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September 9, 2024  | Updated | Apparently the Fed has decided to end the battle against inflation a little early, a remarkable development given that the central bank has barely reduced the level of bank reserves and home prices have not fallen significantly. Yet the fact is that the Fed is unwilling to reduce liquidity for fear of causing another systemic market event a la December 2018 or March 2020. Even though the Fed goosed home prices with a sharp decrease in interest rates from 2019 to 2022, for example, bank reserves are essentially where we started pre-COVID. Indeed, the Fed tightening cycle this time around has not even stopped the appreciation of existing homes and land. “It’s been a funny such cycle to say the least,” writes Simon White of Bloomberg . “Chastened by the repo-market flare-up in 2019 that put an end to its last attempt to shrink its balance sheet, the Fed’s current tightening cycle has proceeded along different lines. In fact, from the market’s perspective there has arguably been no tightening as reserves – a primary determinant of market liquidity – are unchanged since QT began in June 2022.” Lest we forget, the collapse of the Treasury market in March 2020 was a seminal event that has forever changed the way that the Fed conducts monetary policy. Yet few market observers or economists are even aware of the messy details. Lev Menand and Joshua Younger described the scene facing the Treasury in an important 2023 paper for Columbia Law School : “In March of 2020, as the COVID-19 pandemic spread, Treasury markets became so impaired that simple transactions were difficult (if not impossible) to execute. Prices dropped rapidly even as investors moved toward, not away from, low-risk assets. A financial crisis loomed. To prevent what some warned could be a catastrophe rivaling the 2008 collapse, the U.S. monetary authority, the Federal Reserve, intervened with a massive program of “market functioning purchases.” It bought more than $2 trillion of Treasuries and offered to finance trillions more as part of an unprecedented and open-ended commitment to stabilize the market. Although the effort was successful, it raised questions about the line between money and debt issue as mechanisms of public finance, and whether there in fact was one at all.”   The official view of monetary policy from the Fed and other central banks does not make room for what is the elephant in the room, namely the US Treasury and the federal deficit. When the Treasury is creating so much new “near money” in the form of short-term government debt, the idea that the Fed can combat inflation by merely changing the target for Fed funds is laughable. John Cochrane describes the official view of Fed policy, real and imagined, in his latest survey of the monetary policy world : “There is a Standard Doctrine, explained regularly by the Fed, other central banks, and commentators, and economics classes that don’t sweat the equations too hard: The Fed raises interest rates. Higher interest rates slowly lower spending, output, and hence employment over the course of several months or years. Lower output and employment slowly bring down inflation, over the course of additional months or years. So, raising interest rates lowers inflation, with a 'long and variable' lag.” Cochrane notes that Monetarist theory requires that money and Treasury bonds be distinct assets. But is this true? Menand and Younger make a compelling case that the fiat currency first created by President Abraham Lincoln to finance the Civil War and Treasury debt are essentially interchangeable. That is, we're all 100% MMT right now when the Treasury is in deficit. Thus how can the Fed profess to control the “money supply” when the Treasury is issuing trillions of dollars a year in new "near-money" debt? Good question. To believe the Fed’s claim to be able to control inflation, you must accept the claim by all of the major central banks, Cochrane notes, that they can control inflation by merely raising interest rates without any money supply control . Since 2008 and the start of massive asset purchases by the Fed, the central bank has largely lost control of its balance sheet. Thus when Powell and other FOMC members talk about tapering the runoff of the Fed's balance sheet, the correct reply is: "What runoff?" It is useful to recall that the Fed used to depend upon a chief transmission mechanism – housing – to control economic activity and deflation. The policy mistakes made by the Powell FOMC in 2018 and 2020 have contributed to boosting home prices 40% in the past four years, a massive increase of consumer inflation that has not been addressed by the Fed’s modest tightening. The Fed has been unwilling to use deflation to fight rising prices since the FOMC under Alan Greenspan . The unspoken issue for the Fed, however, was whether elevating the cost of buying a home by raising the cost of finance was having any impact on home prices. In such a scenario, the fact of higher funding costs might actually be inflationary and impact the final cost to consumers as lenders tried to limit losses on loans. Lenders have been giving consumers subsidies on new loans, creating market risk in exotic servicing assets now as interest rates fall.  The other issue created by the Fed's actions is the lock-in effect on the 60% of all homeowners that refinanced during COVID and now have below market mortgages. Mark Palim and Rachel Zimmerman of Fannie Mae described the damage done to the housing market by Fed policy in a 2023 comment : “An unintended consequence of the policy response to the COVID-19 pandemic was a dramatic decline in mortgage rates that allowed millions of homeowners to refinance their mortgage at rates well below current levels. Additionally, as housing needs changed and mortgage rates moved lower, home sales jumped, growing approximately 14% from 2019 to 2021 compared to a much slower 1% increase from 2018 to 2019.  In 2022, mortgage rates doubled. Consumers adjusted to those rising rates, in part, by purchasing fewer homes, and so homes sales declined nearly 18% year over year. This year, while  new  home sales have rebounded, the paucity of  existing  home sales has persisted, declining from a peak annualized sales pace of 6.6 million units in January 2021 to 4.0 million annualized in August 2023. In fact, as of August, the number of existing homes for sale hovered around 1.1 million, 40 percent below the level seen in August 2019, pre-pandemic1. As of this writing, in 2023, the 30-year fixed-rate mortgage is at 7.79 percent, more than one full percentage point above where they were at the end of 2022." A larger question raised by Bill Nelson at Bank Policy Institute, George Selgin at CATO and Cochrane in his great blog, is that the Fed pretends to have control over the short-term credit markets, but in fact does not. Few economists and investors appreciate how little control the FOMC has over interest rates or markets given the size of the public debt. We are only a few moments away from another systemic slip a la December 2018 and March 2020, when the Fed essentially had to cross the line and bail out the Treasury in a way not seen since the eve of WWII in 1941. As former FRBNY President Gerry Corrigan taught us years ago, a systemic event is when markets are surprised -- or in this case, merely clueless. Again Cochrane: “But the bigger problem is that this [Standard Doctrine] theory just doesn’t apply to today’s world. The Fed does not control money supply. The Fed sets interest rates. There are no reserve requirements, so ‘inside money’ like checking accounts can expand arbitrarily for a given supply of bank reserves and cash. Banks can create money at will. The Fed still controls the (immense) monetary base (reserves+ cash). The ECB goes further and allows banks to borrow whatever they want against collateral at the fixed rate. The Fed lets banks arbitrarily exchange cash for interest-paying reserves. Most ‘money’ now pays interest, so raising interest rates doesn’t make money more expensive to hold.” We’ll leave the discussion of the Fed’s decision to end reserve requirements for banks for another time, but you can count us as skeptics on paying interest on bank reserves at the Fed, at least at rates at or above yields on Treasury debt. The Fed should never compete with its sponsor, even if the members of the Federal Open Market Committee may believe that doing so is a good idea from a macro economic perspective. The rate on Federal Reserve Bank deposits should always be slightly below Treasury yields. Nelson noted in a comment that “the Federal Reserve recently released an FAQ about bank’s required internal liquidity stress tests that may lead to a reduced demand for reserve balances and so longer duration for QT.  In short, banks can now plan on using the Fed’s discount window and standing repo facility as the means by which they would monetize their liquid assets rather than just sales or market repo of the securities.  As a result, banks can hold Treasuries, agencies, or agency-guaranteed securities to meet their immediate stress funding needs rather than just reserve balances.” In other words, our esteemed colleagues at the Fed are no longer going to discriminate against banks for holding Treasury bills, Ginnie Mae MBS and agency debt vs reserve deposits at the Fed. This is an appropriate concession, after all, since the Fed is now counterparty on most repurchase transactions with nonbank dealers. Since 2008, when more than half of the nonbank primary dealers were annihilated, the Fed has become the center of the money markets. We asked Bill if the change in treatment for Treasuries and agencies meant that the Fed was finally creating a level playing field for Treasury and agency debt vs bank reserves for liquidity rules. “Yes, that’s a good way to put it.  The next step is getting credit for borrowing capacity against non-HQLA collateral,” he opined.  But the real point of this discussion is that even as the Fed declares success on inflation, the central bank's assets and liabilities are likely to rise with the federal debt. Back in 2018, David Beckworth and George A. Selgin mused about the Fed's balance sheet perhaps falling back to $2 trillion, but today post-COVID the Fed owns more than $2 trillion in MBS alone. As the federal debt rises, bank reserves must rise as well and with it inflation. In 1959, Milton Friedman told a joint session of Congress that monetary policies “operate with a long lag and with a lag that varies widely from time to time.” Over the past half century, the Standard Doctrine followed by the Fed was “leaning against the wind.” If the economy is getting too hot in terms of inflation, the Fed should proactively raise interest rates to try to slow it down. But Friedman believed that the effects of monetary policy were too uncertain for this to be an effective strategy. “We know too little about either these lags or about what the economic situation will be months or years hence when the chickens we release come home to roost, to be able to be effective in offsetting the myriad of factors making for minor fluctuations in economic activity,” he told Congress. Or as John Cochrane wrote earlier this week: "Higher money growth means higher inflation, immediately. Higher interest rates mean higher inflation, immediately. That’s exactly how a “frictionless” model should work. Except the sign is wrong relative to the Standard Doctrine we’re trying to chase down . Higher interest rates raise inflation? Are you out of your mind? You won’t get invited back to Jackson Hole if you say that out loud." 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.

