September 9, 2026 | Over the Labor Day weekend, Gina Heeb at the Wall Street Journal got a nice scoop by reporting on the reverse merger between WaFD, Inc. (WAFD) and EverBank. The latter was bought from TIAA-CREF by a group of private-equity firms in 2023 and has assets of around $47 billion. Assuming the transaction is approved, the new bank will be added to the WGA Bank Top 50 test group. The PE firms involved with EverBank included Stone Point Capital, Warburg Pincus, Reverence Capital Partners, Sixth Street and mortgage giant Bayview Asset Management. The group of investors and TIAA, which kept a stake in the 2023 sale, would collectively own around 59.2% of the combined company after the deal with WAFD, the WSJ reports. WAFD will remain a publicly traded company in the deal, change its name to EverBank Financial and trade under the ticker “EVBK.” The fractious group of private-equity firms bought EverBank from the pension fund TIAA in 2023, but the club deal never really worked and the firms were reportedly at odds from the start. The obvious strategy was to let the veteran Warburg lead the deal, but apparently it was not meant to be. Below for subscribers to our Premium Service, we talk about what this transaction means for the two banks and the US industry. As we noted in the most recent update to the WGA Bank Top 50, the banking sector has not participated in the strong US equity markets in 2026, unlike the stellar performance in 2025. No surprise, the WAFD stock has traded down since the transaction was announced.

September 7, 2026 | In this issue of The Institutional Risk Analyst, we feature the second part of our conversation with our friend and fishing partner David Kotok. He is an American financial expert, economist, and author best known as the co-founder of Cumberland Advisors. You can read the first part of the interview here (“David Kotok: Gold & US Credit Default Swaps in Euro”). A note for our Premium Service subscribers, we’ve updated our WGA Precious Metals Top 25 list as of the market close on Friday. Toma Stream, Indian Township, Maine The IRA: David, we ended the first part of our discussion in July talking about euro denominated credit default swaps on the US as a benchmark for gold. Since then, long-term interest rates have backed up and the Trump Administration looks increasingly at risk of being irrelevant. The case for holding gold in investment portfolios is getting stronger by the day, yet Wall Street is still not entirely on board. How do you explain Wall Street’s reluctance to embrace gold as a hedge against the manic swings in American politics? Kotok: The conclusion I have reached on gold is that it is not short-term trading vehicle. Gold tells you that. What gold tells you is that reactive changes in gold prices are driven by forces quite different than other types of asset classes. And we already have a sense of that. But the differences are there. And they are intertemporal with quite a different time span than traders are accustomed to managing. Traders are impatient. They want to know when the gold price is going to go up tomorrow so they can buy it today and then they want to sell it. Gold doesn’t work that way. The IRA: Americans are short-term in their thinking when it comes to gold and most other assets. The rest of the world is not. For example, the rest of the world cares about the growing risk of a US debt default. Some agents are long-term holders of gold because they’re worried about US default. I think that’s what you’ve hit on here. Kotok: Yes, I think so. Why else would a market agent pay 45 basis points in euro for a 10-year Credit Default Swap on the United States Treasury debt? Why is the 30-year federal agency bond yielding 40 basis points more than the 30-year US T-bond? Only 15 years ago, that CDS was priced in single digit basis points. Just 15 years ago, the Treasury-agency spread was single digits. This is the market speaking with real money. Chris, there is a market-based pricing mechanism. We can make assessments of what those folks think, not by what they say, but by how they price the buy and the sale and come together with a price. And the CDS for the US in euro gives us a pricing reference. And what do we know about it? We know as you go out in time, the price of gold goes up. The IRA: Correct. It’s quite odd to compare the heavily manipulated world of securities to a global market like gold. The Financial Times reports that China imported 100 tons of gold from Russia in the first seven months of this year. Kotok: We know we have a directional curve. We know we have a unit-based price per year because we have one, five, and ten-year CDS contracts on US default priced in euro. So, we can interpolate three points and make an entire term structure. And we know that the CDS-gold relationship has mathematical efficacy because the Granger is not zero, it’s a positive number with statistical significance from 3 months to almost 2 years horizon. The IRA: Your work on the correlation between gold and US CDS is quite compelling. Kotok: Thank you. I don’t make up the numbers. I got them from the Bloomberg database. If there are any investors in the entire country who will buy CDS denominated in euro, both are on this Zoom call right now. Americans don’t look at this. Maybe that’s why it helps. The IRA: Americans are still too desensitized to the risk of a US debt default to start buying CDS contracts in euro. They think that it’s not going to happen. When you start to tell Americans that the great game has a finite endpoint, they tune you out. Kotok: Agreed, however, there’s a new player in town and I sent you those charts too. And that player is Shanghai. What did Shanghai do? Shanghai has run a payments system starting in 2015. And the Cross Border International Payments System or CIPS is different. CIPS is something I call a 2.0 version of Bretton Woods. And what is it? CIPS says, hey, you don’t have to clear payments in dollars or other western currencies. You don’t have to use SWIFT for the messaging and you don't have to use one of the major correspondent banks in the Western Alliance payment system. China is still small but growing. CIPSis clearing in domestic Chinese yuan. The dollar is still huge. It still settles about 90% of the world’s payments on at least one side of the trade. China is up to about 3% on CIPS. The IRA: The self-defeating US sanctions regime and other stupidities have given the Chinese and the Russians an opportunity to create an alternative to dollars. But most payments still flow through the dollar and western alliance monopoly. Kotok: Yes. We may be 55% of world reserves, but when it comes to settling payments, we’re 90% of at least one side of every payment trade. And we do that through the correspondent system known as SWIFT. And what do we do? We go to one of the G-SIB banks, depending on where we are in the world, we communicate the trade through SWIFT, and then we go to the correspondent to settle the trade. Counterparty A settles the trade with B. If Siemens is selling an MRI machine to Sarasota Memorial Hospital for a hundred million dollars, that’s how the payment structure would go. Siemens gets euro, SMH pays dollars. G-SIB banks net out the difference. SWIFT communicates. That’s how the dollar mechanism works. The IRA: How does the Chinese system CIPS differ? Kotok: What China is trying to do is fascinating. Number one, it introduced in 2015 a competing payment system currency. It says settle in Shanghai through a domestic Chinese agent and use yuan. So, if a hospital in Malaysia buys the MRI machine from Siemens, they can clear the currency exchange in Shanghai through yuan. The Indonesian hospital pays in ringgit, Siemens gets euro. No correspondent banks in the middle and the payment never touches dollars. The Shanghai Exchange handles the currencies. And CIPS will clear that payment. And CIPS now does that every day. So, the Malaysian hospital has choices, western or eastern payments. Two currency choices dollar to euro from ringgit or clear ringgit to euro through yuan via CIPS. The IRA: CIPS is an alternative system specifically designed to evade the US sanctions network. Kotok: Shanghai doesn’t care who the actors are. So about 20% of the transactions go through the Chinese communication system which is not visible to western eyes. That’s how Iran clears payments for oil it sells to China. Or for missile parts from North Korea or Russia. Suppose I’m one of the bad guys and I don’t want the West to see a payment. I don’t want to use SWIFT to communicate. I use the Chinese system CIPS. The supervisor is the Peoples Bank of China (PBOC). They are the only folks who see the trades unless someone has hacked into their security system. And remember the PBOC are the same folks who manage the dollar-yuan exchange rate. The IRA: Right. Works nicely for Iran and Russia as well. Kotok: So, you get the money, you clear, and the whole mechanism is in Shanghai in the domestic Chinese currency, and nobody sees it. The Chinese have created an option to the dollar and it is growing. What they have also done, what China has done, is brilliant. They have created a gold option. So, if you don’t trust the Chinese yuan, you can use the Shanghai Gold Exchange and take some physical gold into delivery. All this through agents for CIPS. The IRA: Why do you call this Bretton Woods 2.0? Kotok: China has figured out the flaw in Bretton Woods. The flaw was not allowing the market to reset the gold price. So, fixing $35 for the dollar was destined to fail over time. I don’t want to point a finger of fault at Keynes and the others… The IRA: Oh, go ahead David. As my father Richard Whalen used to say, you cannot libel the dead. We adopted a non-gold system because the rest of the world including the British were broke. FDR and the socialists in the New Deal wanted to brainwash Americans into forgetting about gold. A century later, the effort has failed miserably in large part because of America's debt addiction and China. Kotok: The flaw in Bretton Woods was to fix the $35 gold price instead of allowing it to change. What China has done is said, we will have a physical gold hoard and we will have a tradable gold warrant. And that warrant trades in Shanghai in the room next door to the currency payment structure. So I can take my yuan and buy the gold warrant at whatever the price is denominated in Chinese currency. I buy a yuan denominated claim on physical gold. There’s liquid market and the PBOC supervises it. The IRA: China has reversed the idiocy of Franklin Roosevelt a century ago and made gold an advantage instead of a threat to the progressive agenda. We let our physical gold hoard sit inside Ft Knox at a fraction of the market price and pretend that we can pile endless leverage atop a fiat currency. And China encourages its citizens to own gold. Is this system superior to the dollar, David? Kotok: the superiority is that the market agent has the option. You want yuan? You can have it. You want gold? You can have it. You want to do a global transaction with transparency? You can do it. You want to hide it from prying eyes in Washington? You can hide it. The physical gold is in a vault. And if I want to sell the warrant you get paid in Chinese currency. If you want to buy gold from me, you pay in Chinese currency. If we use agents, they must be acceptable to the PBOC. The Chinese are slowly expanding CIPS agents. Deutsche Bank (DB) just became the first official one in Europe. Today almost 100% of the gold warrants are settled with physical delivery in Shanghai. Western markets are much larger. This warrant is only 2 years old. If you go to Chicago or London, what do we do? We have futures contracts that settle in dollars. Most of the west rolls the trade so physical gold delivery is small. The IRA: The difference between the Western markets that settle predominantly in cash and Asian markets where physical delivery is the norm is fundamental. A growing number of global central banks are moving their physical gold out of the US because of the erratic behavior of Donald Trump. They fear expropriation of their gold by a future government in Washington. Kotok: Chris, we are burning up the value of trust. We put Smoot Section 338 tariffs on Canada, our ally and friend with a 3,000-mile peaceful border to our north. We insult everybody. We renege on what we say. And we have craziness on social media at 2 o’clock in the morning. The foreigners who wonder about America have good reason. The IRA: You wrote that in a trade war, the guns are pointed inward. Does that encourage more use of gold? Kotok: I think so. Gold is agnostic. Gold doesn’t fight culture wars. It just sits there as a store of value. Gold ignores the social media posts at 2 o'clock in the morning. In the West, we have various claims on physical gold. We physically don’t move much physical gold, we just roll the contracts. So, I have people say to me, eh, Shanghai is a small market. It’s one tenth the size of London and or Chicago or New York. I say, yeah, but let me ask you a question. If the larger market is replacing a claim with a claim in a security transaction. And only a tiny fraction of the gold is physically settled. And the other, smaller market settles 90% of the trades with physical gold. Where are you better off? The IRA: Good