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October 31, 2023 | This week The Institutional Risk Analyst is in Washington, D.C., for the 12th Annual Housing Conference sponsored by American Enterprise Institute. Tomorrow we’ll be joined by Alex Pollock , Joseph Tracy and our host Ed Pinto to talk about housing, quantitative easing (QE) and modern monetary theory as its is now practiced in Washington. Click below for a copy of our slides. We want to give the folks at Morgan Stanley (MS) a well-deserved hat tip for a leadership transition that makes sense and seems well considered by the board. There is no childish posturing or hasty departures. No screaming. Just an orderly process that seems like a reprise of the House of Morgan in days past. Our discussion with Rachelle Akuffo is below . As we’ve noted in our Premium Service , MS is pretty clearly the winner among Sell Side asset gatherers on this side of the Atlantic and is a direct comparable to UBS AG (UBS) , the leader among bank asset managers in the EU. But don’t think that MS is low risk or removed from things like equity markets trading and clearing, and investment banking. MS, of note, is also the largest derivatives dealer in the US, even bigger than the hedge fund known as Goldman Sachs (GS). Gross bank derivatives positions are 90% or more interest rates across the industry and have been trending lower. Centralized clearing of Treasury collateral may put further downward pressure on bank leverage. Source: FFIEC Meanwhile, the outlook for interest rates is rapidly turning. Michael Green makes the case for no more rate hikes in his latest comment, but also reminds one and all that “deflation” remains the more fundamental concern of the Fed: “Measures of inflation expectation have normalized, and the term structure suggests the Fed might soon be dealing with deflationary conditions rather than inflation.” And nothing is more deflationary than debt defaults. Deflation comes when the accumulation of debt makes it impossible for the obligor to refinance or “roll” obligations, forcing a markdown in principal via a debt restructuring. Most of the industrial nations have already reached the tertiary stage of indebtedness, where the bulk of debt is merely rolled and refinanced. Eventually the cost of rolling the debt forces a reduction in principal. Ponder the possibility of dollarization in Argentina. Imagine the deflation of wealth that will occur in the event, when worthless pesos are exchanged for somewhat more resilient paper greebacks. But a huge deflation has also occurred in the US due to rising interest rates and the negative impact on all manner of assets. Thus it seems pretty easy to call an interest rate peak. One of the effects of QE has been making many banks and real estate investors insolvent, a precursor to debt defaults. When a debt default occurs, the ostensive owner of the assets is wiped out, but the funding behind the loan is also lost. Remember, double entry accounting. Even if we believe the Fed’s definition of inflation (excluding housing, food and energy) has reached pre-COVID levels, the damage caused in terms of future deflation and credit losses seems kind of excessive. If the FOMC merely pauses and leaves benchmark rates unchanged for an extended period, which seems to be the consensus narrative at present, then the banking system will need to internalize the losses on asset prices while navigating relatively weak lending volumes. This is a prospective economic scenario unlike that faced by banks since the 1990s. Office loans are facing the highest levels of deliquency in a decade, reports Jeffrey Fuller of Bloomberg , but the real concern is loss severity, because there are so few ready buyers for these assets. As we noted in our latest edition of The IRA Bank Book for Q3 2023 , the US banking industry was deeply insolvent, a fact that will negatively impact earnings for years to come. The 10-year Tresury was still below 4% at the end of June 2023, thus the situation facing the US banking industry was even more extreme at the end of Q3 2023 with the 10-year Treasury note near 5%. The chart below from the most recent earnings report from Penny Mac Financial Services (PFSI) shows the frightening skew in mortgage coupons caused by QE. Those 3% loans shown above are sitting in a 2% MBS on the books of a bank somewhere. The 2% MBS is trading in the mid-70s today. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 26, 2023 | Premium Service | In this edition of The Institutional Risk Analyst, we ponder the changing fortunes of the sector f/k/a fintech as it returns to its roots in subprime consumer lending. We dive deep into the world of Basel III and mortgage servicing rights (MSRs), arguably the cheapest capital asset in the world of mortgage finance. But first let's look in on Texas Capital Bank v. Government National Mortgage Association et al . The fun in the litigation between Texas Capital Bank (TCBI) and Ginnie Mae has not really gotten started yet. Judging by the number of out-of-town counsel filing for admission to the court Pro Hac Vice this case will chew up a lot of billable hours. And each foreign attorney must find sponsors among local counsel within 50 miles of the Federal Courthouse in Amarillo, TX. TCBI is trading in the mid-$50s today vs almost $90 per share in 2021. We reviewed this considerable mess previously (“ Texas Capital Bank v Ginnie Mae ”) and await developments with some trepidation. The cause of our discomfort is that the folks at Ginnie Mae have created a public process whereby the security of a loan on government guaranteed asset and/or MSRs is called into question. If TCBI is forced to take a loss on advances made to Reverse Mortgage Investment Trust (RMIT) , then the whole market for financing government loans could be adversely impacted. The legal battle between TCBI and Ginnie Mae raises another question, namely how the Basel III proposal will impact nonbank lenders and servicers. When a bank provides warehouse loans or financing for MSRs, the line is contracted for a term but the actual transaction is structured as a repurchase agreement. Regulatory skepticism about mortgage assets could effect financing rates for lenders, which means higher mortgage rates for consumers. Today commercial credits used to finance loan production and sale are 100% risk weight loans for Basel purposes, meaning $8 in capital per $100 of loan. Will that risk weight now increase? JPMorgan (JPM) and New York Community Bank (NYCB) , which we own, are the leading warehouse lenders. Both are likely to remain committed to the residential mortgage sector, but other smaller players will likely exit. Virtually all of the nonbank names we follow in our mortgage surveillance group, shown below sorted by 1 year total return, will be impacted by the new Basel III rule for banks. Mortgage Source: Bloomberg (10/26/23) The risk weight for banks owning mortgage loans is expected to go up under the new Basel proposal -- over 100% vs 50% today for a well-underwritten mortgage credit. The graphic below from the most recent earnings release by Mr. Cooper (COOP) lays out the case for increased nonbank share in both lending and holding MSRs. COOP reported a strong quarter driven by above peer loan production and $970 billion in unpaid principal balance (UPB) of servicing. COOP also claims a significant, 50% cost advantage over large banks in terms of mortgage servicing. It is not always a good thing to publicly declare that you are the low-cost provider in a consumer facing industry, but the COOP direct-to-consumer (DTC) channel is very efficient. Eric Hagen at BTIG on COOP: " We believe the stock valuation has received only partial credit up to this point for having put up one of the strongest relative returns among non-bank originator/servicers as mortgage rates have risen materially over the last year. While it benefits from higher rates, we think the stock has even better opportunity for valuation upside if volatility comes down. We separately see an emerging opportunity for high-yield investors to get more involved as management said it was starting to look more closely at additional fixed-rate unsecured debt for next year, which it could use to stay opportunistic around more bulk acquisitions, and/or pay down some of its secured MSR lines which are typically floating-rate." Pay attention to that last point about nonbanks like COOP accessing the debt markets, as they indicated in their earnings release. Freedom Mortgage just closed a refinancing of two debt issues, both of which were said to be oversubscribed. Our observations in the loan market suggests that there is a significant appetite among high yield investors for commercial mortgage exposures. Due to the changes in Basel III, we expect all of the major mortgage issuers to be adding or increasing term debt and market facing financing facilities for whole loans to diversify away from bank warehouse lines. To that end, w e are seeking some clarity from regulators on how Basel III will impact nonbank mortgage firms such as COOP and Guild Mortgage (GHLD), the latter of which we own. Most of the focus of the Basel III rule is on bank investments in 1-4s and MSRs. There has been no discussion as of yet about commercial warehouse and MSR lines for smaller banks and nonbank lenders. Given the significant changes proposed in the risk weight of the underlying residential loans, a change in commercial exposures is possible but unlikely. Banks are already at 100% risk weight on fully secured warehouse lines and 250% risk weight on financing for MSRs, just like the risk weight for owning the MSR asset. This equates to 20% capital behind the MSR, for example (8% * 250%). The almost European level of hostility toward mortgage loans and MSRs from US bank regulators is astonishing and makes little sense in today's market. Regulators should be encouraging banks to create and retain MSRs, but in fact the opposite is the case. With MSRs trading for mid-single digit capitalization rates, banks ought to be buying with both hands to offset losses on loans and securities. Sadly, the Basel proposal will force smaller banks to shed servicing assets because of the ill-informed perspectives that pass for serious thinking among prudential regulators. We do not expect the existing risk weights for commercial warehouse facilities to change as part of the Basel III process, but the other changes to risk weights for 1-4s held for investment could be punitive and drive more liquidity from banks out of the mortgage market. Nonbanks will be forced to focus on the capital markets in future for funding. The question is how fast that process will move over the next several years. The new 10% cap for bank MSR holdings as a percent of Common Equity Tier 1 capital (CET1) (currently 25%) will likewise force liquidity out of the mortgage market. The lower cap on MSRs is mostly a problem for smaller banks like Comerica (CMA) and Fifth-Third (FITB) , which have already pulled the plug on residential lending. For US mortgage market leader JPMorgan, the $8 billion in MSR and roughly $1 trillion in related UPB of servicing is easily accommodated by $240 billion in CET1 capital. The Basel III proposal is all about advantaging the larger banks, but don't be surprised to see operational risk surcharges for JPM, NYCB, Cenlar FSB and other large bank servicers. One hidden risk and also an opportunity for nonbanks is that commercial banks may start dumping portfolio loans and related MSRs. This may also include unrecognized originated or "OMSRs" as many decide to exit 1-4s altogether. If a bank originates and retains a loan in portfolio, no MSR is recognized or placed on the balance sheet of the bank. When the loan is sold, however, an MSR is created and recognized as part of the consideration, with each piece often going to different buyers. Let's assume half of the $3.7 trillion in bank owned 1-4s were originated by the bank that holds them today, that means that $1.8 trillion worth of unrecognized mortgage servicing assets may suddenly be looking for a home. That is an amount equal to the combined JPM and Wells Fargo's (WFC) mortgage