And what is good, Phaedrus, And what is not good -- Need we ask anyone to tell us these things? Zen and the Art of Motorcycle Maintenance: An Inquiry into Values (1974) September 5, 2024  |Through the end of August 2024, the WGA Bank Top 25 Index (WBXXVW)  was up over 50% vs the Invesco KBW Bank ETF (KBWB) down small since 2022. Why this divergence? One big reason is that a lot of equity managers moved out of large cap financials in Q1 2023 and a year later in 2024. The exodus continued as worries about a recession grow amongst the thundering herd. But as we noted in our last comment: What recession? The fact that equity market valuations have been inflated by the Fed’s actions feeds the fear and loathing among investors. Indeed, it was the fact of secular inflation going back decades to Fed Chairman Alan Greenspan  that made passive strategies appear to be efficient. We hope this is not a completely new revelation to our readers. As we note in the upcoming re-release of "Inflated: Money, Debt & the American Dream" by Wiley in 2025, rising inflation is the constant over the past 50 years of US history. Buy stocks. Ponder the fact that residential home prices have risen 40% during the four years of the Biden/Harris Administration. Was this just the result of supply chokepoints in home construction? How much will home prices rise in 2025 if the Fed cuts interest rates? Can the Fed really, really continue to talk about 2% price stability as a credible monetary policy goal if home prices rise 10-20% next year? Think of how the volatility caused by the Fed's actions has impacted asset valuations from Miami condos to large publicly traded financials. Another factor we see operating in the divergence between the WGA Bank Top 25 and the KBWB is a matter of selection and the role of these choices on passive strategies. The “representative” basket in the KBWB was picked by a group of investment bankers based primarily on size. The index holdings do not change. KBWB represents large cap banks and, as a result, consistently ignores some of the better performers in the industry. Indeed a third of the banks in the KBWB basket perform well-below the average for Peer Group 1, as shown below. Source: FFIEC   WGA’s WBXXVW index, on the other hand, essentially self-selects as a result of a five factor census we conduct each quarter. WGA ranks the entire population every quarter, then employs a unique pure constituent weighting system in constructing the Indices developed with our partners at Thematic .  Notice in the table below that only three banks, JPMorgan (JPM) , First Citizens BancShares, Inc. (FCNCA) and International Bancshares Corporation (IBOC) , were in the WGA Bank Top 10 Index for the past three quarters. WGA Bank Top 10 Index Source: WGA LLC Our qualitative approach to constructing the WGA Indices ensures that the highest scoring banks have the greatest impact on the Indices regardless of size. Because of WGA's unique methodology, the Indices are generally uncorrelated to existing bank indices and passive strategies. Index constituents are updated each quarter and are available to subscribers to the IRA Annual Service . We also make the entire 108 bank test group results available to Annual Service subscribers upon request. So what does this divergence between WBXXVW and KBWB suggest? First and foremost, when the Street does not like banks, the large cap names captured in the “representative” basket of KBWB get hammered. The passive strategy is, well, passive and does not respond to changes in the macroeconomic views of equity managers. When managers want to avoid large caps of whatever market sector, they avoid most passive bank strategies. More than most sectors of the economy, banks are a play on credit. If you think a recession is coming, then banks are likely to suffer. This applies especially to big banks with so-so financial metrics and highly mobile institutional shareholders. Yet the impressive performance of the WGA Bank Top 25 Index suggests that an active strategy focused on the top performers can significantly outperform passive strategies. Smaller banks with strong historical performance also tend to have smaller and, at times, more loyal shareholders. Another wrinkle in the flan comes from the nature of the active management. If we are talking about people picking stocks, then all of the normal caveats about cognitive bias and illusions come into play. Think about the managers who love Ally Financial (ALLY) . But what about an active census designed with numerical rules to let the bank stocks self-select? We reached Nom de Plumber  at a secret risk management cluster buried deep inside a moneycenter bank and asked for his guidance on the issue of active vs passive. He opined:   “Actively managed equity funds, even if diversified, can consistently underperform passive, low-cost index funds, ironically because of single-name risk. Even without seemingly high portfolio concentration, that performance lag can accumulate sharply over time, especially if key market themes like AI manifest abruptly. How? By actively under-weighting the RIGHT stock, or over-weighting the WRONG stock, even if a seemingly small degree or for a brief period. John Bogle was right. Thank you.” We always take note of the sage wisdom of Nom de Plumber , especially when it comes to human intervention in the investment process. When large cap banks come back into vogue and the great herd accepts that we are not in a recession yet, then perhaps KBWB will outperform the better banks?  We are only in the third quarter of publishing the WGA Bank Top Indices, but so far picking quality banks seems to matter more than following the passive ETF herd. In a future issue of The Institutional Risk Analyst, we will be publishing the IRA Bank Book for Q3 2024.  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.

August 22, 2024 | You could say that 2024 was a year when many searched in vain for a traditional recession, but found none. Newly minted finance stocks catering to mildly distressed consumers also postured for a recession last year, but failed in this strategy. In fact, 2023 is looking more and more like the year of modest aspiration for finance company stocks. Some investors decided to return “to da moon” last year in a number of sectors that had little real chance of LT success. Many apparently successful stories were way off from the truly aspirational 2020-2022 COVID highs, when the FOMC “went big” with bank reserves. This made big percentage gains more attainable in 2023 but ultimately unsatisfying. In dollar terms, the moves in 2023 were tiny vs the post March rally in 2020-2021. Take mortgage finance. The top performing stocks in 2023 were two battered penny stocks that used to be the lowest risk ticket in town, Fannie Mae and Freddie Mac. We wrote about the dim prospects for either escaping from government control earlier this year (“ Will Donald Trump Release Fannie Mae & Freddie Mac?? Really? ”). See our latest column in National Mortgage News  for more thoughts on the agenda next year for mortgage finance. Most recently, however, the two GSEs were overtaken by Blend Labs (BLND) , a nouvelle  mortgage tech company that is best known for consuming vast amounts of shareholder capital. BLND, in fact, is up 225% over the past year, perhaps buoyed by the prospect of a big surge in mortgage volumes in the event of a Fed rate cut? Not. BLND is still nowhere near its $15 IPO valuation. The free cash flow summary from the back pages of the Q2 2024 BLND earnings presentation is below. In fairness, losses are down from last year and there is a significant risk of profitability ahead. BLND | Q2 2024 The key question to ask if you are long BLND or any issuer with exposure to residential mortgages is this: How big is the mortgage refinance opportunity in 2024 and beyond given multiple Fed rate cuts? Since purchase mortgage volumes are pretty steady, the real upside to any mortgage stock is from refinance volumes. Even a 1% cut in the short-term rate for federal funds, however, may not move the needle much in terms of volumes, especially compared to the free cash flows earned from servicing. The chart below from Ginnie Mae illustrates how low loan prepayment rates have fallen from the extraordinary 2020 levels. “At a 6.50% primary rate, conventional 6.5s and 7.0s are in the money, with 6.0s on the cusp due to the large number of borrowers with 6.875%-6.99% WACs,” notes Scott Buchta of Brean. “At a 6.00% FHA/VA rate, 6.5s and 7.0s are well in the money, with 6.0s also on the cusp (and in the money assuming a 5.75% driving rate). Again, this weeks drop in the average size of a conventional refi point to the cuspiness of these borrowers.” “Cuspiness” may be a new term for some readers of The Institutional Risk Analyst . Translated into plain terms, well fewer than 10% of all mortgages are in the money for refinance after the rate rally earlier in this quarter.  Even a full point reduction will mean little because of the heavily skewed distribution of mortgage coupons. One very large player in mortgage finance, Wells Fargo & Co (WFC)  is getting out of mortgages as fast as possible, both residential and commercial. WFC agreed to sell most of its commercial mortgage servicing business to Trimont LLC, ceding the title of biggest US commercial and multifamily mortgage servicer to the Atlanta-based firm. The news comes as the OCC has finally ended the consent order against WFC for creating fake customer accounts. The table below from the WFC 2023 Annual Report shows the residential and commercial servicing books. WFC | 2023 Trimont will buy Wells Fargo’s non-agency third-party commercial mortgage servicing business, the companies said in separate statements. It is interesting to note that the deal announcement does not include terms. Estimates of the consideration from bankers in the CRE channel range from a large positive number to an equally large negative number.  That is, unless we hear otherwise, WFC may need to pay the buyer to take the servicing asset and a loss may be in the cards.  The ostensive buyer of this considerable business is a non-bank servicer known as Trimont LLC, which in turn is owned by funds controlled by Värde Partners , a privately-owned alternative credit manager located in WI and named after a city in Jutland. Värde manages about $13 billion in AUM and has owned Trimont since 2015. Funds controlled by Värde often make loans on property that are serviced by Trimont, such as the Alliance HP office tower in Ft Lauderdale . It is not clear whether Värde takes risk on any of the loans it manages for investors. There are no public financials available for Värde or Trimont, a point that may interest Treasury Secretary Janet Yellen and her colleagues on the Financial Stability Oversight Council or FSOC.   The deal is expected to close in early 2025, CNN  reports , and will result in Trimont managing over $715 billion in US and international commercial real estate loans. Upon the close of the transaction, in fact, the private nonbank finance company will be the largest servicer of commercial mortgages in the US, just ahead of WFC, PNC Financial (PNC), KeyCorp (KEY) and CBRE Group, Inc. (CBRE) . If Trimont wants to play in this league, an IPO may be in the cards sooner rather than later. Of course, servicing commercial loans is very different from residential mortgages, most particularly since the servicer does not advance cash on defaulted loans. Yet the fact that WFC is selling this business as the tide of defaults is rising in CRE may raise a few eyebrows. Servicing is not a high-margin business and is usually paired with higher return activities as a loss leader to benefit large customers. “Over the next three years, there’s about $2 trillion of debt coming due, and as those loans come due, the combined platform is positioned well to capture an increased amount of services and provide those services to clients,” Trimont CEO Jim Dunbar joyfully told Bloomberg . Meanwhile in the wider world of nonbank finance, the leading stock in our surveillance group is  Coinbase Global (COIN) , up 161% over the past year.  The largest US crypto exchange is profitable, but trades at half of the firm’s multi-year high back in 2021 with the COIN IPO. Despite the surge in the stock over the past year, COIN as an aspirational stock seems to be suffering from the ill-effects of profitability and familiarity.  After COIN, the nonbank group features Afirm Holdings (AFRM) , which has been giving back gains made in 2023 through the first half of this year. Like COIN, the bloom is off the rose and lying on the garden path with this once high-flying fintech stock. The five-year high for AFRM of $176 per share is just a distant memory now with AFRM trading below $30 per share. AFRM reported a GAAP loss of $160 million in the quarter ended March 2024 including $77 million for stock based compensation for company management and more millions for warrants to entice enterprise partners. The management team and commercial partners are taking the lion’s share of the value of AFRM it seems to us. It just goes to show that given adequate disclosure, anything is possible. Source: Google Finance Neck and neck with AFRM in terms of 1 year returns is NU Holdings (NU) , a provider of banking and payment services in Brazil, Mexico and other nations in South America. NU has been rising for the past year after a difficult beginning. NU came out in December 2021 and promptly got crushed, losing two-thirds of its value by the middle of 2022. The stock wallowed around $4 for more than a year but has since managed to build its way back up to around $14. When you start from a very low base, wracking up big percentage gains is relatively easy.  That said, NU has significant market penetration in Brazil and is expanding in Mexico and other large markets. The top level NU entity is domiciled in the Cayman Islands and is a foreign filer in the US, but operates banks and financial companies in a number of different markets. NU claims significant market share in Brazil and Mexico, where it is able to offer a broad range of banking and investment products.  We’ve been accumulating NU stock and see it as a LT play on growth in the region and also among the Latin community in the US. We also like the relatively new platform and the fact that the management team is coming from the world of nonbank finance and growing organically in each market depending upon the legal framework in those venues. Finally, NU appears to be profitable and well-capitalized, and adding new customers rapidly as they grow into new markets like Mexico.  In our next Premium Service edition of The Institutional Risk Analyst, we’ll be taking a look at the consumer lenders among the top 100 US banks to see if there is any sign of a recession in 2025.   The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

