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December 11, 2023 | Over the weekend, Bill Nelson , Chief Economist at Bank Policy Institute, put out an intriguing note (“ Forward guidance:  The Fed is probably solvent”) that argues that the central bank still has positive net worth despite its substantial operating losses. Nelson concludes: “So before taking into account the value of seigniorage, the Fed’s economic value is $1 trillion ($6.7 trillion minus $5.7 trillion).  If currency plus the TGA is expected to grow, as it always has before, the value of seigniorage is positive and the Fed is definitely solvent.  For example, assuming a discount rate of 4.5 percent (the 10-year Treasury rate), if currency plus TGA is expected to grow at 3.8 percent per year (the FOMC’s outlook for nominal GDP growth in the long-run), the value of seigniorage is $15.9 trillion.  But if currency is expected to shrink 2.5 percent per year, the value of seigniorage is -$1.05 trillion, the economic value of the Fed is negative, the Fed is insolvent.” Our view of the Fed is that it is merely the alter-ego of the U.S. Treasury, a convenient canard whereby an additional layer of leverage was added to the American economy on the eve of WWI in 1913. A liability of the taxpayer is treated as an asset on the books of the central bank, which was not even allowed to own government debt at inception. The Fed was focused entirely on financing the private sector. So is the solvency of the central bank an important issue for public policy? Not really. It is part of the growing insolvency of the U.S. Treasury. The assets and liabilities of the central bank, net of private equity contributions of member banks, ultimately belong to the United States, just as with all of the parastatal creations of Congress.  And for this reason, the Fed can never actually show a profit in a true economic sense and is always an expense to the taxpayer.  As a result, the only truly relevant fiscal question when it comes to the Federal Reserve System is how much of an expense does the central bank represent? Nelson and other former employees of the Fed, ourselves included, have long fretted over the growing operational and financial stress visible at the central bank. As we opined last week with a chart published by the Federal Reserve Bank of St Louis (FRED), the deviation in financial performance by the central bank is extraordinary and begs the question as to why nobody in Congress has asked Fed Chairman Jerome Powell for an explanation. The chart below shows historical “remittances” from the Fed back to the Treasury.  While Nelson and other researchers like to pretend that the Fed is a separate institution independent from the U.S. government, in fact the central bank lost its prized independence more than half a century ago. In 1966, when Congress “allowed” the central bank to purchase debt from agencies that are owned or guaranteed by the federal government, the central bank lost any real independence and became a captive funding vehicle for the Treasury. Many economists, of course, have trouble accepting the reality of the fiscal relationship between the Fed and the Treasury. Nelson notes a paper published by Federal Reserve System Staff in 2016 – “ Fiscal Implications of the Size and Composition of the Central Bank’s Balance Sheet ,” which largely supports the idea of separateness and also solvency. Fed staffers Bi, Cavallo, Del Negro, Frame, Malin, and Rosa (2016) observe that a central bank is solvent if the market value of its assets minus the market value of its interest-bearing liabilities plus the expected present discounted value of future seigniorage is positive.  Put another way, the central bank is solvent if the expected present value of its "profits" is positive.   Nelson relies upon two main factors to support the idea that the Fed is solvent.  First, the natural inflation of the currency and second, the likewise inflating value of seigniorage  (the monopoly on providing the public with currency).  We tend to discount these arguments, however, because ultimately the legal tender monopoly of the greenback that goes back to the Civil War belongs to the Treasury itself and not its instrumentalities. Consider an example. “In August 1861, a couple of weeks after the Union’s disastrous defeat at Bull Run, Treasury Secretary Salmon P. Chase traveled from Washington to New York in search of money,” writes Nicholas Guyatt  in a wonderful review in the NY Review of Books  (“ Blues, Grays & Greenbacks ”). At the time, there was no central bank and the nation’s paper currency was issued by private state-chartered banks, with paper money backed by gold. Any potential for seigniorage related to public money obviously belonged to the Treasury. When Chase demanded that the largest banks lend the Treasury all of their gold, the banks naturally refused. This led Chase to eventually decide to issue unbacked paper money, “greenbacks,” to finance the war. If the bankers in Boston, New York and Philadelphia refused his request for financing, said Chase: “I will go back to Washington, and issue notes for circulation; for it is certain that the war must go on until the rebellion is put down, if we have to put out paper until it takes a thousand dollars to buy a breakfast.” As we noted in " Inflated: How Money & Debt Built the American Dream (2010) , " Treasury Secretary Chase’s famous gambit to finance the Civil War with fiat money ultimately succeeded and in the process made the US stronger financially. The natural growth of the economy and insatiable demand for currency inflated the value of greenbacks back to parity with gold, this after paper lost much of its value during the conflict.  The difference, of course, is that the audacious actions of Chase to finance the Civil War without borrowing gold from the banks helped grow the value of the US economy. The US had little debt in 1865 and even the float represented by greenbacks was quickly absorbed. The more recent experience with quantitative easing and fiscal largesse from Congress in the wake of COVID, however, begs the question asked by Nelson about the “value” of the Fed in a deflationary environment. If the value of the Fed's esatz assets falls instead of inflates, then the central bank is insolvent using Nelson's methodology. Fortunately, the dire prediction made by Secretary Chase about paying $1,000 for breakfast has not yet arrived.  Ultimately, the real question facing the Fed and the economist community is not whether the Fed is broke or whether the FOMC can get inflation back down to the 2% target, but rather whether the central bank can keep asset prices growing indefinitely. As the deflationary pressure of tens of trillions in public debt relentlessly pushes us toward a general deflation event, possibly led by a home price correction later in the decade, the Fed’s job remains promoting inflation. In our next comment, we'll be providing an update on PNC Financial (PNC) for subscribers to our Premium Service. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

December 8, 2023 | Premium Service  | It is more than a little surprising to see how few Fed watchers appreciate that the Street’s rotation out of Reverse Repurchase Agreements (RRPs) and into T-bills essentially provided the catalyst for the November rally – and the cash to fund the ¾ of a point decline in yields in the Treasury market. As we were sitting in the trading room this AM, the jobs number came out and the 10-year Treasury moved from 4.17% to 4.25% in less than a minute. In this issue of The Institutional Risk Analyst , we take stock of the world of fixed income and credit as the year ends. As in December of 2018, the Street has essentially closed its books for the year.  Large banks led by JPMorgan (JPM) have in so many words told the Street “no thanks” to new exposures, meaning that we may see more trouble in Repo land before the New Year.  Look at the upward spikes in the Fed funds rate over the past two weeks. First let’s set the stage with a little data. The two major “adds” to the US markets in the past month have come from the runoff of RRPs at the Fed and expenditures by the Treasury from the TGA.  As we noted in our last post, when the Treasury spends cash, it results in increased reserves/deposits at banks.  Indeed, the inflows have largely offset the Fed’s QT policy to reduce reserves. The chart below from FRED shows RRPs (red) falling fast as the Treasury spends cash from the TGA ((blue). Over the past year, as the Treasury has issued a large amount of T-bills to raise cash, the outflow from RRPs and also normal payment flows from the TGA into banks has more than floated the Treasury’s cash needs. The balance was available to flow into stocks and longer-dated Treasury debt, and it did! The result was a pop in stocks and also a rally in the long-end of the Treasury curve. Our view is that once liquidity tightens in the markets in December and the next Treasury refunding approaches, the markets are likely to retreat in both stocks and fixed income. The Treasury plans to auction $816 billion in debt in the first quarter of 2024. This is in addition to $776 billion in debt that will be auctioned off in the final quarter of 2023.  Many of the names that have rallied in the past month such as Customers Bancorp (CUBI) . CapitalOne Financial (COF)  and Ally Financial (ALLY)  all rallied based upon an assumption of no recession in 2024. Even Citigroup (C)  managed to rally 15% based upon announced layoffs to improve operating results. Note that despite the rally, Citi is still trading below 0.5x book. Source: Bloomberg (12/7/2023) Many of the names in our surveillance group continue to trade at significant discounts to book value, including our one common holding in New York Community Bank (NYCB) .  The rally in November is likely to be very helpful to NYCB’s Flagstar unit because of increased lending volumes for the bank’s warehouse and loan servicing businesses.  We note in this regard that PennyMac Financial (PFSI)  just completed a $750 million six-year unsecured debt offering that was upsized from $650 million. The notes pay 7.875% and are rated Baa2 by Moody’s. The moral of the story is that November was a good time to be an issuer of debt, especially if you understood the context of what is going on at the Fed in terms of cash flows into the financial markets. We believe that many of the consumer-facing names that rallied in November may now be set up for an equal or larger sell-off in the next month or so.  Notice in the chart below that T-bills (blue) are trading significantly above the yield on RRPs (red). As markets come to appreciate that the FOMC may not be cutting short-term interest rates for some or possibly all of 2024, we think that the dynamics of the Treasury refunding in January and the near-complete runoff of RRP’s back into T-bills is likely to weigh on the markets. Simply stated, with T-bills trading significantly above the yield on RRPs, there is no reason for money market funds and other counterparties to leave cash at the Fed. 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.

