Hey There Income Hunter,
The banks are up to their old accounting gimmicks again.
And this time it could be a sign of how bearish they are on the housing market.
Yes, internal signposts I’ve spotted are alerting us to a brewing financial system crisis. And it’s important for you to be aware of them and take advantage of the edge they provide when the timing is right.
As you will see today … the timing IS right.
Earlier in Q3, the banks presented better-than-expected earnings reports. However, they pulled an accounting trick to hide a massive mortgage asset write-down on their balance sheets …
I’m talking about $17 billion in unrealized losses that were not included in their income statements.
JPMorgan Chase & Co.(JPM), Citigroup Inc.(C), Bank of America Corp.(BAC) and Wells Fargo & Co. (WFC) all tapped into an accounting loophole to hide these losses.
Today, we’ll take a look at what the bank’s moves say about housing and a trade to consider to take advantage of a renewed down trend in housing.
Billion With A ‘B’
The $17 billion in unrealized losses may not have hit the banks’ income statements, but the negative numbers still ended up landing on balance sheets.
They are accounted for under the line-item accumulated other comprehensive income (AOCI).
The drop in AOCI has surged this year …
These write-downs are coming at a tough time for a few reasons:
- Banks need to come up with new capital to meet higher regulatory requirements
- New accounting rules require banks to set aside reserves as a result of rising inflation that’s threatening the overall economic outlook
- Banks have also been battling back an increase in risk-weighted assets, which are used to determine minimum capital levels
One credit analyst recently told Bloomberg, “Share repurchases will be curtailed or continue to be suspended as the banks meet their capital requirements.”
The banks had previously been able to hide their mortgage bond losses by shifting them to their “held to maturity portfolios” in order to boost capital …
After soaring from $495 billion to $805 during the Covid pandemic, the banks had avoided taking a hit from the recent drop in values via the accounting loophole.
However, with another $157 billion still designated as available for sale, banks are beginning to panic since housing prices are poised to accelerate downward.
The banks need to meet a common equity Tier 1 ratio (CET1) of 13%, but right now Citi and JPM are below that level … and just as we enter the toughest time of year for investors in Treasury and Mortgage bonds (November and December).
Treasury bond volatility as measured by the MOVE index started to rise again last week, so this presents a good opportunity to set up bearish interest rate-sensitive strategies.
What’s the Trade?
My highest conviction trade is to short the SPDR Select Sector Homebuilders ETF (Ticker: XHB).
The housing sector is in serious trouble.
That message is what I believe is revealed by banks selling mortgage bonds. Why would they sell their mortgage bonds if they truly believed mortgage rates would come down?
With the Fed selling mortgages every month and housing prices expected to drop, the banks can’t afford to sit with mortgages as homeowners’ equity turns negative.
This narrative is not currently in the market so selling home builders could reap great rewards in the weeks ahead.
The technical picture (chart below) also reveals that there is an air pocket below the market for XHB …
Notice the deeply discounted implied volatility for XHB. We are talking about a 15% discount, which indicates this is a very cheap period for buying puts.
An efficient play would be to buy the XHB 61/57 put spread for $1.30. If XHB closes below $57 at expiry, traders maximize their return.
Traders make the full put spread $4 – minus the cost of $1.30 – for a $2.70 profit, or 200% gain. If XHB goes to $57 by Dec. 2, traders would make around 110%.
I would stop the trade out if XHB closes above $63, which would limit loss of capital invested to 50%.
The trade has a good risk reward ratio and high probability of success.
Bring It Home
With a less liquid holiday week ahead of us, we could see a pickup in volatility.
Mary Daly from the Fed speaks today and on Wednesday Jerome Powell speaks at the Brookings institute.
We will also get a lot of data on Wednesday, including initial jobless claims, S&P manufacturing survey data, University Michan sentiment and FOMC minutes from the September meeting.
I don’t see a high probability for a big increase this week, but the upcoming FOMC meeting will demand some put protection and we could see volatility pick up – with potential for a flush to the downside into the massive Dec. 16 options expiration.
Live and Trade With Passion My Friends,
Griff