August 12, 2024 | The reaction to last week's brief market kerfuffle tells you a lot about markets and those who work in and around them. There are many thousands of analysts and media focused on the capital markets, yet some very large events go entirely unnoticed. Meanwhile, eager financial media were ready to describe the end-of-the-world market collapse early last week -- yet the promised apocalypse did not occur. This is fortunate since the BLS jobs data turned out to be wrong. Economist Bob Brusca notes that there were "significant distortions in the July employment report that the BLS did not feature and, in fact, seemed to go out of its way to hide." He argues that the market disruption that followed the July report "would have been avoided had BLS pointed out that the July report was affected by weather disruptions." More important, as more overheated sectors of the equity markets swooned, few observers picked up the obvious reference to the December 2018 market rout. This was the last time that the markets sold off in response to Fed action or lack thereof. Given the amount of discussion in the media about "carry trades," there seems little discussion of the near-disaster five years ago. The 10-year chart below from Bloomberg shows the spike in short-term interest rates for repurchase agreements in that year and the rapid capitulation by the FOMC which followed. DTCC Repo Index Source: Bloomberg (08/09/24) The cause of the market tantrum on Monday and Tuesday of last week was a reprise of a familiar story, where the equity and credit markets suddenly retreat together , and the Federal Open Market Committee panics and then capitulates. By providing the needed liquidity, the Fed rebalances the scales, but this time around the selloff quickly lost steam. No response was needed. Last week may have been a faux crisis, but a sudden loss in value awaits the inflated markets. Fear of contagion like that seen in December 2018, when the S&P 500 lost 15% of its value in a matter of weeks, still haunts Fed Chairman Jerome Powell and the FOMC. The Fed provokes contempt from private markets because of the way the central bank messed things up in 2018. Powell shattered that precious illusion of 1) a God's Eye view of markets globally and 2) firm control of said markets that allows investors to trust the judgement of Fed officials despite their lack of actual market experience. Jerome Powell After Breakfast Economist Komal Sr-Kumar  describes the scene in December 2018 to his readers on Substack :  “Jerome Powell started 2018, his first year in office as Chairman of the Federal Reserve, on a high note. Inflation in the consumer price index had accelerated from 2.2% in February when he became the Chairman, to 2.9% by mid-year despite repeated increases in the Federal Funds rate. By November, inflation was back to 1.9%. Proud of his success, Powell told investors at his press conference on December 19 to be prepared for further monetary tightening during the following year. In response, equities cratered during the final days of 2018, and the Chairman’s message abruptly changed on January 4, 2019. The Fed would be patient with monetary tightening, he assured his listeners, and the central bank actually reduced the policy rate several times during the year.” As in 2008, in 2018 the Fed lost credibility because the Board's GDP model did not capture the actual, effective level of liquidity in the markets. And the Fed's model of liquidity as a function of GDP still does not work. We discussed this situation in 2019 (" George Selgin on Frozen Money Markets & Competing With the Fed in Payments "). To compensate for their lack of clarity in 2018, the central bank made a dramatic and little noted change in monetary policy. Powell and the FOMC went "big" with reserves in a speculative and many would argue counterproductive fashion. The new monetary operating system at the Fed is a key topic of a new chapter in the revised version of our 2010 book “Inflated.” Some excerpts for the new book follow below.    Not only did Powell capitulate in January 2019 with rate cuts, but he and the other Committee members then authorized the de facto nationalization of the US money markets. By greatly expanding the Fed's open market operations, and making other legal and regulatory changes, the Fed essentially subsumed the private markets. This process began in the 1970s, when the FOMC under Chairman Arthur Burns began to target the yield on federal funds traded between banks as a policy indicator. But after 2019, the Fed's control of the markets was complete -- at least until investors decided to revolt. Early in 2019, the chastened FOMC started to intervene aggressively in cash and forward markets, this a year before COVID. The Fed flooded the markets with liquidity and essentially made itself the counterparty in the credit markets. Combined with the centralized clearing of Treasury debt, the Fed now operates the US credit markets like a market simulation in the 1999 film “The Matrix.”  As we’ve told readers of The IRA  before, you still think that’s air you’re breathing?  The new policy regime abruptly put in place in January 2019 required the Fed to grow its balance sheet enormously, by purchasing securities using Treasury funds and paying interest on bank reserves to fund it. Remember, the Fed is the alter ego of the Treasury, its opposite. And the central bank is always an expense to the Treasury. When the Fed loses money, the Treasury takes a loss -- but Powell and the other governors don't talk about that very much. And the servile media rarely asks about the hundreds of billion in losses to date on Jay Powell's hedge fund. By allowing the Fed to pay interest on bank reserves, Congress enabled the central bank to fund its own fiscal agenda and compete with the Treasury for funds. Quantitative easing is essentially the Fed's own fiscal policy project, separate from the Executive Branch. This illegal effort is enhanced by rules requiring banks to hold reserves at the Fed instead of Treasury securities. The SEC rule on central clearing of Treasury securities and Basel III favor holding bank reserves at the Fed over Treasury securities. Why? Powell sought no authority from Congress for these changes nor made public notice about expanding bank reserves dramatically. The Fed merely put this momentous change into effect, funded with reserves paid for out of the Treasury's cash with no congressional appropriation. And because the Fed still does not understand the dynamics of bank liquidity, it appears that markets are even less stable now than before the Powell FOMC made these changes. “The record indicates that the FOMC did not appreciate the consequences of its decision at the time,” wrote Bill Nelson of Bank Policy Institute in 2022, “and the question now is whether the decision will be revisited given how manifest and serious those consequences are.”  Nelson continued:  “Specifically, the Fed announced that it would conduct monetary policy by over-supplying liquidity to the financial system, driving short-term interest rates down to the rate that the Fed pays to sop the liquidity back up. Previously, the Fed had kept reserve balances (bank deposits at the Fed) just scarce enough that the overnight interest rate was determined by transactions between financial institutions; those transactions consisted of banks with extra liquidity lending to those that needed it. Now the rate is determined by transactions between banks and the Fed. Moreover, the Fed has committed to providing so much extra liquidity that it would not need to adjust the quantity of reserve balances it is supplying in response to transitory shocks to liquidity supply and demand.”   On January 4, 2019, Powell completed the Fed’s capitulation to the markets and also signaled that the Board staff in Washington had badly misjudged the situation on reserves and liquidity. Few in Washington outside of the professional staff of the Fed and Treasury took note of Powell’s debacle. His failure required his two previous successors to close ranks around the Fed Chairman in a public media event on January 4, 2019. Again, the Fed staff was too busy looking at their models and focused too little on the financial markets which they routinely take for granted. In 2019, the FOMC essentially nationalized the US money markets, eliminating private price discovery for a synthetic representation of a market with the Fed at the center of the known universe. The Fed and the clearing house are now the counterparties for all large trades in US Treasury securities.  More, the 2019 policy change featured a dramatic increase in banks reserves. Going big assumes that the Fed would need to get much bigger in the future to avoid market disruptions like December 2018.  The Powell Panic in 2018 led to the explosion of the central bank's balance sheet in 2020. Yet as events showed, a larger Fed balance sheet seems to coincide with greater market volatility.  Look for the new edition of Inflated in 2025! The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

August 8, 2024 | The market tantrum which began on Friday was largely over by the market close on the following Tuesday. While a number of individual stocks have gotten crushed because of earnings misses and other offenses, the markets overall have muddled through. JPMorgan (JPM)  is off just 5% vs the end of Q1 2024, hardly a market debacle. But there certainly has been a lot of movement within the WGA Bank Top 100 since March and total test scores have fallen significantly for the entire group. Index constituents are now available to subscribers to The IRA   Premium Service .  Of note, the high levels of delinquency seen in the JPM portfolio of home equity loans continues, as shown in the chart below from BankRegData .  JPM is charging off the portfolio rapidly, but the fact remains that this largely “prime” portfolio of bank-owned HELOCs is displaying a level of delinquency several times higher than many other loan categories. Note that the delinquency rate on JPM's HELOCs is 6x the delinquency rate on JPM's 1-4s, but the bank does not mention this fact in JPM's earnings release.  The bank's form 10-Q was not released until August 4th. JPMorgan | Q2 2024 Source: FDIC The brief market rally provided some hope that the poor performance of mortgage assets is coming to an end. “Thanks to the strong relative outperformance of MBS vs Corporates over the past few months, MBS Excess Returns have finally caught up to, and currently match, those of corporates on a YTD basis,” writes Scott Buchta of Brean. Yet yields on longer-dated Treasury debt have backed up with the 10-year note again at 4%. While the Street is anticipating another interest rate bonanza a la 2020-2021, this time the increase in loan volumes may disappoint some expectations.  "Mortgage rates falling to their lowest in more than a year increases the potential of loans issued since 2022 being refinanced and has worsened convexity for the MBS index," according to Bloomberg Intelligence . "Duration hedging may start to have a knock-on affect for rate shifts,” BI strategist Erica Adelberg wrote Wednesday. Fannie Mae 6s for delivery in August are trading 100-22 this AM. "The recent rally in interest rates increased the share of coupons in the MBS index trading above par to about 17%," writes Adelberg. The share above $102, which are especially sensitive to refinancing risks, has risen to 8% after falling to near zero last year," she notes. Speaking of hedge risk, the table below summarizes the option-adjusted duration for Fannie Mae 30-year MBS. Notice that the duration of Fannie Mae 6s is just above 2, but lower coupons of 4% and lower where most of the market resides is over a 6 duration. TBA Monitor Source: Bloomberg (8/07/24) “While another large refinance wave is unlikely in the foreseeable future, lenders are using new strategies to incentivize homeowners to refinance their mortgages,” notes Ginnie Mae in the most recent global market analysis . “One lender recently rolled out a new program, offering a 125-bp incentive fee for most Veterans Affairs (VA) and Federal Housing Administration (FHA) streamline refinancings.” That lender, of course, was United Wholesale Mortgage Corp (UWMC) , which has been conducting an unrelenting price war in the wholesale channel for buying mortgages. How does UWMC afford to spend 1.25% on additional incentives to brokers when they are paying 1-2% for every loan?  By selling mortgage servicing rights (MSRs). But buying loans with the MSRs on a 6-7x multiple and selling the MSR on a 4-5x multiple is a bad trade IOHO. “While we also like this backdrop for other originator/servicers, we especially like UWMC's move to sell MSRs again last quarter in an effort to shed risk and focus on its core competency of being the industry's centralized hub for mortgage brokers,” writes Eric Hagen  at BTIG. But of course when we shed “risk” and "leverage" in MSRs, we are also shedding future cash flow, new loan recapture and customer relationships.  