In this issue of The Institutional Risk Analyst, we feature a conversation with David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors, that was published earlier this week. Next in the Premium Service of The Institutional Risk Analyst, we present "Alien vs Predator" by comparing Goldman Sachs (NYSE:GS) with Morgan Stanley (NYSE:MS).
Market Commentary - Cumberland Advisors - Q&A with Chris Whalen
Christopher Whalen is a longtime friend and confidant, so this interview with him inevitably reflects the sorts of biases that result from engaging, enlightening conversations over many years. Many know Chris from TV appearances or press quotes or social media commentary. Others may know his three successful books: Inflated: How Money and Debt Built the American Dream (2010), Financial Stability: Fraud, Confidence and the Wealth of Nations (with Frederick Feldkamp, 2014), and Ford Men: From Inspiration to Enterprise (2017). I’ve read all of them.
Christopher’s career includes stints in government and central banking and as head of research, and corporate and financial ratings, at Kroll Bond Rating Agency. In between working as a banker and consultant, he writes a column for National Mortgage News that often delves into obscure areas of the fixed income and mortgage markets. His impressive skill set in banking, mortgage finance and fintech enables him to delve deeply into the functioning of US and global financial institutions and how they manage risk. Chris has agreed to a Q&A, so here goes.
Kotok: Chris, you have a free public newsletter that is readily available to any interested person (you can sign up to receive it here: https://www.theinstitutionalriskanalyst.com). I read it regularly. What can our readers expect to find in it?
Whalen: Thank you David. The Institutional Risk Analyst was started in 2003 when I worked with my friend Dennis Santiago in Los Angeles. The title was a bit of a tease for our friends at Institutional Investor and reflects the focus on risk in the global political economy at the time. We like to keep that emphasis on risk as a central theme, although we do wander from financials to markets to monetary policy. They all inhabit the world of financial mechanics.
Kotok: You also have a premium service that is focused on banks and nonbanks. You really get specific in it. I have read that detailed reporting, and I found your analysis of Wells Fargo (NYSE:WFC) especially helpful. Please tell readers what they can expect and how they can try your service.
Whalen: In 2017 we migrated our web site to WIX, which makes production and editing of the newsletter very easy. Subscribers get a reminder of new posts from WIX and we also have payments functionality via Stripe. The Premium Service of The Institutional Risk Analyst is $99 per quarter and includes our company risk profiles, market comments and the quarterly IRA Bank Book, which covers the macro view of the US banking industry. We monitor a couple of dozen commercial banks and nonbank mortgage firms. Our goal for the Premium Service is to publish a couple of profiles and market comments per month. Some of our recent risk profiles include the following assessments:
Citigroup (NYSE:C) Negative
Goldman Sachs (NYSE:GS) Negative
Deutsche Bank AG (NYSE:DB) Negative
Wells Fargo (NYSE:WFC) Neutral
Ally Financial (NASDAQ:ALLY) Negative
Whalen: We published the profile on Ally Financial publicly as an example of the type of work our readers may expect to receive in the Premium Service. Our goal with the profiles is to illustrate the operating performance and business model differences of the large banks and nonbanks, which are often considerable. As Dennis says, US banks are truly a coral reef of business models.
Kotok: We always appreciate the operating insights and historical references in your comments. Reminding readers about the Norwest legacy at WFC was a great way to illustrate the bank’s enormous presence in the mortgage market today.
Whalen: People forget that Norwest, Countrywide and Citibank were the take-out investors for subprime mortgages in the late 1990s and 2000s. The GSEs pushed the banks away from the secondary market trough in 2003-2004, then collapsed in 2007. Of note, we also published the bear case for the US mortgage market as a counterpoint to all of the IPOs announced in the wake of the Rocket Mortgage (NYSE:RKT) offering in August. The follow-on mortgage equity offerings that have priced since then have had a tough time. Selling a mortgage story to PIPE investors in the SPAC market is not an easy task.