point. What the Chinese have done is create an alternative payment system to the dollar. Brilliant. Kotok: I think so. They have taken a payments mechanism and they have taken the $35 gold price of Bretton Woods. They said, wait a minute, we’re going to let the markets set the price. Buyers and sellers will set the price of the gold. And we will give them a tradable security, the gold warrant priced in yuan. And anybody in the world who wants to go see how much it is, how big it is, how it’s growing, can get the information. They are very transparent about the Shanghai Gold Exchange. The IRA: How long has the Shanghai Gold Exchange warrant market been trading? Kotok: It’s just two years old. The IRA: And it started at zero? Kotok: Correct. Now it is growing weekly. The last report was almost 115 metric tons as of September 1. That is a new record high. The IRA: Fixed prices are an idiotic affectation of the Western democracies. Where is the gold deposited? Kotok: They have physical hoards and the Shanghai Gold Exchange operation has vault locations. Each warrant represents a 3,000-gram serialized gold bar. The supervision is the Chinese Securities Regulatory Commission and the PBOC. There is an elaborate process of random and scheduled audits and designated inspections. China is trying to build trust in the system. They are slowly achieving that. This is what is competing against SWIFT and the dollar correspondent system. And by the way, the Chinese system now has agents around the world so that about 30 countries can use this system The IRA: Well, President Trump or Treasury Secretary Scott Bessent can give the 30 counties an ultimatum to choose between SWIFT and CIPS. I doubt they would like the response. Kotok: Indeed. Look at where we are. You can arbitrage with SWIFT versus CIPS. You can arbitrage any currency and the gold price and do it in two markets. And the big market, which is the Western alliance, ignores this. Which is why China has such enormous possibilities. Now, not everybody ignores it, but if you write up something on US CDS, most people are going to roll their eyes. But a few astute observers of the global political economy are gonna say, Gee, they’re on to something. And I never knew that. The IRA: Any closing thoughts? Kotok: One last point. The US could act differently and not ignore the fledgling competitor. In fact, we could replicate it with a credible dollar if we wanted to. Instead, we keep shooting ourselves in the foot. Now Vice President J.D. Vance is out talking about lower interest rates and preaching to Fed Chairman Kevin Warsh. And Chairman Warsh knows he must keep the real interest rate positive to get inflation down. Chris, we need mature adults in the room. Your father worked for one. You and your Dad knew Paul Volcker and saw him in action. It wasn’t always like this. The IRA: No, it was not. But a majority of Americans voted for President Trump in 2024. We got what we asked for. As Peter Dinklage as Tyrion Lannister told King Joffrey Baratheon in The Game of Thrones: “We've had vicious kings, and we've had idiot kings, but I don't think we've ever been cursed with a vicious idiot for a king!” Thank you, David. Don’t forget to watch “The Wrap with Chris Whalen” on The Julia LaRoche Show every Saturday on YouTube to catch our discussion of what’s hot and what’s not in Washington and on Wall Street. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

December 18, 2018 | First a safe and happy holiday to all. In this issue of The Institutional Risk Analyst, we ponder past prognostications and future risks in 2019. And we are happy to announce the publication of The IRA Bank Book for Q4 2018. For those of you who were furiously buying copies of the Q3 edition last week, for which we are most grateful, hit the download link again to get the Q4 edition. You’ll want to read about why US bank earnings growth is now 100% correlated to interest rates. FYI, new editions of The IRA Bank Book are published about two weeks after the FDIC and other regulators release their institution level and aggregate data (roughly day 60 after the quarter end) for US banks. The popular IRA Top Ten Banks usually appears after quarterly earnings are complete. And yes, to your questions, we only sell the most recent edition of each report. So what is our top concerns in 2019? First comes liquidity. For the past several weeks, US equities have fallen as the great unwind gathers speed. The same pressures that are causing the Federal Open Market Committee to consider pausing on rate hikes in 2019 are forcing stocks lower. Never mind the parade of mindless reasons for the stock market reset – trade, China or even a weak US economy – the key factor pushing markets lower is the radical tightening of credit by the FOMC. Even without a single rate hike in 2019, the tightening caused by the runoff of the Fed’s bond portfolio will continue to suck liquidity out of the financial system. And lowering the target rate for Fed funds really won’t help if markets lock up. Just as quantitative easing expanded the US liquidity base, quantitative tightening or "QT" represents a structural decrease in liquidity. As the Fed’s balance sheet contracts, there is a dollar-for-dollar decrease in liquidity because the Treasury is running a deficit. A bank deposit becomes a Treasury bill on the national balance sheet, illustrating why the Fed and Treasury are two faces of the same agency. But the key point is that QT is beginning to impact markets and credit spreads. The destruction of trillions in equity market valuation is creating a level of panic in the US markets not seen since 2016, when China fears caused the capital markets to seize up. We may be replaying that scenario again. With high yield spreads headed to the danger zone of 500bp over Treasury yields, that tells you that the policy message coming from Washington is off key. But it also means that the market for subprime debt, including leveraged loans and CLOs, is grinding to a halt. That sound you hear is Wall Street choking on conduits full of loans that cannot be sold. Feldkamp’s First Law states that when spreads widen too much, debt markets stop functioning and equity markets lose value. We talked about this in “Financial Stability: Fraud, Confidence and the Wealth of Nations.” When the mix of policy and personalities is toxic, spreads blow out, debt markets freeze and wealth as measured by the equity markets falls. Sadly there are only a handful of people on the Street who get the joke. The majority is captive of a narrative where trade tensions are responsible for market weakness. Next on the string of worry beads is Europe. The European Central Bank just announced the end of its version of “quantitative easing” or QE, but unlike the US the ECB intends to reinvest its bond portfolio indefinitely. There will be no “quantitative tightening” in Europe by actually allowing the portfolio to run off as in the case of the US Federal Reserve. We reported this to readers after our trip to Paris last March. This past week, ECB Governor Mario Draghi confirmed our belief that EU banks cannot withstand a significant increase in rates. The list of banks in Europe that are effectively insolvent is long and growing, in part because the EU banking system is not particularly profitable. Again, as we noted in previous comments, strong banks are profitable banks. Profits allow you to build capital and deposits, and fund credit losses. For the banks of Europe and particularly nations like Italy, far too often there is little or no real profitability. This leads banks to hide credit losses and asset quality problems. We were amused to read that Qatar is considering increasing its stake in Deutsche Bank, as the newspaper Handelsblatt reported Sunday. This brings back memories of a decade ago when Korea Development Bank was touted to be looking to acquire Lehman Brothers. Then as now, the reports are not particularly helpful. What DB needs is to be recapitalized or acquired, but so far no credible investors has been willing to put new capital into this troubled bank. Merge Deutsche Bank with Citigroup (12/04/18) As we have discussed previously, the fact that insolvent Chinese aviation conglomerate HNA is selling its stake in DB means that the bank badly needs a new shareholder. And keep in mind that HNA was not a cash buyer of DB shares, but instead used leverage to fund its position. Presumably the Qataris have cash. We see the failure or restructuring of DB as a very real possibility in 2019, an event of default that will force the larger issue of bank solvency in Europe. With the bank trading below one quarter of book value, the stock of DB is not suitable as an investment. When will the EU authorities accept the fact that DB is crippled and requires state aid in order to stabilize? In the event, the mirage of German economic power in Europe will evaporate. Last comes China, both because of the growing potential for violent change and because western audiences are completely unprepared for this eventuality. Credulous western observers talk about the “long term” perspective of the Chinese Communist Party (CCP), but in fact this gang of “running dogs” to borrow the Maoist terminology is no different than western politicians. The make it up as they go. The CCP is no more able to manage a economy than is President Donald Trump. The key difference in China is mountains of debt, no real equity leverage in the economy, and a payments system that is entirely focused through the Bank of China. But the most troubling development in our view are the growing signs that the CCP and paramount leader Xi Jinping feel compelled to take more and more authoritarian measures to retain political control. The brutal rise of Xi Jinping to sole power in China is nothing if not a display of massive insecurity, starting with the elimination of all rivals and ending with the dissolution of collective leadership. Revelations that Beijing feels the need to imprison over a million Muslim Uighurs in work camps, a mere 10% of the 11 million population of Xinjiang, also suggests a very direct fear of instability. Mao Tse-Tung wrote in World Marxist Review in 1961: “A potential revolutionary situation exists in any country where the government consistently fails in its obligation to ensure a least a minimally decent standard of life for the great majority of its citizens. If there also exists even the nucleus of a revolutionary party able to supply doctrine and organization, only one ingredient is needed: the instrument for revolutionary action.” The revolutionary party is radical Islam, spilling across China’s western and southern borders. The CCP well recognizes the parallels with Chinese history. And it has happened before. Just as the Chinese nationalists and communist forces defeated the Japanese in WWII after decades of brutal occupation of China by Tokyo's fascist rulers, the CCP is now in the position of the oppressor and the Islamist “terrorists” are the liberators. No member of the CCP who understands China’s history could fail to be impressed by this parallel. Watching the liquidation of the HNA Group, a process which we now learn from Reuters is being administered by China Development Bank, you begin to appreciate just how fragile is Beijing’s control of the economy. CDB, of course, is HNA’s biggest creditor, and it in turn is an appendage of the Bank of China. When Wang Jian, the co-chairman and a co-founder of HNA Group, “accidentally” fell off a wall in Provence, France, he was atoning for creating a scheme so gigantically absurd and so heavily leveraged that it threatened the CCP. The CCP is happy to tolerate or even encourage wealth creation, but only so long as it does not become a problem. HNA’s $50 billion debt fueled shopping spree was and is still a problem for China in 2019, but only illustrates a larger issue of national economic solidity and cohesion. Westerners may need to consider the possibility of political change in China, a process that historically has come from the periphery and moved to the center in Beijing. Offshore investors who have become enamored of the illusion of political stability in China may want to recalibrate the reality gauge in 2019. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