The latter intangible assets is perhaps most valuable of all. The table below shows sales of MSRs and comes from the UWMC 10-Q.  UWMC | Q2 2024 Now the little downward move in mortgage rates is going to help the results for issuers considerably in Q3 2024. Business already in the pipeline is going to become more profitable and production for the rest of the quarter will feel a growing tailwind. Issuers will win big on the cash side, selling higher coupons into a declining rate market, but lose money on the hedge. Yet the important thing to keep in mind is that the vast majority of residential mortgage loans are still points out of the money for refinance, as the two great charts from Ginnie Mae illustrate. How much do rates need to fall before we start to really see significant refinance activity? We need to see new-issue MBS yields closer to 4% than to 5%, but this assumes that the Treasury market cooperates. If yields on Treasury 10s on out the curve remain elevated as and when the Fed does cut the target for federal funds, then hopes for a mortgage market rally will be disappointed.  In the meantime, look for competition for those few refinance transactions to intensify. For months now Sell Side analysts have hoped for tighter spreads between MBS and Treasuries. Just as issuers like UWMC must pay-up for loans in today’s supply constrained market, so too we cannot get spreads between mortgage rates and Treasuries to come in until the vast damage of quantitative easing is repaired. Even if the Fed resumed purchases of MBS tomorrow, we’re not sure this would offset the net sale of MBS exposures by banks into synthetic risk transfer deals . Meanwhile, Treasury Secretary Yellen announced the most recent expansion of the Treasury buyback program , where it acquires low coupon securities created during COVID for current coupons. This is a tacit admission of the negative result of QE and other market manipulations such as “Operation Twist” when Yellen was Fed Chair. We are dealing with this period in a new chapter of “Inflated,” to be released by Wiley Global in 2025. In market terms, those Treasury 2s and 3s that Secretary Yellen is repurchasing, as well as comparable vintage MBS, are hundreds of basis points under water vs the cost of funds to dealers. If the FOMC were to find it in its heart to move federal funds down to 4.5% or even 4%, that is more than enough headroom to restore profitability to many dealers and perhaps even help restart asset backed securities issuance. But then the Fed should stop and start asking the Congress to cut the federal deficit to fight inflation. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

July 30, 2024 | The folks at Politico published an article last week by former Federal Housing Finance Director Mark A. Calabria , Thomas Hoenig , Dennis Kelleher , & Aaron Klein (" Why Is the Government Encouraging a Taxpayer Bailout? ") attacking the FSOC proposal for an industry-funded bailout facility for nonbanks. The link to the post on the CATO Institute web site is below: https://www.cato.org/commentary/why-government-encouraging-taxpayer-bailout At one level, the article is useful and very welcome as a public rebuttal of the handling of the Financial Stability Oversight Council (FSOC) under Treasury Secretary Janet Yellen. Unfortunately, the article actually validates some of the more questionable positions taken by the FSOC. At a higher level, however, the article is misinformed and illustrates the gap between two parallel worlds: housing policy and mortgage finance. They write: "A powerful group of regulators known as the Financial Stability Oversight Council (FSOC) recently released a report focusing on the risks arising from the current regulatory structure for mortgage servicing. We applaud attention to these risks." Really? What risks? The authors worry that the failure of a nonbank may somehow inconvenience consumers. But the public record and the private financial markets suggest that the authors are mistaken. Neither the FSOC nor the authors seem able to articulate precisely what financial risks are created by mortgage servicers other than a lot of pointless hand-wringing about consumers. Independent mortgage banks tend to generate a lot of cash and healthy risk-adjusted returns. Profitable mortgage firms tend to take very good care of consumers, far better than banks. Indeed, signed copies our new biography of Stan Middleman , founder and CEO of Freedom Mortgage, are available for sale in The IRA Store . Get your signed copy while they last! As we noted last week, large servicers such as PennyMac Financial (PFSI) and Mr. Cooper (COOP) are piling up profits and tangible equity returns that seem to refute every word ever written by the FSOC on the subject of non-banks. Compare PFSI and COOP to any large bank and tell us which you'd rather own. Source: Google Finance We agree with the authors that nonbank financial firms do not need a government backstop. Yet if you read the FSOC report, Yellen wants to tax the mortgage industry to foot the bill!! No thank you, Secretary Yellen, we already have a federal backstop: US Treasury. Yellen's proposal for a new backstop is merely a canard, a shameless attempt to help Treasury avoid another fiasco next time a Ginnie Mae issuer fails. You see, the $7.5 trillion in conventional mortgages are owned by the GSEs, which are under government control. Uncle owns the risk. As we noted recently (" Will Donald Trump Release Fannie Mae & Freddie Mac?? Really? "), even were the GSEs to be released from conservatorship, the conventional MBS would continue to be guaranteed by the Treasury. This is why the GSEs will never be released, sabe? The $2.5 trillion in government-insured mortgages in Ginnie Mae MBS are privately owned in theory, but government controlled in fact. In the event of default, the Ginnie Mae servicing asset is either sold to another servicer or taken over by the US Treasury. The choice is entirely binary. Readers of The Institutional Risk Analyst recall that the abortive failure of Reverse Mortgage Investment Trust (RMIT) in November 2022 was entirely mishandled by the Biden Administration, resulting in billions in losses to the Treasury and a vexatious litigation with Texas Capital Bank (TCBI) . We updated subscribers of our Premium Service back in April (" TCBI v Ginnie Mae Goes to Trial | Outlook for Commercial & Residential Mortgage Finance " ). Janet Yellen does not want the media or members of Congress looking at her handiwork with Ginnie Mae. For those who missed it, RMIT was the largest government-insured reverse mortgage portfolio in the US. Post default, the business was unsalable and thus the government took it over. And there are more busted HECM portfolios headed for default. The Yellen FSOC report was, in fact, a weak effort by Secretary Yellen to hide her department's mishandling of the RMIT default, but Calabria et al missed this little nuance. The Politico article also contains some erroneous information. First, the authors err in saying that we must protect banks as the predominant originators and buyers of mortgage assets from risky nonbanks. In fact, brokers and independent mortgage banks (IMBs) have always originated most 1-4s, which banks used to buy. Bank share of owning 1-4s has been falling for decades and is now just 12%of total assets vs 25% in 2008. Source: FDIC (RIS) Today larger IMBs fund 80% of all residential loans in their own name, retain the servicing and sell the notes into the bond market. Banks originate loans in footprint and buy MBS from IMBs, but remain net sellers of 1-4s and residential MBS today, both for cash and credit risk transfer (CRT). Yet even with the recent sales of MBS since the failure of Silicon Valley Bank in 2023, the US banking industry still has more than 100% of total capital invested in MBS . This a level of MBS as a percentage of total assets that is at least half again too large for safety & soundness. Why isn't Janet Yellen screaming about the MBS holdings of banks? Federal regulators should limit bank MBS holdings to no more than 50% of tangible capital. Source: FDIC (RIS) The financial markets and real equity returns tell the story of IMBs vs banks in terms of risk. Pick any bank you want and compare it to Mr. Cooper (COOP) , PennyMac Financial Services (PFSI) and Guild Holdings (GHLD) .  Fact is that most banks have in many cases been dead money for years, while the better managed nonbanks have grown shareholder value.  The authors also err by suggesting that banks, which only ever focus on acquiring larger, high-FICO loans, somehow need to be protected in their dealings with IMBs. Banks provide warehouse finance and default line to IMBs on a fully secured basis, so it is not clear to us just what risk worries the authors. Aside from the failure of Silicon Valley Bank, the largest loss to a bank caused by residential mortgage exposures in recent years was TCBI's loss due to the default of RMIT. Remember, banks are GSEs and reflect this fact in their often mediocre earnings and poor risk management results. IMBs don't retain loans and securities on balance sheet, and thus are far more liquid and profitable than regulated banks. In 2008, a third of the large regulated banks in the US by assets failed, while nonbanks were resolved in bankruptcy by the US Trustee without any inconvenience to consumers. So tell us again, Secretary Yellen, why you want to subject IMBs to federal regulation?? Where should Janet Yellen and the FSOC be looking for risk if not among residential mortgage servicers?? Start by looking at banks with MBS > 10% of total assets. Then have a look at Blackstone Mortgage Trust (NYSE:BXMT) , a real estate finance company that originates senior loans collateralized by commercial properties in North America, Europe, and Australia. BXMT is trading at 0.8x book and is highly leveraged to a significantly impaired global asset class. In our next comment, will update readers of the Premium Service on the latest in the world of nonbank finance (f/k/a the "fintech" sector). The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

July 22, 2024 | Through the end of last week, the two leading stocks in the world of mortgage finance were unlisted penny stocks issued by Fannie Mae  and Freddie Mac . In fact, the GSEs are up significantly over the past 18 months, not on the financial results for these parastatal entities but on the prospect for release from government control. Should investors take profits now or wait and hope? Several readers have asked us to game out the process for taking the GSEs out of government conservatorship. Both of the GSEs are book insolvent and have seen volumes fall about 80% from the peak years of 2020-2021, so what’s to like?  We wrote above the prospect for GSE reform for Kroll Bond Rating Agency back in 2017 (" Housing Reform 2017: Can the GSEs be Privatized? ”). First and foremost, both enterprises need to staff up with financial professionals with actual secondary mortgage market experience. After 14 years under government control, both GSEs need to rebuild their management teams and operational personnel to even begin to compete with private banks and mortgage firms. Neither GSE is prepared today to operate as a private issuer in a competitive secondary market.   But second and more important, if President Trump releases the GSEs from conservatorship, they are likely to fail again. Why? Because if we actually make the GSEs private companies for the first time in almost a century, they will lose their comparative advantage in the market for guaranteeing and selling residential loans. A private GSE with a "A+" rating from Moody's cannot sell insurance on residential mortgage loans for 55 bp per year -- especially if they have to compete with the large banks and nonbank issuers. Game over. History buffs may recall that Freddie Mac was created in 1970 in order to compete with Fannie Mae. Now, however, post 2008 and since the passage of the Housing and Economic Recovery Act (HERA) and Dodd-Frank (2010), we can no longer pretend that the GSEs are sovereign credits.  Once the government begins the process of releasing the GSEs, both entities will likely be downgraded by Moody’s and the other rating agencies. And bank regulators likewise will increase the capital risk-weighting for GSE corporate debt as well. Why? Because the GSEs ultimately own the conventional mortgage loans and servicing assets, with all of the financial and operational risk this entails. The GSEs combine an insurance function with the role of a mortgage bank, a business model that only works for a sovereign. When the enterprises purchase mortgages and issue guaranteed MBS, they retain the credit risk of those mortgages. They are exposed to potential losses if a borrower cannot pay back the mortgage. Moreover, the GSEs must reimburse conventional issuers for all expenses after four months and fund loss mitigation of delinquent loans. Under the published ratings criteria used by Moody’s, only with unconditional credit support from a sovereign can a corporate issuer achieve a sovereign rating. Even with a federal charter and a credit line from the Treasury, the GSEs will still be considered to be “private” commercial entities for most purposes. Indeed today, the GSEs are largely treated as private entities in the world of mortgage finance and by the courts. Notice in the graphic below that there is no government backstop behind the GSEs, which cover losses equal to at least 80% of the loan amount. If the private mortgage insurers renege of their insurance, and they usually do, then the GSEs eat the whole loss. Source: GAO (2019) Fannie Mae and Freddie Mac will indeed be private upon release and for the first time ever. Investors should ponder this point. Pre-2008, we all pretended that the GSEs were sovereign while private shareholders made double-digit returns. For this reason, before the GSEs can exit conservatorship, the Trump Administration will need to modify the agreement between the GSEs and the Treasury in order to allow for the continued sovereign backing for the existing and new mortgage backed securities (MBS). Source: MBA, FDIC, FRED Once the government announces its intention to release the GSEs, Moody’s et al will immediately prepare private corporate ratings for Fannie and Freddie using the finance company methodologies. The agencies may even place the GSEs on a watch for a downgrade before they are released and the shares are re-listed. While the credit markets and the enterprises themselves may be able to survive a one-level corporate downgrade to say “A+”, a downgrade for over $7.5 trillion in MBS would be a catastrophe for the housing market, banks and the US economy.  