October 28, 2018 | In his new book, “Keeping At It: The Quest for Sound Money and Good Government,” by Paul Volcker (1979-1987) with Christine Harper, the former Fed Chairman delivers a sound rebuke to Chairmen Ben Bernanke (2006-2014) and Janet Yellen (2014-2018), and other Fed governors and economists, for fretting overmuch about deflation. He argues that the true danger is that loose monetary policy leads to inflation and market contagion caused by the manipulation of risk preferences. Volcker specifically chides Bernanke and Yellen for their fixation on a two percent inflation target, one of the main ornaments on the data dependent Fed Christmas Tree. “How did central bankers fall into the trap of assigning such weight to tiny changes in a single statistic, with all of its inherent weakness?” he asks. Good question. Volcker writes in Bloomberg: “Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk. The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the ‘easy money,’ striving for a ‘little inflation’ as a means of forestalling deflation, could, in the end, be what brings it about. That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of those requirements inexorably lead to the responsibilities of a central bank.” Of course, Volcker is cut from different cloth than his successors. Janet Yellen was only chairman of the Federal Reserve Board for four years and with good reason. She was arguably the most dovish Fed Chairmen in the history of the central bank, with a strong tendency to do too much rather than too little. Yellen confessed to the Financial Times last week that “I really thought we needed to pull every rabbit out of the hat.” And she did. An adherent of the state-intervention school championed by her Yale mentor James Tobin, Yellen has always followed the tendency of the left to support greater ease and tolerate higher levels of inflation. During her tenure as a Fed governor and then chairman, the Fed engaged in the purchase of trillions of dollars in government debt and mortgage securities through “quantitative easing” – a free loan to the Treasury that was couched as “stimulus.” The Federal Open Market Committee (FOMC) under Bernanke and Yellen also engaged in a deliberate manipulation of the term structure of interest rates via “Operation Twist,” a terrible mistake that has yet to be reversed. Operation twist caused untold damage to the financial markets and the US economy – damage that is still in process. In that interview with the FT, Yellen worries that the rhetorical attacks on the central bank by President Donald Trump is “whittling away the legitimacy and stature of institutions the public has traditionally had some confidence in. I feel it ultimately undermines social and economic stability.” She then goes on to say that “Trump has the potential to undermine confidence in the Fed.” Former Chairman Alan Greenspan, the most politically astute Fed chief in half a century, puts such worries in perspective: "I don't know a single President, and I worked for a lot of them, who don't want lower interest rates. Now, obviously that's not possible. You keep lowering them down to zero, where do you go from there?" Like Yellen, many observers worry that criticism of the Fed will make it difficult for the central bank to act when necessary. The dual, conflicted political mandate of full employment and price stability created by the Humphrey Hawkins law is not possible to achieve in practice, thus the FOMC lurches from one extreme to the other, causing enormous collateral damage. Consider the effects of QE and Operation Twist on housing. Think about the thousands of people in the mortgage industry, for example, that have lost their livelihoods because the boom and bust policies followed by the Fed since 2008 and even before. Think about the millions of American families today that cannot afford to buy a home because asset prices have skyrocketed over the past five years. By pulling tomorrow’s home sales and other economic activity forward via various policy manipulations, tomorrow is now light in terms of growth. Tomorrow also carries hidden market and credit risks caused by the Fed’s past actions. As we watch mortgage lending and home building volumes fall next year and thereafter thanks to the property price inflation created by the FOMC under Bernanke and Yellen, remember that Fed policy was explicitly meant to “help” the housing sector. When people talk about “Fed independence,” our response is independence from what? Presidents going back to FDR have tried, unsuccessfully, to bend the central bank to the political circumstances of the day. In the book Inflated: How Money and Debt Built the American Dream, we wrote about how Chairman Thomas McCabe (1948-1951) and his colleagues on the FOMC starred down President Harry Truman on the eve of the Korean War. He won back the Fed’s independence from the Treasury. But the Fed and Treasury, like all federal agencies, are notional institutions, merely alter egos for the United States. The greatest threat to the central bank’s existence is the tendency of Fed governors and economists to pursue abstract economic theories that make no sense in real world terms and often do more harm than good. We have written at length about how the radical policies followed by the FOMC, first under Bernanke and then Yellen, have distorted asset allocations, and the term structure of interest rates and credit spreads. For example, our best guess is that the 10-year Treasury bond, in the absence of QE2-3 and Operation Twist, should be yielding well-over 4 percent today. Instead this important benchmark of risk is barely over three percent. Indeed, the entire Treasury yield curve still shows a strong tendency to fall thanks to debt purchases by the Fed and other central banks. And corporate credit spreads remain compressed, with high-yield spreads up 25bps in the past month but really unchanged from a year ago, as shown in the chart below. Traditionally, Fed chairmen have disappeared into the world of academia, speaking or consulting after leaving office. Bernanke has followed this rule, but Yellen seems unconstrained by such conventions. During her discussion with the FT, Yellen worries about lending to heavily indebted, less creditworthy corporate borrowers, which she sees as a source of potential “systemic risk.” She also talks about the need for more regulation, to counter the potential for systemic risk caused by this accumulation of risk. Is it really possible that Chair Yellen fails to understand that the Fed’s deliberate manipulation of the credit markets since 2008 made this worrisome accumulation of corporate junk debt possible? Does she understand why most corporate debt issuers are clustered around the “lower bound” of investment grade ("BBB")? As we noted this past week, liquidity in the credit sector is the next risk on the merry-go-round of financial markets, a cycle of asset and market risk that the Fed largely controls. Today the FOMC under Chairman Jay Powell is working to “normalize” policy, but without unwinding QE2-3 and Operation twist. Last week, at a talk at the Peterson Institute for International Economics, newly confirmed Fed Vice Chairman Richard Clarida discussed monetary policy normalization, but significantly made no mention of ending other legacies of "unconventional" policy such as QE 2-3 and Operation Twist, or paying above-market interest rates on excess bank reserves. In the language of the FOMC, QE and Operation Twist were a form of stimulus. In the language of the financial markets, they represented a back door loan to the Treasury and the manipulation of credit markets. Even in the supposedly conventional world of Fed monetary policy, the concepts and indicators used to formulate public policy are often vague – a point that has already drawn the critical notice of Chairman Powell. Chairman Volcker is not the first member of the Federal Reserve System to criticize the dangerous policy drift inside the US central bank, but his comments are entirely on point. By substituting nonsensical concepts like “neutral” interest rates for hard data, and by manipulating the financial markets so that they are no longer reliable measures of risk or inflation, the FOMC under Bernanke and Yellen has been deliberately flying blind. Former Cleveland Fed President Lee Hoskins and his former colleague Walker Todd note in a important research paper, “Twenty Years after the Fall of the Berlin Wall: Rethinking the Role of Money and Markets in the Global Economy,” that the Fed is now a source of systemic risk. They write: “Today we bear the fruits of state-managed intervention and seat-of-the-pants monetary policy. Many of the interventions from the 1930s are still with us—the Federal Housing Administration, Fannie Mae, and Freddie Mac, to name just a few—and they all played a major role in the housing bubble and its collapse in 2008… Meanwhile, government guarantees and insurance programs for financial assets, along with bank bailouts, have produced, arguably, the largest increase in moral hazard in the history of financial markets. The Fed’s zero interest rate policy lasted so long (2008–15) that it encouraged excessive risk-taking, certainly riding the yield curve for banks (funding short and lending long). Unless reversed, these policies will plant the seeds for the next bubble.” So far, Chairman Powell and his colleagues on the FOMC have refused to speak publicly about unwinding QE 2-3 and Operation Twist. Meanwhile, former Fed Chairs Bernanke and Yellen travel the globe, congratulating themselves for saving the world from the threat of deflation even while encouraging the accumulation of the biggest pile of debt in modern history. But the full aftermath of the 2008 crisis is still incomplete. As and when the wheels come off the proverbial cart in the credit markets around 12-18 months out, it will not be due to a lack of regulation but rather because of reckless polices of the FOMC under the past two Fed chairmen. As Jim Grant noted recently, Chairman Powell truly is a prisoner of history. Click here to listen to the interview with Jim Grant of Grant's Interest Rate Observer. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 23, 2018 | This past week, readers of The Institutional Risk Analyst awoke to see that banking exemplar Bank of the Ozarks (OZK) had taken a loss on two legacy loans on regional mall properties in the Carolinas. First and foremost, this event shows that commercial real estate many parts of the US have still not recovered from the 2008 bust. Bank OZK, as it is now known since shedding its bank holding company, had previously reserved for the write-down. Our friends at Kroll Bond Ratings, who rate Bank OZK “A-“, summarized the situation nicely: “While reiterating that we consider these two credit issues to be largely idiosyncratic, KBRA notes that OZK’s core business strategy, which is centered on underwriting large commercial real estate loans, certainly offers the potential for some asset quality volatility even in generally favorable economic environments. Notwithstanding these unexpected charge-offs, Bank OZK’s ratings continue to be supported by its long and consistent record of solid risk-adjusted returns, which, in no small part, stem from disciplined underwriting and an effective risk management framework.” So, no, we do not see the earnings miss at Bank OZK as a sign that a wider apocalypse is impending in the world of commercial real estate -- at least not yet. Yes, multifamily and CRE properties are overbuilt and there is a rising glut of luxury properties in many urban areas. But the credit consequences of this latest round of irrational exuberance are probably a couple of years away in terms of bank earnings results. Indeed, we see the near term risks to financials coming from ebbing liquidity rather than festering credit. Writing in The Wall Street Journal, Rachel Louise Ensign reports that the levels of non-interest bearing deposits at US banks are falling. We discussed same in The Institutional Risk Analyst several months ago (see chart below) and in the most recent edition of The IRA Bank Book. Source: FDIC While Ensign correctly notes that rising interest rates are driving the secular decline in non-interest bearing deposits, that is certainly not the only reason. Among the largest components of bank transaction deposits is escrow balances for residential and commercial mortgages. Figure about $1 trillion annually in non-interest bearing float for the $11 trillion or so in outstanding single family mortgages. As large banks such as JPMorganChase (JPM) and Wells Fargo (WFC) have sold distressed servicing and withdrawn from low-FICO lending, the related deposits naturally decline as well. Indeed, we hear that WFC is preparing to follow the example of JPM and withdraw entirely from the Federal Housing Administration market. A sale of all of WFC's GNMA servicing portfolio is also said to be in process. The key insight in the WSJ report is that funding costs are rising – and quickly. How long will it take the financial media and investors to figure out what this means for bank earnings? As we told Grants Interest Rate Observer (October 19): “The average cost of funds for the whole industry right now is a little over 1%. The average earnings on total earning assets is barely 3%. You’ve got about 2 points of spread. If funding costs keep rising faster than earnings, then you will see net interest margin start to contract by Q1. How do you think the Street will react to that?” We have opined previously that the Federal Open Market Committee is not only going to squeeze bank earnings by raising short-term interest rates, but the Fed may very well cause a liquidity crisis in the world of non-bank finance. A year or two hence, we fully expect to see over-leveraged developers of luxury multifamily properties hanging from lampposts – figuratively speaking, that is. A key bellwether to watch is the net loss rate on CRE and multifamily exposures, which at present is deeply negative. That means that when a rare default event actually occurs in the multifamily sector, the bank gets its money back and then some, as shown in the chart below. When you see loss given default back into positive territory, that will be a signal that the period of artificially boosted asset prices is at an end. Source: FDIC Meanwhile, our friend Ralph Delguidice has been sending a steady flow of commentary about the hottest spot in the world of credit risk, namely the increasingly rancid world of collateralized loan obligations or “CLOs”. Remember this acronym. Tomorrow’s headlines about credit risk exploding in the face of investors will originate from this little-known corner of the financial markets. How? As credit spreads eventually start to widen with rising interest rates, the flaws in this deeply overbought institutional market for CLOs will become apparent. But for now the overall tightness in the credit markets is actually causing spreads in CLOs to tighten. Think of this as the melodic prelude to the final, disastrous finale of credit misallocation. The astute folks at TCW wrote: “CLO triple A liabilities are still widening while we see loan collateral prices tighten. The arbitrage is already stressed and every time we see rates go higher, the asset class seems to get incremental inflows from retail funds and SMAs, which only further pressures the arbitrage. Something will have to give. We will either see triple A CLO liabilities begin to tighten again or we will need to see enough outflows in loans that it restores the supply/demand relationship necessary to print new CLOs. However, when CLOs have represented roughly 60% of the loan demand, it is hard to craft a scenario where SMAs and retail funds can replace that demand for a prolonged period of time.” Many late vintage CLOs are indeed headed for credit problems, but the first act in that tragedy will be a massive and relatively sudden reset in credit spreads. The tightness in asset prices due to the FOMC’s twin idiocies of “quantitative easing” and “Operation Twist” will transform overnight into a buyers market. The low-quality leverage buyout and acquisition loans that make up more than half of CLO issuance and have been sold at high-investment grade spreads will suddenly be no bid. A number of observers have noted that the quantity and quality of debt issuance in the US over the past five years suggests troubling similarities to the 2008 credit bust. As was the case a decade ago, mis-pricing of risk thanks to the market manipulation of the FOMC is at the root of the mounting problem in CLOs. Delguidice offers some insights: “The torrential demand for leveraged loans — institutional and now increasingly retail—comes down to two things: 1). The loans float. This gives way to the proposition/myth that they offer protection against an increasingly aggressive Fed. 2) The EBITDA interest coverage is currently solid given the (12%) revenue growth in 2018 YTD. That said, the base line effects of 2015/16 will fade into next year even as the FOMC goes five more times and the fiscal impulse fades. This will (would) require 50%+ of the leveraged loan universe to post the same (12%) EBITDA growth in ALL the coming quarters just to keep coverage ratios from slipping. The red-hot demand for CLOs has also eroded covenants on the deals. This is impossible to quantify but critical to credit recovery and thus cycle dynamics of the structure) to the point where every new deal pushes the limits. Some 75% of the credit stack in leveraged loans is now 'covenant lite.'” Slipping coverage ratios? Mis-pricing of risk? Does that sound familiar? The good news is that the credit quality of US bank portfolios is very strong. The bad news is that many bank customers are leveraged up to their ears and more. When EBITDA coverage ratios start to slip as the FOMC withdraws liquidity from the system, these mis-priced risk exposures in the leveraged loan market will cause a terrible slaughter among fixed income investors who have blindly purchased these toxic exposures. The contagion of credit losses that starts in the market for leveraged loans and CLOs will slowly but surely impact the banking system as well. Early stage companies and leveraged buyouts will fail, causing a cascade of credit losses throughout the economy. Credit rating agencies will scramble to downgrade heretofore investment grade CLOs. And once again, the FOMC will be called upon to solve the problem of collapsing assets prices, a problem that its previous policies have caused. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 19, 2018 | In this issue of The Institutional Risk Analyst, we feature composer and media industry observer Michael Whalen on the prospects for the world of content given the aggressive spending by loss leader Netflix (NFLX). A veteran of three decades in the business of creating and distributing audio and video content, Michael has won two Emmy Awards is a composer of over 650 television and film scores. Question: Can you spend your way to success? Answer: Well, Netflix thinks so. The Economist projected this past June that Netflix will “probably” spend in excess of $12 billion on original programming this year. That’s far more than the $8 billion it was reported they would spend as of October 2017. It would also be way, way more than other studios are spending. HBO spent a reluctant $2.5 billion on content in 2017 (read: “Game of Thrones”), and CBS (the most insightful of the American television networks) will spend just under $4 billion. Upstart Apple (AAPL) will spend about $1 billion on its first few new original content shows. Apple plans to give these shows away for a time starting in 2019 as their platform takes shape and they rebrand iTunes and Apple Music. Apple is planning on spending more than $4 billion by 2022. But, as you will see, that’s barely a drop in the bucket. All those Netflix billions are attracting major talent: Ryan Murphy, Jerry Seinfeld, Barak & Michelle Obama, Chris Rock, Shonda Rhimes and David Letterman to name a very partial list. Netflix will also, according to The Economist, produce, purchase or license an incredible 82 feature films this year, compared to just 23 films for Warner Brothers and 10 for Disney. Goldman Sachs projects Netflix could be spending $22.5 billion on content per year by 2022. This would be more than all the other American television and movie studios combined. Netflix reports that in the second quarter of 2018, Netflix had over 130 million streaming subscribers worldwide. Of these subscribers, 56.71 million were in the United States of America paying $9/month or more on average. Even though the amounts are different, Netflix’ financial power play of 2018 has echoes of another era: The “Golden” Age of Hollywood of the 1930s. A century ago, America’s leading filmmakers settled in and around Hollywood. The many reasons for this westward exodus came down to one factor: location. The enclave of Los Angeles was as far away as possible from the New Jersey home of Thomas Edison. The distance made it impractical for the litigious inventor to sue filmmakers for patent infringements. Furthermore, the LA climate made filming year round possible. Skies were not only sunny but cloudless, providing the consistent light needed for continuity in film. Hollywood was even optimal within the Los Angeles basin; being 15 miles inland, it was little affected by marine fog. Hollywood’s nearby and eclectic terrains—ranches, mountains, forest, desert and seashore—could pass for most locales in the world, particularly in black and white. Into this world arrived the men who founded the Hollywood studio system—Adolph Zukor, Louis B. Mayer, and the brothers Jack, Harry and Sam Warner— all Jewish immigrants from Eastern Europe. With checkbooks out, they tried to out spend each other to get “top” talent under contract (for a certain number of years or films) and keep these actors and directors away from the other studios. Wind the clock forward to 2018. The studios now are trying to attract talent away from Netflix. For example, Peter Roth (head of Warner Bros. Entertainment) paid Greg Berlanti, who has 15 shows on the air, the most of any TV producer in history. These include several adaptations of DC Comics franchises such as Supergirl and Arrow that appeal to tweens and young women. He’s particularly valuable to Warner Bros., which owns DC as well as half of the CW Television Network, where many of its shows air. Of the 12 series that will run in prime time on the CW this fall, Berlanti is an executive producer of seven. So with two years before Berlanti’s contract was set to expire, Roth offered the 46-year-old a deal worth at least $400 million to stay at Warner Bros. through 2024. Berlanti and Roth both declined to comment on the deal. It is believed to be one of the most lucrative for a TV producer in the history of Hollywood, according to published interviews with more than a dozen executives, agents, and producers. It’s also a sign of how traditional studios, tired of losing their best people to Netflix, are fighting back. Warner Bros. bought out Berlanti’s rights to future profits on all his current shows, what’s known as the "back end," a structure that allowed it to offer him more money upfront than he would have otherwise received. Everything in the world of content is upside down… from the “old days”. The real question going forward is this: Are there enough dollars to support Netflix’ content spend or are the gigantic outlays just a extremely expensive game of “Chicken”? The image of Standard Oil and the "good soaking" of a century ago comes to mind, when the petroleum giant cut prices to eliminate competition. If you believe Netflix’ subscription numbers:, yes, there are plenty of dollars and plenty of ancillary dollars waiting in the wings to support Netflix’ expansion. But we haven’t yet talked about Amazon (where founder Jeff Bezos hates coming in second). Anyone who has looked for the “best” talent knows that it is a finite number of people who create, write, compose, direct, shoot and edit the best material. You can have an endless checkbook… but it doesn’t make the number in the talent pool bigger. They just get more expensive. The other studios will have to decide if feeding off the “bottom” or out at the edge of relevance when it comes to talent is enough for them. For the foreseeable future, Netflix is setting the pace when it comes to spending on new content. And we have not even talked about whether Netflix will ever make money as a business. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 14, 2018 | This week The Institutional Risk Analyst is attending the Mortgage Bankers Association annual conference in Washington, D.C., where we will be reporting on the presentations, meetings and other events. Last week we spoke to Michael Lau, CEO at Pingora Asset Management. Mike is one of the leaders of the mortgage finance industry, particularly when it comes to the world of mortgage servicing rights or MSRs. Pingora currently manages $1.5 billion in MSRs representing approximately $125 billion in unpaid principal balance (UPB) of residential mortgages on behalf of a variety of institutional clients. The IRA: SO Michael, you have been traveling the country, meeting with lenders and investors. What is your take on the US mortgage finance sector as 2018 heads to an end? Lau: I was just in Kalamazoo, Grand Rapids, and Scottsbluff. Yesterday I went into the old Lehman Aurora building in Scottsbluff. They only finished the building in 2007 and, it was Lehman, so it was state of the art. They had two million loans there, blah, blah. It is like walking back in time. Every cube is still there. Every office is still furnished. There are still signs that say Aurora Bank. It is bizarre. And of course, the building is two-thirds empty. Mike Lau and James Tunkey at Leen's Lodge, June 2018 The IRA: In the mid-2000s, Aurora was one of our favorite examples of an outlier among banks at Institutional Risk Analytics. The Lehman FSB was the best performing thrift in the US in 2006 because of the flow of mortgages that went through its conduit. They had 50% equity returns. And then one day it wasn’t there. But turning to MSRs, talk about how you view the steady increase in valuations for loans and servicing over the past year and even the past five years. How do you explain this market to clients and help manage their expectations? Lau: In terms of large, bulk acquisitions of MSRs, the pricing has been driven by a handful of firms that have a relatively insatiable appetite for assets along with very cheap leverage. We exercise pricing discipline in order to manage to the return expectations of our investors. When we re-engineer the pricing on some of these large bulk deals being won by other firms, the way we model and particularly this year, these deals are trading on an un-levered basis at a 5-6% IRR. There is risk on these assets regardless of where interest rates are and because of the credit quality of the book. There’s always risk in MSRs. There are a lot of entities in the market today that are incented to grow because of the way they are compensated. The IRA: We could mention some names, but we take the point. All of the mortgage loan production of the past five years was mispriced thanks to the Fed destroying the risk premium and also the term structure of interest rates. The 10-year Treasury, for example, should have a 4% handle had the FOMC not done QE 2-3 and Operation Twist. Adding leverage does not help. In working on the GNMA MSR Liquidity paper this year, we finally understood the risky tradeoff between retaining the MSR and selling participations in the servicing strip to those same hungry investors you describe. How do you parse that risk? When you have to describe MSR credit risk to investors, how do you talk about retaining enough cash flow from the servicing strip to carry you through periods of higher defaults? Lau: The risk we worry about is rising cost to service due to higher delinquencies in the book. At some point in the next few years we are going to have a mild recession. You are starting to see the real estate markets moderating in many of the hot markets like Dallas and Denver. I was in Dallas last week. The home market above $500,000 in Dallas, which is a nice house, has suddenly gone from multiple offers to none. The same thing is occurring in Denver. We are see indicators that we are approaching an equilibrium between buyers and sellers, and even tilting towards a buyers market. The IRA: You see the same in New York. Our friends at Weiss Research called the turn in some of these markets a year ago, but the broad media is only just catching on because the Case-Shiller average lags the market. How do you think about valuation of MSRs in a market where leveraged financial buyers will hit every target in sight? Lau: We put our best foot forward. Honestly, we tend to lose those bulk deals that are $3 billion or more in UPB, Fannie and Freddie collateral and a discount weight average coupon (WAC). We tend to lose those pools by 10-15bps. We find it hard to rationalize being more aggressive on these deals. The IRA: There seems to be a significant divide between how the sellers and newer buyers see pricing and how some of the more seasoned servicers view the longer-term cost of servicing, especially in the discount coupons. The recovery rates on the $2.5 trillion in bank owned 1-4 family collateral are so good that they mask the credit cost – at least for now (see chart below). Banks are still three quarters of the total servicing book, compared to the 50-50 split with non-banks in the lending sphere. But have we see the end of the large bulk sales of MSRs? Source: FDIC Lau: The larger holders of servicing that did not like the asset have parted ways with it. The banks and non-banks that have the larger portfolios today are the ones who want to keep it and like the asset. They are generally accumulating more through origination or outright purchase. I don’t expect to see a material number of large deals in the near term. When you look at the divide between the banks and the non-banks, there will continue to be non-bank portfolios that range from two or three hundred million in UPB to a couple of billion that will be coming to market. On the origination side, margins are continuing to be pressured and volumes are weak. The purchase money market is going to be down next year. Refis have moderated to what we know is closer to normal, roughly 15-20% instead of what we’ve seen due to the artificially low rates we’ve had for the past ten years. The IRA: You can thank the Fed for that. The Fed manipulated the yield curve and drove a lot of loan volume as asset values rose, but now rising rates are killing demand even as spreads tighten. We suspect that a lot of those low coupon FHA loans, which are assumable, will never prepay. But why are volumes falling with so much accumulated equity, especially for refinancing? Lau: A lot of consumers are loathe to tap the equity in their homes. It is hard to rationalize doing a 4 7/8 or 5% loan today. Pricing is not ideal from a consumer perspective. The low coupon FHA loans will be a great tool for owners when they are ready to sell their house. We really have not seen a lot of assumptions in the past ten years but I believe that we will see an increase. The IRA: What is behind the poor profitability in the mortgage market? Is it the tightness of credit spreads generally or the decline in lending volumes? Lau: I honestly believe that there are two major themes on the loan origination side of the equation, whether we are talking about retail, wholesale or correspondent channels. Loan officer compensation is the elephant in the room that needs to be addressed and it is going to be a challenge. Dodd-Frank dictated how the Congress wants loan officer comp to be done to avoid steering, but it has created some unintended consequences as it relates to implementation. Production has always driven this industry. The better companies are around 100 to 110 bps in terms of loan comp, but the vast majority are around 125 to 150 bps. When you look at the loan officers being paid that much money and the companies that take all of the risk and have their equity at risk are working for a 5 bp margin pretax, that is not sustainable. The IRA: Well, as you just stated, the mortgage industry is essentially paying out equity to retain loan officers. What is the solution? Lau: We as an industry go through this periodically when we are on the downside of the lending cycle. We shoot ourselves in the foot because nobody has any pricing discipline and everyone is focused on maintaining market share. Lenders rationalize this by saying that they will be able to maintain fixed overhead. They hope that eventually, the marginal cost and marginal revenue lines will cross and they will make a lot of money. That is the beautiful thing about mortgage banking on the origination side because when you are in that position, you really make a lot of money. But few lenders are going to reach that point because they refuse to deal with the fixed part of the overhead relative to what realistic volumes are today. The IRA: As in the 2000s, the FOMC stimulated interest sensitive assets and a bubble resulted. You have just described the basic problem with neo-Keynesian economics. The