December 11, 2018 | Volatile markets have finally made policy makers start to fret about excessive leverage and sky-high asset prices, two results of years of equally excessive monetary policy. Former Federal Reserve Chair Janet Yellen, for example, worries from the speaking circuit about excessive leveraged lending and the level of corporate debt across Wall Street. "Corporate indebtedness is now quite high and I think it's a danger that if there's something else that causes a downturn, that high levels of corporate leverage could prolong the downturn and lead to lots of bankruptcies in the non-financial corporate sector," Yellen told New York Times columnist Paul Krugman. As with past appearances, Yellen never directly admits that some of her own policy decisions contributed to the problematic accumulation of barely investment grade corporate debt now teetering on the brink of downgrade. But she did make this remarkable concession: "Recent research has identified possible linkages between monetary policy & leverage among financial intermediaries. It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage & excessive risk-taking in the financial system." Bravo Janet. Meanwhile, the US markets continue to suffer from the mounting concerns about future economic growth and, therefore, rising credit costs. Recall that the definition of a systemic event is when markets are surprised. Most categories of new debt issuance are down double digits compared with a year ago, as shown in the table below. While Treasury debt issuance is up 15% year-over-year (YOY), corporate debt issuance is down 18% and municipal issuance is down almost as much. Source: SIFMA Notice that issuance of agency securities is also down, a result of falling lending volumes in the residential and commercial mortgage sectors. Some of the paper that might have been packaged and sold into the agency market in past years is now being retained in portfolios or sold into private deals. Note too that the issuance of asset backed securities is also down double digits for the year. When volumes in key debt markets are falling, it is a pretty good guess that asset prices will soon follow. And even as markets recoil from risks real and imagined, the benchmark 10-year Treasury bond continues to rally, forcing the yield curve to invert. There are endless swarms of experts pontificating on the meaning or not of a flat yield curve, but the obvious observation is that buying pressure on the 10-year bond remains brisk. Indeed, do observe that 2s and 10s have been rallying since early November. Last time the yield curve inverted was 2005, then as now a period with loan volumes falling and asset prices about to follow. Two years later, asset prices collapsed and banks were subject to liquidity runs regardless of the level of capital. When asset prices fall to cents on the dollar, "we were all broke for a while" as one colleague at Tudor observed a decade ago. But don't bother policy makers with facts. Witness Federal Reserve Governor Lael Brainard, who thinks that banks ought to raise more equity capital now that profits are booming and the economy is relatively stable. Sounds great, yes? But sadly Governor Brainard repeats the same nonsense about increased capital that is found too often in the world of academia. Many policy makers see punitive levels of capital as a panacea for addressing market risk. Also, many economists believe that banks should not be profitable at all and instead should simply be managed as public utilities, thus profitability is seen as a secondary concern. The only trouble with higher capital is that it makes banks less stable. Raising capital above the level needed to 1) absorb actual credit losses and 2) grow deposits reduces bank profits, thereby weakening the banks ability to fund credit losses. Provisions for credit losses come from income, not capital. Banks with weaker revenue and profits trade at lower equity multiples, increasing the cost of debt and equity capital. Eventually poor profitability leads to situations like Deutsche Bank (DB). Even as markets show signs of entering a new deflationary cycle, current and former Fed officials roam the financial landscape, talking about increased regulation and capital to solve problems of market risk that the Fed itself created with its extraordinary policies. But static piles of capital sitting safely invested in Treasury bills do not help a bank absorb losses. Big spreads and profits are what make banks like JPMorgan (JPM), U.S. Bancorp (USB) and BB&T (BBT) so stable and so highly valued by investors. Chair Yellen, for example, keeps talking during her numerous public appearances about "holes" in the financial regulatory system, but the biggest holes are intellectual, in the minds of federal regulators who don't seem to appreciate that capital is only important to dead banks and their creditors. In fact, banks like community lenders that manage credit well should be allowed to maintain less capital than their peers. Chair Yellen and Governor Brainard may eventually admit that extraordinary monetary policy increases market volatility, but the corollary to that obvious statement is more ominous. No amount of bank capital can protect financial institutions during periods of investor fear and market panic. If the US central bank is going to use the manipulation of asset prices to conduct monetary policy, then they should expect to see periods of extreme market volatility as a result. And no amount of book equity capital can save you when the bid goes to zero. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

December 16, 2018 | In this issue of The Institutional Risk Analyst, we feature an important comment by Robert Eisenbeis, PhD., Vice Chairman & Chief Monetary Economist at Cumberland Advisors. Eisenbeis raises a key question at the end of his commentary, namely whether the Federal Open Market Committee is going to run down the level of excess reserves back to pre-crisis levels. Should the FOMC refuse to allow the extraordinary levels of excess reserves to run off, then it implies the permanent nationalization of the short-term credit markets in the US by the Federal Reserve Board. Robert Eisenbeis on the FOMC: What Next? In another week the FOMC will have its final meeting of 2018 and its last with the current mix of policy makers. Already, the discussion has turned to what the Committee will do at that and subsequent meetings: Will it proceed with further 25bp increases in the target range for the federal funds rate, or will it pause? Markets appear to have priced in another rate increase in December, at least as signaled by what has happened to the short end of the Treasury curve, shown in the chart below. Chairman Powell afforded this view credibility in a speech he gave on November 28 in New York. Although the purpose of the speech was to highlight the release of the Fed’s first-ever financial stability report, he did touch on monetary policy. After noting the delicate balance between moving policy rates too fast or too slow to achieve the Fed’s dual mandate and the need to consider information contained in incoming data, he stated that, as far as current policy is concerned, “Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy….” What Powell is clearly saying is that he would be comfortable with at least one more rate increase, and this sets the stage for the FOMC’s next move in December. There are two important reasons why the FOMC will move at its next meeting. First, it has provided justification of where rates should be to be “neutral”- that is, neither too tight nor too loose with regards to slowing down or speeding up growth. Second, that justification blunts any perception that the FOMC may be bowing to political pressure from the White House when it comes to setting rates. By saying it is “almost there” and stating that further moves are data-dependent, the FOMC is setting the stage for a possible pause. And the rationale for such a pause will be contained in the Summary of Economic Projections, if the Committee does indeed decide that it has achieved a neutral policy stance. Clearly, world growth is slowing and should the slowing continue that may be sufficient to justify a pause by the Committee. The minutes of the November FOMC meeting, released November 29, reinforce the “almost there” view articulated by Chairman Powell in his speech. The minutes reveal some concern on the part of FOMC participants about the risks to inflation posed by uncertainty concerning the fiscal situation and trade policies. The Committee laid those concerns aside, however, in commenting on the path for policy, and there was agreement that “another increase in the target range for the federal funds rate was likely to be warranted fairly soon if incoming information on labor market and inflation was in line with or stronger than their current expectations.” However, some expressed uncertainty over the timing of further increases, while at least two participants expressed the view that the neutral policy stance had been achieved. The bottom line is that the minutes, combined with Chairman Powell’s “almost there” hint in his NY speech, perfectly position the FOMC for another rate increase at its December meeting, while preserving flexibility to pause at future meetings and putting some distance between the FOMC and the White House. The minutes are interesting for another reason as well, because they indicate the nature of the current state of the discussions about how future policy might be conducted once the Fed has normalized its balance sheet. That decision is shown to hinge critically on whether the FOMC decides to return to the pre-crisis regime of a balance sheet determined primarily by currency demand and a low level of excess reserves or favors instead a large balance sheet with a large volume of excess reserves. The former would imply policy exercised by small changes in the volume of excess reserves achieved through manipulation of the federal funds rate in the overnight market. The latter would imply continuing the reverse repo approach and dealing with a larger number of potential non-bank counterparties, such as money market mutual funds. It is clear from the discussion that no decision on these alternatives has been made, and the decision process is complicated by changes in how financial markets have functioned in the wake of the financial crisis. The clear message in the minutes is that this discussion is “to be continued.” The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

March 22, 2017 | The term mortgage servicing right or "MSR" generally describes a party's contractual rights with respect to servicing or controlling the servicing of a pool of mortgage loans owned by others, including the entitlement to receive servicing compensation. There are a number of risks involved with investing in MSRs, including accurately estimating the prepayment rates of the underlying mortgages and managing the related swings in valuation due to movements in benchmark securities such as the 10-year Treasury. For example, in October 2007 Countrywide recorded a write-down of nearly $1 billion on its MSR which at the time had a book value of $18 billion on a balance sheet of $200 billion in assets, meaning that virtually the bank’s entire capital position was essentially represented by the mortgage servicing asset. The largest risk facing an investor in MSRs and/or a creditor holding exposure to MSRs as collateral, however, is that the ownership of the asset may be “terminated” by a government agency or investor. This risk is binary for the parties at interest and can be particularly significant in the case of non-bank lenders and loan servicers (“seller/servicers”), because as asset managers for loans owned by third parties, the MSR frequently is the only significant asset on the company’s balance sheet. While the academic literature regarding MSRs is limited, those sources that are available most often focus on the risk to the borrower or home owner in the event of interruption. From a credit and business perspective, however, the prospect of an interruption or involuntary termination of servicing rights raises potentially catastrophic risks to counterparties and investors. This idiosyncratic risk of servicing termination is a function of both quantitative factors such as the financial performance of the seller/servicer and qualitative factors such as management, internal systems and controls, compliance and operations. Indeed, in many cases the human resources function of a seller/servicer is one of the most important internal functions in the entire enterprise. All of the federal housing agencies, including government sponsored entities such as Fannie Mae (FNMA), Freddie Mac (FHLMC), and Ginnie Mae (GNMA), have the unilateral right to transfer the servicing of loans and/or securities they guarantee. The GSEs and GNMA also have approval rights over the transfer of MSRs, again associated with securities that these entities guarantee. All three agencies have established review procedures for transfers of MSRs since the 2008 financial crisis. FNMA, for example, has published a Servicing Transfers Overview that sets forth criteria for the approval of MSR transfers. In addition, investors have consent rights to servicing sales and transfers for non-agency mortgages, but the requirements of private transfers of servicing are onerous. “As a condition to providing the consent,” notes a 2015 report by the Federal Reserve Board and other bank regulatory agencies, “investors have historically required that the buyer of the MSAs assume direct recourse liability for origination and servicing defects, regardless of whether that buyer, as the new servicer, originated the loan or caused the servicing defect.” In general, the reasons for an involuntary termination of servicing rights primarily turn on quantitative factors, in particular the financial soundness of the servicer. Virtually all of the servicing transfers seen in recent years have occurred because of financial difficulties at the seller/servicer, but the reasons for a transfer vary. In the case of GNMA, transfers are usually initiated out of concern that the seller/servicer has liquidity problems and cannot either 1) maintain timely payments to bond holders and/or 2) repurchase defaulted mortgages out of GNMA pools. In the case of FNMA and FHLMC, on