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November 12, 2017 | President Donald Trump just completed a relatively upbeat swing through Asia, but made some ominous references to future trade action in his speeches, policy changes that could be focused primarily on China. This week in The Institutional Risk Analyst, we feature a discussion with Leland Miller, CEO of China Beige Book International and one of the best observers of China in the West. He’s also a Non-Resident Senior Fellow for the Asia Security Initiative, Brent Scowcroft Center on International Security, at the Atlantic Council. We spoke to Lee in New York. The IRA: Lee, let’s pick up where we left off more than a year ago, talking about the progressive accumulation of political power under Xi Jinping. How do you assess his success and did he exceed your expectations in terms of the ease with which he has consolidated his grip on power? Miller: He’s fulfilled all of them and probably more. Everyone was pretty much of the mindset over the past year that this consolidation of power by Xi was a done deal. The question was to what degree and how was he going to memorialize this power? How would the systems change to reflect that power? He went just about as far as anyone thought he would go and actually had his thought elevated to the same level as Mao Zedong. The IRA: What does that mean? Is Xi now a demigod in the communist pantheon? Miller: The Chinese Communist Party adopted Xi’s thought as part of the Party Constitution. As long as Xi Jinping is alive, he calls the shots – period. Being part of the constitution puts him on a level that only Mao Zedong himself has achieved, and ensures that his views alone provide the intellectual foundation for all of the Party’s actions. From here on out he is “the man,” whether he holds the title of President or Party Secretary. This is his show going forward. The IRA: Describe how this evolution from collective leadership to cult of personality occurred? Is this just another example of the model of one man rule in China? We are reminded of George Orwell’s classic “Animal Farm,” where the character of the pig Napoleon gradually murders all of his rivals. Miller: Well, it has not happened in a long-time, at least since Deng Xiaoping. There has been a default towards consensus leadership for decades. The people in authority had balancing needs. There were various personalities and factions who jockeyed for position within the Party in a compromise process. This time around, however, it was not a consensus process. Xi has been working for the past five years to take down potential rivals in the Communist Youth League, as well as Bo Xilai and his cabal in Chongqing, who were purged after building up a rival power base. Xi’s ally Wang Qishan went after all the other rival power bases via the anti-corruption campaign, taking them down one by one. Xi is now in control of all of the organs of power in China and that is virtually certain to be the case going forward. The IRA: Well, that’s fascinating, especially with the coincidence of the dynastic purge underway in Saudi Arabia. Is there a power base behind Xi or is he now moving solely by the sheer supremacy of his personality? Xi Zhongxun Miller: Xi was once part of a group that included a number of prominent princelings. His father, Xi Zhongxun , was a famous revolutionary. Then for years he was closely associated with has been called the Zheijiang faction, which refers to the group of people around Xi who served in trusted positions when he was Party Secretary of Zheijiang province. These people now make up a good chunk of the people in Xi’s inner orbit. But even so, there is no real challenge to his power anywhere in the party or the government. He even purged the military and replaced the top officials with younger officers more beholden to him for their positions and influence. The IRA: And created many enemies in the process. Miller: There was enormous turnover in the military, unprecedented changes. There were changes not just in the Central Military Commission, but in the top ranks of the military itself. As I said, this leaves Xi a virtually unchallenged leader and it means that if China is going to do any large-scale restructuring of its system, it is much better positioned to do it now. That doesn’t mean he will opt to do that, it just means that this is a better situation for making such changes if that ends up being what Xi decides to do. The IRA: So how does this change the equation for the US? Or the Russians? Miller: I don’t think it has much effect on Big Power relations. The only real change is that other powers now understand that they are dealing with a core decision maker and that consensus leadership is a thing of the past. The IRA: There are more and more analysts in the West seemingly willing to believe that China will not grow at 7% annually forever. Does the rise of Xi have any impact on the Chinese economy, either immediately or the longer term? Miller: It’s funny, two years ago the people who had been proclaiming that China could grow at 7% forever completely re-wrote their forecasts and started calling for a dramatic economic slowdown or crash. Now, with things looking much sunnier of late, most of those folks have gone back to their old thinking—predicting that China can keep up relatively high growth indefinitely. But they misunderstand the broader context, what was given up to get China this 2017 burst of growth. Analysts have become so ebullient about China that they miss the forest for the trees. The IRA: How so? What is wrong with the never ending China bull case? Miller: They had a great 2017 performance. A year and a half ago we were in the midst of a global contagion that resulted from a crisis in China over currency worries and capital outflows. This type of weakness was obviously unacceptable entering into a year of political leadership change, so they stepped up their interventions and made sure the economy recovered—and then some. So no question, there was an unmistakable on-year recovery in the Chinese economy virtually across the board. The IRA: Where is the catch? Miller: Everyone is on the same page right now in terms of seeing a strong 2017 economy, but the mistake analysts make is seeing this as the “new normal” for China. The Party decided that it would pull all of the stimulus levers over the past year and that’s what made 2017 such a great year for the economy. But this was done at a considerable cost—no deleveraging, an outright reversal of rebalancing, huge stimulus on both the fiscal and monetary sides—so naturally the economy will slow in the coming year as the anxiety cools down. And that’s assuming all else stays the same, which is extremely unlikely. The IRA: We had talked a few months ago about Xi wanting no surprises in 2017 and that seems to be the case. Why is it that the foreign analyst community fails to appreciate the political dimension in China? Miller: We called it the Party Congress put. Every person in China knew that the economy would be kept on track this year because the leadership couldn’t afford any problems in the run-up to the Congress in October. But you’re potentially looking at a much different 2018. They were able to hit this level of economic performance in 2017 because there were no internal or, surprisingly, external shocks. There was no aggressive tightening by global central banks, no strong dollar. In fact you had a very weak dollar through most of 2017. There were no major geopolitical tensions, nothing percolating negatively for them in the South China Sea. And most importantly, there were no Trump trade tensions, none. But we think most of these factors will reverse in 2018. The IRA: Isn’t it remarkable that the US media saves most if not all of its vitriol for Vladimir Putin, while with Uncle Xi in China the honeymoon continues. President Trump’s talk on trade has been remarkably tame with China compared with his campaign rhetoric. His trip to Asia has also been mostly free of aggressive rhetoric. Are we seeing a new Donald Trump? Miller: We think that the good times will be ending soon enough, maybe as soon as early 2018. New problems are clearly brewing for China next year and they are all pointing in one direction. We could even see the Trump Administration take trade action against China in the early months of next year. You have a president who promised tough action against many trade partners and especially China, but nothing so far. This will change. The IRA: So what about it is going to change? Trump likes to have leverage in all of his relationships, perhaps this is how he gets leverage politically and, in his own mind at least, with China. Miller: Everything politically is pushing us towards a trade conflict with China in 2018. Donald Trump wants tariffs. He promised tariffs during the campaign. Trump wants to fix the economic imbalance with China through tariff actions. He talks about this constantly behind closed doors, but so far there have been forces in the White House that have kept him from taking these steps. As the mid-terms elections approach, however, Trump must turn up the heat on trade to be able to reclaim these issues. The ability of moderates in his circle to prevent Trump from imposing tariffs on China has been impressive so far, but his desire to do something big on trade will likely be too powerful to stop in the coming year. The IRA: The global financial markets are really not prepared for such a turn of events. We could easily see the US equity markets trade off by double digits if China-US tensions flare up significantly. Does that possibility figure into the Trump calculations? How does trade action by the US impact the Chinese economy? Miller: The key issue is perception in the West. People have gotten so over-confident on China recently. One of the leading China watchers just got up at a conference last month and declared that China has already had its hard landing and that the next two years are going to be wonderful. People have gotten very cocky about China’s performance, so any volatility will shake foreign investors and markets because expectations are so high. When the US initiates the first trade action against China, perhaps as early as early 2018, it is going to take a lot of people by surprise. How China reacts will be key, both for global markets and for its own economy, but have no doubt that the first move will be made by Trump. He wants a trade war with China. Politically, he needs a trade war with China. How Xi reacts will determine the amount of collateral damage that follows. The IRA: Thanks Lee. 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.