December 5, 2023 | Premium Service  | In this issue of The Institutional Risk Analyst , we release the latest edition of The IRA Bank Book for Q4 2023  for subscribers to our premium service. Copies will be available for purchase in our online store later this week. While the banking industry’s insolvency reached its worst position ever at the end of Q3 2023, the subsequent rally in interest rates has made the ugliness of unrealized losses a little less horrific. The industry’s negative mark-to-market position is shown below with a $1.8 trillion capital deficit below. Source: FDIC/WGA LLC Stocks soared over the past month on the promise of lower interest rates. No surprise, we heard from a reader named Eric, who is a prominent bank owner and also an advisor to banks. He  asks whether the surfeit of liquidity being maintained in the Treasury General Account at the Fed is behind the rally in stocks. By no coincidence, Simon White wrote a comment in Bloomberg  on 11/28/23 claiming that the movement of cash out of the Fed’s reverse repurchase (RRP) facility and Treasury's account at the Fed helped stocks.  White: “The change in the change of reserves typically leads the one-month performance of the S&P (as shown in the chart below). Reserve growth began to accelerate about a month ago, the same time as when the market began to rally.”  The connection between bank reserves held at the Fed and stock prices has long been a favorite topic of conversation on Wall Street, yet we think that the apparent correlation may be coincidental. We asked Bill Nelson  at the Bank Policy Institute  about the connection between stock prices and bank reserves. His reply: “ I can’t think of any reason why reserve balances and stocks would be correlated.  Can you?” No, we can’t.  The chart above from FRED shows yields on T-bills ( red) vs Reverse Repurchase (RRP) agreements with the Fed ( blue ). Obviously the yield on T-bills is significantly above RRPs. Big question is whether the FOMC will maintain the yield differential on RRPs vs T-bills as a floor on rates rather than a ceiling, as was the case for many months. White is correct that the Treasury’s decision to focus new issuance on T-bills helped to reduce the number of money market funds purchasing RRPs from the Fed. He is also correct that when the Treasury spends cash from the sterilized TGA, it results in a net-cash injection into the banking system as payments are received throughout the economy. Again White: “Funding much of the deficit using bills as opposed to longer-term debt has allowed money market funds (MMFs) to absorb the new supply of government debt. The Fed's higher-for-longer message has kept the rate on bills higher than the rate on the reverse repo facility (RRP), meaning that MMFs have been incentivized to draw down on the RRP to buy bills.” Under the Volcker Rule banks cannot buy securities directly using reserve cash except for LT treasury investments. These treasury holdings are entirely passive, one of the more bizare downsides of the Volcker Rule that reduces market liquidity. In The IRA Bank Book , we note that bank securities holdings fell more than 10% in Q3 2023 alone. Since more than 90% of the assets of most banks belong to a customer and industry assets are shrinking, only the holder of a bank liability  can actually convert bank reserves into an equity investment. With banks, all things start with the liability, not with the assets. Thus only bank customers/depositors, who have a claim on the reserve asset cash, can buy stocks in a meaningful way. We queried White about the causal link between reserve growth and equity markets and he kindly replied over the weekend: “Reserves have a balance-sheet cost associated with them, so there is an incentive for banks to do something with them. Even more so recently as the GSIB buckets are decided towards the end of the year (they were announced last week I believe), so banks want to make sure their surcharge is limited.They can consider secured or unsecured lending surplus dollars, eg repo or FX swaps, or funding eg equity future basis trades, etc. FX swaps have been coming in, suggesting some of the new supply of dollars has been lent offshore, but this is becoming less lucrative. So they can also fulfill client demand for buying equity futures, by selling them to them, using the dollars to fund a long in the cash market. Facilitating a natural demand for long equity positions (eg start of month) can gain its own momentum. Overall, the rise in reserves should be equivalent to the rise in reserves from QE, with one of its aims to reduce risk premia through the portfolio effect. But I think the above helps explain how the effect can be pretty much immediate when there's a sudden rise of reserves to the system. This would tie into your t-bills/S&P point, but again I'm not sure that fully explains the immediacy of what happens.” Does this answer the question? Not really. While the return of funds from the sterilized confines of the Fed’s balance sheet to T-bills definitely represents a significant increase in liquidity, the amount of Buy Side cash that has been parked on the sidelines over the past two years is also quite large.  Indeed, every time that officials of the FOMC say that it is too soon to conclude that tightening is over, the bond market rallies. and so do stocks. “Jerome Powell probably did not mean to trigger a significant easing of financial conditions on Friday, but that’s exactly what he did,” wrote Jim Bianco  on X  over the weekend. “The chairman of the Federal Reserve gave a talk today at Spelman College in Atlanta in which he declared that it was ‘premature’ to conclude that monetary policy was ‘sufficiently restrictive’ or to speculate on when the central bank might start cutting rates. He even added that the Fed is prepared to tighten further if needed. The market’s reaction was a flat-out rejection of that idea.” Whether we attribute the rally in stocks to rising reserves due to expenditures from the Treasury General Account or the vast piles of cash on hand among Buy Side managers, the fact is that the inflation injected into the financial system by the Fed has impacted the effectiveness of US monetary policy.  We have a solution for the Fed's messaging problem. Instruct the FRBNY to at least hit the $35B cap on MBS runoff every month from the System Open Market Account. That is, actively sell MBS. As rates fall and MBS prices rise, the Fed should be selling MBS into market strength. Seling more MBS will accelerate the normalization of the yield curve. The FOMC is already losing trillions. Time to double down. Inflation has skewed the investment risk preferences of funds and other nonbanks to such a degree that private credit seems attractive. Going long credit at the top of a LT cycle in asset prices strikes us as a profoundly bad idea. We’ve heard from a number of fund sponsors seeking to enter the world of private credit in the past month and there will no doubt be more.  The common refrain from the large mutual fund managers seeking to stand up a credit trade is that “there is so much cash looking for a strategy.” Very true. When the credit trade goes sideways a year or two from now, however, please do remember that funds and nonbanks have no comparative advantage in managing credit risk compared with a commercial bank. Meanwhile, we note that the Bitcoin ponzi has reached $40k, the highest levels seen since last year. The resurgence of Bitcoin is a fascinating phenomenon, but as we wrote last week, regulators in the G-20 nations are increasingly treating crypto as a legal and compliance problem that triggers anti-money laundering and know-your-customer conserns. No thanks. More notable, in our view, is the rise in gold prices, which is due to a shift in Asian risk preferences from Treasury debt to gold. One long-time reader named Henry, who manages an offshore gold fund, wonders if gold is not slowly going to supplant the dollar and Treasury securities as the prefered risk free asset. With gold, Henry notes, there is no counterparty risk and price discovery in gold has now shifted to Asian markets dominated by China. We'll be looking at how the Treasury's strategy to fund its mounting deficits with T-bills is helping Jay Powell out of his RRP problem but is also forcing offshore counterparties to seek out substitutes like physical gold. You can use gold as collateral in an ISDA swap. Yellen's clumsy management of the Treasury's funding needs is undermining the dollar and setting the US for a funding crisis down the road. Finally, we note the bankruptcy of Rene Benko's Signa Holdings , an Austrian based real estate developer that provides a lovely example of the Basel III concept known as Exposure at Default. Exposure at Default (EAD) measures unused but committed credit lines banks make available to consumers and business. These bank lines are committed and may be drawn at any time. The debt of the Signa group held by some 200 lender banks ballooned in the months before the default, illustrating that committed but unused credit lines can be a significant source of risk for banks. For every $1 of loans held by US banks, there is another $0.80 of unused commitments that can be drawn by the obligor at any time prior to bankruptcy. Sad to say, banks rarely cut unused lines in time to avoid a loss after a default event. Source: FDIC The level of EAD in the industry is over 80% of total loans and illustrates the current high risk appetite of banks. Since the COVID crisis, US banks have added $2 trillion in unused credit lines. Despite worries about an imminent consumer recession, banks remain aggressively positioned with almost $10 trillion in undrawn credit vs $12.4 trillion in total loans. Even with the current carnage in multifamily and commercial real estate that we document in this issue of The IRA Bank Book for Q4 2023 , the great asset price reset for stocks and residential homes is still a couple of years out. Maybe Treasury Secretary Yellen will return to the private sector by then, leaving the mounting mess in the Treasury debt market for some one else to manage. Subscribers to the Premium Service  of The Institutional Risk Analyst  login to download the latest version of The IRA Bank Book for Q4 2023 below. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

