On Friday, Credit Suisse’s (NYSE:CS) bosses accidentally triggered a panic after attempting to reassure staff and customers in an email. Rather than calm nerves, the memo created hysteria over the Swiss bank’s liquidity. Shares would plummet 12% when markets opened on Monday and credit spreads would widen from 140 basis points to over 500.
As the writers of Disney’s 1964 film Mary Poppins all knew, an eight-year-old screaming “give me back my money” is often enough to trigger a bank run.
Yet look deeper, and investors will quickly find that Credit Suisse is not the next Lehman. The Zurich-based bank has been in retreat for over a decade; its balance sheet today is a quarter smaller than it was in 2011 and leverage is 45% lower. The firm’s C-suite has also been a revolving door; over half of the company’s board has been at the bank for less than three years.
These are signs of a mismanaged bank, not an insolvent one. The Swiss bank is more likely to slog along like a Citigroup (NYSE:C) or Standard Chartered than to implode like Lehman Brothers. Mary Poppins’ Mr. Banks can keep his job for now.
The Hidden Leverage in the U.S. Housing Market
But rising rates and weakening asset prices have sent investors scrambling to protect themselves from the next Lehman anyway. Insurance companies, brokerages and diversified financials have all seen their share prices sink in recent weeks. Since September, major mortgage REITs from Annaly Capital Management (NYSE:NLY) to AGNC Investment (NASDAQ:AGNC) have seen their stocks drop a quarter or more. Shanghai-based Lufax Holdings (NYSE:LU) – once a $30 billion personal finance platform – now trades as a penny stock. These are all weak links in an industry prone to over-leveraging.
The biggest issue, however, is likely lurking in the non-bank system, particularly in fintech firms dealing in U.S. real estate.
These young tech startups have proliferated in the U.S. thanks to lax regulation around non-bank firms. Online mortgage lender Rocket Mortgage (NYSE:RKT) is now America’s largest originator for home mortgages; former competitor Wells Fargo (NYSE:WFC) dropped out of the race after high capital requirements proved too onerous. And by 2020, WeWork (NYSE:WE) was the largest office tenant in New York City, Chicago and London, as the company makes clear. The firm essentially operates as a “bank” for real estate, taking on long-term leases from buildings and dividing them into shorter-term contracts for customers… all without registering as an actual financial institution. Meanwhile, NYC’s largest rental landlord, asset management group Blackstone (NYSE:BX), is an SEC-registered investment advisor. The most recent data by Statista Research now counts 10,605 fintechs in the Americas, up from 5,779 in 2019
The growth, however, has come at a cost.
Rocket Mortgage now has a debt-to-equity ratio of 26.6X thanks to its practice of holding onto contracts for the mortgage servicing rights (MSRs). It’s a strategy that earns extra income in good times, but also exposes the holder to mortgage delinquencies and valuation risks. Rocket’s equity base would theoretically go to zero if the value of its mortgage assets declined by more than 3.8% today.
Meanwhile traditional real estate financing companies like mortgage REIT Annaly Capital hold far less leverage. Debt-to-equity ratios typically hover closer to 6X, meaning it would take a 17% decline in asset value to wipe out the equity base.
The next Lehman Brothers is somewhere right under our nose
When Credit Is Due
Credit investors have begun to worry about the leverage. Prices of 10-year RKT bonds now trade for 60 cents on the dollar, down from par last year. And a host of other fintech real estate companies, from Opendoor Technologies (NASDAQ:OPEN) to Offerpad (NYSE:OPAD) trade at fractions of their former values. Much of this hidden leverage is finally coming to light.
“Opendoor’s iBuyer model is a canary in the economic coal mine,” notes Chris Stoke-Walker for Wired Magazine. “Like the housing market on steroids, iBuyers more keenly feel small shifts in house prices, both up and down, as they try to squeeze profits out of tiny margins.”
That’s because the real estate market is slowing.
Data from real estate analytics firm CoreLogic showed that home prices fell 0.7% between July and August. They predict a sharp slowdown in home price increases through 2023.