A sudden credit downgrade of trillions in conventional MBS would disrupt the residential housing market for years.  Conventional MBS currently trade about 150 bp over Treasury debt. Imagine what happens to conventional MBS spreads in the event of a GSE ratings downgrade without a Treasury agreement to guarantee the MBS. Let's be generous and assume that private GSE MBS spreads widen to "only" +250 bp, suggesting hundreds of billions in losses to banks and other holders of MBS globally. In August 2023, Fitch Ratings downgraded the credit ratings of Fannie Mae and Freddie Mac to AA+ from AAA, a day after it cut the US sovereign credit rating. In the event of a release from conservatorship, however, the ratings for the GSEs will drop below the sovereign rating for the first time since Fannie Mae was created in the late 1930s . Keep in mind that the ratings criteria for a private finance company are far more onerous than the criteria applied to a sovereign credit like Ginnie Mae, which is part of HUD. The table below shows the top-ten mortgage stocks sorted by 1-year total return. Mortgage Equity Group Source: Bloomberg (07/19/24) The competitive analysis performed by Moody’s, for example, will place the private GSEs in a secondary market for residential mortgages already dominated by JPMorgan (JPM) , which has a “Aa2” Moody's rating for the bank and will have a far lower cost of funds than the GSEs post release. Again, figure that "private" GSE debt will trade wide of the yields on agency corporate debt. Notice that the risk-implied credit default swap (CDS) spread estimated by Bloomberg is currently 16 bp for the GSEs, 40 bp for JPM, 100 bp for Mr. Cooper (COOP) and ~ 20bp for the Federal Home Loan Banks. Post-release, we could easily see the spread for the private GSEs widen to 50 bp or more.  Our best guess is that upon release, the corporate debt of the GSEs will trade at 1.5x the spread for the FHLBs in the credit markets. One big negative factor that the rating agencies must consider is that the GSEs will be forced to pay a large chunk of their insurance revenue to the Treasury to cover the existing and new MBS. The private GSEs must compensate taxpayers for renting the “AA+” credit of the United States. If we assume that the GSEs will pay the Treasury ~ 15-20 bp per year on over $7.5 trillion in conventional MBS, then that represents about 40% of the pre-tax insurance earnings of the GSEs. The average guarantee fee (gfee) charged by Fannie Mae in Q1 2024 was 54 bp. But what happens when the GSEs are forced to reduce their gfees because of competition for loans from JPM and the large nonbank issuers? Remember, the conventional MBS will be guaranteed by the government, but the GSEs will be private finance companies, albeit with high investment grade ratings. Their funding costs may be twice that of JPM and other banks, such as U.S. Bancorp (USB) , the second largest bank originator of 1-4 family loans after JPM. The FHLBs are paying over 5% for short-term funding today vs half that amount for large banks.  The nonbank mortgage issuers led by Rocket (RKT) , United Wholesale Mortgage (UWMC)  and PennyMac Financial (PFSI)  are orders of magnitude more efficient than the GSEs when it comes to buying loans. Smaller bank issuers, like Western Alliance (WAL)  and their AmeriHome Mortgage unit will also be bidding aggressively for loans in a volume constrained market. Given the cutthroat competition for conventional loans, just how do advocates of release expect the GSEs to survive? Residents of Washington who believe that private mortgage issuers will not go after the market share of the GSEs in correspondent lending on day one are ignoring basic market realities. Private GSEs could easily lose most of their correspondent business post-release. Given that most of the major nonbank issuers are losing money on every conventional loan they make today, led by Matt Ishbia at UWMC, how do private GSEs survive? In addition to losing much of their conventional loan business, private GSEs will be forced out of the mortgage guarantee business. If JPM, PFSI and/or UWMC want to pay the government to wrap conventional MBS in a “AA+” sovereign rating, why should the Treasury say no? The end of the GSE's role as a public mortgage guarantors is, in fact, the big, unspoken issue in the GSE release narrative. If the GSEs are privatized and have an arrangement with the US Treasury to guarantee private MBS, why can’t JPM or any other private issuer get the same deal? The answer is that Treasury will be forced to offer the same deal to all issuers. And again, the GSEs are so operationally inefficient compared to JPM or PFSI or any of the top 25 nonbanks issuers that even suggesting competition is absurd. Now most of the people in Washington who think they understand housing generally do not understand any of the issues discussed above. The Washington mindset on the GSEs is still a function of the pre-2008 world. In those happy days, private investors could benefit from supra-normal returns in GSE common stock and preferred equity that were government guaranteed. But the operating leverage in the GSE model comes from government support. The private equity capital inside the GSEs is largely irrelevant to the credit standing. That last fact, the role of private capital, is a major problem in Washington. A number of prominent conservatives led by former Federal Housing Finance Agency head Mark Calabria , are fascinated by the idea of privatization and ending bailouts for large banks and companies. Trouble is, when a financial institution gets to a certain size and scope, it can only function with sovereign support. All US banks, for example, benefit from sovereign support via FDIC insurance, which is good for a full notch of uplift on bank ratings. Once sovereign support ends, however, so too does the opportunity to earn supra-normal returns for private GSE capital. Once the government converts its preferred equity into common, dramatically diluting the existing holders, we suspect that the shares will reflect the actual financials of the respective issuers.  If as we suspect the GSEs are forced to pay away a significant chunk of their insurance revenue to the Treasury re-insure the conventional MBS, what’s left over is not going to be much of a business. The Treasury may not even get par for their GSE shares. Today the lofty share prices for Fannie Mae and Freddie Mac are a function of the pump-and-dump game played by certain Wall Street firms over more than a decade. Fannie Mae peaked back in March at $1.80 per share and has since lost almost 40 cents or a quarter of its value. Our view is that the long-suffering shareholders in the GSEs ought to take advantage of these periodic episodes of speculative exuberance in the orphaned securities issued by Fannie Mae and Freddie Mac before 2008. We think that the odds of the GSEs ever being released are very long indeed and that shareholders should take short-term trading profits rather than playing the long game that certain unscrupulous dealers are promoting. Political appointees can speculate about GSE privatization, but ultimately the professional staff at the Treasury and OMB will make the call. That said, i f a future Trump Administration disregards the advice of the Treasury and is foolish enough to release the GSEs as they are today, then we think both enterprises will stand a very good chance of returning back to conservatorship within a year.  But at the end of the day, that is precisely the outcome that large banks and conservatives in Congress have always wanted; to destroy the GSEs and leave the mortgage market in private hands other than government lenders and Ginnie Mae. Josh Rosner was right. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

July 15, 2024 | Just when you thought that the Dog Days of Summer had finally arrived, a 20-year old with an assault rifle that reportedly belongs to his father tries to assassinate President Donald Trump  at a campaign rally in PA.  Fortunately the errant shot only clipped an ear, but the chilling footage shows that former president Trump has not lost any of his fight. “Winning political campaigns is all about emotion; emotion is now completely on the side of the Republicans,” writes Mark Halperin . “Trump’s reaction and the iconic images are like nothing any of us have ever seen. Being defiant and theatrical in the face of being shot is unprecedented; it doesn’t even happen in the movies.” Events of the past 30-days present a remarkable turnabout for President Trump compared with a year ago, and now impending disaster for the Democrats. With the prospect of a Republican sweep in November led by Donald Trump at the top of the ticket, it’s time to start pondering how to unwind four years of progressive destruction in the worlds of banking and housing finance.  As you read this comment, recall our earlier discussion of Trump's planned revisions to Executive Order 12866 . At the outset, success in terms of Washington policy requires that the Trump White House have a strong chief of staff and that the process for vetting and putting candidates through the Senate confirmation process is well-organized. That was not always the case in Trump I. If conservatives do not put qualified candidates through the Senate confirmation process, then nothing will change in Washington. We need many hands to drain the swamp. In the world of banking, the obvious question to ask is whether President Trump should repudiate the Basel III Endgame proposal put forward by the Biden Administration. Short answer, yes. Basel III represents the European view of bank regulation. Dozens of members of both parties have already called upon President Biden to walk away from the bank capital rule and start again.  Last November, U.S. Senator Mike Crapo (R-IH) joined Senate Committee on Banking, Housing, and Urban Affairs Ranking Member Tim Scott (R-SC) in sending a letter with 37 colleagues urging the Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) to withdraw the Basel III Endgame proposal. They wrote: "We have serious concerns that, as proposed, Basel III will restrict billions of dollars in capital from those who need it most, resulting in costlier and more limited access to credit for millions of Americans. This would create severe, adverse impacts on the entire U.S. economy, from every day American consumers to the small businesses that are the backbone of our economy." Our view is that the Basel III Endgame proposal is a mess and cannot merely be revised to deal with all of the shortcomings (“ Comments on Basel III Endgame ”). The additional capital overlays in Basel III will force US banks to actually shrink assets, particularly mortgage and other consumer assets, increasing the cost of credit. But the bigger question facing President Trump is whether to walk away from the Basel Accord entirely and put regulation of the US banking industry back into American hands. The Basel Accord, let us not forget, is the creation of former Federal Reserve Board Chairman Paul Volcker and his colleagues at the Fed, who worked at the various Group of 10 central banks in the 1970s.  We was there. In 1975, Dad actually quizzed us during dinner in Cleveland Park about the "Basel Agreement" and the failure of something called the "Herstatt Bank." The failure of Bank Herstatt became one of the landmarks of post-war financial history and led to the creation of the Basel Accord. Yet the days of uncertainty and crisis that drove cooperation five decades ago have been succeeded by regulatory dysfunction. The divergence between the US and Europe on many aspects of bank supervision and capital regulation begs the question as to why the US remains in the Basel Accord at all. For example, European regulators despise single family housing assets and prefer to have all housing finance under state control.  But there are many many other types of finance used in the US that are subject to regulation because of the preferences of European regulators. Everything from tax assets for clean energy to asset backed securities for auto loans and credit cards are more regulated under Basel III. EU regulators do not recognize any intangibles as valid capital assets for banks, directly opposing the US practice of recognizing payment intangibles at the point of sale of the loan. Regressive European thinking on housing has poisoned the discourse inside US regulatory agencies such as Fed, which now treat payment intangibles such as mortgage servicing rights (MSRs) as a "problem." Likewise other agencies such as Ginnie Mae, HUD and even the FDIC parrot the erroneous concerns about MSRs instead of recognizing the value of these assets. What is the single most stable, sought after asset in finance today? MSRs. And cheap since they still only trade on 5-6x cap rates! Don't forget to read our upcoming biography of Stan Middleman, a man who knows something about mortgage lending and MSRs. Reflecting European mores generally, American regulators view small banks and nonbank lenders as a problem that needs to be solved via consolidation and with minimum public fuss. In Europe, the government has a monopoly on much of secured finance, leaving the private banks with the scraps. Many EU regulators would be glad to see all banks under state control, one reason why there is no private bond market or significant economic growth in Europe.  