Fed pulls lots of future sales into the present with low interest rates, but then volumes fall when the market demand is exhausted. Look at what is happening to auto sales. Everyone thought we would stabilize auto sales around 16-17 million units annually, but the auto market is shrinking after years of boom time sales growth driven by cheap credit. Lau: At the end of the day, 70% of the costs for most mortgage lenders is people. It is always challenging to cut people. You can look at the other 30% and tighten the belt, but if you are going to make significant cost reductions you have to lay off people. We have overcapacity. This industry is staffed to do $2 trillion in production annually, but we’ll do $1.6 trillion this year -- maybe. The IRA: Is the solution merely headcount reduction or do you have to come up with a new formula for compensating loan officers? Lau: In order to get the industry back to profitability, we must instill discipline around loan officer comp. The problem is that nobody wants to be the first one. If a lender reduces comp by 25 bp, then the better producers are going to go down the road to a competitor. That’s the fear that companies have with their better producers. Obviously lenders cannot collude on loan officer comp, but this is where we need leadership in the industry. You’ve got to have the bigger lenders take the step first. There has always been a differential between the big banks and the smaller non-bank lenders. And then you have Quicken which does not have loan officers and thus has a huge advantage in terms of their ability to price and be profitable. The IRA: Even with the huge television spend and marketing cost you think Quicken comes out ahead of the industry? That tells you that the industry needs to look at that model. What is the second issue affecting profitability after loan officer compensation? Lau: We are a dinosaur of an industry when it comes to IT. We have not effectively used technology. We still have paper files that are an inch thick. We are so slow to adopt any kind of cutting edge technology. You must have the best technology and work flow to be profitable. It is still a very clunky process to originate loans, which is part of the reason that I don’t work on the origination side. I manage a large servicing portfolio with 34 people, but only because we have sophisticated technology that we built to run our business efficiently. The IRA: Given what you are saying about operating costs and technology, is even being in the lending space a good idea? Should smaller players with access to capital be spending to build a loan business right now? Lau: This is the part of the cycle where the strong get stronger. This creates really good opportunities. The weaker are going to go away, either through acquisition or attrition. You will see much more consolidation next year than we saw this year. Production people are always optimistic. They always think that rates will fall and volumes will come back. But even after the rate hikes by the Fed, I still think that we are 50 to 100 bps away from what the natural market rate should be without the influence of the Fed. The IRA: Thanks Michael. Further Reading Zero Hedge: Donald Trump Is Right About The Fed Hedgeye: "Does Fed Tightening Trigger A Crisis?" The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 8, 2018 | This week The Institutional Risk Analyst ponders Q3 ’18 earnings for financials and what other surprises lie ahead. The conventional wisdom on the Street is that higher interest rates are good for banks, but it is higher SPREADS that really matter. Today spreads are contracting as the Federal Open Market Committee forces short term interest rates higher. There is little demand in the market for higher short-term rates, but who needs demand when you have economists? Q: Will the FOMC’s relentless quest for “normal” as defined by the target for Fed Funds cause a liquidity squeeze among non-bank financial companies later this year or early in 2019? The entire Treasury yield curve moved about 25 bp higher in yield last week, a remarkably synchronized shift upward that caused many financial stocks to rise in reflexive response. Apart from an uptick in high yield spreads last week though, the corporate bond complex continues to see spreads grind lower on brisk investor demand (see chart below). And loan spreads, which compete with bond market execution and private equity, are not moving. Meanwhile in the world of non-bank finance, the prospect of rising rates is adding a significant burden on heavily leveraged lenders in the mortgage and consumer finance sectors. Wells Fargo (WFC), Chase and many others are shedding thousands of staff to right size shrinking residential lending businesses. There is already a steady outflow of firms and people as smaller issuers quietly shut their doors. We estimate that a significant portion of the issuers in the GNMA market could be out of business within the year. Last week in Washington we heard some of the biggest non-bank mortgage lenders in the US declare that while not yet concerned about credit quality today, they are very concerned about liquidity in the industry. In particular, the risk of over-leveraged developers of multi-family properties going bust is seen as a clear and present risk. By no coincidence, commercial banks are bidding aggressively for deposit business, well in excess of LIBOR plus 1%. Given that well more than half of the non-bank lenders in the residential mortgage finance space are probably in breech of loan covenants due to poor profitability, low capital or both, the question arises as to whether anyone at the FOMC is cognizant of this growing crisis. Non-banks are, after all, the customers of banks, typically the top 50 or so institutions. We wonder if Chairman Jay Powell and his colleagues on the FOMC will start to rethink the plan for boosting short-term rates further when a couple of large GNMA seller/servicers fail and file bankruptcy. “In years that end with eight -- like 2008, 1998 and 1988 -- we tend to see bad stuff happen,” notes one veteran mortgage banker. “When we’ve seen Treasury yield spreads invert, it is without exception a precursor to a liquidity issue. Today we have a non-bank mortgage finance industry levered a zillion to one with no credit risk, falling volumes and spreads, and no profits. We have to borrow money to make money, so higher interest rates are bad.” One of the things that economists and many investors fail to appreciate is that an increase in the absolute rate of interest in the market raises the overall cost of funds for banks as well as their customers. The rate charged for advances to fund new mortgage loans or to resolve delinquent loans is an important variable cost for a non-bank. Rising rates are a significant negative factor in terms of credit quality for these highly leveraged businesses. Also, the value of mortgage servicing assets can also be negatively impacted by rising funding costs. As readers of The IRA know very well, the costs of funds for US banks is increasing about 55% every 12 months, but interest earnings are rising by single digits. Thus our prediction in The IRA Bank Book that the growth rate of bank net interest income will flatten out and then go negative in 2019. This developing NIM squeeze is another example of the collateral damage caused by the “extraordinary” policy actions taken by the Fed during 2009-2015. What the Fed giveth in previous years, the Fed now taketh away by arbitrarily raising funding costs. We keep wondering why Chairman Powell and other members of the FOMC refer to the current state of US monetary policy as “accommodative” when assets prices in housing, commercial property and stocks are at record levels. And there is still a shortage of assets, real and financial, in technical terms a dearth of duration measured in the trillions of dollars. For this reason, we fully expect the 10-year Treasury bond to take a run at 3% yield between now and the end of the year as markets discount further rate Fed actions. Without an increase in spreads on bonds and loans of all types, it is difficult for banks to reprice their assets to adjust to rising funding costs. Take JPMorgan Chase (JPM) for example. At JPM, less than half of the total book is actually loans. The overall return on assets is dragged down by the relatively low returns on the bank’s bond portfolio. JPM earned 2.1% on its $2.5 trillion in assets after funding costs in the second quarter vs. 3% for the other 118 banks in the US about $10 billion in assets (aka “Peer Group 1” by the FFIEC). The bank earned a little over 5% gross spread before funding costs on its lending book, putting JPM better than three quarters of its peers on loan pricing, with an average almost a point higher than average. The cost of interest bearing balances at JPM was 1.45% at Q2’18, up 40bp since the start of the year. When you ponder the fact that this cost of funds figure could be 2% by year end, then you start to appreciate the enormity of the surprise in store for investors in bank stocks. As of Friday’s close, JPM was trading over 1.6x book value on a beta of 1.1. The Street has JPM delivering single digit revenue growth through 2022, but we suspect that those forward revenue estimates will be revised downward in good time. Of course, the earnings growth estimates are in the 20-30% range, suggesting continued cost cutting. Indeed, a number of Sell Side firms have recently boosted earnings estimates for JPM. The two key factors behind large bank earnings over the past decade are 1) cheap funding from the FOMC and 2) cost cutting. As funding costs for US banks “normalize” from $30 billion per quarter at Q2’18 to over $40 billion by year end, revisions to earnings estimates for JPM and other banks may start to turn downward. Given where interest rates are today, quarterly bank funding costs should continue to climb into the $60-70 billion range by next summer. The chart below shows funding costs and interest earnings for all US banks. When people stare at the numbers for the banking industry and try to guess what is going to happen next, they most often end up talking about the past. Understanding the oscillating cycles of credit, liquidity and market risk is perhaps more important. At present, high home prices and low loan to value (LTV) ratios provide a buffer for banks and investors against credit risk. We don’t expect to see significant credit losses on residential assets in the banking system for several more years. But there is considerable liquidity risk building in the financial markets as the FOMC continues its clumsy path toward normalization. Former Fed governor Kevin Warsh is right: the FOMC should have reduced the balance sheet before raising the Fed Funds rate. Past actions by the US central bank have distorted traditional indicators of credit demand, raising the possibility that market conditions actually are tighter than policy makers may suppose. Inverted yield curves may not predict recessions, but they do serve as a great indicator of liquidity risk events. 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.