the other hand, servicing transfers have been far more rare and are usually motivated by concerns about the ability of the seller/servicer to service the loans and engage in effective loss mitigation of loan defaults. It is important to understand that GNMA guarantees only the pass-through payments to security-holders, not the credit performance of the underlying loans. The loans which underlie a GNMA security are guaranteed by the Federal Housing Administration (FHA), Veterans Administration (VA) or US Department of Agriculture (USDA). But unlike the GSEs, GNMA has no balance sheet with which to fund advances to bond holders in the event that a seller/servicer suffers liquidity problems. More, GNMA cannot purchase troubled loans or MSRs, and thus the agency tends to be very proactive when it determines that a seller/servicer is in financial distress. Another reason for the GSEs or GNMA to initiate a servicing transfer is reputational risk. Negative publicity with respect to a seller/servicer can lead to reputational harm, which can have adverse effects on other lines of business, the availability of funding from counterparties and on a firm's MSR portfolio itself. Potential borrowers may be less likely to originate a loan with a firm that has had servicing issues, and in some instances reputational harm may have led some bank and non-bank institutions to leave or divest of their mortgage servicing activities. For example, in the case of Ocwen Financial (NYSE:OCN), publicity related to its operational problems and related action by the states of New York and California led to “voluntary” servicing transfers of GSE and GNMA MSRs in 2015 to other entities including Nationstar (NYSE:NSM) and JPMorgan Chase (NYSE:JPM). These transfers were actively encouraged by regulators and subject to approval by FNMA and the Federal Housing Finance Agency (FHFA). In a 2015 comment letter from the American Bankers Association to the MSR Task Force of State Bank Supervisors, the trade group noted: “If a non-bank servicer were to fail, significant questions could arise regarding the capacity of the market to financially absorb and operationalize the transfer of an unprecedented number of servicing rights. We are also concerned about the potential gaps in borrower service and borrower confusion that could occur in this situation.” The Risks of Servicing Transfers First and foremost, the involuntary termination of servicing can result in a total loss to the owner of the MSR and also cause losses to any creditors with a security interest in the intangible asset or the underlying loans. In the event of an involuntary termination initiated by one of the federal housing agencies, the MSR asset essentially disappears from the balance sheet of the former servicer, who receives no compensation from the new servicer. This potential for a total, binary loss with respect to the MSR due to a termination and involuntary transfer has negatively colored the view of these assets within the mortgage finance and credit communities. As discussed below, uncertainty as to how such a transfer process would work in the event of default of a servicer has historically made lenders reluctant to lend against MSRs or loan collateral tied to an MSR, especially for GNMA exposures. This situation has improved recently, however, with changes made by GNMA in its acknowledgement agreement. The new agreement provides some comfort to investors and lenders that GNMA “won't interfere with financiers' rights to servicing,” reports National Mortgage News, “so long as Ginnie is given all the information it needs to be sure the bond payments that the agency insures flow through to investors.” The changes to the GNMA acknowledgement agreement made at the end of 2016 have had a tangible and positive impact on how investors and lenders view GNMA MSRs. Whereas a year ago, lenders were reluctant to lend more that 50% against GNMA MSRs or advances for distressed loan servicing, today the loan rates vs GNMA MSRs and loan collateral advance rates have climbed into the 70s vs 90% for FNMA and FHLMC exposures. In the first quarter of 2017, asset-backed securities transactions using GNMA MSRs as collateral have been completed by PennyMac Mortgage Investment Trust (NYSE:PMT) and Freedom Mortgage. Involuntary termination of servicing have been extremely rare and have usually involved smaller banks and nonbank servicers that have experienced financial difficulties or failed. There have been few forced transfers of mortgage servicing by the FNMA, FHLMC or GNMA involving a mortgage servicer that was still in operation. In cases where the loan servicer encounters financial problems, however, the risk of termination rises dramatically. The Federal Reserve Board noted in a report to Congress: “Mortgage servicing is governed by regulations and contracts that can pose significant legal and compliance risks. Various federal and state agencies' rules and regulations address mortgage servicing standards, including consumer protections. In addition, the GSEs and Ginnie Mae require servicers to comply with guidelines to service loans guaranteed by those entities, while separate contractual provisions govern the servicing of loans in private-label MBS. Mistakes or omissions by servicers can lead to lawsuits, fines, and loss of income. Use of subservicers or other contractors can compound this risk. In addition, when a servicer does not comply with the standards established by the GSEs or Ginnie Mae, these entities can confiscate the servicing, forcing the servicer to charge off the value of the MSA.” “Moreover, negative publicity can lead to reputational harm, which can have adverse effects on other lines of business and on a firm's MSA portfolio itself. Potential borrowers may be less likely to originate a loan with a firm that has had servicing issues, and in some instances reputational harm may have led some banking institutions to leave or divest from their mortgage servicing activities.” With all of these caveats enumerated, however, it is important to remember that most mortgage servicing portfolios have enormous stability and considerable intrinsic value, primarily because when managed properly they throw off large amounts of cash and can thus be readily transferred in the event such action is required. Case Study: Taylor Bean Whittaker In 2002, FNMA terminated Taylor Bean Whittaker’s (TBW) status as an approved seller/servicer after discovering significant fraud in the company’s loan origination and sales practices. FNMA, however, did not formally advise Freddie Mac, its regulator, the FHA or other interested entities about TBW's termination or the reasons for the action. Indeed, FNMA instead entered into an non-disclosure agreement with TBW and then took active steps to conceal the reasons for the termination. Following its termination by FNMA, TBW dramatically increased the volume of its business with FHLMC and GNMA. By 2009 when it filed for bankruptcy protection, TBW serviced a mortgage portfolio of approximately 512,000 loans with an aggregated unpaid principal balance (UPB) exceeding $80 billion. The 2009 bankruptcy of TBW resulted in the confiscation by GNMA of an MSR representing $26 billion in unpaid principal balance (UPB) of loans. The reason for the action was that the financial failure of the entity placed GNMA at risk of default on its insured securities. In a September 2014 report, the Inspector General of GNMA noted: “The ultimate failure, of course, is the inability of an issuer to pass through payments to security-holders or to otherwise demonstrate a lack of compliance so significant as to render it unfit to maintain its nominal ownership of the MSRs. Historically, such failures have resulted in Ginnie Mae’s declaration of a default, with the accompanying extinguishment of an issuer’s rights to the MSRs and termination of approval status. In such cases, the MSRs become government property and are serviced on behalf of Ginnie Mae by a third party subservicer.” On August 14, 2009, Colonial Bank, Montgomery, AL, TBW’s insured depository, was closed by the Alabama State Banking Department. The Federal Deposit Insurance Corporation (FDIC) was named Receiver and sold the bank’s branches to BB&T (NYSE:BBT), but the FDIC insurance fund ultimately took a roughly $3 billion loss. Also, Deutsche Bank (NYSE:DB) and BNP Paribas (NYSE:BNP) together lost over $1.5 billion, due to the fraud related to TBW’s bogus commercial paper operations, which were conducted out of a non-bank subsidiary of the group. In 2010, GNMA bought over $4 billion of non-performing TBW loans out of its guaranteed MBS pools and increased its applicable reserve for losses by $720 million to prepare for anticipated losses. The Federal Housing Administration (FHA) and GNMA Mae eventually lost hundreds of millions on defective loans placed in MBS pools that were guaranteed by FHA. FHLMC lost over a billion dollars on defective loans that TBW sold it, after TBW's frauds were uncovered and the firm ceased operations. Voluntary Servicing Transfers The failure of TBW was an extreme event that involved deliberate acts of fraud, acts which ultimately saw the head of the company prosecuted criminally. The losses due to TBW, however, were actually exacerbated because FNMA did not take active steps to see that the bank’s fraudulent operations were promptly shut down by prudential regulators. In the case of the bankruptcies of both TBW and ResCap, however, the loan servicing operations that remained continued to operate in due course post-filing and, indeed, under the protection of the Bankruptcy Court, which rightly saw the MSRs and whole loans as valuable assets of the bankruptcy estate that warranted protection. Even though the housing agencies suffered losses due to the fraud at TBW, the GNMA servicing assets were eventually sold voluntarily. All of the FHA, VA and Rural Housing Services loans that were current were transferred to Bank of America (NYSE:BAC). Delinquent loans were transferred to either Saxon or Ocwen. In other cases where a seller/servicer merely encounters financial difficulties, it seems reasonable to expect based upon past experience that FNMA, FHLMC and GNMA Mae would likely acquiesce in the voluntary transfer of servicing, as in the case of Ocwen in 2015. Again, the key question in the case of GNMA is whether or not the seller/servicer was able to continue 1) making payments to bond holders and/or 2) fund the repurchase of defaulted loans. With the GSEs, the issue is a more general concern about liquidity in the context of loss mitigation activities on defaulted loans. Both the 2009 bankruptcy of TBW and the 2012 ResCap bankruptcy resulted in the orderly transfer of mortgage servicing and loan portfolios with the consideration flowing to the respective estates. Ocwen Financial Corp and Walter Investment Management Corp (NYSE:WAC) ultimately prevailed in a bankruptcy auction for the ResCap mortgage business with a $3 billion bid that topped rival Nationstar Mortgage Holdings (NYSE:NSM). Ironically, the acquisition of the ResCap MSR caused significant operational problems for Ocwen three years later. Neither the bankruptcy of TBW nor ResCap created a financial panic or broader problems in the financial markets. In both cases, the successful use of bankruptcy suggests that mortgage servicing is inherently stable and that FNMA, FHLMC and Ginnie Mae will acquiesce in a voluntary restructuring of a seller/servicer so long as 1) creditors are kept at bay via an orderly bankruptcy or receivership process and 2) the servicers have sufficient liquidity to maintain in process payments to bond holders and other creditors, in the case of GNMA, and to fund loss mitigation activities, in the case of both GNMA and the GSEs. Conclusion While the potential risk of termination of a mortgage servicing portfolio is very real, in reality the chances of such an occurrence seem to be relatively small. A big part of the reason for the remoteness of involuntary mortgage transfers seems to be the fact that all of the housing agencies carefully monitor the financial stability of the seller/servicers operating in the markets in which they operate. Also, financial problems at a seller/servicer that result in the involuntary termination of servicing rights can cause significant problems for consumers and thus has become a major area of concern for federal regulators. Preserving the value of the MSR is a key consideration in any situation where the liquidity or financial strength of the seller/servicer is in question. As a result, all of the housing agencies tend to take a very proactive approach to surveillance of seller/servicers and require voluntary transfers when necessary, especially for smaller seller/servicers. In the rare cases where a servicer has filed bankruptcy, both the courts, the federal housing agencies and federal bank regulators have worked together to achieve a smooth and voluntary transfer of servicing with consideration paid to the original MSR holder. Despite the ugly details around both bankruptcies, the cases of TBW and ResCap illustrate the fact that a loan servicing business is stable and can operate in bankruptcy. The fact that the MSR is often the most valuable asset of a seller/servicer seems to have made the federal courts and corporate creditors willing to work to