Many senior US officials in the Biden Administration share the European contempt for smaller banks and businesses. But fortunately t he US is moving in a very different direction from Europe. With the landmark Supreme Court decision in Loper Bright Enterprises v. Raimondo , overturning Chevron USA v. National Resources Defense Council , much of the rule making by the Fed and other prudential regulators is exposed to attack. With the end of the federal judiciary's forty-year-old practice of deferring to agencies' reasonable interpretations of ambiguous federal laws, President Trump arguably has a duty to walk away from the Fed’s creation of Basel and begin again.  The Basel Accord is one of the single biggest examples of a regulatory agency literally creating a new law from whole cloth. The fact that Paul Volcker is one of the authors does not give legitimacy to the Basel Accord. Basel is an illegal treaty between nine other nations that has never been presented to the Senate of the United States for ratification. Yet despite this significant legal defect, the Basel Accord has been used as the basis for rule making for US banks over the past several decades. The Basel Accord was never been formally adopted or endorsed legislatively by Congress. For example, 12 CFR § 252.143  refers to the Basel Committee's capital requirements applicable to foreign banks being acceptable for US law, but otherwise Title 12 does not refer to the accord at all . “US regulatory capital requirements are broadly derived from regulatory capital standards maintained by the Basel Committee,” notes Mayer Brown (“ A ROAD NOT TAKEN: WHERE THE US CAPITAL PROPOSAL DIFFERS FROM BASEL ”). “The international standards were revised in 2017 by the Basel Committee, but, as with all US regulations, the changes are not binding on US banking organizations unless and until US regulators formally adopt them through the notice and comment rulemaking process.” Of course, this assumes that the rule process with respect to Basel was valid in the first instance and now particularly in the wake of Loper . Nobody told Paul Volcker to cooperate with his counterparts in Europe. He just did what seemed like a good idea in the very different world of the 1970s. Volcker describes the process in his excellent 2008 Fed Oral History interview . So basically US banks are regulated under rules developed by a conclave of learned bureaucrats in Basel, Switzerland, and then changed and endorsed by the Federal Reserve Board and other regulators via a rule making process? The unofficial, consultative nature of the Basel Committee is documented on the website of the Bank for International Settlements.  The Basel bank capital rules and accounting conventions reflect a European perspective that limits growth and is unsuited to managing the risks of banks operating in the US economy. Volcker himself alluded to the difficulties of aligning the US regulations with the other member of the G-10 in a November 2011 essay in The New York Review of Books :  “We do need, however, to be conscious of the practical difficulties and limitations of setting capital and liquidity requirements. Those problems have long been evident in the effort to enforce the standards established by the earlier Basel agreements. Not surprisingly, they reappear in the ongoing negotiations to strengthen those standards. We see differences in national perceptions, reinforced by intense lobbying by affected institutions, whether central banks, commercial banks, or investment banks. In establishing standards for banks the tendency may be to bend toward a least common denominator, weakening the standards and allowing them to be unevenly applied. Resisting such pressures must be a priority for regulators.” It’s time for the Congress to reclaim control of bank regulation in the US. Obviously in the post- Chevron  world, a large bank or industry organization could sue the Federal Reserve Board et al  to block implementation of the 2017 Basel Accord. Indeed, an enterprising plaintiff might seek to void the whole construct of bank regulation based upon the Fed’s work over the past fifty years. But really this sounds like an issue tailor made for President Trump and the House Republican Caucus. There is no legal basis for the Basel capital rule and somebody in Congress needs to publicly call out the Fed on this small point.  And remember, once President Trump signs EO 12866, the Fed and other agencies must "report up" to the White House, Office of Management and Budget, and the Treasury on bank regulatory matters where Congress is silent. Fifty years ago, it made sense for officials at the Federal Reserve like Paul Volcker to manage banking regulation through secret, informal channels to the Bank for International Settlements. This arrangement suited the largest banks, which were insolvent at the time due to loans to Third World debtor nations. Mexico, Brazil and China all paid off their debts, but the big banks are still insolvent. Go figure. Today such a situation where the Fed and the Basel Committee set US public policy is intolerable, especially if American banks must operate under oppressive European rules that increase the cost of home ownership for American families. The whole framework of Basel capital rules and risk weightings need to be discarded in favor of new legislation from Congress that reflects American priorities. We propose that President Trump and his policy circle seriously consider walking away from the failed Basel Accord and instead put in place a modern bank capital framework that is designed for the US economy in 2025. Regulators do not need legislation to propose new bank capital rules, but we can no longer take direction from bureaucrats sitting thousands of miles away in a foreign nation who do not share American views of banking, finance and growth.  In our next issue, we'll be digging into reader questions on Q2 2024 earnings. So why the pop in defaults for JPM's HELOC book? Keep those questions and suggestions coming. info@rcwhalen.com We'll answer in the blog or @rcwhalen on X.com . Get Your Signed Copy While They Last! The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

July 8, 2024 | Last week, the Federal Reserve Board released the annual bank stress tests mandated by Dodd Frank . The big headline is that Goldman Sachs (GS) failed the stress test, but there are a number of other banks of concern as well. The Fed's bank stress tests are a bit of a mess in terms of analytical methodology, one reason we rarely look at them. The description of how the Fed performs the stress tests on Page iii of the report illustrates the problem. The caption at the bottom of the graphic above tells you that the Board staff will "adjust" the already subjective bespoke inputs from the banks and then produce "custom" economic scenarios? The Fed is clearly conflicted by conducting these discussions in private. We don’t need an economist or an economic scenario to construct a bank stress test. Indeed, the focus on speculative economic scenarios as the point of departure for the Dodd-Frank bank tests clouds the analysis and renders the whole exercise irrelevant in terms of understanding the bank. To conduct a classical stress test for a bank, a ll you need is a loss rate and a time horizon. The net income, credit provisions and counterparty losses in the Fed results are useful in this regard. But why the losses occur really does not matter. The Fed has chosen to inject a huge degree of subjectivity into a legally mandated public policy analysis of bank soundness. By employing bespoke economic scenarios produced in secret with no transparency or accountability, the whole bank stress test process is compromised. Given the clear conflict by the Fed staff in Washington, the stress test results for GS are rather alarming. This is the test result for Goldman that the Fed assigned after the private consultations and hand-holding with Board staff? Notice that GS ended the stress test with a Tier 1 Leverage Ratio of 5.3%. Readers of The IRA know that t he public data provided by large US banks provides more than sufficient information to conduct a stress tests w/o any economic inputs. The bank-specific data provided in response to the Fed-generated DFAST economic scenarios are a hodgepodge. T here is no comparability from one bank to the next. Unlike the consistent public data reported by all large US banks, the Fed's stress test is a deeply biased chopped salad in analytical terms. B y using economic scenarios and then "adjusting" the particular, non-standard inputs from each bank, the output becomes entirely speculative and is useless from an analytical perspective. Remember, bank stress tests are meant to be a public process and not part of the confidential bank supervisory relationship. Since few members of Congress understand finance or economics, nobody notices the obvious analytical bias shown to each bank, unevenly, and other shortcomings of the bank test process required by Dodd-Frank. Anther big drawback of the Fed stress tests is that they work with risk-weighted assets, the four-decade old Basel III construct that focuses on credit risk for assets in the event of default. But the loss rate assumptions that are published in the test are instructive, however, both about how the Fed thinks about a specific bank and the US economy more generally. Below we show the key results from the Fed stress tests for the 24 largest domestic US banks and also the US businesses of seven foreign banks.  Memo to Fed Chairman Jerome Powell : Next year, if you want to dispense with the rest of the report and just show us the spreadsheet below, that would be great. First and foremost, notice which banks ended the stress scenario with higher capital and/or net earnings. Earnings get you through periods of loss, not capital. Federal Reserve Stress Test Results Source: Board of Governors As we all learned with Silicon Valley Bank, credit risk is not the only problem facing banks. You can destroy a large regional bank by gambling naively on interest rates via investments in mortgage-backed securities (MBS). The risk weight on Ginnie Mae MBS is zero under Basel. But the market risk of these variable duration securities makes them among the most problematic assets a bank can own. This is especially true if the people running the bank happen to be idiots, to paraphrase Mark Twain . But we digress. Notice that the Fed stress test is silent on trillions of dollars in mark-to-market losses facing US banks from COVID-era MBS and US Treasury debt.  How can the Fed report to Congress on the state of US banks and not mention that many institutions (and the central bank itself) are insolvent? This sad state is due to radical swings in interest rates engineered by the FOMC since Q1 2020. The chart below comes from our earlier comment with the full mark-to-market analysis for all US banks (" Q2 2024 Earnings Setup: JPM, BAC, WFC, C, USB, PNC, TFC "). Source: FDIC/WGA LLC Adjusted capital = tangible capital less 17.5% M2M haircut on total HTM loans/securities in Q1 2024. Just by coincidence, Stephen Gandel and Joshua Franklin of the FT  wrote an important piece last week reporting on the results for Goldman Sachs. They suggest that the bank is attempting to change the Fed stress test results. " Goldman Sachs faces long odds in getting the Federal Reserve to reconsider its disappointing grade in this year’s bank stress tests, according to regulatory experts," they relate. We reminded readers in our last missive (“ Who Leads the Asset Gatherers? | SCHW, MS, GS, AMP, RJF & SF “) that GS continues to have the worst credit performance of the group. We regret to say that the Fed test results confirm our view and more. If you page through the individual bank stress test results, you will see that GS is clearly the outlier in the group in terms of assumed credit and counterparty risk losses through to Q1 2026. Note that monoline card issuer Discover Financial (DS) has a $21 billion credit loss provision assumed, but the bank's strong profitability renders any concerns moot. The bank's capital increased during the DFAST test simulation, which means that net income exceeded credit costs. There is a reason why DS is consistently among the top bank stocks in the WGA Bank Top Ind ices . Federal Reserve Stress Test Results ($B) Source: Board of Governors “Goldman in some ways fared better on the Fed’s stress test than it did on its own, which the banks also had to disclose last week,” the FT  reports. “Its internally run stress test predicted a bigger drop in revenue and larger trading losses in an economic downturn that the one run by the central bank.” While other, large banks such as Citigroup (C)  were able to negotiate the stressed scenario losses imposed by the Fed’s test, Goldman missed the target completely and ended up below the minimum capital level for the bank. Remember, each test is different for each bank, thus the test results suggest how the Fed views a given bank business model.  Just remember that the Fed stress tests are not a fair comparison of the soundness of one bank to another. The FT  reports that GS may not be able to increase dividends or share buybacks as a result of its poor test performance. Perhaps the Fed has finally discovered that GS is one of the most risky banks in the US. Sure, Morgan Stanley (MS) has a slightly bigger derivatives book than does Goldman, but rarely reports a significant credit loss. Goldman under CEO David Solomon , however, is shoveling money into the furnace in terms of credit losses even with an 11% gross loan spread. Notice, by comparison, that MS barely saw a reduction in capital and reported a small loss relative to GS and other universal banks. Citi compares well with the other top-five moneycenter banks. Federal Reserve Stress Test Results ($B) Source: Board of Governors In the stress test, Citi had a $47 billion slug of income placed into loan loss reserves, $11 billion for counterparty losses, and generated a net loss in the Fed’s two-year scenario. Yet CEO Jane Fraser and her team came through the stress test with flying colors in terms of minimum capital. Capital is what matters at the Fed, even if the rest-of-the-world does not care. Citi’s stressed loss rate on credit cards was inside 20%, but meanwhile the Fed hit  Ally Financial (ALLY)  with a 40% loss rate on credit cards in the stressed scenario? Hello.   