“Political economy is not a science, it’s a clinical art, like medicine.” Eliot Janeway (1913-1993) October 3, 2018 | In this issue of The Institutional Risk Analyst we speak again to an old friend, William H. Janeway. Bill is a Managing Director and Senior Advisor of Warburg Pincus, and now a lecturer at Cambridge University, where he received his doctorate in economics as a Marshall Scholar. Our discussion with Bill back in 2009 (”New Hope for Financial Economics: Interview with Bill Janeway”) was one of the most popular discussions ever published in The Institutional Risk Analyst. He just published a new edition of his important book “Doing Capitalism in the Innovation Economy” We spoke with Bill over lunch at The Lotos Club in New York. The IRA: Bill we loved your book when it came out half a decade ago, but the new edition is even better. Financial pros need to read the discussion of the remarkable series of deals and technologies you worked on over the years. With the benefit of time, talk about how you view the evolution of what you have called the “Three Player Game” between Markets, Speculators and the State? The role of the State seems to be diminished or, as you said, delegitimized as technology has created a new cadre of super corporations. Janeway: There are several elements, and you can trace causal relationships without being mechanistic about it. One is clearly - always in tension - the spillover from the marketplace into the distribution of political power. I talk about this more in the new edition because it is so evident. The IRA: Very clear, but nicely put. Janeway: I refer a lot to the work of Larry Bartels at Princeton who has written a great book called “Unequal Democracy.” For the past two hundred years, since President Andrew Jackson, we have had the coexistence of two sets of institutions, the marketplace and an open political process. Each has certain claims to legitimacy in terms of allocating resources and distributing the return on those resources. It does appear that over the past 30 years we’ve had a shift in the balance of power of the Three Player Game. with the marketplace having a greater weight than the political process than any time since the 1920s or even the pre-progressive era, the 1890s. There is some great work being done in this area. I always like to provide reading lists. The IRA: Would that there was more time to go through all of the wonderful footnotes in your book. You are very generous with your praise of good work. For example, in your book you have a wonderful quotation from Fernand Braudel: “Capitalism does not invent the market or production or consumption, it merely uses it.” Janeway: The noted historians Naomi Lamoreaux and William Novak co-edited a great set of essays in a volume published by Harvard entitled “Corporations and American Democracy.” The book contains a deep history of the evolution of the 14th Amendment and goes through generations of Supreme Court opinions. The second focus of the new edition is the unanticipated consequences of the digital revolution that I talk about at length, for example, namely the rise of the giant, “superstar” digital firms. Here the reference is to the work led by David Autor at MIT, showing that across all of the four digit SIC codes across industries there has been a material increase in market concentration. The top four firms account for a larger share of the market, and this is accompanied by an increase in profit margins. Despite important questions about how we measure profits, the apparent markup enjoyed by these firms suggest that they are able to capture rents. The IRA: Of course. We don’t enforce antitrust laws in the US, as evidenced by the banking sector. The largest banks grew after 2008, depositors and creditors saw their share of the interest earnings of banks cut by 90 percent thanks to the FOMC, and thereby fueled public anger and resentment against Wall Street that you describe in the book. Janeway: David Autor’s biggest contribution may be showing a visible decline in labor’s share of revenues across SIC codes. And then you have to go back through the Game to look at the enormous impact over a long generation through the 1970s of the triumph of the Mont Pelerin Society as translated into economic theory and political prescriptions mostly at the University of Chicago. In the broad political domain, Milton Friedman's book and TV series “Free to Choose” translated into Ronald Reagan saying in 1981 that “government is not the solution…,government is the problem." These ideas were deeply reinforced and rendered not just intellectually legitimate but politically powerful. Like the rise of the efficient market hypothesis and the rational expectations hypothesis, which pervaded the economics profession, we accepted that markets would deliver a solution that is both efficient and fair, and also stable. So the message was that the only economic role for government is to screw up markets that would otherwise be fair and efficient and stable. The IRA: Well 2008 seems to have refuted that idea pretty conclusively. Janeway: From the perspective of the economics of innovation, the field I am most concerned with, the idea of a marginal role for the state is a recipe for at best stagnation and at worst a freeze-frame. Without an entrepreneurial role for a mission-driven government legitimized, to make investments, innovation suffers and so does economic growth. The IRA: Just as banks do not fund risk investments, but instead this is the role for private equity, some investments like space exploration are too large for private capital, at least initially. Janeway: The third related factor in the dark side of the Three Player Game is the institutionalization of the market. With the dominant portion of investment cash being managed by people on behalf of other people, who must hit at least the same performance as the broad indices, there is an endogenous tendency toward short-term herding behavior. Connected with that was the idea that we could address the “agency problem” between management and owners by turning managers into owners by giving them lottery tickets in the form of stock options. Back in the 1970s, we called it “Silicon Valley socialism." If you wanted to induce a senior executive or engineer or anyone else to leave the safe harbor of Hewlett-Packard, you had to give them tickets to the lottery. Most tickets to the lottery and most stock options are never exercised because they expire worthless. A startup is one thing, but giving stock options to the managers of stable public companies with secure market positions is, I believe, a crime against society. I have sat on enough public company compensation committees to know that the directors all look at one another and say “we have a great management team.” It is the Lake Wobegon phenomenon where everyone is above average. The IRA: Get no argument from us. The agency problem is pervasive throughout American society. And the public shareholders or corporations have no effective way to limit executive compensation. But even large unicorns cannot escape from the law of cash flow. As your friend Fred Adler said: “Corporate happiness is positive cash flow.” But how are these changes affecting investment and thus innovation? Janeway: We’ve currently got an Administration in Washington that has decided that science and the use of science to generate evidence is in no way concerned with public policy. Cutbacks in the flow of information and dollars to support scientific research will have a significant impact on future innovation. The other piece of this, which at team at Duke led by Wes Cohen and Ashish Arora have researched extensively is the shortening of research time horizons for American corporations. They track how company-employed researchers have shifted away from publishing in science journals to putting their work in trade publications as a proxy for development funding. The IRA: So coming back to The Three Player Game, do you see any promising developments in the world of “artificial intelligence?” We have largely written off crypto currencies and blockchains as a dead end. We put quantitative models used in economics in the same bucket, but are fascinated by the particular. In your book, you alluded to using computers to do what computers do well, namely count, as opposed to trying to model human financial behavior or speech or whatever. Where is AI now vs when you began your work four decades ago? Janeway: I have been a student of AI since the 1970s when I got involved with Xerox PARC. Since 2008, we have seen speculative capital focused on extending the digital domain, the digitization of all things, and machine learning techniques applied to what is genuinely unique, which are these very large data sets. This is really the third wave of computer techniques being hyped as artificial intelligence. First was the 1960s when DARPA funded some of the earliest AI research in an example of effective state support. Then came expert systems in the 1970s and 80s. Now we have Machine Learning based on “deep networks”. Clearly there are applications where it can be very powerful, but based on my research and discussions with many people in the field, AI systems seem to be very brittle. They are subject to the implicit and explicit bias of the people who set up the training set. The IRA: That has always been the Achilles heel of search engines. Is it fuzzy and forgiving? Or does the search engine require a precise match? Obviously a huge area for military and intelligence research. What is AI good for commercially? This is not “simulated cognition” quite yet, is it? Janeway: AI systems seem to be good at pattern recognition when they have been properly trained as to the pattern in question. They are good at playing games where the rules of the game are given exogenously such as in chess or go. They are good at that. But the games that really matter, like the Three Player Game, are those where we must co-invent the rules as we go along. For example, in any conversation, even with people you know well, you are constantly trying to understand the context of the words used by the other speaker and vice versa. The IRA: Speaking of changing the rules as we go, how do you feel about the various unicorns in the market today that are violating Fred Adler’s rule about positive cash flow and happiness? Janeway: While the unicorn bubble along with crypto-mania has absorbed animal spirits and speculative fever and more money than will of course be realized in due course by the investors, what is missing is the dynamics in this country of applying what we learned in the 1950s and 1960s about creating a new, low-carbon economy in response to climate change. When Richard Nixon declared “war on cancer”, he mobilized the same dynamic as in any war, the suspension of prospective cost-benefit analysis at National Institutes of Health. What matters is being effective, not efficient. The NIH grew by a factor of ten and the new industry flourished. The entire genetics, genomics and biotechnology revolution came out of President Nixon declaring war on cancer. There is a nation state with a legitimate government that has taken climate change as the next category for massive state investment, and of course that is China. The big question facing the US is whether another nation will take the mantle of innovation leader in the 21st Century, much as the US took the lead from Europe in the early part of the last century. The IRA: Thanks Bill 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.

September 3, 2026 | For the past century going back to before the first World War, the credit standing of governments has stood at the apex of finance, with private obligors in a secondary position. But now, with the major nations of the G-20 slouching toward some sort of debt restructuring or even default, it may be time to consider a world in which gold, silver and other physical assets will be far more valuable than any national fiat currency. When the price of gold or other physical assets rise what is really happening is that the value of fiat currencies is falling. The rout ongoing in the bonds of the various industrial nations suggests that the dollar and all of its subsidiary currencies are in big trouble. Yet none of these democratically elected governments are willing to take steps to arrest the decline in their credit standing, namely raising taxes and reducing public spending. Treasury Secretary Scott Bessent buys long-dated Treasury debt and funds this operation with T-bills, yet he is not so much pushing down on LT yields as he is struggling against rising prices for gold and real commodities. The LT increase in the price of gold is a stark refutation of the fiscal position of the United States going back to the New Deal. Rising gold prices suggest that investors may soon be experiencing another prolonged dose of financial repression. The chart below of the Financial Repression Index shows the portion of bank interest earnings that goes to equity rather than debt. In 2020 when the Fed utilized quantitative easing (QE) to force interest rates down, over 90% of the total interest income of banks went to equity instead of depositors and other creditors. And of course, the major beneficiary of QE was the US Treasury. In 1984, most bank interest earnings went to depositors and bond holders. Source: FDIC/WGA LLC When the Treasury under Secretary Bessent buys back long-dated debt and issues T-bills in a futile effort to force down LT yields, we are reminded of the equally inane policy of Treasury Secretary Janet Yellen and “Operation Twist.” Bill Nelson at Bank Policy Institute wrote last week: “The Treasury is currently buying back long-term debt and funding it by issuing bills in an attempt to lower long-term rates. Viewed from a consolidated balance sheet perspective, that’s essentially what the Fed did with QE. If short-term rates rise more rapidly than currently expected, we will look back on the Treasury’s decision to engage in the buybacks and calculate how much it cost taxpayers.” Of course, the lesson we are all learning today is that the short-term machinations of the Fed or Treasury in the debt markets don’t really matter when it comes to yields on government debt. Smart investors who do the math on future deficits at higher interest rates realize that the US must eventually default on and restructure debt, which is why investors are running away from Treasuries and other G-20 public securities. American Weimar The truth of the matter is that a 5% yield on the 10-year Treasury is “normal,” but it also suggests that a US debt default is approaching far more quickly than most observers care to admit. What happens when market yields go higher and the US Treasury can no longer refinance debt? American history suggests a Weimar Republic scenario, named after Germany's first constitutional democracy (1918-1933). The US government will simply continue to emit unbacked paper currency until it becomes entirely worthless. Indeed, the movement of the global bond markets in recent weeks suggests that market yields on public debt are still too low. As market yields rise, the G-20 governments will soon be forced to embrace financial repression in order to avoid an immediate default. In the event, the Federal Reserve Board will become the instrument of financial repression. Banks, 401(k) plans and all savings may be required to hold government debt at artificially low yields as was the case during WWII. America has been in what Hyman Minsky called the Ponzi phase of finance since the 2008 financial crisis (See “AI, Debt & the Death of Fear”). The fact that the two major political parties in the national Congress responded to 2008 with trillion dollar fiscal deficits tells you all you need to know about the future of the dollar. Meanwhile, US officials talk about the “strength” of the US economy without mentioning that we are running a budget deficit of 6% of GDP. The US economy would be a lot slower given a balanced budget, but interest rates would be far lower. How do we fix the fiscal crisis? Cut the federal budget deficit in half every year. Equity markets would soar and interest rates would plummet. The end of the dollar system that has prevailed since WWII is not just about the dollar but will engulf all of the currencies that are tied to it. The “winners” of sorts will be states such as China and Russia, which have been accumulating gold and already function outside of the dollar system. Yet neither of these mercantilist dictatorships will thrive in a world without a common exchange medium. Gold: One Measure This summer we’ve been working on our next book, tentatively titled “Gold: One Measure,” this after the command in Deuteronomy. We first wrote about this remarkable rule in our collaboration with Fred Feldkamp: "Financial Stability: Fraud, Confidence and the Wealth of Nations." One of the things about working on a book about gold is that it reminds you that America is not the first sponsor of a global currency and it will not be the last. When FDR seized the privately owned gold of Americans in 1933, he began a process of currency debasement and inflation that has only accelerated over the intervening decades. The fiat dollar system that was created from the ashes of WW II was an anomaly, especially when you have an increasingly irrational, progressive democracy at its center. In "Denationalisation of Money," published by the Institute for Economic Affairs in 1976, F.A. Hayek warned that money was “too dangerous an instrument to leave it to the fortuitous expediency … of politicians—or, it seems, economists.” Rather, “our only hope for a stable money is indeed… to protect money from politics.” The impending demise of the dollar as the world's default currency threatens the world with an extended period of economic disruption and political chaos. In its place, we will likely see a new global standard for value based upon gold. Ponder the decline of organized trade and finance in Western Europe in the centuries following the fall of Rome in 476 AD and you get the idea. Next week, we’ll be running Part II of our discussion with David Kotok where we talk about the reemergence of gold as the paramount global reserve asset and the rise of China’s gold based payments system as an alternative to the dollar. 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.