servicing portfolios. For the top ten nonbank mortgage issuers, a flight from residential lending by US depositories could represent an epic opportunity. Figure the servicing is worth 1.5-2% of the outstanding balance of a given pool of loans, depending on the default rate of course. MSRs from high default rate pools have negative values, like the folks at UBS AG (UBS) unit Credit Suisse. Source: FDIC The Mortgage Bankers Association is said to be working on a comment letter that asks regulators to push the risk weight for commercial warehouse lines down to the same levels as the loans held as collateral . Makes absolute sense, but don't expect clear thinking from Fed Vice Chairman Michael Barr or the other agencies right about now. The fact that 99% of all mortgage assets have US government credit guarantees seems to somehow have been missed in the Basel III shuffle. We hold out only modest hope that the Basel III proposal can be fixed in terms of the housing industry and the banks. And yes, we'll be writing comments of our own before January. Fintech Deflates Finally in the world of fintech, the rumor of a slowing economy has taken the air out of several overheated names. Our fintech surveillance group is shown below. Note the dramatic divide between the strong performers vs the weak. Fintech Source: Bloomberg (10/25/23) Looking at one-year total return calculated by Bloomberg , digital commerce platform VTEX (VTEX) leads the group, followed by Mercado Libre (MELI) , SoFi Technologies (SOFI) and payments giant Fiserve (FI) . SOFI has shown the best inter-period performance, while FI with its $67 billion market capitalization shows far less volatility. Compare FI to the roller coaster of Global Payments (GPN) , for example, a stock one third the size of FI. Coinbase (COIN) ran up almost double during the summer, but has since given back a good deal of the gains. As the largest crypto currency exchange in the US, COIN takes on a lot of regulatory and headline risk along with the other challenges that come with virtual party poker. The large correlation with Bitcoin prices and related market hype is a key attribute to the stock. This week, everyone is bullish. That perennial favorite of the punters, Affirm Holdings (AFRM) , doubled in price between the end of August and mid-September, then gave back half the gain since. AFRM has the highest beta in the group and for good reason. With a market cap of only $5 billion, this stock is a plaything for the momentum crowd and is now headed lower. AFRM is also a stock of the narrative today, the buy now, pay later story. With the stark warning from EU fintech Worldline (WLN) about the outlook for consumption, AFRM, Paypal (PYPL) and Block (SQ) are all retreating. Stocks like SQ and Lending Club (LC) were once mainstream components of the fintech narrative, but no more and now occupy the bottom of the fintech list. Other aspiring mortgage fintech names like SoftBank hells pawn Better Home & Finance (BETR) are struggling. BETR just heard from NASDAQ that it’s out of compliance with the exchange’s listing requirements. Better’s shares have been trading below $1.00 a unit for several weeks now. In accordance with the rules of the exchange, the company has 180 calendar days to regain compliance. Given the outlook for interest rates, we doubt that BETR will be benefiting from any tailwinds soon. Speaking of narrative, all of these consumer facing names are suffering from a mainstream storyline that says that the US economy is headed for recession. The housing complex is certainly slowing, but the rest of the consumer ecosystem is not. Thus we should look at the weakness in fintech as further evidence that the Buy Side narrative is way over the ski tips in terms of a consumer led recession. As we noted in our last comment, we think the US economy is unlikely to really slowdown unless the Fed is willing to take more liquidity out of the system. Since that seems to be increasingly unlikely, we think the US economy will continue to over-perform and defy expectations into next year. We keep waiting for a short, sharp uptick in credit costs, but the actuals are going in the other direction at present. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 09, 2023 | Premium Service | In this issue of The Institutional Risk Analyst , we update subscribers to our Premium Service on the latest developments at Texas Capital Bank (TCBI) . Back in August, we told our readers that TCBI did not seem to be in any hurry to disclose the $40 million loss it took on the collapse of Reverse Mortgage Investment Trust (RMIT) and affiliates last November. The US Treasury now owns the RMIT portfolio. TCBI has sued Ginnie Mae (GNMA) and HUD ( 2:23-cv-00156-Z -BR ), alleging that GNMA President Alanna McCargo provided verbal guarantees to the bank for post-filing debtor-in-possession (DIP) financing. TCBI’s Madison Simm stated in a sworn affidavit: “President McCargo assured [TCB] that TCB would be able to look to the Collateral for repayment even if Ginnie Mae were to seize RMF’s MSRs.” Sadly, that was not the case. Akiko Matsuda of the Wall Street Journal reported that “Texas Capital Bank said it was convinced by the U.S. government to loan $28 million in December to help a bankrupt reverse-mortgage company fund payments to elderly homeowners and avert a crisis in the reverse-mortgage industry.” The trouble, of course, is that President McCargo has no power to commit the United States financially. More, McCargo should never have met with TCBI or the creditors of RMIT. HUD, and not private banks, have the legal obligation to advance cash to reverse mortgage borrowers in the event of an issuer default. Apparently McCargo did not know this and, more important, did not ask HUD's lawyers for advice. McCargo, who has no background in business or finance, apparently did not understand her position as President of Ginnie Mae and has now created a legal mess for the Biden Administration. Rather than ask a private lender such as TCBI for cash to help elderly borrowers, for example, HUD itself should have advanced the cash to consumers. McCargo apparently did not understand this legal and operational reality. McCargo's tenure at GNMA is fast becoming a disaster for the Biden White House, although the flaws in the reverse mortgage market long predate the 2020 election. The RMIT reverse MSR is now owned by the US Treasury and has cost taxpayers over $2 billion in advances to borrowers and loan buyout expenses since last December. The legal dispute between Ginnie Mae and TCBI makes additional defaults by HECM lenders more likely. Good news is that GNMA deserves to be sued for the ill-considered actions of President McCargo in the RMF bankruptcy, actions that the Federal Housing Administration has allegedly disavowed. Bad news is that despite all of the extraordinary evidence of duplicity by GNMA and President McCargo, and the notable role of the Quinn Emanuel law firm as lead counsel, TCBI may still never be made whole. While the bank’s interest in the Home Equity Conversion Mortgage (“HECM”) participation or “tails” may remain, the bank does not possess the mortgage note. When a consumer takes out a HECM reverse mortgage, the note is contained in the first GNMA securitization. The “tails” that fund subsequent cash advances to the consumer are participations only. Thus when GNMA extinguished the MSR held by RMIT, any viable claim by TCBI died with it. Because of the ironclad statutory position of HUD with respect to government insured assets, McCargo was able to pretend to offer comfort to the creditors like TCBI, but nonetheless GNMA’s professional staff seized the asset a week later. As we’ve noted previously, a private lender never has a secured interest in a government insured loan or servicing asset, or any indirect interests such as participation. The implications of this latest fiasco at GNMA for the government loan market are substantial and may cause the remainder of the HECM market to collapse. Specifically, if TCBI and other “secured” lenders take losses on the RMF bankruptcy, then other lenders will likely step back from the market. Again, a bank lender never has a perfected interest in a government-insured loan. This ugly reality has been exposed by the default of RMIT. Moreover, if the FOMC maintains its present interest rate policies, the remaining private issuers cannot finance HECMs – especially without support from banks. As TCBI notes: “Ginnie Mae’s assertion that it has somehow extinguished TCB’s rights also has chilled and will continue to chill future HECM lending (including from TCB) to the detriment of HECM borrowers.” Very true. Trouble is, when TCBI states that “There is no basis, however, for the proposition that Ginnie Mae’s seizure of RMF’s servicing rights extinguished TCB’s rights to its collateral,” the bank’s counsel is engaging in skilfull puffery. No private agreement, even if blessed by a US bankruptcy court, changes GNMA’s statutory rights regarding the insured FHA loan and the servicing asset, which are inseparable . The Mayer Brown law firm published a note on this issue in 2020 : “This difference in treatment is in part due to the fact that, unlike Fannie Mae and Freddie Mac, Ginnie Mae does not itself reimburse servicers for advances. Servicers instead must instead look to subsequent mortgagor payments and mortgage insurance and guaranty proceeds on the underlying pooled mortgage loans. Moreover, a secured creditor is afforded a very “skinny” cure right, if a Ginnie Mae servicer defaults in its pass-through obligations. If the secured creditor fails to cure the monetary default (within one business day), its security interest is automatically extinguished. Ginnie Mae will neither reimburse the secured creditor for its outstanding debt, either directly or indirectly through net sales proceeds, nor require the successor servicer to remit to the secured creditor reimbursement of servicing advances as and when received.” We’ve checked with several lawyers who have practiced for decades in front of the GSEs and GNMA. The unanimous decision is that no agreements made in the bankruptcy affect GNMA’s right to enforce the security agreement against a defaulted issuer. This is why, for example, Ginnie Mae does not participate in the bankruptcy of a government issuer because there is no need. As we noted in 2020 (“ Improving Liquidity for Ginnie Mae Servicing Assets “): “Contrary to the liberal view attributed to GNMA by some market participants and financial advisors, in fact the agency has not provided any real surety to secured creditors with respect to GNMA MSRs, whether in a securitization or directly held by an issuer.” Whereas Fannie Mae and Freddie Mac do provide a mechanism for the transfer of servicing within the context of an issuer default, GNMA essentially provides one day – 24 hours – for a servicer to cure a default. Otherwise GNMA will transfer the servicing, but this assumes that a servicer with ready capacity and financing to accept the transfer of servicing, and make the required bond payments, is standing by to take over the servicing obligation. RMIT's 2022 bankruptcy and the failure of the auction which preceded the seizure by GNMA has shaken some of the basic assumptions in the $2.3 trillion residential government loan market. A GNMA MSR only has value if the owner has sufficient liquidity to meet any cash calls required, even if this means going into loss on a net cash basis temporarily or permanently. And if GNMA cannot find a qualified issuer to take ownership of the MSR, then the US Treasury owns the portfolio. So given the above, why is TCBI pursuing a litigation strategy? Because attempting to collect on a hopeless claim against the United States is better than reporting a mid-double digit loss. We can certainly understand why the FHA would take the part of TCBI in this imbroglio. TCBI has been one of the largest financiers of the HECM program. TCBI facilitated RMF’s operations—and thus a significant portion of the HECM program—by providing RMF with multiple credit facilities. Ultimately we think that TCBI management may have decided that paying Quinn Emanuel a couple of million to drag GNMA through the mud in an embarrassing lawsuit is better than reporting the loss in 2023. When the Texas bank says that “Ginnie Mae never bound TCB to any agreement that would have allowed Ginnie Mae to extinguish TCB’s property rights without compensation,” that’s a hint. The sad tale of TCBI illustrates, yet again, that the representations made by political appointees of the US government are not to be trusted. At the same time, however, TCBI should have known that HUD is responsible to advance cash on HECM reverse mortgages. The $28 billion asset bank never should have even considered McCargo's request for DIP financing. Sadly, the actions of President McCargo may now accelerate the collapse of the remainder of the HECM program. During the Trump Administration, Treasury Secretary Steve Mnuchin , Housing Secretary Ben Carson and Federal Housing Finance Agency Director Mark Calabria , sought to put limits on new reverse mortgages guaranteed by the FHA. Calabria told The IRA last month that, during his tenure at FHFA, he supported suspending all new HECM endorsements because of the operational problems in the FHA program. The RMIT bankruptcy has now exposed this ugly reality. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 24, 2023 | Q: Do the Fed's massive open market operations in 2020-2021 mean that rates stay at current levels for years? But no recession? Yup. The other day Paul Muolo at Inside Mortgage Finance asked if PIMCO and other Buy Side shops are buying mortgage-backed securities (MBS) in anticipation of an eventual refi boom. Well, maybe, but that depends which coupon MBS you are buying. The to-be-announced (TBA) market summary from Bloomberg for mortgage contracts to be delivered in November is below for your reading pleasure. Source: Bloomberg (10/23/23) So if you are a cash investor, and have no concerns about funding costs, then you might buy some of those orphaned low coupon MBS for yield. When and if you get a prepayment, you will receive the principal back at par. You paid in the mid-70s for the security. Capital gain, sabe ? Those borrowers with 3% mortgages will need to move or die before they prepay those COVID era mortgages. But if the effective floor of interest rates is now say 4%, those MBS 2s and 3s may not be in the money for refinance for a long time – maybe a lifetime. If you buy the higher coupon MBS at a higher price, say Fannie Mae 5s at 91, you still get a nice discount to par but much shorter duration – maybe. With the Street selling new production mortgages into MBS with 7% or even 7.5% coupons, it will take a few rate cuts for the mortgages inside those 5% MBS to be in the money. A number of bond market bears have recently called the turn in interest rates, closing out short positions and positioning for the long anticipated Fed pivot. But what if that pivot turns out to be a pause or better, a back to the future, taking us all the way back to the early 2000s when Alan Greenspan was Fed Chairman. In January of 2000, the effective Fed funds rate was 6.5%. The brief recession of 2001 so spooked Chairman Greenspan and other FOMC members that they took Fed funds down eleven times to 1% by 2004. That was the year that the private label mortgage market peaked and securitization volumes flowing through Countrywide and Washington Mutual started to fall. Two years later, the private mortgage market began to collapse and the Fed lost control over the US economy. By the end of 2007, the Fed funds rate was zero and much of the financial system was insolvent -- as it is today. Since 2008, the Fed’s answer to just about every contingency has been to supply massive reserves to the system. As we learned in 2019, however, not all reserves are created equal. First in December 2018 and later in mid-2019, the money markets seized up because the models used by the FOMC to predict the required levels of bank reserves were badly wrong. Even though the Fed was paying interest on reserves, these funds were largely frozen, as we discussed with George Selgin in 2019 (“ George Selgin on Frozen Money Markets ”). Now Bill Ackman and Bill Gross are touting a drop in market rates by year end, Bloomberg reports. We wonder about their investment thesis because it seems stale and out of touch with the markets. Yes, there is a lot of dry powder on the sidelines, so much that private investors are taking down private loans points below levels where the credit makes sense. But we do not see a lot of investors lining up to buy MBS or Treasury paper. In fact, the smart money is going the other way, buying mortgage servicing rights (MSRs) on 5x cap rates. With the quality of the stock market clearly in doubt and PE investors taking desperate measures to liquefy sinking private equity portfolios, the notion of going long duration in bonds strikes us as a bit premature. The buoyant economy and job market are basically the result of the fact that the Fed has refused to drain liquidity from the economy for fear of causing, well, another liquidity crisis. But the Fed’s insistence on paying market rates on reserves means the central bank is going to generate $1.6 trillion in losses to the taxpayer. Because the FOMC fears to unwind the trillions of dollars in Treasury and MBS purchases made in 2020-2021, the US economy is not responding to the policy signals and is unlikely to do so. All sorts of Wall Street managers and gurus have predicted that the US economy is going to roll over soon, in 2024 for example, but we see most of the damage being done in the financial markets. The few observers on Wall Street who understand that the FOMC has no idea about the direction of the economy or interest rates will benefit. JPMorgan (JPM) CEO Jamie Dimon has excoriated the Fed, criticizing the central bank for getting their prediction about the economy “totally wrong.” Notice that JPM’s astute management of the duration of the bank’s balance sheet has given them an unassailable lead over other large US banks in terms of operating results. “I don’t think it makes a piece of difference whether rates go up 25 basis points or more,” Dimon said during a panel at the Future investment Initiative summit in Riyadh, Saudi Arabia. And Dimon is 100% correct. The Fed has become irrelevant to the economic outcome, but is an increasing drag on the federal budget. Losses on the Fed system open market account (SOMA) cost taxpayers over $100 billion in FY 2023. Meanwhile, Katherine Dogherty of Bloomberg confirms our earlier comment that Bank of America (BAC) , by being completely insensitive to market conditions, now has a portfolio of mortgages and other paper yielding less than 3% in a world where funding costs are above 5%. For many banks, rising interest rates are an earnings problem. But for large poorly managed banks like BAC, higher for longer could become an existential crisis if as we suspect the FOMC leaves interest rates where they are for years to come. As we note in our latest comment in National Mortgage News , the Fed was badly wrong about the “transient” nature of inflation. Then they tied their hands by purchasing trillions of dollars in securities that now they cannot sell, locking the US economy into an interest rate trap that may last for years. We don’t see any recession ahead in 2024, but neither do we see a scenario for interest rate cuts in the foreseeable future. We look for modest rate cuts in 2025, followed by an equally modest boom in mortgage lending and then a long-term correction in home prices a la the 1990s. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 19, 2023 | Premium Service | Are bank stocks cheap? Banks are certainly inexpensive compared with other sectors and have been for a long time. Banks trade for single digit price-to-earnings multiples. Residential mortgage REITs at least trade in the low teens in terms of P/Es. We recall the judgment of Kevin O’Leary on CNBC a few years back: “Banks are dead money.” Indeed, today many banks are book insolvent thanks to the Federal Open Market Committee, but that is mostly an earnings problem. This week we had caught up with Ralph DelGuidice , who has contributed to this blog in the past, about the world of banks. As we discuss below, commercial banks have a number of ways to deal with impaired assets that are not readily apparent to equity investors. But the large universal banks that ply the capital markets and make use of essentially infinite leverage in the derivatives markets also face a number of serious challenges ahead. If you think of all of the low-coupon debt and loans sitting in the portfolios of large banks, these assets are going to be with us for years, even decades, to come. But is that bearish for commercial banks? That depends on whether we are talking about banks that make loans and take retail deposits vs banks that trade the markets and manage assets, real and borrowed. The former group is currently under downward pressure due to fears about credit, while the latter are still benefiting from the lift they experienced during COVID and zero interest rates -- for now. The latter group of dealer banks, joined by some of the larger hedge funds, use leverage that is proportional to what the system allows , to paraphrase Ralph. Two words: centralized clearing. In a world where derivatives dealers and their customers must actually own the Treasury collateral they use in centrally cleared trades , the use of leverage will be significantly reduced. Systemic risk and dealer earnings will decline. The chart below shows some of the mind-boggling gross derivatives positions of the larger dealers and Peer Group 1. Source: FFIEC Let’s consider two of the larger “asset gatherers” among the bank group. The results from Morgan Stanley (MS) in Q3 2023 were modestly down, but the market punished the leading Wall Street dealer and asset manager nonetheless. Asset management, the most stable MS line item was actually up. Trading and ibanking were down small, leading some bears to pile on the stock. Overall, this was not a bad quarter, but the Street responded negatively because MS is still relatively expensive vs other mainstream banks. Unlike Goldman Sachs (GS) , which saw earnings drop by a third, the MS business remains stable and liquid. And most important, MS has very little in the way of credit expenses, at least on balance sheet. The stock market chart below going back 40 years suggests that MS is delivering better value than GS and by a wide margin. Source: Google Finance At current market valuations, you might argue that MS is relatively cheap, but the firm is still trading significantly above early 2020 levels, reflecting the boom in capital markets activity during the period of zero interest rates. In fact, the asset gatherers such as GS, MS, Charles Schwab (SCHW) are still trading well-above early 2020 levels, but depositories as a group are arguably cheap looking at the five-year chart. But will they get cheaper? Most likely, in large part because the equity manager herd is largely clueless about credit markets. Source: Google Finance GS got crushed after reporting a one-third drop in earnings YOY but up sequentially from the horrific Q2, mostly on the back of higher expenses. You can see why the firm has been cleaning house of personnel because compensation expenses (up 16%) led other line items higher – $1.3 billion higher in terms of operating expenses. If you want a reason to criticize CEO David Salomon , it is for being a poor operating manager. The good news for GS is that provisions for credit losses fell 99% from Q2 2023, a reflection of the fact that the firm moved the festering GreenSky loan portfolio into held for sale as it heads out the door. GS has been reporting very high credit losses vs average assets compared with the other large US banks. Hopefully the disposal of GreenSky will end this period of outsized credit losses, although GS is still growing its credit card portfolio. GS does not break out net losses in its GAAP disclosure, so we’ll have to wait for the Form Y-9 to be released by federal regulators. Source: FFIEC At GS, MS and many other banks with market facing businesses, the drop in transaction volumes is forcing