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Amidst somewhat surprising signs of resilience this year in the U.S. economy, Fed watchers expect two more rate hikes this year to combat stubbornly high core inflation rates. Goldman Sachs Research’s chief U.S. economist believes a healthy labor market rebalancing that includes a large decline in job openings without an increase in unemployment is a positive sign for the potential for the U.S. to orchestrate a softer landing.
Although initial jobless claims and layoff rates are ticking up, the labor story has a positive side to it — wage growth appears to be coming down, dampening its inflationary pressures, the Goldman Sachs Research group said. Additionally, supply chain problems that recently vexed the economy are continuing to heal, leaving room for rebuilding of inventories that should be deflationary.
Within housing, the dichotomy between existing and new homes construction continues. The National Association of Realtors said existing home sales fell 20.4 percent year-over-year in May, the large annual decline in 11 years. MBA reports that after the 2021 market had set records for purchase ($1.86 trillion) and refinance originations ($2.57 trillion), originations fell to an estimated $2.2 trillion in 2022, and are forecasted to fall further to $1.8 trillion this year. Fannie Mae lowered its 2023 Single-Family Originations Forecast to $1.59 Trillion.
The National Association of Home Builders/Wells Fargo Housing Market Index reported that “solid demand, low existing inventory, and improving supply chain efficiency shifted builder confidence into positive territory in June for the first time in 11 months.” Home construction surged in May and prices of new homes have ticked up, even with interest rates at a 15-year high, surprising some analysts.
Zillow recently issued a report that suggesting there is a deficit of 4.3 million homes, with “roughly 8 million individuals or families who lived in another person’s home in 2021 and just 3.7 million homes for rent or sale.”
Fed Chairman Jay Powell is on the Hill delivering the Fed’s semiannual report on monetary policy to the Senate and House. He told the House Committee the Fed is likely to raise interest rates in the coming months but at a slower pace than they have moved over the past year, weighing the risk that the combination of their 10 consecutive rate hikes and recent banking stress is more than enough to slow the economy to tame inflation (perhaps causing an deeper economic downturn than expected) against the risk that the combination of economic strength of the first two quarters and inflation staying elevated may require additional tightening. Powell pushed back on the notion that last week’s pause was indeed a pause, signaling the Fed will not hesitate to take future action on inflation.
In the absence of recent negative headlines around regional bank stress in the US, Morgan Stanley said they believe there is complacency setting in while “key data points on bank balance sheets show that things have worsened on the margin since March.” We’ve been watching this relative to its potential impact on the commercial real estate loan refinances expected in the next 12-18 months.
Green Street said commercial deals are down a “stunning” 70% year over year.” With the U.S. vacancy average at 18 percent for office properties verses 3.8 percent for industrial properties, and given a lower per-square-foot cost relative to conversion to residential brokerage firm, a Newmark report find conversions from office to industrial are on the rise. Although delinquency rates for office properties are low, with office vacancy rates on the rise, the Financial Stability Oversight Council (FSOC) said Friday that they are stepping up scrutiny of how exposed banks are to commercial real estate.
Meanwhile, a slight decline in 30-year fixed rates over the past few weeks was met with a Mortgage Bankers Association (MBA) report that purchase applications increased “driven by a 2 percent gain in conventional purchase applications and a 3 percent increase in FHA purchase activity,” according to Joel Kan, MBA vice president and deputy chief economist. (The average contract interest rate for 30-year fixed-rate mortgages with conforming loan balances ($726,200 or less) decreased to 6.73 percent from 6.77 percent, MBA said)
The American Bankers Association’s Economic Advisory Committee said they expect credit conditions to tighten the rest of the year and loan losses to rise. Still, given the low inventory, the Census Bureau and HUD jointly reported this week that privately owned housing starts in May hit a seasonally adjusted annual rate of 1,631,000, 21.7% above the revised April estimate of 1,340,000 and up 5.7% year-over-year. The May rate for units in buildings with five units or more hit 624,000. Single-family housing starts were just shy of 1 million at 997,000, or 18.5% above the revised April figure — the largest single-month jump since June 2020 which occurred as the market rebounded from the initial shock of the COVID pandemic.