achieve an orderly resolution in the event of a bankruptcy by a seller/servicer. In general, when assessing the potential risk of the involuntary transfer of mortgage servicing, it seems obvious that investors, analysts and regulators should pay close attention to quantitative factors such as the financial soundness and sources of liquidity of the seller/servicer. Another area of interest should be the management team and its ability to assess and control risks to the enterprise. Any evidence of operational problems at a seller/servicer are obviously a red flag for investors and counterparties. But perhaps the biggest issue in assessing a mortgage servicer is operational, namely whether the seller/servicer can effectively manage the compliance, training and human resources challenges in servicing residential loans. As we have seen with Ocwen and other large legacy seller/servicers including banks and nonbanks, failure to effectively manage the loan servicing process can result in fines and sanctions, public censure and reputational risk, and a cascade of events that can even threaten the ability of the enterprise to remain a going concern. The bottom line is that the most egregious example of termination of mortgage servicing rights, TBW, involved deliberate acts of fraud and criminality. Most of the other events shown in the table of GNMA terminations of mortgage servicing involved smaller banks and nonbank servicers that encountered financial difficulty and subsequently failed or were sold. In those cases where a large seller/servicer has filed bankruptcy, the transfer process for MSRs has been smooth and the rights of creditors have been protected, suggesting that outside of cases where fraud is present the overall risk to investors and creditors is relatively manageable given a surveillance program that follows the criteria outlined above. A version of this commentary with footnotes and appendices can be found on SSRN https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2936422 The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

December 3, 2018 | Last week Federal Reserve Board Chairman Jay Powell blinked and thereby changed the monetary narrative. We suspect that this is just the start of a tactical retreat by the Fed in the face of mounting evidence of financial stress. Like the sailors who traveled to the New World with Columbus, Powell said something about nearing the “neutral rate” and promptly trimmed his sails for fear of encountering a reef. That reef, dear readers, is the sudden move in credit spreads. Equities rallied and, more important, corporate bond spreads narrowed a bit last week, slowing a worrisome trend towards the repricing of credit that almost certainly implies bad times ahead. The fact of a mountain of mis-priced corporate debt has become an almost commonplace topic in the financial media. We know that bond covenants have been weakened to an absurd degree, stripping investors of assets or any legal right to the supposed security. We also know that the Fed’s manipulation of interest rates and the term structure of same has likewise distorted the pricing of risk. Yet default rates remain extremely low, begging two questions: First, how much of the downward skew in current defaults is due to the Federal Open Market Committee? Second, how quickly will credit spreads reprice, especially with a market that is tightening by the day as the Fed’s bond purchases slowly run off. Even were Powell and his colleagues on the FOMC to do one more rate hike this year and then pause in 2019, the runoff from the FOMC System Portfolio would continue to shrink the US deposit base and thereby tighten liquidity. Thus the term “quantitative tightening.” Unknown to most Fed analysts, Chairman Powell actually has a great deal of leeway in terms of the Fed’s “data driven” policy. Even with no further rate hikes, the liquidity in the US markets will continue to tighten apace. Every dollar of Treasury debt that runs off from the Fed’s books means a dollar’s worth of bank deposits disappears (H/T to Lee Alder at The Wall Street Examiner). While many economists inside and outside of the central bank continue to waffle about the need to raise rates to enhance future “policy flexibility,” a truly bizarre construct, in fact the only decision that matters today is whether the FOMC is a net buyer of Treasury debt. Ponder that. Next week we’ll be releasing the Q4 edition of The IRA Bank Book, which will delve into this phenomenon of domestic bank deposit shrinkage more deeply. Suffice to say that the Fed and Treasury are alter egos, two faces of the same fiscal ledger, so that what one manifestation of America gives in terms of market liquidity the other takes away. Thus in our day job we see core bank deposits trading at a healthy mid-single digit premium again after years of no premium or even discounts. And yes, non-interest bearing bank balances at US banks fell again in Q3 2018. With non-interest bearing deposits falling, offset of note by growing foreign inflows into US banks, the bias for US deposits overall is flat to down, as shown in the chart below. Source: FDIC Ralph on the left coast notes that the fund community is already gearing up for the opportunity to purchase busted corporate bond deals, especially the collateralized loan obligations or “CLOs” that first became famous in the financial crisis. These deals typically have a weighted average rating factor or “WARF” in single digits for “B” rated debt, meaning that if too much of the collateral in the deal is downgraded below that rating, then the covenants kick in to protect the senior debt. Ralph sees several new funds with WARFs of 50% “CCC” being created to clean up the impending mess in corporate debt. “In nutshell, the new deals are designed to allow for up to 50% CCC with no WARF test, so they will be in perfect position to be buyers of the newly downgraded CCCs that will be puked up across the whole CLO surface,” opines Ralph. Yummy. It needs to be said that out of every market contagion, great fortunes are created. But the fact of these large opportunities to profit also attracts swarms of politicians, regulators and members of the trial bar. Just as there is a great concentration of public companies around the “BBB” investment grade band, there also is a large pile of “B” rated crap inside CLOs that is just perfectly situated to slide down into “CCC” nowhere land at the right moment. Again, ponder the velocity of the transition from apparent credit ratings visible today to where they ought to be in a world without the Fed. Sound like 2008? The value of QE and "Operation Twist" in terms of option adjusted duration is an important question in this regard. The gradual repricing of risk will not only bust more than a few CLOs, but may also provide some surprises in the world of investment grade credit. Consider a home owner in CT or CA or NY who has a FICO score north of 800, seven figure income and a home that in theory is worth $5 million. At the moment, however, there is no bid near that valuation. The home has a 50% mortgage on an appraised value of $4.5 million and is being rented for less than half of the monthly carrying costs. Q: How long will the affluent home owner fund the negative carry asset? A: We’ll find out. It's called "strategic default" by the way. Q: What is the true loan-to-value ratio of this mortgage? A: Higher than 50%. Just as there is an awful lot of toxic corporate exposures inside the world of CLOs, there is also a fair amount of apparently prime credit that are, in fact, susceptible to a forced reset due to the prospect of a buyers market in residential or commercial real estate. Indeed, the current vapor lock in high end residential property reminds us an awful lot of 2005, when the real estate market began the long slide that did not end until 2012. When the loan sales volumes at WaMu and Countrywide started to fall, you could tell that the party was over. And loan volumes have been falling for years. The toggle that starts the repricing process is not merely the absolute level of interest rates but rather spreads. We know that Chairman Powell and his colleagues watch many types of market indicators, but the most important and fast moving over the past month has been the rate of change in high-yield (HY) credit spreads. The folks at the Fed may want to increase interest rates to provide increased flexibility, but they are also trying to avoid a repeat of 2016, when worries about China drove high-yield spreads through the roof. Notice that even the modest uptick in spreads at the far right side of the chart was enough to almost destabilize the US equity markets. Owing to the China syndrome in the first part of 2016, when high yield spreads rose to more than 800 bp over Treasury yields, the bond and ABS markets were basically dead for six months. Nobody on the FOMC wants to repeat that experience. In plain English, when high-yield spreads jump 20 percent in a 30-day period, you can be pretty sure that the spaceship is approaching the neutral rate. Thankfully Chairman Jay Powell noticed. Yet even his soothing words last week are unlikely to slow the exodus of investors from CLOs and corporate debt more generally. Of note, the Fed is considering big change in how it sets US interest rates, possibly targeting the OBFR instead of the fed funds rate. But what is the OBFR? The Fed tells us that, "The overnight bank funding rate is calculated using federal funds transactions and certain Eurodollar transactions." All we can say is that Europe is short dollars and always has been. When the next idiosyncratic event strikes – Italy, Deutsche Bank, BREXIT, a New Hanseatic League – look for the dollar cost of credit in Europe to spike large. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 26, 2018 | Reading the financial press over long holidays in essential. In the days immediately before or after a holiday, there are inevitably important news items that will be missed. Exhibit 1 is the festering situation in the world of non-bank mortgage finance, where a combination of excessive regulation and interest rate manipulation by the Federal Open Market Committee has set the industry on a collision course with reality in 2019. Eddie Small at The Real Deal in New York summarized the situation: “Lenders are trying to navigate the new landscape using tactics like selling their mortgage-servicing rights or lending to borrowers they would have previously overlooked. Dan Gilbert, chairman of the largest nonbank lender Quicken, told the Journal that purchase mortgages are becoming more central to the company’s business.” Let’s set the stage. Back in 2008, the FOMC opened the proverbial floodgates, pushing interest rates down to near zero and ushering in a bull market in both commercial and residential real estate starting in 2012. To give you a sense of just how far up the FOMC has manipulated home prices, the chart below shows loss given default (LGD) for the $2.5 trillion in bank-owned 1-4 family mortgages. Source: FDIC In Q3 ’18, the LGD for bank owned 1-4s was negative 15%, meaning that recoveries on foreclosed homes actually exceeded the gross amount of defaulted loans. The long-term average loss rate for bank-owned 1-4s is 65% going back to 1984. And the level of both recoveries and defaults for the portfolio is very low, below $1 billion. But both the negative level of credit loss and the low default rates are outliers that will be reversed. By engineering an artificial sellers market in real estate after 2012, the FOMC also created a huge opportunity for adept mortgage firms to make piles of money, both on mortgage refinance transactions and also by managing the vast flow of defaulted mortgages coming out of the crisis. At the start of 2012, by comparison, the LGD on bank owned 1-4 family mortgages was 94%, meaning that banks were loosing $0.94 per dollar of face amount of loan every time a mortgage defaulted. Today, with home prices now above 2008 levels, mortgage servicers are actually making $0.15 profit per dollar of the original loan amount in those rare cases where a mortgage actually goes through foreclosure. With interest rates rising and the accumulated backlog of defaulted mortgages largely (but not entirely) resolved, mortgage firms are now facing the worst of all possible worlds. On the one hand, mortgage servicing is no longer profitable for many non-banks because of the Dodd-Frank, the regulations imposed by the Bureau of Consumer Financial Protection and the 50 states. While mortgage firms are able to generate decent margins on mortgage refinancing, the cost of originating new purchase loans is over $8,000. Kroll Bond Ratings put the market into context in a recent report: “[N]on-bank lenders are experiencing [gain on sale] GoS margin compression and falling origination volumes as the industry transitions to a higher rate, purchase-focused market. For large banks, 3Q18 mortgage banking results largely mirrored industry trends with slightly better GoS margins and declining origination volumes. While linked quarter margins improved for some (JPM, WFC, HTH), margins compressed further for Flagstar (FBC), HomeStreet (HMST) and PennyMac (PFSI). More notably, GoS margins year-over-year (sometimes a better proxy given seasonality associated with the market) for all companies in KBRA’s