"When we get piled upon one another in large cities, as in Europe, we shall become as corrupt as Europe." Thomas Jefferson August 11, 2017 | When William Clay Ford Jr., Chairman of Ford Motor Co (F), fired CEO Mark Fields earlier this year, he in part confirmed the view expressed in our book “Ford Men: From Inspiration to Enterprise,” that figuring out which supposed techno trend to believe (and invest in) will be a challenge. After surviving the automotive equivalent of nuclear winter in 2008-2011, Ford and the rest of the auto industry rebounded nicely in terms of sales and profits, peaking last year at 18 million units sold in the US. But beyond next quarter’s financial results, every leader of every major global automaker is worried about one greatly glorified word: mobility. “If there’s one takeaway from Ford ditching Fields,” concludes Wired magazine, “it’s that in our current transportation environment, ‘mobility’ isn’t so much a strategy as it is a euphemism for ‘we have no idea what’s happening next.’” Bill Ford recently told The Wall Street Journal that his company lacks vision, but he’s going to fix it – by bringing in yet another new Ford Man, Jim Hackett. We warned in “Ford Men” that Fields was starting to sound like Jacques Nasser, a view that turned out to be prescient. But Bill Ford’s prattle about vision also sounds like some of his ill-considered comments about safety and the environment of a couple decades ago. For long-term observers of the auto industry, this leadership transition at Ford Motor Co. raises concerns, in part because of what it says about the Blue Oval in a period of technological consolidation. We worry that Ford’s board of directors clearly liked the style of leadership under former CEO Alan Mulally, but still does not fully trust Bill Ford, especially given the widespread confusion over how to deal with the challenge of “mobility.” Alan Murray wrote for Fortune in May 2017: “Mark Fields’ ouster as CEO of Ford yesterday is another example, if anyone needed one, of just how hard it is to lead a company in the midst of disruptive change. The auto industry is actually riding the waves of three separate disruptions, all at the same time: electric engines, ride sharing, and autonomous vehicles. Fields enthusiastically embraced all three, investing in a Silicon Valley research center, becoming a regular at the CES tech fest, and talking of making Ford a ‘mobility company,’ with one foot firmly in the present and one boldly in the future. But shareholders weren’t buying it.” The mainstream auto business is being distracted by a growing number of irrational players and attendant consultants. The most obvious of these is Tesla (NASDAQ:TSLA), the love child of serial entrepreneur Elon Musk, who has spent billions pursuing the dream of an electric car powered by a battery with little hope of generating a profit. TSLA is in the high yield market even now borrowing another couple of billion, funds which will cover well less than a year of the company’s prodigious capital burn rate. TSLA cars are heavily subsidized by US taxpayers and are not especially green either, especially when you consider the manifold inputs needed to make these pricey toys for wealthy car aficionados. There is no question but that DC motors powered by the appropriate generator are the best way to propel a train or a ship, but using batteries to power an automobile is a strikingly retrograde development. As we note in "Ford Men," a century ago Thomas Edison was fascinated by battery powered electric cars, but ultimately advised Henry Ford to use gasoline as a power source. But specific to the idea of mobility, there are a growing number of players outside of the auto industry that have decided to ride a wave of changing consumer preference when it comes to how people use transportation. These new entrants to the world of conveyance include global limousine network Uber, online search engine provider Alphabet (NASDAQ:GOOG) and computer giant Apple (NASDAQ:AAPL). None of these names have any competency in manufacturing cars and trucks, but all are attracted by the relevance and potential audience for mobility worldwide. The tech incursion into the auto sector marks a strategic attack by one industry against another in a contest for consumer attention. Like TSLA, AAPL, GOOG and Uber are not particularly focused on making a profit – thus providing a serious problem for F and other incumbent automakers. The culture of growth that surrounds all of these new economy interlopers does not require profit – only liquidity and, for the profitless, a steady supply of greater fools. This is the economic environment defined by a growing list of money eating global monopolies – Amazon (NASDAQ:AMZN first and foremost -- that are managed for expanding market share rather than operating income and equity returns. Part of the “collateral damage” from the Fed’s zero interest rate policies (referred to by economist Paul McCulley in a past IRA comment) is that investors how readily accept the idea of deploying capital into big, new ventures with no expectation of income or even the immediate return of principal. GOOG and AAPL spend billions of shareholder cash annually pursuing various speculative notions, while TSLA spends both equity and the proceeds from debt raised with its “B“ junk credit rating. But investors don’t seem to mind. The fact of growth drives valuation ever higher. How does Bill Ford or any sane leader in the auto industry plan strategy when surrounded by seemingly irrational competitors such as these? One of the interesting threads driving the mobility narrative in the auto industry is the idea that everyone is moving into the revived inner cities and fleeing the suburbs. Retailing clearly is in a state of apocalypse, but in part because of a huge surfeit of retail space built with cheap money. The debt placed upon the major retailers and their commercial real estate was “crazy”, to paraphrase retail expert Howard Davidowitz, “built by the lunatic ideas for growth led by Wall Street.” The other factor in the deflationary spiral in commercial real estate for retail is AMZN, which is leading the world in online fulfillment for consumer purchases. But is it really the case that the suburbs are being abandoned? We spent some time with our friends at CoreLogic recently, specifically deputy chief economist Sam Khater, who has done a lot of work on trends in population and pricing for residential housing. No surprise, Sam confirms that house prices in the outer rings around major cities have displayed more weakness than cities. He also notes that prices in the cities and inner suburbs have skyrocketed in recent years. But do these data points necessarily suggest that we are headed for a sharing economy where we’ll never own a car or go to a suburban mall or own a single-family home or travel long distances by car? What Sam’s work does suggest is that prices in the outer rings around major metros are starting to accelerate after years of under-performance. He also identifies some interesting areas of risk for lenders, investors and loan servicers (aka “asset managers”) involved in consumer lending for things like homes, automobiles and other significant credit exposures. The weakness of home price appreciation (HPA) in the outer bands around major cities could support a couple of conclusions: High HPA in cities will intensify the relative attractiveness of the outer suburbs, causing an acceleration of the long-term shift in populations that is already underway. Households with lower incomes and with young children will continue to be attracted to the relatively lower cost and greater living space of suburban housing, but will also face the cost of commuting into the city center for work and to access services. Lower price appreciation in the suburbs means less equity accumulation for home owners and thus higher spatial income inequality compared with inner city households. CoreLogic shows that HPA in outer suburbs is half the rate of cities. Changes in home buyer behavior, such as the shift to a multi-family model in heretofore single family communities, suggests pressure on outer suburban localities in terms of zoning and taxes. Lending to lower income borrowers in urban areas has fallen dramatically since 2008, one side effect of the Dodd-Frank legislation, forcing many potential home owners into rentals. These households are not able to purchase a home, meaning that they will not even be able to participate in the increase in urban home prices. The low income share of suburban home purchases is slowly rising, but still trails the overall rate of lending to all home buyers. For lenders investors and managers, the movement of less affluent populations to the suburbs suggests that the credit profile of these geographies will decline accordingly. To paraphrase Sam: “The credit risk gradient is shifting to the suburbs.” Whether the household is in a home with a mortgage or a rental, the changing demographic of the suburban dweller will be of concern to investors in mortgages and REITs specializing in residential rental properties. And for the car industry? The future is unclear. Bill Ford apparently shot long time Ford Man Mark Fields because of F’s slumping share price vs. aspirational and irrational competitors like TSLA, GOOG and Uber. AMZN will probably get into the mobility game too at some point. But the bigger problem at Ford is that the board of directors still does not have confidence in either Bill Ford or the incumbent management culture. John Baldoni wrote in Forbes: “When a company hires from the outside it is an acknowledgement that things are not working well. What the board is really saying to senior management: “We don’t trust you guys to run the company.’ No matter how you spin it, bringing in a new CEO is a slap in the face to the people already there.” For our money, we think Bill Ford ought to focus on making cars and leave the vision thing to the markets. And Jim Hackett may turn out to be a great CEO, whether he’s got the idea on mobility or not. If Ford and the other automakers listen carefully (and ignore the consultants), their customers will inevitably tell them what type of mobility solution is required for their needs. Those families rotating out to the suburbs will all need wheels, whether powered by gasoline, hybrids or batteries, private car or public transportation. But for investors focused on housing, no matter how you cut it, the dramatic trends in HPA and demographics already suggest big changes in the years ahead. The wall of hot money created by the Fed has so inflated urban commercial real estate values from London to New York to Hong Kong that the repricing of housing is likely to drive many low income households out the cities for good, what one activist likens to “ethnic cleansing.” Mobility, at the end of the day, is a trend that favors the most affluent members of our society. #Ford #GOOG #Tesla #mobility #housing #retail #ZeroHedge #AAPL

"It is not down in any map; true places never are." Moby Dick Herman Melville August 7, 2017 | News reports that prosecutors have dropped their case against Bruno Iksil, the former JPMorgan (NYSE:JPM) trader many know as the “London Whale,” comes as no surprise to readers of The IRA. Iksil, who resurfaced earlier this year, has been living in relative seclusion in France for the past few years. In previous comments posted on Zero Hedge, we dispensed with the notion that the investment activities of Iksil and the office of the JPM Chief Investment Officer were either illegal or concealed from the bank’s senior management. The fact is that Iksil and his colleagues at JPM were doing their jobs, namely generating investment gains for the bank. The outsized bets made by the “whale” in credit derivatives contracts resulted in a loss in 2012, but the operation generated significant profits for JPM in earlier years. As veteran risk manager Nom de Plumber told us in Zero Hedge in 2012: “This JPM loss, whether $2BLN or even $5BLN, is modest in both absolute and relative terms, versus its overall profitability and capital base, and especially against the far greater losses at other institutions. In practical current terms, the hit resembles a rounding error, not a stomach punch. As either taxpayers or long-term JPM investors, we should be more grateful than sorry about the JPM CIO Ina Drew. If only other institutions could also do so ‘poorly’………” When JPM and other large banks began to implement the Volcker Rule after the passage of the 2010 Dodd-Frank law, the activities of Iksil and his colleagues in New York began to come to light. Principal trading, which is now outlawed by the Volcker Rule, creates enormous opportunities – and conflicts -- for banks that act both as traders and lenders. We wrote in ZH in 2012: “[D]ear friends in the Big Media, it is time to get a collective clue. The real problem with CDS trading by large banks such as JPM is not the speculative positions taken by traders like Bruno Iksil, but instead the vast conflict of interest between the lending side of the house and the trading side, whether the trader is on the arb desk or, in the case of Iksil, working for the CIO trading for the bank’s treasury.” When caught in the act, the bank naturally cast Iksil’s activities as being somehow illicit and against company policy. But in fact his trading activities had been understood, blessed and even directed by the JPM’s senior management going back years. Far from being a hedge for other exposures of the bank, in fact the strategy of the CIO’s office was to generate returns as the bank’s internal hedge fund. When as early as 2010 discussions reportedly occurred about “hedging” Iksil’s illiquid credit derivative positions, presumably those involved understood that this was a risk position taken as part of a deliberate investment strategy. That Iksil apparently believed that he could not be bullied by other counterparties because of the fact of trading for JPM speaks to