We are awaiting the Fed Board’s decision on interest rates Wednesday afternoon, when they are expected to pause, albeit with a hawkish tone, signaling they may not be done with rate hikes this year, and in fact lean toward keeping rates higher for longer to quell lingering inflation, before deciding to go lower late in the year.
As we’ve discussed here, the backdrop has been an economic dichotomy — a strong first quarter, followed with what appears to be even stronger second quarter amidst signals (credit tightening, profit margins tightening, consumers tightening, hiring slowing notwithstanding the strong May) the economy will slow later this year. We may not have seen the last of the bank failures either — while the Fed’s lending facility has calmed the outflow of deposits from smaller and regional banks, the longer these rates stay higher, the more pressure we will see.
Adding to those signals was a report from Attom indicating increased foreclosure activity in May, resuming what it said is “a slow climb back toward levels seen prior to the pandemic.” Meanwhile, Redfin reported 33.4% of home purchases in April were all-cash, reflecting tight supply and reduced affordability for mortgage borrowers, almost the highest share in nine years and up from 30.7% in April 2022. Median down payments were down in April, with the typical down payment of $52,500, down 18% year-over-year, the second-biggest drop since May 2020. Down payments have been falling year-over-year since November.
Redfin said FHA loans “were up as a percentage of purchases, at about 16.4% in April. That’s a notable increase from 10.4% a year earlier. They’ve become more common as high mortgage rates have cooled the market–FHA loans were losing out to buyers with all-cash or conventional loans during the stretch of highest competition.”
The Mortgage Bankers Association reported that mortgage credit availability declined in May, the third consecutive month and the lowest reading since January 2013 “as the industry continued to see more consolidation and reduced capacity as a result of the tougher market.”
Although stress in the banking sector continues in this rate environment, total borrowing from the Fed’s three emergency lending programs declined from $288.7 billion the week prior to $285.7 billion last week (the figure peaked in March at $343.7 billion in the wake of the Silicon Valley Bank collapse). Borrowing from the Fed’s Bank Term Funding Program rose slightly to $93.6 billion from $91.9 billion in the prior week, while borrowing from the Fed discount window declined to $3.97 billion from $4.2 billion in the prior week, MarketWatch reported. It continues to point to tightening credit and consumers who are expected to pull back.
Meanwhile, the Mortgage Bankers Association (MBA) reported that commercial mortgage delinquency rates increased for every major capital source during the first quarter, “foreshadowing additional strains that are likely to work their way through the system,” MBA said. As we’ve discussed here on a few occasions, and MBA summarizes: “For most capital sources, delinquency rates remain low by historical standards. But with 16 percent of outstanding loan balances facing loan maturities this year, the first edge of properties is just beginning to be pushed to adjust to today’s markets – with higher interest rates, uncertain property values, and questions about some property fundamentals. As they do, delinquency rates are likely to continue to rise.”
The labor market, and the consumer, however, continue to spend during this second quarter. We learned Friday that U.S. employers added 339,000 jobs in May, and the numbers were revised upward for March and April, 52,000 and 41,000 respectively. Mike Fratantoni, Chief Economist at MBA: “Job growth was stronger than anticipated in May, with growth averaging 341,000 per month over the last 12 months, adding to the momentum thus far in 2023.”
“Thus far” might be the operative term, perhaps — as credit tightens, surveys are indicating consumers are beginning to feel increased pressure. A survey conducted by the BMO Financial Group found two-thirds of those looking to buy a home say that current high mortgage rates are keeping them from doing so. The Morgan Stanley US economics team, which predicts a “soft landing” because of the labor picture that should allow the Fed to achieve its 2% inflation target without diving unemployment significantly higher, conducted a survey that found consumers, except in groceries and household products, fully expect to pull back their discretionary spending later this year, and in fact Morgan Stanley sees that pull back already beginning. “Interest rates on new consumer loan products,” Sarah Wolfe of the team noted, “hit 20 to 30-year highs, raising overall debt service costs and forcing consumers to reduce purchases of interest sensitive goods.”