FI Mortgage Panel were down an average of 33 bps (24%).” According to the Mortgage Bankers Association, the average pre-tax production profit for non-bank mortgage lenders was 21 basis points (bps) in the second quarter of 2018, up from an average net production loss of eight bps in the first quarter of 2018, but down 24 bps from the second quarter of 2017. Keep in mind that residential loan officers typically make 1% or more in commissions on new loans, thus the industry is still operating deep in the red on every loan originated. As lending volumes have slowed over the past several years and purchase mortgages have become the dominant loan type, the profitability of many non-bank lenders has disappeared. Unlike banks which are able to earn money from the custodial deposits related to mortgage payments, non-banks must survive on gain-on-sale of new loans and servicing fees. With the cost of servicing loans up 200-300% since 2008, however, many independent mortgage banks no longer can count on a profitable servicing book to see them through periods of a sellers market in housing, when new home purchase mortgage lending is typically unprofitable. The same market manipulation by the FOMC that has caused interest rates to fall and real estate prices to soar has also encouraged non-bank mortgage firms, which are already struggling with profitability, to sell a portion of future loan servicing fees at premium prices. New production mortgage servicing rights (MSRs) for conventional Fannie Mae and Freddie Mac loans are currently going at between 5.5 and 6x annual cash flow, record price multiples for MSRs that again illustrate the huge distortions introduced into the world of housing finance by the FOMC. Which brings us to that little pre-holiday data point. On November 15, 2018, the Government National Mortgage Association (aka “GNMA”) published a bulletin to issuers operating in that market that makes a number of changes to how MSRs are financed and sold. A few members of the industry press commented on the rule before T-Day, but by and large the mortgage bankers still don't get the joke. The memo from GNMA COO Michael Bright states: “Effective immediately, Ginnie Mae is implementing new notification requirements for Issuers engaged in certain subservicer advance or servicing income agreements, which do not require prior Ginnie Mae approval, but can impact an Issuer’s ongoing liquidity position and financial obligations. While Ginnie Mae currently permits subservicers to advance funds on behalf of an Issuer to pay security holders under the MBS Program, subservicers will now be required, upon request, to notify Ginnie Mae about such advances, including details about the frequency, amount, and purpose. Similarly, Issuers that enter into pledges of servicing income, or other transactions that encumber an Issuer’s Servicing Income, that are not subject to an Acknowledgment Agreement, must notify their Account Executive via email no later than 15 business days after the date that the transaction agreement is executed. Upon notification, Ginnie Mae may require the Issuer to provide the specific terms of the transaction, relevant documentation, or updated financial information.” The new GNMA regulations require all banks and non-banks operating in that market to disclose all past financings, sales and participations of MSRs. Why is this important? Because the ability of an issuer in the $2 trillion GNMA market to 1) pay bond holders and 2) purchase bad loans and conduct loss mitigation is crucially dependent upon the solvency of the issuer/servicer. When an independent mortgage bank “sells” part of their future servicing income to help offset current losses on lending, for example, we create a scenario where the mortgage bank is more likely to fail when 1) interest rates rise and/or 2) default rates increase. The Economics of Servicing Let’s quickly dive into the economics of loan servicing in the Ginnie Mae market, which we addressed in depth last summer in a working paper entitled “Increasing Capital & Liquidity for GNMA Mortgage Servicing Rights” last summer. Let’s assume that we have a hypothetical mortgage with an unpaid principal balance of $300,000 and a loan coupon of 5%. The typical GNMA issuer gets a net servicing fee of 32bp annually. Take 32 bps on $300k and you get $960 per year in gross servicing. Most servicers can administer a performing mortgage for $7 per month, so again 12 x $7 or $84 per year. This means that, in theory, the non-bank could “sell” the other $880 or so of the servicing income or "strip" to a financial investor like Black Rock or Apollo. But this works only if there are no problems with the loan, no need to speak to the obligor, call them or send them mail, etc. Sending out a piece of first class mail costs at least $1, for example, vs an electronic mortgage statement. The moment a GNMA loan goes delinquent, the cost of servicing skyrockets, 10x the normal cost or more, as do the fees the servicer eventually receives for fixing the loan. But all of the excess fees for servicing a distressed loan are on the back end and must be financed by the non-bank, along with advances of interest, principal, taxes and insurance required to protect the value of the home. The only cash the GNMA issuer/servicer receives each month is the 32 bps servicing fee. Thus the reason why GNMA wants to know how much of a non-bank’s 32 bps of servicing has been sold away. Remember that the full 32 bp strip is capital meant to finance operations during periods of peak defaults. Under the current practice in the mortgage industry, many non-banks have sold away more than half of their gross spread from their MSR. We hear in the channel that GNMA is considering in the near future imposing a 25bp minimum for retention of income from the MSR. Note that the annual float on the mortgage example above is in excess of $30,000 per year in a high tax state. This float can generate twice the fees that a servicer receives for actually administering the loan, but only a bank can fully capture this benefit. Note too that larger loans generate bigger servicing fees, one reason that big banks like Wells Fargo and Bank American will pay up for jumbo loans, which they often hold in portfolio. The trouble for investors in MSRs arises from the optionality regarding termination of servicing rights by GNMA, an issue that is fundamentally connected to the solvency of the issuer/servicer. Thus the new GNMA regulations provide a stark warning and also a roadmap to future contagion in the non-bank sector. Keep in mind well more than half of the non-banks in the US residential space have probably blown through their bank credit covenants due to impaired capital, poor profitability or both. The other issue for investors in non-bank mortgage firms and MSRs is participations. When a non-bank sells or finances part of their 32 bp GNMA servicing strip to a financial investor, this is most often done via a participation agreement. There is no “sale” and the mortgage bank remains the owner of record of the MSR. In the event of default, a bankruptcy trustee for a non-bank or the FDIC acting as receiver for a failed bank will likely try to reject the participation agreements that have not been fully isolated. As we noted in American Banker, some lawyers like to pretend that the current practice on Wall Street regarding loan participations is safe and sound, but in fact unless the asset is legally isolated from the failed bank or non-bank, the purchaser of participations in loans or MSRs stand at risk of total loss. It happened before in a little mess called Penn Square Bank. The FDIC repudiated all of the dead bank’s loan participations, gutting five large banks in the process and causing four (Chase Manhattan, Continental Illinois, Seafirst and Michigan National) to subsequently fail and be sold. Of the five banks most impacted, today only Northern Trust Co (NTRS) survives that default event as an independent bank. The Road to Contagion The first step toward contagion in the world of non-bank finance, as we’ve noted before, will be a liquidity squeeze that is ongoing and forcing many smaller non-bank firms out of business. Even were the FOMC to do just one more rate hike in 2018 and then wait awhile for the System Portfolio to unwind, it is unlikely that loan spreads in residential loans or other asset classes are likely to recover in the near term. In fact, so great is the concern about profitability that GNMA is meeting with the largest issuers, industry maven Rob Chrisman wrote just before the holiday: “Ginnie Mae sent a "liquidity letter" to its 14 largest issuer/servicers in late October, telling them to come up with contingency plans as the profitability picture worsens. The management teams of these 14 shops will be sitting down with Ginnie officials in early January to discuss the matter further. Ginnie also issued an all-participants memo, dictating new standards for firms seeking to become issuers, including the stipulation that applicants submit to a corporate credit evaluation similar to what the rating agencies put them through.” The industry currently has capacity to do at least $2 trillion in new mortgages annually, but volumes in 2018 will be closer to $1.4 trillion and declining – and with little profitability. We easily could see a 10% reduction in the number of non-bank mortgage firms this year and a larger downward headcount adjustment in 2019, a grim figure that suggests thousands of job losses in the world of residential mortgage finance. Step two in the Merry-go-Round of non-bank risk will be credit. The real fun is some two to three years out. This is when years of low-interest rate lending starts to mature and throw off supra-normal loss rates. We suspect that some of the REITs and Buy Side shops that have been hungrily acquiring MSRs at single digit returns may become sellers when the true cost of credit is revealed. As Mike Lau told us a few weeks back in The Institutional Risk Analyst ("The Interview: Michael Lau on the State of Mortgage Finance"), MSRs are a mid-single digit internal rate of return asset (IRR) through the credit cycle and w/o leverage. Just as credit spreads have galloped 20% in the past 30 days, we suspect that indicators such as LGDs and loan default rates for bank owned loans will also start to move pretty quickly as and when movement occurs. Whether or not home prices start to soften as quickly as credit turns across the US is really the big question. If we see loss rates for residential and commercial assets start to rise in a sustained way, then we’ll know that overheated home prices are headed for a correction. Watch those LGDs over the next year. We’ll be addressing this point in the next edition of The IRA Bank Book. Further Reading Goldman Chairman Met Privately With Fugitive Accused in Malaysian Fraud The New York Times By Emily Flitter, Matthew Goldstein and Kate Kelly A Cautionary Tale from the '80s for Today's Loan Participations American Banker By R.C. Whalen The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

November 18, 2018 | Last week in The Institutional Risk Analyst we mentioned the transition from that carefully managed reality, that “new abnormal” of the past decade, to something very unfamiliar to most investors. Over the past two months, wildfires have swept over numerous industry sectors, leaving a lot of previously expected investment returns in ashes. The real human tragedy in CA will certainly hurt economic growth, but the carnage on Wall Street also is immense and growing. Financials have taken a hit over the past 12 months, even as the benchmark S&P 500 has managed to stay positive single digits. Exemplars among financials like US Bancorp (USB) have actually stayed even with the S&P at plus single digits, but the KBW Bank ETF is basically flat for the year. In the latest edition of The IRA Top Ten Banks, we talk about why USB is the best performing money center bank in the US. And we also tell you who we believe is the weakest CEO among the top ten US depository institutions. Most of the market’s attention currently is focused on two related risk hot spots: Asia and Technology. In the case of the former the great deflation in China is gathering speed thanks to Beijing's spending and President Donald Trump’s asymmetrical trade war. As illustrated by the massive liquidation of HNA, the implosion of Uncle Xi’s paper tiger continues apace. When we say “paper” of course we are not only referring to mystical papier-mâché creatures that can be used in parades, but rather our suspicion that China’s mountain of bad debt may be imploding under its own weight. When global investor Kyle Bass says China needs a reset, he knows not how right he is this time around. Savings obsessed Japan is very different from crazy rich China under the early years of Xi Jinping. The use of leverage in China over the past decade dwarfs even American levels of fiscal profligacy. China’s banking system, for example, is twice the size of the US if you believe the statistics. “It’s insane how levered this market has become,” Bass told Reuters. “You’re starting to see bankruptcies across the board in China that are hard to hide, if you look at the corporate default rate, the bankruptcy rate, M1 and M2 (money supply), the slowest money growth in over four decades.” When