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

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Q: How much of a rate cut did Fed Chairman Jerome Powell deliver to the markets last month when he stopped the runoff of the Fed’s portfolio of securities? 

A: Half a point.  

Now why hasn’t President Donald Trump reciprocated with some flowers via Twitter for Chairman Powell?  But hold that thought.

We are filled with sadness watching members of the Sell Side trying to concoct a rationale for going long banks stocks in front of Q3 earnings.  We own bank common (USB) and preferred (USB, BAC, C) primarily for income, definitely not for alpha.  Financials have badly under performed the indices for the past year but are still expensive.  Thus we feel little need to beat that particular dead horse. Yet so long as there are central bankers who are willing to keep interest rates negative, even the dead can walk among us.

A case in point is provided by the office provider WeWork, which is apparently in the midst of a road show for an initial public offering of shares.  Billed as an “American real estate company that provides shared workspaces for technology startups, and services for other enterprises,” WeWork has used a lot of borrowed money to acquire commercial real estate – this as global central banks were deliberately manipulating the price of real estate of all sorts ever higher. 

Readers of The Institutional Risk Analyst know that loss given default on most real estate classes in the US has been negative for years, this due to soaring prices for property and buildings.  Reuters reports such that WeWork owner, called “The We Company,” may seek a valuation in its upcoming initial public offering of between $10 billion and $12 billion, a dramatic discount of the $47 billion valuation it achieved in January.

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One of the remarkable accomplishments of central bankers such as Ben Bernanke, Janet Yellen and Mario Draghi over the past decade has been to enable financial fraud.  By shifting the cosmic risk curve away from low risk quality assets and in favor of pure garbage, companies such as WeWork, Softbank and Tesla (NASDAQ:TSLA) were able to raise funds from investors for highly speculative ventures with little chance of achieving profitability.  If money has no or even a negative cost, then asset quality is irrelevant, right?

While the central bankers were helping to promote and fund these financial swindles, they used negative interest rates to tax honest, hard-working retail investors. This dichotomy between the impact of negative interest rates on everyday people (bad) vs the effect on financial speculators and frauds (good) is significant both financially and politically.  

News reports suggest that the last meeting of the board of the European Central Bank featured nearly a third of the council members voting against more negative interest rate medicine recommended by Mr. Draghi. The outgoing ECB chief, let’s recall, formerly headed the Bank of Italy after a glorious banking career at Goldman Sachs (NYSE:GS).  Thanks to Mr. Draghi, savers across Germany and other northern European nations are in a state of revolt, threatening a political backlash more severe than the tongue lashing given to Draghi by his German colleagues.

The growing pressure on central bankers to end the use of negative interest rates is bad news for the markets overall and for a couple of reasons.  The trouble is not so much in the leveraged loan markets or collateralized debt obligations (CLOs), where much of the media buzz has concentrated in recent months, but instead in global equities both public and private. The accumulation of unprofitable stocks in a global market populated by hundreds of unicorns suggests that the source of the next bout of raging contagion is not the mainstream bond markets, but rather global equities and related leverage. 

Just imagine the scene if and when WeWork prices this truly wretched IPO with a single digit valuation vs the $47 billion value of just nine months ago.  What does this say about the Softbank investment portfolio, including its stake in WeWork? And just why were some of the largest US banks prepared to advance billions in new loans to this Ponzi scheme built atop overvalued commercial real estate?  Reuters reports:


“Eleven banks were initially asked to make commitments of US$750m-US$800m in early August. But as doubts grew about WeWork’s valuation and new banks were invited to join the credit, changes were made to make lenders more comfortable with the large tickets, sources said. A cash collateralization was added to a US$2bn letter of credit, after lenders demanded additional protection. In a cash collateralization, the banks require the borrower to deposit cash in an amount equivalent to the size of the loan (in this case the letter of credit) as collateral.”

The days when investors will support fanciful scams such as Softbank and WeWork seem to be at and end.  Meanwhile, all is just peaches and cream in the world of debt capital markets, at least since the Federal Open Market Committee ended the runoff for the systems open market account (SOMA).  Since the end of July, rates for financing conventional RMBS have fallen by half a point, as shown in the chart below.

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Notice how agency REPO rates on transactions cleared via DTCC basically fell off the edge of the proverbial table after the FOMC’s July decision on ending the reduction of the SOMA portfolio.  Volumes have also fallen sharply, but are still within the range of the past year. 

Note as well the huge upward skew of rates and volumes in the agency REPO market last December, when Fed Chairman Jerome Powell and the other members of the FOMC almost wrecked the family car.  Remember, these happy PhD economists actually thought that they could raise interest rates.

Suffice to say that compared with May and June, when we told viewers on CNBC that the credit markets faced a potential train wreck due to "quantitative tightening" or QT, today the picture is sublime.  Short terms rates have stabilized, spreads on agency loans have widened and mortgage lenders are actually making money. 

It appears that the Fed’s decision in July to end the balance sheet shrinkage was worth a half point cut to the money markets.  Memo to Potus: Stop beating on Chair Powell.  He’s doing exactly what you asked by resuming the QE drip.

Meanwhile in the land of fantastic adventures (aka Washington), the Trump Administration has been making more noise about the privatization of the housing GSEs, Fannie Mae and Freddie Mac.  We wrote in National Mortgage News last week:

“Most executives who operate mortgage companies view the Washington conversation about GSE reform with a combination of bemusement and dread. On the one hand, the childlike naivete displayed by policy makers regarding the business implications to the GSEs of ending the conservatorship elicit chuckles and outright incredulity. But the prospect of Secretary Mnuchin and Director Calabria handing the residential mortgage market to the big banks on a silver platter as part of ‘leveling the playing field’ is a most unwelcome, even disastrous development.”

We later in the week had a great discussion with Andrew McCreath from BNN in Toronto, who asked some very basic questions about the impending privatization of half of the US mortgage market.  Remember, it’s not just about Fannie Mae and Freddie Mac as corporate entities, but also the $5.5 trillion in agency mortgage securities that they guarantee. 

The bottom line is that most of the risk facing the financial markets today is largely a function of dumb, at times childlike idiocy coming from our beloved policy makers at the Federal Reserve Board and other agencies in Washington. 

For example, nobody who works in the world of credit and mortgage finance thinks that negative interest rates are good for the economy, yet some economists persist in holding this view.  When the working people of Europe finally revolt against the diktats of the ECB, problems like Brexit will fade by comparison.

And nobody who works in the world of mortgage finance thinks that Fannie Mae and Freddie Mac can be truly privatized without legislation from Congress. Anything short of a new law fully covering the extant debt of the GSEs with a full "AAA" Treasury guarantee risks causing another market collapse a la Lehman Brothers. But in Washington, anything is possible.

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.