how he viewed his activities, which were entirely visible to other market participants. The JPM CIO’s office under Ina Drew ran an active trading strategy, making markets around positions on a continuous basis to provide live valuations and generate short-term returns. The fact that big banks no longer trade their investment books illustrates the diminution of liquidity that has occurred since the adoption of the Volcker Rule. But for the banks, the legacy of the London Whale and the larger implementation of Dodd-Frank has left a deep mark on risk managers and those concerned with maintaining internal systems and controls at large banks. But now Iksil has accused JPM's Chief Executive James Dimon of laying the ground for what was eventually a $6.2 billion loss, Reuters reports. In an account on his website, Iksil also blames senior executives at the bank for the investment strategies that led to those losses. Iksil’s account now sounds an awful lot like what we heard from his former colleagues in New York some six years ago. At the time, JPM’s counsel had already mandated the elimination of the managers and traders in the CIO’s area as part of implementing the Volcker Rule, leading to a number of redundancies in New York. We know about the Whale because of the implementation of the Volcker Rule. But the key event that broke the scandal open was the public statement by Dimon, this in response to persistent press queries from The Wall Street Journal and Bloomberg News, that the rumors of losses in the CIO’s office were “a tempest in a teapot.” But for the public statement by Dimon, which required additional clarification and disclosure, the activities of the CIO that might otherwise have been dealt with in the fine print of JPM’s earnings release. Instead, JPM was forced to not only enhance disclosure of the CIO’s trading results, but then went through a firestorm of congressional hearings, regulatory questions and litigation that continues to this day. We recall sitting in the analyst presentation at JPM’s HQ dealing with the London Whale as Ken Langone glared at the assembled audience of Sell Side analysts. In his congressional testimony, Dimon attributes the bank’s loss to a modeling error, but in fact the exposure was simply ignored. Notice that at no point has the financial media or regulators questioned the company line about what actually happened and when. Iksil’s statements seem to take us back down that road and, specifically, to suggest that senior management at JPM was actively aware of the strategies taken by the CIOs office years before the big losses occurred. Our old pal Nom de Plumber commented over the weekend: “In the end, the London Whale disaster reflected the mis-marking of generic Index CDS trades, which then-CFO Doug Braunstein ignored. The problem was not complex risk modeling or market risk measurement. The quants tried to re-jigger VaR measurement of the trades, to avoid breaching risk limits-----for CIO trades which Jamie specifically demanded of Ina Drew......regardless of preceding protests from risk managers like John Hogan and Robert Rupp.” Nom de Plumber tells The IRA that Ina Drew was essentially running a hedge fund directed by Dimon and other senior managers, a fund that was largely kept outside of the bank’s risk management and reporting procedures. Consider the bizarre situation in 2011-2012 when counterparties of Iksil facing the JPM commercial bank were unable to make margin calls, but the JPM investment bank was making margin calls on these same counterparties for positions in the very same indexed credit derivatives. Bruno Iksil has waited for the proverbial concrete to harden over the past few years before coming forward with his latest accusations. This makes it difficult or impossible for Dimon and his lieutenants to change their story now. It will be very interesting indeed to see if anyone from the financial media or even the regulatory community picks up the new trail illuminated by Iksil’s statements. The episode involving the London Whale illustrates how difficult it is to learn the truth about the inner working of large banks. Big banks profit by exploiting information and conflicts found between the world of credit and the world of securities. Indeed, the CIO's office generated big returns for JPM over the decade or so that Iksil was with the bank. But the London Whale episode also shows in graphic terms why the Volcker Rule prohibitions against banks trading for their own account need to be preserved and strengthened. There is a fundamental conflict between a bank acting as a lender and trading credit derivatives. More, if the CEO of a bank – any bank – can short circuit the internal controls of his institution in order to enhance returns with a bet at the credit derivative roulette table, then by definition that bank cannot be safe and sound. Further Reading Long and the Short of JPMorgan http://www.zerohedge.com/contributed/2012-19-11/long-and-short-jpmorgan JPMorgan: What's the Fuss? http://www.zerohedge.com/contributed/2012-20-15/jpmorgan-whats-fuss Bruno Iksil, JPMorgan and the Real Conflict with Credit Default Swaps http://www.zerohedge.com/contributed/2012-15-11/bruno-iksil-jpmorgan-and-real-conflict-credit-default-swaps 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.

“While the US and the UK have been mired in political chaos this year, the EU has enjoyed improved economic conditions and some political windfalls. The question now is whether this good news will inspire long-needed EU and eurozone reforms, or merely fuel complacency – and thus set the stage for another crisis down the road.” Philippe Legrain Project Syndicate July 31, 2017 | This week The Institutional Risk Analyst takes a look a the recent reports out of the EU regarding a proposal to “freeze” the retail accounts of failing European banks. The original story in Reuters suggests that our friends in Europe actually think that telling the public that they will not have access to their funds, even funds covered by official deposit insurance schemes, is somehow helpful to addressing Europe’s troubled banking system. Investors who think that Europe is close to adopting an effective approach to dealing with failing banks may want to think again. Judging by the reaction to the story by investors and on social media, it appears that the EU has learned nothing about managing public confidence when it comes to the banking sector. In particular, the idea that the banking public – who generally fall well-below the maximum deposit insurance limit – would ever be denied access to cash virtually ensues that deposit runs and wider contagion will occur in Europe next time a depository institution gets into trouble. “The plan, if agreed, would contrast with legislative proposals made by the European Commission in November that aimed to strengthen supervisors' powers to suspend withdrawals,” Reuters reports, “but excluded from the moratorium insured depositors, which under EU rules are those below 100,000 euros ($117,000). While some Wall Street analysts are encouraging investors to jump into EU bank stocks, the fact is that there remains nearly €1 trillion in bad loans within the European banking system. This represents 6.7% of the EU economy, according to a report and action plan considered by EU finance ministers earlier this month. That compares with non-performing loans (NPL) ratios in the US and Japan of 1.7 per cent and 1.6 per cent of gross domestic product, respectively. But the most basic point to make about the proposal for a “temporary” suspension of access to cash is that such moves never work. Moratoria are part of the banking laws in Germany and many other European nations, but they are never used because once invoked the institution is dead for all practical purposes. In Spain, for example, the government had the power to impose a temporary suspension of access to deposits in the case of Banco Popular, but did not do so because it would have killed the franchise. Jochen Sanio, the former president of the German Federal Financial Supervisory Authority (BaFin), commented about banks subject to “temporary” deposit moratoria that “they never come back.” Sanio, who guided Germany through the 2008 financial crisis and forced the clean-up of insolvent state-owned banks, was retired and gagged for the rest of his life for challenging Germany’s corrupt political status quo of covert bailouts. So again, one has to wonder, why any responsible official in Europe would support the plan reported by Reuters. As the US learned the hard way in the 1930s and with the S&L crisis in the 1980s, the lack of a robust national deposit insurance function to protect retail depositors leaves an entire society vulnerable to banks runs and debt deflation. Until the EU is prepared to do “whatever is necessary,” to paraphrase ECB chief Mario Draghi, in order to protect retail bank depositors, the EU will remain far from being a united political economy. Readers of The IRA may recall the comments of German Chancellor Angela Merkel last Fall, when she suggested that the German government would not support Deutsche Bank AG (NYSE:DB) in the event that the institution got into financial trouble. At the time, DB was trading at about $12 per share in New York. We spoke about DB and the ill-considered comments made by US and German officials from Dublin on CNBC on September 30th. At the time, we reminded investors that political officials should never talk about a depository institution while it is still open for business. This is a basic, well-recognized rule that has been followed by prudential regulators around the world for many years. Yet because of the popular political pressures on elected officials such as Merkel, the temptation to engage in absurd hyperbole with respect to big banks is irresistible. We see this latest piece of news out of Europe as further evidence that there is still no political consensus about how to deal with troubled banks. As we learned last year, Merkel could not even make positive public comments about DB for fear of committing political suicide. The more recent bank resolutions in Spain and Italy were made to look like touch measures in public terms, even as the Rome government quietly subsidized the senior creditors of two failed banks in the Veneto. We noted in an earlier comment, “Fade the Great Rotation into Europe,” that the EU pretends to play tough on bank rules while bailing out the senior creditors: “Of note, Italy is being given control over the remaining ‘bad bank’ to wind down as the assets and deposits are conveyed to Intesa SanPaolo. This permits a bailout of senior unsecured creditors. So Italy gets what it wants – continued circumvention of EU bailout rules. If a bank disappears, notes a well-placed EU observer, ‘state aid rules do not apply.’” The Europeans appear to be playing a very dangerous game. On the one hand, EU officials talk publicly about getting tough on insolvent banks and even suspending access to funds for retail depositors. On the other hand, EU governments are continuing to bail out banks and large creditors in a display of cronyism and business as usual. “Under the plan discussed by EU states, pay-outs could be suspended for five working days and the block could be extended to a maximum of 20 days in exceptional circumstances,” Reuters reports. “Existing EU rules allow a two-day suspension of some payouts by failing banks, but the moratorium does not include deposits.” Contrast the EU proposal with standard practice in the US, where the Federal Deposit Insurance Corporation (“FDIC”) begins to market troubled banks before they fail and tries to execute bank closures and sales on a Friday to avoid frightening the public. The branches of the failed bank then open on the following business day as part of a solvent institution without any interruption in customer access to funds. Importantly, all insured depositors, as well as brokered deposits and advances from the Federal Home Loan Banks, are always paid out by the FDIC when the failed bank is closed in order to avoid precipitating runs on other institutions. In Europe, on the other hand, there appear to be a significant number of officials who seriously believe that denying retail bank customers access to funds covered by deposit insurance will not result in financial contagion. If such a proposal is adopted, the sort of bank runs seen in Cyprus and Greece could intensify and spread to the major countries in Europe. Imagine that a large bank failure occurs in Italy next year and Italian officials tell retail customers that they will not have access to any funds for several weeks. As we saw in 2012 in Spain and Cyprus and 2015 in Greece, retail bank runs tend to spill over into other countries and markets, creating a situation where fear takes over from rational behavior. The trouble is, Chancellor Merkel cannot commit Germany to supporting an EU accord to support the banks in the Eurozone without ending her political career. “If capital flight from the peripheral economies gathers pace, it could trigger runs on entire banking systems,” notes the infamous “Plan B” memo prepared for Merkel in 2012. “That would put the ECB—and thus, indirectly, the Bundesbank and Germany—on the hook for deposits worth trillions of euros.” In the dark days of 2012, Merkel’s government prepared for “Plan B” and was essentially ready to allow the weaker nations on the EU’s periphery – including Spain, Greece, Italy and Ireland -- to fail and drop out of euro as Germany withdrew to a core group of nations. Just as the EU still refuses to deal with Greece’s mounting debt, likewise it cannot seem to accept that protecting the small depositors of European banks is the price to be paid for preserving social order and the EU itself. Otmar Issing, former Chief Economist and Member of the Board of the European Central Bank and the German Bundesbank, summarizes the situation: “The euro crisis is not over.” 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.