November 29, 2023 | Premium Service  | Since the end of the third quarter of 2023, all manner of equity securities have soared on the promise of lower interest rates. Meanwhile, the latest US Treasury auctions are a decidedly mixed bag, with shorter duration securities flying off the virtual shelves but longer dated maturities drifting higher in yield. Everything from 7s on out the yield curve is slipping as short-dates rally. Like we said last week, a normal yield curve beckons. Below we catch up on some of the latest action in banks and fintech firms. By far the best performer among our three areas of focus is Coinbase Global, Inc. (COIN), one of the survivors in a sector that has seen excessive hype overtaken by enforcement actions and prosecution for firms like FTX . COIN provides "financial infrastructure and technology for the cryptoeconomy in the United States and internationally." The company’s equity market capitalization has doubled to $28 billion over the past year. COIN has a beta of 2.66 and trades under 5x book or 10x sales, hardly an astronomical valuation. Yet fact is that COIN is up over 260% LTM, according to the Bloomberg . Coinbase CEO Brian Armstrong says the industry can finally close the chapter of bad actors after the recent settlement between Binance and the U.S. Department of Justice. COIN has been helped by a groundswell of positive comment about crypto in 2023, due to some losses in court for the SEC and a general desire to try one more time. We point out to clients, however, the federal bank regulators, FINRA, the SEC, IRS and most state agencies are treating crypto as a problem . We just got done with CE for our FINRA principal tickets and annual disclosure. “Informal assets” are basically becoming a legal and compliance ghetto for anyone working in regulated finance. Also, just to add to the fun, crypto kicks in a presumption of enhanced compliance monitoring for anti-money laundering (AML) and know-your-customer issues up the wazoo. Our fintech surveillance group is shown below. Source: Bloomberg (11/28/23) Next we move to Affirm Holdings (AFRM) , which is up over 200% in the past year.  This is a volatile stock with a market cap below $10 billion or 1/4 of COIN, where insiders and special channel partners like Amazon (AMZN)  carry off huge chunks of equity. There is just enough filling and crust left for the daring investor to take a wild flier on this 3 beta stock (which means AFRM is 3x more volatile than the S&P 500).  The chart below shows AFRM over the past year.  Source: Google Finance Like many of the names in our fintech group, however, AFRM is slowing down a great deal, especially when you look at the equity over the past five years. This is a natural maturation process whereby the Buy Side managers fall into and then, sadly, out of love with certain names. Block (SQ) , PayPal (PYPL)  and other higher flyers litter the animal graveyard of tech stocks. Look at the chart for AFRM going back five years. Source: Google Finance Whenever you do analysis of a new stock, the first thing to do is go back as far as the data goes. Are we still climbing the value mountain, or are we done? When you look at that long-term chart for AFRM, it shows the coming of age of yet another fintech, point-of-sale play in the world of consumer finance. Will firms like AFRM survive the eventual correction in consumer credit? We love the whole buy now, pay maybe phenomenon, mostly as a sign of the times, but in a real recession all of these subprime consumer plays will be vaporized by credit and operations risk. We note that number of retailers facing lower income consumers such as Dollar General (DG) are reporting a pullback in discretionary spending. Also significant is the still torrid pace of cash-out refinance transactions by low-FICO, high LTV FHA borrowers reported by several Ginnie Mae issuers. Are consumers who are willing to refinance out of a 3% loan coupon into a 7% loan in order to take out cash in trouble? Yeah, probably. You could also call these consumers smart for taking cash out before the residential housing market corrects in a couple of years. Enjoy the fun while it lasts. If the gloom & doomers are right about an impending consumer seize up in credit, then we’d expect most of our fintech universe to lose significant value in 2024. But not quite yet, as we keep reminding clients. Yes, the bottom 20% of FICO scores in cards, autos and mortgages are seeing higher net default rates, but the rest of the credit stack not so much. Is this a tale of two credit markets? We’d be remiss not to mention that Kingdom Holdings , the investment company of Prince Alwaleed Bin Talal , has raised its stake in Citigroup (C)  to 2.2% after buying a $450 million stake from the Saudi billionaire. This gives the Saudi government one of the largest stakes in the bank and also a control position since most of the other large equity holders are passive custodians.  Citigroup is still trading at less than half of book value, but the stock is now in the middle of our bank group after rising in the high teens percent over the past month.  We attribute the rise in Citi’s equity market value to news of cost cutting and layoffs at the bank, which is only just starting to address the poor operating leverage. Citi’s researchers are predicting strong growth in earnings for S&P 500 companies, but we cannot say that yet for the bank. Source: Google Finance And in recent news, Citigroup is reported to be among several global banks that provided credit to a now-insolvent unit of Rene Benko’s Signa  group of companies, Bloomberg  reports, “making the Wall Street firm the latest in a long list of banks with exposure to the Austrian real estate tycoon.”  Amazing. The term "adequate systems and controls" comes to mind. Finally, we also note that Apple (AAPL)  has ended its credit card relationship with Goldman Sachs (GS) , putting another exclamation point underneath the Wall Street bank’s retreat from traditional commercial banking. Apple gave Goldman Sachs “a proposal to end its credit-card and savings account partnership within the next 12 to 15 months,” CNBC  reported yesterday.   AAPL also announced an end to its quest to manufacture smart phone modems, another sign of good decision making at the electronics giant.  Suffice to say that GS has had about as much reason to get into white label credit cards as AAPL did getting into the manufacture of low-margin generic parts like modems. Only monumental hubris made Goldman Sachs think that they could compete profitably with the large bank issuers of credit cards in terms of funding costs or operational proficiency. What now David Solomon ?  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 27, 2023 | Updated | Our note last week in The Institutional Risk Analyst about yield curve normalization  generated a lot of comments, mostly from aggrieved bankers who want to know why the vast moral hazard created by the FOMC’s interest rate policies should not be reversed immediately.  For those of you who missed the S&L crisis in the 1980s and the 2008 financial collapse, moral hazard is when the government allows insolvent banks with federal deposit insurance to operate with nothing in the vault except the FDIC insurance logo on the bank window. As we have noted in past commentaries, the Federal Reserve Board wiped out the capital of the central bank during COVID and continued to spend money that was never authorized by Congress. When our friends at CNBC once questioned why we thought the Fed’s actions were illegal, this was the point. But naturally, nobody in the world of global equities or media wants to talk about the fact that the Federal Reserve System and most US banks are now profoundly insolvent and will remain so for years to come. Andy Levin and Bill Nelson wrote a paper for Mercatus Center in January : “It might seem extraordinary that a US government institution could conduct any program that is likely to incur a cost of nearly $1 trillion to taxpayers. And it might seem equally extraordinary that such a program could be undertaken without congressional approval or even any forewarning about the magnitude of the risks. Yet that is the expected outcome of the Federal Reserve’s securities purchase program known as QE4 (its fourth round of quantitative easing).” Quantitative easing is the most radical and irresponsible fiscal action ever taken by a federal agency, yet the Congress remains strangely silent. Not a single member of either political party has called for Fed Chairman Jerome Powell to explain his illegal expenditure of Treasury funds, even during appearances before Congress. Again, the Fed’s capital is authorized by law; QE is not because the Fed is spending the Treasury's cash. We have noted previously in this space that the central bank cannot make a “profit” and is always an expense to the US Treasury on a net basis (See " The Interview: Bob Eisenbeis on Seeking Normal at the Fed ") . The intellectual author of the Fed’s illegal actions is former Fed Chairman Chairman Ben Bernanke , who tours the country collecting kudos and speaking fees for saving the world after 2008, but in fact is a fraud. Instead of seeking authority from Congress, Chairman Bernanke and other members of the FOMC merely turned on the public spigot. Chairman Bernanke at al made the problem of post-2008 deflation go away by spending tens of billions of dollars in funds that were never authorized by Congress. By the time that Chairman Powell took the helm of the FOMC, the Fed's staff merely added a “0” to its tab at the US Treasury and kept right on spending. While the cost of QE to the Treasury is enormous, the impact of these actions on the private economy is far larger.  