Vanguard & Black Rock Control JP Morgan? | PNC & United Wholesale Mortgage

April 4, 2024 | Premium Service | As Q1 2024 earnings approach next week, investors are left with a plethora of confusing and contradictory indicators spurting from the Federal Reserve Board.  The unseemly parade of Fed officials around the media, offering their personal insights on monetary policy, is decidedly unhelpful. But one thing that we can say for sure is that, regardless of what the FOMC does or does not do in 2024, loss rates on commercial credit exposures are likely to move higher this year.

A number of readers asked The IRA about the investigation by the Federal Deposit Insurance Corporation into the massive public investments in banks by Black Rock (BK) and Vanguard. Short answer: The issue at work here is part politics, part statute. 

Long-time readers of The Institutional Risk Analyst will recall that FDIC once imposed tough restrictions on “passive” investments in banks, especially when there were other indicia of control in the form of brokered deposits or business ties. We learned about the criteria for assessing control of a bank at the FRBNY long ago, before the thaw in FDIC policy on passive investments in excess of expressed legal limitations.

Our view is that the FDIC is right to ask the question. BK and Vanguard are two odious monopolies that can exercise effective control over the public securities markets and manipulate politicians like puppets. Both firms are clearly in a position to influence the actions of the banks in which they hold controlling stakes, particularly smaller banks. The table below from the 2023 proxy statement of JPMorgan (JPM) illustrates the source of the FDIC’s concern. 

Large banks do a lot of business with these buyside behemoths. These relationships are typically bilateral and non-public, safely hidden under the cloak of client confidentiality. Yet even though Vanguard and BK loudly declaim beneficial interest and control in the JPM shares held for investors, BK and Vanguard, in fact, own these shares in their street name. Large institutional firms like BK and Vanguard control in excess of 60% of JPMorgan, for example, ostensibly on behalf of third parties. But the shares themselves are not really the point. The point is market power.

In progressive Washington, the issue of controlling stakes in big banks presents a juicy opportunity in a difficult election year. Imagine if some third level official of Vanguard or BK decided to punish a smaller bank by, say, changing the weighting of a stock in an exchange-traded fund (ETF). Or the same functionary might suddenly threaten to drop a bank stock from an ETF for technical reasons. If the bank does not carry Vanguard fund products in its 401(k) program, for example, no more love. Oh, so sorry little bank!

That scenario may sound entirely unlikely, but the possibility of the market power of these vast firms exerting illegal influence on an insured depository institution is very real – especially if BK and/or Vanguard does other business with the bank. Thus the concern by the FDIC is entirely legitimate and, indeed, required. 

As we noted above, both BK and Vanguard are above the 4.9% legal limit on ownership of voting shares of a bank. This fact gives the FDIC et al the power to ask for BK and Vanguard to apply annually to continue to hold the shares. If you exceed the statutory limit on ownership of voting shares in a bank, then you must submit to regulation by the Fed, FDIC and other regulators. 

If Vanguard and BK don't like the idea of complying with the Bank Holding Company Act of 1956, then they should divest of these businesses that require the disclosure. Stay tuned on this one. The fact that BK and Vanguard are odious monopolies in the growing world for ETFs adds to the flavor. ETFs are half of the volume on US equity markets, thus the FDIC raising the issue of control of bank shares is entirely appropriate. 

PNC Financial

One bank that investors should follow is PNC Financial (PNC), at $561 billion the eighth largest US bank in between U.S. Bancorp (USB) and Truist (TRU). PNC has a net loss rate in 2023 that is roughly in line with its peers. But if you look at commercial real estate exposures, PNC had non-accrual CRE loans equal to 3x Peer Group 1 at year-end. 

Fortunately, the bank has little multifamily exposures, but watch PNC in Q1 for a benchmark for the rest of the industry. Even though CRE is only about 10% of total loans, over 8% were non-performing in Q4 2023.  Criticized loans and leases were 24% of the portfolio. The table below comes from the Q4 2023 earnings presentation. 

One of the little games being played by banks and the FASB when it comes to disclosure of loan losses is that “troubled debt restructurings” are no longer being reported. Instead we have “financial difficulty modifications” or “FDMs.”  This Orwellian doublespeak is significant, however, because it highlights the growing use of modifications (aka “a compromise with creditors”) to conceal credit losses.  If investors had access to all of the non-public data on FDMs, the view of the banking industry would be considerably affected and not in a good way. The table below shows non-performing loans for PNC.

This paragraph appears on Page 115 of the PNC 10-K:

Before COVID and the related economic changes, we would have agreed with this statement. But the fact of the matter is that the half-life of commercial tenants in office buildings has been considerably shortened. When buyers of commercial office space assess an asset, the operative assumption today is that half of the tenants could leave in the next 12 months.

As a result of uncertain net operating income and rising cap rates for new capital in office properties, we cannot see how any serious financial institution does not create a reserve against a significant drop in the value in these assets. Any credit at PNC or other banks that ties back to commercial real estate assets needs to be considered impaired until proven otherwise.

United Wholesale Mortgage

One of the more amusing developments this week came with news that United Wholesale Mortgage (UWMC) has been accused in a published report and related class-action lawsuit of thousands of potential RESPA violations arising from its take-no-prisoners approach to the wholesale mortgage channel. The firm now faces a racketeering lawsuit and, more significant, a public report that accuses the firm of widespread violations of state and federal law.

For the past several years, UWMC has been engaged in a price war with the rest of the mortgage finance industry. CEO Matt Ishbia first locked up brokers to only sell loans to his firm, then allegedly gave consumers inferior execution in order to enhance his profits. And all the while, Ishbia has been selling his mortgage servicing assets to finance his price war.

“The first-ever report by Hunterbrook, a venture capital-backed outlet, claims UWM holds independent brokers captive and overcharged borrowers by hundreds of millions of dollars,” reports National Mortgage News. “The publication's editorial board suggests the wholesale giant is at risk of wide-ranging consequences, and shared its findings with regulators and a law firm that filed a class action suit.”

The fact that investors were willing to spend large dollars to prepare this report, then publish it and then launch the related class action lawsuit is notable. The report also illustrates the huge reservoir of negative feeling that Ishbia has created in the mortgage industry. We cannot even repeat many of the comments we’ve heard from loan officers regarding UWMC’s behavior in the secondary loan market. And frankly none of the new allegations surprise us given the company’s kamikaze model when it comes to loan pricing. 

We have said several times in The IRA that UWMC looks to us like a bad copy of Countrywide Financial, with more aggressive tactics and fewer net assets. UWMC is a very efficient machine for buying and selling residential mortgages, make no mistake, but we don’t think the model is sustainable through a credit cycle. At least Angelo Mozilo, God bless him, kept his MSRs! Ishbia sells his seed corn to finance a price war he cannot win. Suffice to say that should Ishbia and UWMC go down in flames, you won’t see many people in the mortgage industry shedding tears.

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