September 30, 2018 | Last week we almost welcomed the news that the Securities and Exchange Commission had accused Tesla Motors (TSLA) founder Elon Musk of securities fraud. This is not because we hold any ill will towards Mr. Musk, but rather because news of the SEC action provided some relief from the political spectacle that dominated the past week. Speaking of real news, we were on CNBC Monday to talk financials with Brian Sullivan (below). Fortunately Mr. Musk was smart enough to cut a deal to settle the SEC charges on the following day, but that changes little for the hapless shareholders of TSLA. After years of false promises and worse, TSLA seems headed for a reckoning as a dearth of liquidity forces more difficult decisions. Access to liquidity provides time and protects control. As we said on Twitter over the weekend, the bond holders of Tesla own the company -- regardless of whether Musk is an officer of the company or not. But moving on to more promising considerations, we return to the question of the evolution of Goldman Sachs (GS) from securities dealer to commercial bank as the firm prepares to go through a leadership change. The leadership transition process at Goldman is not unlike a reptile shedding its skin. The century old firm gains a glossy veneer, a new outer shell, but inside the operational machinery of financial chicanery remains unchanged. Does it matter whether Lloyd Blankfein or David Solomon sit at the top of the house built by Marcus Goldman or Samuel Sachs? Not really. After all, the culture of Goldman Sachs is bigger than any single person. Goldman has always been a firm that seeks unique opportunities at the edge of propriety and often at the expense of clients and counterparties. Between July 2004 and May 2007, according to the Financial Crisis Inquiry Commission, GS packaged and sold $73 billion in synthetic collateralized debt obligations (CDOs) that referenced subprime mortgages. When the subprime loan market and related derivatives began to collapse, Goldman deliberately sought to shift its exposure to its clients. “Despite the first of Goldman’s business principles—that ‘our clients’ interests always come first’—documents indicate that the firm targeted less-sophisticated customers in its efforts to reduce subprime exposure,” the FCIC concluded with considerable understatement. In the Abacus 2004-1 CDO, the FCIC reported, GS earned nearly $1 billion while “long investors lost just about all of their investments.” As we’ve noted previously in The Institutional Risk Analyst (“Is Goldman Sachs Really a Bank? Really?”), GS is not so much a commercial bank as much as a large broker dealer with a small depository attached. In the decade since GS involuntarily converted its Utah non-bank industrial loan company into a commercial bank, and thereby came under the supervision of the Federal Reserve Board, the firm has become less innovative, if that is the right word. But the core competency of the firm remains informational arbitrage combined with all of the magic of derivatives and structured finance. For example, GS makes half the interest income of other large banks on its almost $1 trillion in total assets, just shy of 2% vs over 4% for the 119 members of Peer Group 1. GS is in the 90th percentile in terms of interest expense vs earning assets, a reflection of the bank’s tiny deposit base and dependence upon costly market funding. Of note, GS saw its cost of funds rise 68% year over year as of June 30, 2018, according to the latest FFIEC performance report, following the disturbing trend in the US banking industry of rising funding costs that we have highlighted previously. Indeed, when pondering the future under incoming CEO Solomon, ask yourself how much is Goldman Sachs willing or able to change its culture. To us, the first question facing Solomon and his colleagues on the board of GS is whether the company ought to reverse the 2008 decision to become a bank holding company and return to being a broker dealer that owns an industrial bank domiciled in Utah. If Goldman is to remain a trading firm, rather than a full service depository, then this would be the logical course of action. Support our Team in the Fight Against MS! For many years, there has been a lot of talk at GS about growing the existing bank’s business, but this has not materialized in assets, revenue and earnings. Just as Elon Musk has promised electric cars for his clients, GS has promised banking revenue for its shareholders. The bank was even given a name – Marcus – after firm co-founder, Marcus Goldman. GS has always been better at formulating investment schemes to deprive the less astute of their hard earned savings than lending them money for some productive purpose. Consider the Shenandoah and Blue Ridge investment trusts of 1928, a precursor of the derivatives mess at American International Group (AIG) in 2008. John Kenneth Galbraith in his essential book “The Great Crash 1929” wrote that Goldman’s nearly simultaneous promotion of Shenandoah and Blue Ridge in 1928 “was to stand as the pinnacle of new era finance. It is difficult not to marvel at the imagination implicit in this gargantuan insanity.” Galbraith immortalized the subsequent 1932 exchange between Senator James Couzens of Michigan and Samuel Goldman, the co-founder of the firm, during hearings on the market crash: Senator Couzens: Did Goldman Sachs organize the Goldman Sachs Trading Corporation? Mr. Sachs: Yes, sir. Senator Couzens: And it sold stock to the public? Mr. Sachs: A portion of it. The firms invested originally in ten percent of the entire issue for the sum of $10,000,000. Senator Couzens: And the remaining 90 percent was sold to the public? Mr. Sachs: Yes, sir. Senator Couzens: And at what price? Mr. Sachs: At $104. That is the old stock… the stock was spit two for one. Senator Couzens: And what is the price of the stock now? Mr. Sachs: Approximately $1¾. The fraud perpetrated by GS with respect to Shenandoah and Blue Ridge was monumental, but none of the firm’s principals did any jail time. Yet it took the great Goldman Sachs managing partner Sidney Weinberg decades of labor in corporate boardrooms and the salons of Washington to redeem the sins Goldman Sachs committed in the 1920s. By the time that Lloyd Blankfein took over as CEO in 2006, Goldman was as respectable as any investment bank – admittedly not much of a statement. But then as now, the business today is about arbitrage and sales, not the lending and credit management of commercial banking. If GS really has no intention of growing a commercial banking business, then why not save millions of dollars a year and simplify the firm’s regulatory structure by de-banking? The same comment goes for Morgan Stanley (MS), of note. If GS is really not serious about building a large depository business to go alongside the investment bank, then there is no point in dealing with the Fed and several other federal regulators. If, on the other hand, GS does truly want to become a full service bank, then Solomon and company need to consider a combination with an established regional depository, a bank that has core deposits and also has a commercial lending business. A wealth management business would be desirable as well. There are a number of possibilities including: Keycorp: With $138 billion in consolidated assets, Keycorp (KEY) is a solid regional bank headquartered in Cleveland, OH. The stock trades at 1.5x book on a beta of 0.9, so below market volatility for a stable business. But more than just a retail business and a $100 billion core deposit base, KEY is a significant national lender and has a strong position in financing and servicing commercial real estate – a sector that GS knows well. First Republic Bank: At $88 billion in total assets, this San Francisco based state-chartered unitary bank has carved out a profitable niche in wealth management and prime mortgage originations. First Republic Bank (FRC) has $66 billion in core deposits, $5 billion in fiduciary assets and another $12 billion in custody and safekeeping assets, and $21 billion in off balance sheet securitizations. And FRC competes head-to-head with Wells Fargo (WFC), JPMorgan (JPM) and Bank of America (BAC) in the prime jumbo channel, another asset class that Goldman knows and loves. At over 2x book value, FRC is not cheap – but then again, neither is GS at 1.1x book. Now of course the big question is whether the Fed and other regulators actually would allow the folks at GS to acquire a real bank with retail deposits. Some would argue that a decade after the financial crisis, GS has already lost much of the recklessness and “innovative” vision that characterized the firm’s market actions prior to 2008. Acquiring a large depository might help Goldman finally leave behind the bad old days and complete the transition to true mediocrity under the vigilant gaze of federal bank regulators. But somehow we think that GS under its new leadership will continue to focus on trading and investments, not commercial banking. Banking is about patience, prudence and care. Leaving aside the fact that GS resides at the bottom decile of Peer Group 1 when it comes to Tier One Capital, the idea of the masters of the universe making loans to consumers and managing credit seems too far fetched. Just as the Guardians of the Galaxy would never forsake their heritage as ravagers, the traders and bankers at Goldman are all about being smarter than everyone else. Better for Goldman to stay true to the proud legacy of Blue Ridge and Shenandoah, Penn Central and AIG Financial Products, ABACUS and Timber Wolf. In those glorious transactions, where the firm put its own interests ahead of those of its customers and counterparties, it proved that they will never really be bankers. Further Reading “YOU CAN’T OUT-LLOYD LLOYD”: AT GOLDMAN SACHS, THE DAVID SOLOMON ERA BEGINS WITH SUBTLE BUT SIGNIFICANT CHANGES William Cohan | Vanity Fair 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.