Losses to US banks and investors stretch into the trillions of dollars and are causing vast dislocation throughout the US economy. These very real costs are considered collateral damage at the Federal Reserve Board.  Yet for banks, pensions and other investors, the ultra-low interest rates of 2020-2021 represent a potentially fatal cancer eating away at the financial stability of the US economy. “ The unrealized loss problems, whether bonds or loans, is so large and widespread that the FDIC does not have the funds or human resources to handle properly,” writes Sam Moyer, CEO of Heritage Bank . "As you point out, many banks have zero or negative GAAP capital.” Heritage Bank of Wood River, Nebraska, is a well-capitalized community bank with a liquid balance sheet and a 30% efficiency ratio. The bank's negative mark-to-market losses are less than 15% of capital and the bank earns 3% on assets or 3x its larger peers. Moyer and other bankers avoided the risk of interest rate volatility ℅ the FOMC by keeping their securities positions short and relatively small. These bankers wonder why the FDIC is not forcing large banks to take losses. By allowing large, insolvent banks to operate with little or no tangible capital, are the Fed and FDIC not encouraging massive moral hazard? A: Yes. Unrealized losses are true economic losses, Moyer tells The IRA . The money is gone. The value of the cash flow stream on the bond or note has decreased significantly. It does not matter if you take present value today or the payments as scheduled over time, the diminution of value has already occurred. "Bankers and bank boards struggle with this," Moyer opines. "They have their heads in the sand. They are wishing away reality." Does the FDIC Board and executives have fiduciary duty to protect the BIF fund such that they have to at least require these broke banks to unwind or otherwise hedge these asset/liability positions that caused the losses?, Moyer asks. “It is one thing to allow the broke banks to stay open being under capitalized, but quite another to allow banks in this position to take future risk on the direction of interest rates. The zombie banks are a moral hazard.” If rates go down, the zombie bank shareholders win, Moyer notes. But if rates go up, the shareholders do not lose. They no longer have any capital at risk. So if the bank fails, the FDIC fund takes the hit. Allowing the zombie banks to maintain the long asset and short liability position that cost them all their capital over the past 18 months is imprudent. Is it a breach of duty for those on the Federal Reserve Board and FDIC board of directors to not require that such risk positions be returned to a neutral position??? The objections of Moyer and other bankers are especially relevant because market expectations about a decline in interest rates in 2024 or beyond may not actually include LT interest rates, which is how the losses to the Fed, banks and pension funds are calculated. As we noted last week, the FOMC believes that they control the short-end of the Treasury yield curve, but the markets control the long end.   Source: US Treasury Our big worry is that short-term interest rates may fall in 2024, but long-term interest rates will rise due to the Treasury’s vast deficits and mounting interest expense. We estimate that the Treasury would need to pay 5.5-6% to sell new long bonds today. Because the Fed’s balance sheet is already polluted with low-coupon Treasury and mortgage debt, the central bank has little remaining flexibility to respond to a large bank failure or other contingency. In coming months, we may all get an objective lesson in why moral hazard is to be avoided. 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 21, 2023 | Last week, as we noted earlier, the thundering herd in the equity markets decided that the Fed’s battle with inflation is won and happy days are here again. Raging bulls drove yields on the long end down sharply and generated intense speculation about when and how much the FOMC will cut short term rates. Brokers loudly recommend the purchase of current coupon mortgage-backed securities. Some brave souls among our readers even began to ask for recommendations about which banks to buy .  The chart below shows the yield on the 10-year Treasury (blue) and prime conventional loans (red). We’re back to market yields seen in early September. First, let’s reset some benchmarks. Last week saw the 10-year Treasury around a 4.45% yield and 30-year prime 1-4 family mortgages around an average 7.2% coupon. This represents a considerable rally from the 5% plus yields seen at the end of Q3 2023. The rally in the 10-year moved the price of Ginnie Mae 3% MBS from 81 to 83 bid, a small but still significant improvement, yet not enough to matter to most bank shareholders.   Even with the rally in the Treasury market, most US banks remain insolvent on a mark-to-market basis. We say this because many banks are waiting, we think in vain, for Fed Chairman Jerome Powell & Co at the FOMC to ride to the rescue.  We think that doing nothing is a fool’s trade, to be blunt, because the next Treasury refunding could pull market yields sharply higher. More important, a normalization of the Treasury yield curve may see the “belly” of the mortgage TBA curve return to normal, meaning on-the-run contracts closer to the middle of a positively sloped curve. Despite the rally last week, the "belly" of the TBA curve is arguably a Fannie Mae 6.5-7% contract for December delivery. This implies profitable conventional loans with 7.5-8% loan coupons. Source: US Treasury There are a few folks out there who understand that the rally in the bond market may be fleeting, like the last roses before the frost. Earlier this week, Pacific Premier Bank (PPBI)  did a significant clean up of its balance sheet of COVID-era assets. PPBI “announced the Bank completed an investment securities portfolio repositioning.” The press release continued: “The Bank sold approximately $1.27 billion of available-for-sale securities consisting primarily of lower-yielding agency and mortgage-backed debt securities with an average yield of 1.34% for an estimated after-tax loss of approximately $182.3 million. The Company expects to deploy the net proceeds during the fourth quarter into a mix of cash and higher-yielding earning assets with an expected average yield of approximately 5.0%. The Company anticipates that the repositioning will contribute an incremental $50.4 million in net interest income on an annualized basis and will be neutral to tangible book value per share.”  PPBI has taken a proactive decision to rid its balance sheet of low-yielding QE-era securities and redeploy the net proceeds into higher yielding assets. The bank only had a mark-to-market loss on its $20 billion balance sheet equal to 10% of capital. Yet PPBI has above-peer capital and earnings, allowing the Irvine, CA, commercial lender to sell the underwater securities at a loss. Sadly, there are few other large banks in Peer Group 1 besides PPBI with the focus to take the short-term pain necessary to put COVID and QE behind them. Bottom line is that the change will increase PPBI’s net interest income by almost 10% vs the roughly $600 plus million in annualized NII reported in Q3 2023. The key factor in this successful repositioning of the bank, of course, is that the bank’s accumulated other comprehensive income (AOCI) was never that large vs the bank’s capital in the first place. If you own or operate a financial institution and you are sitting on a significant negative AOCI position, then you should be lightening the load before the end of the fourth quarter of 2023. The simple reason we say this is the deteriorating tactical situation facing Secretary Janet Yellen and the US Treasury in the debt markets. We think that the FOMC has effectively lost control of the long end of the curve, especially with inflation still running above target. Since we price MBS and residential mortgages off of the 10-year Treasury note and not off SOFR or Fed funds, the weight of Treasury issuance ahead seems important. Even if the equity manager herd is correct and the FOMC plans a reduction in short-term interest rates next year, the long end of the curve may continue to rise as the Treasury is forced to pay higher rates. We doubt that many equity managers or economists think about what the normalization of the yield curve implies for banks and other financials. In the absence of more QE, in fact, we’d argue that the normalization of the yield curve must include higher LT yields. Think about the yield that would have allowed the Treasury to issue its full planned allocation of long-dated paper in the most recent refunding. "The swift ascent of yields is not only felt in government borrowing costs, since the 10-year Treasury yield also underpins the rates on corporate debt, consumer mortgages and many other types of debt around the world," Joe Rennisson wrote in The New York Times . So if we eventually see Fed funds drop down to 5% or lower, but 10-year Treasury notes are trading at say a 6% yield, is that better for banks? If you are talking about a bank with no significant deficit in terms of mark-to-market losses, then the answer is yes. But if we are talking about a bank with 20% or more of negative AOCI vs tangible capital, then the answer is decidedly no. The pain for banks that hold low coupon paper goes up with the yield on the 10-year Treasury note.   Seen in this light, the actions of PPBI and other banks that have taken the pain and sold QE era securities (a/k/a “toxic waste”) may be seen in years hence as exemplary. Banks such as Bank of America (BAC) , as we noted in our Premium Service profile (“ Update: Bank of America "), will see NII hurt by low yielding securities buried deep in held-to-maturity portfolios for years to come.  