Failed Risk Controls
April 30, 2023 – Weekly Comment
The Chicago trading floors were famous for funny (and occasionally vulgar, even funnier) nicknames, and I was introduced to that fact shortly after becoming a runner on the Chicago Board of Trade floor. There was a girl that was trading in the bond pit, I don’t recall her name, sort of pretty in a tom-boyish way, with shoulder-length dishwater blond hair, canvas Converse gym shoes. I heard she had gone to an ivy league school…Princeton maybe? But was said to be just a little ditzy. Anyway, the acronym on her membership badge was AFS. Known as: Awfully F’ing Stupid. After all this time, it’s one of my favorites. I can imagine her being instantly christened with that moniker by some Irish kid from Beverly who proudly graduated from Brother Rice highschool and immediately started filling bond option orders.
First Republic Bank. FRC. Appropriate nickname? I went with Failed Risk Controls for the title (sort of tame) but also considered Fed Reduced Collateral and a couple of others. YZ offered up Fed Rate-hike Casualty, and First-Rate Collapse. Faulty Regulator Confidence? Fake Reserves Counted?
Oh, they made a BIG deal of UNINSURED deposits going to FRC. $30 billion from 11 institutions. $5b each from JPM and BofA. Now what? Can’t agree on who gets to pick the meat from the Fetid Rotting Carcass. (Don’t worry, there will be others). I can imagine being JPM involved in negotiations: “Sure, bail-in ALL depositors for 5%. We’ll buy the good assets and probably get at least $250 million in discounts which will cover our bail-in loss. The FDIC can keep the really bad stuff and give us a guarantee on our buys. And we’ll get at least $10 billion in new deposits that we can easily make 2.5% on, because all the new depositors are scared shitless and buying safety, not yield. That’s why we ALREADY have 10% of the nation’s deposit base.”
You know and I know that the problem is not contained. The core issue is that rates went up quickly, assets are worth less, and depositors flee. But what if the bank loans were floating-rate? Then of course, the borrowers have a more difficult time servicing the debt and can more easily slide into the NPL column. You can see it in your own portfolio, with AAPL and MSFT trading like bonds at a record 14% of the market-cap weighted S&P500 and a lot of smaller companies just trading on the fringe. The big just get bigger. F Retail Clients.
(BBG) Former Treasury Secretary Lawrence Summers criticized Washington regulators and US banking giants for not having already figured out a solution for the beleaguered lender First Republic Bank.
“I’m surprised and disappointed that this situation has continued to linger as long as it has, with the bank’s stock down 95%” and credit gauges deteriorating, Summers said on Bloomberg Television’s “Wall Street Week” with David Westin.
“I hope that between the banks, the FDIC, the other public authorities, that the best way forward will be found within the next week or 10 days.”
Isn’t that adorable? The former Treasury Sec’y is surprised and disappointed. And the current Treasury Sec’y just can’t seem to put her finger on what caused the problems. From six years ago in June 2017:
“Would I say there will never, ever be another financial crisis?” Yellen said at a question-and-answer event in London.
“You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be,” she said.
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I listened to Grant’s Current Yield podcast this weekend with guest Harley Bassman. Well worth a 30 minute listen:
https://grantpub.libsyn.com/non-linear-returns?tdest_id=522046
On a macro theme, Bassman thinks the curve may be too inverted given the stickiness of inflation in a service based economy. However, I am going to focus on a couple of other points from the presentation. First, I used to keep a couple of trading cards in my jacket pocket with a bunch of equations and adages that I found important and regularly useful. The several things I would have jotted on those cards from this podcast: 1) the MOVE index divided by 16 is approximately the number of bps the market moves in a day. I.e. a MOVE of 100 equates to around 6 bps per day. 2) Long term average range in MOVE is 80 to 120. 3) mortgages are usually about 75 bps above the ten year treasury yield.
