Feedback Loops: Is The Tide Going Out?

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Strength in Numbers

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Soundbite: Skyrocketing earnings forecasts for hyperscalers have given way to a new set of forecasts questioning whether AI can generate the cash flow to pay for the data center buildout. The rise of vendor financing was met with investor optimism because it locks in clients for years, but the downside is that the seller’s free cash flow is lowered until its customers pay the loan back. That makes the seller more reliant on external financing to fund its capex plans. It also makes the seller dependent on a concentrated customer base. The number of connected transactions between sellers and future buyers is mind-numbing and includes very long-term obligations and off-balance sheet items, making it difficult to make confident revenue projections.

Uncertainty and high valuations are not an optimal combination. Yet, both the hyperscalers and investors are locked in. Mega-cap tech firms’ stock prices have been rewarded for increased spending, and they fervently believe they risk obsolescence unless their spending pace borders on the ludicrous. Investors are also convinced they will underperform without these stocks at least at a market weighting in their portfolios.

Meanwhile, revenue projections now carry higher risks given the recent concentration between major customers and AI providers. From the expense side, the consensus is projecting $3 trillion in capex required over the next three years and $5 trillion over the next five. Customers are expected to spend anywhere between a quarter and a half of what would be needed to maintain those capex outlays reasonably. Looking at the next three years, and assuming Morgan Stanley’s more optimistic revenue forecasts, the hyperscalers will need to seek $1.5 trillion externally. The financing breakdown assumes 75% of the funding gap will be provided by private equity and private credit firms.

Investors have ignored the inescapable conclusion of huge pending losses by the AI leaders for two reasons:

· The forecasts are a few years out, and we are living in a “pretend and extend” state of exuberance.

· The perception is that these outlays are a necessary expense to create artificial general intelligence. These losses are simply borrowing against the present in the hope of being able to increase revenues substantially in the future.

Bears would say that the necessary expense argument was also voiced in the C-suites of internet companies in 1999 and 2000.

Any ray of sunshine? At the height of the tech bubble, those internet telecom companies hit double the current Capex to Revenues ratio as the hyperscalers. Therefore, bulls can argue there is runway ahead before any substantive concern is warranted.

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Three Card Monte

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Soundbite: Banks have been entering into their own style of vendor financing. All is well if the economy does not drop below stall speed, but it is important to be aware that a downside accelerant exists, thanks to bank financial engineering that reclassifies loans cosmetically.

When investors begin to question the degree of discipline in bank due diligence, that is when buyers turn into sellers. If consumer demand falls with decreasing job security, that leads to a drop in top line revenue for firms. At that point, layoffs can occur, resulting in a rapid rise in delinquencies that are not even on investors’ radar.

By modifying loans before they hit delinquency and selling Commercial Real Estate loans off their books while still retaining their risk exposure, banks give the impression they are better capitalized than they actually are. This could mean their loan loss reserves may not be sufficient if the economy turns down and delinquencies rise.

First, banks created new loans by “selling” their Commercial Real Estate loans to a new client but providing them with the financing to assume the loan. The CRE transaction goes back on their books as a Consumer & Industrial loan at a lower amount because the collateral is worth less than its original face value. The bank can sweep the bad CRE loan off its books, though it remains exposed to the lower-quality collateral, as the new client can return the loan to the bank without penalty.

A second way to get bad loans off their books is through loan modification. When a bank client becomes delinquent, the bank modifies the loan by reducing the monthly payment to an affordable level to avoid writing off the loan. If that customer makes twelve consecutive payments on that lowered payment schedule, the loan is no longer counted as modified and returns to its base portfolio, masking the fact that this customer is more likely to default. 

Both practices make the bank more exposed to delinquencies than is generally considered.

Furthermore, many C&I loans were reclassified as loans to Non-depository Financial Institutions; lending to private equity and credit nonbanks is now a significant percentage of bank loan portfolios. We have written about the umbilical cord tying private equity or private credit blowups to systemic risk caused by these sizable bank loans.

When subprime lender Tricolor declared bankruptcy last month, it was considered an isolated event, but now that First Brands is causing losses at banks, the question quickly becomes “Who is next?”

First Brands is an interesting microcosm of this banking sleight-of-hand. They created the appearance of growth through acquisitions and a reliance on off-balance sheet borrowing. Their tactics masked problems in the same way reconfiguring loans creates an illusion of a growing loan portfolio with declining delinquencies.

The collapse of First Brands may dampen new capital flows into private credit. This could also hasten a halt to banks lending to non-depository financial institutions. That could create a backlog in the credit pipeline that may expose unexpected underwriting weakness, given their accounting maneuvers.