some painful choices. Professionals who were tasked with processing new deal volumes in 2022 are now migrating to restructuring tasks in 2023. As one veteran commercial loan buyer told The IRA this week: “It may be time for me to go fix broken toys again.” For GS, the drought in deal flow is a far more painful problem than for MS because the latter has a more diversified business. GS is a two legged stool, with capital markets and investment banking as the primary drivers, and the firm’s low yielding asset and wealth management business a distant second. The platform solutions segment is too tiny to matter in terms of revenue, but holds the firm’s credit card portfolio and other non-core assets. That is, risk. So if the asset gatherers are a bit pricey, what about the mainstream banks? The answer is that each institution will need to work through its own particular loan portfolio issues. While the commercial real estate sector is currently experiencing a lot of credit losses, the worst exposures are in the market for commercial mortgage backed securities (CMBS) rather than on the books of banks. Indeed, the restructuring of commercial real estate assets may not actually be bad for banks and may create some opportunities. Let’s take an example. A number of highly excited analysts have contacted us in recent weeks, declaring that regional banks are toast because of their exposure to commercial real estate in footprint. The truth is more complicated because banks are mostly protected by the 50% loan-to-value ratios in commercial loans. So in the event of default, the bank wipes some or all of the equity and demands more cash from the “owner.” If the debtor balks, the bank owns the property at 50% of the original loan amount. Even if we assume that the Federal Open Market Committee is going to keep interest rates at current levels indefinitely, we think it is important for investors and risk managers to remember that commercial real estate is unlike residential assets in some very fundamental ways. For banks with non-performing commercial assets on their books or in CMBS servicing portfolios, restructuring the loans may actually generate value. But, again, if you think of all of the performing, money good low-coupon debt and loans sitting in the portfolios of large banks, the only way out is restructuring. As Ralph notes correctly, banks will sell risk shares on these assets to the Street and use the proceeds to buy as much new, high coupon paper as possible. That is not a very exciting trade compared with other industry sectors, but at least it holds the promise of getting bank equity returns positive over time. Bottom line: We are starting to like some of the commercial lenders and are adding to our position in New York Community Bank (NYCB) . We believe that the bank's Flagstar loan servicing platform will be well-positioned to benefit from today's commercial real estate market and the coming correction in residential real estate -- still several years away. We are not big fans of the large dealer banks such as MS, GS and to some extent JPMorgan (JPM) because of the poor outlook for capital markets volumes and interest rates. Even more profound, however, is what the SEC's central clearing rule and the Basel III capital proposal implies for future leverage and thus equity returns. We think bank derivatives activity will continue to trend lower and may actually accelerate downward, with negative implications for earnings. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 17, 2023 | First a big thank you to our readers for the questions and comments on bank earnings. Below we summarize the Q3 2023 results for Charles Schwab (SCHW) . One reader recently asked us if we were “bearish on SCHW,” but in fact we love the Schwab model. We dislike how the reckless actions of the FOMC in 2019-2023 almost caused an important financial institution with over $7 trillion in customer assets to fail. The first thing to note is that even though the bank is earning more money on its investment and loans, SCHW is taking less down to the bottom line. When you hear a Buy or Sell Side pundit talk about how higher interest rates are "good for banks," remind them that book value of equity for financial institutions typically falls in periods of rising interest rates. The most recent five years has seen the return on earning assets fall dramatically for all banks. This is called " financial repression " for those of you unaware. Note in the table above from the Q3 2023 SCHW earnings release that interest expense has risen 560% in the first nine months of 2023 compared with the same period in 2022. Over that same timeframe, interest revenue rose only 45%, illustrating how the interest rate arbitrage that made sense in 2020 and 2021 has disappeared with the Fed’s increase in short-term interest rates. This “trade,” if you will, motivated SCHW management to grow their balance sheet to take advantage of ultra-low interest rates, a trade that is now being unwound. The chart below shows the total assets of SCHW going back to 2019, when our esteemed Fed Chairman Jerome Powell panicked and began to push down short-term interest rates. This change in FOMC policy incentivized names like Silicon Valley Bank and SCHW to put more sail up on the mast and take advantage of low funding costs. As the chart below illustrates, the SCHW balance sheet is now shrinking rapidly. Source: EDGAR, FFIEC As net interest revenue shrinks, the importance of the $7.8 trillion in SCHW advisory business grows. This is the point of SCHW as a business, not the bank's balance sheet. The bank was a secondary feature of the SCHW business until Chairman Powell stepped on the gas and drove interest rates into the floor and kept them at zero for years. SCHW swelled in size until the depository actually surpassed U.S. Bancorp (USB) in total bank assets, but with a balance sheet focused on securities rather than loans. As the balance sheet of SCHW has started to shrink, the bank’s exposure to the gyrations of the bond market has also declined. Available for sale securities have fallen 50% over the past year, but held-to-maturity securities have risen 69% YOY. Deposits have continued to fall as the bank sheds assets and liabilities, while LT debt grew modestly. The result of all of these changes is that SCHW’s accumulated other comprehensive income (AOCI) was essentially flat in Q3 2023. Source: EDGAR, FFIEC As the SCHW management team shrinks the bank’s balance sheet, the stock price has fallen to reflect the changes. The anomalous growth in the bank’s equity market valuation that saw SCHW outperform industry leaders like JPMorgan (JPM) is now at an end, suggesting that the days of the bank trading at 4-5x book value are probably over without some new catalyst. The key question for investors is to ponder what the run-rate revenue and earnings of SCHW will look like over the next several years as the bank shrinks further. Bottom line for us is that we like the SCHW business in terms of risk-adjusted equity returns, but the process of right-sizing the bank to a more sustainable level of assets will probably not endear the stock to investors. All banks in the US are going to be under pressure to shrink assets as the latest era of Fed-induced asset inflation ends. The days of SCHW trading at a significant premium to larger banks like JPM may be over. If and when the FOMC decides that it must expand its already swollen balance sheet to prevent a credit default by the U.S. States Treasury, banks like SCHW with a heavy focus on investments in securities will also grow in size, but real equity returns will be diminished. It is notable that equity returns at SCHW have been growing even as the size of the bank has been declining. But with the SCHW equity market valuation now falling back to earth, look for this relatively small bank to possibly be acquired at some point in the future. Source: Google Finance The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 16, 2023 | Premium Service | Bank earnings began in earnest Friday with reports from JPMorgan (JPM) , Wells Fargo (WFC) and Citigroup (C) . Each was notable for different reasons. Below we discuss Friday's results and also the implications for Goldman Sachs (GS) and Morgan Stanley (MS) . Of note, our interview Friday with Yahoo Finance about the Fed’s bank capital proposal is below. We noted in our conversation with Nicholas Jacobino and Julie Hyman that Fed Vice Chairman Michael Barr and other US regulators have managed to piss off just about everyone in the housing market. This is one of several reasons why we suspect that the latest Basel III proposal is going to be DOA on Capitol Hill. Bank earnings so far can be best described as cautiously mediocre. JPM managed to get net interest income to rise sequentially, something that other banks are unlikely to achieve without buying a dead bank. Revenue was down 5% sequentially, however, but JPM continues to show big growth looking at the year-over-year comparisons including First Republic (FR). Excluding FR, for example, JPM’s loans grew only 2% instead of 17% with FR. Ex-FR, average deposits were also down. We noted on X this week that JPM was really the only possible buyer for FR, first because JPM was the warehouse lender to the CA based loan production shop. As with Bear Stearns, JPM financed and cleared for FR. The San Francisco bank was really more nonbank than depository, making a large part of its profit on originating and selling jumbo residential mortgages. Some may take offense to JPM CEO Jamie Dimon profiting from this failure, but JPM has been triaging dead nonbanks since 1907. When the Knickerbocker Trust collapsed and there was no Federal Reserve, President Theodore Roosevelt tasked the House of Morgan to clean up dozens of dead trust companies using cash from the Treasury. The large banks have always consumed the net assets of failed smaller banks. The big positive for all three reporting banks on Friday was lower credit costs with provisions expense down or at least rising at a slower rate. Consumer credit exposures continue to normalize, but are not quite ready to explode despite the intense expectation among the media and allied pundits. The chart below is from the Q3 2023 earnings report of JPM. Of note, JPM’s efficiency ratio rose to 55 from 49 last quarter, another indication that the salubrious effects of the FR transaction will not last forever. Even as the House of Morgan reports another respectable quarter, the looming prospect of higher bank capital regulations is reportedly making JPM and other lenders look to push down “risk weighted assets” to minimize the need for raising more capital. JPM is reported to be seeking to sell or securitize loans over the next several quarters, although a yet there is no sign of balance sheet shrinkage. JPM's negative accumulated other comprehensive income (AOCI) increased from -$14 billion to -$17 billion in Q3, this even as the bank aggressively sold securities and continued to report losses in this area. JPM held $580 billion in investment securities and $1.3 trillion in net loans and leases at Q3 2023. If you haircut the $1.8 trillion in securities and loans total by 20% to reflect the movement in interest rates, the mark-to-market loss is over $370 billion or roughly equal to the bank's book equity. At Citigroup, net interest income was down slightly as interest expense rose 12% vs 7% for interest revenue. Provisions for credit losses were up only single digits. The reserve build by Citi slowed 30% vs Q2 2023, illustrating the fact that the consumer recession predicted by many has yet to occur. Flat expenses and a $500 million surprise in principal transactions helped Citi to beat the Street’s admittedly modest predictions with net income up 21%. Net credit losses rose only 9% but were up 85% YOY. Net income was up 22% sequentially but only 2% compared with Q3 2022. The income surprise at Citi is most welcome, but CEO Jane Fraser still has many miles to go to get the bank back into good graces with institutional investors. Citi’s efficiency ratio was 67% in Q3 2023 or 12 points above JPM. To get the bank into the low-60s in terms