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June 12, 2024 | Premium Service | For some time now, we have struggled to understand the net, net picture in commercial credit, on the one hand. The pristine state of residential mortgages and even relatively low defaults on credit cards and auto receivables, is on the other side of the coin. Down a second level, we see the clear deterioration of valuations for commercial real estate and mounting defaults across the wider commercial sector. Yet simultaneously a flood of cash is welling up from the ground in private credit to fund credit risk-transfer transactions and in size. Banks, REITs and non-bank investors alike are transferring doubtful credits to investors in growing volumes. The acronyms used to describe these transactions are also expanding, a worrisome sign. Will CRT be enough to save the banks from credit Armageddon in 2025?  NPLs for commercial real estate loans owned by banks are already at levels not seen in over 15 years and the crisis in commercial real estate is not nearly begun. US banks just ended disclosure of loss-sharing agreements with the FDIC, but is it time for banks to disclose private credit risk transfer (CRT) transactions?  Earlier we had written about some of the challenges facing Merchants Bank of Indiana (MBIN) . “Eight quarters ago we see almost no NPLs in MBIN's Non Owner CRE portfolio,” writes Bill Moreland at BankRegData in his review of “sentry events.” “Then over the next seven quarters we have 7 'events'. The $21,753,000 increase to $21,783,000 is what we call an NPL Spike. Most likely this is 1 or 2 CRE loans that have gone on Nonaccrual or are 90+ Days Past still accruing interest.” What Bill is describing is a significant change in  the rate of increase  in the losses for MBIN and other lenders. The net loss numbers are still low, but they are moving fast, enough to signal concern for a veteran analyst like Moreland. We have seen similar “motion” in the loss data for other banks, something we attribute to the long period of suppressed default activity from the mid-2010s through COVID.  Has the proverbial rubber band of loss been released? To us, the big question facing investors in bank equity and debt is whether we are about to see the normalization of credit loss rates after 15 years of artificial life support from the Federal Reserve Board.  You cannot look at the chart for loss given default (LGD) for all bank loans below and not conclude that the past decade and more have been extraordinary. Yet we are nowhere near the volume and rate of LGD seen in 2008.  Notice that loss severity actually fell in Q1 2024. Source: FDIC/ WGA LLC In terms of asset quality, banks are showing increased losses in senior credit, but the situation in publicly traded commercial property vehicles that own the equity is becoming increasingly dire. KKR & Co. (KKR)  just put $50 million of fresh capital into one of its major property trusts and agreed to a plan to support its valuation as the money manager looks to weather the ongoing turmoil in commercial real estate. Starwood Property Trust, Inc. (STWD)  has basically put its funds invested in CRE into “survival mode,” prohibiting redemptions by bond investors and refusing to mark or sell assets into a declining market.  "Commercial Real Estate Values Continue To Be ‘Slashed’ 60% to 70%," writes Jonathan Miller of Miller Samuel in New York , "But Investors Still Trust The Asset." He continues: "I’ve been posting commercial office price drops here fairly regularly and the anecdotal drop in value is hovering around two-thirds of the pre-pandemic value (before WFH was super-charged). The most recent commercial office sale in Manhattan was a 67% discount from a 2018 purchase. This building, 321 West 44th Street, ironically houses the headquarters of the Commercial Observer, a widely-read commercial office trade publication." Yes, investors do still trust the CRE asset. That may change over the next several years, even in rarefied markets such as Dallas and South Florida. Our colleague Nom de Plumber , as usual, had some incisive comments earlier this week about the collapse of private equity and commercial real estate, and the coincident rise of the private credit trade by retail advisors and funds: “Now that public pension funds and private endowments have been tapped out, and angrily await long-promised capital returns, PE sponsors can ignore them and raise new capital instead from high-net-worth retail investors. A new pigeon is hatched every day.” While deteriorating asset quality for banks clearly is a problem, the real question that we cannot answer is whether the astute banks can sell enough first loss credit exposure to avoid the reckoning. Trouble in CRE also awaits funds and REITs. Nonbank investors are also utilizing private CRT transactions of various flavors to deal with commercial delinquency. What we and the short-sellers of bank stocks do not know is how much these private credit transactions will impact bank losses, provisions and thus earnings. When you sell the risk, you also sell the income. Meanwhile, the firms that have been waiting for a Fed rate cut this summer may need to recalibrate their expectations and assumptions above cash flow. Business investments and capital spending are both falling due to the growing prospect that interest rates to remain elevated.  Default rates on loans to small businesses in April hit an annual rate of 3.2%, matching the highest level in at least a decade, according to credit bureau Equifax. All of this will impact loss severities on commercial exposures for banks and credit funds alike. “It might be the ultimate risky bet,” write  Laura Benitez , Allison McNeely and Natasha White of Bloomberg . “Pension funds, insurers and hedge funds are taking on the first losses of loan failures of banks around the world — without even knowing the identities of the borrowers behind those loans.” The writers disclose a world that promises retail investors double-digit returns on blind pools of loans.  What could go wrong? Could there be a problem, to recall 2008, with this private unregistered collateral being pledged to more than one private credit fund? Some type of CRT transactions are approved for banks , but the exotic repo-style transactions are more risky and include copious amounts of leverage. As the crowd of investors chasing private credit grows, the unlevered returns are being pushed down to mid-single digits. "Investors poured about $200 billion into private credit funds between January 2021 and the start of 2024, swelling the coffers of general partners (GPs)," wrote S&P Global in May of this year. "This saw the size and market penetration of credit funds shift, with ticket sizes growing and the breadth of limited partners (LPs) investing into funds widening. The steep take-off in rates, which has more than doubled the yields of many private credit assets, has further propelled the growth of these funds." How much in synthetic CRT transactions will be done in 2024? Our best guess is many hundreds of billions globally including institutional and retail HNW offerings. Add to this inflow of funds to banks the proceeds of ABS transactions, whereby banks are dumping all manner of consumer credits, auto loans and other assets into securities for investors. Huntington Bancshares (HBAN)  just priced a $345 million ABS containing auto loans that was rated by Moody’s. Banks are not the only sellers of assets in a feeding frenzy of private credit that is unfolding in 2024. Many private equity firms manage funds that are hopelessly underwater vs five years ago. The debt tied to these “private equity” deals with leverage was typically +500-600 over the 7-year Treasury at inception, but now the prospect of high single-digit or double digit coupons makes refinancing problematic. But the wave of private credit will accommodate these impaired assets as well. As with the banks, losses will be mitigated by selling some of the risk exposure via instruments such as credit-linked notes . Both funds and banks are using these instruments to offload tens of billions worth of credit risk. The market for synthetic credit is actually more developed in Europe. Mayer Brown wrote an good primer on credit-linked notes last year: "Many banking organizations have sought to use synthetic securitization to transfer credit risk and to reduce the amount of RWAs against which they must hold capital. This is because synthetic securitization allows the banking organization to retain the entire asset on its balance sheet and avoid realizing a loss on sale of the asset or foregoing the revenue stream provided by the interest-generating assets. In Europe and other jurisdictions, synthetic securitizations are common, with over $189 billion worth of synthetic securitizations being completed in Europe in 2023. However, only a few synthetic securitizations which include capital relief have been executed in the United States in recent years."   The pace of synthetic credit trades has accelerated. Yet the unspoken truth in the financial markets regarding this trend is that now two years into the tightening by the FOMC, the drop in new securities issuance that we outlined last month (“ Inflation & CRE Deflation Too? UMB Financial + Heartland = ? ”) has created a dearth of supply for every asset class except US Treasury bills. Nowhere is the scarcity of duration more pronounced than in residential mortgage assets, where loans with servicing are fetching record multiples. Last week, for example, one Ginnie Mae issuer told The IRA that a recent vintage pool of mortgage servicing rights (MSRs) traded at 7x annual cash flows in a contested auction. The buyer, a large private issuer with close to $700 billion in unpaid principal balance of servicing, has never sold a single basis point of servicing income to finance loss-making operations. They got the cash, plain and simple. But as we note in our upcoming biography of Stan Middleman , founder of Freedom Mortgage, MSRs traded for 9x cash flow in the late 1990s. The handful of public and private servicers that retain their servicing strip may now use their vast internal cash flow to buy market share and, ultimately, LT survival in a market where 90% of the residential mortgages are out of the money for refinance. And since 90% of the residential mortgage market is now controlled by nonbank issuers of conventional and Ginnie Mae mortgage securities, the fact that these firms continue to access the capital markets for debt finance further enables their hunger for MSRs. The chart below shows bank owned MSRs, which remarkably still includes a representative portion of Ginnie Mae servicing in the $44 billion portfolio. Our estimate of fair value for the bank MSR portfolio is 1.71bp, but the current average mark reported by the banking industry is 30% higher at 2.21bp. Are the banks and their valuation agents wrong? Not necessarily. Source: FDIC/WGA LLC In a market where the issuance of new securities has been muted by the historic change in interest rates, everything is relative. The move in the 10-year Treasury from 2020 through to today is enormous in relative terms, making non-performing commercial assets trade at deep discounts and negative duration mortgage servicing assets trade at what seems a significant premium. We think that the same logic that makes savvy investors in MSRs pay what seems like astronomical multiples for cash flows from servicing assets is going to literally rip the credit problems out of the banking industry through this year and next. The fact is that the banks need to raise cash and sell credit, and the growing army of private funds want to do just the opposite and in size. The two parties are going to come together and solve their mutual problems: mitigating credit losses for funds and banks, and a lack of easily acquired duration for investors. Whether investors like the actual returns is another matter. 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 10, 2024 | In this issue of The Institutional Risk Analyst , we feature a conversation with Robert Brusca , Chief Economist of Fact and Opinion Economics . Bob was a Divisional Research Chief at the Federal Reserve Bank of New York (Chief of the International Financial Markets Division), a Fed Watcher at Irving Trust and Chief Economist at Nikko Securities International. We spoke over lunch at The Lotos Club earlier this month. Robert Brusca The IRA: Bob, good to see you again and, as usual, in interesting times. You have been pretty critical of “how the Fed chooses to communicate with us” in your recent writings and also how the FOMC seems to change the meaning of language depending on the time of day and the context. You have spoken of being “very disturbed” by statements from Committee members. Going back to when Treasury Secretary Janet Yellen became Chairman in 2014, the Fed has talked of being data dependent, but then changes the meaning of that data through time. How do investors and consumers make sense of what the Fed is saying? Brusca: You have to try to understand what the changing standard or goal of the Committee is today. Some people argue that the Fed is too data dependent, a statement that I find shocking. I can’t imagine anything further from the truth. To me the problem is not data dependence. Rather, the Fed sees the data or they ignore the data, or they try to cram the round peg into the square hole metaphorically. This year, when the FOMC came up with three rate cuts, it was not an official policy. It was only in the “dots,” but still the markets took this as guidance. The IRA: Correct. The dot plot is a truly idiotic indicator of public policy, but it also seems to be what passes for objective policy guidance at the Board of Governors, at least so far as the media is concerned. The whole process whereby the Fed communicates with the public has become a media circus. Brusca: The dots showed where the members were leaning, the number of cuts, etc. When the data started to go against the idea of three rate cuts this year, they kept saying “yes, but” until that position became untenable. Then it became “yes, oh, I guess we can’t do that.” It took three different inflation reports before the Committee decided that they really could not go ahead with three rate cuts. The IRA: Is the Fed too open? Do the dot plots get the Fed in trouble with the media and Congress by communicating too much? Do we need FOMC members on the financial media every day? And having provided the dot plots, the Fed cannot withdraw the forward guidance when the data changes. Is the Fed guiding expectations or is the media? Brusca: The Fed is herding the media and the markets. Because of that, when the Fed does things, the media and the markets react. And this, in turn, causes the Fed to be circumspect in taking action because they know that the media and the markets are watching. For example, when the Fed is getting ready to cut the target for interest rates, it doesn’t want to let you know too far in advance. Otherwise the markets might react ahead of the Fed and even undermine its plan. The IRA: When we worked at the Fed of New York, we just acted. We did system repurchase agreements or intervention in the foreign exchange markets with no warning whatsoever. We did system RPs mid-morning or even before the opening on the NYSE. Two financial crises have turned the private markets into a high school lab experiment curated by the Fed. Would it be better if the Fed spoke less and simply acted when it comes to the markets? Brusca: That is what I have always thought. I left the Fed in the mid-1980s and became a Fed-watcher, so I went from being an insider to being an outsider. In those days, Fed officials did not talk, but there were numbers. You looked at the reserve numbers and you looked at the data for open market operations. You looked at what they did and the details of the numbers, you could figure out that they were trying to achieve. But now forty years later, they are talking. Language is evil. The IRA: Language is certainly imprecise, especially in politics. There is nothing more political than money. So then we are not data dependent, but rather language dependent. You and other Fed watchers actually look for the portions of the Fed minutes that were pasted verbatim from the previous month. It’s like the folks at PentAlpha looking for anomalies in the documentation for a new ABS deal. Brusca: Language offers the prospect of