SEARCH

July 26, 2023 | This week The Institutional Risk Analyst is in Washington, D.C. for meetings in the mortgage and banking channels. Below follows our comments to the Center for Strategic Tax Reform on Wednesday, 2:00 PM at the Tax Foundation in Washington. Inflation is called a “hidden tax,” but lately the tax is not even barely concealed. Under the 1978 Humphrey Hawkins law, the Fed is supposed to work toward price stability and full employment. Yet precisely the opposite situation seems to be the norm. William Dunkleberg writes in Forbes : “Did you realize that since 2020 we have all experienced an “across-the-board” tax increase of 15%? The prices of goods and services we buy are about 15% higher than they were in 2020. So, unless your income has risen by 15%, your real income, what you can buy with your 2020 income today, is much reduced. And, with inflation running at 7% you are still losing ground. If you had $10,000 in a savings account (IRA, 401k, etc.), it will buy only about $8,700 worth of stuff today. Rising income and/or returns on your investments could offset these losses, but not 100%, and for too many, not at all.” How did the inflation happen? Simply stated, the Fed lost its nerve after the money market collapse in December 2018. Fed Chairman Jerome Powell and his colleagues decided to double-down on the pro-inflation policies of former Chairman Ben Bernanke and “go big” with reserves. Powell hugely inflated the Fed’s balance sheet and bank balance sheets too, and in the process pushed up home prices by a third. And all this started 15 months before COVID. Since the end of 2021, the Fed gradually ended new purchases of Treasury bonds and mortgage securities and is now slowly allowing its portfolio to run off. The Fed has raised the target for federal funds to nearly 6%, imposing roughly $1 trillion in mark-to-market losses on securities held by US banks. This is a tax too, BTW. In addition to imposing market losses on banks and other investors, the FOMC’s actions have badly disrupted the term structure of interest rates in the mortgage and asset backed securities markets. Home lenders face a contango market . Lender are losing money on every mortgage they make, both in terms of carrying costs and secondary market execution. This is also a tax. The chart below shows the losses being incurred by mortgage lenders per dollar of volumes from the latest MBA Performance Survey. Source: Mortgage Bankers Association Three large regional banks failed in Q1 2023 at the cost of tens of billions in investor losses on equity and debt securities. PacWest Financial (PACW) is reportedly in talks to be acquired by Banc of California (BANC) in a club deal with Warburg Pincus and CenterBridge Partners . In the event, PACW is likely to trade at a significant discount to book value. Another tax. The loss to the FDIC’s bank insurance fund so far is about $30 billion in terms of the cost of liquefying the deposits of Silicon Valley, Signature and First Republic banks. Consider this a tax on bank investors. Just to add insult to injury, the Biden Administration is preparing to adopt the poorly considered 2017 Basel capital proposal. Despite the narrative coming from the FOMC and the economist community about a “soft landing,” in fact the Fed has largely lost control of its balance sheet and thus inflation because of "going big." The Fed is losing about $1 billion per day on the interest rate mismatch on its portfolio, where is earns much lower yields than it pays on reserves and reverse repurchase agreements (RPs). Chairman Powell refuses to sell bonds at a loss, even to help normalize the bond and housing markets, thus the Treasury yield curve remains inverted. Lenders should arguably be writing 8% loans or higher, but the Fed’s massive securities portfolio holds down LT rates. The table below shows TBA pricing from Bloomberg at the close yesterday. Notice that Fannie Mae 6.5s for August are trading at 102, implying at least 7.5% loan coupon rates for a profitable loan. Source: Bloomberg (7/25/23) Most striking, home prices in the US have started to rise again, this despite the fact that 30-year mortgage rates are up five percentage points over the past 18 months. The Fed may need to go back to double-digit levels of mortgage rates not seen since the 1990s in order to force home prices lower. This will be a tax too. Yet unless the Powell FOMC sells bonds, long-term interest rates will remain muted. Unless interest rates rise, home price inflation will not be tamed. If all of this were not enough good news, the losses being incurred by the Fed means that the central bank will not be remitting any savings to the US Treasury for the next decade. This is another tax, of note. "The Fed is on the way to operating losses of an estimated $110bn this year," writes Alex Pollock . "Its mark to market loss as of March 31 2023 was $911bn." Indeed, the costs imposed by the FOMC's actions over the past five years total into the trillions of dollars. But the Fed and Treasury have added so much liquidity to the system, that the real economy is still not slowing down. So while the FOMC is meant to be helping the economy and ensuring price stability, in fact the Fed has inflated home prices to record levels and has left the banking system capital impaired. The Fed is going to be a considerable expense to the US Treasury for the next decade as it slowly earns its way out of hundreds of billions in losses incurred by the FOMC under Jerome Powell. On Sunday, June 25, 2023, the Bank for International Settlements released its Annual Report . The chapter on monetary and fiscal policy concludes with the following advice for central banks: "Careful consideration should also be given to keeping central bank balance sheets as small and as riskless as possible, subject to delivering successfully on the mandate . This would have three benefits. First, it would limit the footprint of the central bank in the economy, thereby reducing the institution's involvement in resource allocation and the risk of inhibiting market functioning. Second, it would lessen the economic and political economy problems linked to transfers to the government. Finally, it would maximise the central bank's ability to expand the balance sheet when the need does arise . Given the costs of large and risky balance sheets, the initial size is a hindrance, not an advantage. The balance sheet needs to be elastic, not large." 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.