Goldman has almost $20 billion allocated to loss provisions and another $18 billion for trading and counterparty losses in the stress tests, easily the highest in the group vs total loans. The good news with GS and MS is that they don’t have a big securities book with hidden unrealized losses like most of the industry. As we’ve noted for subscribers to our Premium Service though, GS loses more money on credit than its larger peers.  Total loans and leases for GS were only $256 billion out of $1.6 trillion in total assets at Q1 2024, yet the bank lost 62 bp vs total assets in Q1 2024 ? More than JPM? Of note, the Fed modeled a stressed 16% loss rate on Goldman’s C&I book, just shy of 16% on commercial real estate and 25% on credit cards.  The stressed loss rate on cards was only 16% for Citibank. At CapitalOne (COF),  the modeled loss rate on credit cards was only 24%. Again, Goldman is the outlier in the group looking at the Fed's loss assumptions. The credit loss rate on the Goldman credit portfolio says a lot about the target customer for that bank. Goldman said last week that the Fed’s scoring didn’t reflect the evolution of the company, which has been exiting certain businesses and shrinking outside investments. “We will engage with our regulator to better understand their determinations,” said CEO David Solomon. Q: If Marcus and related retail exposures are gone, why do the credit losses continue? The Fed's loss rate assumptions for C&I loans and total loss for GS suggest that institutional exposures are the culprit. If the folks at GS really, really want to do credit going forward, then David needs to have lunch with Jane Fraser soon. He and the Goldman bankers run the broker-dealer, but Citibank runs credit. Problem solved. The bank founded in 1869 by Marcus Goldman and Samuel Sachs to discount short-term commercial paper has proven, once again, that trading commodities and extending credit to second-tier corporate credits are two different skill sets. As we noted to our readers last week, GS reported an average gross yield of 11% on its credit book or 2x JPM. Just imagine the credit default profile of the average GS institutional customer given that gross spread. We could name names, but let's not. The chart below shows actual net losses for the top banks through Q1 2024. No, we don’t make these numbers up. These numbers come from the Fed and the Federal Financial Institutions Examinations Council . The public data from the FFIEC is more than sufficient for stress testing, but instead the economists at the Board demonstrate how not to perform a financial assessment. And remember, the modeled loss rates tell you how the Fed's supervisory staff sees each bank. The Fed stress tests are not about the bank, but rather about the bank stress test model and the legions of Fed economists who love to build models.  The purple line is GS. Source: FFIEC Goldman Sachs is easily the laggard among the top-10 US banks this year, but they can take some comfort in the fact that they are not the loss-leading appendage of a foreign bank operating in the US. The history of foreign banks investing in the US is abysmal, as the table below suggests. We wrote about Bank of Montreal (BMO) and their purchase of Bank of the West earlier this year. When you see that many of these foreign-owned operations start the stress test with negative income, that tells you what you need to know. More, look at the size of the provision for credit loss among these banks vs net revenue. Look at BMO, a bank with a US operation that is arguably insolvent if you subtract the intangibles and M2M losses. Like we said. What does this say about how the Fed views credit risk inside these banks? Note that the $165 billion asset US unit of Banco Santander (STD) , the largest retail bank in the Eurozone, has the highest assumed loss rate in the group after the monoline consumer lenders. Federal Reserve Stress Test Results ($B) Source: Board of Governors * Top tier BHC in the US The moral of the story, of course, is that income matters more than capital. Think of bank capital as a security deposit, a performance bond with the FDIC. Banks with strong asset returns like DS, American Express (AXP) and Charles Schwab (SCHW) ploughed though the Fed loss scenarios with little trouble. And JPM easily handled some very large loss assumptions in the test. But the projected losses for Wells Fargo & Co (WFC) and Bank of America (BAC) suggest that the Fed expects rough sailing for the banking industry ahead. Buckle up. More reading on the Fed's bank stress tests: A Realistic Assessment of Bank Capital Adequacy vs the Federal Reserve Board’s Stress Test Fiction | Paul Kupiec | American Enterprise Institute The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

July 1, 2024 | In this edition of The Institutional Risk Analyst , we ponder the world in the wake of the Fed’s latest bank stress tests and the gutting of the  Chevron  doctrine by a 6-3 majority of the US Supreme Court. The former is reason for grim amusement, while the latter is probably the best news the business community has received since Republicans trounced progressive forces led by William Jennings Bryant in 1896.  Jim Lucier of CapAlpha in Washington sets the stage for the Chevron  party: “When we saw that Chief Justice John Roberts had written the majority opinion in the Supreme Court’s 6-3 decision  in the Loper Bright  and Relentless  cases we thought that surely the Chief would have added a subtle touch, a dash of nuance, or some qualifiers to his opinion to mitigate its impact.  Nope. It is a deep, broad, thorough, and total repeal of the Chevron doctrine – and one that scatters salt in the ruins of what is left, much as the Romans destroyed the city of Carthage.” Now we can understand how progressives might be a bit saddened by the performance of President Joe Biden last week in the presidential debates. But the real disaster for the American left was the evisceration of Chevron , which in very simplistic terms mandated court deference to regulatory agencies. An earlier decision whereby the USSC ordered the SEC to try securities fraud cases in civil court is also a reclamation of prerogative and political turf by the federal courts.  Again Lucier: “Roberts’ decision basically said that only the courts interpret the law, and that the only correct reading of a statute is the one that a court determines. There is no range of possibilities in which federal regulators get to choose the one that they prefer. The implications are far reaching and profound. The ruling would affect almost anything the federal government does – from health care, labor law, financial services regulation, tech and telecom to tax and tariffs.” The USSC decision on Chevron  winds back the political clock in the United States to before the New Deal and the creation of a myriad of federal agencies in the 1930s. For decades since the establishment of agencies from the SEC to the Environmental Protection Agency to the Consumer Financial Protection Bureau, the progressive regulatory community served as a  de facto fourth branch of the federal government. But no more.  Not only can private businesses fight the edicts of all federal agencies in the courts, but these agencies now have no special standing to defend attempts to expand regulation beyond the specific statutory direction from Congress. Given the level of confusion and incompetence we see in many financial agencies, for example, it is long past time for the banks and the mortgage industry to use litigation to push back the more unreasonable mandates starting with Basel III and the Ginnie Mae risk based capital rule. Important as the USSC decision on Chevron may be, the next shoe likely to drop will be even more profound in terms of limiting future federal regulatory action. We discussed this in an earlier comment (" At the Federal Reserve Board, It's 1927 All Over Again "). When President Donald Trump signs a revision to Executive Order 12866 , all federal agencies will be compelled to “report up” to the White House on all matters where Congress has not provided specific directions. Originally promulgated by President Bill Clinton to improve the federal budget process, the revisions to EO 12866 was meant to be signed in the first Trump term.  Zombie Bank Stress Tests Although it is encouraging to see the courts finally reclaiming their prerogatives from the progressive regulatory mafia, don’t expect rational action coming from Washington anytime soon. We should remember that the US used a policy of explicit currency inflation to augment the economy in the decades leading up to the Great Crash of 1929. The more recent experiment by the Fed in monetary expansion has left the federal government with $36 trillion in debt and a banking industry that is visibly insolvent.  Don't hold your breath waiting for anybody in the financial media to ask about zombie banks. One of the signs that our society is a bit delusional is the fact that we can talk endlessly about living wills for large banks as though it were even possible to avoid a public bailout in the event of default. Taking the GSEs out of government conservatorship is another example of magical thinking. Meanwhile, the US banking industry is insolvent to the tune of -$1.3 trillion at the end of Q1 2024 (“ Q2 2024 Earnings Setup: JPM, BAC, WFC, C, USB, PNC, TFC ”). Keep in mind that the eye-watering negative capital number is just from mark-to-market losses on securities. The average yield on the several trillion in bank owned securities is just 3%, which implies a M2M discount of 15-20% from par. The average cost of funds in the banking industry is 2.5% vs total assets. Overhead expenses run about 2.3% of total assets annually. Do the math. Bank's need yields above 5% to cover their costs. Source: FFIEC Like the currency inflation and financial speculation of the early 1900s, t he Fed bank stress tests are another sign of magical thinking in Washington. Even though the industry is insolvent on a M2M basis, and even though losses from CRE could cost trillions of dollars in losses to developers, REITs and banks, the Fed has given most banks a "pass" on stress tests.  This means higher dividends and stock repurchase programs, but not nearly at the levels seen five years ago. Source: FFIEC How can the Fed can give the industry a pass based upon a “stressed” scenario created by an economist, when the credit markets suggest trouble ahead for banks and nonbanks alike? Good question.  Goldman Sachs (GS)  analyst Richard Ramsden , for example, noted that the Stress Test results “were broadly worse than expected for the banks.” Ramsden explained that the year-over-year change in results was largely driven by banks generating much lower pre-provision net revenue (PPNR) during the test period. For the largest banks, Bloomberg reports, PPNR fell by 9% year-over-year. The table below shows Q1 2024 stock repurchases by the largest banks as a percentage of Common Equity Tier 1 (CET1) capital. Source: FFIEC One reason that banks might generate less pre-provision net revenue in the future is that the yield on bank owned securities is abysmal. It will take years for the average yield on bank owned securities to crawl up to 4%. The only way many banks can survive is to swap some of the eventual upside on these low-duration securities for cash today. But no true sale please. Keep in mind that bank regulators and the major audit firms have for years been quietly softening rules for delinquency to mask the truly gnarly state of credit for low-income borrowers and businesses. Bank regulators and housing agencies have contributed to this dumbing down of credit measures. Mortgage Credit Source: MBA, FDIC Think about the default rating of the bottom third of households post-COVID. Some progressives think you can just ignore low income, the cause of low credit scores and rising loan defaults, and just talk and talk about helping low income families. The solution to low scores and high default rates is higher income.  Our educated guess is that bank default rates are understated by a third due to loan modifications for consumers and business. Of note, Bill Moreland at BankRegData has recently introduced an Adjusted Coverage Ratio which modifies the standard Coverage Ratio by adding in 'Performing' troubled debt restructuring (TDR). Love it. Before Marty Gruenberg left the building at FDIC, we suggested to our favorite agency that they ask the FFIEC to include some type of credit risk transfer metric by loan category type. We’ll see. The chart below shows the commercial real estate (CRE) concentration ratio for all large banks. Source: FDIC/BankRegData Even as the Fed waives in the banks in the latest stress tests, c redit is growing more and more opaque. There are a lot of “performing” loans in the banking system that are really modified loans that have essentially defaulted. Call them zombie loans. Such is the level of political fantasy in Washington under President Joe Biden that delinquent borrowers can be modified multiple times, and fail each time, yet still be shown in the loan portfolio of a bank as “performing.” Likewise defaulted commercial borrowers are being modified to varying degrees to avoid foreclosing on a property that nobody really wants.  Part of the reason we think that the Fed and other agencies need to address the issue of unrealized mark-to-market losses is liquidity. When a bank has more and more assets that are trading at a deep discount to par, that discount becomes a current debit against capital. When we then face credit issues that force us to provide forbearance to borrowers, the bank becomes even less liquid. Because the impaired, modified loans pay less or not at all, and cannot be sold anywhere near par, the solvency of the bank is damaged. Ultimately, whether a bank faces a loss on a low-yielding security or carries a zombie loan on the books as performing, the result is the same. The bank receives less cash and it holds assets that cannot be sold for face value. We suspect that a significant portion of the $13 trillion in total loans and leases on the books of US banks is impaired.  Just in the world of consumer mortgages, there are hundreds of thousands of borrowers in the system who have been modified multiple times and now are heading to an eventual resolution. As we noted in an earlier piece (“ Capital Confusion at Ginnie Mae & Mortgage Servicing Rights ”), the delinquent consumers rarely go through to foreclosure and most often sell the house and pocket the surplus above the loan balance. As and when home prices soften, then the cost of default will again become positive as it is today in commercial and multifamily credits.  The only real question is why the Fed is unwilling to tell banks to retain capital rather than allowing increased dividends and stock repurchases. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