In remarks last week, Fed Governor Philip Jefferson said he believes “the overwhelming majority of banks have strong balance sheets with limited leverage, high levels of loss-absorbing capacity, and healthy liquidity. Moreover, household and business balance sheets are generally strong… While the resilience of the financial sector will limit the spillovers from recent events, I expect those strains to lead to a further tightening in credit supply from banks that will weigh on economic activity.”
The Wall Street Journal reports that after the average city office occupancy rates surpassed 50% earlier this year for the first time since the pandemic began, “many landlords viewed this milestone as a sign that employees were finally resuming their former work habits.” Office usage rates have barely budged since, as most companies have settled into a hybrid work strategy “that shows little sign of fading,” the Journal wrote.
Meanwhile, total consumer debt hit $17.05 trillion, an increase of nearly $150 billion, or 0.9% during the January-to-March period, the New York Federal Reserve reported Monday, up about $2.9 trillion from the pre-Covid period ended in 2019, though the level of those taking on new housing-related debt dropped sharply, the New York Fed said.
The Fed said Thursday its emergency lending to banks rose to $92.4 billion in the week ended May 10, from $81.1 billion last week. Bank borrowing from the Fed peaked at $164.8 billion in mid-March. Bank loans from the Fed’s emergency Bank Term Funding Program totaled $83.1 billion, up from $75.8 billion in the prior week. Banks borrowing from the Fed’s traditional discount window rose to $9.3 billion from $5.3 billion last week.
The Mortgage Bankers Association (MBA) is urging the Federal Housing Finance Agency to delay implementing proposed changes to the Enterprise Regulatory Capital Framework, saying they “oppose strongly” any risk-weighting of re-securitizations issued by one of the GSEs that contain securities issued by the other GSE. In a letter to FHFA MBA said they support the changes in the proposal that would reduce the risk weight and credit conversion factor for commingled securities form 20% and 100% to 5% and 50%, respectively.” MBA says “The existing 20% risk weighting resulted in the implementation of a 50-basis-point commingling fee last year.”
MBA also expressed concerns that implementing a change to capital framework “ahead of the transition to the bi-merge credit report requirement could artificially raise scores for some borrowers.” It then recommends that FHFA delay implementing the change and perform additional analysis, and then report any findings “as part of the new credit score implementation process.”
Last week FHFA announced a rescission of the controversial LLPA charge for DTI ratios over 40%. Yesterday, FHFA also issued an RFI seeking feedback on the single-family guarantee fee and LLPA pricing framework. Comments are due by August 14.
Both Warren Buffet and Jamie Dimon said in the days following the JPMorgan take-over of First Republic that the banking crisis is over, two pretty good sources on banking stress. It doesn’t mean there won’t be more bank failures—it seems inevitable there will be in the months ahead with the Fed tightening another quarter point last week putting several more under increased pressure. But it may mean from their vantage point banks with the interest rate exposure and those likely to feel the most pressure are small enough that consolidation is not going to cause contagion. It also means, however, that credit conditions will continue to tighten, slowing the economy. With the continued robust consumer activity and strong employment, however, that expected slowing appears slightly delayed and/or softened.
The banking credit tightening is certainly part of the story here because it may give the Fed room to stick with the plan to pause (in June) in order to observe whether recent rate moves are having the intended effect on inflation. The Federal Reserve survey of bank loan officers, out Monday, showed that credit conditions for U.S. business and households continued to tighten in the first months of this year.
In housing, the Mortgage Bankers Association (MBA) reported that mortgage credit availability fell in April to its lowest level since 2013, “matching the tightening in broader credit conditions stemming from recent banking sector challenges and an uncertain economic outlook,” Joel Kan, MBA Vice President and Deputy Chief Economist said.