Steven R. Gardner , Chairman, CEO, and President of Pacific Premier, commented in a press release:  “We elected to proactively reposition our securities portfolio during the fourth quarter, which we anticipate will provide significant earnings benefit as we enter 2024. We expect the repositioning will add approximately 26 basis points to our net interest margin and contribute approximately $37.1 million to annual net income in 2024. Through this securities portfolio repositioning, we have significantly improved the Company’s future earnings power, while simultaneously preserving our strong capital levels and further enhancing our liquidity.” Happy Thanksgiving! 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 17, 2023 | Premium Service | This past week The Institutional Risk Analyst  was in Dallas for client meetings. While we toured the Texas miracle, the thundering herd in the US equity markets decided that the Fed’s battle with inflation is done. The outburst of exhuberance drove yields on the long end down sharply. Intense speculation followed about when and how much the FOMC will cut short term rates. Only days earlier, of note, the Treasury had trouble selling long-dated debt at yields half a point higher than Friday’s close. But hold that thought. On Thursday we attended the annual Garrett McAuley  client dinner in downtown Dallas and got to hear Doug Duncan  from Fannie Mae  talk about interest rates and related questions. He noted that the Fed remains the largest holder of MBS in the US and the GSEs are not available to support the market. Duncan also noted that the market seems disinclined to support issuance of MBS at even today’s current low volumes ~ $1.5 trillion. Meanwhile, demand for agency eligible loans in private label MBS is growing as investors hunt for yield. Divergent data points make the road ahead less than clear.  We had an opportunity to hear Stan Middleman , founder and CEO of Freedom Mortgage, talk about the markets and mortgage servicing rights (MSRs) at the Garrett McAuley event. His simple rules: 1) Make loans that you expect to pay you and your investors back and the rest will follow. 2) If you want good MSRs, make good loans. Simple. Stan makes no secret of being an aggressive buyer of mortgage servicing assets. What does that say about forward interest rates? The mood in the Dallas mortgage community is subdued, much like the atmosphere after an especially good summer party. The housing finance sector did five years worth of business between 2019 and 2021, leaving the pipeline a tad light, both today and looking forward over the next several years. More to the point, retail establishments in the affluent regions of Dallas are showing visible signs of a pullback by consuers and a related slump in commercial property rents and valuations. What you see in Dallas and many other communities is massive overbuilding of office and retail venues, almost on a scale of the malinvestment seen in communist China. In effect, many developers in Northern states moved south and contrbuted to massive construction of real property. The related financial assets may now be headed for years of deflation. As Robert Shiller wrote in the New York Times last year , the period before October 1929 was good for stocks: "Great as that was, the stock market in most of the Roaring Twenties was even better: It was the biggest bull stock market in U.S. history, when you factor in inflation. I calculate that the real total return for the Standard & Poor’s Composite Index (an S&P 500 predecessor), including dividends, from September 1919 to September 1929 averaged 20 percent a year. That implies a sixfold increase in real value over the decade." If you ponder the recent meeting between President Joe Biden and Chinese leader Xi Jinping , and various western business executives, the scale of the misallocation of investment resources represented in that the audience is mind boggling. Ultra-low interest rates created a vast amount of investment in public and private equity, commercial real estate and various cash consuming innovations like housing, electric-vehicles or even “artificial intelligence.” The Biden Administration has given away hundreds of billions in federal debt proceeds over the past three years, everythings from housing assistance to debt forgiveness to subsidies for producing lithium batteries. The White House just decided to subsidize the manufacture of heat pumps, another act of hubris on par with the economic edicts of the Xi regime. As domestic subsidies for EV’s fade, of note, the sales of electric vehicles fall. In the US we call it “industrial policy.” In China it is called “Belt & Road” or “ high quality consumption ,” but note that the managers are always wrong in their economic decisions. The “business leaders” who feted Xi Jinping at dinner in San Francisco are almost entirely managers, not business owners, the perfect companions for Chinese cadres. In both the US and China, the result of growing government involvement with the economy is largely a disaster in financial terms. Increased levels of spending in both nations created a lot of public debt that cannot be repaid, banks and corporate issuers that are deeply insolvent, and late vintage commercial assets that are underutilized at best. The amount of vacant office and residential space in Texas, for example, is unprecedented in a strong economy, but problematic in a slowdown. The notion that a “soft landing” is possible after such a frenetic period of asset allocation decisions is really laughable. But the approaching pain will be visible first and foremost in commercial assets, with consumer following as much as a year behind. In China, the mark-to-market on the property sector represents  a significant threat to the country’s financial stability and social peace. Efforts by Beijing to support the several insolvent property developers have been inconsistent, resulting in falling public confidence and even lower prices for housing. Published indices of home prices in China are down roughly 20% from the 2021 peak values. In the US, whole swaths of the commercial real estate sector are being marked down by lenders in major cities. Commercial assets in downtown Dallas or Atlanta are just as empty as are sections of New York or Chicago.  We note that this week’s auction by the FDIC of the rent stabilized multifamily assets  of Signature Bank was essentially a bust.  The good news of sorts is there is not yet any sign of a consumer led recession, the scenario that the Street economist narrative is seeking. Credit losses have normalized to pre-COVID levels but the rate of change is slowing. Kevin Barker at Piper Sandler notes: “Industry-wide net charge-offs (NCOs) increased to 3.85% from 2.41% in October 2022, a +59% Y/Y increase compared to +62% in September. Industry-wide 30D+ delinquencies (DQs) increased +36% Y/Y in October after increasing +31% in September and +34% in August. Consolidate NCO rates surpassed pre-pandemic levels in October by ~11%, which we expect to continue given the elevated DQ growth rates. That being said, the rate of growth in DQs has moderated to ~35% Y/Y the last three quarters from running 40%+ in the preceding five quarters. DFS continues to see outsized growth in DQs, now +103 bps above 2019 levels. SYF continues to outperform peers with DQ rates only +2% above pre-pandemic levels, while COF has seen a slowdown in the rate of growth over the past six months.” The bad news is we are going to see a slowdown next year and eventually that reduction in consumption will be visible in credit and employment. The year will start and continue along with increasingly bad news in commercial assets and exposures, but the default rates on consumer assets will slowly rise during the course of the year. This change will come at the same time that the US Treasury will be funding progressively larger amounts of cash to fund government operations, putting upward pressure on longer Treasury maturities.  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 15, 2023 | Premium Service | Whalen Global Advisors (“WGA”) has published its latest outlook on the US Housing Finance Sector . Suffice to say that things in the world of 1-4 family residential mortgages are as tough today as they were fantastic in mid-2020. Could not be more different. Mortage lenders just reported another negative quarter in terms of income. Copies of the IRA Housing Finance Outlook are available to subscribers to the Premium Service of The Institutional Risk Analyst . Standalone copies of the report are also available for purchase in our online store . Media wishing to receive a courtesy copy of the report please email: info@theinstitutionalriskanalyst.com “Home prices around the nation are starting to see signs of fatigue from high interest rates and a resulting dearth of rate sensitive buyers,” notes WGA Chairman Christopher Whalen . “The strong demand for cash out refinance transactions continues, however, as home owners monetize record equity vs 20% plus credit card rates.” The report notes that rental rates are starting to soften in some urban markets. The new report from WGA notes that that residential mortgage interest rates will likely rise towards 8% and new origination volumes are likely to be at or below $1.5 trillion, with more than 90% purchase mortgages in that flow, for the next two years. Baring some considerable emergency, the Fed seems on track to keep interest rates at current levels indefintely. “Lending capacity in the mortgage industry needs to decline by about half in order for the surviving lenders to become profitable,” notes Whalen, who adds that one operator recently quipped that "it has definitely been better to be a servicer in this environment." “Meanwhile, the new Basel capital proposal for banks will cut the profitability of mortgage lending in half,” Whalen relates. "The whole proposal ought to be reworked to focus on market risk and balance sheet management." He adds that the market share of nonbank lenders and servicers will grow rapidly if the Basel proposal is adopted. Meanwhile, home price compression is visible in many high end markets. “In a recession, prices above the $440k median home value are likely to see compression before lower priced assets, but the process of normalization of home prices may take years,” the report notes. “Homes priced below the median level are likely to resist downward pressure due to supply constraints.”   In the IRA Housing Finance Outlook , we look at how members of our mortgage equity surveillance group have performed over the past five years, going back to before COVID and “go big” ℅ the FOMC and Chairman Jerome Powell.  Who are the best performers in the mortgage equity group in terms of total return over the past five years? Subscribers to the Premium Service login to download the report below. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