In certain markets, the picture has gotten even worse. Prices in Long Island’s Suffolk County saw a 2.7% decrease in September – a product of fast-rising mortgage rates. And in Toronto, a market in which many U.S. financial firms still have a stake, prices fell an astonishing 17% since March.
The news is particularly worrying because many fintechs have little experience navigating stagnant housing markets, let alone falling ones. Opendoor’s top executive team hails from quantitative trading and data analysis; none have experience in real estate investing. In mid-September, Bloomberg reported that the iBuying company may have lost money on 42% of its resales. In the Phoenix market, the share may have been 76%.
Could Fintechs Crash the Housing Market?
This isn’t the first time that forced sellers have created a negative feedback loop. A rising Federal funds rate in the mid-2000s slowed the pace of homebuying, eventually triggering a collapse in home values and the mortgage-backed securities they represented. More recently, high cryptocurrency leverage has caused even some of the most prominent coins to go to zero.
Older firms like Zillow (NASDAQ:ZG) and Redfin (NASDAQ:RDFN) are already cutting their losses in real estate investing; in November, Zillow offloaded $2.8 billion of its housing assets to institutional investors at an estimated $460 million loss. But these massive losses are only the tip of the iceberg. Of the five most-indebted U.S. financial firms, four are non-bank mortgage services – UWM Holding (NYSE:UWMC), Rocket Companies, Ocwen Financial (NYSE:OCN) and LoanDepot (NYSE:LDI). Together, their $80 billion in assets is backed by less than $2 billion of equity.
Other fintech stocks are also showing signs of strain. Opendoor’s 2026 convertible bonds now trade at 56 cents on the dollar, down from 85 cents earlier this year. The firm receives a “1/100” score in Thomson Reuter’s combined credit risk model, implying a credit rating of CCC-. Offerpad is even further behind. As mortgage rates continue to rise, investors could see anywhere from a 5%-20% decline in home prices in 2023, a factor that will get magnified by high financial leverage.
None of this points to a clear weak link in the real estate fintech industry. Rising mortgage rates reduce the prepayment risk of MSRs, which increases their value. And a tight housing market creates a buffer for home prices. Zillow was able to offload an outsized portfolio with little trouble (even though it was at a significant loss).
But modern accounting rules are inadequate for instruments like MSRs and other securities backed by non-homogenous assets. MSRs are considered “level 3” assets by the U.S. Federal Reserve, since the inputs for valuing these assets are unobservable, making them prone to gross misvaluations.
“Each portfolio is typically associated with mortgages that differ by loan size, interest rates, servicing fees, maturity, credit quality, and the entity, if any, that provides a credit guarantee on the underlying loan, among other characteristics,” warned the U.S. Federal Reserve in a 2016 memo to Congress. “Accordingly, a firm generally will not be able to value its MSAs based on comparable sales alone.”
With non-bank firms now holding onto vast swaths of these assets, it’s these issues – not Credit Suisse’s stumbles – that should truly scare investors.
The Fintech Stocks Investors Should Buy Instead
Rising rates will create a host of winners in 2023. Companies like Charles Schwab (NYSE:SCHW) and SoFi (NASDAQ:SOFI) will see a surprise boost to their bottom line, since rising rates increases the net interest income these bank-like firms. For every 1% that rates rise, Schwab’s net interest revenue goes up 6.2%, according to company estimates. And analysts are now predicting SoFi’s net interest income to jump from $252 million last year to $703 million in 2023.
These are the fintechs that investors should buy for an eventual turnaround. SoFi’s price target sits at $8.50, a stunning 60% upside from current levels, while the more conservative Schwab offers 17% upside.
Meanwhile, non-bank fintechs will remain a sector to avoid at all costs. As housing prices decelerate… and even reverse… the fair value of MSRs and leveraged real estate holdings will fall off a cliff. Investors beware: The next Lehman Brothers is somewhere right under our nose.
Tom Yeung is a market analyst and portfolio manager of the Omnia Portfolio, the highest-tier subscription at InvestorPlace. He is the former editor of Tom Yeung’s Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad.