June 15, 2017 | Below are some thoughts for the discussion at Cato Institute in Washington, D.C., today, “Financial Crisis and Reform: Have We Done Enough to Fix the Government-Sponsored Enterprises?” The title for today’s discussion is a question “Have We Done Enough to Fix the Government-Sponsored Enterprises?” The short answer is “Yes.” A decade and a half before the US government took over the GSEs in 2008, Harold Ramis came out with a film called “Groundhog Day” starring Bill Murray, Andie MacDowell, and Chris Elliott. Murray’s character, an arrogant TV newsman from Pittsburgh named Phil Connors, is caught in a time loop, repeating the same day over and over again. Talking about GSE reform has taken on a similar quality. There is a crisis in the world of mortgage finance, but it has nothing to do with the debate of government-sponsored enterprises such as Fannie Mae and Freddie Mac. The situation with the GSEs is a Washington story that deals mostly with issues of equity and public policy, but gets virtually all of the attention from the financial media. To the bond market, though, the only validation needed to support the “AAA” rating of the GSEs is the credit support of the United States, period. The “sale” of the GSEs 50 years ago was a financial fraud perpetrated by members of Congress and a number of Presidents going back to Lyndon Johnson. The US government never “loosed dominion” over the GSEs, to paraphrase Supreme Court Justice Louis Brandeis, who ruled in 1925 that an incomplete sale “imputes fraud conclusively.” The erstwhile shareholders of the GSEs, seen through that prism, are really creditors rather than owners. Meanwhile, the business of making and servicing loans is being slowly decimated by over-regulation, soaring operating costs and uneven interest rate markets. Over-regulation of the mortgage industry hurts banks and non-bank financial institutions, and their customers and shareholders. More the any other change to the Dodd-Frank law, the standard for regulation of lenders needs to be revisited. A bizarre line of thinking prevalent in the academic world says that increased regulation of commercial banks since 2008 has somehow made non-banks more competitive that depositories, which are after all GSEs just like Fannie Mae and Freddie Mac. Banks have access to the Discount Window, federal deposit insurance and other subsidies, and are protected from hostile takeovers by the Fed. But of course, we all know that Feinberg’s First Law states that no private entity can compete with a GSE. In fact, the increased regulation of home mortgage finance has made it virtually impossible for many smaller non-bank firms and community banks to operate profitably in the residential mortgage market. There is a steady exodus of both banks and non-banks out of residential lending and servicing, particularly from the government guaranteed market overseen by the Federal Housing Administration (FHA). The growing dominance of the remaining non-banks in the FHA market raises both liquidity and credit concerns. Non-banks have the least ability to fund FHA lending, servicing and loss mitigation tasks, yet they are now well more than half of the total market. And the FHA is taking share away overall from the GSEs through insuring below-prime loans, paper the commercial banks won’t touch. In 2014, JPMorgan (NYSE:JPM) Chairman Jamie Dimon very publicly moved his bank out of the FHA market, a trend that has been followed by many other commercial banks. Dimon is especially critical of the FHA’s use of the False Claims Act, Civil War era legislation that was intended to protect the government from fraud by suppliers. Many industry participants say that the False Claims Act has been used abusively by the Department of Justice to extort fines and settlements from banks and non-banks alike. Many of the supposed “violations” of law alleged by the DOJ did not happen at all, but the mere threat of criminal prosecution of a bank’s officers and directors has been enough to compel most private lenders to settle and pay. Not only have these unwarranted fines been costly for shareholders, but the withdrawal of banks from the FHA market has, according to Dimon, reduced mortgage lending by banks to the tune of about $300 billion annually. Likewise, the undefined “abusive practices” standard contained in the Dodd-Frank law has been used to extract billions in fines from banks as well as non-banks. Only in rare instances such as Quicken’s litigation with the DOJ and PHH Corp’s (NYSE:PHH) now famous Constitutional challenge of the Consumer Finance Protection Bureau (CFPB) have private lenders been willing to fight back against this abuse of power by the CFPB and DOJ. Most of us are familiar with the travails of Ocwen Financial (NYSE:OCN), but literally dozens of other non-bank mortgage firms have been unjustly penalized by the CFPB and state agencies. Most recently, the CFPB issued a sensational statement, saying it was fining Fay Servicing, a high-touch distressed mortgage servicer in Chicago, more than $1 million for “illegal foreclosure practices.” According to the CFPB, an “investigation” found that Fay Servicing was “keeping borrowers in the dark” about their foreclosure prevention options. Like many mortgages firms that have settled with the agency, Fay founder and CEO Ed Fay took issue with the characterizations in the CFPB’s remarkable press release. He notes that his firm was not asked to pay a fine, otherwise known as a civil penalty payment. Rather, Fay was asked to pay $1.15 million in redress to borrowers; to offer borrowers opportunities to pursue foreclosure relief; and comply with mortgage servicing rules. This action against Fay, PHH, Ocwen and many, many other firms follows the familiar pattern of the National Mortgage Settlement and the CFPB’s rule making authority, both of which essentially allow aspiring politicians to tax private mortgage firms for “abusive practices” or “violations of law” without any due process or transparency. And at the top of the political food chain, the US Attorney and the CFPB act as judge and jury in a modern day Star Chamber in issuing enforcement actions and fines. The cost of regulation is seen in the expense required to make or service a home loan. According to the Mortgage Bankers Association, the average cost of servicing a performing loan rose to $181 in 2015, three times higher than in 2008 when the cost per loan was $59. The average cost of servicing a non-performing loan grew to $2,386 in 2015, almost five times higher than in 2008 when the cost per loan was $482. This increase in cost was driven by one public policy priority enshrined in Dodd-Frank, namely protecting American consumers from abuse of process when they failed to repay their home mortgages. Defaulting on your mortgage has become a new American entitlement. With the election of Donald Trump, both banks and non-banks believed that salvation was at hand. Stock prices soared on the promise of deregulation of the financial services industry, both via reform legislation and more simply by putting agencies such as the DOJ and CFPB back into business friendly hands after eight years of bleeding under the Obama Administration. The Trump Administration has proposed that the CFPB be substantially stripped of its powers, but events in the bond market have created even bigger headaches. Yet despite a lot of positive talk coming from Washington, the situation facing the mortgage industry is dire as Q2 2017 comes to an end. First and foremost, the talk early on regarding infrastructure spending and lowering taxes took Treasury bond yields up half a percentage point in the three months after the election. The sharp rise in rates right after November 2016 put the kibosh on mortgage refinancing, driving industry volumes down sharply. As shown in the chart below, the Mortgage Bankers Association (MBA) has future refi volumes flat lined at $100 billion per quarter into 2019 vs $250 billion per quarter in Q2-Q4 2016. Because of the upward move in interest rates in the three months following the election of Donald Trump, today the mortgage industry is running light on home lending volumes to the tune of $300-400 billion this year. When you hear us suggest that the Federal Open Market Committee could easily sell $50-100 billion per month in mortgage bonds from its hoard, this decline in agency issuance is partly the reason. The chart below shows the 10-year Treasury bond and 30-year mortgage rate. If you understand the concept of option adjusted duration, then you’ll perceive that by maintaining a position of over $2.2 trillion in mortgage securities, the Federal Open Market Committee has created a downward bias on long-term interest rates. The resulting compression in bond yields (and credit spreads) now visible in the mortgage and forward rate/TBA markets is in direct opposition to the policy objectives of the FOMC, of note. This is why we believe that Chair Yellen and the FOMC err in putting increases in benchmark rates ahead of portfolio sales. The operating results for the industry reflect the political and financial confusion that the two above charts illustrate. MBA Vice President of Industry Analysis Marina Walsh and her colleagues have dutifully assembled statistics for the US mortgage industry in Q1 2017 and the results are truly dreadful. "The drop in overall production volume in the first quarter of 2017 resulted in the highest per-loan production expenses reported since inception of our study in the third quarter of 2008," said Walsh. "While higher production revenues mitigated a portion of the cost increase, production profitability nonetheless declined by more than half the previous quarter. For those mortgage bankers holding mortgage servicing rights, an increase in mortgage interest rates resulted in MSR valuation gains and helped overall profitability." Other key MBA findings: Average production volume fell to $455 million per company in the first quarter, down from $690 million per company in the fourth quarter. Volume by count per company averaged 1,944 loans in the first quarter, down from 2,811 loans in the fourth quarter. Average pre-tax production profit fell to 10 basis points in the first quarter, down from an average net production profit of 24 bps in the fourth quarter. Since inception of the Performance Report in third quarter 2008, net production income has averaged 51 bps. Purchase share of total originations, by dollar volume, rose to 68 percent in the first quarter, compared to 58 percent in the fourth quarter. For the mortgage industry as a whole, MBA estimated purchase share at 59 percent in the first quarter. When our friends in the regulatory community ask us why the mortgage industry does not make more investments in expensive new technology to improve the servicing process, we gently remind them that half of the industry is not profitable. Most of the rest have equity returns in mid-single digits at best, paltry results that consign these businesses to mostly debt financing, with full collateral of course. A cynic might say that no sane investor would allocate capital to this business -- unless there is serious scale involved, say at least $100 billion in unpaid principal balance (UPB) of loans serviced. Go big a la Nationstar (NYSE:NSM), Quicken, Flagstar (NYSE:FBC) or Lonestar’s Caliber, or go home. Since for most non-bank mortgage firms the intangible MSR is the only real capital asset, innovative financing for loan servicing assets is currently the holy grail. For regulators and researchers to compare non-banks with heavily subsidized and regulated banks is fanciful, but it also reflects an indifference on the part of the policy community regarding the real world impact of regulation on people and markets. The changes in regulatory incentives in the banking world since 2008 have made residential loans among the least attractive loan types for any financial institution. Regulators have actively discouraged banks from engaging in either lending or servicing below-prime loans. With some notable exceptions, most banks have decided to avoid residential lending. Why? Because the risk-adjusted returns are relatively low once high operating expenses and regulatory/reputation risk is factored into the equation. The goal of any regulatory change in the mortgage world should be to preserve the protections for consumers that were codified in the National Mortgage Settlement and also contained in Dodd-Frank, but make the regulatory process less adversarial and, frankly, more fair. The current regulatory environment for consumer lending in the US is entirely counter-productive for both consumers and investors. Former Solicitor General Ted Olson said of the Dodd-Frank consumer agency in arguments for PHH: “The CFPB’s structure is the product of aggregating some of the most democratically unaccountable and power-centralizing features of the federal government’s administrative state.” Nothing better proves Olson's point than the treatment of the mortgage industry by the CFPB over the past five years. The employees, customers and investors of mortgage companies enjoy the same Constitutional protections as all Americans. They should be treated with respect and fairness, rather than disdain and indifference. No other industry in America faces the level of punitive hostility that the mortgage community endures at the hands of the CFPB and other agencies. If regulators work with the industry to balance fairness with regulation, mortgage industry profitability will improve and with it the possibility of operational improvements that best serve consumers and investors as well. 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.

“Stock prices have reached what looks like a permanently high plateau." Irving Fisher October 1929 This Thursday The IRA’s Christopher Whalen will be in Washington to participate in an event at Cato Institute, “Financial Crisis and Reform," We'll talk with Cato's Ike Brannon about whether enough has been done to “fix” the problem, real or imagined, with Fannie Mae and Freddie Mac. The question posed by the title of the Cato Institute panel suggests that Washington has the slightest idea about the “problem” in the mortgage business much less a solution. You can be sure that nobody actually working in the US mortgage market is losing any sleep over the fate of these troublesome government sponsored enterprises. Whether you’re lending, servicing loans or managing interest rate risk, you’ve got bigger issues than the fate of the GSEs. Excessive regulation and fickle benchmark interest rates top the list. More on Mortgage Finance in the Age of Trump in our next comment. And that same evening also at Cato, we’ll be speaking to The Prosperity Caucus about the new book “Ford Men: From Inspiration to Enterprise” and talk about the brave new world of “mobility.” And we’ll have some good stories to tell about John Carbaugh, Robert Novak and other former members of the Prosperity Caucus. The past eight months since the election of Donald Trump has been anything but stable, either for investors, lenders or consumers. Coming off of the Brexit vote in the United Kingdom last summer, the events that followed the Eighth of November have seen markets soar on waves of optimism, only to be thrown down in bitter disappointment. And the economic indicators are no more clear than they were before the US election. Wall Street desperately wants to believe that interest rates are headed higher, part of a larger need to confirm that the current market and economic situation is returning to normal. Yet fact is, after eight years of monetary experimentation by Bernanke, Yellen & Co, interest rates are falling, debt markets are at record levels of issuance and the new-issue equity markets are largely barren of value. It is notable that despite the downward movement in Treasury yields, there are still analysts willing to make public arguments about the benefit to banks of rising interest rates. While net interest margins for all US banks did rise about 10bp in 2017, this was largely due to the upward move in rates after the surprise electoral win by President Trump, as shown in the chart below. Since the end of the year, however, the twin pillars of the bull trade in financials – rising interest rates and deregulation – have been eroded to the point of disappearing entirely. We spoke about the prospects for legislation helping the banks with our friends on CNBC’s “Squawk Box” on Friday. The fact that there are still analysts willing to tout the positive aspects of rising interest rates when the 10-year T-bond is sinking towards 2% yield illustrates the indomitable optimism of Wall Street – and the degree to which forward risk indicators are diverging. We called for a 2% yield on the ten year T-bond at the end of last year, a viewpoint that is confirmed by the mounting evidence of credit problems in asset classes from credit-cards to commercial real estate to auto paper. By embracing the modern equivalent of “trickle down” economics via asset price manipulation, the Federal Open Market Committee has succeeded only in adding a new layer of speculative debt atop the financial carcass as it stood around 2010. As this latest vintage of debt issuance ripens, we may be surprised at the rate of change in terms of credit losses at banks and inside ABS. "Although card standards were extremely tight in the years following the financial crisis, if underwriting then loosened materially, as the rise in charge-offs suggests, asset quality could continue to deteriorate rapidly going forward, especially in the event of a recession," notes our colleague Warren Kornfeld at Moody's. As we opined in earlier missives, the key relationship to watch when it comes to bank earnings is not interest rates or even net interest margin, but provisions for credit losses vs operating income. This is an especially important topic because the folks at the FASB are currently negotiating with the banking industry about changes in estimated future loss rates on loans that could add 10% or so to the cost of bank provisions for credit losses. Our friends in the bank credit channel say that the impact of the rule change by FASB will be for banks to over-report likely loan losses, which will then lead to larger recoveries after the defaulted loan is fully resolved. The standard is expected to take effect in 2020, although FASB has indicated that it may revise the rule to address industry concerns. It is more than a little amusing to see the FASB advocating a change in presentation to bank loan loss provisions that will effectively result in over-reserving for credit losses. This was traditionally the position taken by prudential regulators, while the SEC always tended to want to see loan loss provisions kept to a minimum so as not to artificially understate earnings. Shareholders will, eventually, see the cash returned to the bottom line via recoveries, but seeing this reversal of roles is a rather delicious irony. Changes in accounting rules, however, will not change the underlying economic reality of excessive debt. We worry about the fact that the latest period of exuberance engineered by the FOMC has embedded significant future losses in the financial system. While the US may be a good bit healthier than the EU or China when it comes to absolute debt levels and credit quality, the fact remains that the predominant tendency in the US credit markets remains deflation. The 20th Century US economist Irving Fisher worried about the decline of income in the event of a debt deflation, yet today we face a different problem. A combination of technology, innovation and the aging demographics of the key industrial economies is limiting income growth even as asset prices are goosed ever higher by monetary policy and structural constraints. One reason we expect that the widely anticipated rate hike by the Fed this week will be the last is that members of the FOMC seem to at least understand that the US economy is slowing. Rising credit losses in a variety of asset classes will force the central bank to pause on the road to normalization and prepare to battle another bout of old fashioned debt deflation. Irving Fisher noted in 1933 “that great depressions are curable and preventable through reflation and stabilization,” but it remains questionable whether the FOMC has in fact achieved either of these blissful ends over the past eight years. Fisher worried that “when over-indebtedness is so great as to depress prices faster than liquidation, the mass effort to get out of debt sinks us more deeply into debt,” but in 2017 the problem is different. In the 1930s, the debt markets were allowed to clear without government manipulation or support, resulting in catastrophic debt deflation. Today the Fed artificially supports elevated asset prices in the vain hope that a “wealth effect” of some sort will “trickle down” and boost incomes. Memo to Chair Yellen: There is no wealth effect, there is no wealth effect. What is clear is that the Fed has added to the collective credit bubble, begging the question as to when asset prices will readjust downward again to match flat income levels. Not only has US public debt almost doubled since 2008, but private debt has likewise risen by mid-double digit rates. The slowly rising cost of credit visible in banks and the bond market may herald the start of a new type of debt deflation cycle. Thus we expect June to be the last rate hike by the Fed in 2017 and perhaps for years to come. As with January/February 2016, our friend Nouriel Rubini writes, concerns about faltering US growth could put further rate hikes on hold. Just imagine how Wall Street will greet that happy news. The real question for investors is when will the Fed be forced to publicly reverse course on rate increases, then cut rates and maybe even resume asset purchases to keep debt deflation at bay for a while longer. #Bernanke #yellen #Cato #Banks #CNBC #GSEs

June 8, 2017 | In this issue of The Institutional Risk Analyst, we speak to John A. Kanas, Chairman of BankUnited (NYSE:BKU). Kanas rose to prominence in the banking world first by building North Fork Bank into a leading northeast community lender, then selling it in 2006 to CapitalOne Financial (NYSE:COF) for $14 billion in cash and stock . In 2009, he led an investor group, which included Blackstone, Carlyle Group, Centerbridge Partners and WL Ross & Co, that acquired a failed Florida thrift called BankUnited. Kanas and his veteran team rebuilt the bank and doubled the institution’s assets over the past seven years. He stepped down as CEO of BankUnited in January, handing the reins over to COO Rajinder P. Singh . We spoke to him last week from Florida. RCW: John, thanks for taking time to speak with us. When you look back over building North Fork and BankUnited, two very different banks, how do you think about these two institutions? JK: Building North Fork really was about the banking market of the 1990s and 2000s. BankUnited was a failed bank that we acquired from the FDIC in 2009. Both banks were similar in that they served a local community of businesses and consumers, classic relationship banking. You had to understand the local landscape and give your customers white glove service. As today, the competition for deposits and loans in those days was intense. RCW: Is there more competition today in the industry among smaller banks than the larger institutions? JK: Competition among smaller institutions has always been intense. The larger banks have very different funding models. The smaller banks are going head-to-head for the best customers in the markets they serve. The larger banks really don’t focus on those types of customers, small to mid-size businesses, for example. RCW: And the larger banks tend to be half market funded as opposed to core deposits. It sounds like the smaller banks need the deposits. Is that good? JK: Yes, there is clearly an ongoing need for deposit growth at banks. Mid-cap and smaller banks tend to be fully loaned out with ratios of loans to deposits in the 90 percent range vs. the 70s years ago. RCW: The data from the FDIC suggests that, over the past 30 to 40 years, banks have seen the average return on earning assets fall from over 1% to just 75bp today. Has this shrinkage in asset returns forced banks to increase their leverage by making more loans? JK: In part that is definitely true. Remember that we have been operating in a period of declining interest rates for decades, so banks have been forced to adjust their business models to support returns. RCW: Your peers among the better run community banks tend to have loan to deposit rations in the 90 percent range, yet the old models used by bank regulators and rating agencies penalized banks for being fully loaned out. Does the credit sector need to rethink how they assess loan to deposit ratios and bank business models? JK: That is correct. In today’s market, a well-run institution has to be fully loaned out to make the asset and equity returns work. RCW: Does the question of success or failure for a bank ultimately come down to credit management? Look at Bank of the Ozarks (NASDAQ:OZRK). We get calls constantly from investors looking to short that stock because of the focus on C&I lending and commercial real estate. Our response is “be careful what you wish for.” Bank of the Ozarks has a very strong credit culture and went through the financial crisis pretty much unscathed. In fact, our friends at Kroll Bond Ratings just put OZRK on watch for a ratings upgrade ! JK: A lot of people have lost a great deal of money trying to short OZRK over the past several years. The bank has performed extremely well despite their focus on real estate lending. RCW: At BankUnited, you tended to stay away from areas such as residential mortgages and auto loans, preferring to focus on commercial lending. Has this included lending on construction and development in your footprints in New York and Florida? The banking industry’s portfolio numbers on C&D lending are literally half of where they were before 2008, largely because the loans were charged off and restructured. A number of banks failed because of C&D. How do you view the C&D sector given your focus on FL and NY? JK: The regulators have been very direct with their guidance to the industry regarding C&D lending because of the experience that you mentioned. It has been very tough to expand that asset class. The message from regulators is that C&D lending must be done very carefully. RCW: The number of home builders have been cut by a third since 2008. It is not hard to understand the concerns of regulators given the number of bank failures. How does the US grow the amount of credit available to support new construction of single family homes? The asset prices for residential properties in your footprint have been soaring and the credit metrics for defaulted construction loans are extremely good. JK: C&D loans today tend to be 30-40 percent loan to cost as most, meaning that there is a lot of equity in these deals. The regulators have a very cautious posture toward construction lending and this is reflected in LTV ratios. Yet if I were running my own bank today, without being accountable to other shareholders or regulators, I would do nothing but construction lending because there is such a great need. RCW: And better returns than residential mortgages or prime auto loans. Let’s go back to BankUnited transaction for a moment. When you acquired that bank from the FDIC, what was different about that experience vs building North Fork? JK: When we bought BankUnited in May of 2009, we were one of less than five bids for the bank. I was working with Wilbur Ross at the time to identify opportunities in the banking sector. The situation in the markets was very uncertain. Nobody in the financial world had a clear vision about what to do next. The prices for failed bank assets reflected this uncertainty. North Fork was a much more conventional story having been forged out of 18 acquisitions over 30 years. RCW: When then-FDIC Chairman Sheila Bair and her colleagues at the FDIC sold Indymac in January 2009, the literally room was empty. The FDIC put loss-sharing on the table and got the party started, but it sounds like not much changed in several months between that transaction and the acquisition of BankUnited. JK: The pricing did not change immediately. Our original plan going into the BankUnited transaction was to buy a number of failed banks in Florida but once we closed the acquisition, the pricing in the market improved dramatically for the FDIC. That ultimately drove our decision not to continue with a more aggressive acquisition plan. RCW: So how about today? The whole industry was taken up by 20-30% following the election of Donald Trump. What do you tell your shareholders about the movement in banks stocks over the past six months? JK: There was a lot of enthusiasm after the election given the prospect for tax cuts and deregulation, but this promise has faded. It is not clear what will actually be changed in terms of the regulatory environment this year. RCW: It looks like the regulatory relief for small banks will be the easiest thing to get through the Congress. Do you agree with that? JK: Yes, there is clearly support for regulatory changes to help small banks. The support for rest of the agenda is far less clear, including tax cuts and other changes outside of the regulatory sphere. The community bank sector is very competitive right now when it comes to deposits particularly. There is a case to be made that smaller banks need relief so that they can continue to provide credit to local customers. RCW: So talk about the community banking sector going forward. There is a flood of opinion coming from the investment bankers and consultants that says that community banks are doomed and the industry will consolidate down to 1,000 banks. Is that your view? JK: I can remember first hearing those arguments about the demise of community banking back in the 1970s. Community banks are more relevant today than ever. So long as you have small communities with local businesses that need to be financed, community banks will be the only option to support this part of the American economy. RCW: Former Fed Chairman Paul Volcker reportedly once said that the only innovation in banking has been the ATM machine. Is that true? Is the industry changing of its own volition or is change being imposed? JK: Technology is clearly changing the industry in a number of ways, but there are also cases where the local demand for services actually goes the other way. We had looked at closing some branches in FL, for example, but when some of our competition shuttered branches, we found that our business grew at our facilities. The fact is that when people enter into a significant transaction like a business loan or home purchase, they want to talk to someone face-to-face. RCW: There is a lot of talk about how technology is pushing the industry towards branchless banking, yet the statistics seem to suggest that while consumer like to shop online, they also like to sit across the table from a banker when they enter into a major transaction like buying a home. And bankers often like to have a look at a prospective customer before committing on a loan. JK: Correct. When consumers or small business people enter into a significant commitment, they frequently want to do it in person. Going back to my earlier comment about “white glove” service, community banking is about individual service above all else. In the competitive environment in the industry today, you must be as aware of your customers’ needs as you are about new technology. RCW: We are part of a debate in the financial economics community about whether the fact of the Fed paying interest on excess reserves negatively impacts lending. Given the competitive environment you described, do you think that the fact of the Fed offering 1% risk free on excess reserves impacts your calculus as a lender, either in terms of price or the actual decision to lend? Net of FDIC deposit premiums, you’re making 85 to 90bps. JK: Any time risk-free investments are available to banks they present competition to building loan assets. Interest on reserves at the 1% level is no exception. RCW: We hear periodic rumors about you possibly going to Washington. The Wall Street Journal had a comment earlier this year. Is there any truth to these reports? JK: I have had some discussions with the Administration about a number of possibilities. There are some very capable people being considered for positions in the bank regulatory world but the process is ongoing. There are something like 150 individuals being considered for the positions that require confirmation alone. I don’t have any specific plans at the moment. I have a two year commitment as Chairman of BankUnited and look forward to being helpful to the industry as opportunities arise. RCW: Thanks for your time John. 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. In terested parties are advised to contact Whalen Global Advisors LLC for more information.

February 17, 2026  | Last week Federal Reserve Board Vice Chairman for Supervision Michelle " Miki" Bowman gave a very significant statement  about banks and the Basel III risk weights for residential loans and mortgage servicing rights to the American Banker Association. This statement was important because it is the first time in 15 years that an American regulator implicitly rejected the European view of mortgage loans, MSRs and other intangible assets related to consumer finance. The changes proposed by Governor Bowman, if made effective, will have a significant and very positive impact on banks and non-banks operating in the residential mortgage market. The United States began negotiating the Basel III framework with European counterparts and other international members of the Basel Committee on Banking Supervision (BCBS) shortly after the 2008 financial crisis, specifically starting in 2009–2010 under Presidents George W. Bush and Barack Obama . Following the collapse of Bear Stearns in March 2008 and then Lehman Brothers in September 2008, the takeover of the GSEs and the forced sale of Countrywide to Bank of America, the BCBS began a comprehensive revision of capital standards, with a focus on strengthening the framework in 2009 and announcing the overall design of the Basel III package in July 2010.   What Basel III represented in practice was a rejection of GAAP accounting and the well-established acceptance of intangible assets in American finance, especially payment intangibles like MSRs with identifiable cash flows. Instead the US negotiators, who had no discernable brief from the Obama White House or the banking industry, accepted the European hostility towards intangible assets under the IFRS accounting rules and particularly real estate finance. Both fully secured mortgage loans and MSRs were unfairly demonized by US and European officials who frankly did not understand or appreciate the economic significant of secured finance in the US economy. MSRs were assigned a 250% risk weight even though servicing assets carry no credit risk. Today, MSRs are one of the most sought after and valuable assets in finance. More, even after the 250% risk weight assigned to servicing assets under Basel III, banks were forced to subtract the MSR from capital, mimicking the treatment of this valuable intangible asset under international accounting rules. Adding to the damage, the mortgage agencies such as Fannie Mae, Freddie Mac and Ginnie Mae mimicked the idiotic Basel III treatment of MSRs and imposed similar requirements on independent mortgage banks (IMBs). Under Basel III, Mortgage Servicing Assets (MSAs/MSRs) are subject to strict limits, requiring banks to deduct amounts exceeding 10% of Common Equity Tier 1 (CET1) capital. Additionally, the aggregate of MSRs, deferred tax assets, and investments in unconsolidated financial institutions exceeding 15% of CET1 must be deducted. Amounts below these thresholds are risk-weighted at 250%. It is difficult for Americans to understand the hostility of EU regulators towards intangible assets and mortgage finance in particular. Regarding MSRs, everything that doesn’t affect European banks, who don’t engage in disintermediated finance in mortgages, is regulated out of existence. Secured finance in Europe is largely controlled by government agencies, one of the reasons why economic growth in Europe is so constrained. The crucial mistakes made during the negotiations for Basel III led to a bank withdrawal from residential lending and holding MSRs over the decade following the implementation of Basel III. For this reason, the import of the changes suggested by Governor Bowman are enormous. She suggests two key modifications to Basel III: Two regulatory proposals will soon be introduced that, among other broader changes to the regulatory capital framework, would increase bank incentives to engage in mortgage origination and servicing. First, the proposals would remove the requirement to deduct mortgage servicing assets from regulatory capital while maintaining the 250 percent risk weight assigned to these assets. We will seek comment on the appropriate risk weight for these assets.  This change in the treatment of mortgage servicing assets would encourage bank participation in the mortgage servicing business while recognizing uncertainty regarding the value of these assets over the economic cycle.   Second, the proposals would also consider increasing the risk sensitivity of capital requirements for mortgage loans on bank books. One approach would be to use loan-to-value ratios to determine the applicable risk weight for residential real estate exposures, rather than applying a uniform risk weight regardless of LTV. This change could better align capital requirements with actual risk, support on-balance-sheet lending by banks, and potentially reverse the trend of migration of mortgage activity to nonbanks over the past 15 years.     It is way too early to discuss the significance of Bowman's proposal, but there are some obvious points for both banks and IMBs. First, if banks no longer must subtract MSRs from Tier 1 capital, the economics of holding MSRs will change a lot. Banks will retain or purchase more MSRs for portfolio, adding a strong incentive for banks to increase their share of residential lending. IMBs will remain more efficient than banks, however, and will likely remain the largest servicers of mortgage loans. The same point applies to Bowman's proposal regarding whole loans, which have been declining as a portion of bank assets for 40 years (see chart). Scoring the risk of residential mortgages by loan-to-value (LTV) ratio makes enormous sense. More, by ending the need for banks to subtract MSRs from capital, the Fed's proposal will almost certainly force the FHFA and HUD/Ginnie Mae to revisit capital requirements for IMBs that were based on the misguided Basel III framework. Source: FDIC We'll be writing more about this issue in coming editions of The Institutional Risk Analyst . 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.

"[F]rom early spring throughout 2009 and until mid-year 2010, the Fed engaged in the first major quantitative easing program of purchases of government agency debt and agency-guaranteed mortgage-backed securities. The Fed’s purchases reached a cumulative total of $1.285 trillion, and excess reserves reached nearly $1 trillion. Essentially, the new reserves provided by the purchases program enabled the banking system to fund the repayment of about $1 trillion of various forms of advances to financial institutions under the [Fed’s] emergency lending program. The emergency lending program ended, but quantitative easing replaced it." Walker F. Todd "The Problem of Excess Reserves, Then and Now" American Institute for Economic Research May 2013 June 6, 2017 | Is the neo-Keynesian era over at the Federal Reserve Board? Press reports indicate that the Trump Administration finally has decided upon at least two new appointees for new Federal Reserve Board governors. President Trump is expected to nominate investment banker Randal Quarles and economist Marvin Goodfriend to two of three vacancies at the central bank. Despite the media attention to these new appointments, Wall Street does not yet seem to appreciate how the eventual selection of three new Republican governors could change the policies and personal chemistry at the central bank. At a minimum, the arrival of two and eventually three GOP appointees on the Fed board may have a significant impact on how Fed policies impact the credit markets. Since the appointment of Janet Yellen in February 2014 for a four-year term ending February 2018, the Federal Open Market Committee has followed a predictably neo-Keynesian path, at least in rhetorical terms. The Fed’s use of “quantitative easing” or QE was an attempt to synthetically create the economic impact of deficit spending by the federal government. Yet as the above quote from our friend Walker Todd suggests, the central bank has pretended to focus on stimulating growth and employment, when in fact it has been bailing out the big banks once again. This symbiosis between the Fed and the largest banks, who are the chief beneficiaries of QE, has seen the central bank create trillions of dollars worth of risk-free assets for the biggest banks in the form of $4 trillion plus in excess reserves. The massive overhang of liquidity created by the Yellen Fed has swelled the monetary base of the US economy, but has had little or no impact on employment, consumption or inflation – at least not yet. To quote from Todd’s important talk at Levy Institute last year: “The Fed should have learned from the experience of the earlier quantitative easing programs that its purchases of securities do little or nothing to increase the quantity of bank credit actually supplied to the general economy. Purchase programs might make sense in some circumstances if they helped make real interest rates positive, but generally real rates have been negative since 1Q 2009. The Fed’s methodology is not necessarily entirely irrational, but the evidence is that it simply has not worked.” Once there are three new Republican governors on the FOMC, however, Chair Yellen may find herself being challenged on some of the most basic assumption that underlie current Fed monetary policy. The incredible description of QE as a form of economic stimulus, for example, may be questioned given the paltry success of the policy so far. Both Quarles and Goodfriend are reliable conservatives who are unlikely to acquiesce in this view of current Fed policy. For example, Goodfriend’s current position as the “Friends of Allan Meltzer Professor of Economics” at Carnegie Mellon’s Tepper School of Business and his published research makes it seem improbable that he would support the FOMC’s direction under Yellen. His 2014 essay, “Why Monetary and Credit Policies Need Rules and Boundaries,” illustrates how he differs from the radical monetary policy regime under Yellen. But as one reader of The IRA does note, Goodfriend did advocate NIRP in his remarks at Jackson Hole. It is important to recognize that the Yellen Fed has diligently worked to weed out any dissenting voices among the regional Reserve Bank presidents, thus dissonant views among the governors will represent a new challenge for Chair Yellen, a change that could see her step down before the end of her term. Fed Chair's have traditionally resigned when they are on the losing end of policy votes by the FOMC. The unfortunate departure of Richmond Federal Reserve President Jeffrey Lacker, who announced his resignation in April after admitting that he indirectly discussed sensitive information with an analyst regarding the Fed's plans for economic stimulus, conveniently eliminated an important dissident on the FOMC who had consistently questioned the efficacy of QE. "I wouldn't have gone down this asset-purchase path. I'm in the camp that we should taper and stop right now," Lacker told CNBC’s Squawk Box in a 2013 interview. "I think a reasonable case can be made that path of unemployment wasn't affected much by quantitative easing we've seen over the past few years." The big change facing the Yellen Fed is that the chair actually may start to hear questions from the Republican governors asking what the FOMC is doing in terms of monetary policy and why. The fact that the Fed did not immediately start to shrink its balance sheet following QE 2-4 speaks volumes about the intellectual orientation of the FOMC, which has been entirely willing to accept the neo-Keynesian, Paul Krugman worldview that additional open market intervention was required even after the abortive 2009 fiscal stimulus. But the true irony is that the supposed stimulus of QE was in fact a sop for the banking industry, especially the largest banks. As Todd notes, the start of QE 1 was not meant to help the economy, but instead a move by the FOMC to liquefy the US banking system in the immediate aftermath of the 2008 financial crisis. Without QE1, the major US banks could never have raised sufficient liquidity to repay the emergency loans made by the Fed in 2009. In addition to the immediate subsidy for the largest banks, the Fed’s open market purchases of securities since 2009 have compressed credit spreads but done little to help boost employment or consumption. As we noted in previous issues of The IRA, the cost of credit in bank loans and bonds has been suppressed by the Fed's actions, suggesting that above-average credit losses await banks and bond investors down the road. The chart below shows relative corporate and government credit spreads going back a decade. Source: FRED With the significant exception of the China market hiccup at the start of 2016, high yield spreads have been consistently below the long-term average during Yellen’s tenure. The current FOMC frets about the potential dangers of unwinding the Fed’s bond portfolio, but the reality is that today the duration-starved capital markets could easily absorb the entire amount over a period of a couple of years. Keep in mind that new issuance of mortgage backed securities by the GSEs is running several hundred billion dollars below last year’s levels. With this significant decrease in bond issuance by the GSEs, it is unlikely that the Fed can raise interest rates until the central bank’s portfolio has been significantly reduced. The prospect of Quarles joining the Fed raises an interesting historical question. The last Mormon banker to sit as a Fed governor was Marriner Eccles, who became associated with the term “pushing on a string” after his testimony to Congress in 1935. Then as today, Eccles knew that monetary expansion such as QE did not work because consumers were unwilling to spend. But the Eccles was not doctrinaire in his economic views and actually became a strong advocate of fiscal stimulus to offset a deficit in investment spending, a situation very similar to that existing today. As Allan Meltzer noted in his classic book, “A History of the Federal Reserve: 1913-1951,” Eccles went further than any of his colleagues on the Fed and attributed the excess of savings to inequitable income distribution. “Eccles differed from his predecessors in his belief that government had to take responsibility for the economy,” wrote Meltzer. “He devoted much of his time to advocating fiscal measures, especially increased spending on investment financed by government borrowing to expand demand.” Like Donald Trump and the Republican majority in Congress, both FDR and Henry Morgenthau believed in the 1930s that a balanced budget and cuts in government spending were the surest path to economic recovery. Yet Marriner Eccles believed just the opposite and became a leading advocate for deficit spending to address the lack of investment and consumption during the Great Depression. As noted in our 2010 book “Inflated: How Money & Debt Built the American Dream,” John Kenneth Galbraith would later describe the Fed under Eccles as “the center of Keynesian evangelism in Washington.” It seems pretty clear that confirmation of Randall Quarels and Marvin Goodfriend will mark a significant and welcome change at the Fed, but observers of the central bank should remember the case of Marriner Eccles when it comes to predicting the behavior of Fed governors. That said, the transition from Democratic to Republican control on the FOMC may finally signal the return of a bear market in the world of fixed income after decades of manipulation by the US central bank.

May 31, 2017 | Financials swooned this week as investors now seem to accept that much of the Trump program is in doubt – at least for 2017. No surprise then that yesterday large-cap financials actually closed down for the year. In our last edition of The Institutional Risk Analyst, "Macro-Prudential Delusions: Bank Credit Outlook 2H 2017," we referred to how in April the forward guidance from Capital One Financial (NYSE:COF) caused financials to begin their swoon six weeks ago. The bank’s comments to analysts during Q1 earnings concerned prospective loss rates’ on the bank’s consumer loan book through '17. COF is off its high of $96 per share in February and closed yesterday at $76, largely due to concerns about eroding credit quality and a failure to deliver in Washington. What gives? Short answer is that the period of artificially low loss rates c/o the FOMC is ending and investors are squirming. The first thing to notice when starting your analysis of COF is that the majority of the bank’s loan book is in consumer loans. While the larger peers of COF tend to view credit cards and consumer lending as an important adjunct to a broader business, this bank is just the opposite. There are two bank subsidiaries of COF, Capital One, National Association in MacLean, VA and Capital One Bank (USA), National Association, Glen Allen, VA. The risk profiles of the two banks are very different. The former earns a “A” bank stress rating from the Total Bank Solutions Bank Monitor, while the latter earns a “C” due to the high default rate on the credit card business. Capital One Bank is about one quarter of COF’s assets and reported 721bp (7.21%) of default in Q1 ’17. Loss given default last quarter was 80%, but COF’s credit card bank boasted 1,500bp of gross spread on its loans -- not including fees. The whole company reported 300bp of default in Q1 ‘17, illustrating that COF has a far riskier portfolio than most commercial banks, large or small. The average default rate for all US banks was only about 60bp in Q1. COF’s loan loss rate is several standard deviations above the industry average, but it is not nearly the most risky member of the credit card specialization group defined by the FDIC. Consumer lending was a traditionally hard-money, nonbank business. But COF has turned itself into one of the largest subprime consumer lending businesses after Citigroup (NYSE:C). There are smaller niche providers of subprime credit that have loss rates and gross loan yields far above those of COF and the larger banks. But among the top 50 banks, COF is clearly an outlier in terms of business model and internal default rate targets. By comparison, Citi’s credit card portfolio showed 125bp of default in Q1 ’17, the highest among the top four banks by assets. But then again, what COF’s team calls “commercial lending” at Capital One Bank was throwing off over 300bp of default last quarter. The industry average default rate for C&I loans is about 44bp. Back in 2009, COF peaked at 740bp of default for the whole bank vs one third that figure for all banks. COF’s default rate for the credit card book touched 1,100bp (11%) of total loans in 2009. Obviously funding costs, which in the case of COF include core deposits as well as brokered money, are a crucial part of the model. The chart below shows COF’s gross default rate vs the large bank peer group. The red circle shows Q1 '17. Source: FDIC To make this subprime model work, COF and consumer lenders must make more money per dollar of assets than typical commercial banks. Adjusted operating income as a percentage of earning assets is 7.5% vs less than half that rate for the large banks in Peer Group 1. The gross yield on COF’s loans and leases is over 9% vs 4.3% for other large banks. So, for example, COF generates a net interest margin over 6% vs below 3% for most large banks. The high yields on credit cards and consumer loans enable the bank to absorb oversize losses. COF’s provisions for loan losses are 10x the industry average, but earnings coverage of losses is far lower than for average banks, just 2x vs almost 20x for Peer Group 1. This may explain the sharp stock selloff last month following COF’s earnings warning and 50bp uptick in defaults. That said, C with a beta of 1.55 is technically a more volatile stock than COF as of yesterday’s close. Behind the profitability, COF has a significant backstop with 13% equity to total assets. The almost $400 billion asset bank is also significantly more efficient than its larger peers. And the low double leverage at the parent level allows for accessing the capital markets to fund growth opportunities. But the fact remains that COF is an outlier among large banks because of the high-risk nature of its loan portfolio. If you convert the 329bp (3.29%) of COF defaults into a bond rating, it comes out to a “B” rating. The implied “B” bond rating of COF’s portfolio illustrates the deliberate business model decision that COF has made by focusing on credit cards and consumer credit. The scale below shows the approximate credit ratings breakpoints for actual credit default levels that my friend Dennis Santiago included in the original IRA Bank Monitor in the early 2000s. Target Debt Rating/ Loan Default Rate (Basis points) AAA: 1 bp AA: 4 bp A: 12 bp BBB: 50 bp BB: 300 bp B: 1,100 bp CCC: 2,800 bp Default: 10,000 bp Think about it: On a good day, the average American consumer is maybe a “B” credit in terms of a default probability, one out of 8-10. The good news is that the bank’s emphasis on consumer exposures gives COF a very short duration loan book – less than three years average life – but also more exposure at default with 150% unused lines vs credit already utilized by customers. Even when COF has acquired other banks, the management team has tended to focus on growing the credit card book while running off other categories such as residential mortgages. The chart below shows the major components of COF’s loan book since 2011. Source: FDIC And even with all of the income from the below-prime loan book, COF barely manages to earn positive risk-adjusted returns in the TBS Bank Monitor, not due to the loan book but because of market exposure from the bank’s securities investments. The big factor for investors to ponder with COF is that this 1.2 beta stock may move lower, faster than other large cap banks when default rates start to rise. Think of it as a measure of equity beta linked to loan credit quality. If COF has 10x the default rate of other large banks now, after years of credit market manipulation by the Fed and other central banks, the downside for the stock could be considerable if our thesis about the Fed suppressing the cost of credit turns out to be correct. Only time and the FOMC can tell. 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.

February 16, 2026  | Last week saw significant declines in many stocks, both in the broad world of technology and other sectors. Some of the more significant declines were actually in biotech and health sciences, but AI-related stocks have borne much of the brunt of the selling. If publicly owned stocks are cratering, what does this say about valuations of tech companies funded by private equity? In a timely article just published, Forbes asks: " Why Private Equity Is Suddenly Awash With Zombie Firms?" Tech bellwether Nvidia (NVDA)  dropped dramatically last week, but less than the stock had fallen in January or in December of last year.  Cisco Systems (CSCO)  tumbled 11%–12.3% on a downbeat outlook, making it one of the largest single-day drops last week. Microsoft (MSFT)  is down 20% since January due to investor fatigue over the absurd AI narrative. Are these stocks a buy on the bounce?   Source: Google Finance It is difficult for investors to discern true value in technology stocks, public or private, even as it becomes apparent that the AI mania is largely a waste of economic resources. As political opposition to creating the electrical generation infrastructure to power terrestrial AI operations grows, the statements of Elon Musk about putting AI into space to access solar power look more and more prescient. But the real issue with valuations of AI schemes is more basic. The low-interest rate period of 2020-2024 created by the FOMC not only distorted the money markets, but also skewed the valuation of equity -- all equity. Following close on the heels of electric vehicles and private credit, AI was just the latest false marketing narrative to emerge from Wall Street. The inflation caused by QE distorted investor perceptions and left hundreds of billions of dollars in mispriced public and private equity investments littering the financial marketplace. These investments span sectors from AI to software to commercial real estate. “Private credit funds have not yet taken significant writedowns on their loan books — but cracks have begun to show,” the FT  wrote last week about the growing debacle in private equity investments in software . “Investors are on edge after a BlackRock fund took a knife to its valuation of education software company Edmentum, sending the value of the fund to its lowest level since March 2020.”  Witness the fact that the AI startup Anthropic just raised $30 billion on a massive $350 billion private valuation. But this begs the question: What would happen to the valuation of Anthropic if the firm were public today? Only in the fantasy world of private equity can a company pretend that such supposed valuations are reasonable. But the key thing to remember about private “equity” investments is that they often involve a lot of debt.   Take the example of Apollo Commercial Real Estate (ARI) . The commercial real estate REIT had traded at a substantial discount to book value in the 70s, so the sponsor Apollo Global Management (APO)   sold almost the REIT’s entire portfolio to another affiliate, insurance company Athene , at a price of 99.7. How is it possible for APO to engineer a transaction that apparently disadvantages a regulated insurer whose business is providing annuities to retirees? Good question. Notice that even after selling the commercial real estate to Athene, ARI is still trading at a 20% discount to book. Source: Yahoo Finance As of January 2022, Athene was no longer an independently traded public company and became a wholly owned subsidiary of Apollo. Athene previously traded under the ticker "ATH" but it merged with Apollo to create a combined company, with Athene acting as its retirement services business. The transaction allows Apollo to conceal distressed commercial real estate loans inside an insurer, which generally book assets at “cost” rather than fair value. “What has raised eyebrows among some industry observers is the price Athene agreed to pay for the loan portfolio: a roughly 20% premium to the real estate investment trust's recent trading levels,” wrote Warren Hersch  in Life Annuity Specialist . “For the past four years, ARI said, its shares had traded at a substantial discount — averaging about 77% of book value — a gap the company attributed to public-market skepticism toward commercial real estate credit.” The fact that private sponsors like APO and Blackstone (BX) are retreating from the pricing discipline of public markets strongly suggests that investment vehicles sponsored by these firms are facing financial problems. The equally interesting fact that many financial sponsors jumped onto the AI band wagon is cause for even greater concern given the falling public valuations of such ventures.  Blackstone Real Estate Income Trust (BREIT) is a publicly registered, non-listed REIT. While it is registered with the SEC and provides regular disclosures, it does not trade on a public stock exchange, meaning shares are not liquid and are valued monthly by Blackstone rather than by market demand. BREIT was hit with large demands for redemptions in 2024, but rebounded last year because of investments in – you guessed it – data centers tied to AI. “Blackstone Real Estate Income Trust, known as Breit, posted a total return of 8.1% for the year and ended with over $54 billion in assets, according to the firm,” writes Peter Grant  of the Wall Street Journal . “That is up from a 2% return in 2024 and a loss of 0.5% in 2023.”  But like the Apollo investments in commercial real estate sold to insurer Athene, BX puts the debt from its private equity investments inside a private vehicle, which it values. Our friend Victor Hong  reminds us that under the classical Modigliani-Miller Theorem ,  the value of a business depends upon the NPV of its assets, regardless if financed with debt or equity. Put another way, the capital structure of a company does not affect its overall value, but it does directly impact the fees for the sponsor. The private equity community likes to pretend that they are adding great value to companies by using debt leverage, but isn’t this just an old fashioned leveraged buyout? The debt investors in a private company are the true owners unless and until the debt is satisfied. The fact that investors in private "equity" transactions must rely upon the conflicted sponsors for valuations is a red flag. Modigliani-Miller Theorem “Why would private equity funds need to use ANY debt?” Hong asks. “Company owners can add true value without debt, having full financial flexibility. The Miller-Modigliani Theorem posits that debt itself creates no incremental value. Perhaps, private equity funds make money by just selling debt and extracting dividends and fees -- even if the privatized companies do not improve performance.”  As valuations for speculative private equity investments related to everything from AI to commercial real estate seek a new equilibrium, questions about the LT viability of these massive investments will grow. The obvious example is electric vehicles, which were once all the rage and now have caused losses to automakers in excess of $100 billion. Commercial real estate too during COVID was seen as a sure bet, but now is a source of massive and continuing losses for private investors. Will the eventual rationalization of AI investments cause damage on a similar scale?  In a future comment, we'll look at the selloff in large cap bank stocks to update our subscribers about the big changes in the WGA Bank Top 100. 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.

May 29, 2017 | In the mid 2000s, just before the financial crisis began, US banks were reporting credit metrics for all asset classes in loan portfolios that were quite literally too good to be true. And they were. The cost of bad credit decisions was hidden, for a time, by rising asset prices. The same aggressive, low-rate environment used by the Fed to artificially stoke growth in the early 2000s has been repeated in the aftermath of the 2008 crisis, only to a greater extreme. Today US banks report credit metrics in many loan categories that are not merely too good, but are entirely anomalous. Negative default rates, for example, are a red flag. A decade ago, the more aggressive lenders such as Wachovia, Countrywide and Washington Mutual were actually reporting negative net default rates, suggesting that extending credit had no cost – in large part because the value of the collateral behind the loans was rising. In those heady days of comfortable collective delusions, non-current rates for 1-4 family loans were below 1%, the lowest levels of delinquency since the early 1990s. This situation changed rather dramatically by 2007, when several large west-coast non-bank mortgage lenders collapsed. By the start of 2008, funding for banks, non-banks and even the GSEs was drying up and default rates were rising rapidly. The cost of credit reappeared. Net-charge off rates for 1-4 family loans in particular went from 0.06% early in 2005 to 1.5% by the end of 2008 and peaked at 2.5% by the end of 2009. Today the irrational exuberance of the Federal Open Market Committee has created huge asset price bubbles in sectors such as residential and commercial real estate. A combination of low rates, a dearth of home builders (down 40% from ~ 550k firms in 2008 to ~ 330k firms today) and even less construction & development (C&D) lending (down ~ 30-40%) has constrained the supply of homes. But low rates sent prices for existing homes soaring multiples of annual GDP growth – both for single-family and multifamily properties. Keep in mind that the folks on the Federal Reserve Board think that asset price inflation is helpful – thus the “wealth effect.” Specifically, the FOMC believes that manipulating risk preferences, credit spreads and therefore asset prices helps the economy to generate more income and employment. Many analysts have debunked the notion of a “wealth effect,” but the FOMC persists in this thinking even today. Mohamed E-Erian writing in Bloomberg has it right: “Forced to use the 'asset channel' as the main vehicle for pursuing its macroeconomic growth and inflation objectives – that is, boosting asset prices to make consumers feel wealthier and spend more, and also to increase corporate investments by fueling animal spirits – the Fed has ended up providing exceptional multiyear support to financial markets using an experimental array of unconventional tools and forward policy guidance. Indeed, most investors and traders are now conditioned to expect soothing words from central bankers – and, if needed, policy actions – the minute markets hit a rough patch, virtually regardless of the reason.” In an economic sense, the Federal Open Market Committee is the heart of the Administrative State. The use of the “asset channel” to pretend to boost economic activity is part of the larger delusion at the Fed known as “macro-prudential” policy. The macro-prudential worldview sees the Fed as an all knowing, all-seeing global managerial agency that can somehow balance goosing economic growth using asset bubbles with preventing the associated systemic risks. Note that regulating whole industries and constraining growth is, in fact, a key part of the Fed’s macropru model. Having maintained low interest rates and used trillions of dollars of bank reserves to fund open market purchases of Treasury bonds and agency mortgage paper, the FOMC now faces an asset market that has understated the cost of credit for over a decade. From 2001 through 2007, and then 2009 through today, the FOMC has boosted asset prices – but without a commensurate and necessary increase in income. The Fed has, to paraphrase El-Erian, decoupled prices from fundamentals and distorted asset allocation in markets and the economy. SO the question that concerns The IRA is when will the credit cycle turn and how much of the apparently benign credit picture we see today is a function of the Fed’s social engineering? If this latest round of Fed “ease” is more radical than that seen in the early 2000s, will we see an even sharper uptick in bank loan loss rates than we saw in 2007-2009? Total Loans Let’s start with the big picture perspectives of all US banks using our favorite chart, which juxtaposes pre-tax income with provisions for credit losses in the chart below. Note that quarterly pre-tax income for all US banks has slowly crawled back over $60 billion, resulting in net income in the low $40 billion range. The industry’s average tax rate was just below 30% on the $18.8 billion in taxes paid in Q1 2017. Source: FDIC Looking next at the $9.3 trillion in total loans for all US banks, the picture in the chart below is relatively calm. Note that the rate of non-current loans at 1.3% is still elevated above pre-crisis levels as are net loan charge-offs. Also, particularly note that in 2009 all non-current loans spiked to over 5%, yet net-losses after recoveries (loss given default or “LGD”) peaked at just 3%. Source: FDIC Loss given default at 75% is near the historic lows seen in 2006 and previously in the early 1990s. Think of LGD as the inverse measure of recoveries since the quality of the collateral behind the bank’s loan is the key determinant. Industry LGD for all bank loans fell to a low of 70% in 2014 when the bubble in residential and commercial real estate was roaring. Rising LGD for all bank loans today suggests that the bloom is off the rose in bank loan portfolios. Source: FDIC 1-4 Family Loans The $2.4 trillion in loans secured by 1-4 family residential properties is actually smaller in absolute terms and as a percentage of the bank balance sheet than it was a decade ago. In Q1 2000, loans secured by 1-4 family homes were 32% of total bank loans, but today that same metric is just 25% of total loans. Keep in mind that bank balance sheets have more than doubled since 2000 from $4.3 trillion in total loans to $9.3 trillion today. How’s that for an inflation indicator? Sales of residential mortgages in the agency and government market are also down sharply for all US banks, reflecting a secular migration by banks away from 1-4 family mortgage loans as the asset class of choice for American banks. Compliance risks and high operating expenses make the residential mortgage sector among the lowest return on equity asset classes. With non-current rates still at 3% vs 1% for the decade before the 2008 crisis, the credit quality of bank portfolio loans does not seem to have improved looking at the numbers. Net charge-offs at 0.4% are back down at pre-crisis levels. Looking at the chart below, loan losses seem to have been suppressed for almost two decades starting in the early 1990s. Source: FDIC More interesting, however, is the sharp, falling off the cliff movement of LGD for 1-4 family mortgages. Since the 2008-2010 period when LGDs were near 100% of the total unpaid principal balance, today loss given default for the average bank portfolio home loan is just 40% and lower than at any time since 1990. The chart below really shows the effect on credit performance of the Fed-engineered increase in asset prices since the financial crisis. But when do we revert to the mean? Source: FDIC So while the percentage of 1-4 family mortgage loans past due remains high, LGD is at all time lows. Go figure. Again, the principal driver of low loss rates seems to be the double digit home price appreciation since 2012. Credit Cards Another asset class that has been very popular with investors and the financial press of late is bank credit cards. The industry’s $750 billion in total portfolio credit card loans has seen non-current and default rates rising. The chart below shows noncurrent loans vs. charge-offs. Unlike other loan categories, notice that charge-offs of bad credit card debts are above the rate for noncurrent loans. Source: FDIC Capital One (NYSE:COF) warned last quarter on future defaults. COF saw net charge-off rates rise 42 bps year over year to 2.50% compared to the industry average of 3.6%, a statistic that suggests there are some far riskier books in the industry besides just-below-prime operations such as COF. Further, COF reported that provision for credit losses surged 30% from the year-ago quarter to $1.99 billion. Sadly the FDIC does not release publicly the data on provisions for future losses by loan type, an important piece of information that would enrich the public record. The chart below shows LGD for the credit card portfolio of all US banks. Notice this is a pretty stable metric for loss net of recoveries that fluctuates between 80-90% of the loan amount. Source: FDIC “During the first quarter, banks charged-off $11.5 billion in loans, an increase of $1.4 billion (13.4 percent) over the total for first quarter 2016,” notes the FDIC’s Quarterly Banking Profile. “This is the sixth consecutive quarter that charge-offs have posted a year-over-year increase. Most of the increase consisted of higher losses on loans to individuals. Net charge-offs of credit card balances were up $1.3 billion (22.1 percent), while auto loan charge-offs increased $199 million (27.7 percent), and charge-offs of other loans to individuals rose by $474 million (66.4 percent).” C&D Loans Today the world of real estate construction lending is very different than before the 2008 financial crisis. A decade ago, much of the C&D book was focused on single-family homes. Today banks focus on commercial and multifamily properties. The latter category has tended to be rock solid in the major metro areas, even through the 2008 crisis. From 2008 to 2010, about 1/3 of the ~ $600 billion C&D portfolio for all US banks was charged off, restructured or repaid. New lending dried up. This left a lasting caution on the part of regulators and the industry when it comes to lending on dirt. In the beginning of 2008, the total bank C&D portfolio in the US was $631 billion, but today it is just $390 billion. In 2008, there was $180 billion in 1-4 family residential construction loans held by all FDIC insured banks, but today there is just $70 billion. When you consider the factors behind the lack of supply in single family homes in the US, start with the sharp reduction in credit for the construction sector. And recall that bank balance sheets have grown 20% since 2008, so the proportion of bank portfolios allocated to financing housing construction has also dropped sharply relative to other loan types. Source: FDIC But to really see the handiwork of the FOMC, you need only look at the loss given default for C&D loans. During the early 1990s and the 2008-2012 periods, note that LGD was nearly 100% of the loan amount. Banks in the Southeast and Southwest failed in droves as development loans were taken to the curb and then written off entirely. But since 2012, the market manipulation of the Fed has caused LGDs on construction and development loans to go sharply negative, suggesting that this credit exposure has no risk or cost. In mathematical terms, recoveries on defaults are exceeding charge-offs by a wide margin, suggesting that asset prices for land and improvements are rising very rapidly. There may also be some resolutions of past defaults in the data -- going back five years or more. Source: FDIC So how does this all end? In the short term, look for default rates on consumer exposures to continue rising. But in asset classes like commercial real estate, residential homes and C&D lending, we suspect that the party may continue, at least in statistical terms, through at least the end of the year. After that, however, we full expect to see loss rates and LGDs start to snap back to the middle of the proverbial distribution. As one well-placed bank CEO told The IRA over breakfast, “there are lots of sweaty palms” in the New York commercial real estate market. Read this little missive in The New York Times about the Park Lane Hotel to get a sense of the level of exuberance in the commercial real estate market in Gotham. Without a rather robust confirmation of asset prices with rising incomes, as El-Erian and many others have observed, current levels of assets prices are unlikely to be maintained. In the event, look for bank default and recovery rates to normalize, with a sharp increase in credit costs for lenders and bond investors alike. Trees do not grow to the sky, credit costs are never really negative, and last we looked, Fed chairs cannot fly through the air or spin straw into gold. But they can manipulate asset prices and cause other mischief that, we suspect, represents a net cost to consumers and investors alike. But this is hardly a novel state of affairs. In that regard, we appreciate your comments about our earlier missive, “Buy Britain, Sell Europe.” Many of you challenged our idea that Britain is an enduring nation state, while the EU is merely a bad idea whose sell by date has passed. To address these comments, we refer to one of our favorite reads of late, “Playing Catch Up,” by Wolfgang Streeck. The emeritus director of the Max Planck Institute for the Study of Societies in Cologne, Streeck writes regularly for the London Review of Books. He is ready to suspend democratic processes to support “willing governments” that advance German-style reforms, but Streeck has a cogent view of the European political economy: “Here, as so often in her long career, Merkel is anything but dogmatic, and certainly isn’t beholden to ordoliberal orthodoxy since what is at stake is Germany’s most precious historical achievement, secure access to foreign markets at a low and stable exchange rate. For several years now, Berlin has allowed the European Central Bank under Draghi and the European Commission under Juncker to invent ever new ways of circumventing the Maastricht treaties, from financing government deficits to subsidising ailing banks. None of this has done anything to resolve the fundamental structural problems of the Eurozone. What it has done is what it was intended to do: buy time, from election to election, for European governments to carry out neoliberal reforms, and for Germany to enjoy yet another year of prosperity.” Sound familiar? In the US as well as Europe, what passes for fiscal and monetary policy are merely a series of short-term expedients meant to get us from one day to the next. The nonsense of macro-prudential policy represents the apex of such thinking. As we look out to credit conditions in the US banking sector in 2H 2017 and beyond, the one sure bet is that the cost of credit will not remain suppressed forever. #bank #credit #COF #macroprudential #macropru #FOMC #assetbubble

May 22, 2017 | In this issue of The Institutional Risk Analyst, we speak to Sanjiv Das, CEO of Lonestar’s Caliber Home Loans, a home mortgage originator and servicer established in 2013 by the merger of Caliber Funding and Vericrest Financial. Prior to joining Caliber, Das served as Executive Vice President, Global Financial Solutions at First Data Corporation (NYSE:FDC), where he led the international business and played an instrumental role in taking the company public. He has also held executive management positions at several other companies, including the CitiMortgage unit of Citigroup (NYSE:C) Das spoke with The IRA’s Chris Whalen last week. RCW: Sanjiv, thank you for talking to us. We first met you back in your days at CitiMortgage and since then you’ve done a lot of great things. Bring us up to speed on Lone Star/Caliber Mortgage and this new platform you’ve created for loan originations and servicing. SD: Thank you. Caliber is now among the top four non-bank lenders in the US mortgage market. We have a distributed model of sales professionals focused primarily on purchase loans. About three quarters of our volume is in purchase loans. Caliber's entire platform is engineered to partner with realtors, builders and brokers to enable financing home purchases across the nation. RCW: It is notoriously difficult to build a true retail channel through realtors, for example, as opposed to the advertising driven, direct to consumer approach of say Quicken. SD: Caliber's phenomenal growth is based on its dedicated loan officer distributed model, and is a testament to the fact that our Distributed Sales model and Quicken's Direct model, can both co-exist in a low-touch/high-touch world. Generally speaking, Direct lenders specialize in low touch refi's whereas Caliber specializes in Purchase. Caliber leverages its technology and digital capabilities to help our loan officers provide Realtors, Builders and Brokers transparency and confidence for their customers who are a buying a home. Our Distributed Sales and Operations model eases the complexity of getting approved for a mortgage and gives homeowners and realtors/builders the highest confidence of closing on time. Our entire team works like a trusted home purchase advisor. RCW: Well that is certainly a fortunate choice given that refinancing volumes have fallen by a third since the start of the year vs 2016. The MBA is looking for maybe 10% in purchase volumes, on the other hand, which is good news for Caliber. SD: Caliber’s model has worked very well. By focusing on strong realtor and builder relationships, with a primary focus on purchase transactions, our growth remains very solid despite the cyclical nature of the mortgage industry. We grew from $12 billion in loan originations in 2014 to $26 billion in 2015 and $41 billion in 2016. This is a great testament to a well implemented and robust Distributed Sales model. We are confident we will continue to grow in 2017. RCW: What drove your success? What took you down the road of focusing in home purchases? SD: Quite simply, there were not that many firms specializing in helping people buy homes. People define themselves as either Mortgage companies, tech companies or fintech companies, whereas at Caliber we define ourselves as a home purchase company. In Caliber’s business model, technology and digital capabilities enable the loan officer and realtor to provide a best-in-class homebuying experience, instead of front running the loan officer. We realize that even today, buying a home can be a complex, intimidating process. We believe our distributed sales model with best in class technology and digital support creates a high-confidence environment for buying a home. RCW: And I imagine that the realtors welcome your model as well. You are both focused on relationships. SD: That’s absolutely correct. The realtors know that Caliber is singly focused on closing purchase loans and can handle complex transactions that require extra diligence in some situations. The realtor-loan officer relationship is extremely important in ensuring the homebuyer has all the confidence they need to close on a home, no matter how complex. By the way, despite what's said about millennial home buying behavior, it is interesting to note that approximately 35% of our customers are millennials. This means that while people shop for rates online, a vast majority still turn around and come to their broker, realtor or builder to get a mortgage during the process of buying a house. The IRA: Given the enviable position you have created for Caliber in the purchase channel, how do you see the rest of the market adapting – or not – to fall-off in refinancing volumes? SD: We anticipated that the refi boom would eventually subside. There is a lot of evidence that Q1 was difficult for many refi players. We expect that many smaller, less-capitalized players will exit the market. Caliber has the advantage of scale and capital. As part of this, we fully expect to see a number of acquisition opportunities with the right retail sales partners, this year. The IRA: We have that situation