November 13, 2023 | This week The Institutional Risk Analyst  releases our latest Housing Finance Outlook for Q4 2023 . The picture is remarkably mixed, with residential default rates still hugging the bottom of the chart but volumes and industry profitability also testing new lows. Multifamily and commercial assets have long since reverted to pre-COVID default rates or higher. Former FHA Commissioner and past MBA CEO Dave Stevens foresees the " worst winter the industry has ever faced " in 2024. Mortgage bankers at industry events say “Survive till ‘25,” referring to the small probability of an interest rate cut by the Fed in the next year. But of course on Wall Street, where the sun always shines, the Sell Side is already arguing about when and how much the Fed will cut rates.  The new WGA report will be available to Premium Service subscribers and in our online store on Wednesday AM. We look at how members of our mortgage equity surveillance group have performed over the past five years, going back to before COVID and “go big” ℅ the FOMC and Chairman Jerome Powell.  Who are the best performers in the mortgage sector over the past five years? See our comment about COVID loan forebearance for veterans below in National Mortgage News . Last week saw two significant systemic events hit the market, almost unnoticed. First we had the cyber hack of Industrial and Commercial Bank of China's  U.S. broker-dealer. Reuters reports that the event was so extensive that “corporate email stopped working and employees switched to Gmail, according to two people familiar with the situation.” ICBC was a small dealer, but the problems caused big reverberations in the markets. “This is a very big deal, even if most people don’t get the joke,” notes one large bank chief risk officer. “This ICBC hack makes me nauseous. Someone is not afraid to play with the big boys!” As we wrote last week (" ACH: The Bank Deposit Ain't in the Mail "}, there reecently were several significant hacks of financial institutions and the US clearing system. The fact that the Federal Reserve and other players in the clearing system have not put out a more detailed explanation makes us wonder. Is the US financial system under attack via increasingly bold and high profile incursions?  Even as these latest attacks on the US clearing system were underway, the Treasury had one of the weakest auctions of long bonds in years. The yield on the 30-year US Treasury bond surged to 4.8% last Thursday, raising a lot of eyebrows on and off the trading floor. Dealers retained 25% of the offering, which is a very weak auction result vs the average of 11% dealer buy in in most auctions. The price volatility reflects the fact that so much of the audience for Treasury debt is hedge funds and highly leveraged traders as opposed to large cash, buy-and-hold investors like central banks. “New government bond issuance last month was already seeing softer demand, though bond traders were recently encouraged by the Treasury Department's surprise decision to limit the sale of long-dated US debt,” reports Bloomberg regarding the latest Treasury statement . Did the Treasury “decide” to change the composition of the auction or did indications from primary dealers force Treasury Secretary Janet Yellen’s hand? We continue to worry that the rising cost of servicing the Treasury’s debt, and the equal and steady increase in the Treasury General Account at the Fed, makes a funding crisis inevitable. And yes, the Fed buys Treasury paper to collateralize the growing TGA. The sale of the remaining rent-controlled multifamily assets of Signature Bank by the Federal Deposit Insuance Corp is also weighing on credit markets. Look for a series of asset write-downs as and when sales are finally announced. "The bidding difference finally provides a mechanism for valuing the effect of rent control on asset values," notes one insider. The ongoing collapse of the commercial real estate market is largely obscured from the view of consumers and retail markets, but the losses in Q4 and 2024 could be quite startling and not particularly good for liquidity. Konrad Putzier in the WSJ gives you a taste of what is to come: "The increase in mezzanine-loan foreclosure announcements—while not large in absolute numbers—matters because it offers a more immediate measure of commercial real-estate distress than mortgage foreclosure rates." But it gets better. The fact that the Biden Administration and the SEC under Chairman Gary Gensler are pressing ahead with plans to require centralized clearing of Treasury debt strikes us as risky right now. The Washington narrative led by the Federal Reserve’s Powell and Treasury Secretary Yellen says that centralized clearing will reduce market volatility and uncertainty. Yellen last October 2022: “We want to make sure that going forward our Treasury markets remain deep, liquid and well-functioning,” she said at an event in New York City. “We are working actively to try to bolster the functioning of that market to carefully look at what might be appropriate. I think the ability of broker-dealers to intermediate that market — their capacity has not grown in line with the size of the market. So we’re looking at a number of ways to improve resilience.” Centralized clearing of Treasuries is Yellen's "big" idea. Of course, no mention of the FOMC or QE is ever made when discussing recent Treasury market volatility. The Yellen Treasury, of note, is still planning to buy back low coupon debt in 2024, an amusing prospect given the current narrative regarding Treasury market liquidity. We think one near certainty is that centralized clearing will reduce the number of buyers for Treasury debt and the leverage available for such purchases. The volatility in Treasury debt comes from low coupons and even lower capital behind a lot of interest rate arb trades.  We also observe through our conversations with traders and back office professionals that the impending transition to T+1 settlement of US Treasury debt could throw another spanner into the proverbial gearbox of market liquidity. The SEC adopted the rule to shorten the settlement cycle to T+1, effective May 28, 2024, for all U.S. securities transactions that settle through DTC . Canada has adopted a parallel rule covering their markets, however, given the three-day Memorial Day holiday in the United States, Canadian securities will begin trading using a T+1 settlement date on May 27th, one day before U.S. securities.  What impact will this change to T-1 clearing of Treasuries have on the post-trade processing of securities transactions?  The short answer is that the initial transition to T-1 is going to be a gloal train wreck, especially for smaller firms. Throw in the possibility of a hack affecting a large bank primary dealer and we’re off to the races. Ponder this encouraging message from DTCC: “With the shortened settlement cycle, allocation and confirmation must happen on trade date, impacting all institutional trades that clear and settle through DTCC’s various services. The new guideline of 7:00 PM ET for allocations and 9:00 PM ET cutoff for straight through processing of affirmations on trade date puts added pressure on global investors to ensure the proper processes are in place. Firms — investment managers, broker-dealers, custodians — will need to consider their target operating model. Asia now has one day to reconcile, but after the move, that will be reduced to as little as two hours, depending on the market.” What could go wrong? Bill Meenaghan at S&P Global notes :  “T+1 will remove some market risks, but risk doesn't go away, it simply moves to another area and, right now, it looks like that area will be back-office operations…. Compressing the settlement cycle to T+1 will demand that operational risk is mitigated. Any manual processes will immediately come under pressure, as automation is a prerequisite for a T+1 environment to ensure exception management is limited and there is as little risk as possible. US banks, brokers and investors need to initiate an assessment of their current post-trade technologies and processes, from the front-office to back- to ensure that they are ready both from a technology and an operational standpoint for T+1.” For the longest time, regulators have equated faster processing times and increased regulation of financial institutions as operative goals of public policy to benefit investors . As with the Volcker Rule for banks, the move to centralized clearing of Treasuries and next-day settlement seems destined to reduce market liquidity. We wonder if the focus on technological improvement (a/k/a "speed") does not lead to qualitative degradation of markets and the people they represent. The move to T+1 for US Settlements, which will likely start in the first half of 2024, is great news from a market and counterparty risk perspective. The leap for great efficiency may be really, really bad news for the markets from an operational risk and liquidity perspective. Op-risk because a lot of back office clearing is still manual and cannot transition to T-1. Maybe it will just go away. Liquidity risk because T-1 will of necessity force buyers (aka small dealers) out of the market. T-1 clearing is basically an invitation to leave for small counterparties who can’t or won’t pay the freight to upgrade systems to support 100% automated clearing. That's part of the same authomated clearing mechanism that broke down last week, of note. So just to summarize, at the moment when US debt service costs are rising and support for Treasury auctions is largely in the hands of indirect bidders, we are going to move to centralized clearing and T-1 settlement of all securities trades. This process will reduce the number of bidders in Treasury auctions and reduce the effective leverage counterparts can put under Treasury and agency debt.  