November 6, 2017 | Writing this week in Barron’s , Harvard economist Martin Feldstein nails the proverbial issue of excessive debt square on when he notes that European Central Bank chief Mario Draghi has run out of runway when it comes to policy prescriptions. He writes: “One of the goals of large-scale bond purchases—so-called quantitative easing— was to drive down long-term interest rates in order to stimulate business investment and housing construction. But with long-term interest rates now close to zero, bond purchases would not be able to lower them any further.” But Professor Feldstein then concludes that when the inevitable economic slowdown comes in Europe, “an appropriate response to this dilemma may be a policy of coordinated fiscal expansion.” The fact that the world from Beijing to Brussels is literally choking on debt – thus Draghi’s infatuation with zero or even negative interest rates – does not dissuade Feldstein and other economists from recommending ever more debt-funded fiscal expansion. Of course, if you ask ECB chief Mario Draghi, the ECB still has plenty of room to maneuver. All central bankers suffer from the deadly sin of hubris. Last week, we posted our thoughts on the tactical situation facing the new Federal Reserve Chairman-designate Jerome Powell on Zero Hedge . We asked: "How do you think, Governor Powell, equity markets will react if Chair Yellen inverts the yield curve on her way out the door?" Might ask Governor Draghi the same question. As US interest rates rise and the policy gap between Washington and Brussels widens, our friends in Europe are going to be faced with some profound challenges. Chief among them is how to prevent Italy and other EU member states from defaulting on their debts. And the longer Draghi waits to “normalize” monetary policy, the more investors and markets will question the solidity of the European economic rebound. Wolfgang Munchau writes in the FT : “Even after a decade-long recovery, the ECB may never be able to halt asset purchases.” Ditto. His comment implies that Europe is slipping into a Japan-like state of permanent debt repudiation via QE to manage the fiscal crisis for its weaker members. But insolvent countries are just the beginning of the world's debt problem. Another important read in Barron’s this week features JPMorgan industrial analyst Stephen Tunsa talking about General Electric (NYSE:GE). Tunsa thinks that the dividend on the common shares -- now changing hands around $22 -- is going to be cut to better align with actual cash flow. He also sees the once high-flying GE, formerly a blue chip equity name, soon trading in the teens. Tunsa opines: “I think most active managers expect a [dividend} cut, but a smaller one, to the 60- to 70-cent range. Certainly if it’s below 50 cents, the stock should go down. I don’t think this stock deserves a market yield, which is around 2%, so a 3% dividend yield on 50 cents or below gets you to a share price in the teens.” Of interest, Barron’s reminds us that the financial-industrial conglomerate assembled by Jack Welch remains among the more complex financial services companies in the US even after shedding its status as a regulated financial holding company. Not only does GE Capital still finance much of the receivables of the industrial business, but the company also keeps many of these assets on its own balance sheet under complex leasing arrangements. GE notes in its most recent 10-K that its non-US activities “are no longer subject to consolidated supervision by the U.K.’s Prudential Regulation Authority (PRA). This completes GE Capital’s global exit from consolidated supervision, having had its designation as a Systemically Important Financial Institution (SIFI) removed in June 2016.” But past financial machinations still represent big a negative for GE shareholders. The company’s insurance unit, for example, remains a source of future potential financial risk due to poorly priced long-term care insurance contracts. In its latest public disclosure, which Barron’s notes is shrinking in terms of quality and quantity of its content, GE demurred on whether GE Capital will have to take additional reserves for its insurance unit. “A charge related to a probable [reserve] deficiency is not reasonably estimable at September 30, 2017,” GE notes in its last 10-Q. “Until the above described review has been completed we have deferred the decision whether GE Capital will pay additional dividends to GE.” Really? Could GE shareholders expect an unwelcome Christmas present from the new CEO John Flannery? Tunsa concludes: “If these issues are as bad as they seem from a cash-flow perspective, there’s a systemic problem that won’t be quickly fixed with cost cuts and portfolio tweaks.” The problem with GE, or course, is that they are migrating back towards righteousness after years and years of high-risk financial engineering under Neutron Jack and his hyperactive management progeny. By aspiring to profitability and stability, the story has become entirely boring and subject to the laws of financial physics. Flannery would do better to emulate Amazon (NASDAQ:AMZN) and especially Telsa (NASDAQ:TSLA) when engaged in corporate renovation. TSLA trades on a price-to-loss ratio, a unique measure that allows for unlimited growth. Unfortunately, Tesla shares closed down last week, in part because the Trump tax cutting proposal would scrap the $7,500 federal tax credit for electric cars. Much like AMZN, TSLA is about selling the future rather than present day profits. With the setbacks recently reported by TSLA in terms of actually making cars, Elon Musk and his minions dare not even speculate about eventual profitability at this stage of the game. When confronted by the most recent failures to meet manufacturing goals, Musk pivoted on a dime and announced the construction of a new factory in China. By comparison, GE sports a $175 billion market cap vs $51 billion for TSLA, which is still near its all-time high but is unprofitable and has $10 billion in high-yield debt. Cutting tax rates is great for the profitable, but of limited value to those like TSLA who have yet to report taxable income and can’t seem to hit operational goals. But investors love TSLA and hate GE, and perhaps with good reason. Mark Twain said it is easier to fool people than to convince them they’ve been fooled, a statement tailor made for the TSLA phenomenon. Perhaps that’s why TSLA continues to raise new money to feed its growing burn rate, this even as GE sinks. Meanwhile, the major automakers show signs of ganging up on the new era car maker TSLA. Short-seller Jim Chanos said last year, after the $2.6 billion merger with SolarCity Corp, that Tesla Motors is a "walking insolvency." Agreed. TSLA certainly has negative cash flow, but unlike GE, it has a positive narrative. Henry Ford said that you cannot build a reputation on what you are going to do, the polar opposite of the approach by TSLA founder Elon Musk. Ford Motor Co returned its seed investors’ capital in full after the first year of operations, but investors in TSLA may never seen dollar one. Of course, a century ago cars were the new thing, while today electric cars are a strange novelty meant to make wealthy people feel responsibly green – even if lithium batteries are a dirty and expensive way to store and deliver energy. In his effort to change the world, Musk is fighting the tides of history as well as the relentless logic of accrued interest. Musk's love child is also in a technological race with firms that want to put a sustainable propulsion source inside electric cars. The Economist reports that Mercedes-Benz is planning to introduce a plug-in hybrid SUV that combines a battery pack with a fuel-cell generator. This design is meant to replace internal-combustion engines when the EU plans to go entirely electric in 2040. We continue to believe that hybrids are the answer for clean transportation, even if the auto industry must kowtow to political correctness and build absurd battery powered cars. But forget the batteries and firms like TSLA that are pursuing this retrograde technology. Call us when the all electric Ford F-250 Super Duty truck with a compact gas turbine for power is ready for a test drive. And, no, we’re not buying or selling short TSLA or GE, but we are still accumulating a position in PayPal (PYPL) , one of the more interesting names in fintech. BTW, hard copies of "Ford Men: From Inspiration to Enterprise" are again available in our online store . 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 29, 2017 | During our travels over the past two weeks, we tried to keep up with the financial press, particularly the growing sense of unease felt by many observers with the relentless rise of valuations for equities and other asset classes engineered by the Fed and major central banks. Suffice to say the number of queries we receive about bank stocks being overvalued has soared. Last week saw some real gems from the world of crypto currencies. Bitcoin and the enabling technology known as “blockchain” are just the latest shiny objects to fascinate the less cautious members of the investing public. The folks at Grant’s Interest Rate Observer flagged this precious headline from Bloomberg News : “This Company Added the Word ‘Blockchain’ to Its Name and Saw Its Shares Surge 394%” The world of “investing” in blockchain schemes has always given us a feeling of amazement, but tempered with a tinge of chagrin for those credulous souls caught up in this web of intellectual fraud. Sure blockchain has some interesting attributes, but other than enabling the bitcoin phenomenon, it has limited uses that make commercial sense. Blockchain rather blatantly violates the Three Laws of technology investing – cheaper, better, faster – but nobody seems to care. Even more amusing than blockchain, however, is the fact that some of the sponsors of various “initial coin offerings” of nouvelle crypto currencies have taken the position that the ICO is an act of charity and that the investment received is a “non-refundable donation” rather than a distribution of a stake or equity in the issuer. While ICOs seem to be clearly at odds with the anti-fraud provisions of the Securities Act of 1934, so far the Securities and Exchange Commission and Department of Justice have been unwilling to put an end to the marketing of these schemes in the US. The SEC rightly describes crypto currencies as “tokens” that may be considered securities under US law, yet the widespread public confusion over these get rich quick schemes has overwhelmed the government’s willingness to call out this activity. One reason why so-called crypto currencies have gained such a following is that there is no real money to be found anywhere in the world. In the US, the legal tender laws of the 1860s forced members of the public to accept paper money – greenbacks – “for all debts, public and private,” this to help finance the Civil War. When Franklin Delano Roosevelt confiscated gold held by the public in the 1930s, paper money ceased to be a store of value directly convertible into gold or silver by individuals. Today what people refer to as “money” operates as a means of exchange and a unit of account, but the dollar ceased to be a store of value decades ago. An item purchased for $20 in 1913 when the Federal Reserve System was created would cost nearly $500 today, a cumulative rate of inflation of 2,400%. So much for central bank independence. At least the Treasury notes that circulated in the US prior to the Civil War paid interest. Today’s greenbacks issued by the Federal Reserve System are just memorials to dead presidents. More recently, central bankers have decided to confiscate private wealth represented by even fiat paper money via such means as negative interest rates and market intervention disguised by misleading labels like “quantitative easing.” As we’ve discussed before, negative interest rates imply the global confiscation of private financial assets for the benefit of debtors, especially public sector debtors. Of note, in his last blog post, John Taylor examines a thesis advanced by Allan Meltzer that QE was a policy of competitive devaluation. The US moved first, and others followed, as one of our colleagues noted last week. But the only thing that has resulted is a vast flow of capital back into the US economy. With almost $10 trillion in negative yielding bonds globally, dollar assets have become a refuge from global confiscation by the European Central Bank and Bank of Japan. Mark Twain alleged that “there is no distinctly native American criminal class except Congress,” but we wonder what would he say about the bureaucrats at the Federal Reserve Board, ECB or the BOJ? Indeed, when you survey the world of investing, it is hard to get annoyed with the starry-eyed followers of bitcoin. Call bitcoin virtual tulips. The crypto adherents at least have decided to reject the authoritarian world of fiat paper currencies issued by insolvent governments and instead embrace an alternative standard. Professor Larry White wrote in a blog post entitled “Blockchain + Gold”: “The Bitcoin system has the great virtue of securely sending value directly from stranger to stranger. It is open to anyone, anywhere in the world. The sender does not need to trust the recipient, nor any bank or other institution, to accurately record the transfer.” And what can you say about those individuals who lack the courage to take a flutter in bitcoin, but comfort themselves by talking about the “benefits” of the inefficient blockchain tech behind it? Bitcoin holders at least have the possibility of gain, but “investors” in blockchain are literally shoveling money into the furnace. Several years on and many billions of dollars later, we still have yet to see one example of a blockchain outside of the bitcoin instance that makes any economic sense. Meanwhile, we would be remiss if we did not note the ten-year anniversary of the shotgun wedding of Merrill Lynch and Bank of America (NYSE:BAC). We got several queries about the anniversary of this combination last week. One investment manager confessed during a private session in an office on Park Avenue that BAC was his best performing position, but then asked nervously if a 50% run up in less than a year is “cause for concern.” We referred to the excellent piece by Chris Cole of Artemis Capital, who notes that the “investment ecosystem has effectively self-organized into one giant short volatility trade like a snake eating its own tail, nourishing itself from its own destruction.” Cole goes on to note that in addition to central banks buying $20 trillion in public and private assets, public companies have repurchased almost $4 trillion in stock – this by issuing debt. “Like a snake eating its own tail, the equity market cannot rely on share buybacks indefinitely to nourish the illusion of growth,” notes Cole. Ditto. Of course big bank stocks are “overvalued” in terms of earnings or revenues, but do such measures really matter in a world without value? When you have global central banks gunning all asset prices in a desperate effort to avoid a sovereign debt default starting in Japan and then Europe, pedestrian metrics like price/earnings ratios and net-present value have little relevance. Remember, the reason that the Fed slammed Merrill Lynch into BAC a decade ago was in a desperate effort to preserve the US Treasury’s access to the bond market. In those dark days of 2008, primary dealers were collapsing left and right. Dealers operated by Washington Mutual, Bear, Stearns & Co, Countrywide and Wachovia all evaporated in a matter of days. When all's said and done, the Federal Reserve Board cares not about inflation or employment or the safety and soundness of banks and the financial system. The paramount concern of the Fed is to preserve the ability of the US Treasury to issue more debt and thereby keep the great game going awhile longer. The growing pile of public debt in the US is why price stability will never be part of the mix -- unless and until the Treasury is forced to live within its means. This is also why dollar-alternatives like bitcoin, imperfect and even fraudulent as they may be, will continue to capture the attention of those seeking to escape the economic tyranny of fiat paper money. Finally, we cannot fail to mention that The IRA's Chris Whalen has been included in the list of enemies compiled by the minions of George Soros. We are in decidedly good company. David Ignatius. Ann Coulter. The editor of The Nation . The "tout US journalism." Apparently everybody who is anybody in the world of media has earned the enmity of Mr. Soros, the architect of the Ukraine disaster and one of the world's great war mongers. We bask in his scorn. 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.