now. We could see 10-20 percent of the seller/servicers in the GNMA market exit the space in the next 12 months. They’ve been hanging on by their fingernails as the cost of servicing trebled. SD: That’s true. Non-bank players that will be successful in this coming cycle will be those that have capital, scale, efficiency and a robust business model. It sounds contrarian, but Caliber has been waiting for a year like 2017 to separate those of us that are extremely well capitalized from the rest. The IRA: Well, you worked at Citi with some of the best minds in the risk business. But the idiosyncratic risk of smaller businesses sometimes makes the financial analysis irrelevant. SD: Yes, as leaders in this sector, we understand capital and liquidity risk extremely well and have spent a considerable amount of time with the Agencies around how best to de-risk the industry in the event of a liquidity risk faced by smaller, less capitalized players. I'm delighted to report that the agencies and regulators understand the issues and are aligned with us in finding more robust solutions for the mortgage industry. The IRA: It is interesting that you are focused on the consolidation opportunity in the mortgage industry. Certainly helps to have the folks at Lonestar behind you. Much like Apollo with Athene and their subsidiary Amerihome Mortgage and then Fortress with NationStar and New Residential. Do you retain your entire MSR? Do you think about alternative financing for the MSR, kind of “capital light” if you will? SD: Yes we are very fortunate to have Lonestar behind us. They are extremely disciplined and assess us on our financial strength as a standalone company. We look at consolidation opportunities on the basis of the strength of our own balance sheet. We retain our MSR. With regards to alternative financing structure, we are constantly evaluating the most efficient capital structure for the company. We are very fortunate to have some great anchor financing partners in helping us explore new, cheaper ways to financing. The IRA: Do you sell any of your excess servicing strip (ESS)? Or do you carry the whole asset? SD: We carry the whole MSR asset. The IRA: How do you see the economy and the mortgage market going forward? The numbers from the MBA are pretty gloomy, both the loan origination numbers and their forward estimates for GDP. SD: We are taking a wait-and-see attitude on the economy. I would have thought that home buying would have picked up more significantly by now. It's clear the supply-demand imbalance is causing stress on home affordability. It will be interesting to see how future interest rate increases will impact home buying behavior. I feel comfortable about how Caliber is positioned in the purchase market, but I do think that 2017 will be an important inflection year in purchase. The IRA: The credit box is clearly opening. SD: There are a large number of customers who were impacted in the 2008 crisis with a good credit history that want to get back into mainstream borrowing. Many bank lenders are not ready for that. Good quality, non-agency eligible borrowers who demonstrate the ability to repay are a newly emerging market. We see that as an opportunity to work with these customers in a responsible way. The IRA: Are these scratch and dent sort of borrowers? SD: These are people who’ve had an event that disqualified them for an agency loan. Of the production that we have done, the delinquency rate experience has been extremely low. The IRA: How do you view the regulatory world? With the election of Donald Trump, the industry is hoping for some relief. SD: I take a slightly different view of regulatory matters. I’ve always believed that as long as lenders continue the highest standards of underwriting and risk management, regulation can be a good ally. The IRA: The simple answer is that by and large most large banks and non-banks are horribly inefficient. Platforms like Caliber and Amerihome are new, integrated operating and data platforms. The difference in efficiency, including avoiding errors, is staggering. SD: That is absolutely correct. Large banks had multiple platforms in the mortgage business, as a result of acquisitions that never got integrated. Now at Caliber we have one platform. By definition, we get it right. The IRA: Thanks for your time Sanjiv. #Caliber #SanjivDas #Lonestar #Citimortgage #CFPB

“Europe is now a continent of widespread economic misery, of financial collapse, of disappearing faith in ‘mainstream’ political parties and rising support for ‘extremist” parties, of a loss of sovereignty and thus of legitimacy and democratic control, and of the destruction of law, both domestic and international, by the judicially larcenous European Court of Justice (sic).” Bernard Connally Rotten Heart of Europe: The Dirty War for Europe's Money 1997/2012 May 16, 2017 | With the elections in France safely recorded as a win for the pro-EU forces, the bull migration back into European equities has begun. Our usually sensible friends at Barron’s declare the raging bull buy signal on this week’s cover: “Buy Europe.” And by Europe, they mean excluding the United Kingdom. “Given attractive valuations, diminished political risk, low interest rates, and a pickup in global growth, international markets, and Europe in particular, could finally start to outperform,” declares none other than Vito J. Racanelli. The driver of the EU bull trade? Emmanuel Macron’s ambitious plans to rebuild the eurozone. His plan has been backed by Germany’s Finance Minister Wolfgang Schäuble, who wants to push deeper European Union (EU) integration. Go deeper or go home pretty much sums up the situation facing the Europeans. Most analysts have been focusing on the downside for the UK in a BREXIT scenario, but we wonder whether the EU is really viable – with or especially without the UK. Even as the cheering for the victory of Macron is dying down in Paris, officials of the International Monetary Fund are preparing for a new debt bailout for Greece. And then comes Italy. The IRA also notes that the “experts” have consistently underestimated the prospects of the UK post BREXIT, all the while waxing effusive about Europe. The dire predictions regarding the future of the UK economy, for example, have been largely wrong. The experts seem to miss the basic fact that the UK is a key player in global finance and will continue to be after it leaves the EU. United Europe, on the other hand remains a badly flawed work in progress that, for our money, has a better than 50/50 chance of outright failure. Everything written two decades ago by former EU economist Bernand Connolly in his classic book “Rotten Heart of Europe” has been proven correct and then some. Last week we got to catch up with Brian Barnier of ValueBridge Advisors LLC, who we first met while fishing up at Leen’s Lodge in Maine. He confirmed our suspicions that the EU project is in far more fragile condition than its departing member. More, Barnier says that most models of the long-term impact of BREXIT on the UK are fatally flawed and often rely only on aggregate averages for inputs, ignoring extensive details from statistical agencies in Europe. Barnier is an economist who asks questions. Rather than just accepting the output from a given model or data source, he likes to ask what is in the model. Like fully understanding what is in the chopped salad at the Greek diner. And he delights in asking model-building economists uncomfortable questions like “are you using the correlation factors from the SAS package or are you calculating them yourself?” For example, Barnier wonders why so many analysts projects a ponderous EU process for negotiating trade agreements with the UK – especially when the UK already has a dozen trade agreements ready to go and others in process. Good question. When he is not consulting for institutional investors, Brian is the proprietor of Fed Dashboard & Fundamentals, a portal dedicated to spreading economic enlightenment by highlighting errors and discrepancies in official data and how it is used to guide official policy around the globe. In a recent FDF comment, he noted that “BREXIT will unnecessarily hurt shoppers in the UK and EU unless governments recognize that prices of different products don’t necessarily move together and that inflation doesn’t necessarily cause growth.” “In the Euro area, consumers have enjoyed low average price increases over the past few years; often buying more as prices fell. This defied the European Central Bank’s (ECB) expectations that rising prices over time are needed if purchases are to grow. Thus, the ECB reacted to the perceived danger with aggressive monetary medicine,” Barnier continues. Of course, the whole point of “quantitative easing” in Europe has not been to promote growth but instead as a palliative form of hospice care for insolvent sovereign debtors such as Greece and Italy. The decline of inflation from 5% peak in 2009 to half that rate today certainly is a problem when it comes to monetizing sovereign debt. As Moritz Kraemer, S&P's head of sovereign ratings, told Tom Keene of Bloomberg News this week, the credit standing of EU nations is “going sideways” rather than improving. He also notes that unemployment in the EU is almost 10%, far higher than before the financial crisis. But Kraemer, like most observers, persists in thinking that the UK is the big loser in BREXIT. Thus we sat up in our chairs when Barnier next advanced the view that the EU and not the UK is most threatened by BREXIT. The whole bull thesis about Europe is that the French elections open the door to new prosperity in Europe while the UK must carefully negotiate an exit with Brussels. Barnier, on the other hand, declares that the negotiations are over and that the UK government led by Theresa May basically told the EU to sod off when it comes to large alimony payments. A “disastrous” meeting at the end of April between British Prime Minister Theresa May and European Commission President Jean-Claude Juncker apparently marks the end of any idea of a large British payment to essentially buy a smooth exit. As Juncker said of May: “I have noted that she is a tough lady.” Right. Wolfgang Münchau, writing in the Financial Times, thinks the EU miscalculated the mood of the British people when it offered David Cameron "a rum deal" before the Brexit campaign began in earnest. He adds that Brussels should learn from that error and be sure not to repeat it. And the mood of PM Theresa May is particularly noteworthy. We recall the excellent essay last Fall in The London Review of Books, “Home Office Rules,” by William Davies. He explained that: “[May’s] long tenure (six years) and apparent comfort at the Home Office suggests that the mindset may have deepened in her case or meshed better with her pre-existing worldview. This includes a powerful resentment towards the Treasury, George Osborne in particular (whom she allegedly sacked with the words ‘Go away and learn some emotional intelligence’), and the ‘Balliol men’ who have traditionally worked there. In making sense of May’s extraordinary speech at this year’s Conservative Party Conference, the first thing to do is to put it back in the context of her political experience. For her, the first duty of the state is to protect, as Hobbes argued in 1651, and this comes before questions of ‘left’ and ‘right’.” He continued: “Home secretaries see the world in Hobbesian terms, as a dangerous and frightening place, in which vulnerable people are robbed, murdered and blown up, and these things happen because the state has failed them. What’s worse, lawyers and Guardian readers – who are rarely the victims of these crimes – then criticise the state for trying harder to protect the public through surveillance and policing.” Indeed, May could be as much of an outsider as Donald Trump, albeit one that grew inside the state from a career as a professional politician instead of from outside as a business mogul. And she leads Britain combining a decidedly domestic political perspective with a deep knowledge of the workings of that country’s administrative state. The best advice for President Juncker seems to be don’t mess with this lady. With the EU itself predicting flat GDP growth below 2% through 2019, it is hard to get behind some of the enthusiasm of our colleagues for the European trade. The fact that the Germans and French are falling in love again does little to cheer the nations of Eastern Europe, which are among the most dynamic and fastest growing parts of the EU. In fact, the rush into Europe looks an awful lot like the bull market stampede last October that took US financials up 20 and even 30% and more by the end of March. There are increasingly hyperbolic comments coming from Sell Side analysts about European valuations relative to opportunities in the US and Asia. But when we consider the underlying economy, it seem hard to reconcile the exuberance with the appalling data. Meanwhile we note that Greek Prime Minister Alexis Tsipras seems to be running out of political support and Greece is running out of cash, again (despite the current account surplus). Say what you might about the promise of Europe, the UK made the right decision to keep a foot outside of this experiment in statecraft. And say what you will about the new “unity” in Europe after the Macron victory, the UK has ‘first-leaver” advantage. We are far more bullish than the consensus on the prospects for the UK economy separate from the eurozone and far more cautious on the European project. To us, the UK is going to evolve into the Singapore of Europe as what remains of the EU must decide if they will pay the price of unity. So far, the EU’s response to that question has been QE care of Mario Draghi and the European Central Bank. But the only way that the EU can survive is to take a more aggressive and authoritarian approach towards weaker members. Thus we see Wolfgang Schäuble tightening his grip on Greece even as political tensions in that country continue to grow. The Daily Express notes that Greek protesters took to the streets in recent days to react to more demands that the country cut pensions by up to 18 per cent. Rather than new unity in Europe, we see a continued process of the Huns bullying the weaker nations, first up being Greece and then likely followed by Italy. 