Halyard’s Weekly Wrap – 12/1/23 – Have the regulators fallen asleep at the wheel?

There were two news stories this week that made us double check the calendar to ensure that we hadn’t transported back sixteen years to pre-crisis 2007.  The first had to do with the Federal Housing Finance Agency (FHFA) and the second was the proliferation of private credit.

The mission of the FHFA is to supervise, regulate, and provide oversight of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.  As you’ll recall, the FHFA swept Fannie Mae and Freddie Mac into government conservatorship during the mortgage crisis and continues to sweep all profit from the companies into the government coffers.  Fannie and Freddie buy and hold mortgages from banks to facilitate home ownership for low- to middle-income housing.  The much-maligned agencies have faced steady criticism from Congressional leaders since they blew up during the financial crisis.  With that, we were surprised by the announcement this week that the FHFA would lift the maximum value of the mortgages the agencies can purchase from $726,200 to $766,550.  According to the Federal Reserve Bank or St. Louis, the median home sale price in the quarter just ended was $431,000. Granted, home prices have risen steadily as the inventory has remained depressed, but $766,550 is significantly above low and middle-income home prices.  Reading further into the release we were stunned to learn that high-cost cities like New York and San Diego will have the maximum cap raised above $1 million.  It appears that FHFA is looking to increase the profitability of the agencies.

The second pre-crisis throwback has been the proliferation of private credit funds.  The private credit market is the shadow banking source of capital for borrowers with a lower credit score than what would be acceptable for a bank loan.  Prior to the financial crisis, the private credit loans were called “leveraged loans” because the borrowers were typically over leveraged and had a weak credit-rating.  The pitch, at the time, to lure investors into leveraged loan funds was that they’re higher in the credit structure and, as a category, they have never traded below 90 cents on the dollar.  That is until the economy tanked and they fell to 50 cents on the dollar.  We witnessed on three occasions this week the exact same argument in favor of the funds.  Private credit offers a better return than investment grade fixed income investments.

Expanded mortgage lending and a significant amount of dollars flowing into private credit; have the regulators fallen asleep at the wheel?

Economic data for the week portrayed a weakening economy with new home sales coming in below expectations and continuing unemployment insurance claims ticking up a surprising 86,000.  The bright spot was that Q3 GDP was revised slightly higher to 5.2%.  Offsetting that, the personal consumption sub-category was revised lowered to 3.6% from 4.0%.  Given the slowdown in activity since the start of the quarter, market consensus is that the Federal Reserve rate hike cycle is over.  That consensus has supported strong rallies in both stocks and bonds.  Month-to-date the S&P is more than 10% higher and the yield on the 10-year Treasury note is 70 basis points lower.

Next week will bring the final non-farm employment report of the year.  The expectation is 190,000 net new jobs, an uptick from the 150,000 created in the previous month.  The unemployment rate is expected to remain steady at 3.9%