MBA’s SVP and Chief Economist Mike Fratantoni perhaps summarized the current status well following the Fed statement last week: “We expect that the Fed will be ‘data dependent,’ and certainly would react to any renewed increase in inflation, but [the statement made by Chairman Powell] is consistent with a plan to pause rates at this level. Inflation is likely to trend down over the course of the year, particularly as weakness in the rental market begins to be reflected in the inflation numbers. In the near term, tighter credit conditions will slow the pace of economic activity. The housing sector is already operating under tight credit, so we don’t expect this headwind to outweigh the benefits from somewhat lower mortgage rates. The housing market is likely pulling the economy out of this slowdown, as it typically does.”
Activity at the Fed’s discount window and the Bank Term Lending Program rose in the past week, with banks borrowing $73 billion from the window and $82 billion from the program, up slightly and continuing to stay at high levels. With the seizure of First Republic Bank over the weekend and JPMorgan picking it up early Monday, pressure continues on banks that are similarly exposed to interest rate risk and risk of deposit flight. The Federal Home Loan Banks said advances rose 28% at the end of the first quarter from the close of 2022, reaching a record $1 trillion during the March banking crisis, slowing toward the end of the month.
Following the First Republic deal, shares of a few other banks — Comerica, PacWest Bancorp, Western Alliance Bank and Zions Bank — all sank in Tuesday trading. Eyes and ears will be on whether these potential failures cause dissenting votes Wednesday within the FOMC.
First Republic was the 14th largest bank at the end of 2022 and is now the second largest bank failure in history after Washington Mutual in 2008, which JPMorgan also acquired. Of note here is that JPMorgan will share a loss with the FDIC on loans, with the FDIC reportedly taking 80%. Commercial real estate loans were reportedly a relatively small portion (6%) of First Republic’s loan base. The residential mortgage loans are believed to be low interest, low LTV loans to good credit borrowers. Nearly 60 percent of First Republic’s loans were single-family mortgages, according to their most recent annual report.
The Wall Street Journal reports that home builders are enjoying stronger-than-expected business this spring, capitalizing on the recent fall in mortgage rates and the shortage of existing homes for sale. Active listings in March stood at roughly half of where they were four years earlier, according to realtor.com, in part because higher mortgage rates made many homeowners reluctant to sell and give up their current low rates, the Journal said. WSJ said newly built homes made up “about one-third of single-family homes for sale in March, according to data from the Commerce Department and the National Association of Realtors. The proportion of newly built homes reached nearly 35% in December, a record in data going back to mid-1982 and up from a historical norm of 10% to 20%.”
There continues to be a conundrum in US markets: Q1 was very strong for consumer spending, above pre-pandemic levels, substantially. There has been decent, though slowing, payroll data — the Bureau of Labor Statistics reported Friday that total non-farm payroll employment rose by 236,000 in March. It was the smallest increase in more than two years, but it was enough to push the unemployment rate down to 3.5 percent.
Still, there are real signs of wear and tear on the economy. A Black Knight analysis found more than 11% of borrowers who took out loans to buy houses last year had properties worth less than the debt on them in February. According to Inside Mortgage Finance, production of agency mortgage-backed securities fell to its lowest level in nine years in the first quarter of 2023.
We’ve discussed here the vulnerabilities of regional banks given exposure to the commercial sector, with retail hurting and office space values falling amidst higher rates and post-covid shifts in remote work. Regional banks with the weakest balance sheets and heretofore unrealized losses, even with the Fed facility lending at par, continue to give investors concern. Whether that is powerful enough to cause contagion is difficult to determine, but recent history makes it easy to see how another bank failure could re-ignite flows out of regionals with high levels of underwater loans and assets that have been propped up by lower rates (soon needing to be refinanced in a higher rate environment).