deniability. It’s not just that conversation is an imprecise form of communication, but language may actually be intended to deceive. The IRA: Of course, former Fed Chairman Alan Greenspan comes to mind. Uncle Alan dissembled better than any Fed chief in the past fifty years. Brusca: For Greenspan, the obfuscation was out in the open. His middle initial was “O” and he was a believer in all of the Ayn Rand stuff. When the markets fell apart and he discovered there was all of this cheating and cutting corners in finance, he was shocked. Greenspan truly believed that efficient markets would discipline behavior and that people would not commit fraud and do stupid things that undercut reputation. Since 2008, the Fed and other agencies have reassessed the way markets work and changed the rules accordingly, so today it is all about being in the middle of the pack. You can always fail, but if you look like the pack in terms of risk, you are safe because the pack cannot fail. The IRA: As Ulrich Beck and Anthony Giddens said, it is “the socialization of risk.” The managers run the world, spawn passive investment strategies and, also, have decided that we all need to invest in private credit opportunities this year. Talk a little more about how the Fed’s clumsy efforts to “communicate” are creating problems for markets and investors. Brusca: Back in 2015, we had come out of the financial crisis and the Fed was looking for an opportunity to raise rates. Chairman Ben Bernanke, being an expert on the Great Depression, argued that you could not raise interest rates too soon. The Committee was initially impatient but became more focused on rate hikes in 2015. They did not want to leave rates too low for too long, even though oil prices had collapsed in 2015 and other deflationary conditions persisted, they hiked. They were actually trying to get rates back to normal, but they could not say that publicly because the markets would react adversely- too quickly. The Fed wanted to get rates higher on its own schedule not on one set by the markets. And members also were not at all in agreement of what “normal” was or even is today. The IRA: Well, the Fed cannot seem to define “price stability” accurately, but we can certainly say that “normal” for commercial real estate is at least 2% price inflation annually. At least. Do you think that Fed Chairman Jerome Powell or his colleagues have a picture in their minds as to what “normal” interest rates or r* really are today? Brusca: At that time they were estimating r* values, but you cannot really calculate it and we try to guess where r* exists. Concepts like r* do not exist in the empirical world. You must use a model to even estimate it and we’ve had all of these changes and shocks in recent years. How do we rely on an empirical estimate drawn from this shifting period? The Fed tries to describe things like r* or 2% inflation, but they do not articulate how they are going to get us there. So in 2015, the Fed finally raised interest rates and there was a lot of concern about possible deflation. But Vice Chairman Stanley Fisher warned that the Fed was ready to hike rates aggressively and markets were not prepared. It turned out he was wrong and the markets were right about the risk of deflation, as those risks lingered through 2017. The IRA: So the Fed continued to push rates up through this period. Were they trying to normalize rates in 2016 and 2017 without saying so explicitly? Brusca: I think the Committee was trying to normalize interest rates during this period, but it is important to understand that they were not as Chairman Powell does today, talking at every press conference and public appearance about the dual mandate. Methinks he protests overmuch. I see the profession of faith in the dual mandate as a cover story. Once you say that, you can do whatever you want in fact. Powell won’t hit the two percent target, but he won’t change the target either. The IRA: So we get up to 2018 and the Committee continues to raise the target for fed funds until they discover this thing called bank reserves. The large banks led by JPMorgan (JPM) step back from the funds market at the end of Q3 2018, causing a generalized liquidity squeeze in the fourth quarter. What happened? Brusca: In December of 2018, I was arguing that they should hold up on further rate increases. Larry Summers was also arguing that the Fed needed to focus on the lagged effect of all of the rate hikes since 2017. But more striking than such warnings was the Treasury yield curve, which was flat and perhaps was the most unusual yield curves I had ever seen. And yet the Fed was determined to raise interest rates because they had said so. This is the trap that the Fed now occupies. The Fed told the market that it’s going to do it and now the market expects it. Because markets expect it, the Fed has to do it – hoist on its own petard comes to mind. The IRA: So it’s really about expectations at the end of the day? Brusca: Of all the former economists from the Fed, I am perhaps most guilty of heresy when it comes to expectations. I am very much opposed to the idea that monetary policy and inflation is about expectations. While expectations are important, when they put these ideas in models and give them precise values, there is a disconnection from reality. People do expect things, and that motivates behavior, but all evidence suggest expectations are not accurate and should not be entered in models with such precise values. Like r*, nobody at the Fed knows the future and nobody understands how these assumed values interact with other variables. So at the end of 2018, they raised interest rates but also changed the forward guidance, leaving the markets unclear about whether the central bank intended to hike again. Systemic hikes were off the table but was the Fed done hiking? The IRA: And by early 2019, the FRBNY was not so quietly buying MBS and TBAs to add liquidity to the markets. The FOMC cut the duration of the $8 trillion in MBS markets in half before mid-year of 2019. By June of 2019, the Fed was cutting interest rates explicitly and drove rates down to zero nine months later. And five years later, we still have no clear idea of what the Fed will do next. BBG GINNIE MAE MODIFIED DURATION INDEX Source: Bloomberg Brusca: We should learn from our mistakes. We have learned a lot from the Great Recession, the Fed’s 2015-2018 tightening cycle, and then from its behavior under Covid. To the layman I’d describe this as a bit like Elon Musk and the self-driving car. Cars can drive themselves! But maybe they are not refined enough to replace humans in all driving endeavors. The Fed’s desire to use models and expectations is simply too ambitious, albeit academically correct, but unworkable in practical terms. The state of our ability to form expectations is not advanced enough for this to work. The IRA: So what is the answer? Brusca: The Fed itself, with more highly trained economists than anyone, the best software, the best hardware and best economic-intel, cannot forecast well, so how could every person or market do so well? How could their expectations set the standard? It makes no sense! The Fed needs to be less ambitious and more industrious (assume less, work more). Making policy from current data and deciding how past trends will play out while addressing how new events will affect growth is complicated stuff. By comparison, putting everything in a model and getting a forecast is simple once you have a model. But it might be completely wrong. That’s the trade-off. And the use of models is so attractive, so technological, sophisticated, so cutting-edge, the allure is hard to avoid. But when models depend on expectations they go awry. The Fed needs to analyze and handle more data. As Elon is finding out, too, auto pilot is not working. It may, some day, but its not working right now. The IRA: Thank you Bob! 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 5, 2024 | Readers and friends in media have been asking for a while about this crazy little thing called “private credit,” the latest stratégie du jour  from the largest Buy Side managers. The “credit trade,” as it’s also known, is actually quite old and is basically known as direct lending . Investors large and small are being pitched on private credit even as the US enters the most serious debt default cycle since 2008. The rising number of M&A transactions involving chapter 11 cases, says White & Case, suggest restructuring is the new growth sector for private investors. Is catching the falling knife of private credit a good idea for retail investors? Direct lending is conducted by hedge funds, dealers, business development corps (BDCs), REITs and other specialized vehicles that pursue credits banks won’t finance. The private credit sector, by definition, excludes  the toxic world of consumer lending and servicing entirely. But direct lending does include some consumer credits like business purpose loans, owner-occupied commercial real estate (CRE), and various manner of bridge financing. Direct lenders are the pawnbrokers of the 21st Century for subprime commercial borrowers, usually firms financed via leveraged buyouts. If you are an old school direct lender, you underwrite and fund loans for hard cash, and then either retain or sell loans to various end investors. But today the world of private credit includes layers of leverage atop private equity. The crowd of large institutional investors in credit is similar to the happy group that ran into CRE in 2020.  The CRE chart below is from FRED. Direct or “hard money” lending, in its purest form, is one of the oldest forms of credit and usually does not involve leverage. Private credit shops lend to borrowers that for a variety of reasons, usually related to credit or reputation, cannot raise money from banks or even HY bond investors. In private credit, think of banks and investors as the victims in the ever repeating story, with direct lenders/credit managers as the perpetrators and universal banks as the enablers. The most successful direct lenders have relationships with insurers, pensions and large funds such as PIMCO and Black Rock (BLK) , who buy their loans. Yet now private credit is becoming just another retail speculative strategy alongside crypto currencies and AI stocks. Q: Given that loss severities on relatively prime bank credit exposures are approaching 100% of the principal amount of the loan in CRE and corporate debt, is investing in private credit really suitable for retail investors?  The chart below comes from the most recent IRA Bank Book for Q2 2024 . Source: FDIC/WGA LLC Banks are the biggest players in credit because they have the size and the funding, but they tend to avoid subprime borrowers. Banks often make mistakes rather than get paid for fixing the mistakes of others. Some banks will provide “secured” leverage to funds, BDCs and REITS that engage in subprime direct lending. Private credit managers make new loans and also get paid for fixing other peoples’ mistakes.  Retail investment firms like Wellington, Franklin Templeton, Lord, Abbett & Co and Blackstone (BX)  offer credit-oriented retail funds that invest in better assets, but below investment grade credit is where the real money is made. No less than Swiss private banker Lombard Odie, for example, is marketing a retail private credit strategy with a $250,000 minimum and a mere 18-month lockup period. What could possibly go wrong? Many retail offerings promise retail investors quarterly liquidity and “rolls forever.”  BDCs and REITs compete with large banks and direct lenders in the credit trade, but have even less comparative advantage in terms of funding vs commercial banks. While the world of hard money lending usually is done in cash, today we see large commercial loans extended by nonbanks using leverage and equity provided by funds as the source of cash. Remember, private equity investors are expecting double digit returns. But sometimes the direct lender must become a debt collector and ultimately the new owner. Some of you may recall when hedge fund Elliott Capital Management seized a ship belonging to the Argentine navy in 2012 . The big time credit trade is about being a repo man globally and with enough money in the bank to go to war. The idea with the private credit trade is to lend against large distressed assets at high-yield rates and then pursue repayment through various legal means – hopefully without breaking the peace. In classic direct or “hard money” lending, you are usually ready to own the asset at or around the appraised price.  An affiliate of Ares Management (ARES)  known as AREEIF Lender LLC., for example, just foreclosed on a 188-unit apartment building Russland Capital developed at 1411 South Michigan Avenue, in Chicago, The Real Deal  reports . The lender filed an $80 million foreclosure lawsuit on the property in January. The equity of the owner is wiped out and Ares now will pursue a recovery. Data providers such as Bloomberg now track hundreds of private credits managed by a range of different firms, including credit managers and specialized banks. These deals often have private equity firms involved as capital providers and private lenders providing the senior leverage. When the issuers becomes distressed, the private equity may be wiped out and the lenders may end up owning the company. “ Goldman Sachs (GS)  was an early leader in private credit,” notes Eric Platt at Bloomberg . “Credit is an area of asset management that is increasingly in vogue as insurers, sovereign wealth funds and pensions up their commitments to the asset class.” But the near-banks like GS, Morgan Stanley (MS) , SoftBank unit Fortress, Apollo (APO) , Barclays (BCS) , Nomura (NOM) , all play in below-prime corporate credit but have no funding advantage vs a bank. And investors want at least 20% equity returns on private credit strategies. Institutional interest in credit has spawned a new cohort of leaders within the alternative asset investment industry , with the likes of Ares Management, HPS Investment Partners, Churchill Asset Management, Clearlake, Blue Owl and Sixth Street among some of the noted players. Veteran credit shops such as Golub Capital (GBDC)  and The Carlyle Group (CG)  round out the list. And there are now a growing number of firms offering turnkey credit strategies for large global investors who suddenly decide to get directly involved in big time direct lending and debt collection. The common thread with all of the nonbank players in credit is using investor funds to finance the assets and, if needed, take the hit when an event-of-default leads to a loss. Models such as APO’s use of insurer Athene (ATH) , Bayview’s investments in residential mortgage servicing assets and insurers, and the Ares credit portfolio in CRE, offer examples of how sophisticated global investors seek double digit returns. With the collapse of CRE valuations several years ago, however, the calculus of getting repaid in the worlds of corporate credit and commercial real estate has changed dramatically. There are a number of nonbanks that make gobs of money in consumer credit, but they are mostly licensed lenders/servicers and operate in a world of regulatory risk that large investors cannot tolerate. Doing private credit as a fund means you avoid consumer assets and focus on big commercial loans and CRE assets. You are competing with professionals globally and thus must be a lot smarter and very lucky since your leverage costs 3-4x what it costs a bank. When the credit trade bottoms out and causes systemic problems, it will be among the near-banks that play in subprime corporate and CRE credit. The trouble may begin in commercial credit, but consumer exposures are also a concern for some of the firms involved in private credit such as GS and APO, which are heavily involved in lending on Ginnie Mae exposures. We can divide consumer vs commercial credit exposures in many respects, but when the economy deteriorates and asset prices for homes and CRE fall, then the two sectors will coincide.  Tracking consumer credit is a relatively easy task. W ith commercial private credit exposures, however, we don’t and won’t really know about a default by a corporate issuer or on a building unless the event is so significant that it hits the headlines. But the investors in private credit strategies will know. After all, private credit is private.  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.