June 26, 2024 | Updated | Premium Service  |  In this edition of The Institutional Risk Analyst , we provide notes and impressions on the IMN mortgage servicing rights (MSR) event in Dallas this week. The first panel of the event featured a discussion with several issuers, who described how the competitive environment in Ginnie Mae servicing is being impacted by the prospective risk-based capital (RBC) rule that goes into effect at year-end. We wrote about the RBC rule in our most recent comment for National Mortgage News (" Ginnie Mae risk-based capital rule is unworkable "). Ginnie Mae officials seem to be preoccupied with the idea of MSR values suddenly falling when the FOMC cuts interest rates. History suggests that this concern is not well-considered as in 2020-2021, when prepayment rates jumped to 50% in a matter of months. What Ginnie Mae is essentially saying via the RBC rule, which requires issuers to subtract the excess servicing strip (ESS) from capital, is that they’d rather have issuers hold cash than MSRs. It seems that Ginnie Mae officials would rather have issuers raise the net present value of the MSR in cash today than take the price risk of holding the whole MSR asset through time. The staff of Ginnie Mae do not seem to appreciate that MSR valuations increasingly reflect the value of future recapture of existing customers. As discussed below, the Ginnie Mae RBC rule is actually forcing MSR valuations higher . Issuers that pay 6x or 7x price multiples for MSRs are doing so because of the proposed RBC rule. Only with assumed recapture rates of 50% of total prepayments do these valuations make sense, but that's tomorrow's problem. Of note, one speaker at the IMN event reported that more auditors are willing to accept the optionality of future loan recapture for the purposes of GAAP valuations of MSRs. This change alone has been forced by the RBC rule proposal by Ginnie Mae and is probably good for a 20% boost in MSR valuations. Bill Greenberg  of Two Harbors (TWO)  repeated his view that people are wrong about "stress" on the MSR in a falling rate environment. The scenario that people think is most stressful, namely a falling rate environment, is actually not because there is so much cash sloshing around the system. The more stressful scenario, says Greenberg, is a rising rate environment where issuers must post more margin on the hedges that they can get in cash from financing the MSR. Since the RBC rule lowers leverage on the MSR from 65-70% to just 50%, the Ginnie Mae proposal will actually increase stress and reduce liquidity for independent mortgage banks. Scott Buchta from Brean Capital said that in comparison to the massive 2020-2021 refinance wave, today 1% of conventional borrowers and 4% of Ginnie Mae borrowers have 50 bp of refinance incentive in Q1 2024. Thinking about the market today at 6.5% coupons, if we go down to 5.5% on conventionals, it helps. We need rates to go down 150 bp to really move the needle, Buchta commented. Some 60% of borrowers have rates below 4%. Newer borrowers should be easier, faster and cheaper to refinance. If we get below 6% mortgage rates, that’s when we start to see things pick up. At 5.5% mortgage rates, we start to unlock the housing market and encourage more voluntary sales. Source: FDIC/WGA LLC Nolan Turner of Carrington talked about how the proposed Ginnie Mae RBC rule is impacting MSR valuations: “If you think about how this risk-based capital rule impacts issuers, let’s do the numbers. Everyone that originates loans loses money today. Screen price for a Ginnie Mae 6.5 is 150 bp. That loan costs at least 400 bp to originate. So you sell the loan for 150 bp and you are upside down 250 bp. Even if you put a 4x multiple on the Ginnie Mae MSR, you are still losing money on the loan. The only way to make ends meet is to increase the valuation on the MSR. Did I say a 4 multiple? No, I meant a 5x. Or was it a 6x? I can’t remember. But the point is that the MSR needs to be overvalued to make all of this work.” Mike Lau of Pingora/Bayview made the point that rising taxes and insurance costs are going to take some issuers by surprise. Higher home prices and related increases in home insurance may even cause unexpected advances for taxes and insurance on these assets, creating obligations that may take months to recover. Lau ventured that increased costs for insurance is a major unrecognized issue facing lenders in terms of the impact on consumer credit. A reader, however, notes that higher insurance and tax payments mean bigger escrows, which ultimately are good for mortgage banks. Lau also said that any rate cuts by the Fed will lead to a feeding frenzy in conventionals that will make pricing "very challenging." Buchta noted in this regard that we are still 200 bp away from a mortgage rate that brings a significant number of loans into the money for refinance. Of note, rate buydowns remain a significant part of the market and the market continues to produce 4.5% and 5% coupons in significant volumes. Turner of Carrington noted that consumers are facing a lot of stress due to inflation. He said that we are seeing a "rinse & repeat" cycle in distressed servicing where borrowers fail modification multiple times. He notes that some 40% of Ginnie Mae loan mods are going into redefault, illustrating the true level of stress affecting many households. Turner says that households below $150k income are showing particular levels of distress. Taxes and insurance have doubled, forcing up DTI ratios. Also, Turner notes that he expects to see strategic defaults as and when home prices begin to fall. He says that many of the prepays seen now reflect sales by troubled debtors that finally took the equity off the table after multiple failed modifications. Sales were 20% of prepays before COVID, but now outright sales are more like 70% of total prepayments. As long as the equity in the house is positive, Turner notes, borrowers can essentially fund the loan modifications with their own equity. When the equity declines or disappears, however, the visible cost of default will rise proportionately and actual foreclosures will grow. FHA and VA programs to modify borrowers to below market rates will help, but the low income consumer is taking a kicking due to inflation in the current economy. Jeff Lown of Cherry Hill Mortgage Investment Corporation (CHMI) noted that last time prepayment rates (CPRs) went to 50% in 2020, it took four months to get there. Next time it will take 45 days because of changes in technology. Something for us all to look forward. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

June 17, 2024 | In this issue of The Institutional Risk Analyst, we feature a discussion with another close observer of the Federal Open Market Committee, economist Brian Barnier . Brian is co-founder and editor of economic and market site Fed Dashboard & Fundamentals , where he applies decision science analysis to bust market and economic myths. Brian’s work deciphering Fedspeak is more akin to Ghostbusters than a polite lab experiment, and always insightful. The IRA: So Brian, great to connect again. We sent you a bunch of questions about the economy and inflation, and how the Fed is handling both parts of the mandate in Humphrey-Hawkins. In typical fashion, you have responded with two cool graphics from Fed Dashboard. Barnier: In terms of inflation, the first chart tells the true story of price increases across different sectors of the economy. In Chart 1, the rather complicated circle in the negative in terms of price inflation are, in order: Sports and RVs, household maintenance, fuel oil, personal care products, furniture, schools, men and boy’s clothing, postal service, photo equipment, other clothing and footwear, water supply and sanitation and rental value of farm dwellings. The IRA: Yes, auto prices were decelerating last year as the effect of COVID on loss severities was reversed. Everything else is going up in price. This suggests that the Fed has not even begun to address inflation to date, only the future rate of increase. We’d need high rates for longer to deflate these prices, but the collateral damage of such a deflation would be horrible. Does the FOMC actually realize the extent to which they have been marginalized? Barnier: The FOMC has been in never-never land since the economy globalized in the early to mid-1990s. Some people date this trend toward globalization starting in the late 1980s and increasing globalized financial markets. Some products and services face rising and falling prices – see my immediate past version of Chart 1 below. The IRA: What does this chart tell us? Barnier: The FOMC cannot control the economy the way they did in the post-WWII period. For example, today, the FOMC cannot control building permits or all cash buyers for housing. The CPI for the entire country was recently distorted by higher Detroit imputed rents. Thus, imputed rent is beyond the FOMC’s reach – this was not always the case. In the 1950s through maybe into the late 1990s, the FOMC could control mortgage interest rates and building permits flowed freely for expanding families. The IRA: Neverland is a realm where many people refuse to grow up. In our interaction with Fed people, they seem to understand much of what is happening in the markets, but perhaps we are too kind. We have been screaming about commercial real estate for some while now, but this fiasco is very much a private affair. Commercial defaults happen quietly, in conference rooms with lawyers. The impact arrives years later. Barnier: The FOMC has minimal CMBS in their portfolio. Where I live and where I travel, I see numerous “for lease” signs, occupancy (parking spaces low) and hear lectures about commercial landlords handing the keys back to the lender. The IRA: This time it’s different in a sense that commercial is leading the way. We just suggested to the folks as FDIC that banks need to start disclosing credit risk transfer transactions soon. Numbers will simply be too large. But even as the mainstream narrative has been talking about rate cuts, you are arguing that the Fed is not actually tightening now. Tell us why. Barnier: As Chart 2 above shows, we are tightening and also we still are well above historical levels for most of the FOMC’s Balance Sheet (this chart is just securities). A little over one year ago, I participated on a panel from the NYC Bar Association , that addressed these bank regulation issues. Then, of course, we must consider the Treasury’s deficit spending. The IRA: We are in the midst of re-editing the portion of “Inflated” that deals with the Progressive crusade for silver coinage in the post-Civil War era. The vast inflation created by the Treasury purchasing physical silver paid for in fiat paper greenbacks probably led to the financial crises starting from the 1880s through to the Great Depression. We worry that the COVID era inflation, likewise, will result in a maxi economic reset later in this decade, a deflation led downward first by commercial and then by residential housing. The Fed has no impact on residential home prices at all, yet we are talking about rate cuts. How do we make sense of this mess? Barnier: The big political question for me is 1) when will the FOMC realize that it lacks the control over the economy that it once had and 2) when will the Fed seek a more engaged relationship with the U.S. Treasury. Certainly not that the FOMC must finance budget deficits. Creating a more productive economy for residents. Open the conversation to the public. Like when the Great Depression ended and after WWII. Until this issue of “control” is resolved, the FOMC will be in a quandary. The IRA: We always smile when economists recite the profession of faith with respect to central bank independence. The last Fed Chairmen to assert independence from the Treasury were Thomas McCabe and William McChesney Martin. Chairmen Volcker and Greenspan focused on keeping the system afloat. But the Fed is now the tail, a mere appendage given that we are borrowing one quarter of public spending every year. The Treasury is the dog and the financial alter ego of the central bank. Barnier: You said it with “keeping the system afloat.” Looking back at the data, we can easily see the turn. It was after Volcker, Greenspan maybe did not notice as the pattern was not yet clear. William McChesney Martin is the one we should follow today -- he was a balancing act. For a good Greenspan biography, I like Sidney L. Jones . The IRA: Thanks Brian. 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.