Tomás de Torquemada (1420-1498) “Assassins Creed” October 22, 2017 | This week The Institutional Risk Analyst is in Rocky Mountain country for the Mortgage Bankers Association meeting. The event comes amid a mixed picture for the mortgage finance industry. On the one hand, lending volumes have improved a bit over the course of the summer, but refinance volumes are still down compared with 2016, the result of volatile interest rates and a growing shortage of homes for sale. Chart 1 below shows the most recent MBA projections for residential mortgage origination for 2017 and beyond. Source: MBA On the bright side, however, seven years of Spanish Inquisition focused on the mortgage industry by state and federal regulators seems to be slowly coming to an end. The big news came last week when HUD Secretary Ben Carson said that the government’s use of the Civil War era False Claims Act as a nuclear weapon against mortgage lenders could soon be coming to an end. He asked the obvious question, namely why the US government ever began to use this 1800s law meant to prevent war profiteering against American mortgage firms. “I’m not exactly sure why there had been such an escalation previously, but the long-term effects of that escalation is obviously providing fewer appropriate choices for consumers,” Carson said of the use of the False Claims Act’s criminal penalties to bully lenders into big settlements with the Department of Justice. Housing Wire reports that he added. “And that’s exactly the opposite of what we should be doing.” Another bit of positive news came when Anthony Alexis, the Consumer Financial Protection Bureau’s enforcement chief (aka the "Inquisitor"), announced that he is stepping down after more than two years overseeing the agency's efforts to “combat abuses by the financial industry,” in the words of National Law Journal . The publication goes on to note that the departure is “certain to fuel speculation that Director Richard Cordray will leave soon to pursue the Ohio governorship.” Like the Tribunal of the Holy Office of the Inquisition in 15th Century Spain, the CFPB has a persecutorial mentality -- but without the burden of actually proving that a crime was committed. That is, the CFPB is all about politics and punishment. Yet rather than ensuring anything like a fair and transparent market for consumers in the market for mortgage finance, the CFPB instead extracts payments from private business to feed the Progressive faithful. This includes members of the trial bar who prosecute shareholder class action lawsuits, hedge funds who engage in short-sales of companies targeted for punishment, and elected officials operating in the public sector. Under the leadership of Mr. Alexis and Director Cordray, the CFPB frequently demanded payments from mortgage companies without any actual evidence of wrongdoing. This follows the familiar pattern set by Mr. Cordray when he was attorney general of Ohio, where he unsuccessfully attempted to extort millions of dollars from several private mortgage firms we know well. Big banks, not wanting to take the headline risk of litigation, would pay the CFPB’s extortionate demands. The non-bank mortgage companies, on the other hand, lacking the excess cash of a government sponsored bank, chose to fight in court rather than accede to the CFPB’s blackmail. But the larger point is that the CFPB has taken government regulation of consumer finance to a new height of capricious arrogance. Consumers ultimately pay the cost for this exercise in Progressive punishment. Sadly for Mr Alexis and his remaining colleagues at the CFPB, the bull market in former regulators has ebbed since the election of Donald Trump to the White House. Prior to November 2016, former employees of the CFPB could demand a hefty price in the private sector world of lobbying and regulatory relations for their inestimable talents. When you have a regulator as brutal and arbitrary as the CFPB, an assortment of fixers are advisable. But no more. With the impending lobotomy of the CFPB now at hand, the street value of former CFPB regulators has fallen to a discount, says one well-placed Washington lawyer. In addition to Director Cordray, Senator Kamala Harris (D-CA) is another example of a state level politician who achieved national status because of the emergence of “consumer protection” as a key part of identity politics. Some observers hope that Democrats will abandon identity politics and help liberalism become once more a unifying force for the "common good," but we see no evidence that the likes of Cordray, Senator Elizabeth Warren (D-MA) or Harris have gotten that memo. Some observers have speculated that the states will pick up the ball when it comes to the regulatory Inquisition in the world of consumer finance. But sad to say, the CFPB was the point of the spear for militant Progressives seeking to make the world safe for trial lawyers. Their political allies such as Mr. Cordray, Ms Harris and their fellow traveler, Senator Warren, will be profoundly frustrated once the CFPB is forced to assess the actual harm to consumers before issuing a demand for payment with an enforcement notice. Aaron Klein of Brookings Institution notes in an exchange on Twitter that “Unfair, abusive and deceptive practices (UDAP) has been illegal under FTC Act since 1938. Somehow capitalism has survived & thrived.” Survive is an apt description, but just barely. Capitalism died with the Robber Barons and the New Deal, but we digress. Fact is, regarding states picking up enforcement, they will have some difficulty because state laws are general tighter and with more precedent allowing less discretion to investigators. When CFPB was created, long-standing proposals from state law were brought into federal, but with a clean slate for interpretation. The CFPB represents a dangerous evolution of the UDAP principle as enforced by the Federal Trade Commission, one that lacks any notion of due process or fairness. As conceived by Dodd-Frank, the CFPB’s mission is to attempt to condemn, a priori , millions of Americans who work in the world of housing finance, from realtors to appraisers to loan underwriters to mortgage servicers to investors. No one who believes in fairness and the rule of law should support the behavior of the CFPB over the past six years. The departure of Mr. Cordray for his next adventure cannot come soon enough for many in the housing market. To see the actual economic cost of the CFPB’s reign of terror, consider one of the larger and better known names in the world of mortgage finance, New Residential Investment Corp (NYSE:NRZ). While the stock for this large real estate investment trust (REIT) is trading near its 52-week high at around $17, the $2 dividend gives it a yield over 11%. NRZ specializes in holding residential mortgage servicing rights or MSRs. When you do the math, the overall cost of capital including debt for this large, $5 billion market cap buyer of residential MSRs is well into the teens. Compare this to a government-sponsored bank such as Wells Fargo (NYSE:WFC) with an equity dividend yield under 3% and you begin to understand the enormous disadvantage of non-bank firms operating in the world of mortgage finance, especially compared with GSEs. Table 1 below comes care of our friends at Kroll Bond Ratings and shows dividend yields NRZ and other mortgage REITS. The cheapest capital for REITs generally comes from common equity and preferred shares, not debt. Note that there are a couple of outliers on the list with yields in mid-double digits, which pull up the average to 12% for these three dozen names. The 9% median for the group illustrates the skew. Keep in mind that NRZ and its affiliates in the constellation created by Fortress Investment Group (NYSE:FIG) have experienced relatively few regulatory issues and little headline risk, yet the stock trades at a deep yield discount to banks (and a 6 price/earnings ratio vs double digits for banks) with significant mortgage exposure like WFC or even other mortgage REITs. When investors look at NRZ or other players in the world of residential mortgage finance and MSRs, they generally see enormous regulatory danger and price the capital accordingly. But notice that Redwood Trust (NYSE:RWT), a REIT which specializes in acquiring and securitizing prime jumbo mortgages, has one of the lowest dividend yields in the group at just 6.7%. Going into 2018, the mortgage industry is looking forward to a more balanced and productive relationship with both regulators and policy makers. In the past year, CFPB officials have rather bombastically demanded increased investments in technology by mortgage companies. We frequently ask our friends in the regulatory community just how they expect such investments to be financed when a large part of the industry is under water in terms of profitability, this due to increased regulatory costs. As 2017 draws to a close, equity returns in the mortgage industry have never been lower. Achieving a more reasonable balance between protecting consumers from actual harm and helping the mortgage finance sector restore profitability (and sustainability) should be an important goal for the Trump Administration and the state and federal regulators responsible for enforcement. More than a few large non-bank servicers are for sale, though perhaps not the names that first come to mind. And banks continue to migrate away from the government guaranteed loan market and Ginnie Mae. A key goal for HUD Secretary Carson and his colleagues at the Federal Housing Administration ought to be restoring fairness to the relationship between private mortgage firms and the federal government. A big part of the problem starts with the use of the False Claims Act by the Department of Justice, an absurd policy that is hurting consumers by driving some of the largest players out of the FHA market. But the DOJ’s use of Civil War era law to intimidate mortgage firms is not the only reason why banks have fled the FHA. The sad fact is that residential mortgages have the lowest return on capital, both nominally and in risk-adjusted terms, of any asset that an insured depository institution can originate. Selling a residential mortgage loan creates additional incremental risk, one reason many banks are reducing loan sales and retaining the mortgages that they are willing to underwrite. So while changing the policies of the DOJ regarding FHA claims will be a big improvement, it will not be sufficient to bring commercial banks back into the FHA market. Changes must be made in the way that the CFPB regulates banks as well as non-bank companies before the returns available in residential mortgage lending will begin to approximate the risks. 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 16, 2017 | Almost as soon as it started, the excitement surrounding earnings for financials in Q3 2017 dissipated like air leaving a balloon. Results for the largest banks – including JPMorgan (NYSE:JPM), Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) – all universally disappointed, even based upon the admittedly modest expectations of the Sell Side analyst cohort. Bank of America (NYSE:BAC), the best performing stock in the large cap group (up 60% in the past year), disappointed with a $100 million charge for legacy mortgage issues. Despite strong loan growth, year-over-year BAC's net revenue is up about 5% but actually fell in the most recent period compared with Q2 '17. As with many other sectors, in large-cap financials there was little excitement, no alpha -- just slightly higher loss rates on loan portfolios that are growing high single-digits YOY. Yet equity valuations are up mid-double digits over the same period. The explanation for this remarkable divergence between stock prices and the underlying performance of public companies lies with the Federal Open Market Committee. Low interest rates and the extraordinary expansion of the Fed's balance sheet have driven asset prices up by several orders of magnitude above the level of economic growth, as shown in Chart 1 below. Meanwhile across the largely vacant floor of the New York Stock Exchange, traders puzzled over the latest management changes at General Electric Co (NYSE:GE), the once iconic symbol of American industrial prowess. Over the past year, GE's stock price has slumped by more than 20% even with the Fed's aggressive asset purchases and low rate policies. Just imagine where GE would be trading without Janet Yellen. To be fair, though, much of GE’s reputation in the second half of the 20th Century came about because of financial machinations more than the rewards of industry. A well-placed reader of The IRA summarizes the rise and fall of the company built by Thomas Edison: “For years under Welch, GE made its money from GE Capital and kept the industrial business looking good by moving costs outside the US via all kinds of financial engineering. Immelt kept on keeping on. That didn't change until it had to with the financial crisis. No matter what, untangling that kind of financial engineering spaghetti is for sure and has been a decade long process. No manager survives presiding over that. Jeffrey Immelt is gone.” Those transactions intended to move costs overseas also sought to move tax liability as well, one reason that claims in Washington about “overtaxed” US corporations are so absurd. Readers will recall our earlier discussion of the decision by the US Supreme Court in January not to hear an appeal by Dow Chemical over a fraudulent offshore tax transaction. The IRS also caught GE playing the same game. Indeed, US corporations have avoided literally tens of trillions of dollars in taxes over the past few decades using deceptive offshore financial transactions. Of note, the Supreme Court’s decision not to hear the appeal by Dow Chemical leaves offending US corporations no defense against future IRS tax claims. Like other examples of American industrial might such as IBM (NYSE:IBM), GE under its new leader John Flannery seems intent upon turning the company into a provider of software. Another reader posits that “they’re going to spend a decade selling the family silver to maintain a dividend and never make the conversion they would like and never get the multiple they want. GE is dead money at a 4% yield, which given some investors objectives – retirees and the like -- might not be such a bad thing.” The question raised by several observers is whether the departure of Immelt signals an even more aggressive “value creation” effort at GE that could lead to the eventual break-up of the company. Like General Motors (NYSE:GM), GE has been undergoing a decades long process of rationalizing its operations to fit into a post-war (that is, WWII) economy where global competition is the standard and the US government cannot guarantee profits or market share or employment for US workers. GE's decision this past June to sell the Edison-era lighting segment illustrates the gradual process of liquidation of the old industrial business. Henry Ford observed that Edison was America’s greatest inventor and worst businessman, an observation confirmed by the fact that Edison’s personal business fortunes declined after selling GE. In fact, the great inventor died a pauper. And of the dozen or so firms that were first included in the Dow Jones Industrial Average over a century ago, GE is the only name from that group that remains today. But the pressure on corporate executives to repurchase shares or sell business lines to satisfy the inflated return expectations of institutional investors is not just about good business management. The expectations of investors also reflect relative returns and asset prices, which are a function of the decisions made in Washington by the FOMC. Fed Chair Janet Yellen may think that the US economy is doing just fine, but in fact the financial sector has never been so grotesquely distorted as it is today. Let’s wind the clock back two decades to December 1996. The Labor Department had just reported a “blowout” jobs report. Then-Federal Reserve chairman Alan Greenspan had just completed a decade in office. He made a now famous speech at American Enterprise Institute wherein Greenspan asked if "irrational exuberance" had begun to play a role in the increase of certain asset prices. He said: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.” In the wake of the 2008 financial crisis, the FOMC abandoned its focus on the productive sector and essentially substituted exuberant monetary policy for the irrational behavior of investors in the roaring 2000s. In place of banks and other intermediaries pushing up assets prices, we instead have seen almost a decade of “quantitative easing” by the FOMC doing much the same thing. And all of this in the name of boosting the real economy? The Federal Reserve System, joined by the Bank of Japan and the European Central Bank, artificially increased assets prices in a coordinated effort not to promote growth, but avoid debt deflation. Unfortunately, without an increase in income to match the artificial rise in assets prices, the logical and unavoidable result of the end of QE is that asset prices must fall and excessive debt must be reduced. Stocks, commercial real estate and many other asset classes have been vastly inflated by the actions of global central banks. Assuming that these central bankers actually understand the implications of their actions, which are nicely summarized by Greenspan’s remarks some 20 years ago, then the obvious conclusion is that there is no way to “normalize” monetary policy without seeing a significant, secular decline in asset prices. The image below illustrates the most recent meeting of the FOMC. The lesson for investors is that much of the picture presented today in prices for various assets classes is an illusion foisted upon us all by reckless central bankers. Yellen and her colleagues seem to think that they can spin straw into gold by manipulating markets and asset prices. As Chairman Greenspan noted, however, “evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.” While you may think less of Chairman Greenspan for his role in causing the 2008 financial crisis, the fact remains that he understands markets far better than the current cast of characters on the FOMC. Yellen and her colleagues pray to different gods in the pantheon of monetary mechanics. As investors ponder the future given the actions of the FOMC under Yellen, the expectation should be that normalization, if and when it occurs, implies lower returns and higher volatility in equal proportion to the extraordinary returns and record low volatility of the recent past. 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 9, 2017 | Last week financials continued their relentless march toward the sky as investors chased the happy prospect of higher interest rates from the Federal Open Market Committee and maybe even tax cuts from Congress. In a world with too much debt and regulation, and too little economic growth as a result, driving financials (and all other asset classes) up to valuations not seen since the roaring 2000s is a fool’s errand, especially when you notice that credit spreads remain largely unaffected by the threat of “tightening” by the US central bank. As we noted last week, credit spreads are so constricted and lending volumes so weak that it is becoming increasingly difficult for larger banks and other intermediaries to earn a profit on old fashioned lending. Yet the members of the FOMC continue to think of current policy as a form of “stimulus.” The sad fact is that most Fed governors and staff economists don’t really know how to think about banks or the credit markets. Like their collaborators in the financial media, Fed officials largely think of benchmarks like Fed funds or the discount window, but it is credit spreads that really matter, both to bank earnings and economic growth. In fact, benchmarks like Fed Funds have very little impact on the credit markets compared with other factors. The folks at Fed Dashboard , for example, note: “The Federal Open Market Committee (FOMC) expects their interest rate decisions to change the economy because they expect the Effective Federal Funds (EFF) rate implemented at a trading desk at the New York Federal Reserve Bank to consistently cascade across credit classes from Treasury Bills to business and consumer borrowing.” But they warn that the Fed Funds rate “has not been consistently cascading through credit rates for decades, reducing the benefit to borrowers.” Of course, folks at the Fed do not seem to have much time for thinking about banking matters much less the functioning of the credit markets. One senior DC counsel told a group last week that Fed Chair Janet Yellen is “not terribly interested in bank supervision” and instead is focused on how monetary policy affects “working households.” The same observer says that the Board of Governors is likely “to be forced to do something about the Wells Fargo & Co (NYSE:WFC) board.” But apart from the intricacies of monetary policy, there is hope on the horizon for financials as President Trump changes the composition of the Federal Reserve Board and the leadership of other federal regulatory agencies. The Fed Board will remain at just four governors next month with the departure of Stanley Fisher and last week’s Senate confirmation of Randall Quarles as vice chair for bank supervision. Regardless of whether the Trump Administration makes any additional appointments to the Fed or other agencies, over the next year and more we look for a roll-back of regulations put in place since 2008. This is a primary reason why we believe that Chair Yellen is ultimately headed back to the private sector. Even before Quarles was approved, banking agencies were exercising their rather considerable discretion in a number of areas such as capital charges on commercial real estate and the Volcker Rule. The massive regulatory friction accumulated in the banking system and also in consumer facing nonbanks over the past eight years is being reduced. “The trend is clearly going the other way,” a veteran bank lobbyist opined last week. “Statutory provisions can largely be eviscerated by agency interpretation.” Indeed, despite the fact that the Trump Administration has not appointed many agency heads with responsibility for financial services, the fact is that the Treasury under Secretary Steven Mnuchin is driving the bus on reform and is making a lot of regulatory changes that are already in process. Deregulation is a far more important factor for financials than the illusory prospect of higher interest rates. Overall, the trend in terms of reduced regulatory burden on both banks and nonbanks is clearly positive and may contribute positively to earnings and economic growth next year. As we discussed last week , loan yields for the largest US banks are not that strong and volumes are modest, so with Q3 ’17 earnings we don’t look for many positive surprises on the asset side from the large banks as a group. Several names including Goldman Sachs (NYSE:GS) have warned on sales and trading revenues. We expect to see some weakness on the mortgage banking line due to weak volumes, frothy collateral pricing and small down marks on mortgage servicing rights (MSRs). The rebound of yields on the 10-year Treasury in September, however, may be helpful in this regard. While Chair Yellen may be able to justify rate increases to at least two of the other members of the FOMC, the continuance of QE in Europe and Japan promises to maintain downward pressure on market rates and credit spreads. There is simply not enough demand for credit from the real economy to satiate the need for assets from the financial sector. The world of large banks, institutional investors and insurers, for example, is basically Jurassic Park, where large carnivores compete for limited food in a shrinking marketplace. For example, sales of all types of asset securitizations by US banks are down 10% year-over year, an illustration of the drought of duration that exists in global markets and has been ongoing for years. Sales of securitizations (which is 90% residential mortgages) was once a multi-billion dollar per year proposition for US banks in terms of revenue, but now is just pennies. Table 1 below shows assets securitized and sold for all US banks through Q2 2017. Source: FDIC A big part of the reason for the decline in asset securitization volumes since 2008 is the Dodd-Frank law, but also is due to regulation and the resulting migration of US banks away from residential mortgage lending and also a decline in volumes. As in the case of Europe, public debt issuance in the US since 2008 has seen a big increase, mostly via borrowing by the US Treasury. Debt issuance by corporations, which have tended to borrow to fund stock repurchase programs, has also surged. But neither of these factors is actually bullish for economic growth or bank earnings. Zero rates and QE a la Yellen, Draghi and Abe is not about growth so much as it is about subsidizing debtors, especially governments and other public obligors who are beyond the point of recovery in terms of ability to repay debt. This financialization of the US economy is perhaps the single biggest driver behind the bull market in US equities and bonds, but has done little for income or employment growth. Chart 1 below show total US debt issuance in most asset classes. Source: SIFMA The regulatory pendulum in the US is clearly swinging towards ease and that is good for inflated expenses in most banks and consumer facing non-bank financials. Overall, though, the prospect is for bank earnings and revenue growth to stay “lower for longer,” even as the actions of global central banks drive up prices in many asset classes. Until global central banks end asset purchases and allow credit spreads to revert to something closer to the norm, it is going to be very hard for banks to generate any real earnings growth -- particularly if the Fed’s obsessive increases in short-term benchmark rates result in a flat Treasury yield curve. An end to QE also implies a significant increase in credit losses for US banks, an eventuality that will not be a problem given robust reserve and capital levels. But the wild card for global financials is whether the suppression of credit spreads by the Fed and other central banks has caused the formation of another hidden hot spot of risk that is currently hidden from investor scrutiny. And for our money, that hot spot of risk may well be in Europe, where many banks are lingering on the edge of insolvency and politicians are absolutely frozen in place. In that bad idea called the European Union, the tragicomedy known as banking lurches from one absurdity to the next as the community struggles with trillions of euros in bad debts. Last week, the European Central Bank (ECB) “launched a fresh push,” reports the Financial Times , to get European banks to take reserves on bad loans. The only problem is that the new regulation applies only to loans that go bad after the start of 2018, leaving a decade of accumulated bad debts untouched. Under current international accounting rules, EU banks can essentially ignore (and accrue interest) on bad loans. This makes published financials for EU banks completely useless for investors and credit rating agencies. More, just as “quantitative easing” in the US has not particularly helped either the resolution of bad loans or new lending, in the EU the opportunity created by ECB chief Mario Draghi’s efforts has been largely wasted. More public sector debt has been incurred and the banks – which admit to some €850 billion (6%) in non-performing loans – are essentially insolvent as a group. The FT’s Lex column notes with considerable understatement that EU banks “may be treading water” and that, when off-balance sheet exposures and derivatives are considered, EU banks are running at about 25:1 or more leverage. This compares favorably to large US banks such as GS, JPMorgan Chase (NYSE:JPM) and Citigroup (NYSE:C), but is far higher than all US banks as a group. It is some measure of the extremis in which Europe’s banks now operate that the former Italian premier, Matteo Renzi , almost immediately attacked Draghi’s actions as possibly causing a decline in lending to small and medium size enterprises in Italy if implemented. “Some European officials in the banking sector ignore that their duty is to AVOID credit crises, not CREATE them,” he Tweeted on Thursday, borrowing from the communication style of President Donald Trump. Later Renzi added: “If these rules pass, credit to small businesses will be impossible. We are making the same mistakes as 2013.” In Europe the “mistake” leading up to 2013 was when the ECB forced the tiny nation of Cyprus into a forced banking liquidation. Lacking a mechanism like the FDIC in the US to resolve insolvent banks, the Europeans instead destroyed the Cypriot banks and pushed all of Europe to the verge of a financial collapse. Since then, the EU and its members states have subsidized failing banks, most notably in Italy. And the ECB under Draghi has doubled down on QE and negative interest rates to keep the prospect of further financial contagion at bay. So as earnings season begins in earnest in the US this week, there are two big risks facing investors who hold exposure to US financials. First, there is still little in the way of revenue growth to support rising valuations. Remember, don’t fight the Fed (and ECB and Bank of Japan). Some of the better performers like Bank of the Ozarks (NASDAQ:OZRK) are up double digits this year, confirming our earlier warning about short positions in this national C&I lender. Even GS has managed to show some upside of late even though it may have some of the more disappointing results for this quarter. But at 1.9x book, OZRK and many other names are fully valued using any sort of Warren Buffett measure of future cash returns. Second, the continued incapacity of EU leaders to deal with the festering problems inside Europe’s banks creates a very dangerous situation for investors. The media and their enablers in the Sell Side chorus have been touting the prospects of Europe for many months, but the reality is very different indeed. Europe is drowning in debt and there are a number of large EU banks that are demonstrably insolvent. The use of derivatives and off-balance sheet financing to “double down” and save some of the bigger zombie banks is bound to end in tears. And such machinations increase the chances for a “surprise” event, which as we all know is the precursor to systemic contagion. With low levels of visible volatility in evidence, we can only note some very big contrarian options trades in the VIX of late that remind us of 1992 when George Soros broke the pound sterling. Have a great week. This Tuesday The Institutional Risk Analyst’s Chris Whalen will appear at American Enterprise Institute in Washington, D.C., to talk about “How has a decade of extreme monetary policy changed the banking system.” With Q3 earnings looming next week, a discussion of the Fed’s structural distortion of banks and banking seems most appropriate. Click here to see our presentation. 