What was quite interesting in the podcast is that Bassman says that current mortgages are about 175 over the 10y treasury, and CHEAP. He perceives NO credit risk. He cites the FNM 5’s which currently yield about 5.2% vs 10y treasuries at 3.45%. (this is just from the podcast, I have not done my own verification). He gives reasons for this pricing, first, high implieds (as expressed by MOVE) and second the severe inversion in the curve. The embedded call option in mortgages (and callable munis) has exploded in value, making the yields on MBS higher than they ‘should’ be. The buyer of mortgages is essentially selling this inflated call to juice up the yield. Bassman’s idea is to buy these mortgages, which he says will rally in price as the curve steepens (becomes less inverted).
Now, in terms of inversion, August 2023 FF contract settled 9494.5 or 5.055%. If the Fed hikes Wednesday, then the new Fed Effective should be 5.08% or 9492, so FFQ3’s price is close enough for government work. FFQ4, another year forward, is 9660.5, a rate of 3.395%, a spread of -166 to FFQ3. As Bassman notes, the market is pricing a hard landing.
On the SOFR curve, the lowest priced contract Is June’23 at 9491.5, again, essentially equal to the prospective new EFFR of 5.08%. The highest contract is SFRZ5 at 9715 or 2.85%. The spread is 222.5 bps. When one looks at nominal midcurve straddle levels, the atm red Sept (0QU3) 9675^ is 93.5 bps, green Sept (2QU3) 9712.5 is 77 bps and blue (3QU3) 9712.5^ is 65.0. My first thought is that buying FNM bonds and buying blue midcurve strangles or covered puts could work as a reasonable hedge. This is not a recommendation, just an initial thought.
If the Fed stops hiking, the curve will almost surely become less inverted. You’ll notice that Summers prominently starts his “hopes” with “BANKS” and adds “other public authorities” to patch the Fear-Related-Cracks in the financial architecture. What helps banks? A positive curve. Here’s a plan: Bail-in depositors. Let a bunch of smaller banks fail and make the big ones bigger, and then start cutting rates so that the curve steepens and the big banks can restore capital and prevent panic. Fixed it.
OTHER THOUGHTS
Harley. Another Harley story? Yes but this one is about Harley-Davidson. Here’s a fabulous BBG headline: Harley-Davidson Says Repo Shortage is Fueling Credit Losses. From the piece:
There are not enough people to repossess all the motorcycles. That was the message from Harley-Davidson Inc., which said Thursday its credit losses in the first quarter were due in part to a shortage of repossession agents.
From an ABC News piece this weekend:
“…Home foreclosure filings have begun to surge. According to data from ATTOM, a property analytics company, US foreclosure filings totaled 95,712 in the first qtr of 2023. That’s 6% higher than in the previous quarter and 22% higher than a year ago.”
Job description: (perfect for someone who has been laid off from a technology company desk job and wants to experience some outdoor adventure). Go repo this guy’s Harley:
| 4/21/2023 | 4/28/2023 | chg | ||
| UST 2Y | 414.0 | 406.0 | -8.0 | |
| UST 5Y | 365.2 | 353.3 | -11.9 | |
| UST 10Y | 357.2 | 344.8 | -12.4 | |
| UST 30Y | 377.6 | 367.3 | -10.3 | |
| GERM 2Y | 292.0 | 269.1 | -22.9 | |
| GERM 10Y | 248.1 | 231.3 | -16.8 | |
| JPN 30Y | 134.1 | 122.2 | -11.9 | |
| CHINA 10Y | 282.9 | 278.0 | -4.9 | |
| SOFR M3/M4 | -145.0 | -158.0 | -13.0 | |
| SOFR M4/M5 | -62.5 | -62.5 | 0.0 | |
| SOFR M5/M6 | -2.0 | 0.5 | 2.5 | |
| EUR | 109.92 | 110.17 | 0.25 | |
| CRUDE (CLM3) | 77.87 | 76.78 | -1.09 | |
| SPX | 4133.52 | 4169.48 | 35.96 | 0.9% |
| VIX | 16.77 | 15.78 | -0.99 | |
Some bonus features:
“Your line of work requires a specialized vocabulary”
Denzel at his best: “… you gotta look around. The ‘rest of us’ is a category you haven’t qualified for in a long time.”
