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November 17, 2022 | No matter how many books we read, there is really no single quotation that sums up the modern state of affairs in the US in 2022 better than Charles Dickens in “A Tale of Two Cities.”
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair.”
Most people never read or see more that the first line of this famous passage, but it is in the entirety of Dicken’s genius that the fundamental human condition is revealed. Many people are simply born to be cheated and robbed, as we now see with the very long list of financial advisors, celebrities and media who were taken in by the great crypto fraud.
From a reader, consider this from FTX’s new CEO John Ray in his declaration for the company’s Chapter 11 bankruptcy petition:
“I have over 40 years of legal and restructuring experience. I have been the Chief Restructuring Officer or Chief Executive Officer in several of the largest corporate failures in history. I have supervised situations involving allegations of criminal activity and malfeasance [Enron]. Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”
If your bank or financial advisor encouraged you to “invest” in crypto assets, now is the time to look for a new relationship. Any supposed professional that could not see that the crypto wave was a temporary redux of the speculative froth seen in the US a century ago, albeit for different reasons, should be dismissed. John Kenneth Galbraith described the “innocent fraud” of the Roaring Twenties, but there is nothing innocent about crypto fraud.
How can any fiduciary, officer or director do business with the likes of Bank of New York Mellon (BNY) or Signature Bank (SBNY) unless and until these federally insured depositories see wholesale changes in management and board members? As we write these lines, a new copy of the fabulous book by Daniel Gross, “A Banker’s Journey: How Edmond Safra Built a Global Financial Empire,” sits on our desk.
What would Edmond Safra say to us about crypto? Safra’s whole life was devoted to accumulating and preserving wealth for his clients. The crypto craze was just the opposite, a period of wealth dissipation driven first and foremost by our friends on the Federal Reserve Board. When you tell the inmates that the dollar has no value as collateral via zero interest rates, we make new games to play. That is the human condition, to chase the shiny object. Yet crypto was the result of far larger forces than mere greed.
The recent conclave to consider the shrinking liquidity in the Treasury market, for example, never discussed the role of the Fed and other agencies in reducing market liquidity over the past decade. Treasury Secretary Janet Yellen, who is the architect of the liquidity problems in the Treasury market c/o “Operation Twist” and quantitative easing (QE), now offers us a solution. But everyone on Wall Street knows that it is the Dodd Frank law and the Volcker Rule that hurt market liquidity first and foremost. QE and its aftermath only compounded the problem.
Below we show bank securities holdings and accumulated other comprehensive income (AOCI), which was negative $250 billion in Q3 2022. For the same reason that the Fed itself is losing money on payments it makes on reserves, US banks face billions in market losses on QE era loans and MBS with low coupons.
Source: FDIC
The $6 trillion in bank owned securities are entirely passive. Before the London Whale and the Volcker Rule, banks made active, two-way markets around these portfolios, providing ready liquidity and, important, valuations to the Street and small issuers. Now this huge block of securities, including $1.5 trillion in Treasury paper and $3.3 trillion in MBS is entirely inert. The Fed’s $3 trillion in legacy MBS is likewise entirely passive and unhedged.
The solution to market risk a la Paul Volcker and Senator Elizabeth Warren (D-MA) is to dispense with the market entirely. We turn large banks into walled islands of cash and then wonder about ebbing market liquidity. In his latest contribution to The New York Review of Books, Professor Cass Sunstein of Harvard reviews “The Tragic Science: How Economists Cause Harm (Even as They Aspire to Do Good) by George F. DeMartino (no relation to Danielle). Sunstein writes:
“DeMartino points to the distinction, drawn by Frank Knight and John Maynard Keynes, between ‘risk’ and ‘uncertainty.’ For example, consider the suggestion from some economists that there is a greater than 50 percent chance of a recession in 2023: a recession is a risk, and we might be able to assign a number to the likelihood that it will occur. But in circumstances of uncertainty, we do not know enough to assign probabilities at all; consider the likelihood of a war in Europe in 2100. As Keynes once put it, on some topics ‘there is no scientific basis on which to form any calculable probability whatever. We simply do not know.’ DeMartino thinks that economists often find themselves in that situation but pretend otherwise.”
The embrace of “quantitative easing” by the Fed going back a decade to 2012 is the root cause of the inflation seen in the financial markets ever since. The amount of stupid money that is still sloshing around the financial markets and still over-paying for all manner of assets is enormous, even after wiping out trillions of dollars in paper wealth in the stock market since January. The fact that the dollar swaps curve is inverted from 15s to 50 years tells you all that you need to know about the future direction of US interest rates and, by connection, the dollar.
Dollar Swaps vs Treasury Yields
Source: Bloomberg
The sudden end of the crypto craze, added to the collapse of foreign investing in Xi Jinping’s communist prison in China, is forcing liquidity into other sectors and, yes, US stocks. But the real question is, how “credible” are those published book value numbers from JPMorgan (JPM) et al in the banking world? Even as the world clamors for dollar assets and issuance of all manner of securities falls, the destruction of wealth c/o the FOMC goes on apace.
In that first chart about we showed the components of the bank securities portfolio and accumulated other comprehensive income (AOCI). But if we drill down to the composition of the bank portfolio, the discussion becomes even more interesting and illustrates the culpability of Yellen and Fed Chairman Jerome Powell in the approaching bond market and banking system correction.
In the chart below we consider the actual securities holdings of banks. Notice that banks own a lot more MBS than Treasury debt, 3x as much in fact, or over $3.4 trillion at the end of Q2. The trouble is that a lot of that paper was originated during the period of QE on an initial duration of say 3-4 years.
Source: FDIC/WGA LLC
Today the duration of bank-owned MBS is in double digits, 12-15 years. The adjusted MBS series above crudely approximates the financial impact of extending maturities on the overall market risk facing the banks and other holders of MBS and whole loans. The cost of hedging these exposures is enormous, thus the surge in AOCI. But the coming mark-to-market on bank MBS and whole loans could make the AOCI number pale in comparison.
Source: FDIC
The true “risk weight” of the bank MBS portfolio is closer to $10 trillion or 3x US banking industry equity capital. The entire $13 trillion in notional unpaid principal balance of all residential mortgages has a risk-weight closer to $30 trillion. Or to put it another way, when Fed Vice Chair Lael Brainard says that the FOMC should slow interest rate hikes, she is right, but for the wrong reasons.
As we noted in our last missive ("Loan Delinquency, EBOs & Ginnie Mae MSRs"), the only way current book value of MBS and related servicing assets works is if we assume negative prepayment rates. Fortunately, the FOMC has not figured out a way to push cash into our bank accounts – yet. That’s why we are building “FedNow” – the new face of Big Brother.
In the meantime, look for some truly ugly QT-related disclosure from banks, REITs and mortgage companies in Q4 2022 and thereafter. There are literally dozens of banks in the US made insolvent by the policy moves of the FOMC over the past year. Somebody ought to ask Chairman Powell about this.
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