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 11, 2017 | Last week we heard optimistic noises coming from some of the top executives in the world of mortgage finance at the Americatalyst 2017 event. Falling interest rates have managed to get new applications for mortgage refinancing even with purchase loans for the first time in months, this as the 30-year mortgage has fallen back to pre-election levels. We're still calling for the 10-year Treasury to go to 2% yield or lower. The good news for Q3 ’17 earnings is that production volumes and spreads are improving for many lenders after a dreadful start of the year. Bad news is that falling yields on the 10-year Treasury implies a significant mark-down for mortgage servicing rights (MSRs). The movement of benchmark interest rates, coupled with significantly lower lending volumes and surging prices for collateral, could make Q3 ’17 a very interesting – and treacherous – earnings period for financials with exposure to MSRs and other aspects of residential housing finance. Away from the blissful consideration of the housing sector, tongues were set wagging late last week when Liz Hoffman at The Wall Street Journal reported that Goldman Sachs (NYSE:GS) commodities head Greg Agran will leave the firm. “Mr. Agran’s departure follows the worst slump in Goldman’s commodities unit since the firm went public in 1999. Bad bets on the prices of natural gas and oil contributed to a second quarter in which the unit barely made money,” The Wall Street Journal reported. The GS “Fixed Income, Currency and Commodities Client Execution” (FICC) arm has seen performance fall by double digits sequentially and year-over-year, causing investors to ask whether Wall Street’s preeminent trading shop has lost its edge. With investment banking and asset management essentially flat last quarter, GS’s net income dropped sequentially. Only a strong performance in equities prevented GS from seeing the Institutional Client Services income line break below $3 billion last quarter . Even though our contacts in the world of credit have been reporting better-than-expected results in the world of energy production, many Wall Street firms have been playing the long-side of energy (and bond yields), and with disastrous results. GS under Agran’s direction in particular was reportedly stung by taking principal exposures related to the Marcellus shale market in OH and PA. This fact is significant for several reasons. As we discussed last week with Paul Murphy , CEO of energy lending specialist Cadence Bancorp (NASDAQ:CADE), prices for natural gas are unlikely to see great upward volatility any time soon. Oil prices too remain under considerable downward pressure as domestic producers continue to develop new ways to cut production costs. “The Permian is still red hot with people paying high prices for acreage,” Murphy reports. “The Permian works at $49 per barrel all day every day.” While most commercial banks can make money primarily by lending, GS is forced to earn its profits by being smarter than other market execution platforms and thereby attracting institutional client trading volumes. Many buy side investors give their business to GS because they believe – rightly or not – that the boys of Broad Street have an edge when it comes to market intelligence. But the past few quarters of underperformance by FICC and the particular misstep with respect to the Marcellus trade suggest that GS may be losing its premier cachet when it comes to market acumen and related mindshare among institutional customers. Indeed, since the start of 2017, GS has significantly under-performed its peers and the S&P 500. With a price-to-book ratio over 1 and a beta of 1.4, GS is still quite fully valued – especially when you consider that the Street has negative revenue growth rates for the bank for the rest of the year. But magically the Street has GS showing a 4% positive revenue growth rate for 2018 and a 20% positive earnings growth rate to boot. Wall Street, after all, is about selling hope. Looking at the big picture for all US banks, commodities trading for customers has not be a strong contributor to total earnings since the implementation of the Volcker Rule in 2012. First comes investment banking fees, followed by credit products which contributed significantly to Q2 ’17 results. Income from commodities and other exposures has significantly trailed other components of non-interest income for all US banks. Notice how the big negative swings in credit contributed to losses in the 2008 and 2012 periods. Source: FDIC For universal banks such as GS, a lot of trading and other types of capital markets activity is conducted outside of the bank in the broker-dealer and is not captured by the FDIC data. For GS, total non-interest income of $14.9 billion at Q2 ‘17 is about 3x the bank’s $5.9 billion in net interest income, the reverse of the distribution seen in most large banks in Peer Group 1. Or to put it another way, the net interest income of most US banks averages 2x the non-interest income. With non-interest income at GS equal to 3.37% of total assets vs 1.3% for most large banks, the dependence of GS on transactional income is pretty much total. In many respects, GS is a hedge fund with FDIC insurance and access to the Fed's discount window. But not being able to overtly trade its own account represents a huge disadvantage compared with its larger peers. There are an awful lot of former GS bankers running around Washington, but the fact that Chief Executive Lloyd Blankfein and his colleagues actually allowed a bet on rising gas prices anywhere makes us wonder. Just about anybody and everybody The IRA speaks to regarding energy prices thinks that natural gas is a dead trade for years to come. The fact that GS chose to bet on whether a privately funded pipeline would be completed on a date certain illustrates the risks that universal banks must take to earn their keep. More, as Liz Hoffman reported in the Journal in August , the ill-fated Goldman trade with Marcellus apparently was to ride the price up as the transportation related discount for production from that region ended, but that sure looks like a principal trade to us. Why is GS even making wagers on Marcellus shale for its own account given the Volcker Rule? Good question. You can be pretty sure that nobody in the bank regulatory community will deign to ask that question so long as former Goldman President Gary Cohn remains employed at the White House. But then again, just about every major Wall Street bank has its own list of exceptions to the Volcker Rule. Look at the earlier chart and note the way that income from credit positions has languished until last quarter. Isn’t that remarkable? Could it be that the largest Wall Street banks are already starting to cheat with respect to Volcker Rule compliance by trading credit exposures for their own account on the assumption that this part of Dodd-Frank will eventually be repealed? The banking industry has made repeal of the Volcker Rule its number one priority in Washington, perhaps explaining the large number of GS alumni operating inside the Beltway since the election of Donald Trump. But to us, the real question with GS and the Volcker Rule is whether the smallest of the major universal banks can survive long-term without being able to aggressively trade its own account. With larger players such as JPMorgan (NYSE:JPM), Bank America (NYSE:BAC) and Wells Fargo (NYSE:WFC) able to use their balance sheets to win business, GS is the low man on the proverbial totem pole of big banks. Will the firm that survived the Great Crash of 1929, the Mexican peso crisis and the financial collapse of 2008 be the next name to follow in the unfortunate footsteps of Lehman Brothers and Bear, Stearns & Co? 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 18, 2017 | Some of the housing industry’s largest trade groups reportedly want housing finance agencies Fannie Mae and Freddie Mac to look at using new types of credit scores for assessing default risk on residential mortgages. These groups argue that existing scores are "unfair" to low income borrowers. Housing Wire reported last month that the groups sent a letter to Federal Housing Finance Agency Director Mel Watt, the Mortgage Bankers Association, National Association of Realtors, the National Association of Home Builders, and other groups pressing Watt on the issue. Watt, a former congressman from North Carolina and long-time member of the House Financial Services Committee, threw cold water on the idea that Fannie and Freddie would begin using alternative credit scoring models at any point in the next two years. “Watt said that making any changes to the government-sponsored enterprises’ credit scoring models before 2019 would be a “serious mistake,” reports HW . Ditto. FHFA chief Mel Watt is nobody’s fool and in particular understands the state of pay to play in Washington. The push for new credit scores is not really about competition or access to credit for low income households, but rather the corporate ambitions of the major consumer credit bureaus. “In 2006, VantageScore Solutions was introduced as a joint venture between three national credit bureaus – Experian plc , Equifax Inc. and TransUnion – aimed at providing an alternative solution to the widely used FICO score through the introduction of the VantageScore,” writes DBRS in a June 2017 report . “Recently, evidence points at VantageScore gaining traction in consumer lending and, by extension, in structured finance.” The three national credit bureaus or data “repositories” share a monopoly on individual credit reporting in the US. Yet as we’ve learned recently with Equifax (NYSE:EFX), the repositories take no responsibility for protecting consumer data or even telling consumers when they have been compromised. Nor do the repositories take any responsibility for the accuracy of data gathered or how it is used, as with identity theft and credit fraud. Because the GSEs require three credit reports for conventional and government mortgages, the repositories apparently decided to come together in an anti-competitive alliance to promote the new VantageScore as a way of displacing Fair Isaac Corp (NASDAQ:FICO) , publisher of the FICO score traditionally used to assess consumer credit. By spending money on marketing and Washington lobbying activities, the three credit repositories have orchestrated a seeming groundswell of support for the VantageScore. But to us, the combination of the three data monopolies in the world of housing finance sure looks like anti-competitive behavior. Of course there are instances where an anti-competitive business combination constructed as an ancillary restraint will survive antitrust tests, but this situation with the three incumbent consumer credit repositories looks like an illegal attempt to stifle competition – namely FICO -- and create a vertical monopoly atop the existing horizontal data franchise shared by the three firms. In the rest of the world of consumer credit, there is competition between the three credit rating bureaus. By maintaining an accurate profile of a consumer’s credit, auto lenders, employers and other parties can quickly assess a subject’s basic credit standing with one report. Only because the GSEs require credit reports from all three agencies is a competitive market transformed into a murky, monopolistic alliance between the three incumbent credit data repositories. Some consumer advocates and Washington policy organs, including many that receive direct financial support from the owners of VantageScore, argue that the new score is more fair than the multiple versions of FICO scores, which are tuned for different industries and can vary by as much as 10% either way depending on the credit type. They also argue that the inclusion of limited rental payment data gives lower income borrowers a better chance of approval. Both private research and internal assessments reportedly conducted (but not published) by the GSEs, however, raise significant doubts as to the numbers of additional low income borrowers that might be approved using VantageScore vs FICO for mortgage lending. Some policy advocates have claimed that seven million new borrowers might be added to the mortgage rolls by wide adoption of VantageScore. “The credit score model used by the GSEs needs to be updated,” writes Laurie Goodman at Urban Institute. “The credit score model the GSEs essentially require mortgage originators to use for mortgage lending— FICO 4—is outdated, based on models estimated in the late 1990s. Both FICO and VantageScore have much more recent models, including FICO 9 and VantageScore 3. VantageScore is also rolling out VantageScore 4.0 this fall.” Goodman and other market participants note that the GSEs and the rating agencies are still using antiquated versions of the FICO model in their own models, versions that ignore advancements