of operating leverage, where it will be possible to attract more institutional support, Citi needs to reduce headcount another 10% from the 240,000 employee total. But, to the contrary, Citi’s expenses were up 5% YOY in Q3 2023. Negative AOCI at Citi increased to $46 billion in Q3 2023, up just 1% from the previous quarter. Citi reported $508 billion in total investment securities and $648 billion in net loans and leases. If we haircut the $1.2 trillion total by 20% to reflect the move in interest rates the -$231 billion negative balance exceeds the bank's book equity of $190 billion as of September 30, 2023. WFC saw net interest income fall slightly in Q3 2023, continuing a trend that goes back more than a year. Sell Side analysts and media like to tell themselves that higher interest rates benefit banks, but in this cycle that does not seem to be the case, especially when you look at the sequential comparisons. Interest income was up 6% vs Q2 2023 but interest expense was up 17% sequentially. Historically, rising interest rates tend to see book value of equity fall, as the chart below illustrates. WFC reported an efficiency ratio of 62% in Q3, seven points above JPM but very much improved over the past year from 73% in Q3 2022. The bank’s balance sheet actually grew slightly vs Q2 2023, but mortgage banking income was less than half the levels of a year ago. Home lending was down 14% YOY due to a decline in mortgage banking income driven by lower originations and lower servicing income, which included the impact of sales of mortgage servicing rights. WFC has largely withdrawn from residential correspondent lending and is now the second largest mortgage servicer in the US after JPMorgan. Loans serviced for third parties fell over $100 billion YOY to below $600 billion in Q3 2023, reflecting a strategic withdrawal from mortgage lending and servicing. WFC once controlled one third of the residential loan market. WFC’s net interest margin shrank for the third quarter in a row to 3.03% vs 3.20 in Q1 2023. Net interest income for the nine months ended in September was up 26% vs 2022, but with income growth decelerating. Interest income was up 72% over the past nine months but interest expense grew 381% during the same period. Provisions for credit losses at WFC were down 30% in Q3 2023 vs Q2, reflecting the broader trend in the industry. Over the nine months ended September, provisions were up more than 600% vs the same period in 2022, reflecting the continued normalization of credit losses, as shown in the chart below. WFC stated on Page 3 of its earnings presentation: "A decline in accumulated other comprehensive income driven by higher interest rates and wider mortgage-backed securities spreads... resulted in declines in the CET1 ratio of 8 bps from 3Q22 and 16 bps from 2Q23." In Q3 2023, WFC reported AOCI of -$15.9 billion, which in relative terms is larger than JPM. If we take $928 billion in net loans and leases, plus the bank's securities portfolio at $490 billion, and adjust the $1.4 trillion total by 20%, the result is a mark-to-market loss of $283.6 billion or $100 billion more than the bank's book equity. Outlook for MS & GS It is difficult to compare JPM, WFC and Citi to GS and MS because the businesses are so very different. Whereas the large commercial banks have significant unrealized mark-to-market losses on their portfolios, GS and MS do not. Looking at the results for these three banks, the results suggest that the capital markets side of the major banks will be weak as GS and MS report this week. Citi, for example, saw revenue for its institutional clients group up just 2% sequentially and 12% vs Q3 2022. JPM saw investment banking up vs Q2 2023, but principal transactions and commissions fell and non-interest income overall was down sequentially. WFC was the surprise of the three, with investment banking fees and gains from trading activities up by double digits, but mortgage banking flat compared with Q2 2023. Investment advisory fees, the single largest component of non-interest income at WFC, rose slightly even as the bank continued to shed assets under management. Another key indicator for both GS and MS is the investment bank Jefferies Financial (JEF) , which reported earnings for the quarter ended August 2023 last month. JEF saw asset management fees rise nicely in the third quarter of its 2023 FY, but the single largest increase was interest revenue. The table below shows the results for JEF. Investment banking revenue was down 30% during the first nine months of the JEF fiscal year, but principal transactions doubled. Interest revenue is now the largest revenue line for JEF, even larger than revenue from investment banking. Look for similar results from GS and MS this coming week. Notice that interest earnings rose 180% in the most recent quarter for JEF compared with 2022, but interest expense rose 167% over the same period. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 11, 2023 | Last week, we had the opportunity to speak with Julia LaRoche (a/k/a " Sally Pancakes ") about the financials and the economy . During our conversation, we focused on what we call the “Silent Crisis” created by the FOMC in the banking and commercial finance sectors. Following on the heels of the Powel Panic and the COVID lockdowns in 2020-21, the Silent Crisis is led by banks, and residential and commercial real estate. But not consumers -- yet. Wait for it. The asymmetry of the current financial crisis in terms of “traditional,” consumer-led recessions represents a huge threat to the US economy, the banking system and the credit standing of the United States. But the threat is largely invisible to policy makers and economists. The Mortgage Bankers Association (MBA), National Association of REALTORS® (NAR), and National Association of Home Builders (NAHB) wrote to Fed Chairman Jerome Powell this week: “According to MBA’s latest Weekly Applications Survey data, mortgage rates have now reached a 23-year high, dragging application activity down to a low last seen in 1996. The speed and magnitude of these rate increases, and resulting dislocation in our industry, is painful and unprecedented in the absence of larger economic turmoil.” Notice the end of the last sentence. There is no “larger economic turmoil,” only confusion and incompetence at the Fed and within the Biden Administration. As we noted in our last comment (“ Texas Capital Bank v Ginnie Mae ”), President Biden’s appointees at HUD, the Federal Housing Administration and Ginnie Mae have done immeasurable damage to the US housing market. The Powell Panic starting in 2019 is shown below in a marvelous Bloomberg chart showing the effective duration of all GNMA MBS. The Powell Panic Source: Bloomberg First the banks left the government mortgage market a decade ago. Prudential regulators told banks not to lend to low-income families. Now many nonbank lenders that support underserved communities are fleeing the Ginnie Mae market as funding costs reach impossible levels. The Biden Administration's new capital requirements for nonbank issuers make profitable operations impossible in the government loan market. Leaving aside the public displays of idiocy within the Biden Administration, the Fed remains the real culprit in the malfeasance, first and foremost by inflating home prices by roughly 40% over the past five years via overmuch QE. Now the FOMC is trying to correct that "fine tuning" error by driving the housing market into the ground. It is basically a forgone conclusion that the entire market for government-insured reverse mortgages will be owned by the US Treasury before long. The damage done by the Powell FOMC to housing is but a secondary effect to the real disaster, which shows the US banking system headed for another peak in unrealized losses on loans and securities created during the great ease of 2019-2021. The chart from our earlier comment on Q3 bank earnings is below . Source: FDIC (RIS), WGA LLC By our calculations, the US banking sector will be almost completely insolvent in Q3 2023 vs $2 trillion in tangible capital . Proposals to restart TARP so that the Treasury can lend US banks a mere $1 trillion to offset part of these unnecessary mark-to-market losses illustrates the degree to which the Federal Reserve Board has careened out of control. And these same people want to talk about increasing bank capital? Really? H/T to Jack Farley . At the end of last year, Bill Nelson at the Bank Policy Institute and his co-authors issued an NBER/Hoover working paper about the outlook for Fed losses . Nelson: “One of my coauthors, Andrew Levin (an econ professor at Dartmouth) has just finished an updated forecast based on the current configuration of market rates. This projection indicates that the Fed will make no remittances to Treasury until 2032. Indeed, from 2023:Q4 to 2039:Q4, the Fed’s net interest income (and hence its cumulative remittances to taxpayers) will be about $1.6 trillion lower than if its balance sheet consisted solely of Treasury bills. That’s more than the annual GDP of Spain. About $1 trillion of this cost to U.S. taxpayers is a direct result of the Fed’s QE4 purchases from May 2020 onwards (that is, its securities purchases made after the Treasury market turmoil had subsided).” The longer that interest rates stay at current levels, the more likely it is that banks and eventually the US Treasury itself will be engulfed by the interest rate mismatch created by the Powell FOMC. With SOFR at 5.3% this morning, most market participants cannot hold Treasury debt or corporates or mortgage-backed securities without taking a loss on carry. Just how do Treasury Secretary Janet Yellen and Fed Chairman Powell propose to finance the US budget deficit if dealers are losing a point or more annualized on their inventory ? It is not just that the US banking system or housing is in trouble thanks to the Fed. The entire complex of public and private debt created over the past half century is now about to enter a period of debt deflation as described by the great American Irving Fisher a century ago . The only way to avoid catastrophe is for the FOMC to drop interest rates and publicly demand that Congress start cutting federal spending aggressively. The Powell Fed needs to drop short-term interest rates back down to 4% and leave them there indefinitely. At that level, banks and lenders will be able to function and slowly dig themselves out of the hole created by the FOMC. Then, however, Chairman Powell must discard his reticence about lecturing Congress on fiscal policy and demand that the federal deficit be cut in half. Powell may lose his job by jawboning Congress, but it is the right thing to do. Aside from short term considerations like bank failures or collapsing home prices, the larger threat facing all Americans is the federal debt. The growing likelihood that the Treasury will eventually default in economic terms represents an existential crisis for the US government. If the deficit is not cut, then the Fed will be forced to again actively purchase government debt. If the Fed is forced to grow its already swollen balance sheet from current levels, any pretense of “fighting inflation” will be discarded. Banks will balloon in size as their losses mount, the special role of the dollar will be destroyed and Americans will face hyperinflation that will make the 1980s seem tame by comparison. Merely keeping the Treasury from defaulting on $35 trillion in debt in nominal terms will require double digit inflation. Ponder that. In political terms, the Biden White House and most members of Congress are on the wrong side of the inflation issue. Nor does former President Donald Trump have any credibility on fighting federal deficits or inflation. It may be, ironically enough, that the conservative tendency in the House of Representatives that will force the change to business as usual in Washington. “In the end, a government of the people cannot escape the 'debt contraction deflation' disaster Irving Fisher described in 1933 by which the people suffer when the government foolishly thinks its obligations can be ignored or unfunded,” notes veteran securities counsel Fred Feldkamp . “We either grow or we will collapse, as one nation—we are inseparable in that regard. Fortunately, as long as we act responsibly, the world will support us. It has no alternate choice.” Let's hope Fred is right. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 4, 2023 | In this issue of The Institutional Risk Analyst , we provide a setup for top five bank earnings in Q3 2023. The big issue facing the industry is rising interest rates, which are causing a squeeze on net income and rising losses. Look for flat to down net income for US banks in Q3 2023 and a 10-20% increase in unrealized losses vs Q2 2023. Did we mention that rising interest rates are causing margin calls on Treasury and mortgage-backed securities (MBS) owned by REITs and dealers. And rising mark-to-market losses on securities and, yes, loans too? Apparently we're not even going to do $1 trillion in new 1-4 family mortgages in 2023. Just imagine how things will be in credit with the 10-year Treasury at 5%. Source: FFIEC There are many ways to measure the impact of rising interest rates on banks, but suffice to say that in Q3 2023 the negative mark-to-market on all securities owned by banks could exceed Q3 2022 and approach -$1 trillion. Our mark-to-market for the industry follows below. Mark-to-Market | All Banks Source: FDIC (RIS), WGA LLC The good news about mark-to-market losses is that the average coupon for all ~ $18 trillion or so in securities, loans and leases owned by banks is above 3% and slowly climbing. Slowly. The bad news is that securities with 3% coupons are trading in the low 80s and high 70s as of the end of Q3 2023. With the 10-year Treasury note trading above 4.7% yield at quarter end, we'd probably look for a 20-22% mark-to-market adjust in Q3 '23. The 10-year was at 3.8% at the end of Q2 2023. Of note, in terms of equity valuations U.S. Bancorp (USB) is the worst performer in the top-five banks, followed by Bank of America (BAC) , Citigroup (C) , Wells Fargo (WFC) and JPMorgan (JPM) leading the pack. USB continues to work through the December 2022 acquisition of MUFG Union Bank’s core regional banking franchise from Mitsubishi UFJ Financial Group (NYSE: MUFG). JPM is leading the rest of the group by a significant margin and is the only stock in the top five that still is up for the year. Source: Google Finance (10/02/23) The reason for our negative comments about Citi, USB and BAC is that they are spotting 10 points or more of operating leverage to JPM. Ten points explains a lot of the public equity market valuation gap, period. Notice that Peer Group 1 is at 59% efficiency (Overhead expenses / Net Interest Income + non-interest income). WFC is at least heading in the right direction at 64%, but needs to drop five more points to be credible. Also note, in this regard, how stable is the simple average of efficiency for the 140 banks in Peer Group 1. Source: FFIEC Even allowing for the positive effects of the First Republic transaction, JPM is still setting a blistering pace for the other banks to follow. Notice that near-banks Morgan Stanley (MS) and Goldman Sachs (GS) are not even in the big bank game with efficiency ratios in the 70s, but Charles Schwab (SCHW) is right behind JPM at 61%. At 65.7% in Q2 2023, Citi is way out of line in terms of expenses and thus the urgency of CEO Jane Fraser in launching the latest restructuring. But of course with net interest income slumping the first half of 2023, the higher efficiency ratios seen at large banks is not really a surprise. Less efficiency ratio means more net income, if you have the income vs overhead. Source: FDIC | *Six months The analyst pack has JPM earnings ~ $16 per share this year, but then falling to just $14 in 2024 because of a bad landing? Or maybe net asset shrinkage in the bank. This is remarkable because the curve is meant only to be upward sloping on Wall Street, right? The Sell Side's downbeat view of JPM certainly aligns with the public comments of CEO Jaime Dimon , who has been a vocal seller of current Treasury yields and soft landings. For those who missed it, Dimon told Bloomberg TV it’s possible the central bank will continue hiking short-term rates by another 1.5 percentage points, to 7%, a level that would assure more bank failures. In a rising rate environment, finding buyers for the assets of failed banks is problematic. Seven percent would be the highest federal funds rate since December 1990. In March 2022, when the current hiking cycle began, rates were at 0.25%-0.50%. Another down quarter in terms of net income will press many Sell Side analysts to back off their equity recommendations. Of concern, the growth rate for bank interest earnings continues to slow. The rate of increase in funding costs is also slowing to a lesser degree, but basically we are giving back the supranormal asset and equity returns of 2022 in 2023. As we noted earlier, JPM is now the largest servicer of residential mortgages in the US, surpassing WFC at the end of last year. JPM is also the largest warehouse lender to other mortgage shops. But is JPM going to be able to stay in the residential mortgage business under the new Basel III proposal? Meanwhile, Rithm Capital Corp (RITM) entered into a definitive agreement with Computershare Limited (CPU) to acquire Computershare Mortgage Services Inc. and Specialized Loan Servicing LLC , for a purchase price of approximately $720 million. Even if the Basel III proposal is watered down, nonbanks will continue to take share in residential mortgage lending and servicing. The folks at Bank Policy Institute have done a comprehensive look at how the new Basel III proposal will impact mortgages . Answer: Badly. If adopted, this draconian proposal will double the risk-weight on 1-4 family loans and impose large market risk adjustments for MBS. Just for the record, we think ALL MBS and Treasury debt ought to have 100% risk weights because of the market volatility, a dash of convexity and potential for employing double digit leverage under the assets. Loans? Not so much. Sane people really only put 1x leverage under a residential loan and then only if it has an agency or government credit guarantee. We think risk weights for 1-4s ought to start at 50% and move higher, faster with LTV regardless of the guarantee. That is the part of the Basel III proposal we think is long overdue. Private label loans ought to start at 100% depending on LTV. But the big ask ought to be raising Treasury and MBS risk weights to the same level as corporate exposures. Silicon Valley Bank could never have run 40% of total assets in MBS unless those securities had low or zero Basel capital risk weights. Source: FFIEC The chart above tells the story of top-five bank earnings in 2023. JPM is running about 40% above the group and Peer Group 1 in terms of earnings since the acquisition of First Republic. JPM was over 1.4% ROA vs BAC, WFC and Peer Group 1, which are clustered around 1% ROA. And Citi is at the bottom of the group at 0.6% ROA, a decidedly unacceptable position driven by poor operating leverage. Citi needs to cut expenses until efficiency starts with a "5." If Jane Fraser cannot get Citi's expenses down so it can at least meet peer levels of asset and equity returns, then she should break up the bank. The value of the pieces may indeed be greater than the current equity market value of C. Ponder the value of the Citi payments platform and the subprime consumer loan book in a sale. The only thing that prevents Citi from being broken up via a hostile takeover is federal banking laws. Notice in the chart below that the rate of increase in asset returns has slowed dramatically over the past two quarters. How is it that JPM and BAC are tied for last place among the top five banks and Peer Group 1 in terms of asset returns? Meanwhile, Citi's high yield loan book enhances asset returns, but the poor operating efficiency prevents this income from reaching the bottom line. The key battleground for US banks in 2023 and beyond is at least maintaining operating efficiency. Source: FFIEC The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

October 2, 2023 | Premium Service | The Financial Times carried an important article Friday about UBS AG (UBS) subsidiary Credit Suisse unwinding its relationships with Apollo Global Management (APO) . We explore the implications of this split for the world of secured finance and mortgage servicing rights (MSRs) in particular below. Always must read the Saturday press. UBS is seeking to reassure investors that buying Credit Suisse isn’t going to land it in a similar morass of regulatory probes and scandals, the Wall Street Journal reports. Yet the US mortgage business of Credit Suisse may be another pain point that has been overlooked by investors and the media. Notice that the WSJ report never mentions the US mortgage business of UBS. The litigation section of the most recent Credit Suisse financial report goes on for eleven pages, but does not mention the latest developments. A full DOJ investigation into Russia-related sanctions reportedly is underway at Credit Suisse, and UBS was being probed too, Bloomberg reported last week. UBS denies the report and says that the banking giant is reducing its exposure to Russia. Over the weekend, UBS unit Credit Suisse announced a settlement to the decade old “tuna bond” scandal, which involved the alleged theft of hundreds of millions of dollars in loan proceeds and the collapse of the nation’s currency. “Credit Suisse has reached an 11th-hour out-of-court settlement with Mozambique over the decade-old $1.5 billion-plus "tuna bond" scandal, the Swiss bank's new owner UBS said on Sunday,” Reuters reports , “drawing a line under a damaging dispute it inherited.” All's well that ends. Readers of The IRA are aware that over the past decade, Credit Suisse was one of the more significant players in the US mortgage market until the Archegos failure blew up last year. The bank had a significant presence in the market for financing Ginnie Mae mortgage servicing rights (MSRs), a role that no other US bank was willing to take up. Eventually, the investment bankers in the special products group of Credit Suisse were sold to a newly created portfolio company of Apollo Global Management (APO) known as Atlas SPG. Click the link below to read our past notes on APO: https://www.theinstitutionalriskanalyst.com/search?q=Apollo Credit Suisse owns a substantial Ginnie Mae MSR that so far the bank has been unable to sell. It also owns Select Portfolio Servicing , the largest private label residential loan servicer in the US. Credit Suisse reportedly rejected three bids proffered on the $37 billion in UPB of mostly non-agency mortgage servicing rights, according to Inside Mortgage Finance . The SPS unit may now include the Ginnie Mae MSR among the assets listed, one reason it is difficult to sell. Here is the disclosure from Credit Suisse released last week. “In 6M23, we reported negative net revenues of CHF 1,275 million compared to net revenues of CHF 437 million in 6M22. The decrease in net revenues primarily reflected CHF 1,527 million of fair valuation adjustments reflecting changes in exit strategies and principal markets as well as changes of intent in connection with UBS’s plans and intentions for underlying positions or portfolios, mainly within our rates, securitized products, corporate loans and life finance portfolios. The decrease also included a loss of revenues from businesses transferred from the Investment Bank and losses on the valuation of certain financing arrangements associated with the Apollo transaction. These decreases were partially offset by a gain from the Apollo transaction of CHF 726 million in 6M23. In 6M22, net revenues included a loss of CHF 521 million on the equity investment in Allfunds Group.” The table above from the 06/30/2023 Credit Suisse financial reports includes references to the Archegos event, which arguably led to the sale of the bank. Reading through the intentionally vague disclosure, it appears that Credit Suisse is taking back control of some of its servicing assets from APO. We assume it includes the entire servicing book that was not sold last