July 24, 2023 | Premium Service | Last week we heard from our friend Alex Pollock , who had an interesting letter in the Financial Times about the growing insolvency of the Fed and other global central banks as interest rates rise. He writes: "In the past nine months, the Federal Reserve has suffered previously unimaginable operating losses of $74bn from its deeply underwater interest rate risk position, a loss which far exceeds its total capital of $42bn. In misleading and arguably fraudulent accounting, the Fed refuses to reduce its reported capital by these losses; with proper bookkeeping, it would now be reporting capital of negative $32bn, growing more negative every month. It insists that no one should care about its negative capital, but carefully cooks the books to avoid reporting it." Speaking of financial boondoggles, the Fed just launched its “FedNow” payments system at considerable cost to the taxpayer. Why does the central bank want to compete with the large banks that it regulates? George Selgin , Senior Fellow and Director Emeritus, Center for Monetary and Financial Alternatives, Cato Institute, noted in testimony before Congress in 2019 regarding FedNow : “The Federal Reserve banks enjoy many legal advantages over private suppliers of payment services. They command a monopoly of bank reserves that serve as means of final payment; they are empowered to regulate commercial banks and some other private-sector payment service providers; and they are exempt from antitrust laws. Finally, although the 1980 Monetary Control Act requires that the Fed charge prices for its services that recover those services' capital and operating expenses, it only needs to do so over a ‘long run’ of unspecified length, and then only according to accounting methods of its own choosing that are not subject to external review. These and other Fed privileges mean that, when it enters into direct competition with private-sector payment service providers, it does so on a playing field that it can easily slant in its favor. It is owing to this that the Fed itself has established strict criteria it must meet before offering any new payment service, including the requirement that the service in question ‘be one that other providers alone cannot be expected to provide with reasonable effectiveness, scope, and equity.’" Here's our question: When is Fed Chairman Jerome Powell going to announce the privatization of most of the equity value of FedNow to recover the cost? When the Fed incurs any expense, it spends public funds. Other than as a systemic backstop, there is no reason for FedNow to compete with the Clearing House member banks. If the Fed were to sell down its Fed Now position to 24.9%, it could mitigate the obvious conflict of interest and create an arm’s length relationship in terms of governance and day-to-day management. The Fed can still exercise control over standards and operational risk. In his note, Alex and some readers queried us about the appropriate level of double leverage for a bank holding company (BHC). Our answer: That depends. Double leverage occurs when a parent company raises debt capital and downstream that capital to a subsidiary bank, dealer or company as common equity or debt. But the parent company must receive enough income in dividends to support the cost of the debt, thus a more profitable bank can support a higher double leverage ratio (DLR) by the parent BHC. “The Federal Reserve's typical guidance encourages maintaining a DLR below 120,” a reader notes. “The average BHC in Peer Group 1 falls well within this guidance. This Richmond Fed blog gives Fed guidance on double leverage… To my knowledge, aside from a few narrow exceptions, such as permitting small BHCs to operate with high leverage temporarily after acquisitions, the Fed only allows (and through TLAC debt issuance requirements actually requires ) G-SIBs to operate with high holding company leverage. Currently, all G-SIBs maintain double leverage ratios near 200%, which equates to a 1:1 debt-to-equity ratio (and that’s even with counting their preferred stock as equity though it is really another form of debt).” The table below shows the double leverage ratio of selected large banks from the FFIEC. We use total leverage, which in most but not all cases closely approximates the classical measure of Equity investments in Subs/ Equity Capital. Source: FFIEC Notice that JPMorgan (JPM) has a 180% DLR, virtually all of which represents equity investments by JPM in the subsidiary bank and broker dealer. Other BHCs use debt to provide capital to their subsidiaries, in part because the interest payments are tax deductible. These numbers do not move around a lot over