Kotok: No indeed. Let me get to a few serious and specific questions. We have the large and G-SIB banks (eight of them in America), the middle-sized or regional banks, and the community banks. You’ve described how these are now actually three different businesses. Can you give us some views on each of these cohorts? And please mention how they are coping with the current Federal Reserve posture of a near-zero interest rate policy for IOER (the interest rate on excess reserves). For the G-SIBs, please add a view on how they manage their size so as to reduce charges for capital.
Whalen: George Selgin reminded me on Twitter the other day that the Fed no longer enforces reserve requirements, so it’s just reserves now. As we wrote this week, US bank balance sheets have doubled in size since 2000, refuting the official fiction regarding low inflation. All US banks have seen their returns on earning assets fall due to the Fed’s low interest rates policies. Funding costs have of course fallen, but asset returns are falling fast. Remember, banks and other investors are getting negative returns on agency and government mortgage backed securities (MBS) because of the resumption of quantitative easing or QE. The Fed, FDIC and other regulators have given banks a pass on capital to support the new short-term deposits created by QE as well as deposit insurance assessments. But we cannot “sterilize” the effect of prepayments on residential and commercial MBS. If you pay 109 for a Ginnie Mae 2% MBS and six months later get a prepayment or insurance payment at par, that hurts. Same for a commercial MBS guaranteed by Freddie Mac. These risk-free assets contain a lot of risk now thanks to QE and this impacts the performance of all banks.
Source: FDIC/WGA LLC
Kotok: Within that framework, we have to ask about your outlook for the future, when net interest margins (NIMs) are likely be under pressure for several years. Do you expect the number of community banks to shrink? How will the shrinkage take place? If deposit size isn’t a driver of value now because of low interest rates, what will drive values?
Whalen: Market rates tell part of the story, but NIM is really about spreads over funding. What we have seen since March is that markets are pricing new assets independent of the FOMC’s actions, but spreads are contracting rapidly. The cost of funding in some markets has essentially stopped out at 1% for some government-insured products, suggesting that there is less and less elasticity of supply for funding as the FOMC buys $50 billion in new MBS each month. Prepayments are so high that it will be difficult for the Fed to keep the system open market account’s MBS at $trillion even with this level of open market purchases. This is a concern because, to recall Bagehot’s warning about low rates too long, investors can always take their cash and go home, leaving the Fed of New York standing alone. American policy makers and politicians seem determined to test the practical limits of the special role of the dollar as a reserve currency. The cost of QE to banks and depositors is enormous. Today some 90% of the interest revenue of banks now goes to equity holders instead of deposits and bond holders. That’s what we call Financial Repression.
Kotok: Let’s move to housing-finance territory, which is among your areas of deep expertise. The first area is mortgage servicing and the value of servicing as interest rates change. We are at a low threshold for rates. Mortgage refis have surged, but that is only a one-time shot. Most observers do not expect rates to go any lower. Let’s make “no lower” the assumption for this question. If rates remain at present levels or start to rise, we may see a massive change in the value of servicing and a strategical low of refi activity. Do you agree? Disagree? And, either way, what do you see for the banks and related servicing enterprises?
Whalen: It is the best of times and the worst of times. Some of the mortgage firms that were making IPOs in October were on the verge of failure the past April due to the FOMC’s decision to “go big” with open market purchases. Margin calls in April and May for the TBA market were more than the net worth of the industry. That problem was fixed in June as volumes surged and cash was returned. But now, the mortgage industry faces the cost of COVID and the idiocy of the Cares Act, where Congress unilaterally imposed costs upon mortgage servicers and other lenders without any thought of compensation. State governments have also imposed moratoria on auto and commercial loans. Congress and the states need to fix this deliberate act of negligence before the wave of refinance volumes subsides. As we noted in the The Institutional Risk Analyst October 5, 2020 post, “The Bear Case for Mortgage Lenders,” so long as the volume of mortgage refinance volumes remains strong, the industry will continue to use the float from mortgage prepayments and payoffs to finance COVID advances. This money, however, belongs to bond holders. Issuers will ultimately need to replace such escrowed funds to make payments to bond holders in respect of such prepayments and mortgage payoffs. That is why the outlook for mortgage production in 2021 is the key question facing policy makers at the Fed and mortgage agencies such as Ginnie Mae and the FHFA. The good news for lenders is that those Ginnie Mae 2.5% coupons that they issued this year will be ripe for a refinance when the FOMC forces rates lower next year. Bad for investors.