“I came of age on Wall Street when the Chairman of the Federal Reserve Board—he was William McChesney Martin—condemned even trace amounts of inflation as an economic and moral evil. In the interval of 1960-65, there was not one year in which the CPI registered a year over year rise of as much as 2%.” Grant’s Interest Rate Observer July 26, 2017 | BTW, below is my latest comment on housing finance reform in American Banker, “Fannie, Freddie are irrelevant to a government-backed mortgage system.” I'll be participating at the CoreLogic Risk Summit next week in Dana Point. Come say hello! We’ve all heard of fake news, but consider the growing possibility of fake or at least virtual assets. Investors face a deliberately orchestrated shortage of real investments c/o global central banks in markets such as stocks and real estate. Is there any wonder that the financial engineers of Wall Street have again begun to manufacture new derivatives leveraging the real world? Case in point, bitcoin. The most recognized “digital currency,” bitcoin is a form of high-tech gaming instrument that fulfills just one of the traditional roles of money, but is among the world’s fastest appreciating – and most volatile-- “asset" classes. Adherents call the limited supply of bitcoin the ultimate expression of Milton Friedman style monetarist discipline. They view the digital medium as a rational response to the fiscal and monetary chaos visible in most of the industrial nations. But despite the huge gains seen in bitcoin vs conventional currencies, Jim Rickards says he’s sticking with his preferred investments: gold, cash and silver. “I don’t own any bitcoin, but for those who have a preference for bitcoin, good luck,” he told Kitco News. Bitcoin has been blessed by a federal regulatory agency in Washington. “On Monday, a bitcoin options exchange called LedgerX won approval from the Commodity Futures Trading Commission to clear bitcoin options, making it the first U.S. federally regulated platform of its kind,” reports The Wall Street Journal. LedgerX’s chief executive Paul Chou is on the CFTC’s Technology Advisory Committee. Not surprisingly, a CFTC spokeswoman said “no committee, including the Technology Advisory Committee, plays any role in any registration decision.” OK. Regardless of whether you view bitcoin as an investment or the electronic version of tulip bulbs, the fact of a traded options contract is intriguing. It allows speculators to take a flutter on bitcoin without actually touching the ersatz currency or the varied folk who are said to traffic in this ethereal world. To be fair, drug dealers, terrorists and members of organized crime organizations in nations like China, Russia and North Korea are not ideal counterparties for a US bank or fund. But a US traded option contract may allow you to play the bitcoin game, pay your taxes, and sleep at night. A lot of managers may find that degree of separation attractive. Of note, less than 24 hours after the CFTC announcement, the Securities and Exchange Commission has declared that “tokens” such as bitcoin can be considered securities, and therefore, may be need to be registered unless a valid exemption applies,” Reuters reports. "The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets," said Stephanie Avakian, the co-director of the SEC's enforcement division. Part of the “problem” with bitcoin is that it is not easy for an individual to move in and out of the stateless, “offshore” market. It will be interesting to see which financial institutions are willing to provide the infrastructure to allow a bitcoin options contract to settle in dollars and in size large enough to satiate institutional players. But the more interesting question is how investors will deploy capital in this volatile and entirely opaque market. The idea of an option on bitcoin certainly seems to have some utility. Bitcoin may not be a store of value or a unit of account, but it serves that same purpose as the dollar in terms of acting as a means of exchange. Like the dollar, bitcoin promises to pay, well, nothing, so the two moneys have rough equivalence in that regard. Our guess is that a successful launch of the bitcoin option contract could significantly increase cash trading volumes, which will manifest in higher value vs traditional currencies. But the real issue is how to gauge the ebb and flow of demand for the bitcoin tokens. A large portion of the “float” in bitcoin cannot trade because the “owners” have lost their ID numbers, thus measuring how much supply is available to meet a given amount of demand is a challenge. Additional bitcoin cannot be issued beyond the 21 million limit of the system, although the coins can be subdivided. In the short run, the only variable that can change with demand is the spot price. Also, high and sometimes variable settlement costs add to the complexity of trading bitcoin. In many respects, a conventional option contract may be significantly more efficient than the cash market for bitcoin driven by the clunky blockchain technology. While the news of the CFTC’s approval of the bitcoin options contracts may turn out to be good news for the digital currency, please note that our dim view of the blockchain clearing technology that enables bitcoin has not changed. The Journal reports that CFTC Acting Chairman Christopher Giancarlo states publicly that he’s optimistic about blockchain technology’s future. We’d like to see him explain why, paying specific attention to operational efficiency and cost. A derivative contract on a derivative digital currency has a lot more promise that the technological dead end known as blockchain. To date, we have yet to see a single commercial application of what people call “blockchain” that has real commercial potential. The same robust and expensive encryption technology that helps the bitcoin market ward off attempts at manipulation also makes blockchain unsuitable for other business uses. As Saifedean Ammous wrote in American Banker last year: "[D]espite banks' attempts to test and use blockchain technology for their own commercial gain, it is outside the realm of possibility for the technology to serve any useful purpose for the intermediaries it was designed to replace. That is akin to burdening horses with engines in the name of technological innovation: the approach would only slow down the horse and alleviate none of its problems. Such a ridiculous notion will find no real world demand." In simple terms, blockchain is just a form of industrial grade encryption tied to a bulletin board for the public portion of the keys. When it comes to clearing options contracts, the existing centralized technology solutions are far more attractive in terms of speed and cost. Indeed, it will be interesting to see how LedgerX manages delivery of bitcoin as contracts expire or whether it will require cash settlement, as is customary with gaming instruments. So let’s keep our eyes on this bitcoin options contract. It promises to expose a far greater number of investors to this global gaming instrument. We suspect that the SEC is right when they refer to them as tokens, albeit ones that can only be settled electronically. If bitcoin are eventually determined to be securities by the SEC, however, it both validates and changes the market forever. With recognition comes regulation and reporting. What the success of bitcoin says about the world of dollars, euros and yen is unsettling at a number of levels, but then again, bitcoin is ultimately just a brilliantly designed virtual market that, initially at least, promised security and anonymity. Whether those qualities can endure as the audience grows is a very intriguing question that investors need to consider. 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.