you combine decades of economic mismanagement with the natural tendency of members of the Chinese Communist Party (CCP) to steal everything in sight, the obvious conclusion in that there is no equity underlying China’s economy or financial markets. Add the random factor of President Trump and the CCP is left in disarray. The “Belt and Road” initiative is alienating many important overseas relationships for China and leaves behind a huge cost in terms of bad debt, but economics is not the point. As one close observer of China joked during dinner in New York: “Think of Chinese infrastructure spending as a giant pension plan. It is literally a way to occupy people and get them out of the cities or even out of the country entirely. Profit is secondary.” Goldman Sachs: Chasing Growth Much of the risk coming out of Asia has to do not just with economic slowdown but also plain vanilla fraud. Consider the 1 Malaysia Development Berhad (1MDB) scandal involving Goldman Sachs (GS), which has seen its common shares drop double digits for the year and now trades comfortably below book value. Vampyroteuthis infernalis The 1MDB scandal features Malaysia's former Prime Minister Najib Razak and "financier” Jho Low and is Exhibit A for the Age of Credulity scrapbook. As with highly leveraged conglomerate HNA, nobody had any idea as to the origins of Low or where the money came from or was going. Somehow GS raised another $6 billion from investors to support this apparent act of fraud against the Malaysian state. We can’t help but wonder if GS, the organization famously dubbed the “vampire squid” by Rolling Stone’s Matt Taibbi, knew about the assistance one of its partners gave to Mr. Low, contrary to what former Goldman Sachs CEO Lloyd Blankfein suggests. Or maybe they did not want to know. And here's our question: Did Blankfein step down as Goldman CEO in anticipation of the 1MDB blow-back? Like Citigroup (C), which suffers periodic breakdowns in its internal controls related to the offshore venues where it does business, Goldman is also known for regular operational risk events. And chasing growth in Asia, to paraphrase Blankfein, is an ideal way to get into big trouble. That noise factor, the near certainty that both Citi and Goldman will trip up when it comes to operational risk events such as fraud and money laundering, seems to keep these names trading at a discount to less exciting peers like USB. We could tell you a story about John Reed, Citibank Private Banking and Raul Salinas de Gortari in Mexico, but we digress. Ben Walsh at Barron’s writes: “[T]he bank has warned that the investigation could result “in the imposition of significant fines, penalties, and other sanctions. Whether or not Goldman is penalized, the 1MDB scandal is a huge setback to its campaign to repair its public image after the financial crisis.” Agreed. But we wonder, regarding Q4 earnings, whether GS will be forced to take a reserve for the cost of cleaning up this mess, including the return of $600 million in ill-gotten investment banking fees? To us the bigger question is whether the new CEO David Solomon, who headed the GS investment bank, will survive the 1MDB scandal. No matter how you cut it, the answer to the key question to Goldman Sachs of why didn’t you know about the relationship between Goldman Asia banking head Tim Leissner and Jho Low is unsatisfactory. Whether the answer is (1) a breakdown in systems and controls or (2) a failure to supervise, Solomon must ultimately shoulder the blame for failure to supervise one of his key managers and direct reports. Goldman Chairman Blankfein says that Goldman investment bankers “evaded our safeguards, and lied—stuff like that’s going to happen.” Really? Bank holding companies and broker dealers subject to Fed and FINRA supervision, respectively, are supposed to have systems and controls in place that prevent employees from evading safeguards. Blankfein telling us “that’s going to happen” is an absurd response. The risk facing Goldman is very similar to the situation at Wells Fargo & Co (WFC), where the board of directors failed to take action for more than a year in the face of clear acts of fraud. Given that Solomon was the manager of Tim Leissner, it seems difficult to envision a pathway for the GS board that does not involve Solomon stepping down. At the very least, the SEC, Fed and other regulators will need to extract a pound of flesh from Goldman Sachs a la Wells Fargo to atone for what seems like a truly ugly example of management failure. Spreads Widen, Deals Slow Meanwhile in the world of emerging technology and high yield debt, the great deflation being led by the Federal Open Market Committee is starting to show a modest upward impact on credit spreads. Some names are doing better than others. Deal flow is starting to suffer as a result. Members of the financial punditry will fashion endlessly ingenious explanations for why tech stocks are cheap – and getting cheaper -- yet the simple fact is that rising rates will sink many speculative stories in the debt and equity markets. For example, even with all the "good" news of the past several weeks, Tesla Motors (TSLA) 5.3s of 2025 trade + 475 bp to the 10-year Treasury bond. This puts TSLA on the wrong side of “B” in terms of ratings breakpoints even after a remarkable rebound for the stock since October 8th when it was down 20% for the year. Of note, the FOMC seems perfectly content to crater the market for leveraged loans and collateralized loan obligations or “CLOs,” an acronym you unfortunately want to remember. A key indicator of rising investor caution, namely credit spreads, are starting to widen, as shown in the chart from FRED below. From a low of 316 bp back in early October, the ICE BAML high yield index has widened more than 20% to 400 bp over the Treasury yield curve. That is a very rapid change. As and when this indicator gets to 450 bp or higher, that is a danger signal for both market contagion and economic recession. Deal flow stops when spreads widen too much too fast. When high yield debt spreads get near 500 bp over the Treasury curve, financing activity for speculative firms essentially stops and related bank lending will follow that example. Of all of the time series and indicators that the FOMC can watch, high yield and corporate credit spreads are the most relevant. Rising high yield spreads will accelerate the reckoning in leveraged loans and CLOs. The temporary redemption of Elon Musk’s little science project at TSLA, however, cannot reverse the overall market gloom due to the fall of Facebook (FB) one of the big tech beneficiaries of the irrational easing of the FOMC. Going back to 2012, FB is still up more that 330% vs last week’s close – this at a time when the economy was barely growing. But over the past quarter, the stock has moved sharply lower, from up 20% in the first week in July to down a like amount last week. Idiosyncratic Risks The negative factor weighing down GS, FB and TSLA, however, is idiosyncratic risk coming from the CSUITE. In the case of FB and TSLA, these two publicly owned organizations have founder risk. Both have reached the point in their development where a transition to a more stable and competent management team could benefit shareholders. But an exit by either Musk or Zuckerberg could crater each stock. Goldman Sachs, on the other hand, may be in serious jeopardy because of its big dependence upon risky investment banking revenue. GS is a compliance violation disguised as a going concern. Bankers always evade. Or as Richie Metrick, COO of the investment bank at Bear, Stearns & Co was famously known to say about bankers: “If their lips are moving, they’re lying.” JP Morgan & Co (JPM) was known a century ago as “The Octopus.” Goldman Sachs is merely a squid. That is, fish bait. JPM has trillions of dollars in core deposits, while Goldman has yet to bank the first $100 billion in stable cash funding. GS is too small to be credible as a commercial bank and ranks just behind the largest universal bank, JPM, in the overall global league tables for deals. In the world of deals, GS is pursued by Barclays, Merrill Lynch, Morgan Stanley (MS) and Credit Suisse (CS), among others. But in the next few weeks and months, Goldman’s fate may rest on how it extricates itself from the 1MDB mess, a when not if proposition that we think could be visible in Q4 earning for GS. The eventual cost of salvation may include disgorgement of the $600 million in fees, appropriate fines and penalties, and perhaps the departure of both Blankfein and Solomon. But atonement in the world of investment banking is, as the Economist wrote in 2002 about the WorldCom scandal, “a worrying process whose end still seems a long way off.” #GoldmanSachs #VampireSquid

November 14, 2018 | Last week in response to popular demand we published our first Top Ten List for the largest US lenders. We noted that credit performance for the top institutions is pristine, but we also noted that spreads on loans and securities remain extremely tight, discouraging lenders in high-cost markets in such sectors as residential mortgages and even multifamily lending. This seems to be the paradox of the post 2008 markets: credit underwriting standards are better, but the profitability of originating assets is minimal and cash flow coverage is stretched, suggesting serious problems ahead that will cause loan and bond default rates to rise. The present situation in the financial markets reminds us of our favorite quotation from “A Tale of Two Cities": This week we got to hear FDIC Chairman Jelena McWilliams talk about current market conditions at a bank conference sponsored by Kroll Bond Rating Agency. Taking a page from “A Tale of Two Cities,” McWilliams said it is “the best of times” but noted that regulators need to work with banks to make the cost of compliance balance with the size and resources of the bank. Chairman McWilliams then made a comment on credit conditions that could easily be applied to the equity markets as well: “There has not yet been a single bank failure this year but as you all know that is not normal. We are in abnormally good times. Usually we have three or four bank failures per year. That happens and it is a normal part of the business cycle. We have been in what I like to call the best of times this year. This is the new abnormal. At some point we will get back to normal.” What is most striking about Chairman McWilliam’s comments is that they could apply to many sectors of the debt and also equity markets. The premium pricing seen for many assets and, as one reader put it so well, the “velocity of collateral” moving through the financial system, makes us wonder if the target for the next crisis has moved from asset quality to the operating and market stress caused by excessive competition on price. The impact of an abnormal market on many normal businesses is profoundly negative. We note from the banking channel that while there may not have been any bank failures this year, there are certainly a lot of smaller banks for sale at the present time because these businesses simply do not make money. The rising cost of regulation and compliance has likewise raised the bar in terms of the minimum size of a bank that can be economically viable. To give you some idea of the scale of cost increases for the industry, the direct cost of servicing a performing mortgage loan in the US is about 15 basis points (bp), according to The Mortgage Bankers Association, or half of the income from the gross servicing strip. A decade ago the cost to service a performing residential mortgage was closer to 5 bp. With rising operating costs and horrible execution on the loan origination and secondary market sale, many banks have decided to flee residential lending. Meanwhile in the market for multifamily and commercial construction and finance, there are growing signs of stress due to years of abnormal markets c/o the Federal Open Market Committee (“FOMC”). We heard Eric Thompson, Senior Managing Director of the Real Estate group at KBRA, remark at the same conference that “interest only” mortgages are now all the rage in the market for commercial mortgage backed securities or CMBS. In the brave new world of Dodd-Frank, lower loan to value (“LTV”) ratios are supposed to protect lenders and investors from shoddy underwriting, right? But nature finds a way. A case in point regarding the new abnormal is New York City multifamily. Andrew Dansker, a first vice president of finance at Marcus & Millichap, writes in The Commercial Observer about the combination of historically low capitalization or “cap” rates and low interest rates: “Because of these underwriting constraints, and the low loan-to-value ratios that they imply for low capitalization rate deals, almost every acquisition made in New York City in the past five to 10 years has a loan which was underwritten to a maximum size based on the ratio of available cash flow to the cost of the debt. The low leverage points make these deals appear to be conservative, but they are actually very aggressive on current cash-flow underwriting standards.” The moral of the story is that asset prices are high, abnormally so, but so is the cost of acquisition and construction. As interest rates rise, deals that seemed “normal” three or four years ago based upon cash flow coverage of debt may no longer work at higher interest rates. And the same logic that suggests that there is trouble brewing in the commercial real estate sector also applies to leveraged loans and collateralized loan obligations or “CLOs.” One of the most interesting and frightening aspects of the great normalization is the way in which the earlier machinations of the FOMC, which were supposed to help the economy, have now become a gale force headwind in terms of both liquidity and credit. Rising interest rates, for example, are pushing many obligors over their debt covenants with lenders. Meanwhile, regulators are downgrading these cash flow stressed exposures, making lenders far less inclined to roll the credit. And tenants are pushing back on sky high rents, further hurting the cash flow and ultimate viability of new projects. The collective effect is a reduction in liquidity that will result in higher defaults in commercial real estate. As the market for luxury multifamily properties in New York and other major metros around the US rolls over, look for sponsors to seek renegotiated terms on loans, a dangerous strategy that can get the credit flagged by auditors and regulators. But a more likely outcome is that lenders will refuse to renew these credits, notes Dansker, “forcing the issue into the arms of borrowers.” He concludes: “Whatever course of action is chosen, it seems we are poised to see a rise in transaction volume in the coming year. Investors should be ready to transact either with banks or with owners opting to sell instead of recapitalizing their holdings.” The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