in new data and how events such as medical expenses are weighted in credit models. Credit professionals operating in the ABS market also wonder whether either the GSEs, the rating agencies or bond investors are ready to make a change, especially if it results in any expense to make the transition. Many policy advocates in Washington are innocently unaware of the magnitude of change that shifting to, say, FICO 9 would entail for the housing agencies, the credit rating firms and for major bond investors. In tactical terms, the GSEs are the source of the problem when it comes to antiquated credit scores in the world of housing finance. By mandating universal usage of raw credit reports from all of the three repositories, on the one hand, and then dragging their feet on adoption of new credit scoring models – from either FICO or Vantage – the GSEs have created an intellectual and operational bottleneck in the US mortgage industry. But ultimately this Washington conversation is ignoring the most important constituency, namely global bond investors in the US and around the world. One of the dirty secrets of the pro-VantageScore, access-to-credit crowd in Washington is that not all consumers have enough of a credit history to get a FICO score. If you can fog a mirror, you can pretty much get a VantageScore. In fact, VantageScore 3.0 can generate a score for up to 35 million more people than conventional models, according to company claims. And the VantageScore model is about to get even more forgiving, according to The Washingtton Post . The basic credit models used by FICO and VantageScore are similar, but not comparable. An 800 FICO is not the same as an 800 VantageScore. The rental and utility payment data included in Vantage is limited and, to the earlier point on FICO, really does not tell you about the obligor’s ability to pay a 30-year mortgage and take care of the house. These differences between FICO and VantageScore make the credit rating agencies, lenders and servicers, and end investors in residential mortgage backed securities (RMBS) nervous about depending upon newer scores to judge default risk. Think about the folks at the Bank of Japan, for example, who are traditional and size buyers of GNMA securities. Goodman notes that the newer version of FICO and VantageScore are more closely aligned, but the fact remains that you cannot compare a FICO and VantageScore because of differences in the data and methodology. Yet the GSEs could do a great deal to help illuminate and clarify these issues. She writes: "In their 2017 Scorecard, the FHFA directed the GSEs to 'Conclude assessment of updated credit score models for underwriting, pricing, and investor disclosures, and, as appropriate, plan for implementation.' In addition, 'The Credit Score Competition Act of 2017,' HR 898 in the House and an expected companion bill in the Senate, would encourage the GSEs to consider alternative credit risk scoring models when making mortgage purchasing decisions. In particular, the GSEs would be required to establish and make public their procedures for validating and approving credit scoring models." Watt told an industry group last month that the FHFA is supposed to issue a request for information this fall addressing the impact of alternative credit scoring models on access to credit, costs and operational considerations. We agree with Goodman and others that it would be helpful to understand the rationale behind how the GSEs assess different consumer credit agency models for the purpose of default probability. But we also think that the GSEs moving from FICO to VantageScore is probably not practical either. There is not enough of a significant positive difference between the two models to make a change worth the time and money. We also think the idea of the lender selecting the credit score to be used in the underwriting process is a non-starter with investors – and prudential regulators. Real simple: the answer is no. More, there are some far bigger analytical issues that must be settled before the industry moves forward to new credit scores. Last week, Jack Kahan and Steve McCarthy of KBRA wrote an important research note on this issue of default risk estimates in residential RMBS: “Investors and originators alike tend to use the 2001-2003 mortgage origination vintages to establish underwriting standards and to benchmark base case default expectations on newly originated loans. Many industry participants have expressed the view that the market struck the perfect balance between credit availability and prudent underwriting during this period, pointing to pristine mortgage performance for those loans as evidence. Indeed, depending on the metric chosen, defaults for crisis vintage loans were 5.9x that of loans originated between 2001 and 2003. However, our research suggests that credit standards seem to explain only a fraction of this increase when judged through the lens of expected default rates. Based on the Urban Institute‘s HFPC Credit Availability Index, average GSE default risk due to borrower attributes was five percent between 2001 and 2003 and six percent between 2005 and 2007, a 20 percent increase.” More that just a request for information, we’d like to see a public, head-to-head comparison of the different scores supervised by the GSEs and their respective regulators, and with input from the credit community. The last word on this topic is not going to come from Mel Watt or anybody in Washington, but from the bond investors who hold $9 trillion in RMBS. Remember, if the GSEs were to mandate VantageScores, the entire analytical infrastructure of the credit, ratings and regulatory community would need to be revamped. And then the SEC would need to evaluate and validate the new models, especially given the new rules governing RMBS in Dodd-Frank. But of course this all implies that the three monopoly credit repositories would allow their “private” data on millions of consumers to be exposed to the public. Stay tuned. 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 25, 2017 | We start the week in downtown Manhattan with a presentation to the International Association of Credit Portfolio Managers in New York ( click here to download slides ). We’ll refer to some of the slides in the comments below. And we appreciate the feedback about last week’s comment about the role of Equifax and the other consumer credit agencies in the mortgage market. Of note to one reader’s question, lenders do not need a FICO score to submit a mortgage to the federal housing agencies for insurance, but the GSEs do require all three raw credit reports be pulled into a “Tri Merge” file as part of the underwriting process. And by no surprise, the consumer credit bureaus also have credit scores or their own. The competition between FICO and the three credit repositories is a glorious race to the bottom in terms of credit scores for mortgages. Suffice to say we’ll be coming back to the question of credit scores in the context of mortgage lending soon. Got a cheery missive from Jerry Flum at Credit Risk Monitor ( OTC:CRMZ ): “Debt is at its highest levels since 2007, and with interest rates near their all-time low, there’s reason to be concerned about the amount of risk growing in your public company customer and vendor portfolios.” They add: “Corporate debt is becoming excessive…” Of course, Jerry is preaching to the choir when it comes to our appreciation of America’s migration towards national insolvency. To review, there are three phases of indebtedness, this progression codified by our friend Bill Janeway in a November 17, 2008 issue of The Institutional Risk Analyst kindly republished by Barry Ritholtz . The first phase is solvency, then mere liquidity sustains the growing debt, and finally default results when both interest and principal must be borrowed or "rolled." Janeway noted regarding the creation of “the largest pile of leverage the world has ever seen” via the birth of financial economics: “The core of this grand project was to reconstruct financial economics as a branch of physics. If we could treat the agents, the atoms of the markets, people buying and selling, as if they were molecules, we could apply the same differential equations to finance that describe the behavior of molecules. What that entails is to take as the raw material, time series data, prices and returns, and look at them as the observables generated by processes which are stationary. By this I mean that the distribution of observables, the distribution of prices, is stable over time. So you can look at the statistical attributes like volatility and correlation amongst them, above all liquidity, as stable and mathematically describable.” Part of the reason that the US economy is growing more slowly now than in the Roaring 2000s is that the amount of leverage on private capital from banks has actually been reduced by the forces of the progressive oversight. The other day, we heard Mike Mayo, now of Wells Fargo Securities BTW, wax effusive on Citigroup (NYSE:C) . The common stock of this zombie money center bank has moved up over 20% in the past year, trailed by JPMorgan Chase (NYSE:JPM) at +8% and Goldman Sachs (NYSE:GS) barely registering positive movement. But the thing to keep in mind about Citi and all of the big banks is that the ways of expanding actual profit margins are few. We are witnessing multiple expansion in the stock prices of financials, but no margin expansion to validate the higher equity market valuations. With a gross loan spread of 6.42% vs 4.40% for the large banks in Peer Group 1, Citi does have a higher return on assets but with a higher cost of funds, mostly in deposits raised from institutional investors. The notion that somehow larger banks are going to develop pricing power in the current loan market is kind of laughable. Loan margins have been under pressure for years, so even if the Federal Open Market Committee could make market rates go up, slack volumes in new C&I lending suggest that pricing dynamics could get even more competitive. The chart below from the St Louis Fed’s FRED system illustrates the slowing in new commercial lending. A big part of the issue here is that magical notion known as macro-prudential regulation. Even as the FOMC and other world central banks have been busily purchasing trillions of dollars worth of private securities to encourage investment, bank rules have effectively lowered loan-to-value or LTV ratios. Bank borrowers must have more skin in the game, which lowers the leverage on private capital throughout the US economy. Home builders, for example, must have more equity in deals compared to the 2000s. Today a homebuilder must have 50% equity in a deal for a 50 LTV loan instead of 30% capital in a 70 LTV loan. As George Gleason of Bank of the Ozarks (NASDAQ:OZRK) told us , he has less leverage on his book than he did decades ago. Prospective short sellers please take note. The result of regulation is less growth, but lower loan default rates and, at least partly, improved recovery rates for banks. But the other obvious effect is lower levels of economic activity. This is the pound of flesh extracted by supporters of the Dodd-Frank law in their crusade against Wall Street excess. Even as global bank regulators try to reduce leverage levels inside bank portfolios, the FOMC is engaged in a massive experiment in social engineering to encourage borrowing and investment by keeping rates artificially low. The Fed bought almost $2 trillion mortgage bonds to help the housing market, this even as prudential regulators discourage lending on construction and development loans. Indeed, C&D lending is perhaps one of the greatest opportunities today in financials. In Washington, one hand does not know what the other hand does. Fed Chair Janet Yellen expresses puzzlement about inflation, but clearly the lower levels of leverage on capital in the US banking system seemingly provide part of the explanation. A home builder can start three new homes at 70 LTV, but can support only two new housing starts at 50 LTV. Hmmm. Meanwhile back to Citi, we love to hear analysts talk about margin expansion at a bank with “stable funding” that is two-thirds foreign deposits, placing the bank in the top quintile of banks in terms of funding costs. The bank’s premium cost of funds is almost 2x the 43bp average for Peer Group 1. And did we mention that the bank’s return on earning assets is actually lower that its large bank peers? Even with the high-yielding returns on Citi’s subprime consumer book, the bank’s paltry overall yield on earning assets is a function of low returns on the bank’s business loans. With the large US banks as a group and Citi in particular, there ain’t no leverage pickup apparent in the latest financials. The all-important factor of loan demand is constrained by the idiocy of macroprudential regulation. This will not prevent Sell Side managers from bidding up Citi and other large caps, however, because quite simply there is nothing else to buy. Kudos to Pete Najarian for holding his ground against the bull stampede into financials. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