July 18, 2017 | Earlier this week we appeared on CNBC’s “Squawk Box” to talk about bank earnings and the Fed. The results from the top-four banks – Bank America (NYSE:BAC), JPMorgan (NYSE:JPM), Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) – are really no surprise to readers of The IRA. The largest banks all beat small on revenue and earnings, but showed weakness on fixed income and the mortgage banking lines. We suspect that there will be even more pain on the mortgage banking line for WFC, JPM and BAC next quarter. As we told Andrew Ross Sorkin, bank stocks have essentially been going sideways since February and are likely to continue side-stepping because most of the large cap names are fully valued after the Trump Bump. But the biggest obstacle to rising bank stock valuations is the Federal Reserve System’s policies of low rates and open market purchases of debt. At the Fed of New York back in the 1980s, one and a quarter times book was seen as the natural limit for bank valuations. Have a look at our previous note if you have any questions on the particulars. Suffice to say that 1x book value for BAC is about right given the bank’s asset and equity returns, and the state of the credit markets. Tight credit spreads make life tough for all but the best run banks. When we suggested US Bancorp (NASDAQ:USB) to Squawk Box as our favorite large cap, that was because of the operational excellence as opposed to the stock price, which trades above 2x book value. But the more interesting question from CNBC's Andrew Sorkin had to do with the choice of the next Fed Chairman. News reports suggest that White House chief of staff Gary Cohn is the leading contender to take over from Fed Chair Janet Yellen. We would welcome Cohn’s appointment not because he is an alumnus of Goldman Sachs (NYSE:GS), but because he understands financial markets and is not a PhD economist. For too long the Fed’s internal deliberations have been dominated by academic economists who do not understand the real world impact of monetary mechanics much less the workings of the financial markets. Having Cohn and other non-economists on the Federal Open Market Committee would be a welcome change that would support economic growth by encouraging investment. During our trip last week to Jackson Hole, we had the pleasure of hearing from Paul McCulley, an American economist and former managing director at PIMCO who is now teaching at Cornell. Paul is an articulate and unabashed advocated of neo-Keynesian economics (aka “socialism”). He is noted for authoring such memorable phrases as “shadow banking” and “Minski Moments.” Like most of the members of the FOMC, Paul believes that additional deficit spending was the proper response to the financial crisis of 2008. And like Chair Yellen, he apparently thinks that the fact that Congress refused to ratchet up public spending five years ago was a sufficient excuse for the unelected central bankers to “do something” in their stead in the form of near-zero interest rates and, more important, quantitative easing or “QE.” Paul explicitly equates democracy and socialism, believing that people of modest means will always vote for the smiling bureaucrat offering a bag of free groceries or subsidized health care. He also says that the Fed has too much independence and should coordinate its actions with fiscal policy. To his credit, McCulley at least concedes that while QE was the right policy "there is collateral damage.” There are two basic problems with the pro-fiscal spending argument of liberal economists. First, it is pretty clear from the literature that deficit spending does not produce any benefit in terms of increased consumer spending or jobs. For decades, American policy makers have been pulling tomorrow’s sales into today by using cheaper credit, but the efficacy of such policies has been pretty much exhausted. Some even believe rising public deficits choke off growth. The second and more important issue is that Congress has shown itself to be completely incapable of restraining spending during good times to balance off Keynesian stimulus during slack times. Keynes was no apologist for debt and explicitly assumed that government would in good times promptly repay debt incurred to fund public spending. Today repayment of public debt is never even discussed. Davidson (2003), for example, notes that Keynes believed that government should always maintain a balanced operating budget. When considering the arguments of economists such as McCulley and others who advocate increased federal deficits, the only conclusion possible is that they implicitly are taking us down the road to eventual debt default and hyperinflation. Since they never once suggest that the debt incurred to fund deficit spending should be repaid in kind, as Keynes would have insisted, the only reasonable scenario would be for the FOMC to eventually make QE a permanent feature of the American political economy. In such a scenario where the FOMC explicitly and continuously suppresses interest rates and credit spreads, and monetizes the Federal debt with open market purchases, private sector entities such as banks, companies and pension funds soon will become superfluous. Quaint notions about private property and free enterprise would be discarded in favor of a “single payer” model for the entire US economy – namely the Fed. The free market capitalism of the US would mutate into something that looks a lot like the state-directed economy of Communist China. Fortunately there still are enough Americans who understand the fallacy of the neo-Keynesian socialist model. The path to making America “great again” has nothing to do with who is in the White House, but a great deal to do with who occupies those seven seats on the Federal Reserve Board. In particular, we need a Fed Chairman and governors who are not afraid to say “no” to the fiscal profligacy in Washington. Rather than facilitating the issuance of public and private debt as the FOMC has done under Yellen, the US central bank needs to become an advocate for savers and private investment, and a vocal critic of the dissolute fiscal policies of the Congress. The members of the FOMC need to appreciate that the polices followed by Chair Yellen and the FOMC after QE1 (which re-liquefied the US banking system) were detrimental to job growth and economic expansion. Subsidizing public and private debtors at the expense of savers is no formula for private sector economic growth and job creation. For example, the folks on the FOMC don’t seem to understand that low interest rates and artificially tight credit spreads retard private business investment and advances in productivity. Since 2012 when the Fed started QE, public companies have eschewed new investment – and instead bought back trillions of dollars worth of stock financed with debt. As Ben Hunt wrote in his blog Epsilon Theory: “In exactly the same way that QE was deflationary in practice when it was inflationary in theory, so will the end of QE be inflationary in practice when it is deflationary in theory. That’s the real world impact I’m talking about, the world of wages and output and productivity. You know, the real world that used to be the touchstone of our markets.” We told Andrew Ross Sorkin today that we like the idea of Gary Cohn as Fed Chairman because he would normalize monetary policy. We like the idea of JPM CEO Jamie Dimon running for President in 2020 even better. Based upon on his recent public comments, Dimon seems to be interested: ““And you know at one point we all have to get our act together [so that] we will do what we’re supposed to do [for] the average Americans.” Ditto Jamie. America hungers for credible leadership that can truly foster a positive environment for the US economy to grow and create opportunities for our people. The markets were hopeful that Donald Trump would provide that leadership, but this hope has been dashed. If Cohn takes the job as Fed Chairman, that is a pretty good sign that the former GS partner has given up on Trump and is looking for his next challenge. But that could be the most bullish signal investors see coming from Washington this year. 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.

July 13, 2017 | In this issue of The Institutional Risk Analyst, we take a prospective look at Q2 2107 earnings for the large cap banks in the financial services sector. By way of disclosure, we don’t own any banks. Our direct exposure to financials is in fintech and in just two names – Square (NYSE:SQ) and PayPal (NASDAQ:PYPL). More on these names in a future issue of The IRA. The larger US banks experienced a mini bull rush following the most recent stress tests conducted by the Fed and other prudential regulators. The good news is that the banks have too much capital. The bad news is that, well, the largest banks have too little business to support revenue and earnings, leading to the obvious conclusion that share buybacks must go up. First, looking at the best valued of the large banks, let’s consider US Bancorp (NYSE:USB). With an “A+” bank stress index rating from Total Bank Solutions, USB is among the lowest risk large banks in the US. Trading at over 2x book value, the shares of the $440 billion total asset USB are up 2x the S&P 500 over the past year. Needless to say, with a beta of 0.93, this is one large bank stock most hedge funds don’t dare sell short. The Street estimates that USB’s revenue will be up 5% for the full year and earnings up 7% in 2017. Because USB does not depend upon Wall Street investment banking and derivatives activities to make its earnings number, this bank has among the most dependable financial performance of the top five commercial banks by assets. Next we move to Wells Fargo (NYSE:WFC), which like USB is primarily a lender with relatively little (but growing) exposure to Wall Street. Like USB, the $1.7 trillion asset WFC has an “A+” bank stress index rating from Total Bank Solutions. WFC’s equity currently trades a 1.5x book value reflecting the 12% return on equity, but WFC has just a 1% risk-adjusted return on capital (RAROC). The stock has a beta of 1.0, which means that its volatility matches that of the broad market. The Street has WFC growing revenue at less than 3% for 2017 and earnings up almost 4% for the same period, suggesting that cost-cutting and capital returns will be supporting investor expectations. We tend to discount these projections, however, because of WFC’s huge role in the residential mortgage finance sector. As we never tire of reminding our readers, the US housing finance sector is running about 30% below last year’s levels in terms of mortgage loan origination volumes. This sharp drop in new loan volumes is translating into an equal drop in issuance of agency mortgage securities. The result is a vicious scramble for collateral that is driving down profitability in the 1-4 family mortgage sector. Our sources in the mortgage channel say that WFC and JPMorganChase (NYSE:JPM) have been bidding up the price of whole loans in the secondary market in order to fill the shrinking mortgage securitization pipeline. The aggressive bid from WFC and other aggregators is killing margins for everyone in the secondary market. This makes us wonder if the resi sector won’t be the cause of an earnings miss for WFC and other large banks in Q2. Coming off a record low loan origination spread of 8bp in Q1 2017, the mortgage industry faces another difficult quarter. The ten-year average spread compiled by the Mortgage Bankers Association is 51bp, thus the continued drop in profitability has ominous implications for smaller mortgage firms that purchase production from third parties. If you’re a seller of loans, on the other hand, life is pretty good. Big lending and mortgage servicers such as WFC are desperate to buy collateral from third party originators, both to prop up agency securitization volumes and also to forestall eventual shrinkage in the servicing foot print. Also of note, Fred Small at CompassPoint reckons that this quarter banks and non-banks alike could be facing a 5% downward adjustment in the value of our favorite asset, mortgage servicing rights (MSRs). Moving right along to the next most valued mega bank, we turn to JPM. Trading at 1.4x book, JPM is fully valued to put it mildly. With lower asset and equity returns than WFC, to see the House of Morgan trading at these levels suggests to us a good bit of downside risk for the shares – regardless of how many managers want to own the stock. JPM has a beta of 1.2, indicating that the equity market valuation is more volatile than the broad market or asset peers such as WFC. While USB and WFC are predominantly lenders, JPM relies on lending for only about a third of its business. Trading, derivatives and asset management fill out the rest of the bank’s business model footprint – and contribute to earnings volatility. This results in a 0% RAROC for all of the JPM businesses combined vs the nominal 10% equity returns. JPM has an “A” bank stress index rating from Total Bank Solutions. We fully expect that JPM CEO Jamie Dimon will hit the admittedly low bar set by the Street’s estimates of 2.5% revenue growth for 2017 and 7% earnings expansion, mostly due to further cost cutting. Yet these earnings and revenue figures don’t really support the current equity market valuation for JPM – especially compared with more conservative names such as WFC or USB. Look at the Y-9 performance report for JPM and notice that the bank is consistently in the middle of the large bank peer group compared to WFC and USB which tend to be in the top quartile. Moving from the sublime to the ridiculous, we come to Bank of America (NYSE:BAC), a stock that is up 81% over the past year on the draconian cost cutting by management. And yet even with this amazing upward move, BAC currently trades at just 1x book value -- albeit with a beta of 1.6 or 60% more volatile than WFC or USB. Even though the Street has BAC growing revenue about 4.5% in 2017 and 2018, and earnings up a whopping 18% this year and 21% in 2018, the stock still does not impress managers enough to earn a premium to book. Perhaps this is because the bank’s earning rebound started from such a low base. BAC currently has an “A+” bank stress index rating from Total Bank Solutions and, like WFC, derives more than half of revenue and income from traditional banking. The presence of Merrill Lynch in the mix is neutral factor for the organization from a risk perspective, but BAC as a whole does not compare that well to its large bank peers looking at the Y-9 performance report published by federal regulators. Finally we come to the least valued US large bank, Citigroup (NYSE:C), which currently trades at 0.80x book on a beta of 1.6. C has an “A” bank stress index rating from Total Bank Solutions. Like JPM, C’s business model puts equal emphasis on lending, trading and investing activities, resulting in a lower RAROC at 1% vs a nominal equity return of a bit shy of 7%. Keep in mind that C has lower asset returns and higher credit costs than other large banks, begging the question as to whether the Fed should really be allowing the bank to increase payouts to equity investors. If you look at Page 3 of C’s Y-9 performance report, you’ll see that C’s yield on loans is 2% higher than the large bank peer group, yet the bank has a spread on earning assets half a point lower than other large banks. The Street has C’s revenue down in Q2 2017 but magically up 1.5% for the full year. Earnings are also expected to be down this quarter, but then will rise an astounding 9.5% for the full year. Despite the market bump following the release of the stress test results, which will result in returning more capital to investors than C actually earns in profits, like BAC the C common still trades at a discount to book. Unlike names like JPM, C does not have a significant asset management business and also announced an exit from residential mortgage origination and servicing earlier this year. This may turn out to be a blessing in disguise. C is up 58% over the past twelve months vs 13% for the S&P 500, so like JPM we’d say that the risk is on the downside for this much maligned stock. Will C hit its revenue and earnings numbers for Q2 2017? Probably, especially now that they’ve jettisoned the mortgage business. But the larger question is why does C still exist? In the wake of the 2008 financial crisis, C has been struggling to redefine itself in a way that makes sense to investors. But having sold the asset management business to Morgan Stanley (NYSE:MS) and the mortgage business to New Residential (NYSE:NRZ) and Cenlar FSB, there is not much left besides the consumer lending book and the payments business. As we’ve noted in previous comments, C’s board ought to consider selling the payments business for a premium price, spin the proceeds to shareholders, then dispose of the other assets for whatever they can get before turning off the lights. Bottom line is that earnings for the largest banks are likely to be a relatively disappointing exercise given the poor visibility on both earnings and revenue growth. Managers clearly want to own these large cap financials, but a combination of a slowing economy and the Fed’s manipulation of the credit markets is making sustained top line growth elusive. Longer term, the issue that investors must grapple with in 2017 and beyond is quantifying how much hidden credit risk is embedded in the portfolio of all US banks as a result of the Fed’s aggressive manipulation of the credit markets over the past five years. Corporate credit spreads remain extremely tight. Lurking beneath the currently benign credit metrics, however, lies significant potential losses for both banks and bond investors as an when we revert to the mean. 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.