“Internal stability and social tranquility are legitimate goals of every society, yours and mine. But along the road there are temptations. It is easy to understand how one country or another can be tempted to shirk its responsibilities to the international community. including the maintenance of monetary order.” John Connally May 1971 May 30, 2024 | During an exchange on X this week, it occurred to us that the deflation building in the commercial real estate sector in the 2020s may be an important parallel to the collapse of the farm sector in the 1920s. The speculative excesses of both periods are different, however, making the comparison imprecise. History does not repeat itself, Mark Twain  noted, but it often rhymes. The engine of our collective downfall, then and now, was the economic rollercoaster operated by the Federal Reserve System. Congress created the Fed on the eve of WWI in 1913, enabling the US to finance allied war purchases. When the war ended, the US was thrown into an economic depression that peaked and then subsided by 1921. Great Britain added to the weight of deflation when it returned to the gold standard in 1925. Henry Ford shut down his plant in Dearborn for two years in 1927, this to finally transition from the Model T. The Ford plant closure created waves of unemployment around the country and led to the collapse of the Detroit banks in the early 1930s. Deflation on the farm combined with growing speculative excesses in stocks set the stage for disaster, as described by John Kenneth Galbraith  in “The Great Crash 1929.” Significantly, as banks fueled stock speculation in the late 1920s, liquidity backing bank deposits plummeted. By  1927, the heads of the Bank of England, France, and Germany urged the U.S. to lower interest rates. The Fed did cut ST interest rates from 4% to 3.5%. “The greatest and boldest operation ever undertaken by the Federal Reserve System, and…[it] resulted in one of the most costly errors committed by it or any other banking system in the last 75 years!" said Adolf C. Miller , a Federal Reserve Board member who dissented. When the Fed dropped interest rates a mere half a percentage point in 1927, the resulting swell of speculation led to the collapse of the stock market two years later. The interest rate cut by the Fed in 1927 set the stage for economic disaster. “From that date, according to all the evidence, the situation got completely out of control,” noted Professor Lionel Robbins  of the London School of Economics. We recounted the meeting between President Hoover and GM founder (and Elon Musk analog) William Durant in Financial Stability (2014): " In April of 1929, a yellow taxicab turned into the White House grounds carrying the great Wall Street speculator William Durant, Earl Sparling recounts (Sparling 1930). It was after 9:30 P.M. and the visitor had no appointment. After convincing the staff and the private secretary to President Hoover that the matter was urgent and, indeed, secret, the visitor was shown up to the second floor study. After a while the president appeared and listened to one of Wall Street’s greatest investors warn that the worst financial panic in the history of the republic impended. He cautioned the president that unless the Federal Reserve Board was forced to cease its attempts to curtail brokerage loans and security credit, a crisis was inevitable." When the Fed increased interest rates in 1928 and 1929 to limit speculation in the stock market, it was already too late. Huge amounts of cash had flowed out of banks into stocks. Thousands of banks would fail between 1929 and 1933. By March 1933 when FDR took office, every bank in the country was closed. As we wrote in "Inflated" (2010) which will be reissued next year: "On March 4, 1933 President Franklin Roosevelt took office. Most of the nation’s banks were closed and panic ruled the streets of American cities and towns. New York, which held out almost a month after the bank crisis began in Michigan, declared a bank holiday on the morning of Inauguration Day. Terrified citizens were lined up outside New York banks as the new president took his oath of office. Ten days after FDR’s inauguration, he ordered an extended bank holiday. Even as the stronger banks in the nation gradually were allowed to re-open, the banks in Detroit remained closed. Almost a million individuals and businesses in Michigan were cut off from their funds for over a month and the larger depositors of the banks—including Henry Ford—were compelled to wait for the liquidation of the insolvent banks." Of course, FOMC members don’t dissent very often today. The progressive intellectual monoculture at the Fed does not tolerate much debate, which is largely truncated by the Fed’s staff and the turgid process for adopting the now famous FOMC minutes. In 1993, when the predecessor to The IRA  known as Wires Washington disclosed the existence of the then-secret Fed minutes , they were actually worth reading. Three decades later, Fed minutes just confirm the growing political dysfunction menacing the country. As the chart below illustrates, the Dow Jones Industrial Average has doubled over the past decade, yet FOMC members prattle on about "price stability." The Fed is pondering an interest rate cut later in the year, this even as the Biden Treasury under Secretary Janet Yellen  is funding one quarter of federal spending with debt. If the Fed were actually foolish enough to drop the cost of credit when stocks are hitting new highs and home prices are still rising on the sea of post-COVID liquidity, then we all deserve a financial crisis of equal proportions. Obviously, there should be no interest rate cuts by the FOMC without deficit reduction by Congress. Here’s how we see the balance of the year unfolding. Markets continue to move sideways as hopes for an interest rate cut are put on hold, but stocks surge higher on the knowledge that inflation is still the real problem. We think the catalyst will be when a near-bank involved in private credit rolls over, causing turmoil in the debt markets. Not a fund involved in credit, but a highly leveraged broker dealer. We'll be discussing the world of private credit in our next Premium Service issue of The IRA . The Fed will respond to problems in the credit markets with new lending facilities, but the contagion will continue to build. By November 2024, President Donald Trump  will have defeated VP Kamala Harris , who presides over the destruction of the Democratic Party at a contested convention in Chicago. President Barack Obama is unable to convince Harris to step aside, leading to an epic political disaster for the Democratic Party. Trump beats Harris by more than 20 points, providing a wonderful historical analog for the defeat of Ambassador John W. Davis  and Progressive Senator Robert M. La Follette  by Calvin Coolidge in 1924. Being a progressive institution, the Fed drops interest rates in December as unemployment starts to rise. Several members of the FOMC appointed by President Joe Biden  resign to protest the Trump win and make preparations for exile in Canada. Stocks surge along with home prices as the massive inflation in the system floats all manner of financial obligations ever higher.  Even though the Fed only makes one rate cut in December, the additional fuel for the fires of inflation pushes the 10-year Treasury above 5%. Growing numbers of financial institutions are visibly insolvent as LT bond rates rise and CRE losses start to snowball. By early 2025, as the nation prepares for four more years of managerial chaos under President Donald Trump, bank failures multiply because of the ongoing crisis in commercial real estate and rising mark-to-market losses. Calls for a federal solution to the trillions  of dollars in moribund urban real estate fall upon deaf ears in the Trump White House, which instead pushes for the extension of early Trump tax cuts as well as new fiscal “stimulus.”  The new Fed Chairman appointed by President Trump is easily approved by a Republican Senate, which now features a ten-vote majority over Democrats thanks to the Kamala Harris fiasco. The Trump Fed moves to lower ST interest rates and resumes aggressive bond purchases. The Fed’s actions cause an equally large ST surge in debt valuations a la the 1920s that flows into stocks and housing. Home prices gallop higher by double digits on a wave of new lending, pushing the residential housing bubble to record levels but, of note, not really helping either commercial real estate values or consumers.  By the end of the Trump Administration, the federal debt reaches $50 trillion. The Treasury is facing calls from foreign creditors for an IMF-led debt restructuring for the United States. President Trump tells our foreign partners to take a hike, channeling former Treasury Secretary John Connally .  After the dollar collapses from its lofty heights, President Trump directs Treasury Secretary Robert Lighthizer  to begin negotiations on a debt reduction deal. The US fiscal crisis causes bond prices to crater and an end to the special role of the dollar. Home prices fall 20-30% back down to 2019 levels, banks and nonbanks alike fail in droves. The great financial reset of 2028 begins as aspirational stocks lose 30 percent of peak valuations. Donald Trump takes a page from his political alter ego, President Andrew Jackson , and returns home to Mar-a-Lago, leaving the nation in financial chaos. Editor's Note: I am editing "Inflated" How Money & Debt Built the American Dream" for re-issue in 2025 by John Wiley & Sons. The similarities between the 1920s and the 2020s, especially the lack of clarity on economic issues, is striking. Add the absurd federal debt and a global constituency for our fiat dollar. The first rule of any fiat system is no fiscal deficit. The leverage is already baked into the currency. Layers of leverage, the thesis of "Inflated," are dangerous. Sale Ends Tomorrow! 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.