“The great wheel of circulation is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods, and not in the wheel which circulates them” Adam Smith, 1811 October 1, 2017 | This week in The Institutional Risk Analyst , we return to one of our favorite topics – namely credit spreads – as we consider the most recent statement from the Federal Open Market Committee. Fed Chair Janet Yellen made a presentation last week to the National Association of Business Economists illustrating that while she is puzzled by low inflation, Yellen is entirely clueless as to the workings of the financial markets. For some time now, we have been concerned that the FOMC’s overt manipulation of credit spreads has embedded future credit losses on the balance sheets of US banks. But now we are starting to see even greater signs of stress as the large Wall Street banks again return to derivatives in order to manufacture the appearance of profitability. The leader of this effort is none other than Citigroup (NYSE:C), which has surpassed JPMorganChase (NYSE:JPM) to become the largest derivatives shop in the world. Citi has embraced the most notorious product of the roaring 2000s, the synthetic collateralized debt obligation or “CDO” security, a product that fraudulently leverages the real world and literally caused the bank to fail a decade ago. “It’s an astonishing comeback for the roughly $70 billion market for synthetic CDOs, which rose to infamy during the crisis and then faded into obscurity after nearly destroying the financial system,” reports Bloomberg . “But perhaps the most surprising twist is Citigroup itself. Less than a decade ago, the bank was forced into a taxpayer bailout after suffering huge losses on similar types of securities tied to mortgages. Now, many in the industry say Citigroup is responsible for over half the deals that come to market, though precise numbers are hard to come by.” As we note in a new working paper appropriately entitled “ Good Banks, Bad Banks ,” large financial institutions are not particularly profitable. In times of tight credit spreads, the pressure on these banks to “cheat” when it comes to risk taking and disclosure becomes irresistible. The dilemma large banks face when credit spreads are very low is similar to retailers that cannot compete, for example, with the efficiency of Amazon (NASDAQ:AMZN). Low cost competitors compel other retailers to match prices, even if that forces them to lose money on each sale. Trying to “make up” the loss by increasing sale volume is the obvious path to retailer insolvency. In banking, high spreads eventually force borrowers to default and must be cured before the economy fails. Low spreads force banks to “match or lose customers” by cutting prices. When a “matching” bank’s costs are greater than the spread borrowers pay, the correct result is to shrink the number of deals done, eventually causing spreads to rise. But that’s disastrous for bank managers. As in retail, therefore, the initial reaction of bank managers is to make up for the “low yield” on each transaction by writing more deals. As long as government is willing to “insure” deposits of banks that speculate in this manner, it creates an obvious condition of “heads managers win” and “tails shareholders and taxpayers lose.” The most obvious use for a “synthetic CDO” is to generate a lot of fictional (“synthetic”) transactions that increase the bank’s “deal flow” without need to find actual customers that want “real” loans. Bad banks generate a capacity to make up for the low yield on each “real” transaction by creating “synthetic” transactions. Synthetic derivatives are an obvious source for permitting fraud that necessarily harms the perpetrating bank and, ultimately, the markets as a whole. “Bottom line,” notes our colleague Fred Feldkamp , “it is ‘impossible’ to convert ABS securities into a ‘risk free’ 20% return. As Goldman Sachs (NYSE:GS) proved in 1970 with bankrupt Penn Central's commercial paper, one cannot sell bad assets to customers that you want to keep.” Feldkamp observes that for a while now credit spreads have been too low for rational credit expansion. Banks are now forced to create and hide leverage off balance sheet (e. g. new "synthetic CDO" frauds and leveraged buyouts (LBOs) with outrageously high EBITDA ratios) in order to generate returns sufficient to pay employees when that is not available in the spreads associated with well-balanced bond sales. Again Feldkamp: “When I do my spread charts, I consider the upper and lower limits to define Adam Smith's concept of a ‘Complete Market.’ Above that range of spread, there is a cushion between equilibrium and a ‘crisis zone’ because experience tells me that the ‘drag’ of high spreads can be tolerated for a while as leaders ponder what to fix. Affected firms refinance when spreads fall.” He continues: “BELOW that equilibrium, however, I think there's only ‘irrational exuberance’ because (as Smith noted) ‘the Great Wheel of Circulation’ lacks the ‘grease’ of adequate net-interest margin (NIM) needed to keep it rolling and starts to wear out. The damage starts immediately and only the extent of the necessary ultimate repair is debatable. When banks die over dumb deals, we have no choice except to rescue depositors--thus it becomes ‘HEADS I WIN; TAILS TAXPAYERS LOSE’ at US-insured banks.” Feldkamp reminds us that had regulators stopped the losses generated by thrifts in the 1980s after Congress passed the ill-fated 1982 Garn-St Germain law, the cost might have been contained at a hundred billion. “By waiting seven years, however, we were just a few years away from creating a Weimar Republic collapse. Having enjoyed an eight year recovery today, the US markets are now FAR more leveraged and are therefore far more capable of a rapid descent into oblivion than 30 years ago.” We do not need to look back 30 years, however. Synthetic CDOs were a key source for the excessive and unreported “off balance sheet” leverage at Citigroup that exploded to create the Great Financial Crisis of 2008. Starting mid-September of 2007, the Fed successfully led markets back from a “mini-crisis” that began when Bear Stearns followed the path Goldman Sachs chose decades before when Penn Central went bankrupt. Bear abandoned support for two mortgage investment funds into which it had invested customers’ money. In mid-October, US Treasury Secretary Hank Paulson announced an intent to create a “Super SIV” (to be backed by the US government) that would “rescue” Citi from losses suffered in off balance sheet ”commercial paper conduits” that Citibank supported with standby liquidity facilities. Thankfully Hank’s ill-considered proposal never materialized. His announcement kicked off the Great Financial Crisis (that peaked thirteen months later). Within days, credit spreads for US corporate bonds leaped from “euphoric” lows to “crisis zone” highs. Credit markets required more than three years to regain spread levels observed before Paulson’s October 2007 announcement. To get a sense of just how tight lending spreads are for the major banks, the tables below shows the gross loan spread, and the percentage of loans and total assets, for each loan type at Citi and JPM. Source: FDIC/Total Bank Solutions The table above illustrates the great dependence of Citi on its credit card portfolio when it comes to yield, while more that half of its loan portfolio is generating less than 3% gross yields. Citi is clearly the weaker competitor compared to JPM. And as we noted last week , Citi’s dependence on offshore institutional funding sources gives it a cost of funds almost 2x JPM and other large banks. The moral of the story with Citi and other large banks is that there is no free lunch, but sadly no one on the FOMC seems to appreciate this subtlety. When the Fed pushes down interest rates and then manipulates credit spreads to achieve some illusory goal in terms of monetary policy, the result is a change in the behavior of investors and lenders that is profound. The fact that Citi, JPM and GS are now pushing back into the dangerous world of off-balance sheet (OBS) derivatives just illustrates the fact that the large banks cannot survive without cheating customers, creditors and shareholders. And just as retailers cannot compete with AMZN, Citi and GS certainly cannot compete against the monopoly power of the House of Morgan. In the case both of Citi and JPM, just half of the banks’ operating business comes from lending, while the remainder comes from risk bearing investments and trading. With some $50 trillion in off-balance sheet (OBS) derivatives, which is almost six standard deviations above the $1.8 trillion peer average for large banks, Citi and JPM are now the outliers on Wall Street in terms of derivatives exposure. A move of 30bp in the OBS derivatives book of either bank would wipe out their capital. Chart One below shows the OBS derivatives exposure of Citi, JPM, GS and the other major banks. Source: FDIC/Total Bank Solutions Notice that all three of the leading derivatives dealers have been increasing exposures since last year. Note too that the relatively small GS has a notional OBS derivatives book of more than $41 trillion, almost as large as that of Citi and JPM. More alarming, a move of just 7bp in the smaller bank’s OBS derivatives exposures would wipe out the capital of Goldman’s subsidiary bank. This gives GS an effective leverage ratio vs its notional OBS derivatives exposures of 8,800 to 1. And all three banks are clearly outliers compared to the rest of the large US banks, which generally eschew OBS derivatives as the tiny peer average suggests. So ask not whether President Donald Trump should reappoint Janet Yellen to another term as Fed Chair. Rather, ask yourself why Yellen wants to stick around Washington at all given the accumulation of risk inside the major US banks as a result of the FOMC’s manipulation of credit spreads. The combination of a lack of profitability and a huge derivatives book makes another financial collapse increasingly likely despite the apparent solidity of the US banking system. As with the S&Ls in the 1980s, Yellen and other regulators have an opportunity to throttle-back risk taking by Citi, JPM and GS now and avoid a calamity. But Buy Side investors would never tolerate such a move by regulators. As we note in "Good Banks, Bad Banks," larger institutions suffer from a fatal lack of profitability that ultimately dooms them to commit fraud and, eventually, suffer a catastrophic systemic risk event. As Fred Feldkamp never tires of reminding us: "The only thing worse than “excessive” leverage is 'excessive off balance sheet' leverage." 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 5, 2017 | In this issue of The Institutional Risk Analyst, we speak to Paul Murphy , Chairman, Chief Executive Officer and Director, Cadence Bancorporation (NYSE:CADE) and also Chairman of its main business unit, Cadence Bank, N.A. Paul formerly spent nearly 20 years at Amegy Bank of Texas, helping grow that institution from just double digit millions in assets and a single location to a bank with assets of $11 billion, offices across Texas and a growing book of business with a focus on energy. Amegy was sold to Zions Bancorp (NASDAQ:ZION) in 2005. Cadence was created five years later to invest in the US banking sector, starting in 2011 with the purchase of $1.6 billion asset Cadence Bank of Starkville, Mississippi. Today, Cadence is $10 billion in total assets and is rated “BBB” and “stable” by Kroll Bond Rating Agency. The IRA: So Paul, tell us your perspective on the hurricane and its aftermath for the City of Houston, which is an important part of your bank’s footprint. Murphy: Harvey has truly been an unprecedented weather event. Throughout the storm, our banking services remained fully functional and contingency capabilities were activated to ensure ongoing customer service was not impacted, despite local office closures. As challenging as it was, it served to validate the effectiveness of our contingency planning and preparedness protocols, which withstood this test well. The IRA: That is good news. What did you do early on in the storm’s aftermath? Murphy: Employee safety was our #1 concern. We are happy to report that all our team members are safe and secure, for which we are grateful. Sadly, a number of our staff and their families reported water damage to their homes, and many were subjected to mandatory evacuation orders in the Houston area and forced to seek shelter in alternate locations. The IRA: What is the situation in Houston today? Murphy: First responders did an incredible job supporting those impacted by the storm, as did thousands of volunteers. It’s often in trying times like these when we see the best in others. Managing the follow-up to this natural disaster will take a monumental and city-wide effort, and we are committed to helping our clients and communities rebuild and continue to prosper. The IRA: Apart from the tragedy of last week, how are you feeling about the world? We’ve been through the great oil credit bust that wasn’t in 2015, then the election of Donald Trump and related euphoria, and now the long, tormented disappointment? Murphy: We had a really good second quarter. Made $29 million, core deposits are up nicely, a whole 9 basis points of charge offs. Efficiency ratio at 53%. Return on assets is 1.19% and tangible capital is 12%, so we are feeling pretty good. These are pretty decent numbers. The IRA: You are a solid performer in the small regional category. We got to find you another bank to buy. We have a long list of non-bank mortgage firms that need to get married to a double-digit asset regional bank, of note. Create a whole bunch of Flagstar (NYSE:FBC) clones to bolster the profitability and stability of the mortgage sector, especially the FHA market. But we digress. Talk to us about the focus of Cadence since we first got to know you and there was a real focus on banking the energy business. Murphy: At the peak we were almost 19% energy exposure. Today we are closer to 11%. Going into the oil price downturn, we had about $1.1 billion in loans and about 100 energy clients banking with us. We had one disaster in the portfolio with a really tough set of facts. A couple of others got beat up pretty badly and were severely stressed, but just one out of a hundred was a huge disappointment. These were pretty good results, in part because more than half our exposures were in midstream companies where we’ve had zero charge-offs. We’re still in the business. The IRA: These are very good results and beg the question, why? You and the industry as a whole were preparing for the apocalypse in energy coming up to 2015, but the credit losses simply did not materialize as expected. Provisions were way, way too high vs the actual losses. What happened? Is this another impact of the secular rise in the value of financial assets? As with other asset classes, it suggests that credit events have no cost. Murphy: Equity markets have been wide-open for oil field services and E&P. Some of these deals that are getting done are priced against a 2018 EBITDA growth J curve that is just stunning. I don’t think it is going to happen. There is not so much of an expectation of an oil price increase but rather an assumption that there will be an increase in activity. We’ll see. The Permian is still red hot with people paying high prices for acreage. The Permian works at $49 per barrel all day every day. The IRA: So when we see these breathless articles about oil producers operating at a loss, in part because investors are funding the operations, is this accurate? What is the big picture from your perspective as a lender in the energy belt? Murphy: As with most things, you have to be careful with generalizations. The Energy business is still stressed given the prolonged low price environment. Costs have come down and producers are surviving but returns for investors have declined. In the right area, some operators are reporting 20% IRRs. Our portfolio is appropriately 55% Midstream, and that business is doing well. Natural gas prices are going to remain low for some time to come, but this is spurring an industrial renaissance along the Gulf Coast that is not widely understood. Cheap gas is a