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing" Citigroup CEO Chuck Prince July 2007 July 9, 2017 | Watching new era car company Tesla (TSLA) getting knocked down a couple of notches last week, it occurred to us that the Fed’s program of quantitative easing or "QE" amounts to a leveraged buyout (LBO) of the US equity markets. How else can we explain TSLA, a firm whose financial performance is measured by free cash outflow, being more valuable than far larger car companies that actually earn profits? Think of it: TSLA is an LBO without any cash flow. Of course, the global equity markets are all about discounting future earnings or, in the case of TSLA, the next capital raise. With $7 billion in debt and a voracious appetite for other peoples’ money, TSLA embodies the new era notion that it is acceptable for companies to loose money until they grow large enough to be profitable -- maybe. The archetype for this style of corporate management is of course Amazon (NASDAQ:AMZN), a firm that is happily consuming whole industries as it grows into a global horizontal and vertical monopoly – and all of this without so much as a peep from the Antitrust Division at the Department of Justice. These and other questions will be considered later this week when The IRA participates in the Rocky Mountain Economic Summit in Victor, ID, just over the Teton pass from Jackson Hole. Sponsored by the Bronze Buffalo Foundation, The Hero Club and the Global Interdependence Center, the Rocky Mountain Economic Summit features speakers from all over the world considering the financial outlook from the stunning perspective of the Grand Tetons. Our discussion on Thursday in Teton Springs will focus on the financial outlook for 2017 and beyond. Given the fact that the 10-year Treasury bond has risen in yield nearly 20bp in the past week, the first order of business would seem to be the direction of interest rates. But maybe not. We should heed warnings from no less than Ray Dalio that the central banker party is over, but this does not necessarily mean that the bond markets are the first concern. Our basic view remains that this latest uptick in yields for US government debt is a pause amidst a continuing deflationary scenario. The manager of the world's largest hedge fund, Dalio says he is going to "keep dancing" with the markets even though central banks are reversing their easy money policies. Where is former Citigroup (NYSE:C) CEO Chuck Prince when we need him? Reading the pronouncements coming from the latest FOMC minutes, it looks to us like the Fed’s portfolio will not be reduced down to the $1.7 trillion target until 2024. Our friend Bob Eisenbeis, formerly director of research at the Atlanta Federal Reserve Bank now chief economist at Cumberland Advisors, notes that this fact will keep Fed policy relatively easy for the next five years. And the minutes contain no hint that the Fed regrets QE or any of its other policy moves since 2008. At present, the fact of the FOMC’s massive bond position is holding interest rates down. Ask not how long it will take for the 10-year to hit 3%, but rather the number of trading days it will take for the secular forces of deflation and growing global debt to push Treasury yields back down again towards 2% yield. Thus our fascination with Italian banks. Despite the protestations of Fed Chair Janet Yellen regarding the complexity of monetary policy, it is quite easy to borrow billions when the central bank is playing “what if” with the global financial markets. Unlike the 1930s when Irving Fisher worried about debt deflation, this time around the secular demand for investments (aka “duration”) looks to be driving yields down even as the likes of TSLA drown on debt that, today at least, clearly does not seem money good. Our friend Charley Grant gives you the basic facts in a Wall Street Journal analysis: “Yet Tesla needs to raise several billion dollars to meet its goals. Assuming a $1 billion cash balance and four quarters of similarly negative cash flow, Tesla would need to raise nearly $3 billion over the next year. At current prices, that amounts to roughly 6% of the total equity value. The more the shares slip, the greater the potential dilution of existing owners.” Dilution indeed. Examples like TSLA aside, the basic problem we have with the rising rate scenario narrative that emerged last week is that corporate credit spreads remain extremely tight. All during the Trump Bump, let’s recall, as the 10-Year Treasury popped up to a whole 2.6% yield, corporate bond and swap spreads generally tightened. The Fed-induced shortage of investment paper, combined with a shrinking market for equity offerings and a $300 billion drop in agency securities issuance in the mortgage market, are all combining to keep yield spreads tight as suggested by the chart from Fred below. Given the gyrations of the bond market, US mortgage origination volumes likely will barely reach $1.6 trillion in new issuance this year vs $2 trillion in 2016. When we start to see high yield corporate bond spreads as described by the good folks at the St Louis Federal Reserve Bank edging up towards 6%, then we’ll start to give credence to the rising rate trade. Over the past three years, how many investment managers have been annihilated betting on rising interest rates and widening bond spreads? Too many to count. But to us the more relevant concern for Yellen & Co is the equity markets and its recent correlation with bonds, an unnatural circumstance that seems about ready to end. Looking at spreads in terms of the Treasury market, the impact of the FOMC’s baby steps toward normalization is illustrated by the 10-year Treasury bond vs the 2-year T-note. Does this look like a market that is just dying to move higher in terms of yield? Compare the magnitude of last week’s modest move in the 10-year to the massive Trump Bump following the November 2016 election. Our best guess is that the next major leg in the 10-year Treasury bond will be down in yield and up in price until we test the 2% threshold. Corporate debt issuance tracked by SIFMA is $100 billion ahead of last year’s levels through May at $884 billion and, more important, roughly a quarter of this amount was used to fund share buybacks by public companies. Significantly, share repurchases for the S&P 500 in Q1 2017 were $133 billion, just 1.6% less than Q4 2016 and 17.5% less than Q1 2016. Source: SIFMA/S&P The debt issuance numbers from SIFMA and share repurchase figures from S&P dwarf the level of new equity offerings at just $57 billion in Q1 2017, but it is important to note that stock buybacks also peaked in 2016. Of note, Ed Yardeni’s latest report on the subject of stock buy backs is must reading. “The result of the buybacks is that net equity issuance has been negative for the last several years and bears a striking resemblance to the period leading up to the 2008 financial crisis,” David Ader wrote presciently in Barron’s last year. In this regard, consider the coincidence of the surge in corporate debt issuance in Q1 2017 and the performance of US stocks. In the chart above, note the way that total MBS issuance has cratered since Q4 2016 thanks to the election of President Trump. Sadly, even a 10-year Treasury yield well below 2% will not revive the flagging fortunes of the US mortgage finance sector with an uptick in refinancing volumes. So our message to the folks in Jackson Hole this week is that the end of the Fed’s reckless experiment in social engineering via QE and near-zero interest rates will end in tears. “Momentum” stocks like TSLA, to paraphrase our friend Dani Hughes on CNBC last week, will adjust and the mother of all rotations into bonds and defensive stocks will ensue. We must wonder aloud if Chair Yellen and her colleagues on the FOMC fully understand what they have done to the US equity markets. The notion that five years of market manipulation by the FOMC (and other central banks, to be fair) can end happily seems rather childish, especially when you consider that the other great accomplishment by the Fed during this period is a massive increase in public and private debt. Once the hopeful souls who’ve driven bellwethers such as TSLA and AMZN into the stratosphere realize that the debt driven game of stock repurchases really is over, then we’ll see a panic rotation back into fixed income and defensive stocks. The period from QE 1 in 2012 represents one of the most reckless episodes in the history of the US central bank, a period where the FOMC essentially encouraged a partial LBO of the US equity markets. The key question for the FOMC and investors seems to be this: How much new equity issuance can the markets support if public companies eventually need to reduce debt and rotate out of the LBO trade constructed by Yellen & Co? Corporate credit spreads are the key indicator to watch, both in terms of the economy and the financial markets. It’s a game of financial musical chairs. Ray Dalio, Janet Yellen and all of us are dancing. When does the music stop?