"The public again sees inflation as one of the top problems facing the nation, with 62% saying inflation is a very big problem for the country – only slightly down from the 65% who said this last year." Pew Research May 24, 2024  | Now that Goldman Sachs (GS) has finally given up on their call for a cut in fed funds this July, it seems appropriate to ponder the state of the capital markets as we approach mid-2024. When GS CEO David Solomon said that he sees no rate cuts in 2024, we think he’s got it about right. You see, the real question nobody dares state is that the Fed cannot control inflation without action by Congress to reduce the federal deficit.  John Cochrane (aka “ The Grumpy Economist ”) wrote back in April 2022: “Inflation’s return marks a tipping point. Demand has hit the brick wall of supply. Our economies are now producing all that they can. Moreover, this inflation is clearly rooted in excessively expansive fiscal policies. While supply shocks can raise the price of one thing relative to others, they do not raise all prices and wages together. A lot of wishful thinking will have to be abandoned, starting with the idea that governments can borrow or print as much money as they need to spray at every problem. Government spending must now come from current tax revenues or from credible future tax revenues, to support non-inflationary borrowing.” More recently, Cochrane opined in “ Expectations and the Neutrality of Interest Rates, Final Version ”: “ Monetarism and fiscal theory agree, if you drop $5 trillion of cash on people and they only expect that some of it will be soaked up by future surpluses of tax revenue over spending, you get inflation.”   If we take note of the fact that 1) Congress is unlikely to cut the federal deficit anytime soon and 2) US consumers show little fatigue despite constant predictions of default and deflation in consumer credit, then we think it is reasonable to push expectations of a cut in the target for Fed funds into Q1 2025.  This view is admittedly out of line with the Street narrative, but we note that people jumping the shark on rates are getting eaten alive. Charlie  McElligott at Nomura (NMR): “Rates continue to chop people up, where everybody’s favorite Steepener continues to bleed more bodies  with Fed cuts continuing to get pushed-out on the timeline, as data softens but still remains 'good enough' and generally expansive…where it seem that the crowded nature of the trade on the multi-year Fed cutting cycle -view being near fully-reflected in price already…hence the trade seemingly won’t work until growth slows in a much more powerful fashion…” One of the benefits of the current posture of the Fed is that headline market volatility has declined, but this may be a short-term pause. Given the enormous size of the Treasury’s General Account (TGA) at the Fed, the Treasury tail is now wagging the Fed dog. The fact that expectations for market volatility are low may simply be an indication of market confusion or perhaps even delusion. As concerns about inflation increase, equity market valuations rise apace. The chart below from FRED shows the Fed's balance sheet vs the VIX. The vast pile of cash that the Treasury needs to make payments on its debt and other obligations interacts directly with bank reserves, impacting short-term liquidity and, some believe, ST asset prices.  The chart below shows the complex situation that the Fed must navigate with the TGA, Reverse Repurchase Agreements (RRPs) and bank reserves. Notice that the TGA reached $1.8 trillion during COVID. As you can see, the vast flow of cash out of the TGA in Q4 2023, as well as the decline in RRPs, led to an increase in bank deposits and bank reserves. The Fed has recently floated the idea of restoring minimum reserve levels for some US banks and also pre-positioning collateral at the discount window in order to provide liquidity to the markets. But all of these expedients are a function of the federal budget deficit and the ebb and flow of cash into and out of the TGA. Can the Fed get control of inflation without a reduction in the federal deficit? The short-answer is probably not. The fast flows of cash going into and out of the TGA are financed with debt, not tax revenues. Federal transfers are increasing demand and economic activity above the level consistent with price stability or perhaps even falling prices. Some economists argue about whether high interest rates are good or bad for inflation, but printing money to finance the federal deficit is not conducive to price stability.  The real wild card in the equation in terms of inflation and future interest rates is commercial real estate, which continues to sink into a deflationary trap of historic proportions. The decline in value of CRE is destroying hundreds of billions of dollars in equity value accumulated over the past century. The FOMC is largely powerless to address the CRE debt deflation, which is a function of LT financing costs and changes in consumer and business behavior. “ Starwood Real Estate Income Trust , which manages about $10 billion and is one of the largest real estate investment trusts around,” notes Maureen Farrell of The New York Times , “said on Thursday that it would buy back only 1 percent of the value of the fund’s assets every quarter, down from 5 percent earlier.”  But as we all know by now, hope is not a strategy.  The chart below from FRED shows the change in average prices for commercial real estate (CRE) over the past five years. Notice that we are almost 25% below average CRE valuations from 2021. We suspect that the manager of SREIT, Starwood Property Trust, Inc. (STWD) , will be forced to sell assets into a falling market sooner rather than later. Meanwhile, there are tens of billions of dollars worth of commercial real estate assets around the US that are headed for foreclosure and liquidation. Of note, the first "AAA" portion of a commercial mortgage backed securities (CMBS) deal took a loss for the first time since 2008, Bloomberg reports. The American consumer may not yet be ready to roll over, but the accelerating debt deflation in commercial real estate may soon become the main focus of attention for the Fed, federal and state bank regulators and financial markets. In our next comment for The IRA Premium Service, we'll be looking at some of the top performers in the WGA Bank Top Index and comment on the state of credit risk transfers. Subscribers to the Premium Service have access to the Index and its constituents. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

May 20, 2024  | Over the weekend, as we worked on written comments for the proposal by Freddie Mac to buy closed-end second lien mortgages , it occurred to us that we’ve all missed the point on this latest example of progressive innovation. The operative term here is “subprime,” but the incentives are mostly political. And sad to say, any proposal that puts low-income families into the housing market at the top reminds us a lot of 2005.  When the Wall Street Journal criticized the Biden Administration for floating the Freddie Mac subprime second proposal (" Return of the Housing Godzillas "), the word "subprime" appeared only once in a quotation from the 2008 crisis. But make no mistake that President Joe Biden wants to get the GSEs back into subprime lending, hopefully before September. Mortgage bankers should be outraged by Biden's surreptitious proposal to put consumers in harm's way. Freddie Mac wants to take away some of the most profitable business in the conventional loan market from independent mortgage banks. Those lenders who think chasing closed end seconds is a good way to spend time are, in our view, headed for the mortgage dead pool. A pipeline of non-QM first lien jumbos with a sprinkling of seconds is a good mix. But the real victim of the Biden proposal to get the GSEs back into buying subprime mortgages is the consumer.  As we wrote: “Freddie Mac indicates that the primary goal of this proposed new product is ‘to provide borrowers a lower cost alternative to a cash-out refinance in higher interest rate environments.’ But is that really true? A cash-out refinance into a 15-year floating rate first lien may be a better trade for many low-income consumers today vs a second lien with a double-digit coupon. Subprime seconds have coupons in low to mid-teens depending on the credit and LTV. We believe that the illustrations used by Freddie Mac in this proposal are misleading. A loan officer acting in the best interest of a low-income consumer might recommend the 15-year refinance loan vs a second lien so as to eliminate the mortgage debt faster.”  This week the Mortgage Bankers Association  is meeting in New York for the annual secondary market conference. As the industry meets at the Marriott Marquis in Times Square, profitability is at decade lows and headcounts are falling, but very slowly. Many in the industry think that they will be saved from headcount reductions and/or insolvency by an eventual reduction in short-term interest rates. A lower target for fed funds would certainly help production costs, but whether the long end of the curve follows is another matter. As of month-end March 2024, the weighted average coupon (WAC) on outstanding Ginnie Mae MBS increased slightly from 3.56% in February 2024 to 3.59% as seen in Figure 29. In the chart below from Ginnie’s monthly capital markets book, loans originated since 2019 account for approximately 82% of Ginnie Mae MBS collateral outstanding. A number of analysts are predicting a Fed rate cut in 2024, followed by a rally across the board in bonds. Yet issuers seem to be moving to the market now rather than gamble on what may or may not happen this year with the Fed. PennyMac Financial Services (PFSI) just announced a private offering of $650 million of senior notes due 2030. This follows several other senior unsecured debt deals by Mr. Cooper (COOP)  and Freedom Mortgage.   The good news for mortgage issuers is that delinquency remains relatively low and the industry has found a strong reception to new term debt issuance by larger lenders. The bad news is that the pool of banks willing to finance residential mortgage production and servicing is shrinking fast. Last week, New York Community Bank (NYCB)  announced the sale of its residential warehouse business to market leader JPMorgan (JPM) . We expect that the Flagstar servicing business will eventually be sold as well, but losing the cash flow from the mortgage servicing business and the related escrow deposits would probably force the sale of the whole of NYCB.  Unless Steven Mnuchin can waive his magic wand and get NYCB back to investment grade with Moody's , then we expect the Flagstar servicing business will be sold. Who could buy NYCB, deal with the bank’s credit problem and provide a stable home for the number five national residential mortgage subservicing platform? According to Inside Mortgage Finance , NYCB had almost $300 billion in UPB of servicing at the end of 2023. What large bank would be willing to re-enter the market for servicing government loans and Ginnie Mae MBS? Simple answer is  Citigroup (C) .  While the bank has entered and exited from the residential mortgage business several times since the 1980s, the fact is that residential mortgage lending and servicing is one of the few sectors available for Citi that is actually big enough to move the needle. Citi is a subprime lender. They should be directly involved in government lending. If Citigroup CEO  Jane Fraser  wants to add some upside potential to her improving stock, then we suggest first acquiring NYCB in its entirety and then go shopping in the world of nonbank issuers. The mortgage industry is ripe for a rollup strategy focused on acquiring mortgage servicing rights (MSRs) at the low end of cash flow bids. Why? Because there is a growing shortage of assets in the world of residential lending.  A large bank like Citi will have a significant advantage over nonbanks attempting to roll up the sector. Citi could quickly assemble a servicing book that would enhance earnings and compete with COOP, PFSI and the other nonbank leaders. If Jane Fraser likes the idea, we have some specific suggestions. And needless to say, catching the falling knife of NYCB will make Jane Fraser very popular at HUD and Ginnie Mae. NYCB is currently the only remaining large bank servicer in government lending. Why do we suggest that Citi go back to playing in residential mortgages? Because if you look around the markets, the days of nonbanks using leverage and gain-on-sale accounting to pretend profitability are over. Assets are being acquired for net cash flows, but no more. Excess servicing transactions are proliferating and a number of conventional REITs may be headed for liquidation. We think that a significant amount of lending capacity will be leaving the sector. The only question is who will buy the assets of failing nonbank issuers on the cheap. We have a list. This is a great time for Citi and other banks to be buying mortgage assets at a discount. In the next issue of The Institutional Risk Analyst , we’ll be updating readers on Merchants Bancorp (MBIN) , one of the members of the WGA Bank Top 50 Index. Please note that we have created a new page for the exclusive use of subscribers to The IRA Premium Service showing the constituents of the WGA Bank Top 50 index. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

May 10, 2024 | Earlier this week in the Financial Times , famed analyst Meredith Whitney  penned a strange comment supporting an equally peculiar proposal by the Biden Administration for Freddie Mac to buy home equity loans. This is a really bad idea that is typical of the work coming from the Biden Administration and their surrogates who occasionally dabble in mortgage finance. Readers of The Institutional Risk Analyst  will recall Ms. Whitney boldly predicting the collapse of the municipal loan market in 2012. We personally witnessed Cumberland Advisors CIO David Kotok  tell Business Insider  in August of that year from Leen’s Lodge : “ We entirely disagree with Meredith Whitney, who persists in predicting that this world of state and local government finance will end in disaster.   We say it won’t.  In Maine, we can point to a concrete example.” As with the earlier call on municipal defaults, we think Whitney’s comments about a surge in new financing from home equity loans are poorly considered and not well grounded in market realities. Anybody in the residential mortgage market will tell you that spending time chasing second liens that must ultimately be sold to a bank means you are nearing a significant inflection point in your career. The chart below from FRED shows all outstanding second lien home equity lines of credit.  