time. Of interest, Goldman Sachs (GS) and Morgan Stanley (MS) each run over 300% DLR, in part because of the large broker-dealer subsidiaries. Large banks have been growing the use of parent company leverage since the 1970s, when the LDC debt crisis and the energy bust in Texas contributed to a number of bank failures and related mergers. The growth of DLR in recent years reflects the diversification of many large banks into capital markets and asset management businesses. But the Fed has also made a conscious decision to allow large banks to use higher leverage in many different parts of the business, much like having an ocean racer running downwind with lots of spinnakers aloft. This makes the banks larger and, in theory, more liquid. So long as wind conditions are favorable, having more leverage on a bank can contribute to profitability. But as we learned with Silicon Valley Bank, excessive leverage also magnifies mistakes, meaning that institutions which run their business with more leverage at the bank level feel the impact of credit losses in the form of diminished or suspended dividends. Over the years, there have been instances where an insolvent small BHC was restructured without the FDIC seizing the bank. Fitch noted in December: "Rising interest rates have increased unrealized losses in banks’ available for sale (AFS) bond portfolios, causing declines in accumulated other comprehensive income (AOCI) and tangible common equity (TCE) ratios and increasing double leverage for bank holding companies." So if a BHC has a 200% DLR, meaning 50% cash equity and 50% debt, combined the two sources of finance gives us the bank’s cost of capital. If the bank should become under capitalized, then common and preferred shareholders, and even bond holders, can face interruption of dividends and interest payments. Most public investors in banks own highly-levered shares in BHCs, not in the subsidiary bank. Below is a list of the significant subsidiaries of JPM. JPMorganChase From a risk management perspective, first we consider the leverage of the parent company and how those funds are deployed by the bank. What is the payback period, in years, for the debt financing incurred by the BHC? In the case of JPM, the payback on the parent company debt is more than six years, even with the relatively low interest rates of recent times. The comparable metric for small BHCs is one year. As interest rates rise, the effective cost of leverage on large banks grows. Next we look at how the bank leverages its equity capital via loans and investments, which are funded with deposits at the bank and debt, including debt to the parent company. Most banks run at 15:1 leverage, meaning $1 in bank equity capital and $14 in deposits and other borrowed funds. Like a leveraged buyout, large banks employ leverage to boost equity returns. If the parent BHC has only 50% equity, how much leverage is in the bank operating at 15:1 leverage? Finally we look at the bank’s use of derivatives to add further leverage to the overall business. The table below shows the gross derivatives positions of the largest banks as a percentage of assets. The point of the comparison with total assets is to understand the size of the derivatives book relative to the bank’s balance sheet. Notice that American Express (AXP) , one of the best performing banks in the US, has a tiny derivatives book. Source: FFIEC Start with the 1:1 leverage at the parent BHC, add the 15:1 leverage on the subsidiary bank’s capital, then finally assess the exposures and operational risk from the bank’s derivatives activities. When you sum up all of the debt and derivative exposures on the capital of a BHC, the leverage on the balance sheet of JPM is basically infinite. So when we ask why large banks are so big, the answer is that the Federal Reserve Board allows large BHCs to use more leverage than small banks. If the Fed constrained the use of double leverage by large banks to the same levels as smaller institutions, then JPM and other large banks would be far smaller. But in a country where the federal government is running trillion dollar annual deficits, then you need big banks to hold the debt. That's the Fed's dirty secret. The Fed's decision to allow large banks to use more leverage has never been approved or even discussed by Congress. If you are a Member of Congress and want to make large banks smaller, then force BHCs to fund investments in bank subsidiaries with 100% equity. Somebody should ask Chairman Powell about this at the FOMC press conference this week. But does anybody in the media understand finance sufficiently to ask such a question? 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.