July 5, 2017 | News last week that European Central Bank chief Mario Draghi was considering an end to the ECB’s extraordinary purchases of securities quickly let some air out of the Great Rotation into EU stocks. Sure the euro surged against a weakening dollar, but Europe’s mountain of bad debt remains unresolved -- even after the election of Emmanuel Macron to the French presidency. Yet hope springs eternal in some quarters after Draghi’s claim of a successful “reflation.” “All the signs now point to a strengthening and broadening recovery in the euro area,” Draghi told the ECB’s annual conference. “Deflationary forces have been replaced by reflationary ones,” the former head of the Bank of Italy declared. Draghi’s bull call on inflation provides optimism for relief on excessive levels of bad debt, albeit in a context where the EU’s rules on resolving dead banks remain entirely subjective. The July 4 approval of the latest state-supported rescue for Banca Monte dei Paschi di Siena (Montepaschi) illustrates the deflationary challenges still facing Europe. As part of the overhaul, Reuters reports, Montepaschi “will transfer 26.1 billion euros to a privately funded special vehicle on market terms, with the operation partially funded by Italian bank rescue fund Atlante II.” The bank will receive 5 billion euros in new public equity funds for its third bailout in a decade. Two weeks before the EU decision on rescuing Montepaschi, the Italian government supported the sale of two profoundly insolvent Italian banks. The assets of Popolare di Vicenza and Veneto Banca were sold to Intesa SanPaolo Group at an estimated cost to the government of 10 billion euros, marking Italy’s latest breech of the EU’s rules on state support for failing financial institutions. Like Montepaschi, where retail investors were heavily subsidized, the Intesa SanPaolo transaction avoids imposing losses on senior debt and depositors, but wipes out the equity and junior debt. This outcome reflects political as well as financial constraints in Italy, but shows how far there is to go in the process of resolving bad banks in Europe. Of note, Italy is being given control over the remaining “bad bank” to wind down as the assets and deposits are conveyed to Intesa SanPaolo. This permits a bailout of senior unsecured creditors. So Italy gets what it wants – continued circumvention of EU bailout rules. If a bank disappears, notes a well-placed EU observer, “state aid rules do not apply." Compare the sale of these two insolvent Italian banks with the resolution in early June of Banco Popular Espanol, which became the first EU bank to be resolved by the EU’s Single Resolution Board (SRB). Banco Popular had a third of total assets in bad loans and real estate owned, double the 15% average for all banks in Spain. (In the US, by comparison, non-performing loans plus real estate owned equaled less than 1% of total assets for all banks at the end of Q1 2017.) “The resolution of Banco Popular, under which it was acquired by Banco Santander S.A., is consistent with the EU’s Bank Resolution and Recovery Directive (BRRD),” Moody’s notes, “which restricts the use of public funds to rescue failing banks. The route followed by the EU authorities in the case of Banco Popular contrasts with the approach taken elsewhere to other ailing banks, notably in the case of the troubled Italian lender Banca Monte dei Paschi di Siena S.p.A.” The state bailout of Montepaschi, like the sale of the two smaller banks to Intesa SanPaolo, reflects political realities in Italy. “Montepaschi’s liability structure includes large volumes of bonds purchased by retail investors before the [Bank Resolution and Recovery Directive] introduction,” Moody’s continues. “Retail investors also accounted for around 40% of Banco Popular’s share capital and also held an undisclosed share of the bank’s Tier 2 instruments.” Well-advised institutional investors fled Italian banks years ago, partly because they could not trust official disclosure. So the Rome government countenanced the sale of “deposits” to retail investors by Montepaschi and other Italian zombie banks. The process of selling the deposits and good assets of the two Italian zombie banks to Intesa SanPaolo, while retaining the toxic waste in a “bad bank”, represents the true cost of this latest example of moral hazard in Europe. Draghi deserves considerable credit for the worsening situation at Montepaschi, starting with his tenure at the Bank of Italy. When the bank merged with Antonveneta, a troubled bank it bought from Spain’s Santander, Montepaschi’s troubles accelerated. Italy's third-biggest lender, received a 4 billion euro state bailout in 2012. The negative political consequences for the current government in Rome of the latest Montepaschi bailout are still unfolding, but Draghi and his fellow technocrats are the true authors of this mess. More, EU banks still face levels of bad debts that not only indicate insolvency, but under the EU’s often ignored fiscal rules, suggest a haircut for senior debt and depositors without state aid. As with the EU today, American officials in the late 1970s and 1980s bent the rules regarding bank disclosure to enable most of the larger, internationally active US banks to avoid a painful debt restructuring. The Latin debt crisis, trouble in the oil patch, and the S&L debacle pushed some of America’s largest banks to the edge of bankruptcy, starting a process of deregulation that is still little understood by investors and analysts. The Federal Reserve Board under Chairman Paul Volcker and other regulators allowed large banks to engage in off-balance sheet financial transactions that concealed tens of billions in loan exposures. This loosening of prudential standards regarding the treatment of off-balance sheet securities deals eventually led to the 2008 financial collapse. Three decades later, when concealed structured investment vehicles came back to issuers like Citigroup (NYSE:C), the results were disastrous. Today, officials in Europe led by ECB chief Mario Draghi are playing a similar game, pretending that bad public and private debt on the books of EU banks and investment houses, and held by individuals, is somehow money good. As with the US in the 1980s, the stark reality inside the EU banking system is being concealed under a heavy dose of technocratic obfuscation. Mountains of public debt in Europe also indicate proponents of the bullish EU equity trade may be a tad exuberant. Europe just dodged a bullet in Greece, where a last-minute deal with the International Monetary Fund allowed the member nations to kick the can down the road until next year. With debt at 200% of GDP, Greece is crippled economically and requires debt reduction in order to attract new investment. Over the past few months, investors have driven yields on Greek debt to the lowest level in years. To that point, investor optimism on the EU is predicated on an eventual debt bailout for Greece. Yet investors won't see any details on a long awaited Greek debt restructuring plan before the German elections later this year. The EU trade, as it were, depends an awful lot on what happens to Angela Merkel’s coalition this September. Economic reality is slowly leading the EU down the road to the assumption of bad debt of weaker states by the stronger members of the federation led by Germany. EU economic commissioner Pierre Moscovici has called for “debt reduction” in Greece, a proposal that is met with a lukewarm response by Germans. But will Merkel ultimately go along? "In the long run, in a completely integrated euro zone, we would talk about a ‘communitization’ of new debt, but we're not going to start with that," Moscovici told reporters last week. The necessary condition for the bull case on the EU is that the Germans must eventually embrace a federated structure for Europe, this as part of a gradual approach being advanced by leaders such as Macron in France and Moscovici in Brussels. Joint and several responsibility for all EU debts is the cost of unity. Such a scenario faces significant political and practical obstacles, most notably in Germany but also in France, where Macron must somehow convince his citizens to embrace German style economic behavior. A gradualist plan for a European federation seems unworkable so long as member states are able to borrow against Europe’s collective credit without toeing the line on fiscal reforms – as in the case of Italy and its troubled banks. “The euro crisis resulted from the fallacy that a monetary union would evolve into a political union,” writes Yanis Varoufakis, a former finance minister of Greece. “Today, a new gradualist fallacy threatens Europe: the belief that a federation-lite will evolve into a viable democratic federation.”