November 4, 2018 | When we first heard news reports about a new investor in Deutsche Bank (DB), we of course assumed that this meant the purchase of new shares and thus an increase in capital. But no, it was merely an “activist investor” taking a stake in existing shares. Is this really news or merely a sign of a top in large bank stocks? The DB common is trading a hair over $10 or just 0.3x book value and has a beta of 1.5. Douglas Braunstein, founder and managing partner of Hudson Executive Capital and J.P. Morgan's (JPM) former CFO, said in an interview with CNBC that the firm has taken on the stake over the last few months after studying the stock for a year. We’ve been following DB for a lot longer than that and have great difficulty constructing a bull case for the name. But let’s take a look anyway. First on the list of concerns is profitability. DB has been struggling for years to find a business strategy to deliver consistent profitability, the key measure of stability for any bank. Through the first nine months of the year, DB delivered net income of less than a €1 billion compared with €1.6 billion a year ago. For the full year 2017 the bank lost €750 million. As yet, no one on the management team – if we may so dignify DB’s executives – have been able to articulate a coherent plan to move forward. Second is capital. DB has just €61 billion or 4% capital to total assets of €1.5 trillion, one of the lowest simple leverage ratios of any major bank worldwide. The bank tries to hide this capital deficiency behind calculations that exclusively use “risk weighted “assets” of just €354 billion. In the bank’s non-GAPP disclosure, there is just €54 billion in tangible capital disclosed for a leverage ratio closer to 3%. In the Q3 ’18 earnings call, when CEO Christian Sewing said that “we committed to conservative balance sheet management and maintaining a CET1 ratio above 13%,” he was referring to risk weighted assets, not total assets. If one assumes that the entire Basel III/IV framework is a confused mess when it comes to describing risk, then the leverage ratio is what matters. Risk weighted assets is a way to pretend that the rest of the banks in Europe and Asia are solvent. To be fair to DB, most European banks play the game of only referring to “risk weighted assets” in their financial disclosure to investors. The EU bank regulators are entirely complicit in this charade. Indeed, since the end of 2017 DB’s total capital has actually fallen 4%. The last major infusion of capital for DB came from the generous folks at HNA, who are in the process of liquidating their debt financed empire at the behest of Uncle Xi. Regulators in the EU and US never asked about the source of the funds provided by HNA nor the beneficial ownership of the Chinese firm. Since the initial investment was raised to almost a 10% stake in 2017, HNA has been a distressed seller, partly because so much of the investment seems to have been funded with debt. The third key concern among a far longer list of questions is the franchise. The DB supervisory board has shown no vision when it comes to focusing the bank’s business on more profitable areas. DB is more a securities firm than a bank. It does not have a strong banking franchise in Europe and has a mediocre investment banking and capital markets business in London and New York. Ranking eighth in the league tables after Barclays (BCS) and above Wells Fargo & Co. (WFC) in total deals YTD, there is no sector where DB has a commanding presence in either capital markets or investment banking. Like JPMorgan (JPM) and Citigroup (C), less than a third of DB’s book is allocated to loans, reflecting the bank’s focus on trading and derivatives. The bank does have a strong position in commercial real estate in the US, but the greatly stretched valuations in that sector do not inspire confidence about future loan and securitization volumes. Notice, for example, that the bid for agency RMBS had largely disappeared in the US. Spreads are set to widen as the year-end approaches. Sewing says that “Our principal near-term target is to reach a return on tangible equity of more than 4% next year.” Such a goal is relatively bold given the parlous state of the banking industry in Europe, but DB’s US peers have equity returns well in excess of twice this level. Perhaps more frightening is Sewing’s intention to “deploy part of our capital into our business,“ something that DB has never done well. The ill-fated investment in the Postbank, for example, is currently being restructured at a cost of tens of millions of euros as the bank seeks savings by merging the two entities. So will DB have a negative surprise for investors in Q4’18? As Sewing said during the conference call: “I'm well aware of Deutsche Bank's history of negative surprises in the fourth quarter, and we are absolutely determined to not repeat this.” But even without any drama, the fact remains that cost cutting of various types is the predominant activity at DB this year and in 2019. Investors can expect another couple hundred million in restructuring charges in the fourth quarter, although DB management is telling investors that overall charges could be well below original estimates for 2018. But the big challenge will be increasing revenue through the enterprise, for example by moving several hundred billion euros earning negative 40bp at the Bundesbank into other, more remunerative activities. DB executives point to such accomplishments as taking share in the market for leveraged loans, a sector we can be pretty sure will figure prominently in the next downturn in the credit cycle. Despite the happy talk coming from senior management about deploying capital prudently, the fact is that DB does not have a lot of options when it comes to new business outside of a low-quality capital markets business. Putting scarce capital into growing market share in leveraged loans and collateralized loan obligations (CLOs), for example, strikes us a distinctly unattractive right now. But the fact is that for the past decade or more, DB has made a living of sorts by structuring crappy assets that other banks will not touch. The legal and reputational risk from these activities have been enormous. As CEO Sewing told investors: “[w]e are seen as one of the better banks in this business and, therefore, we see increasing volume.” Wunderbar! Later this week and by popular demand, we will be launching our second publication, The IRA Top Ten Banks, which will focus on the ten largest US commercial lenders. Stay tuned for updates! The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

November 19, 2018 | The Institutional Risk Analyst is pleased to announce the publication of The IRA Top Ten US Banks, a quarterly look at the ten largest commercial banks in the U.S. Copies of the The IRA Top Ten US Banks report are available for sale via our online store. In this inaugural issue of The IRA Top Ten US Banks, we profile the financial performance of the ten largest depositories in the U.S., all part of the 119 banks above $10 billion in total assets that are included in Peer Group 1 defined by the Federal Financial Institutions Examination Council (FFIEC). Below are the banks that are included in the report: Source: Board of Governors/FFIEC You will notice that we have excluded Bank of NY Mellon (BK) and State Street Corp (STT) from the list. This is because these institutions are more in the business of custody and data processing than credit. You also do not see Goldman Sachs (GS) or Morgan Stanley among the top ten, this even though the consolidated assets of the parent companies put them into the top of Peer Group 1. The total bank assets of GS and MS are still less than 20% of the total assets of the parent holding company, a reflection of business models that are still predominantly focused on securities dealing (and related bad acts) rather than banking. Below are some basic metrics that illustrate the different business models of the top ten banks. Notice that the largest banks have far less than half of their total assets in loans, again reflecting the diversity of business models that includes securities dealing and wealth management. Source: Board of Governors/FFIEC The first thing to notice about this list is the ways in which the largest US banks diverge in terms of business models. The highest return on assets (ROA) among the group is Capital One Financial (COF), a below prime credit card issuer and consumer lender. Next in terms of ROA is U.S. Bancorp (USB), our long-term favorite among the top five money centers because of the strong earnings, solid funding and business stability. Notice in particular that the USB’s cost of funds at just 0.32% is one third of the peer group average of 1.42%. This is a reflection of the large escrow and other non-interest bearing balances that are the core of USB’s consistent profitability. Another important observation is that JPMorgan (JPM) and Citigroup (C) have less than 40% of total assets in loans, again a reflection of how the universal bank business model differs from more traditional domestic commercial banks. Even Wells Fargo (WFC) and Bank of America (BAC), which are largely domestic, have barely half of total parent company assets deployed in loans. But as we proceed down the list, from USB on in terms of total assets, the proportion of loans to total bank assets is well more than half. Among the top banks, the highest net default rate comes from COF due to the credit card and consumer loan books, followed by Citi, JPM and USB. Notice that USB has more than 80bp better return on its loan book than JPM. And none of these loan spreads are particularly impressive when you remember that the machinations of the Federal Open Market Committee have resulted in the systemic underpricing of risk over the past decade. Just as we think that the twin idiocies of QE2-3 and Operation Twist have understated the 10-Year Treasury by a point in yield, we suspect that commercial and consumer loan yields are off by a like spread vs the Treasury benchmarks. Another observation that needs to be made is the enormous difference in the number of physical branches among the top four banks. Notice that Citi had just 704 domestic branches, but almost 175 offshore. More than two thirds of Citi’s total deposits are offshore and uninsured. While Citi has the second lowest cost of funds among the top ten banks after USB, it is for very different reasons. Citi has a huge float from its global payments business and also manages its institutional funding base astutely, but the results in terms of ROA are still disappointing. Even with a gross yield on its loan book almost 200bp above its peers, Citi’s overall results measured by asset and equity returns are still mediocre. Finally, by subtracting net loan losses and funding costs from gross loan spreads, we generate a nominal return for the lending book for the top ten banks. While these metrics differ from the official stats published (or not) from these respective issuers, they do allow for a comparison of the cash returns on credit extensions from the different banks. Suffice to say that while COF and C may top the list in terms of nominal returns, were we to risk-adjust these figures both of these banks would quickly fall to the bottom of the list. And more importantly, in terms of growth, the biggest share of value creation is toward the bottom of the list among the smaller institutions. Indeed, since 2015 the number of banks above $10 billion in total assets has grown from 93 to 119 today. Copies of the The IRA Top Ten US Banks report are available for sale via our online store. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.