Corporate balance sheets are in better shape than they were prior to the global financial crisis which will help them weather earnings declines from underutilized office space, to a point, but we can expect defaults to rise and banks to continue to feel the pinch of lower interest margins and reduced income from lower loan volumes.
Redfin reported more house hunters are returning to the market as mortgage rates and home prices continue to decline, but low inventory is hampering their searches.
Banks continue to borrow from the new bank term funding program, up $10 billion last week to $64 billion while borrowing from the Fed discount window slowed to $88 billion, down $22 billion according to CNBC’s Steve Liesman. All told, in the month of March, the Fed increased its balance sheet a net $324 billion, although during this past week the Fed’s balance sheet actually declined as they did let MBS and Treasuries roll off — short of their targets but after rising in recent weeks appears to indicate some calming of the crisis, at least for the time being.
Outflows from small banks slowed to $1 billion, CNBC reported, and we saw outflows from large banks to the tune of $96 billion — $65 billion was transferred to money market funds last week, half the week prior, but it set a new record of $5.2 trillion in money market funds as we see the desire for yield play out. Although they are not insured deposits, those investments are mostly in government securities.
Despite the borrowing from the banks, at least for the Fed discount window, appearing reach a crescendo, there are still signs of further weakness and continued fears of a broader recession. One such marker is the growth in the money supply and the velocity of money, which has slowed significantly. Despite the Fed lending to banks, total outstanding liabilities in the banking system are declining rapidly. Morgan Stanley says bank liabilities are falling at a rate of 7% year-over-year, the biggest decline in more than 60 years, which suggests both economic and earnings growth are likely to remain under pressure.
We mentioned commercial real estate lending last week. Morgan Stanley says 70% of the core CRE debt in the banking sector was originated by regional banks, and much is maturing in the next few years — about $550 billion needing to be refinanced per year until 2027 ($450 billion this year). Even where the CRE lending is done by other banks, they point out, these small and medium size banks are buyers of senior tranches of agency commercial mortgage-backed securities. “If their ability to buy these securities decreases because of new regulations, this indirectly impacts the prospects for refinancing maturing debt in the sector as well,” Morgan Stanley’s chief fixed income strategist said.
Markets appeared to be mollified slightly over the weekend after the FDIC found a buyer for Silicon Valley Bank. Nevertheless, the quarter point added to the Fed Funds rate last week has increased pressure incrementally on smaller banks trying desperately to maintain their deposit base and compressing their margins, which will result in the further restriction of credit when banks had already been pulling back for risk reasons.
Remarkably, an estimated $500 billion has been withdrawn from small banks in the past two weeks. Banks have borrowed from the Fed’s discount window at an average of $117 billion each night, and an average of $34.6 billion per day from the newly-created Bank Term Funding Program (up from the previous weeks $3.4 billion). It appears some of this borrowing has been very defensive in nature, a desire to build cash reserves for institutions that aren’t under immediate pressure, willing to pledge assets now in case panic spreads.
While SVB was an outlier in terms of its concentrated depositor base, its failure has caused concerns for other banks with significant interest rate exposure and vulnerable, uninsured deposits like SVB. It is estimated that if marked to market the banking sector is sitting on $2 trillion plus in asset declines. Should the economy slow further (expected as credit is further restricted and that is the intention of the Fed’s tightening) then the ability of smaller banks to weather decreasing deposits from companies with shrinking earnings could lengthen this stress.
A majority of commercial real estate mortgages are held by the small to mid-sized banks experiencing the most pressure. While single family 30-year fixed rates are expected to trend down this year, many commercial deals made in a lower rate environment are coming due and will be difficult to refinance, causing further pressure on that sector. In addition to rates disqualifying firms, the willingness of banks to make the loans, especially if the borrowers are money losing operations, will be curtailed, especially when cash yields them 4.5%. That is to say, an economy that slows is likely to cause additional pain. Fannie Mae is saying the recent bank failures may act as the catalyst that tips the economy into a recession, largely due to tighter lending standards by small- and mid-sized regional banks.