February 20, 2026 | The latest edition of “The Wrap” features our view of the key events in Washington and on Wall Street over the past week. Don’t forget to watch “The Wrap” on The Julia LaRoche Show  every Saturday on YouTube to catch our discussion of what’s hot and what’s not in the world of finance and investing.  Midterm Elections The IRA  was in Washington for a series of meetings this week. While the media is filled with predictions of impending disaster for the GOP in the upcoming midterm elections, the reality is closer to neutral according to some of our more trusted sources. As one insider told us: There are only a handful of seats in the House that will actually be contested. The wildcard: If the US Supreme Court guts the progressive interpretation of the voting rights act , the Republicans will benefit in November. The Supreme Court may soon decide whether to hear an appeal of an Eighth Circuit decision that held that Section 2 of the Voting Rights Act can only be enforced by the Department of Justice — not by individuals or private organizations. The same source, who was inside inside the tent for ‘45, tells The IRA  that Rahm Israel Emanuel  is the odds on favorite to get the Democratic presidential nomination in 2028. Emanuel is an American politician, diplomat, and former investment banker who most recently served as United States ambassador to our most important ally, Japan, from 2022 to 2025.  A senior member of the Democratic Party, Emanuel represented Illinois in the U.S. House of Representatives for three terms from 2003 to 2009. He properly kicked the ass of Republicans as chair of the Democratic Campaign Committee. Emanuel is an effective and relatively conservative politician who will be a viable contender against likely Republican candidate Secretary of State Marco Rubio . Private Credit: Blue Owl Craters Blue Owl Capital (OWL)  shares tumbled this week after a decision to restrict withdrawals from one of its private credit funds raised fresh concern over the risks bubbling under the surface of the $1.8 trillion credit market. The OWL disaster took down the shares of other alternative asset managers. We think this is just the beginning of a major reset in private credit. Blue Owl shares closed 5.9% lower yesterday, while peers Ares Management (ARES) , Apollo Global Management (APO) , Blackstone (BX) , KKR & Co (KKR) and TPG (TPG) . also plunged. “Blue Owl’s decision highlights a key risk for retail investors drawn to private credit: such funds offer less liquidity than public markets, and firms can block their investors from cashing in,” reports Bloomberg .  Shares of the alternative asset manager fell about 10% on Thursday to the lowest level in two and a half years.  We previously warned our readers about problems in the credit sector. All of these private credit managers have told investors that private markets are superior to public markets, but clearly that is not the case. APO CEO Marc Rowan has argued that private markets are superior to public markets due to consistent excess returns (1.5% higher annually), better diversification, and lower risk than traditionally assumed. The debacle around OWL and other examples suggests that Rowan is mistaken. We wrote previously about the busted commercial mortgage REIT sponsored by APO (" Zombie Equity | AI, Debt & Private Market Risk "). Rowan has asserted in numerous public comments that the traditional 60/40 model for prudent investing is broken, driven by concentrated, volatile public markets, and advocates for private credit and equity to serve as the new core portfolio for retirement and insurance. But the fact is that investors in private strategies would have done far better over the past five years by investing in public markets. Silver: the Revenge of the Miners Silver prices dropped dramatically the end of January, but have since moved sideways following gold. A lot of uninformed observers have predicted a collapse in silver and gold prices, but such views ignore the tightness of the commercial market for precious metals and also many other industrial metals. Miners are now price makers instead of price takers, a remarkable reversal of fortunes in less than a year. Source: Google Finance This past week, AuAg Funds published its 2026 outlook , and the analysts said they expect gold prices to push decisively above $6,000 an ounce this year, and see silver prices reaching $133 an ounce - which would put the gold/silver ratio back to last month’s multi-year low of 45. But echoing our earlier comments, the Swedish fund manager warned that investors should be prepared for double digit price swings along the way.  AuAg Funds is a Swedish investment firm founded in 2019 by Eric Strand, specializing inUCITS-compliant funds focused on mining companies, precious metals (gold/silver), and electrification/green tech metals. They offer four active funds—Silver Bullet, Precious Green, Gold Rush, and Essential Metals—with over 100,000 investors across Europe. But the big warning sign we want to highlight for our readers is that China, the largest buyer of physical silver in the world, has imposed draconian limits on futures traders in Shanghai. “Starting February 27, all hedging positions in both the delivery month and the month prior will be forcibly reduced to zero—unless an entity has a pre-approved special hedging quota,” notes The Silver Academy . “Only bona fide industrial users — refiners, electronics producers, and solar manufacturers — will be allowed to maintain positions through physical delivery.”  Meanwhile, the ability of the COMEX in Chicago to deliver physical silver is eroding. If the exchange is forced to impose cash settlement on hedgers, says one observer, the the COMEX is finished in precious metals. Bottom line: We are maintaining our positions in silver and gold. Readers are strongly cautioned against naked shorting either metal since the fundamental demand for both gold and silver remains quite strong. One long-time observer tells The IRA that Chinese buyers are actually approaching artisanal producers of silver because of the extreme shortage in the global spot market.   Mortgage Rates Down US mortgage rates have been slowly, painfully moving lower, but but battle is more a function of lenders than anything happening in Washington. The big driver is prepayments of older mortgages as refinance transactions grow in volume. “Conventional rates pushed down towards 6.00% Jan 9th-16th, and were similar to where we currently stand today,” writes Scott Buchta  at Brean. “We expect to see pay-offs from this rally continue to flow through over the next 1-2 weeks, before backing off slightly until the latest round of refis begin to flow through in March.” The key indicator to watch is the 10-year Treasury note, currently yielding around 4.1%. If yields move up, then mortgage rates will follow. If the 10-year Treasury moves down in yield, then lenders will be incentivized to drop rates on new loans. Thirty year fixed rate mortgages have been grinding lower each month, but have retreated with each new Treasury refunding. Meanwhile, credit quality in the mortgage sector continues to slide as the rollback of COVID era forbearance programs exposes the true state of consumer defaults. We expect to see defaults in the FHA Ginnie Mae market to continue to rise in 2026. “The delinquency rate on loans handled by large mortgage servicers increased significantly during the fourth quarter of 2025. According to Inside Mortgage Finance’s  Large Servicer Delinquency Index, the overall delinquency rate increased by 46.6 basis points from the end of September, hitting 3.29% at the end of 2025.” 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.

June 27, 2017 | Q: Are the annual stress tests good for bank stocks? See discussion on Yahoo Finance by clicking here (Interview starts at 12:30). Early in 2009, when the Federal Reserve Board began the annual exercise of “stress tests” for banks, confidence in the US financial institutions was nonexistent. The year before, Treasury Secretary Hank Paulson almost single handedly cratered the US economy by embracing the creation of a “Super SIV” to buy bad assets from the largest banks. Paulson’s ill-considered comment told investors that US banks like Citigroup (NYSE:C) were insolvent. At the time, JPMorgan (NYSE:JPM) was trading below $30 per share and other large banks were similarly discounted. As part of a broader effort to restore confidence in banks, the Supervisory Capital Assessment Program or SCAP was designed to measure whether the 19 largest banks with more than $100 billion in assets had sufficient capital. The key objective of the SCAP was not to actually measure capital per se, but instead to restore investor confidence in holding bank debt. In that sense, at least, the SCAP was successful. Kudos to Messrs Bernanke & Geithner. Yet the necessary decision to report the results of the SCAP publicly had significant future implications for banks and also for investors. In 2009, investors were concerned about a growing federal role in the banking system. And that is precisely what has occurred. The SCAP evolved into the Comprehensive Capital Analysis and Review (CCAR), which is the key part of the stress test duet that determines if banks can increase cash returns to investors. The Fed noted in May 2009: “The unprecedented nature of the SCAP, together with the extraordinary economic and financial conditions that precipitated it, has led supervisors to take the unusual step of publicly reporting the findings of this supervisory exercise. The decision to depart from the standard practice of keeping examination information confidential stemmed from the belief that greater clarity around the SCAP process and findings will make the exercise more effective at reducing uncertainty and restoring confidence in our financial institutions.” When the Dodd-Frank law was passed a year later in 2010, Congress included an expanded legal mandate to conduct annual stress tests and for hundreds of banks. In October 2012, the various federal regulatory agencies issued final rules implementing stress testing requirements for hundreds of public and private companies with over $10 billion in total assets. Most of these smaller institutions outside of the original 19 banks had no part in the 2008 financial crisis and were in fact victims. The bank stress tests continue the fine American tradition of punishing the victims. Since 2012, the stress tests have devolved, from a modestly useful annual process focused on the top institutions to a monumental waste of time and money. This effort is focused on most of the US banking industry as measured by assets. The chief architect of this regulatory effort was former Fed Governor Daniel Tarullo, who was responsible for bank supervision and resigned earlier this year. Governor Tarullo turned the stress test process into a nearly continuous form of supervisory torment involving bank management, directors and legions of consultants and lawyers. JPM CEO Jamie Dimon remarked frequently about the cost of stress tests, living wills and the various other requirements of Dodd-Frank. On top of required levels of capital, the Fed under Tarullo’s leadership proposed capital buffers and capital surcharges partly based upon the subjective stress test performance of each bank. The stated point of this exercise is supposedly ensuring the safety and soundness of US banks, but the reality is far different because the process has shifted from a short-term focus on restoring confidence in bank debt to an annual media event that impacts bank equity. So intense is Wall Street's interest in how stress tests could affect bank earnings that even Fed Chair Janet Yellen has become involved in the media frenzy. And the stress tests contain no information that would be material to investors. Violating the traditional confidence of the supervisory process to release stress test results serves no useful purpose, especially given that the tests are different for each bank. There is no comparability one bank to the next. How are analysts much less investors supposed to use this chopped salad? First and foremost, the bank stress tests do not measure the ability of a bank to weather the types of market stress seen in 2008. As regulators have known for decades, income is the key determinant of a bank’s ability to offset credit losses. Income, net of provisions for future losses, is also a key factor when it comes to predicting a bank’s probability of failure and thus maintaining investor confidence. When a bank starts to show (or event hint at) red ink due to climbing credit costs, investors start to flee and liquidity evaporates. The amount of capital the bank may or may not possess is immaterial, as illustrated by the events of 2007 and 2008. The added uncertainty caused by off-balance sheet finance (using the very same SIVs made famous by Secretary Paulson) led to the failure of many large firms from 2008 onward. Yet the only time that a bank actually consumes capital is when the institution fails and its net assets are being sold. As shown by the situation facing Citi in 2008, the GSEs, and in Italy last week, by the time that we actually start talking about a bank’s capital, that institution is already dead. Second, because of the public nature of the stress tests, the Fed and other regulators have become the very public arbiters of bank dividends and stock repurchases. The annual process of conducting the Dodd Frank Act Stress Test (DFAST) and CCAR has become a dual yardstick for whether a given banking organization can increase dividends and/or share repurchases to meet Wall Street’s expectations. The fact of the Fed conducting the stress test initial process publicly in 2009 made this evolution to the public stress test process inevitable. But any benefit in terms of bank safety and soundness has been lost as the stress test exercise mutated into a media circus that each year precedes second quarter earnings by a week or so. From an equity market perspective, the Fed’s timing could not possibly be worse. Ryan Tracy at The Wall Street Journal notes: “The tests will continue to matter to investors. The Fed will still use them to audit banks’ plans to boost dividends and buybacks for shareholders, and the numerical part of the exams will still be crucial to determining those payouts.” So are stress tests good for bank stocks? No. The stress test process is part of the expanded regulation of the US economy by the Fed since the 2008 financial crisis. Dodd Frank has reduced the opportunities for banks to earn profits, while limiting their ability to provide new credit to support economic activity. Payouts to investors are now held hostage to the opaque annual stress test process conducted by the Fed and other regulators. American banks have been neutered as sources of alpha for investors. Through the prohibition of principal trading activities and any type of risk lending, banks have become low risk, no alpha platforms. The stress test process has transformed the capital finance dimension of banks into a regime similar to the rate setting process applicable to heavily regulated electric utilities. This is not a problem of bank management, but of our public officials in Washington. While the evidence continues to mount that over-regulation of banks is constraining economic growth and job creation, there are still voices in Washington that seek additional regulatory constraints on banking. Elizabeth Warren (D-MA) told The Wall Street Journal last week that President Donald Trump does not have a mandate to lessen regulation of banks. She said: “You do polls across this country, and I’m talking about polls of everybody—Democrats, Republicans, Independents, Libertarians, vegetarians, everybody. Somewhere in the neighborhood of 80% and upward believe that the largest financial institutions in this country need more regulation, not less regulation.” Senator Warren’s comment is right but only mimics what Teddy Roosevelt proved a century ago, that most people hate big banks. But is her prescription for more regulation a good idea in terms of public policy? Absolutely not. Warren’s comment suggests that politics, not substance, is her true motivation when it comes to yowling about bank regulation. But at least she is asking questions. Looking at the patchwork of regulations, punitive capital rules and meaningless stress tests that have been embraced by Congress since 2008, there is little that either protects the taxpayer or promotes a healthy banking system. The only thing that the current regime for U.S. banks ensures is that financials will have little upside in terms of equity valuations unless and until the regulatory situation changes. That was the whole point of the rally in banks stocks following the November 2016 election. At about 1x book value, today most bank stocks are fairly valued given the current regulatory regime and their business opportunities. Some of the better performers among larger cap names such as US Bancorp (NYSE:USB), Bank of the Ozarks (NASDAQ:OZRK) and Wells Fargo (NYSE:WFC) command higher valuations due to strong financial performance, but most banks simply do not deserve higher book value or earnings multiples in the current regulatory regime. The financial crisis is over. The DFAST/CCAR process needs to be ended as a public exercise. Future capital adequacy analysis by regulators should be performed privately as it was prior to 2009. The regulatory burden on banks needs to be reviewed with an eye to removing regulations that fail either to make banks safer or support economic growth. And remember that bad banks never die from lack of capital, they just run out of cash. 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.