year, including the problematic Ginnie Mae MSRs and related advances on these assets. Also, UBS reportedly has a small legacy HECM financing business acquired with Paine Webber. In the first six months of the year, Credit Suisse completed the sale of a significant part of SPG to entities and funds managed by affiliates of Apollo. Credit Suisse and Apollo entered into various ancillary agreements related to the transaction, including an investment management agreement, certain financing arrangements and a transition services agreement. APO acquired certain assets and agreed to manage other assets. Significantly, the Cayman Island branch of Credit Suisse reportedly provided a large LT credit line to Atlas SPG as part of the sale. CS had previously provided a credit line to support a number of Ginnie Mae MSR financing deals in the bond market, financings that have only been partly supported by Atlas SPG since that time. Suffice to say that APO has neither the capacity nor the appetite to take on the exposures previously supported by Credit Suisse. Apparently UBS is not interested in the Ginnie Mae MSR business either. “The sale of Bank assets to certain entities of Apollo and related financing provided by the Bank to these entities represent asset-backed financings where the Bank has continuing involvement,” Credit Suisse disclosed last week. The net exposure of the SPG group is now sub-$20 billion vs $74 billion a year ago. “In 3Q23, management decided to exit certain loan portfolios held in the NCL, which will result in a reclassification of these loans from held at amortized cost to held-for-sale and an expected loss in 3Q23 of approximately USD 1.6 billion, Credit Suisse disclosed. “In addition, a decision was made to wind down certain management arrangements, which may result in a loss of up to USD 0.6 billion in 3Q23.” This apparently refers to the APO relationship. There are two takeaways from this latest disclosure from Credit Suisse. First, the US servicing assets are being retained in the Non Core and Legacy (NCL) business unit. It is safe to assume that as time goes forward, these assets will cost UBS more money. Specifically, UBS will have a continuing financing role in the assets sold to APO and Atlas SPG. Credit Suisse: “The Bank may have continuing involvement in the financial assets that are transferred to an SPE, which may take several forms, including, but not limited to, servicing, recourse and guarantee arrangements, agreements to purchase or redeem transferred assets, derivative instruments, pledges of collateral and beneficial interests in the transferred assets.” Credit Suisse continues to hold significant on-balance sheet residential loan assets and servicing, and other assets, all this in addition to $260 billion in off-balance sheet exposures in SPEs. The bank indicates that the NCL assets are likely going into a separate SPE unit as well, but UBS will ultimately pay the cost of remediation. UBS ultimately seems intent upon running off the remaining US mortgage assets, including a few billion in exposures on Ginnie Mae MSR financings that cannot be sold. Think of the US subprime and government mortgage business as the last remnants of the old world of mortgage lending. This is one reason why prospective buyers would not pay par for the related advances from the bank on the Ginnie Mae MSRs financed by customers. Bottom line: The US mortgage business of Credit Suisse will not be a LT obstacle to UBS in achieving dominance among the global private banks, the group we refer to as the asset gatherers. It may, however, be the source of significant losses and also operational, headline risks. The bank charged off $130 million in restructuring costs for NCL through June 2023 and we suspect there will be a good bit more to come. Get your signed copy of this classic story today! The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

September 27, 2023 | Premium Service | In this issue of The Institutional Risk Analyst , we return to Charles Schwab & Co (SCHW) , a name that figures near the top of our subscriber emails and the “short-list” for many equity traders. Before we delve into the increasingly problematic world of US banks, however, let’s take note of the latest machinations from SoftBank Corp , the profoundly idiosyncratic Japanese hedge fund guided by the equally unpredictable Masayoshi Son . SoftBank Corp claims that it will attempt to raise up to 120 billion yen ($808.79 million) via Japan's first public offering of bond-type class shares, Bloomberg News reports. Son, of note, owes SoftBank $5 billion which he “borrowed” to boost his compensation after a year of record losses. The latest developments come in the wake of the dismal performance of two SoftBank equity offerings for Better Holdings (BETR) and ARM Holdings (ARM) . Online lender BETR merged with a SPAC f/k/a Aurora on August 23, 2023 and initially traded at $17 per share, but subsequently collapsed to under $1. Today BETR is trading at $0.50 and has been placed on a “death watch” by several mortgage publications. Like many mortgage companies with the misfortune to be public, BETR is suffering a “ valuation reset .” Meanwhile, the “blockbuster” ARM IPO is likewise starting to feel the strong gravitational pull of rising interest rates and a slowing global economy. The much-anticipated offering of a small stake in ARM came after SoftBank’s failed attempt to sell the company to Nvidia (NVDA) . The stock traded as high as $69 per share, but fell down into the mid-$40s on strong selling pressure before rebounding yesterday to close below the IPO price. The poor performance of these two public offerings apparently caused the management of SoftBank to become unglued. SoftBank’s finance chief, Yoshimitsu Goto , lashed out at S&P after the rating agency refused to immediately upgrade the firm’s “BB” junk debt rating from S&P. Somebody needs to whisper in Mr. Goto’s ear that US rating agencies like "smooth transitions," something that SoftBank is obviously not going to provide. Goto told the Financial Times he was “deeply disappointed” with S&P’s decision to stop short of an upgrade, despite raising its credit outlook from stable to positive. He went on yowling like a wounded hound and accused S&P Global of “not trusting the management.” True. Of note, SoftBank has "A" ratings from several non-US agencies . Just for the record, Mr. Goto, most reasonable people don’t trust SoftBank management because of the firm’s very apparent lack of internal systems and controls. We also find it interesting that SoftBank is seeking to raise capital via a debt offering after a series of missteps and market disappointments. Has the equity tap run dry, Mr. Son? As “Big in Japan” noted in a comment to the Financial Times : “A finance director who can’t hold his nerves is probably dealing with a very unsustainable financial situation…And yes we don’t believe SoftBank financial discipline or investment policy. The evidence is written all over the wall!” Again, very true. So much of the image of success used by SoftBank to raise billions in private equity in past years was predicated on the illusion of value in a zero-interest rate environment. In today’s market, however, we think risk managers and investors ought to ask themselves whether the public behavior of Softbank’s executives deserves to be met with confidence or terror. The public behavior and decision-making processes of SoftBank suggest that the organization is in trouble. The choice to move forward with the BETR IPO, for example, oozes of desperation and may create legal liability for SoftBank. It’s not clear whether Son or Goto or their other colleagues care. A year from now, will we be speaking about SoftBank and Masayoshi Son in the past tense? “[BETR’s] SPAC partner, Aurora Acquisition Corp., once traded as high as $62.91 a share,” notes Paul Muolo of Inside Mortgage Finance . “Might a reverse stock split be in order at some point?”. Maybe. Do you think that the Financial Stability Oversight Council discussed SoftBank last week? Probably not. Charles Schwab & Co Back in March of 2023, as the proverbial wheels were falling off the cart in banks, Charles Schwab (SCHW) fell off the edge of the table, dropping from ~ $80 per share down to the mid-50s. We mentioned this fall from grace with respect to both SCHW and Citigroup (C) , which has been wallowing at 0.4x book value since COVID. Is the 30% downward price adjustment in SCHW due to some structural problem with the bank or simply reflects less air in the valuations for all banks? Or was the runup in the stock from 2021 simply a bubble? We suspect the latter is the case. Note that looking back over the past five years, SCHW is actually up 10% even today. Source: Google Finance The first question to ask is the Street’s posture on the stock. Short-interest has been trending lower since mid-year, but was never more than 30 million shares vs a 10 million share per day average. SCHW has a $100 billion market cap at the close on Tuesday or a price/book of around 3.5x vs over 5x pre-March ‘23. Despite some vociferous critics, SCHW does not seem to be distressed at present. But that stability may be temporary thanks to the FOMC The Street, needless to say, has “buy” and “strong buy” ratings on SCHW, but these recommendations may be tough to fulfill given the rising questions about banks in the minds of investors. Earlier we discussed how names like SCHW and Citigroup (C) have experienced significant declines in valuation, but obviously the former has been merely marked down to “only” 3.5x book value while Citi has been trading below 0.5x book for several years. If we compare SCHW with the other asset gatherers in our surveillance group, the picture is considerably better than the market performance suggests. The big question we are pondering is whether SCHW and other names are starting to spread out again in terms of valuation after a five-year roller coaster ride c/o the FOMC. We include Goldman Sachs (GS) , Morgan Stanley (MS) , Raymond James (RJF) and Stifel Financial (SF) . First, we look at credit performance and SCHW and SF are in competition for the lowest net-loss rate. SF has actually reported zero credit losses for several quarters, while SCHW has a loss rate that is slightly above zero. The rest of the group are normalizing their credit profiles, but losses remain very low with the notable exception of Goldman Sachs. GS at 62bp of net loss is 2x Bank of America (BAC) and just behind Citi. Remember, we are talking net credit losses as a percentage of average assets . GS has a much smaller credit book than other commercial banks, thus our concern. We noted earlier that even with the sale of Marcus loan assets, the credit performance of GS is still festering. What is going on? Source: FFIEC Notice that the net credit losses for GS have almost returned to 2020 levels, again begging the question as to why the bank is reporting such anomalous results in credit. SCHW, by comparison, reported 1bp of net loss in Q2 2023. Most of the other asset gatherers have low credit loss rates that are also stable. Next on the agenda is the gross spread on loans and leases, a measure of how the bank prices risk. The spread also gives you an idea of the sort of customer that the bank is pursuing in its business operations. As the chart below suggests, most of the group has repriced their portfolios to about 6% gross spread, but GS is over 10%, suggesting that the target customer is decidedly subprime. The spread also suggests that GS is under significant pressure in terms of funding, as we’ll discuss below. Source: FFIEC Notice that SCHW and SF have the lowest gross loan spreads in the group, which reflects their lower funding costs and also a less aggressive stance in the market. In terms of unused credit that may be drawn, SCHW has less than $2 billion in the unused portions of HELOC commitments that are fee paid or otherwise legally binding and not much else. GS, on the other hand, has $69 billion in unused credit card lines, $2.5 billion in commitments for construction loans, $125 billion in unused commercial & industrial and other commercial credit lines, and another $6 billion in standby letters of credit. In terms of exposure at default, a Basel I measure of vulnerability to market turns, GS leads the pack but SCHW is at the bottom of the list. The two business models could not be more different. Net loans & leases at SCHW was only 20% of total assets at Q2 2023, with 50% of total assets in debt securities and mutual funds. GS had only 14% of total assets in loans, 40% in deposits and federal funds sold, and the remainder in trading assets. GS reported negative $3.2 billion in accumulated other comprehensive income (AOCI) at Q2 2023 while SCHW reported -$20 billion in AOCI at Q2 2023. The fact that GS does not hold securities for investment is a major advantage for the firm and somewhat offsets the outsized market and credit risk taken by the firm. Bloomberg reports that the average price of all fixed income securities in the US is 86 cents on the dollar, meaning that many banks and other intermediaries are insolvent now. If the FOMC makes another quarter-point rate hike, the average will fall towards 80 and GNMA 3s will be trading in the mid-70s vs par. For SCHW, bonds is a big pain point because its half of the balance sheet and also because in capital terms, the Treasury, GNMA and agency MBS has zero or low (20%) risk weights for Basel purposes. The chart below shows the swings in SCHW AAOCI Since 2020. Half of the bank’s $38 billion in equity is impaired as of Q2 2023 and we expect this capital impairment to grow. Source: FFIEC In response to these changes, the management of SCHW has taken significant steps to change the composition and funding of its balance sheet. As we predicted in an earlier note, SCHW has decreased the assets of the bank 20% since 2021 and deposits by over 40% in the past year alone. The bank substituted debt for the deposit runoff, allowing management to control the duration of the book. Brokered deposits and short-term debt have grown significantly. SCHW is below $500 billion in assets as of Q2 and we’d not be surprised to see further significant runoff. The shift in funding and other changes are clearly one major factor behind the drop in valuation. Yet having said all of that, SCHW’s funding costs are tracking at the bottom of Peer Group 1, as shown in the chart below. Source: FFIEC Note that SCHW is trending at only about 60% of the funding cost for Peer Group 1 and the other banks in the group. GS has thankfully seen a decrease in the rate of change for its average funding costs. And MS has engineered a dramatic decrease in funding costs by dropping 80% of the bank’s more costly MMDAs and savings accounts. Of note, MS had only -$6 billion in AOCI vs $100 billion in equity capital in Q2 2023. In terms of reported earnings, SCHW is in the middle of the herd, tracking Peer Group 1 and MS. RJF and SF are the best performers in the group measured against average assets, but the entire cohort of asset gatherers is headed lower as the Fed’s market operations squeeze net income. Notice that GS is in a nose dive, with next income to average assets half of Peer Group 1, but MS is trending lower as well. Source: FFIEC Bottom line on SCHW is that management is making significant changes in the business, dropping deposits and assets as the bank slowly unwinds its large fixed income position. While the bank's balance sheet is a source of fascination for short-sellers, its is the $8 trillion in assets under management that is the core of the business. We expect SCHW to continue to shrink the bank, perhaps as low as $400 billion by year end. But in the meantime, we see no reason to go long the stock at this juncture and believe that the Sell Side "Buy" recommendations are misplaced. As the prospect of a further increase in interest rates looms, SCHW and other banks may come under renewed selling pressure as the year grinds to an end. 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.

September 25, 2023 | This week, The Institutional Risk Analyst is headed for the Digital Mortgage 2023 in LAS . But first a quick comment on higher interest rates for longer after the latest FOMC meeting. The cries of “surprise” from the Wall Street analyst herd about the prospect for no significant interest rate cuts in the near-term are so predictable. We think the obvious statement is that maybe the ultra low interest rates of the post 2008 period were excessive, at least judging by the mounting losses at the Fed. The fact that the Yellen Treasury is preparing to repurchase “illiquid” bonds to augment “market liquidity” is another big hint. Do you think banks want to sell Treasury notes and bonds with the 10-year note at 4.4%? And yes, bank stock prices may even go down in the near term. We'll be updating readers on Charles Schwab (SCHW) later this week. We think that equity managers need to start thinking about whether the past five years of downward skewed interest rate markets is really a good indicator for the future. Perhaps the new lower bound for short-term interest rates is not zero but more like 3-4%? The 10-year was 4.49% on Friday and the yield on the conventional loan index was 7.2%. Fed funds, meanwhile, seems stuck below 5.5%. Imagine if the Fed cuts short-term rates a whole quarter a point 12 months from now and that's it. At the Digital Mortgage event, we will be participating in several panels, including a discussion in the PM 9/26 at the Wynn with former FHFA Director Mark Calabria about the future of Fannie Mae and Freddie Mac. Needless to say, the outlook for either GSE being released from government control seems more distant now than ever before. Our short take on the future of the GSEs looks a lot like the character played by Bruce Willis in the 1995 film by Terry Gilliam , “Twelve Monkeys,” but we’re looking forward to a great discussion. In this regard, read our latest comment in National Mortgage News (" Washington's fretting over nonbank risk is misguided "). Imagine if the GSEs were released from conservatorship, but then were immediately designated as a "systemically important financial institution" (SIFI) by the FSOC How do you think that would work for private investors? In a perfect world, the private sector would lift most of the prime and middle thirds of the mortgage world, while the GSEs and Federal Housing Authority and other agencies would support housing policy for the lower income portions of the markets. The key role for government, IOHO, is promoting first-time home ownership with subsidized products focused on the bottom third of consumers (< 670 FICO) in terms of credit. Notice that the market for non-agency private mortgages has largely disappeared since the start of 2023. Fact is, virtually the entire residential housing sector currently operates with government credit support, so that investors need only ponder market risk and funding. Sadly, Silicon Valley Bank forgot that option-adjusted duration thing. But the key point is that virtually the entire market for 1-4 family mortgages reflects a government subsidy worth several points in terms of loan price. Keeping the GSEs in conservatorship simply makes this middle class subsidy a permanent fixture of the mortgage markets. Because of the federal credit wrap on agency and government-insured 1-4s, credit risk is mostly taken off the table with US mortgages, but with a lot of operational risk borne by banks and nonbank servicers of government assets. The pricing of mortgage-backed securities reflects this credit subsidy, thus if we raise the fees charged by Fannie Mae and Freddie Mac for guaranteeing MBS and the underlying loans, the conventional loan rate would rise accordingly. Private mortgages, even prime jumbos, are relegated to the world of "fringe" products that ebb and flow with interest rates and funding costs. The irony is, of course, that the current enterprise capital rules now in place for the GSEs essentially require Director Sandra Thompson to raise gfees. At the end of 2022, the FHFA reported on the fees charged by the GSEs . Total average guarantee fees increased 2 basis points (to 56 basis points), average upfront guarantee fees increased 2 basis points (to 13 basis points) and average ongoing guarantee fees remained unchanged at 43 basis points. So, let’s set the table. Imagine that FHFA Director Thompson follows the current capital plan and proposes a 20-25bp increase in the total average gfees charged by Fannie Mae and Freddie Mac so that they can “accumulate capital.” As and when home prices start to weaken, the urgency for accumulating capital and putting back "defective" loans to issuers will intensify. Let’s also imagine that new residential loan volumes will be lucky to touch $1.6 trillion in 2023 and 2024 and that loan rates are going to slowly rise toward 8% as the industry struggles to eliminate capacity and thereby restore profitability. The Darwinian struggle for loans in the primary loan market will start to resemble WWI trench warfare. Finally, let’s imagine that loan delinquency slowly rises to above 2019 levels over the next 12-18 months and loss given default (aka “net loss”) for 1-4s likewise normalizes back into positive territory. Keep in mind that delinquency for the bottom quartile of mortgages in the FHA market are already in the low teens and climbing. Source: FDIC, MBA In the event of a gfee increase by Fannie Mae and Freddie Mac, we might imagine that the GSEs would lose significant market share, both to private issuers and the Federal Home Loans Banks. Lower FICO borrowers would no doubt migrate back to the FHA. But any real decline in GSE market share assumes that private investors are willing to take first loss on credit risk for conventional loans for an extra 75bp in yield. Probably not. As the FHFA under Director Thompson has injected more and more politics into the operations of the GSEs, the execution at the cash windows of both GSEs has suffered. With a 75bp average total gfee, would the market for private label MBS return? Or, more likely, would conventional lending volumes simply crater as consumers balked at 8.5% mortgage rates? That's our bet. "Raising to 75 would be counter intuitive to their mission," one top-ten correspondent lender tells The IRA . "That level of gfees makes FHA a much better option for customers, so the customers on the border of doing an FHA or a Conventional loan will now go FHA – typically they are the lower income borrowers FHFA is trying to serve. Further, a gfee hike makes the housing affordability worse as less borrowers will qualify in the highest rate environment we’ve seen since the 90’s. In addition, the good middle class borrowers getting the $350k house may also go FHA as the rate differential will be so much greater." But of course mortgage rates already are headed over 8% because of the inversion of the Treasury yield curve. The on-the-run Fannie Mae MBS for delivery in October (TBA) is a 6.5% coupon trading at 100-26 bid at the close Friday. If you are writing 7.5-8% mortgage loans, you really want to sell that loan into a 7% MBS in TBAs for October, if you can find a bid. Notice that there are no 7% contracts on the screen. Remember, lenders sell short in TBAs so that they can lock the cost of a pool delivered a month hence. To add to the misery, the mortgage market is still in contango , meaning the near MBS contract is trading at or below the price for TBAs for October and November. Lenders are slowly going to ratchet up loan rates until the secondary market execution returns to profitability. Keep in mind that warehouse funding for prime clients is SOFR +1-2%, so you are lucky to break even on carry until you sell new loans into the MBS pool. And just for giggles, the average coupon in the Bloomberg MBS index is still below 3%. TBA Prices & Spreads Source: Bloomberg (09/22/2023) So, again, if Fannie Mae and Freddie Mac take their gfees up to 75bp, will that convince private investors and banks to own 1-4 family loans? Probably not. Will the volumes in the conventional loan market likely fall further? Yep. If you want to hear the rest of the story, come join us at Digital Mortgage 2023. 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. 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