Whitney writes:  "Last month, the government-sponsored mortgage finance agency Freddie Mac filed a proposal with its regulator, the Federal Housing Finance Agency, to enter into the secondary mortgage market, otherwise known as home equity loans… A Freddie Mac second mortgage/home equity proposal could unleash a tidal wave of new liquidity - if it's approved.” And later Whitney writes: “In 2007, just before the financial crisis, there was more than $700bn in home equity loans outstanding. Today, there is roughly $350bn. Home prices have risen more than 70 per cent since then, so why have home equity loans halved?” Short answer: Because there is little actual demand. But today's politicians never worry when private markets are telling them that a given policy won't work. The Biden Administration's approach to housing over the past four years has been a complete disaster for consumers and lenders. Andrew O'Hagan, writing about the disgraced Republican congressman George Santos in the New York Review of Books , describes the rules of engagement in the New Gilded Age: " The most moving thing about Santos’s lies is how many of them could be disproved in seconds. He doesn’t care about the truth, and it may be that his lack of prep is consonant with the radical style in populist politics today, which runs on the idea that everything can be brazened out, everything can be believed, as long as one subscribes to the use of a magical verbal currency in which statements are beyond proof and somehow truer than truth." Whitney talks about the GSEs unlocking trillions  of dollars in new financing for home ownership by having the GSEs purchase second liens. No, sorry Meredith, this is completely wrong. Second liens are mostly originated by banks and mostly retained in bank portfolio. Having the GSEs waste time and money buying and securitizing closed-end second lien loans is a bad idea. Let’s count the reasons why. First, the demand for all home equity products including HELOCS has been weak since the peak of the market in 2008. Originations actually fell in Q4 2023 as interest rates rose. The unpaid principal balance of HELOCS in the US has been declining for 15 years, but has risen slightly since 2021. The key factor here is demographics. As the population of homeowners has aged, the need for tapping home equity has waned. Low interest rates over the past 40 years have also detracted from interest in second liens. Most banks that offer first lien mortgages will originate and retain a second lien, yet there is scant demand even as the equity in homes has soared. That green line in the chart below shows closed-end second liens owned by banks, basically the entire market. There is a little bit of growth, but rates would need to go back to early 2000s levels and loiter for a period of years to really move the needle. Source: FDIC Second factor is the rise of the nonbanks. Independent mortgage banks control 3/4s of the US residential mortgage market. Nonbank mortgage firms certainly can sell closed-end second lien mortgages, but they cannot originate and service HELOCs because they are not depositories. A HELOC is essentially a credit card loan secured by the house with a fixed tenor and serviced by a bank. You can go to the bank ATM and take a cash advance on a HELOC. The second lien mortgages that nonbanks might originate and sell to Freddie are closed end loans. These products usually allow the borrower to draw cash for a period, then convert into an amortizing mortgage. But most of the originators of closed-end seconds are banks. Encouraging a nonbank sell a second lien loan to Freddie Mac will change nothing other than shifting income from banks to the US government. And it will seriously piss off JPMorgan CEO Jamie Dimon .  Big banks love HELOCs, but there is little money in originating them for nonbanks. Better to do a cash-out refi for that consumer today and write them a new 15-year floating rate mortgage. The market reality that seems to escape Whitney and the Biden White House is that b anks originate and retain second liens because they have the funding. There is vast unused capacity in HELOCs at banks, more than current outstanding loans. But banks will not sell HELOCs to Freddie Mac. They are content to keep these relatively small mortgage loans because the servicing fee of 25-50bp per year more than covers the cost. Like first liens, default rates on HELOCS are near zero. Source: FDIC/WGA LLC There is little financial incentive for nonbanks to originate and sell second liens to Freddie because the note’s value is minimal and the servicing strip is likewise an inferior asset vs a first lien loan. When you sell a loan in the secondary mortgage market, dear Meredith, you are really selling the cash flow from the mortgage servicing right (MSR). The MSRs of HELOCs or closed end seconds have little value because of the small note size and short maturity.  Indeed, it will be interesting to see Freddie Mac profitably sell pools comprised exclusively of closed-end seconds into the MBS market. If banks cannot originate and retain HELOCs given today’s higher interest rates and the vast amount of equity locked away in residential homes, then there is something powerful working in the market that refutes Whitney’s thesis. Again, having the GSEs purchase loans that nobody but banks want is not a particularly impressive policy proposal from President Biden.  A final point that Whitney and other proponents of the GSEs buying second liens do not address is credit. By law, the GSEs cannot loan more than 80% against a home unless the borrower gets private mortgage insurance. If Freddie Mac or Fannie Mae buy a second lien of any description that pushes the total encumbrance on the asset over 80%, does the borrower need private mortgage insurance? The law says yes. Federal bank regulators put limits on HELOC exposures for precisely this reason. A second lien is junior to the first and in a home price correction quickly becomes worthless. It is easy to understand the confusion about HELOCs and seconds. T raditionally home equity loans were products for a rising interest rate environment, yet there is little demand in 2024. There are dozens of banks and nonbanks in the US that offer HELOCs or closed-end seconds, yet the demand from consumers is barely keeping up with the natural runoff of these loans. Part of the issue is that older consumers that predominate among homeowners would be more likely to get a reverse mortgage than a second lien. And many are just happy to let the equity sit given the investment alternatives. Those pushing for the Biden Administration to allow the GSEs to buy HELOCs should consider whether this election year stunt deserves their public support. The Freddie Mac proposal is part of a shameless election year push by the Biden Administration to appear to be supporting home affordability, this after four years of disarray and scandals at HUD. And four years of home price inflation ℅ the Biden budget deficits is not doing much to help Americans buy a home. In fact, the actions taken by the Biden Administration in housing finance over the past four years have been a disaster. The risk-based capital (RBC) proposal from Ginnie Mae for government issuers tops the list of progressive fiascos, but increasing the cost of credit reports for consumers is another great achievement by the White House. Lenders argue that dramatic price hikes by FICO have inflated their credit score costs by as much as 500% since 2022, Inside Mortgage Finance  reports.  The litigation between Ginnie Mae and Texas Capital Bank (TCBI)  is another wonderful achievement by the Biden White House that threatens the market for government loans. If TCBI is forced to take a loss after receiving the direct verbal assurances of the Biden Administration with respect to a bankrupt government issuer of reverse mortgages, then the market for financing government insured loans may be permanently impaired. Thanks so much President Joe Biden, but the housing industry does not really need any more help from Washington.  UWMC’s Shrinking MSR United Wholesale Mortgage (UWMC)  reported earnings yesterday. Suffice to say, we think everyone in mortgage finance and the various mortgage and bank regulatory agencies in Washington should spend a few minutes on the UWMC 10-K.  Eric Hagen at BTIG: “The company sold $70 billion of UPB in the MSR portfolio as earlier reported, taking it down to $230 billion, and the average WAC of the portfolio to 4.58%. Leverage came up this quarter to 3.5x, driven by a slight increase in warehouse lines of credit, but excluding warehouse debt it remained comfortably below 1x. We think the stock valuation can support higher leverage, although we like how the funding risk is being regulated to a degree by sales of MSRs into a market well-bid with demand right now from originator/servicers looking to boost recapture when rates fall.” We are not so generous as BTIG. The big headline from UWMC IR was the increase in gain-on-sale and volumes, but to us the story is the sale of 25% of the firm’s MSR to fund Matt Ishbia’s price war in the wholesale channel. In the UWMC cash flow statement on Page 5 of the Form 10-K, it shows the firm’s holdings of loans up $1.8 billion, in line with a better than expected Q1 for most mortgage banks in the first quarter. But down the page, we see an entry for “Net proceeds from sale of mortgage servicing rights” of $1.3 billion. Really? UWMC 03/31/2024 Note that in Q1 2024 UWMC capitalized $535 million in new MSRs, but then sold more than 2x that amount to raise cash. Why are we raising cash? To fund operating losses caused by the firm’s attempt to corner the wholesale channel for mortgage loans.  But as everyone who works in the mortgage ghetto knows, seeing around corners is a special talent. And visibility is at a premium when the FOMC and various others are trying to make your life difficult. The old fashioned bankers think not about loans but MSRs. What is the yield on the MSR? If you buy loans on a 7x multiple, as we wrote in our last comment, but sell on a 5x, in the long run you are dead. During the UWMC conference call , Bose George of KBW asked Ishbia about the pricing on MSR sales and the fact that some of the disposals were below carrying cost. Ishbia: "Depending on the time of the month and where rates are at that moment, the prices are right in line with what our carrying value is. And so sometimes you pick up a little, sometimes you lose a little bit. In general, it's been not a material negative or positive, to be honest with you." We have always thought that the “sell the loan, sell the MSR” is a bad strategy because it leaves nothing for the future.  Issuers like UWMC that sell the MSR are essentially following the logic of Silicon Valley Bank that a future Fed interest rate cut will make it all better with higher loan volumes. But maybe not. Selling the MSR as a strategy, especially to fund an ill-considered price war in wholesale, a channel nobody owns, we think is a LT loser. But worry not, somehow UWMC managed to pay $194 million to SFS Corp, the holding company controlled by Ishbia and other UWMC insiders. The $2.3 billion non-controlling interest in UWMC represents the true equity of UWMC.  And no, our dear friends at Bloomberg , UWMC is not trading at 104x book value at $7.50 per share. Do the math. If a Fed rate cut is going to wait until December and UWMC continues to pay up for loans in the wholesale channel, then we expect to see more bulk MSR sales from UWMC and other mortgage firms that are burning cash. There are mortgage firms that have refused to cut expenses in line with volumes such as loanDepot (LDI) and then there are firms like UWMC that are selling valuable servicing assets to fund operating losses. When UWMC sells the rest of the MSR portfolio this year, will CEO Matt Ishbia end the price war in wholesale? In the next issue of The IRA Premium Service, we'll be looking at the bottom 25 banks in the WGA Bank Top 100 Index. 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.

“The illusion of freedom will continue as long as it's profitable to continue the illusion. At the point where the illusion becomes too expensive to maintain, they will just take down the scenery, they will pull back the curtains, they will move the tables and chairs out of the way and you will see the brick wall at the back of the theater.” ― Frank Zappa May 1, 2024 | We hope you agree that Q1 2024 earnings season so far is just a bunch of laughs. Bank earnings are basically a wash for 2024 as lenders deal the impact of COVID and the Fed's low rate environment. US Treasury Secretary Janet Yellen has begun to buy back low coupon debt , a stunning admission that Fed Chairman Jerome Powell made a serious error dropping interest rates to zero in 2019. The inflation caused by Powell's actions has now tied the Fed's hands and left the market for Treasury debt with serious liquidity problems. Given the confusion at the Fed and Treasury, f intech financials from Affirm Holdings (AFRM)  to SoFi Technologies (SOFI)  to Upstart (UPST) are getting a lot of pushback from investors. Yet the swings in these once high-flying stocks seen in 2023 were tiny compared with 2021.  The manic stock market moves of the COVID era are long gone, leaving us to pick through the wreckage caused to existing businesses and assets by emerging technology. And it's not about AI. Source: Google Finance Financials are not the worst of Q1 2024 earnings, however. Earnings season has featured the collapse of the investment thesis for several large legacy media properties, led by Paramount (PARA) . Like the controlled implosion of an old casino in Las Vegas, watching Disney (DIS)  and other traditional owners of content struggle with the new world of smart phone slavery is scary.  PARA announced yesterday that CEO and industry sage Bob Bakish is stepping down as CEO of the media company . Bakish will be replaced by three executives in what the company calls the “Office of the CEO,” CNBC reports This just means that PARA is now headed by three really smart people who have not a clue what to do next with their old media business. Remember when PARA bought an NFL playoff game just to boost viewers? How many of those "customers" did PARA retain? Not us. Our composer brother Michael Whalen  predicted just this very consolidation of the old media world in a 2017 issue of The IRA  (“ The Economics of Content: Michael Whalen ”). Now Michael writes in Medium  about the next chapter of the end of the media world that we used to know. But like the good old days of Hollywood, the sponsors still drive the media bus. They are just getting bigger, leaving the incumbent players of TV and film completely Redunzl , to recall the late great composer Frank Zappa . “Video streaming companies (who are also pretending to be TV networks — I am talking about YOU Paramount!) try to make decisions about what shows to produce and which ones not to produce. How is this possible when you literally do not know how much money you will have on hand this month, to say nothing of 18 months from now when a finished series or film is finally shown to the public? If you read the trades, you see a lot of desperate choices being made daily by executives who are still thinking about video content like a television network or a film studio. It is this thinking which is getting them into real trouble and will ultimately seal their fate. At Apple, they create video content as a loss leader to get consumers into their hardware/software ecosystem or to KEEP them there. Apple is very clear on why they are making shows and they can afford to lose billions of dollars in an effort to force their competition to fold or worse, merge. In 3 to 5 years, only the biggest tech companies (Apple, Google, Microsoft) will be in the streaming business because the others will have run out of cash to compete. Yes, it will be a bloodbath. Big milestone: when Disney decides to sell some or all of its streaming operations to keep the lights on at its theme parks. You heard it here first... #magickingdom” Yes, mere media is going back to being just advertising, including the sacred world of Hollywood and the movies. Notice that Michael does not place Netflix (NFLX) among the survivors in the growing media firestorm  In the brave new world of media, films and music are just chum for the great eyeball aggregators to use as bail to acquire new users. Not quite like those comfortable ads before a film in a theater years ago. And what about those M&A transactions swirling around PARA? Michael: "It is a desperate ploy to manage the internal chaos from the last of the Viacom investors. The ship is sinking and before it goes down once and for all, Shari is trying to pretty things up. A “roll-up” isn’t really in the cards. Apple and Google will wait until it is a fire sale." The closed media ecosystem that depended upon monopoly control of distribution is fragmenting into thousands of different pieces called “streaming.” But we could say the same for consumer finance.  Every time a new app gains access to a customer's bank account, that bank is probably going to lose a customer or at least an opportunity to create a new asset.  But the bigger question is how does any business gain the attention of consumers who spend hours a day randomly staring at a phone?  In the early days of new media pre-2000, analysts used to speak of the lifetime value of a customer and the cost of acquisition. Today with the service providers losing any semblance of control over customers, building and managing a business that sells access to content is a crapshoot at best. Just as media properties like PARA or NFLX are losing value to the financial power of the great technology firms, the world of consumer finance is also undergoing vast change as well. In our next issuer of The IRA, we'll be reviewing the latest earnings from the worlds of banking, fintech and mortgage finance for our Premium Service. 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.