September 26, 2018 | Q: How do you say “black swan” in Norwegian? A: sort svane. But hold that thought for a moment. Last week readers of The Institutional Risk Analyst probably did not notice the failure of a small NASDAQ clearing member in Scandinavia. The dollar amount of the default event was relatively small, but the details are disturbing in terms of the use of hidden leverage in the trade and the potential risk to central counterparties (CCPs) such as exchanges. The NASDAQ made the following statement: “On Monday September 10, 2018, the markets in Nordic and German power experienced an extreme movement in the spread. One of Nasdaq Clearing´s members had a portfolio containing a large spread position between Nordic and German Power that was negatively impacted by the fluctuations.” Negative indeed. We hear in the credit channel that the “private trader” leveraged his spread position multiple times, then doubled down again before the trade went sideways. The “relevant clearing member” was unable to meet a margin call, says NASDAQ, so the exchange saw the position closed out and liquidated at a loss. The exchange replenished the default fund via a $107 million euro assessment of the other clearing members. NASDAQ also stated: “When analyzing the data of the event, we concluded that the market movement leading to the extraordinary fluctuations in the defaulted portfolio´s spread was 17 times larger than the normal observed daily spread changes. This has also been confirmed by two external parties, and has been characterized as a true ‘Black Swan’ event.” Somebody call Nassim Taleb. Meanwhile, the aftermath of the NASDAQ default event played out in a lot of overtime for credit managers at a number of major US banks. The speed and suddenness of the event of default, which was apparently caused by excessive leverage in the trader's position, suggested that existing risk tolerances were at fault. But was there any way to even anticipate this market contortion? Did the NASDAQ surveillance function notice the over-leveraged position? Support Our Team for BikeMSNYC! You can of course say that the NASDAQ did their job, closed out the position in good order and passed the hat to the surviving clearing members to replenish the default fund. But the reality of the situation is far more complicated. When NASDAQ liquidated the positions, for example, the exchange had to use its own capital to close the positions. Had multiple clearing members failed at the same time, the thinly capitalized NASDAQ would have been under water. Not long ago the Research Department of the FRBNY posted a comment in the Liberty Street blog praising the manifold blessings of centralized clearing: “First, central clearing allows trades to be netted across all CCP members, lowering net settlement exposures and thereby reducing counterparty credit risks. Second, CCPs employ loss-sharing mechanisms that spread the cost of a member default across all members, thereby lowering the burden of default on any one participant. Third, the clearing process at a CCP is transparent and uniform for all CCP members, which reduces the uncertainty over potential losses owing to counterparty default.” Our colleague Nom de Plumber, a veteran of the world of credit and counterparty risk who appreciates a good bottle, begs to differ. He notes that the socialization of clearing-member counterparty losses “invites both adverse-selection and moral-hazard risks.” He continues: “Low regulatory credit-risk capital requirements (2% to 4%, per US Basel Rule Section 35) for counterparty exposures to CCPs seem hardly to suffice for or even acknowledge such risks, which gap market movements can materially exacerbate.” We agree with a number of our colleagues in the world of credit that while the Scandinavian default event last week was relatively small in terms of dollars, the large magnitude move in the position of a single trader forced the NASDAQ to use its own capital to fill the gap until the clearing members kicked in their share the following day. The loss sharing among clearing members is not instantaneous or equitable, thus the exchange must have capital of its own when a clearing member fails, otherwise the supposed benefits of CCP are an empty promise. One credit manager at a large bank told The Institutional Risk Analyst that the default process “did not work as entirely hoped.” He notes that the NASDAQ is getting a lot of questions from clearing members about the margin process and the auction of the position. One trader says that the NASDAQ did not notify some clearing members of the default for several days. “The lessons learned from securitizations and CDOs in terms of first loss waterfalls and the sequential failure of obligors do not seem to have translated into the world of centralized clearing," notes the veteran credit portfolio manager. "Are all clearing members equal? Are JPMorgan and the smallest clearing member that trades one product equal in terms of first loss? In this case, first loss was not properly assessed." Nom de Plumber agrees and notes that the one-size-fits-all process of CCP margin calls may also be a weakness, especially if non-member counterparties inject idiosyncratic counterparty risks---which can then be socialized to member counterparties, perhaps spawning systemic risk. He observes that the recent NASDAQ counterparty default loss may be an example. The FRBNY says that “CCPs employ loss-sharing mechanisms that spread the cost of a member default across all members, thereby lowering the burden of default on any one participant.” Perhaps. What the default of the NASDAQ member last week seems to illustrate is that a significant market move can take down a clearing member in an afternoon. Had the position been larger, a 10x standard deviation market move could have impaired the capital of other clearing members as well. Regulators take great comfort in the idea of centralized clearing, but a thinly capitalized exchange and clearing members may not provide much surety against contagion regardless of how the mutual clearing regime is labeled. The bottom line is that there is not much different between how centralized clearing exists today and the mutual exchanges that existed prior to the creation of the Federal Reserve System in 1913. As former Fed Chairman Ben Bernanke has noted in his research, sometimes exchanges die (see below). Further Reading Asset-Price "Bubbles" and Monetary Policy 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.

September 19, 2018 | The term financial technology or “fintech” was reportedly coined back in the 1980s by Peter Knight in The Sunday Times, but from the start the buzzword carried political connotations. Banks are among the most protected industries, thus seeking to displace banks is by definition treasonable. Some media and investment circles joyfully described fintech as an alternative to big banks, especially following the 2008 financial debacle and bailout. Big banks are bad, so the post crisis consensus goes, thus smaller, new fintech firms perhaps are a good solution. With the innovation of technology, however, come all the perennial problems of modern finance. Bitcoin, blockchain and fintech all were dipped in the magical waters of salvation via technology, yet much of the time these “emerging” technologies and companies are just plain vanilla. Along with alternative money a la bitcoin, fintech has flourished into a new investment sector, at least in a virtual sense. When you actually peruse the growing list of firms that claim to be part of the fintech vanguard, very few of them actually bring new technology or even new business models to the table. Mostly fintech firms add efficiency and value on top of the old world of banks, which is naturally protected by regulation. The existing bank monopoly on credit and payments, as when a bank clears the payment you make on Amazon (AMZN), is a powerful barrier to entry for fintech firms. For the past several years, New York and other states have been battling with the Office of the Comptroller of the Currency (OCC) over that agency’s plan to offer “fintech” charters to online lenders and payment companies. The states lost the first round of litigation with the OCC, but now New York has just filed a new complaint, again arguing that the OCC’s fintech charters are unconstitutional and an affront to consumers. This fight between the OCC and the states is all ultimately about consumer politics and money. New York’s latest lawsuit reads more like a political manifesto than a serious legal argument as to the OCC’s long ago settled powers under the National Bank Act of 1865. The 2010 Dodd-Frank law gave back to the states significant powers in terms of federal preemption and the ability to bring enforcement actions under state law against national banks. But naturally the states and their political officials, who like the idea of levying big fines on financials firms, want more power. Maria Vullo, superintendent of New York’s Department of Financial Services, called the July 2018 decision by the OCC to let fintech firms obtain charters “lawless, ill-conceived, and destabilizing of financial markets,” reports Reuters. Spokesman Bryan Hubbard said OCC would vigorously defend its authority to grant national charters to qualified companies “engaged in the business of banking.” The OCC plans to allow “fintech” companies to operate under a national charter, thereby potentially replacing 50 state regulators and 50 state attorney’s general with a single federal watchdog in terms of activities. Also, fintech banks would still be regulated by the Bureau of Consumer Financial Protection. Significantly, these limited purpose OCC chartered fintech banks would not be depositories and would not offer deposits or have FDIC insurance. The OCC’s fintech charter offers a non-bank lender or mortgage company a way to avoid state law regulation entirely, but not be a full bank in terms of taking deposits or access to the payments system. Of interest, the OCC just announced preliminary approval for Varo Bank, a full service depository focused on consumer lending. It is notable that Varo Bank is sponsored by private equity firm Warburg Pincus, which has had a string of successful bank investments over the past decade. The firm’s counsel, Sullivan & Cromwell, notes that Varo Bank did not seek a fintech charter but instead sought full bank powers. “Rather, this approval relates to a full-service national bank charter with a nationwide ‘footprint.’ However, this approval, we believe, will be indicative of the OCC’s approach to applications by fintech businesses for special purpose charters.” Varo Bank was chartered by the OCC and approved by the FDIC in terms of federal deposit insurance, but no approval from the Fed was required or sought. Because Varo Bank is a national association chartered by the OCC and since there is no bank holding company, the Fed does not have any direct regulatory authority. Avoiding regulation by the Fed greatly reduces operating and compliance costs for “unitary” banks such as Bank of the Ozarks (OZK) and Signature Bank (SBNY). The developments with Varo Bank and Square, among others, are indications of evolving regulatory arbitrage between state and federal regulation more than the wonders of new technology. The harsh, often arbitrary actions of state regulators have greatly increased operating costs in all consumer facing credit lines and especially in the mortgage sector. Regulatory expenses can sometime exceed loan servicing fees in smaller states, for example, making mortgage lending is those jurisdictions problematic over the longer term. Fintech Bank vs ILC? One of our favorite LT equity holdings is Square (SQ), a payments processor that has created a very profitable niche by disrupting the bad old world of bank vendor accounts for small businesses. With considerable effort, Square pushed its way into the big bank world of payments, even without owning its own set of “rails,” but is Square a “tech” firm? Not so much. Square does not create new technology, but they make use of existing technologies in ways that never occurred to big dumb banks. In the context of the fintech wars between state and federal authorities, Square is significant because they have expressed interest in obtaining a bank charter. Specifically, the non-bank payments processor is reportedly preparing to apply for federal deposit insurance for a Utah industrial loan company (ILC), according to American Banker. FDIC Chairman Jelena McWilliams is said to be prepared to consider new applications for industrial banks aka "ILCs." FDIC officials have reportedly encouraged applicants to file “robust” applications that fully address safety and soundness concerns. While several states offer ILC charters, new entrants would likely select Utah chartered ILCs with FDIC insurance that can both take deposits and make loans. As readers of The Institutional Risk Analyst may recall, SoFi started down road to get an ILC charter but had to withdraw its application due to management turmoil. In the range of potential options for non-banks seeking to become a depository, an ILC seems superior to both a national bank and a thrift because they do not come under regulation by the Fed or OCC. Fewer regulators equals lower cost. A mortgage lender like Quicken or Caliber, for example, would not be considered bank holding companies by owning an ILC. Late vintage banks such as Goldman Sachs (GS), American Express (AX) and Morgan Stanley (MS) used to own ILCs before converting them to full bank charters during the 2008 financial crisis. An ILC would give non-banks access to both state law preemption for lending and servicing, and the ability to take deposits. Why is this important? Two reasons: First, the value of the float generated from the deposits created through lending and servicing consumer loans is growing every day. Second, a war is raging over the efforts by federal regulators to give non-bank financial firms a way to escape the noose of state law regulation. So why wouldn’t a mortgage servicer or auto loan issuer want a fintech bank charter? They might. But the more interesting and relevant pathway for many fintech and consumer finance companies to become banks is the ILC. By creating an industrial bank, consumer finance firms can enhance profitability and reduce operating costs while greatly simplifying regulatory and compliance tasks. An ILC typically is a state-chartered banking institution that functions in almost every way like a commercial bank. ILCs may make all types of loans and, most important, have access to the national payments system. If an ILC has more than $100 million in assets, it may not accept demand deposit accounts (DDAs). Larger ILCs may, however, offer NOW accounts, MMDAs, fiduciary and time deposits (CDs). Today industrial loan companies and industrial banks are FDIC-supervised, state-chartered financial institutions that are owned by commercial firms but not subject to supervision by the Federal Reserve Board and the non-bank activities limitations under the Bank Holding Company Act. The FDIC implemented a moratorium on granting new ILC charters in 2006 after the Federal Reserve Board and, later, the FDIC expressed policy concerns with the control of insured banks by large commercial firms, specifically WalMart (WMT). Section 603 of Dodd-Frank reflected the same policy concerns by Congress and put in place a statutory moratorium, but that freeze expired in 2013. The underlying provisions of law permitting control of ILCs by commercial and financial firms remain in effect. After a decade long hiatus, new players are seeking to own ILCs. If FDIC is indeed ready to process new ILC applications from financial firms, as opposed to commercial companies, then every well-managed and capitalized consumer lender and mortgage servicer in the country should be preparing an application. Is it time to consider turning your mortgage company or consumer lender into some sort of bank? Yes. But the ILC route rather than the OCC chartered fintech bank may be the optimal path. Contact us if you wish to discuss. Further Reading New York sues federal government over fintech bank charter plan Housing Wire 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.

9/13/2018 | People keep asking what we think of the 10-year anniversary of the collapse of Lehman Brothers. Our answer is that not much has changed. Lehman once had the best performing bank in the US and then it was gone. Why? Fraud on loans and securities. Fraud in different forms still prevails in the world of investing, but has migrated from banks to non-banks like funds and BDCs, and of course structured securities. Derivatives are the enablers of fraud. That is the core lesson of the 2008 financial crisis, but a truth that is rarely discussed. Instead we talk endlessly about "capital" as though it matters. Saying banal, irrelevant things about the anniversary of the Lehman failure certainly helps to fill an otherwise empty media void. But we never, ever talk about the true cause of the crisis, namely securities fraud by some of the biggest firms on Wall Street. These bankers and firms were not punished, thus we remain at risk. Not only has nothing changed since 2008, but as in 2006, we have convinced ourselves that everything is just fine. Residential and commercial real estate valuations have gone crazy since 2010, but everything is fine. Just remember that the financial crisis of 2008 really began in 2005 when Countrywide and Washington Mutual began their slow motion collapse, like a small rock slide at the top of a mountain. By 2006 the mortgage market was slowing -- as it is today -- and smaller non-bank firms were collapsing under the double whammy of falling volumes and rising costs. When New Century Financial and Long Beach collapsed in 2007, regulators were approached about the coming contagion, but nobody at the Fed or other agencies believed it. By 2008 came the avalanche. We identified the cause of the subprime crisis a decade ago in a paper published by Indiana State University entitled: "The Subprime Crisis: Cause, Effect and Consequences." We argued that three basic issues were at the root of the problem -- issues that remain unresolved today. First was an odious public policy partnership, spawned in Washington and comprising hundreds of companies, associations and government agencies, to enhance the availability of affordable housing via the use of creative financing techniques. Second, federal regulators have actively encouraged the rapid growth of over-the-counter (OTC) derivatives and securities by all types of financial institutions. And third, also bearing blame for the subprime crisis is the related embrace by the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board of fair value accounting. Again, nothing has changed in a decade. Most of the "sales" of securities done on Wall Street are not true sales at all. For example, how does a lender transfer the ability-to-repay (ATR) risk in a prime, non-QM mortgage to an end investor? Ben Bernanke, Hank Paulson and Tim Geithner are heroes and the regulators will save us next time. Click here to read the paper on SSRN. Further Reading Why Rising Interest Rates Are Not Always Good For Banks https://www.zerohedge.com/news/2018-09-07/why-rising-interest-rates-are-not-always-good-banks The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

August 31, 2026 | Whalen Global Advisors LLC (WGA) has published the latest edition of The IRA Bank Book for Q3 2026, the quarterly review and outlook for the US banking industry. The report highlights a number of mounting risks facing US banks, including soaring market risk from stock margin and securities lending, loans to nonbank funds and sponsors, and significantly overvalued mortgage servicing rights (MSR) in the housing finance sector. The IRA Bank Book Q3 2026 The new WGA report includes a discussion of the composition of industry revenue and earnings, and the outlook for the second half of 2026. The report includes over 30-pages of charts and commentary. Quarterly net income totaled $90.1 billion in second quarter 2026, up $9.7 billion (12.0 percent) from the prior quarter. The sharply higher quarterly increase in net income was driven by surging noninterest income (up $5.5 billion, or 6.1 percent) that was mostly due to trading revenue and fee income due to the boom in AI stocks and related borrowing. Source: FDIC Loans to non-bank financial firms such a private credit sponsors have accounted for a large portion of bank loan growth over the past year, the report notes. But in the most recent quarter, margin lending and borrowing related to securities transactions shown in the all other loans category are actually growing faster than are loans to non-depository financial institutions (NDFIs), as shown in the chart below. Source: FDIC Bank MSRs "Significantly Overvalued" The new WGA report also notes that bank-owned mortgage servicing rights or MSRs have been significantly overvalued since the end of 2023. The massively overvalued MSR was not just a problem for United Wholesale Mortgage (UWMC), as the report details. They were just the most obnoxious about it. Source: MBA, FDIC The WGA report notes that the public accounting firms have encouraged banks to lend against MSRs that are dramatically overvalued. Some IMB MSR portfolios are hedged, but most aren’t. UWMC, according to many accounts, first tried to sell MSRs to raise capital and could not clear the trade anywhere close to their portfolio mark, so instead they took the rescue financing from Oaktree Capital (See "Did a Hedge Kill United Wholesale Mortgage? Really?"). Investors, regulators and policy makers still do not appreciate how close UWMC came to an event of default at the end of Q2 2026. In Q3 2026, commercial banks reportedly are taking market share from independent mortgage banks (IMBs) in 1-4 family loans at low or no margins, creating a possible risk event for both banks and their customers as credit conditions tighten. One leading industry CEO tells The IRA: "The public accounting firms are running an MSR Ponzi scheme. Meanwhile, if banks take market share as they did in Q2, these IMB MSRs are going to be torn up. The speed assumptions are already single digits in many cases and recapture sky high- the assets can’t go any higher. That means they've already pulled forward collectively billions of noncash gains. Some are hedged but most aren’t." Mounting Market Risk to Banks The shift of bank earnings in 1H 2026 to a greater dependence upon fees and market-based lending on stock margin and securities purchases is a concern for the future. Under-reporting and forbearance with respect to private credit and equity exposures is another hidden risk to banks that, again, the public audit firms are complicit in facilitating. The WGA report states: "Bank of America (BAC) CIO Michael Hartnett notes that it is imperative for the Bessent/Warsh combo to stop higher US Treasury yields, since long duration trades are working ”too well.” We view such talk as wishful thinking from the Sell Side of the market. There is no way for the Treasury to force LT yields down, thus the only alternative is for the Fed to 1) raise ST interest rates and 2) restart quantitative easing (QE), an eventuality that would signal surrender on the fight against inflation. Copies of the IRA Bank Book Q3 2026 report are available to subscribers to the Premium Service of The Institutional Risk Analyst. Stand alone copies of the report are also available for purchase in the WGA store. Media wishing to receive a courtesy copy of the report please email us: info@rcwhalen.com. Premium Service subscribers may login and download a copy of the new report at the bottom of this post. 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. 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