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May 9, 2017 | In an October 1925, speech in Birmingham, Michigan, Senator James Couzens, the business partner of Henry Ford, sketched out a vision of "good" businessmen, who are ethical, and "bad" businessmen, who are unscrupulous in their dealings with the public, the ultimate consumer. If you protect the markets from fraud, Couzens argued, you ultimately protect the consumer. The optimistic assumption in the 1920s was that industries could be exhorted and led to ethical behavior by the example and standard-setting of their own business leaders. Today we have given up on people doing the right thing without coercion. Instead we rely upon regulators and experts of varying flavors to moderate and oversee commercial behavior. Thus there is a bias in favor of regulated industries and a negative view of the private sector. For example, there is a constant refrain from the regulatory community when it comes to commercial banks vs. nonbanks. Simply stated, the latter are seen as acts of evil that are inferior to regulated institutions. Leonid Bershidsky, writing for Bloomberg View awhile back, embodies this perspective, chiding “shadow banks” for engaging in “regulatory arbitrage” vis-à-vis the blessed world of regulation. But nothing could be further from reality. Non-banks represent the private sector, the baseline for economic activity. Banks are government sponsored entities with implicit sovereign support. Most of the major rating agencies, for example, assume a degree of “lift” for the credit ratings of the largest US banks because of the presumption of support for the depositors of these mega depositories in times of crisis. We should remember that the regulators who supposedly make commercial banks safer than non-banks have an appalling track record. One word: Citigroup. Regulators failed to predict or avoid financial crises such as 2008 and 2001 before that, to name just two financial events. Our beloved regulators pander endlessly to consumers, but routinely ignore acts of fraud in the world of securities and institutional investors. The false narrative says that the abuse of consumers caused the 2008 financial crisis, but in fact it was widespread securities fraud by the largest banks. Nonbank lending institutions actually must play by the same rules as the banks, except they have no balance sheet and no cheap backup funding from the Federal Reserve Bank or Federal Home Loan bank. Non-bank mortgage firms, for example, are forced to affirm their credit every day because they often fund their business via short-term bank loans. Non-banks with investment grade ratings typically run at leverage ratios of 5:1 or less, but some asset classes such as aircraft, rail cars and other types of transportation assets can and do support higher leverage. Regulated banks by comparison can run at 15:1 leverage on balance sheet and more if they use off-balance sheet (OBS) financing, the core systemic risk issue behind the 2008 financial crisis. Just as large corporations use OBS transactions to hide taxable income offshore, (see The National Interest, “America Reaps Few Benefits from Trump's Tax-Cut Proposal”), commercial banks have long used special purpose entities to hide leverage. Think about that for a minute. Even with the bank’s huge advantages over non-banks in the form of public subsidies such as the discount window and federal deposit insurance, structural subsidies that support higher leverage rates, regulated banks still feel the need to cheat in terms of disclosure of risk exposures squirrelled away in a special purpose vehicle somewhere offshore. The behavior of regulators and journalists generally towards non-bank companies illustrates the statist drift towards a largely regulated environment in the world of finance. In the fantastic world of “macroprudential” policy, regulators soar like star ship pilots who guide the economy and oversee financial institutions simultaneously. European Central Bank governor Mario Draghi typifies this “superman” syndrome. But central bankers do not see all banks as being created equal. For macro economists turned central bankers, a few large banks are preferred to a myriad of smaller banks and non-banks, which are all seen as too troublesome (to regulators) to have any economic utility. Regulators are openly contemptuous of smaller banks and non-banks alike, one reason why the research community treats non-banks firms with such slight regard. Just to illustrate the enormous skew in the thinking inside the Federal Reserve System, an April 10, 2017 blog post by The Federal Reserve Bank of New York, “Financial Crises and the Desirability of Macroprudential Policy,” actually advances an explicit justification for subsidizing large banks in times of market stress. The blog states: We use the model to consider a subsidy on bank equity issuance. That is, for example, for every $1.00 in equity raised, the government would contribute an additional $0.10 in equity. The goal of this regulatory scheme is to induce banks to raise more equity, thereby contributing to strengthening their balance sheets. The first thing to notice is that the folks at the FRBNY are worried about absolute levels of capital rather than bank behavior. In times of market stress, whether a bank is raising capital or not generally does not matter. The reserve of confidence with the bank’s counterparties does matter. The confidence of financial counterparties is a reflection of consistency and character, not capital. Focusing on good governance and the presence of dubious OBS financial transactions is more important for crisis avoidance than the level of capital. Only the fact that the government is the buyer of large bank equity, in the FRBNY proposal, would provide additional credit support to the issuer. Thankfully, the article does note that, above a certain level, a subsidy for large banks is “a cost to society with little or no benefit.” But the FRBNY article never asks if, as a general matter, it as a good idea to support a large, zombie banks with public funds. Like large auto manufacturers, the largest banks generally don’t even earn their nominal cost of capital. Is it really good public policy to support these regulated monopolies at any time? Maybe President Trump is right when he considers breaking up the top four money center banks. What would a mega bank break up entail? Easier than you might imagine. If we disassembled the four largest banks and ended up with 6-8 specialized consumer and wholesale banks with between $500 billion and $1 trillion in assets, the US markets would function far better. Add to that another 8-10 large non-bank broker dealers led by the likes of Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), focused on capital markets and wealth management, and you have an extremely competitive and dynamic capital finance marketplace. Hint: There are several new, emerging broker dealers that are owned by Buy Side firms. For good measure, let’s consolidate the top 20-30 non-bank mortgage seller/servicers down to about 4-5 large platforms, each with hundreds of thousands of loans in their servicing portfolio. These larger mortgage platforms will be more stable in terms of liquidity, perhaps profitable and, maybe, would actually have the money to invest in technology. We might even introduce these large non-bank mortgage firms to some large community banks. Hey, you never know. Suddenly the “risks” of non-banks may start to take on a new complexion for members of the public research, journalistic and regulatory communities. The point of this tirade is that non-banks are not “bad” banks. They just don’t have the fat subsidies that federally insured and regulated commercial banks take for granted. If we focused on important issues, namely preventing systemic crises via regulation of deceitful OBS transactions and broadly enforcing rules against securities fraud, the entire concern about capital for banks and non-banks alike would assume a far smaller part of the public narrative. You can tell a good bank or non-bank from a bad apple by whether they (or their clients) cheat on disclosure of risk and/or taxes in their off-balance sheet transactions, the ultimate source of systemic risk. For example, if a bank or non-bank has a whole department that specializes in constructing innovative tax and/or investment strategies for clients using offshore financing vehicles, then beware. 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.

May 13, 2017 | What do the US residential housing market, the stock market and the dollar all have in common? All of these markets represent bubbles created and driven by the aggressive social engineering of the Federal Open Market Committee. Will live in an age of asset bubbles rather than true economic growth. The investment world is skewed by the latest round of monetary policy experimentation by the Fed, including years of artificially low interest rates and trillions of dollars in “massive asset purchases,” to paraphrase former Fed Chairman Ben Bernanke. These bubbles are caused and magnified by supply constraints, not an abundance of credit. Whether you look at US stocks, residential homes in San Francisco or the dollar, the picture that emerges is a market that has risen sharply, far more than the underlying rate of economic growth, due to a constraint in the supply of assets and a relative torrent of cash chasing the available opportunities. Likewise with the dollar, the image of the financial markets is one of constraints rather than policy ease. Since the middle of 2014, the value of the dollar against major currencies has risen sharply, suggesting a shortage of liquidity or at least a relative preference for dollars vs other fiat currencies. The vast flow of foreign direct investment drawn into the US and then into asset classes like residential and commercial real estate illustrates the abundance of global dollar liquidity and relatively scarcity of assets. Even with the supposedly accommodative policy by the FOMC, key measures of market liquidity continue to suggest either price and/or structural constraints, both in the US and overseas. Looking at the effective cost of dollar credit, for example, illustrated by the notorious London Interbank Offered Rate or LIBOR, the cost of borrowing dollars in Europe has risen steadily risen since the Middle of 2015. Again, the chart below makes us wonder if the good folks on the FOMC appreciate the degree of fundamental demand for dollar credit. With the end of the Mortgage Bankers Secondary Market Conference in New York, American lenders face a market with new origination volumes down 25-30%. Meanwhile, the reinvestment of prepayments on $1.7 trillion worth of mortgage backed securities (MBS) held by the FOMC is essentially taking up new bond issuance by Fannie, Freddie and Ginnie combined. We have been on the record saying that the FOMC should adjust its portfolio now to accommodate private market demand for yield. And there is no need for actual sales. Simply ending the Fed’s reinvestment of mortgage bond prepayments would allow the interest rate markets to find a natural level and, to us, give the Fed a more accurate picture of demand upon which to adjust supply. "I think they're aiming for something in the vicinity of $2.3 to $2.8 trillion, something like that," former Fed Chair Ben Bernanke said Monday on CNBC's "Squawk Box." Ending reinvestment of the Fed’s MBS portfolio would lead to a net monthly runoff rate in high double digit billions of dollars. Or to put it another way, it is time for the FOMC to get out of the way of the private market. Shrink the Fed’s bond portfolio and credit the reserve accounts of the banks. It seems that many market indicators such as the dollar and LIBOR suggest a market that is either schizophrenic or dysfunctional. Our guess is the latter, in part due to excessive prescription-based regulation of traditional banking and finance, particularly low-margin money market businesses which are being abandoned by the big depositories like JPMorgan (NYSE:JPM) and The Bank of New York Mellon (NYSE:BK). There are seismic changes going on in the world of trading cash securities and collateral lending, changes that see a host of non-banking firms returning to this traditional nonbank space. Staring at these charts for the dollar and LIBOR, we wonder how much of the upward price movement is caused by legal and regulatory changes occurring over the same periods. The clear question from all of this: What happens when this latest dollar super cycle ends? Given that zero or negative rates elsewhere are driving much of the emigration into American assets, why should the dollar ever selloff, right? Regards the prospect of a dollar drop, Megan Greene tells us on Twitter that “Only way I see it in the short-run is if everyone else gets in trouble and the Fed opens swap lines w other CBs to supply QE #unlikely We hear all of that, but can’t help but ask the question. All things do come to an end, including the seeming ability of the FOMC to painlessly levitate the fortunes of heavily indebted nations on a sea of easy dollar credit. This works really well when the dollar is strong, otherwise not so much. 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.