April 24, 2024 | Premium Service | In a recent comment in MacroScope, Simon White  of Bloomberg News  stated what seems like the obvious: “It’s Time to Pay Attention to Funding Risks Again.” Yes it is. But we must pay attention to not just the cost of credit, but how having a real cost to credit changes investor behavior. If investors cannot finance aspirational assets at zero carry, what does that say about the assets? Join WGA Chairman Christopher Whalen for the 31st Annual Levy Institute Event! As we prepare to rebalance the WGA Top Bank Index for Q2 2024, it’s interesting to note that the top performers in our group are up double digits over the past three months. Below are the top-10 banks in the surveillance group sorted only by 3-month total returns. Who are some of the top performing bank stocks in the WGA Top Bank 100? The group includes some perennial over-performers as well as some large-cap turkeys that were pulled higher by the flight to quality in Q1 2024. But with the Treasury yield curve moving up half a point as this week’s Treasury auction began, all eyes should be on funding costs and asset returns. “Profitable growth” is again in vogue, both for banks and their customers.  The big change that is sweeping across the financial world is the flight to liquidity that is visible all over the global markets. Chinese speculators are madly buying gold, the world’s most liquid asset. But much of the world remains entombed by low-yielding assets that cannot be sold. Pensions and sovereign wealth funds, for example, are buried in private equity investments that made sense when interest rates were near zero but now are almost worthless. The requirement that new ventures actually have a prospect for profitability is a new wrinkle. New PE funds, such as the SKKY vehicle sponsored by Kim Kardashian  and Carlyle Group veteran Jay Sammons  have encountered tough markets, Bloomberg  reports. But there is hope. SKKY managed to raise $80 million for a new maker of truffle-infused hot sauces. Post money valuation is said to be only $250 million. Surely some truffle oil in the cholula is a compelling proposition?  A number of players in the world of private equity have turned to leverage to offset the illiquidity of PE holdings, a decidedly bad choice in a rising interest rate market. The assumption, of course, is that the Fed eventually will drop short-term rates if the financial markets encounter problems, but that does not mean that the long end of the curve will follow suit. There’s always tomorrow, but the next day may not be like yesterday.  Indeed, as we discuss below for the enjoyment of our Premium Service  subscribers, short-term funding is now above the average asset returns of many banks. Funds, dealers and other nonbank players are points underwater on funding vs existing assets. PE assets that were acquired or financed during the 2019-2022 period are likewise upside down in terms of today’s cost of leverage.  If everything you trade today has a 4 or 5 handle in terms of coupon, then paying ~ SOFR +2 for funding or over 7% really does not work. Just as bonds and CRE assets are getting killed by rising funding costs and cap rates, PE investments are likewise way out of the money in so many different ways. Consider that ARK funds, once an aggressive investor in nouvelle tech, is now labeled as the biggest wealth destroyer of the previous decade. Ark has lost investors a collective $14.3 billion, according to Morningstar . When we tell you that CRE and mortgage servicing assets are trading around the same cap rate, should we all laugh or cry? Think of the cap rate a prospective investor in a private PE will demand today. Say 8x NOI?? This is why we published a little cap rate tutorial in our last comment (“ TCBI v Ginnie Mae Goes to Trial | Outlook for Commercial & Residential Mortgage Finance ”).  The brutal math of cap rates makes you appreciate why the FOMC says that “price stability” = 2%.  For the American commercial real estate market to work, it needs at least 2% inflation annually or the whole heavily leveraged pile of bollocks collapses.  But the same can be said of leveraged PE investments, especially the aspirational stories that assume an easy exit via IPO. “When the IPO market will not offer sufficient pricing and liquidity to unwind the portfolio companies from a past-SELL-BY-DATE private equity fund,” notes Nom de Plumber  from his perch in the risk management trench.  You may have seen Nom de Plumber in the latest John Wick film. “Managers can try to buy more time (plus asset management fees) by borrowing (more) against these (already-overleveraged) companies,” he complains. “In other words, if you cannot sell something which you had bought with debt via an IPO, you try to hock it---with debt encumbrance---at the pawn shop.” The prospect of heavily leveraged PE portfolio companies eventually defaulting on debt raises fond memories of fraudulent conveyance claims years ago in a certain federal receivership in Houston, TX. The political backlash against PE firms raping private companies and then leaving the creditors for dead in bankruptcy is building. More of such behavior suggests may tip over the proverbial dung wagon in favor of federal legislation to discourage leveraged PE transactions.  Nom de Plumber  notes that net asset values of PE portfolio companies, which are their reported fair values minus the original acquisition debts, could support these NAV loans. But if the IPO market cannot validate those privately reported fair values, how can NAV loan providers rely upon them?  Good question. What is the Weighted Average Maturity of BAC? Moving right along, to illustrate the danger of higher interest rates for longer, below we return to Bank of America (BAC) using some of the powerful tools from Bill Moreland at BankRegData . Suffice to say that Bill adds some pretty gruesome color to the tactical situation facing the entire US banking sector as the 10-year Treasury notes rises toward 5%.  Readers of The IRA  will recall that the last time LT interest rates were near 5%, the negative capital position of US banks was over $1 trillion. To make the picture crystal clear, the average yield reported by BAC suggests a mark-to-market haircut of 10% of total assets. Although the duration profile of BAC is similar to that of other large banks, the average yield is more than a point below other large banks. The table below shows too-be-announced (TBA) prices for Fannie Mae MBS, coupon spreads across the table and Treasury benchmarks along the bottom. Notice that those FNMA 4s are trading at 90 cents on the dollar for delivery in May. Source: Bloomberg (04/23/24) The first thing to notice about BAC’s lead unit is that the yield on assets is well-below the large bank average of 5.8%. Keep in mind that SOFR and fed funds are around 5.5% and prime is 8%, so 5.8% is no great shakes. As interest rates rise, the financial pain caused by these legacy exposures will grow. The table below shows the loan & securities returns for BAC, JPM and Peer Group 1. BANK OF AMERICA Source: FDIC/BankRegData (12/31/2023) As we've noted in previous comments, the return on earning assets (ROEA) at JPM is below peer because CEO Jamie Dimon does not need to take duration risk. Half his revenue is non-interest fees. Just half of his assets are bank, the other half is investing and capital markets. Half. Thus the real comparison for BAC is against Peer Group 1. BAC owns a lot of T-bills and a lot of mortgage-backed securities, in fact almost 10% more MBS than its peers. The yield on the half trillion dollars in MBS held by BAC is 2.5%. But if we look at some of the other asset classes, BAC is showing yields that are well-below peer. The yield on BAC's $320 billion commercial and industrial (C&I) book was just 5.4% or more than 150bp below peer at year-end 2023. In a rising interest rate environment, we expect to see increased market concern regarding unrealized losses on loans and securities held by banks. Of the top five commercial banks, BAC has arguably the weakest position when it comes to duration risk and asset returns. Since the end of the COVID pandemic, interest rate in the US have risen to 25-year highs, reflecting the end of extraordinary ease by the Federal Reserve. But 2024 also marks the end of 40 years of steadily lower interest rates funded by the baby boomers. Returns on bank assets have steadily fallen since the 1990s, but now we enter the age of constraint in terms of fiscal resources and surplus savings. Higher real interest rates will benefit banks and real investments, while surreal investments that were encouraged by low or zero interest rates will be disadvantaged. 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.