Kotok: To focus on government-backed mortgages, we get to the perpetual unfixed issues. What happens to Fannie and Freddie? When and how, and even if, there will be some restructuring remain open questions. And these agency securities are now seriously used by the Federal Reserve as an instrument of policy implementation. FNMA and FHLMC have been in limbo for many years. Please step into your bully pulpit and give our readers a Whalen’s-eye view of how their future plays out.
Whalen: Exactly nothing is going to happen to the GSEs regardless of who is in the White House. If you observe the carnage of the mortgage IPOs this month, it suggests that selling a mortgage story to equity investors is a challenge and this even with interest rates and yields on MBS at record lows. Yes, lending volumes are amazing and, in my view, will likely continue in 2021, but with shrinking spreads. We believe that the estimates out there for falling refinance volumes and rising rates in 2021 are wrong. Effective mortgage coupon rates will fall when the secondary markets want them to fall, not because of the FOMC. This is precisely why the GSEs cannot function outside of conservatorship. Stripped of their “AAA” rating from Moody’s and forced to go head-to-head with JPMorgan (NYSE:JPM) PennyMac (NASDAQ:PFSI) and AmeriHome in the secondary market, the GSEs will not survive. Nobody is going to care about paying 60bp for a guarantee from a private “A/AA” rated GSE that must compete for assets and funding with the big banks and nonbank aggregators. If FHFA even tries to take the GSEs out of conservatorship, the prospective corporate downgrade by Moody’s will kill the deal before it happens. Even if the GSEs pay Treasury to wrap the extant agency MBS with a “AAA” rating, say 15bp per year on $6 trillion in issuance, the GSEs as corporate issuers will be at a big disadvantage. If JPM or PFSI can buy that same guarantee from Treasury for residential MBS, then why exactly do we need the GSEs as issuers?
Kotok: One more, if we can segue to geography. You live in New York. You and I have spoken many times about the NYC we used to know and the NYC you now see every day and I experience vicariously through our conversations. Please share with readers what COVID life is like in the city. And please offer a forecast of how you see life in NYC evolving in the months ahead before we have an effective and fully distributed treatment regimen and vaccine and then once we enter in the post-vaccine, endemic period instead of the pandemic period.
Whalen: My dad’s people have lived in New York for 250 years. They came to this country from Kilkenny, Ireland, and settled in Poughkeepsie. We have been hunkered down in New York City since March and have watched an exodus of people and businesses from New York. We are missing about 500,000 people who have left and are not ready to return. The mid-town business district is largely empty, with little in the way of street traffic or tourism. Most of the hotels and entertainment venues are closed. From a credit perspective, New York City faces the prospect of default because of the sharp decline in tax revenues and the various acts of stupidity by Mayor Bill DeBlasio, Governor Andrew Cuomo and the NY state political community, which is overwhelmingly Democratic. Mayor DeBlasio increased the headcount of the city government to levels that were a problem before COVID. Now things are ridiculous and the city will likely fall under the Financial Control Board as in the 1970s and 1980s. The rent control laws imposed by the Democrat state legislature last year, for another example, have made many multifamily rental properties uninvestable. Banks will not lend on these properties because landlords cannot recover the cost of operations and maintenance. New York City and New York State face a financial and political disaster that frankly Washington cannot fix.
Kotok: Chris, thank you for your time and your thoughtful responses for our readers. Please stay safe and careful. And, as we both like to say in Maine, “Tight lines.”
Lunch at Ray's Camp (2019)