And at the same time, we are going to be increasing capital requirements on banks, effectively pushing down effective leverage in the financial system. These same large commercial banks, keep in mind, are arguably insolvent and, that is to say, illiquid, forcing them to be net sellers of Treasury and agency debt and MBS. What could go wrong? The big "what" is that long-term yields rise and the Fed is unable to control the long end of the yield curve. The Report to the Secretary of the Treasury from the Treasury Borrowing Advisory Committee stated in August:  “Based on the marketable borrowing estimates published on July 31, Treasury currently expects privately-held net marketable borrowing of $1.007 trillion in Q4 FY 2023 (Q3 CY 2023), with an assumed end-of-September cash balance of $650 billion. The borrowing estimate is higher than at the May refunding, primarily due to a lower starting cash balance, a higher assumed end of quarter cash balance, and projections of lower receipts and higher outlays. For Q1 FY 2024 (Q4 CY 2023), privately-held net marketable borrowing is expected to be $852 billion, with a cash balance of $750 billion assumed at the end of December. Primary dealer projections for issuance have increased for FY 2023 and FY 2024, with uncertainty driven by economic growth expectations and the duration of SOMA run-off.”  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 8, 2023 | Premium Service | In this edition of the Institutional Risk Analyst , we return to Bank of America (BAC) and take a look at the bank’s Q3 2023 results. BAC has been trading near the bottom of the top-five US depositories, though thankfully above Citigroup (C) at 0.4x book value. BAC is trading at 0.8x book value, but is actually underperforming Citi in terms of total return for the past year. Our bank surveillance list is shown below. Bank Equity Source: Bloomberg (11/08/23) The first thing to notice is that BAC has a very low net interest margin vs its large bank peers. The bank’s net spread was just 1.15% in Q3 and 1.7% for the first nine months. In other words, BAC's NIM has been shrinking as the year has progressed, in line with the rest of the industry. BAC was in the bottom decile of Peer Group 1 in Q2 2023 in terms of the yield on earning assets. Source: FFIEC The poor earnings performance of BAC is largely attributable to below-peer asset returns and also above peer funding costs. Given that the industry is currently experiencing a compression of net interest income due to the shape of the Treasury yield curve, BAC is in a particularly bad position vis-à-vis its large bank peers. Compare the treasury management of BAC with its large bank peers and it is difficult to avoid the conclusion that the bank's duration management is sorely lacking. If you examine Table 6 in BAC's most recent Form 10-Q, what you see is that the bank's return on earning assets is just 4.9%. The $750 billion in debt securities (down from $901 billion a year before) yielded just 2.47% at the end of Q3 2023. The bank's $300 billion in 1-4 family mortgages yielded just over 3%. At the same time, BAC’s cost of funds has risen 5x over the past year, while interest earnings have merely doubled. The chart below shows BAC’s funding costs vs total average assets through Q3 2023. Source: FFIEC, EDGAR Notice that Wells Fargo (WFC) has the lowest cost of funds among the top five depositories, one reason why we are relatively positive about that name compared with the rest of the group. That said, all of the top banks do their best not to show or discuss total interest expense in their financial presentations. Many of the large banks don’t show the components of net interest income in their press releases and investor presentations, yet the rate of change in this key operating metric is higher than the others. Does that make it material to investors? BAC was one of the few large banks that reported higher credit loss provisions in Q3 2023. Provision for credit losses of $1.4 billion increased $659 million. The bank’s net reserve build of $486 million in Q3 2023 was driven primarily by the credit card portfolio. Net charge-offs of $911 million increased $399 million driven by credit card, but thankfully remained below Q4-19 pre-pandemic level, a shown in the table below. With net interest revenue flat and operating expenses essentially unchanged, BAC reported an efficiency ratio of 62 for Q3 2023. Note that JPMorgan (JPM) is seeing its efficiency ratio slowly rise to the high 50s as the positive impact of the acquisition of First Republic Bank dissipates. Notice also that Citi's operating efficiency is deteriorating as the bank continues to restructure its business. Meanwhile, WFC steadily improves its operating leverage and profitability and we expect this trend to continue. Source: FFIEC, EDGAR At the end of Q3 2023, BAC's accumulated other comprehensive income (AOCI) was -$21.8 billion, up slightly from the year before. If you conduct a fire sale analysis of BAC's balance sheet as of Q3 2023, the result more than wipes out the bank's tangible equity and leaves a negative balance of over $100 billion, as shown below. Source: EDGAR, WGA LLC The 20% mark-to-market adjustment factor is relatively conservative and reflects the current market pricing for legacy securities and loans at September 30, 2023. With the rally in the 10-year Treasury since the end of the quarter, these numbers will improve to roughly 12/31/2022 levels, but that does not fix the solvency problem for BAC and other large banks. In November the Federal Reserve Bank of New York published a commentary on the degree to which US banks remain vulnerable to failure in the wake of the collapse of three banks in Q1 2023. Strangley, the economists at the FRBNY do not seem able to conduct a basic fire sale analysis of a bank-- even though they refer to precisely this type of assessment in the Liberty Street blog . The Fed seems incapable of publishing a truly forthright analysis of the solvency of major US banks. Source: FRBNY One of the obvious flaws in the FRBNY analysis is that they are looking at risk weighted assets instead of the current market value of nominal bank assets, which is all that really matters in a fire sale analysis of a depository. Those low-coupon Treasury, agency and mortgage-backed securities on the books of BAC may have zero risk weights for Basel capital purposes, but they are also incrediby dangerous assets for banks and other buy-and-hold investors. The solvency problems affecting US banks illustrate the shortcomings of US rwgulatory policy. If federal bank regulators truly understood real world bank risk, the capital weights for Ginnie Mae MBS would be 100% instead of zero and the risk weights for mortgage servicing assets would be say 100% instead of 250% as is the case under current regulation. With interest rates at a two-decade high, MBS are profoundly volatile and risky assets for banks, but MSRs trading at 4x cap rates are perhaps the most stable assets in the markets today. In any credible analysis of a bank's net assets, the only thing that matters is the current market price. So with the 10-year Treasury yielding 4.5% and Ginnie Mae 3s bid at 81, the only conclusion possible is that BAC and other large banks are profoundly insolvent. Interest rates need to fall 200-300bp in yield to fix the problem created by the FOMC. Bottom line on BAC is that the bank's asset mix and funding costs represent a substantial risk to the bank. If the credit side of the ledger begins to show signs of deterioration, then asset and equity returns will come under further pressure. The low yields on many of the bank's assets suggest that BAC is illiquid and that management does not have a great deal of lattitude in managing the bank's duration profile, especially compared with JPM. 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, 2023 | This edition of the Institutional Risk Analyst is written from Dallas, TX. We are participating in a panel discussion this afternoon at the Texas Mortgage Bankers Association Education Symposium event with our friend and fellow scribe Rob Chrisman . This past weekend was challenging for many financial professionals. A reported "technical problem" at the Electronic Payments Network (EPN), a private-sector operator of the Automated Clearinghouse (ACH) network in the United States, caused B ank of America (BAC) , JPMorgan (JPM) , U.S. Bancorp (USB) and Wells Fargo (WFC) to fail to receive deposits. The EPN is one of two authorized ACH operations, the other being the Federal Reserve's FedACH. The EPN is a financial clearinghouse that handles a variety of electronic funds transfers for the private sector. It provides functions similar to those provided by Federal Reserve banks' FedACH service. The EPN processes electronic funds transfers (EFT) between financial institutions. The two kinds of financial institutions in the ACH network are ODFIs (Originating Depository Financial Institution) and RDFIs (Receiving Depository Financial Institutions). EPN receives entries from an ODFI, distributes entries to the appropriate RDFI, and performs the settlement functions for the financial institutions. The Federal Reserve noted in a bulletin last week : “ On November 3, 2023, a processing issue at EPN, the private sector ACH operator, resulted in a number of ACH entries having certain data elements obscured (file dated for November 1, 2023, processed on November 2, 2023, with effective dates from November 2-3). This error was contained in a single interoperator