April 21, 2024 | Premium Service | In this edition of The Institutional Risk Analyst , we review the most recent earnings for financials and release our latest report on the real estate sector, “Outlook for Commercial & Residential Mortgage Finance.” The good news is that the residential mortgage sector remains very quiet in terms of defaults, but rising interest rates are starting to cause price compression in high-end properties.  The bad news is that the commercial real estate sector is being crushed under the weight of rising interest rates, higher capitalization rates for property valuation and idiotic progressive politics in blue cities and states. The 2019 rent control law passed by Albany is actually reducing the availability of rent-stabilized apartments in New York City. These vital assets have been rendered unfinanceable by banks and will eventually end up owned by New York State as public housing.  Source: FDIC/WGA LLC The extraordinary dichotomy between loss rates on residential properties and multifamily commercial assets is unchanged in Q1 2024. Net charge-offs on first & second lien 1-4 family mortgages are near zero, but loans on multifamily properties owned by banks are averaging 100% loss given default (LGD).  In our report, we note that construction & development loans generally are also near 100% LGD, but C&D loans on residential assets are near-zero default and net-loss rates. The “Outlook for Commercial & Residential Mortgage Finance” report is available to subscribers to The IRA Premium Service  and is also available for sale in our online store .  Meanwhile in Washington, Ginnie Mae President Alanna McCargo   resigned last week , ending one of the more unsettled periods in the agency’s recent past. Under McCargo, Ginnie Mae embraced an ersatz risk-based capital rule borrowed from federal bank regulators for independent mortgage banks. The new rule will limit leverage on mortgage servicing rights (MSRs) to 50% vs 65-70% today. The change crafted by McCargo et al at Ginnie Mae has even less analytical basis than the discredited Basel III Endgame fiasco. It will drive small and mid-sized issuers out of the government loan market. Indeed, many larger issuers tell The IRA that they are quite amused and like the fact that Ginnie Mae is destroying smaller competitors for them. It is unclear, however, whether any GNMA mortgage issuers will be able to hold MSRs at a 50% leverage cap, especially in periods of high loan delinquency and low lending volumes. In a rising interest rate environment, smaller issuers that lack large loan servicing portfolios and related periodic cash flows are basically toast. McCargo and her colleagues at Ginnie Mae made no secret of their desire to eliminate smaller FHA/VA/USDA issuers in favor of a few, larger non-bank mortgage banks. Trouble is, we think the risk folks at Ginnie Mae and the larger issuers are fooling themselves if they think the 50% leverage cap allows for profitable operations for any size government issuer .   Among McCargo’s accomplishments at Ginnie Mae was taking no action before the failure of Reverse Mortgage Investment Trust (RMIT) in December 2021. Caught entirely off guard, McCargo then got very involved in the failure of the largest HECM issuer – arguably beyond the scope of her government employment -- until the Treasury seized the assets in late December. The result of her actions post-filing is a tendentious litigation between Ginnie Mae and Texas Capital Bank (TCBI) . We wrote about the RMIT default in several previous issues of The IRA .  By a remarkable coincidence, just a week before McCargo's resignation, the US District Court in Amarillo, TX, ruled that parts of the lawsuit against Ginnie Mae may proceed. “ A lawsuit accusing Ginnie Mae of unlawfully interfering with a warehouse lender’s rights to FHA loan collateral can continue, a Texas court has ruled,” reports Monica Hogan  of Inside Mortgage Finance , “However, it removed two counts of the lawsuit.”  Story from inside HUD is that McCargo is tired, frustrated and wanted to resign months ago. The fact that the US Department of Justice could not get the entire TCBI lawsuit tossed is notable and illustrates the scope of the mess created by McCargo and the Biden Administration. We expect Ginnie Mae ultimately to prevail in the litigation, but McCargo’s tenure saw a lot of unnecessary damage done to non-bank issuers. The litigation between Ginnie Mae and TCBI, Case 2:23-cv-00156-Z , is most unfortunate for the market for financing government loans and MSRs. Specifically, shining a bright light in a federal district court on the fact that lenders on GNMA forward and reverse mortgage servicing assets do not really, really, have a perfected security lien on the collateral is helpful how?  McCargo's actions and the fact that the case has not been dismissed in its entirety is very unhelpful given current market conditions. McCargo’s tenure at Ginnie Mae illustrates the fact that putting intelligent, personable generalist political operatives into senior government positions that actually require a minimum degree of subject matter expertise and financial acumen is the road to disaster, both for the individuals concerned and the agencies. McCargo is said to be interviewing for jobs in the private sector, but she may be spending some quality time in Amarillo to participate in the TCBI litigation. TCBI reported earnings last week and the market reaction was not bad. TCBI ranks 84th on the WGA Top Bank 100 Index  and mostly scored in the third quartile of the group in Q1 2024.  The bank reported “a $19.0 million provision for credit losses, reflecting increases in criticized and non-accrual loans, growth in LHI and $10.8 million in net charge-offs, compared to a $28.0 million provision for the first quarter of 2023.” In other words, provisions were down YOY.  All that said, we are still waiting for TCBI to come to Jesus on the RMIT mess.  The words “Ginnie Mae” were not mentioned by TCBI in the latest earnings release. While TCBI was able to recover some collateral from the RMIT bankruptcy (“ Reverse Mortgage Bankruptcy Festers; IRA Housing Outlook ”), the rest of the claims arising from the RMIT bankruptcy seem like a dead loss. But because of McCargo's actions, the matter now goes to trial. And TCBI gets to kick the RMIT disclosure down the road. We are fans of TCBI, but must confess to being a little surprised that they have not pulled the plug on lending on reverse mortgage exposures (aka “HECMs”). We had a great discussion with former Federal Housing Finance Agency (FHFA) chief Mark Calabria in Las Vegas, where he recalled wanting to shut down the entire HECM market as unworkable. If there was justice in the world, then the US Treasury would make TCBI whole. But the statute says otherwise. We think rising interest rates make another takeover of a reverse mortgage issuer by the US Treasury inevitable in 2024. Do you think Treasury Secretary Janet Yellen knows about this new expense to the taxpayer? We’d not be surprised to see TCBI pull out of the government sector. The low volumes and growing risks from the remaining issuers in a rising interest rate environment strike us as really dubious opportunities for any lender. There is just not enough business left in either forward or reverse mortgage markets for smaller lenders competing with market leader JPMorgan (JPM) .  Since our comment on the prospect for releasing the GSEs from captivity, the outsized gains on both stocks were paired back significantly (“ GSE Release? Really? Update: Ally Financial ”). From the peak of $1.79 in March, this notable penny stock has retreated to just $1.21 at the Friday close. But hope springs eternal.  Fannie Mae is still up 43% YTD.  Is this a great country or what? A number of readers and X folk questioned our analysis of the prospects for the GSEs outside of conservatorship. Let’s make it simple. If Moody’s has to rate Fannie and Freddie as finance companies, then they get downgraded to ~ “A+” vs “AA+” at the moment for the United States.  If the US gets downgraded again due to the absurd budget deficit, then the GSEs, the large banks and everything else that depends on the US sovereign rating gets downgraded, of note. If the GSEs are downgraded and, more important, recognized as private corporate issuers a la PennyMac (PFSI) , then next comes the question of ~ $8 trillion in conventional mortgage backed securities. If our readers think that the US markets could survive a forced Moody’s downgrade of all conventional MBS to, say, “A+”, then we’ll just wish everybody a nice day now. But if you agree with us that the GSEs would need to pay the US Treasury to wrap the MBS with that “AA+” rating, say 25bp annually on that $8 trillion in MBS, then clearly the GSEs cannot survive outside of the government terrarium. Next! The “Outlook for Commercial & Residential Mortgage Finance” report is available to subscribers to The IRA Premium Service  and is also available for sale in our online store .  Subscribers login to access the report below.  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.

April 15, 2024 | Watching investors struggling with a confused economic narrative c/o the FOMC, we remind ourselves daily that the view of the US markets reflects an equity market perspective as seen by young adults. Anyone who grew up during the peak years of the baby boom believes that interest rates always fall, equities always rise and Treasury paper rallies just in time. But it was not always so.  In 1934, FDIC Chairman Leo Crowley reported: "The Temporary Insurance Fund has been in operation since January 1, 1934 There are now 13,870 banks which are members of this Fund. Since January 1st not a single depositor has lost a penny in a bank which is a member of the Temporary Fund. It is well to give this a moment’s thought. I do not believe it possible to point to any other period in the history of the United States when for over three and a half months not a single dollar of deposits has been lost amongst so large a group of banks as are represented by the members of the Temporary Insurance Fund. On the other hand, there have been during this same period approximately 60 suspensions of banks which were not members of the Fund. Such facts speak for themselves." There was a time in the US when markets controlled interest rates, not appointed officials at the Federal Reserve Board. The Fed uses the prospect of cheaper credit to manage public confidence. Yet h ope for higher earnings was dashed by the big banks on Friday, when the perception of rising interest rates caused some people to hope. Rising market interest rates do not always lead to higher net interest income, as we discussed last week on Bloomberg Radio with Tom Keene .  In fact, falling interest rates  over the past three months drove volumes up, coupons down and generated a bit more fee income than some expected. Total non-interest revenue at Citigroup (C) , for example, almost reached Q1 2023 levels, but still helped to push the bank to a decent quarter. But net-interest income was down as yields fell and funding costs continued to rise small. Same basic story at JPMorgan (JPM) and Wells Fargo (WFC) .  So with inflation indicia headed back up and Fed governors waxing hawkish, is there any likelihood of a Fed rate cut? Is that even the right question?? The Fed Board is preparing to slow the rate at which it sheds Treasury securities from its balance sheet. Reuters reports that policymakers generally favor  “cutting the recent pace by roughly half in an effort to extend the process of shrinking holdings and reducing the risk of market trouble.” As we’ve noted previously in The IRA , bank reserves at the Fed have been rising for the past year, adding an even more interesting twist to the Fed’s pending decision to slow the runoff of the system open market account (SOMA). Bank deposits were growing through year-end, but have been falling since January. By tapering the runoff of the Fed's balance sheet, bank deposits will start to grow, illustrating the connection between bank deposits and the Fed's purchase of Treasury debt. The chart below shows the Treasury General Account (TGA) at the Fed and $17 trillion in bank deposits. T he fact that Dallas Fed President Lorie “Repo” Logan  has been making positively hawkish comments about monetary policy while calling for a slowdown in QT strikes us as a bit confusing. Is Lorie more worried about liquidity or inflation?  Even with reserves rising, falling bank deposits suggests that the Fed needs to start buying more Treasury debt soon to avoid another 2018 market snafu. When you look at the sharp increase in bank reserves starting in 2019, months before the onset of COVID, and then accelerating in 2020, we see the great Powell inflation. But what investors still don’t seem to understand is that the Fed’s ability to lower interest rates is compromised by rising federal deficits. The weak auction of new Treasury debt last week saw the yield on the 10-year note rise to 4.6%.   Given that bank reserves have been rising for a year or more, it seems like Lorie Logan is not so much worried about bank liquidity as liquidity for the Treasury. The move by the Fed to start reinvesting cash redemptions from the SOMA seems like a pretty obvious admission by the Fed that market interest rates will rise further without an increase in explicit debt monetization by the FOMC.    Thus we come to the final piece of the interest rate puzzle, namely the building crisis inside some of the largest banks due to volatile interest rates. Last week saw a bizarre announcement by the Federal Deposit Insurance Corp of a report on the “Orderly Resolution of Global Systemically Important Banks.”  Chairman Martin Gruenberg said at the Peterson Institute: “The ability of the FDIC and other regulatory authorities to manage the orderly resolution of large, complex financial institutions remains foundational to U.S. financial stability. An orderly resolution is far preferable to the alternatives, particularly resorting to taxpayer support to prop up a failed institution or to bailing out investors and creditors. With this paper we are reaffirming that, should the need arise, the FDIC is prepared to apply the resolution framework that the FDIC and many other regulatory authorities in the U.S. and around the world have worked so hard to develop.” The only problem with Chairman Gruenberg’s statement is that the FDIC and other regulators have never actually performed an orderly resolution of a large bank. Never. The notion that the FDIC can liquidate a systemically significant bank without public expense is absurd. Gruenberg’s statement will come as a surprise to Moody’s and other rating agencies, which give large US banks a full notch of uplift in credit ratings based upon the assumption of sovereign support. If we are to believe Chairman Gruenberg, the FDIC will wipe out the shareholders and debt of a public bank holding company, move the operating units to a newly chartered holding company and eventually sell the new company. The US banking industry will apparently take the resulting loss.  You cannot have financial stability and also avoid a taxpayer expense. When the FDIC takes control of a large failing bank (after handing equity and debt investors 100% loss), there will be no bid for US bank equity. The US stock and equity markets will have collapsed and Chairman Gruenberg or his successor will be looking at an empty room.  