Now that private credit losses are causing write downs in our banking system, loose fiduciary practices will not be tolerated much longer. To make matters worse, credit spreads of private credit to high yield corporate bonds and treasuries. That yield compression means any unwind could be painful and spill over into equities.

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Build Baby Build!

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Soundbite: The housing market is now being pressured as the president has aired his desire for the major homebuilders to increase construction to make homes more affordable. Builders are sitting on empty lots because they are burdened with unsold inventory, and it is unprofitable for them to increase construction with tariffs increasing materials costs and immigration pushing up labor costs. We define being forced to build at insufficient margins as a domestic tariff, which explains why homebuilder stocks plummeted last week. This new Trump directive increases the chances that residential construction employment continues its fall, and it is one of our favorite recession indicators.

If these companies are coerced into building, their profitability will be compromised, and it could lead to layoffs. Unless the economic outlook improves and tariff visibility increases, we do not anticipate rising home demand. The downside of increasing the housing supply could be that home prices move lower without increased sales. That could backfire on the White House because homeowners may feel less optimistic, and the wealth effect could dampen consumption.

The president described the major homebuilders as market manipulators, artificially inflating prices by withholding supply. These builders prefer to build, but the government’s tariff and immigration policies have pushed up material and labor costs, making new construction unprofitable. In addition, local restrictions can cause construction delays that increase development costs.

The National Association of Home Builders (NAHB) listed the obstacles to increasing supply, none of which the homebuilders can solve: “The NAHB stands ready to partner with the administration and Congress to remove regulatory obstacles, ease building material and labor shortages, and expand access to affordable financing to enable builders to construct more attainable, affordable housing.”

The administration is correct; there is a housing shortage in the country. Realtor.com estimates that it will take over seven years for supply to match consumer demand. However, the present problem is clearly affordability, as supply exceeds demand. The number of homes available for sale rose by a 10% annual rate, and almost 40% of builders reported to the NAHB that they cut prices by 5% last month.

The homebuilder ETF ITB has fallen 15% in a little over one month due to falling demand, with Trump’s comments the weekend prior accelerating the move, causing an 8.6% drop in the last five days. Pressuring homebuilders to ramp up construction against clear business reasons to sit tight puts them in a compromising position.

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What to Look for This Week

(All times E.S.T.)

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1. Wednesday, October 15 at 2:00 p.m. The Federal Reserve Beige Book for September/October. This Summary of Commentary on Current Economic Conditions by Federal Reserve District will be heavily leaned on, more than usual, due to the dearth of economic releases (CPI was slated for Wednesday but will not be released). The Beige Book contains reports on Labor Markets and Staffing Services, Prices, Retail and Tourism, Manufacturing, and Residential and Commercial Real Estate for each of the twelve Federal Reserve Districts.

2. Tuesday, October 14, before market open, Q3 Earnings Season kicks off with JP Morgan, Wells Fargo, Citigroup, and Goldman Sachs. Blackstone may be the most interesting to see if they have any guidance on private equity or private credit.

3. Tuesday, October 14 at 12:20 pm, Federal Reserve Chair Jerome Powell speaks. We will be looking for any comments regarding tariff uncertainty that could lead investors to consider no rate cuts at the October 28-29 FOMC meeting.

FOMC Voters Speaking: Cramming before the blackout period starts Saturday, October 18. Fed Governor Michele Bowman speaks in a moderated conversation Tuesday October 14 at 8:45 a.m., followed by Powell at 12:20 and Governor Chris Waller at 3:25 p.m. Miran speaks twice on Wednesday October 15, at 9:30 a.m. and 12:30 p.m. with Governor Waller speaking also at 1:00 p.m. an hour before the Beige Book release. Kansas City Fed President Jeffrey Schmid speaks at 2:30 p.m. Thursday October 16, Waller speaks at 9:00 a.m. Barr is scheduled to speak at the same time, and Governor Miran is also going to be speaking at 9:00 a.m. at a moderated discussion. Governor Bowman speaks at 10:00 a.m. that day, and Miran speaks for the fourth time this week and his second moderated discussion in the same day at 4:15 p.m. St. Louis Fed President Alberto Musalem speaks on Friday October 17 at 12:15 p.m.

Earnings: In addition to Tuesday’s reports listed above, Wednesday October 15 before market open: Bank of America (BAC) and Morgan Stanley (MS) as well as ASML Holding (ASML). Taiwan Semiconductor (TSM) is scheduled before market open on Thursday October 16. Friday October 17 before market open, American Express (AXP) and Truist Financial Corp (TFC).

By Peter Corey

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