huge boost for industry and the economy. The IRA: We’re waiting for somebody to invent a teeny gas turbine that can go in a car and then maybe Elon Musk will have something with Tesla (NSADAQ:TSLA). In addition to energy, talk about the rest of your credit book. Cadence has a good amount of C&I loan exposure and also some residential. Talk about how you view the rest of the business. Have you participated in the great Texas real estate boom over the past few years? Murphy: We are heavy on commercial lending. Our residential portfolio is about $1.1 billion and we like the single family asset. Over the past couple of years, we’ve originated over $2.3 billion in residential loans and have charged off $220,000. We sell about half of our new residential originations, the longer-term fixed rate paper. We tend to keep the floating rate jumbos, the private banking paper. The IRA: And this sounds like well-underwritten production with a 50% risk weight presumably. Murphy: Correct. Its granular and diverse from a risk perspective. Great paper really. The IRA: Do you retain the servicing on the residential loans that are sold? Murphy: We do retain the servicing on some of the fixed rate paper. Over time I expect that we will retain servicing on more of our production. The IRA: Well, the large banks tend to overpay for loans and servicing, then have to play games with the average life to justify their earlier acts of optimism. But skyrocketing prices have choked off the move-up home purchase market thanks to the Federal Open Market Committee. Dan Perl at Citadel Servicing taught us years ago that the real average life of a mortgage is generally about four years, which is the decision cycle for most families. But maybe that is changing. How has Houston real estate come through the decline in oil prices? Murphy: Texas, in particular, is growing nicely. If you had asked me three years ago if we’d be adding new jobs every year, I would have said no way. But we have. But to the point about the duration of new production mortgage loans, if you account conservatively for the mortgage servicing rights created when the loan is sold, it is not a problem and can be a very nice business. You also have a choice as to how much of the MSR to capitalize. The IRA: Subjecting MSRs to fair value accounting has always struck us as a complete waste of time and money. Non-banks are so strained having to finance the purchase of the entire MSR, when all they really want is the 8 basis points servicing fee. Then they end up selling the excess strip for a concessionary price to a financial investor. What is your footprint in terms of residential production vs commercial lending? Murphy: We are throughout the service area on residential and our biggest originations team is in Houston, and Birmingham is where we have most of our loan production people. There are some soft spots in both residential and commercial credits in the energy corridor going up I-10. There was overbuilding in multifamily and they have some real problems. But in town, no. The mid-town, east side of Houston is booming. We have one client giving away maybe a little too much free rent to sign new tenants, but they are 93% leased. We hold the construction loan, but they will have no problem getting that project refinanced. The IRA: We would agree in the current environment. Loss given default (LGD) on bank owned multifamily loans has been negative going back several quarters, suggesting a very strong asset market. Residential LGDs are in the 50% range, the lowest in decades. How do you see the retail sector in particular? Your economic footprint is growing faster than most of the country. Is retail headed for a serious contraction? Murphy: Retail is the sector that worries me the most. This thing with Amazon (NASDAQ:AMZN) is a real problem. Everybody is talking about it. For us, we do not do unanchored retail loans. We must have WalMart (NYSE:WMT) or Kroger or somebody of that quality. And we have very low loan to value ratios. We have 40% and more equity in these deals, going back to your point about strong asset prices. But part of the reason for the great credit performance is the economy. Houston in 1975 had a million jobs. Today we have three million jobs. Over forty years we added 50,000 jobs per year on average. The IRA: What has been driving this remarkable growth in Texas? Murphy: The Port of Houston is a huge factor, the Texas Medical Center is growing, the pro-business environment, no state income taxes, attractive demographics and in bound migration all contribute. If Houston were a stand-alone country, we would be #25 in GDP. We have more jobs than 35 other states. It is a great place to live and do business. The IRA: Talk about the rest of your book. Murphy: We do commercial lending and real estate primarily within our footprint, though we will support national customers as well. Our restaurant team has a national focus. We’ve done great in that space. We have almost $900 million in exposure and have experienced almost zero credit events in that book. We sold one credit we did not like a while back at a discount, but that has been it. We have participated in a number of technology credits with Silicon Valley Bank (NYSE:SVB) and have our technology team in Austin. The IRA: Have you been involved with any of the new consumer lending platforms? Murphy: We are talking to a couple of players as an add-on to our production capacity. There were 400 of these on-line lenders at the peak, now there are 20 of them. We are interested in having that capability to originate loans. If they can meet our lending criteria, we’re interested. And we can help them finance and sell production that we don’t necessarily want to keep in portfolio. The IRA: Given how the FOMC has manipulated credit spreads, how much do you worry about the underlying credit risk that is currently masked by frothy asset values? Murphy: We worry about macro factors and everything else, but where I come back to is underwriting the specific credit risk. We don’t approach it with over-confidence, but we do depend on our lenders and credit people to manage the individual credits. There is more equity in deals today, in part because of regulatory guidance. But we have flexibility as well. We had some E&P credits that were real banged-up in 2015, but we came to the table, told them they had to recapitalize, then offered some ideas on how to get that done. But we worked with these credits and they all did in fact get it done. We looked through the cycle and had a more patient approach to helping what were truly viable businesses add equity and stay right side up. The IRA: Credit management is one of the main reasons that the $1-10 billion asset class banks in the US have the best financial performance. Thanks for your time Paul. #CADE #Houston #Birmingham #energy #MSR #PaulMurphy #hurricane

August 29, 2017 | Fed Chair Janet Yellen’s defense of the benefits of regulation last week in Jackson Hole probably killed her chances for reappointment , but the more pressing reason to see Yellen return to the private sector is visible in the US real estate market. Chair Yellen and her colleagues have created large bubbles in many assets classes from residential homes to commercial real estate to construction lending. As in the 2000s, this latest bout of asset price inflation will not end well for banks or investors. In this issue, The Institutional Risk Analyst looks at the most recent bank portfolio data from the Federal Deposit Insurance Corp for Q2 2017 to see what it says about asset prices and inflation. For some quarters now, the credit statistics for the $16 trillion asset banking system has been too good to be true, in some cases suggesting that credit events have no cost. The last time that this circumstances existed was the mid-2000s, when several large mortgage banks were reporting a negative cost – that is, a profit – from default events. The same real estate market dynamic that allows growing numbers of Americans to take cash out of their homes is depressing the cost of loan defaults to half century lows. Even faced with this rather striking situation, our faithful public servants on the Federal Open Market Committee can actually stand up in public and say that inflation is too low. The skews in the credit world are so large that some banks are actually earning a profit on recoveries after a loan balance is repaid in full. First let’s examine credit trends for 1-4 family mortgages, a $2.4 trillion asset class for US banks. Loss given default (LGD), a fancy way of expressing net charge-offs, shows the average loss for 1-4 family mortgages. At the end of Q2 2017, the LGD for this asset class was just 24%, the lowest loss rate net of recoveries since at least 1990. Last quarter, the volume of defaults on 1-4s fell below $1 billion or less than 1/10th of one percent of total loans. Source: FDIC The chart above suggests that residential assets prices are quite high, as reflected by the high recovery value -- 76% -- implied by the 24% LGD in Q2 '17. Since 1990 the average loss rate after a default for 1-4 family loans is 67%, thus it seems reasonable to ask when US home prices will adjust downward. How you feel about that depends upon whether you view the extraordinary home price inflation seen since 2012 as being permanent and thus immune to mean reversion. The situation in the world of construction lending is even more profound, with LGD’s well into negative territory for the first time since the 1990s. In Q2 ’17, LGD on those few construction loans that actually defaulted was negative 94% . Given that C&D loans tend to be mostly multifamily paper and have loan-to-value ratios around 50%, when you see a bank reporting such unusual profits on defaulted loans it suggests that the value of the real estate has basically doubled since the loan was made by the bank. Note that the downward move in LGD coincides with the end of quantitative easing by the FOMC. Source: FDIC Of note, home equity lines of credit are showing similar behavior to the 1st lien mortgages, which typically stand in front of HELOCs in the credit stack. LGD for HELOCs reached a mere 31% in Q2 ’17, implying that banks are recovering almost 70% of the value of a loan when a borrower default occurs. The 25-year average LGD for HELOCs is 65%, illustrating that Chair Yellen and her colleagues on the FOMC have literally turned the world of real estate credit on its head. As the chart below suggests, the value of the collateral backing HELOCs has surged since 2012. Source: FDIC Next we move to the $780 billion in credit card loans held by US banks, an asset class that has seen recent growth after years of flat to down portfolio levels. The interesting thing about credit card loans is that they are totally unsecured. Thanks to the generosity of Chair Yellen and the other members of the FOMC, credit card loss rates have fallen dramatically since 2008. First let’s take a look at default and non-current rates, which are both turning up after the years of irrational easing by the FOMC. Source: FDIC Notice in the credit card chart that charge-off rates are above that for loans which are non-current, the opposite of this relationship for most other loan types held by US banks. This is due to the fact that, being unsecured, these credits tend to be charged-off before they have an opportunity to be classified as non-current. The next chart below shows LGDs for credit card loans, which at 83% is at the lowest levels since the mid-2000s. Source: FDIC The real question that the previous two charts raise is much on the minds of bank analysts, namely how much future default risk has been buried under the comforting blanket of low interest rates. The average rate of net-charge offs for credit cards is almost three quarters of a point above current levels, again begging the question as to when we shall revert to the mean. The answer to that question will have a significant impact on bank earnings and the ability of banks to return excess capital to shareholders. Finally, let’s take a look at the $1.9 trillion portfolio of commercial and industrial (C&I) loans, traditionally one of the most important indicators of future US economic growth. Defaults and non-current rates are both below the averages going back to the 1980s, while credit spreads are as compressed as ever over that same time period. The chart below shows net defaults and non-current rates for all bank-owned C&I loans. Notice that net charge-offs are below non-current loans, which may end up being worked out or restructured short of a formal default. Source: FDIC While the chart for net-charge offs for C&I loans looks relatively normal compared to the real estate related asset types, loss rates measured by LGD have been climbing since 2015. More important, new loan production rates (as well as sales) are falling so that the portfolio of bank owned C&I loans is no longer growing very much. This suggests that the US economy is slowing and demand for credit is therefore on the wane. The chart below shows LGD for all C&1 loans. Source: FDIC It’s important to note that the charge-offs and recoveries reported in each period by FDIC insured banks are disparate events. A recovery reported today might be related to a loan charged off three years ago. But the key element of price is reflected in the aggregate data reported by each bank, so that a rising recovery rate/falling LGD strongly suggests that prices in the underlying market are quite frothy. Just as in the 2000s and the 1990s, the Fed again has stoked an asset price bubble in real estate that may lead to significant losses for banks and bond investors should prices correct. Whoever gets the top job at the Fed, the FOMC must live with the balance sheet and market conditions served up by Chair Yellen and her predecessor, Ben Bernanke. While the Fed’s initial focus on narrowing credit spreads was correct, the FOMC should have stopped after QE1 ended in 2010. Instead, concerned that banks were not lending, the Fed continued to buy securities. The Fed has kept the pedal to the metal, repeating the errors of the 2000s by fueling a credit driven bubble in residential real estate. This time around, the bubble is more focused on affluent areas of the country, but the result is likely to be more tears. BTW, we’re rooting for Kevin Warsh as the dark horse candidate for the Fed job in the event that White House chief of staff Gary Cohn decides to stay put. But the biggest challenge facing Yellen's successor as Fed Chair is having the courage to admit that inflating asset bubbles does not create jobs or prosperity, just future financial crises. #inflation #janetyellen #FOMC #credit #KevinWarsh #bubble