June 24, 2017 | The IRA is writing today from Camp Kotok, which is held each year at Leen’s Lodge in Grand Lake Stream, Maine. We are in Washington County, which is on the border of New Brunswick, Canada, and about 200 miles north of Bangor up Rt 9. This is Down East Maine, the land of Thoreau with rolling hills and lots of beautiful rivers and lakes. The conversation this year is much the same as the narrative on Wall Street, focused on the new records for asset values and questions about what happens next with the Fed and the markets. Each day, analysts ask whether the markets can continue to climb the wall of worry to every higher (and more incredible) valuations. But at Leen’s we are concerned about more weighty matters. This week brought the latest results of the Fed’s annual stress test circus, a strange coming together of financial media and regulators in a celebration of disinformation. The stress tests don’t test the ability of banks to withstand losses, but rather the skill of bank managers at responding to the inane procedures set forth by the central bank. The real risk in banks is not what you can read in published financials or Fed stress tests, but the unknown. They key indicator of a bank’s ability to absorb loss is not capital, but income. During the 2008 financial crisis, the US banking industry diverted tens of billion of dollars from income to provisions for future losses. After a couple of years, the crisis was contained and banks regained profitability. In those cases where capital (or more specifically, confidence) was in doubt, such as Citigroup (NYSE:C) and Wachovia, the institutions failed. The Street cares about stress tests because it is believed that good results will allow banks such as Citi to return more capital to investors. The fact that the Fed’s manipulation of credit markets and spreads via QE makes higher future credit losses likely for banks is not even mentioned. Indeed, the fact that stress tests don’t explicitly include the negative impact of monetary policy on bank loan portfolios makes a mockery of “macro-prudential” policy. We should always remember that the bank stress tests were not meant to measure capital or loss absorption capacity, but rather to restore confidence. Investor confidence is a function not of capital, but of the degree to which investors believe that they understand risk. In 2008, markets disintegrated because trust was broken by acts of financial fraud contained in the “off balance sheet” liabilities of major financial institutions. Today, markets are far too trusting of the clairvoyance of the leadership at the Fed and other government agencies. We are especially amused by reports coming out of China about official concerns regarding the credit quality of heavily indebted state companies. China is a festival of bad debt and inadequate disclosure that makes the shenanigans of 2008 pale in comparison. As in 2008, what the markets don’t know is the real risk, not the amount of capital in published reports. You can be sure, however, that in the days and weeks ahead new surprises will keep emerging from China’s corrupt kleptocracy . We continue to be cautious about the outlook for financials in Q2 2017 and beyond, in part because the catalysts behind the bull trade in financials early in 2017 have largely failed. Interest rates are falling, bank earnings are flat and new lending volumes are decelerating. Credit costs for consumer and business loan portfolios are rising. Yet it is still possible to find analysts who think that financials are the next big thing. The one truth that remains unaltered is that financials are a reflection of the markets which they serve. We worry that by gunning the economy with years of unnecessary QE, the Fed has embedded significant future credit losses on the books of many banks and funds, raising questions as to whether the income and capital of today is adequate to meet the requirements of tomorrow. Loan losses and future risks are currently understated, thus investors need to exercise caution in making asset allocation decisions. But fortunately, our main concern today is catching fish and wishing the readers of The IRA tight lines and a good weekend.

“Markets go up on an escalator, they come down on an elevator. This is the most hideously overvalued market in history.” David Stockman June 19, 2017 | Last week’s action by the Fed was an effort to restore normalcy, but in the context of extraordinary action by the central bank. When you tell markets that the risk free rate is zero, it has profound implications for the cost of debt and equity, and resulting in different asset allocation decisions. Ending this regime also has profound implications for investors and markets. In the wake of the financial crisis, some investors found comfort in the fact that when risk free interest rates are at or near zero, the discounted future value of equity securities was theoretically infinite. Markets seem to have validated this view. But to us the real question is this: If a company or country has excessive and growing amounts of debt outstanding against existing assets, what is the value of the equity? The short answer is non-zero and declining. But hold that thought. Reading through Grant’s Interest Rate Observer over the weekend, we were struck by the item on China Evergrande Group (OTC:ERGNF), a real estate development company and industrial conglomerate that has reported negative free cash flow since 2006, but has made it up in volume so to speak. The stock is up over 200% this year, Grant’s reports. The real estate conglomerate has its hands into all manner of businesses and seems to typify the China construction craze. Grant’s recalled an earlier observation by a US Texas real estate manager in the 1980s, something to the effect that real estate is not a cash flow business, but rather an asset appreciation business – until you can no longer service the debt. We can recall hearing similar cautionary comments about the dangers of leverage from Kevork S. Hovnanian years ago, when he spoke about holding on to some of his land investments in South Jersey for decades and with no debt. Today the idea of investment without leverage draws ridicule, partly because unlevered returns in most industry sectors are down in single digits. The observation from the unknown Texas real estate man three decades ago pretty much sums up the state of the US economy. This week as The IRA heads for Leen’s Lodge in Grand Lake Stream for some Spring fishing, we see bubbles in the water just about everywhere, but little in the way of revenue growth. Empty retail locations are multiplying across Manhattan. Earnings in sectors like financials are up on cost cutting and share repurchases, but supported by little else. Asset prices for all manner of investments have risen by double digit rates or more, but income – that is cash flow – seems wanting. As in the early 2000s, the Fed has squeezed credit spreads and thereby gunned asset prices, but to little effect in terms of employment or especially income. QE did not work, notes FT Advisors. While some of our fishing partners believe that tight spreads are always a benefit to the economy, when spreads fail to differentiate relative credit risk, then eventually equity must be restored via a little old fashioned deflation – right? Consider the case of Amazon (NASDAQ:AMZN). Here’s a company with relatively little debt and fewer profits, but high revenue and equity market growth rates. The company has less than $2 billion in net working capital supporting $140 billion or so in revenue, but trades at 3x sales and 21x book value. Moody’s has AMZN at “BBB+” based upon improving debt service cover for its $20 billion in long term and lease obligations. One of the fabulous FAANG stocks – this after Facebook (NYSE:FB), Apple (NASDAQ:AAPL), Amazon, Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOG) -- AMZN last week announced the acquisition of Whole Foods Market (NASDAQ:WFM) for $13.7 billion. The consideration to be paid, in cash of note, is a rounding error compared with the $472 billion market cap of AMZN. And like AMZN, WFM is a low or no margin business as well, thus the pairing seems entirely appropriate -- but is also enormously disruptive. AMZN + WFM adds to the financial black hole created in retailing by AMZN. The combination of AMZN and WFM is seen as bringing the deflationary apocalypse for the retail food sector, one of the more vulnerable parts of the US economy. Jim Cramer of CNBC says "AMZN is a deflationary force. Fed needs to think about it." True, but the more interesting question is how the massive expansion of debt orchestrated by the Fed since 2008 and particularly with QE after 2012 has impacted equity market valuations for stocks such as AMZN, as shown in the chart below. By pulling trillions of dollars worth of duration out of the US financial markets via quantitative easing (QE), the Federal Open Market Committee has shifted risk preferences for both debt and equity. The net result is a series of debt-fueled bubbles in various asset classes, but none larger and more problematic than in large cap US equities. In order to “normalize” the credit markets, the Fed must be willing to let the equity and debt markets adjust in the short-run – by no means a given. With the toppy state of equity market valuations, the components of FAANG may be in for some significant downside. Part of the reason that the FOMC remains so clearly hesitant about reducing the size of its balance sheet is the well-informed suspicion that the Street will be unable to absorb the increase in volatility that will accompany true market normalization. Since much of the market in US Treasury debt and agency mortgage paper such as GNMAs is controlled by foreign central banks, the free float is small. Dealer inventories are minimal, thanks to the Volcker Rule. The end of portfolio reinvestment and even modest sales will increase both longer yields and market volatility. For those of us who have been critical of Fed policy since the end of QE1 in 2012, the return of more normal levels of volatility would be a positive sign that the central bank finally is willing to allow markets to once again price risk. But the downside is that the fiscal situation in the US and overseas could see yields on government debt rise dramatically once investors fully appreciate that the days of QE are ended. Having redefined “normal” based upon the extraordinary environment maintained by the FOMC since 2012, the Yellen Fed is now faced with its greatest test, namely allowing the financial markets to engage in price discovery without overt government support. We’ve been talking for years about the financial implications of the Fed’s portfolio and how trillions in duration negatively influences yields and spreads, but credit also impacts equities. At the same time, mounting levels of public and private debt call into question whether investors can really invest in equities for the longer term without an assumption of more or less continuous QE. Where would stocks like AMZN and WFM be trading in the absence of QE? Just as a zero percent risk free rate suggests an infinite valuation for equities, the end to official market manipulation by the Fed suggests an equal adjustment in market valuations as we walk back from extraordinary to normal. 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. 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