Chairman Gruenberg was sharply critical of Swiss authorities for merging the crippled Credit Suisse with UBS AG (UBS)  as though there was an alternative. But was there really a choice? As with many large bank mergers in the US going back to the acquisition of Manufacturers Hanover by Chemical Bank in 1991, when large banks stumble the only practical alternative is to merge the inferior bank with a stronger institution. By definition there is no bid for the assets of a dying bank. When Chase Manhattan was crippled by the failure of Penn Square Bank in 1982 , it was eventually merged with investment bank JPMorgan in 2000.  Could the FDIC have liquidated Chase, especially after it repudiated billions in loan participations originated by Penn Square Bank? No. Like many other parts of the 2010 Dodd-Frank legislation, the prompt resolution provisions regarding troubled banks are entirely unworkable. When you recognize that the American system is based upon steady asset price inflation, the notion of liquidating a large bank after wiping out the equity and debt becomes truly laughable. But this is not really very funny. If we consider the failures of Silicon Valley Bank, First Republic Bank and Signature Bank, in each case the FDIC was forced to sell the banks to other institutions at a discount to net asset value and impose the cost on the surviving banks in the system. The FDIC did not follow the procedures outlined in Chairman Gruenberg’s report and, in fact, had to borrow over $100 billion from the Fed to finance these transactions. Progressives in Washington led by Chairman Gruenberg give speeches about prompt resolution of large banks even as the credit standing of the US slides into the toilet. Question for Chairman Gruenberg: Why didn’t the FDIC put Signature Bank into a conservatorship as the FDIC describes in the report?  Why did the FDIC sell the assets of Signature Bank to New York Community Bank (NYCB) , creating another bank crisis less than a year later? The fact that Chairman Gruenberg is hiding billions in toxic Signature Bank assets inside the bank insurance fund suggests that the approach outlined in the FDIC report is unworkable. But the real question is why is Marty Gruenberg rejecting the views of his hero, former FDIC Chairman Leo Crowley. In the hallway outside of Gruenberg's office at the FDIC in Washington, there is a portrait of Leo Crowley , who was the second Chairman of the FDIC and organized the corporation as it functions today. Along with Jesse Jones at the Reconstruction Finance Corporation, Crowley restructured the US banking system. But like most politicians, Crowley was far from perfect. Critics of President Donald Trump should consider the example of Crowley. FDR quashed a federal indictment of Crowley in Wisconsin, who went on to run the Lend-Lease program during WWII. Stuart Weiss wrote in his 1996 biography " The President's Man: Leo Crowley and Franklin Roosevelt in Peace and War ": "Crowley was confirmed as chair of the FDIC in 1934 despite a charge, unknown to President Roosevelt, that Crowley had committed fraud as a banker in Wisconsin. Crowley then served with distinction for more than eleven years as the administration twice buried a 1935 Treasury Department report that, had it been handed to Wisconsin authorities, could have sent him to prison: Roosevelt valued Crowley’s political and administrative talents too highly to allow that to happen." Crowley and his contemporaries understood the rule of benevolence that we discussed in " Financial Stability: Fraud, Confidence and the Wealth of Nations. " Catching a failed bank and avoiding a debt deflation is always the best route in terms of avoiding public panic and preserving long-term wealth. In the 1930s, Crowley and Jesse Jones preached tough love to US banks, demanding salary reductions and dividend limits to ensure bank safety and soundness. In 1939, however, the New Deal was failing and the prospect of a generalized economic contraction loomed despite years of effort by the Roosevelt Administration. By early 1939, the New Jersey Title Guarantee & Trust Co failed, threatening depositors and the State of New Jersey with total loss. Crowley flew to Jersey City and over a weekend the FDIC merged over a dozen banks together to protect depositors. In mid-1939, The New York Times wrote that the bank mergers engineered by Leo Crowley and the FDIC during that terrible year "aroused little public interest," which is of course the idea. The agency's swift action to consolidate a number of failing banks prevented a large financial crisis, wrote the Times , and that "the public has regained its confidence" as a result. Crowley was protecting FDR as much as the depositors of dozens of banks in New Jersey. The fact that FDIC Chairman Gruenberg would publish a report so clearly at odds with the wisdom learned during the Great Depression by people like Leo Crowley is cause for concern. Progressives like Chairman Gruenberg can stand up and give speeches about resolving zombie banks without public subsidy, but never once talk about the impact of the budget deficit and inflation on banks.  Most people don’t realize that the US banking system has grown deposits by 300% since 2008, a rather stark description of the systemic inflation coursing through the US economy. As the size of US banks has grown, the ability of the FDIC and other agencies to manage a large bank failure has been greatly diminished. But the single biggest risk to the US banking system comes from the confused thinking of officials in Washington. If we followed the advice of Chairman Gruenberg and tried to resolve a large bank w/o public subsidy, the result would be a financial market collapse and a vast debt deflation a la the 1930s. Giants like Leo Crowley and Jesse Jones knew this. The fixation within the G-10 nations with resolving large zombie banks without public expense, this even as the unpayable public debt of these nations grows to the sky, will be seen in years hence as evidence of our collective delusion.  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.

“We are worried about a loss of adequate liquidity in the market.” Treasury Secretary Janet Yellen October 2023 April 8, 2024 | Premium Service | Last week, we made several changes to the WGA Bank Indices in the wake of the 70% drop in the share price of New York Community Bank (NYCB) . Below we have a little pre-earnings look at Bank OZK (OZK) . We interviewed founder and CEO George Gleason  back in 2017 (“ The Interview: George Gleason, Bank of the Ozarks ”). Last week, we updated our methodology for the WGA Bank Indices  to allow us to drop a stock when it becomes not timely with the SEC and/or federal bank regulators. Since we use published financials for our tests, when an issuer says that their financials are no longer to be relied upon, then you may be dropped from the index immediately. If the restatement is material, then you lose your LA privileges . Second, we have added a new test to the WGA Bank Indices to give some weight to size. Size matters. As we noted in an earlier comment, “ Big Banks Good, Small Banks Bad ,” in times of stress, investors flee to size. Thus in Q1 2024, for example, the best performing bank stock in our 108 bank surveillance group was Citigroup (C)  owing to cost cutting announced in 2023 and market concerns about regional banks. Subscribers to The IRA Annual Service  may inspect the latest WGA Top Bank 100 list below. By adding a fifth test for size to our WGA Bank Indices, we keep the focus on operating strength, but acknowledge the human desire to avoid financial loss. When the fundamentals for the US markets are under a growing cloud, people line up in the parking lot at Costco (COST) in the wee hours to buy 1 oz gold bars. Only in the strange confines of Washington do you still find people who think that the federal budget deficit is not a problem. But then again, the left in Albany and Buenos Aires still have yet to repudiate socialism.  We naturally say “told you so” on interest rates as the Wall Street consensus walks back the idea of multiple rate cuts this year. Back in January, most bankers were telling investors to look for three cuts in 2024. But for banks, frankly, higher rates and thereby higher gross yields on earning assets is what the industry needs to support market valuations and deal with loss mitigation. Troubled banks survive because they have enough net operating income to clean up the mess without spending capital. Recall the performance of BB&T after 2008, when the bank just kept on going without suspending dividends or showing any real operational stress. But the volatility injected into credit markets by the FOMC and the Treasury’s debt issuance makes running a bank or any financial enterprise today increasingly problematic. Retired Tudor Investment Corp partner Robert Dugger opined in The International Economy  that the shrinking pool of savings globally will make financing the US public debt far more difficult. “Asian asset managers argue that the cost of investable capital worldwide is determined where the curves of world net savings supply and demand intersect,” writes Dugger. “They refer to this cost as the “savings-market clearing rate” (SMCR). There is a yield curve of SMCRs ranging from hours to decades. In their view, the SMCR curve is the key determinant of national interest rates at all maturities and currency values worldwide.” As the pool of investable savings tightens, the US, China and Europe will be drawing down savings to pay for their respective retirement waves. The cost demanded by those asset managers to finance tomorrow's fiscal deficits will rise, meaning that nations that balance spending and revenue will be advantaged. Dugger continues: "Currently, Powell prefers to “stay in his lane” and not discuss fiscal policy. However, because the SMCR and ideas like R* are directly affected by Congressional budget policy, he will have no option but to comment on the need for fiscal sustainability. When he does, it will mark the end of the beginning of Congressional resistance to fiscal reform." Financial institutions that understand this dynamic of a rising floor on interest rates and prepare themselves accordingly will prosper in the years ahead. The age of saving surpluses and lower interest rates forever is ending as the Baby Boom dissipates, another great example of entropy right in our faces. Source: FDIC In the world of banking, as shown above, the two key relationships investors must follow are operating income on the one hand and credit expenses in the form of provision for future loss on the other. The ebb and flow of these two key parts of the expense ledger determine what is left for equity holders in the form of earnings. This brings us to Bank OZK, a bellwether in the industry when it comes to commercial real estate and banks generally. Bank OZK Probably the biggest accolade that we can give OZK is that when much of the industry saw earnings decline in 2023, the $34 billion asset lender had a record year even as income weakened along with the rest of the industry.  OZK has outperformed USB and the rest of the industry over the past year. In the latest version of the WGA Bank Top 100 for Q1 2024, OZK came in 22nd overall. The only reason that the bank did not score higher is that OZK is still only trading around book value because of fears regarding commercial real estate. WGA Bank Top 100 Source: WGA LLC When we talk about commercial real estate, naturally people think of OZK because this relatively small bank is a key national player in the world of construction and development of commercial properties. The table below is from the OZK earnings presentation. The key thing to understand about OZK is that they focus on construction and development finance in CRE. They look to exit the exposure upon completion of the development process, usually with another lender providing a commercial mortgage. By focusing on the early part of the life cycle of a property and other carefully chosen verticals, OZK has delivered best in class credit performance. Below we compare OZK to U.S. Bancorp and Peer Group 1. Technically OZK is part of Peer Group 2, but we'll compare them to the big boys. Source: FFIEC, FDIC Basically, OZK with its southern branch network and national lending focus manages to deliver a loss rate that is one-fifth that of USB and below the average for Peer Group 1, which includes all banks above $100 billion. The data from OZK comes from the FDIC since the depository has no parent holding company. Below we show the gross spread on loans and leases. Again, OZK handily outperforms both USB and Peer Group 1. Source: FFIEC, FDIC Yeah, OZK CEO Gleason almost got his bank up to a 9% gross spread in Q4 2023. Bank OZK has been quite adept at managing its balance sheet to increase spread in times of rising interest rates. In fact, even as the market rallied more than a point in terms of residential loan yields since October 2023, OZK has continued to increase its gross loan spread in C&D lending, dealer finance for new RVs and boats, and specialty asset-based lending. Common thread here is lending on new assets early in the life cycle. A numbers of banks that compete with OZK in the C&D channel pulled back in 2023, allowing the bank generate record revenue and earnings," noted President Brannon Hamblen : "When there aren't nearly as many competitors on the field, you tend to get calls that you might not have received before. And our guys have done a phenomenal job of converting on new relationships, and obviously, loans with existing relationships. The pie has been smaller, without question. We're just able to take a proportionately larger slice of that pie with our team. And this year will be very interesting in terms of how things play out." The chart below shows funding costs for OZK, USB and Peer Group 1. Notice that OZK's funding costs are higher than Peer Group 1, but since the bank's gross spread is almost 3 points higher than USB, the net is very positive. This fact helped OZK report a return on assets over 2% when the rest of the industry was struggling to get over 1% ROA. More, look at the volatility in the movement of US interest rates since 2019 under the Powell FOMC. Source: FFIEC, FDIC The results for Bank OZK at year-end 2023 was a stellar performance. Whlle the bank did see returns drop due to the FDIC insurance assessment and other factors, OZB still delivered results that were 2x Peer Group 1. Note that OZK actually grew earnings in 2022 when the industry was suffering from NIM compression thanks to the FOMC and QT. Source: FFIEC, FDIC One reason that OZK does so well compared to its larger peers is operational efficiency. Bank OZK has an efficiency ratio half of the average for Peer Group 1. In terms of overhead costs, the bank is in the bottom quartile of Peer Group 2, which are banks from $10 billion to $100 billion in assets. Average personnel expenses at OZK are in the bottom 20% of Peer Group 2 at less than $100,000 average annually. Source: FFIEC, FDIC Bottom line is that despite worries about commercial real estate, Bank OZK manages to outperform and take market share when other lenders are very literally running away from the market. When the industry sees efficiency ratios going up, OZK's CEO George Gleason and his team are pushing their operating costs down and thereby increasing the dividend to shareholders for the 54th consecutive quarter. Worries about commercial real estate will weigh on OZK in the near term, but when the sun starts to shine again this perennial over-performer will run ahead of the pack. 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.