file that was distributed by EPN to its participants during the November 2 6:00 p.m. processing window. These entries contain valid Nacha syntax, but obscured account information and recipient information.” Why is this all important? Because a significant number of deposits were not made on Friday, leading an equally significant number of bankers and executives to spend time over the weekend discussing the problem. Today a lot of people will be looking for their money. "We did not have many problems Friday," one large New York regional banker told The IRA . "We had a couple of hundred non-posts because of missing account information. We ran the tape again and no problem." But larger banks seem to have been disproportionately impacted by the glitch. Many consumers noticed the problem via their mobile app. We first became aware on Friday when BAC issued an alert to mobie customers, saying that some deposits may be "temporarily delayed due to an issue impacting multiple financial institutions." And the deposits did not arrive. Was the breakdown of the normally stable and, indeed, routine workings of the Clearinghouse the result of bad actors? Did this failure have anything to do with deliberate cyberattacks on several financial institutions and governments over the past month? Nobody knows and the Fed's not talking. The fact that payments flows can be impacted by technical problems and/or active attacks should give all investors and consumers pause. “We’re aware of an industry-wide technical issue impacting some deposits for Nov. 3,” Lee Henderson , at U.S. Bank, told CNBC in a statement . “Customer accounts remain secure, and balances will be updated when deposits are received.” Emphasis on when. It is important to state that payments participants such as Amazon (AMZN) and other large players routinely have issues with sending and receiving, usually after making changes in systems or software. The problems are fixed and life goes on. But the fact that so many consumers, businesses and financial institutions were affected last week should caution one and all about the fragile nature of the payments system. 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 1, 2023 | Premium Service | In this edition of the Institutional Risk Analyst , we look in on PennyMac Financial (PFSI) for a sanity check on interest rates and mortgage credit. It is pretty clear that Uncle Jay and the gang on the FOMC have reached the limit of interest rate hikes, but credit in residential mortgages has yet to show any cracks. Net loss rates on bank owned loans are still barely positive after a decade in negative territory. Our latest portfolio also is shown below. Even as foreclosures mount in the world of commercial real estate and WeWork prepares for bankruptcy, reports the Wall Street Journal , residential assets remain quiet – perhaps too quiet. And then there is the question of valuations for mortgage servicing assets. If we are marking balance sheet assets to actual market in the age of deflation, what of the heavily modeled world of mortgage servicing assets? PFSI is an important benchmark for fiancials because the firm is the largest aggregator (i.e. buyer) of conventional residential mortgage loans in the US. It is also a large Ginnie Mae issuer and has a top-ten servicing portfolio. PennyMac Mortgage Investment Trust (PMT), is a passive REIT that contains all of the group's conventional exposures from Fannie Mae and Freddie Mac. PFSI holds all of the Ginnie Mae risk, of note, and manages the REIT. Our mortgage equity surveillance list is shown below sorted by one-year total return. Notice that Mr.Cooper (COOP) and Guild Holdings (GHLD) , which we own, have traded places with PFSI as the latter has lost ground in the mortgage equity group. And yes, the laggards Better Home (BETR) and Blend Labs (BLND) are at the very bottom of the list. Mortage Equity Source: Bloomberg (10/31/23) Of interest, despite several dire predictions of imminent collapse since the COVID pandemic, the PennyMac binary of PFSI and PMT is still here. As the chart below from the PFSI earnings suggests, the level of credit losses on the firm’s owned and subserviced portfolios remains quite low despite the high level of mortgage interest rates. We are not surprised to see the equity market value of PFSI fading, however, due to management changes earlier this year. The PFSI portfolio is showing low levels of credit loss but also relatively high levels of hedging losses on its MSR. Also notable in this regard is that PFSI continues to report that prepayments are covering P&I advances in delinqunt loans. “Servicing advances outstanding for PFSI’s MSR portfolio decreased to approximately $321 million at September 30, 2023 from $407 million at June 30, 2023,” PFSI reported. “No P&I advances are outstanding, as prepayment activity continues to sufficiently cover remittance obligations.” PFSI reported $25 million in production profit in Q3 2023, but mortgage bankers are not working for much with the primary-secondary spread (PSS) below 90bp. When mortgage bankers were writing 2% MBS in the middle of 2020, they were working for more than one and a half points of spread. But what are those low coupon loans and servicing assets worth today? That is the question. The TBAs from yesterday's close are shown below. Notice that Fannie Mae 7% MBS for delivery in November are the only premium contract shown on the screen but 7.5%s are also trading. Source: Bloomberg (10/31/23) With the “belly” of the Treasury/mortgage yield curve at the top of the scale, execution is difficult in correspondent lending but impossible in retail channels. Most of the major issuers have shuttered retail entirely. Direct to consumer is the most profitable channel for most issuers not willing to compete for brokered loans against United Wholesale Mortgage (UWMC) and Rocket Companies (RKT) . Although the correspondent channel was 80% of the PFSI volume this quarter, it resulted in just over 40% of the revenue. Consumer direct, with a tiny slice of the volume, produced a third of total production revenue. What is the message here? Issuers with strong consumer direct channels will thrive in this difficult environment. Correspondent is a loss leader. While the results published by PFSI are consistent with GAAP, it is important to state that the presentation of earnings by PFSI deviates significantly from the cash reality. Unlike most issuers, of note, PFSI provides a statement of cash flows with the quarterly and annual reports to the SEC. Gain on sale accounting allows firms like PFSI to book the full economic gain on a loan sale up front including the MSR, which is retained and revenue booked even before the cash is received . Also, many of the data points in the earnings release are modeled rather than actuals. So, for example, the value of the MSR shown below is based upon modeled cash flows rather than actuals. Notice that PFSI is modeling their financials assuming a 6.7% prepayment rate, but the weighted average coupon is below 4%. So long as credit expenses and related operating costs remain low, the low volume situation in the mortgage sector is manageable for PFSI and other lenders with large servicing portfolios. Should default rates rise, however, then the situation could change quickly and funding becomes a vital concern. The fact that so much of the GAAP disclosure of firms like PFSI is modeled vs actuals raises additional concerns. The table below shows the modeled gain on sale of the MSR from the PFSI earnings release. Notice in the table above that even though volumes are down, and gain-on-sale margins are also compressed, the "receipt" of the MSR -- the non-cash gain on sale -- is larger in Q2 and Q3 2023 than a year ago. And the MSR value, 5.35x annual cash flows, is modeled. The modeled cash flows for the low coupon servicing assets held by PFSI are likely above the actual cash receipts by a significant amount. Richie May noted in an important comment last year : “ As owners of the MSR asset, it is important to look beyond the change in the MSR value and dig deeper into the servicing cash flows that are supporting the estimate of the fair value. Are the cash flows used on the determination of the fair value achievable? Most importantly, how do they compare the actual cash flows earned? ” In other words, if the actual cash flows from low coupon servicing assets are actually falling but the modeled MSR valuation is rising, then we have a valuation problem. The cash flows supporting the MSR fair value estimate may include some assumed factors that may or may not be supported by the actual cash receipts achieved and earned by the MSR owner. Ironically, the MSRs from those low coupon loans with the gigantic gain-on-sale margins from 2020-2021 may now suffer because of the low coupons. If interest rates remain at present levels, but delinquencies rise, then issuers like PFSI may face a cash squeeze because modeled cash flows are above actual cash receipts. And even with a modest rate decline, volumes and profitability may not improve significantly. If interest rates fall, however, then issuers like PFSI may face margin calls as the value of the late vintage MSR is dissipated by prepayments, forcing the issuer to replace collateral with new production MSRs. Or to put it another way, is the MSR on those new issue Ginnie Mae MSRs really worth more than 5.35x gross servicing income? Really? Don't you love residential mortgage finance? In a falling rate environment, the surviving lenders will fight over the few in-the-money loans at shrinking spreads as their MSRs disappear in a hail of prepayments. That is why that 5.35x multiple used by PFSI is arguably conservative or aggressive, depending on your assumptions about interest rates and compared to other issuers. But we still think that those Ginnie Mae 2% and 3% MSRs from 2020 are going to be a good investment over time, even with the compression in cash flows for the lower coupons. Disclosure 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.