDITOR'S NOTE

This Hedgeye Guest Contributor piece was written by Christopher Whalen, 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. This piece does not necessarily reflect the opinion of Hedgeye.