July 20, 2023 | Premium Service | U.S. Bancorp (USB) had a decent quarter in Q2 2023, but one that is still obscured by the accounting for the Union Bank purchase from Mitsubishi UFJ Financial Group, Inc. (MUFG) . The Q2 numbers in terms of returns were down from Q1, but the analyst community took comfort from the fact that the capital levels rose. In terms of USB, we need to see the efficiency for the combined entity down in the mid-50s before we are ready to declare success. That said, Buy Side manager are already buying USB on the assumption that management will ultimate return to trend earnings. The table below shows key performance indicators for USB from the Q2 2023 earnings presentation. USB has guided to $1 billion in "notable items" due to expenses from the Union Bank purchase in 2023. The Union Bank acquisition added 1.2 million new consumer and small business accounts and 3,000 commercial customers to USB’s platform. Indeed, this purchase is one of the more significant bank M&A deals in recent years. The transaction also boosted USB’s mortgage volumes, pushing the bank up into the top-five issuers nationally. “Second quarter mortgage banking revenue at USB came in at $161 million compared to $128 million in 1Q23,” Inside Mortgage Finance reported, but the bank announced layoffs in its mortgage unit last week. Q1 & Q2 results include almost $500 million in charges related to Union Bank. Even with adjustments considered, however, USB’s net interest margin is still sub 3%. When we look at the public market’s valuation for USB, it is pretty clear that the drop in reported financial performance is affecting the stock. Market leader JPMorgan (JPM) is trading just shy of 1.6x book while USB is at 1.3x after the most recent equity market rally. In past years, USB traded even with JPM, but that is no longer the case today. We expect to see USB trading at a discount to JPM and Peer Group 1 until the bank improves its operating leverage to pre-COVID levels. Of note, USB has grown its deposit base through the Union Bank acquisition and also organically, but the shift from non-interest bearing deposits to time deposits is quite pronounced and hurt Q2 results. As USB shrinks its balance sheet and makes other operational changes, we expect the bank’s performance to improve, but this process could take several more quarters. Moving from the sublime to the problematic, we come to the Q2 2023 earnings results from Goldman Sachs (GS) . In Q1, just to review, GS announced a restructuring of the Marcus banking unit and the sale of assets. In Q2, the board of GS endorsed the leadership of CEO David Solomon and a two part strategy focused on investment banking and asset management. The remaining loan portfolio of Marcus was sold at a $100 million gain in Q2. Even as GS has completed the sale of over $1 billion in loans from Marcus , GS has been increasing exposures in other areas, particularly in residential mortgage lending. Our readers know from past reports that GS has no particular comparative advantage in terms of funding costs, nor has the bank covered itself in glory in terms of credit performance on it’s small loan book. We reviewed the Q1 results for GS in June (“ Update: GS, MS, SCHW, RJF & SF ”). Source: FFIEC GS was the only large bank to miss Street estimates to far. As GS sheds the consumer loan exposures to Marcus, it reportedly picked up commercial loan exposures in areas such as funding warehouse and mortgage servicing rights (MSR) for nonbank lenders. Rithm Capital (RITM) , the largest nonbank holder of Ginnie Mae MSRs and a former customer of Credit Suisse (CS) , is said to be working with GS. Of note, RITM has apparently acquired the last slug of consumer loans from Marcus. When CS folded its tent in 2022, most of its clients migrated to Atlas SPG, a portfolio company of Apollo Global Management (APO). Many key bankers from CS also went to Atlas. But other than the credit line that CS extended to Atlas, APO has no comparative advantage for funding mortgage warehouse facilities, advance lines and/or MSRs. Given the low level of new loan volumes, an uptick in delinquency could quickly overwhelm some of the more high levered nonbank owners of Ginnie Mae servicing. With Comerica (CMA) and Fifth-Third Bank (FITB), among others, exiting warehouse lending, GS may be getting more inquiries from nonbank lenders. We wonder about the staying power of GS and other commercial lenders in the mortgage channel, including Texas Capital Bank (TCBI) and M&T Bank (MTB) . As the mortgage market consolidates into a primarily purchase market in 2023, roughly half of existing capacity will need to be eliminated. JPM and New York Community Bank’s (NYCB) Flagstar unit rank 1 and 2 in the warehouse space. The table below is from the Q2 2023 GS earnings release. The other question regarding GS that we have addressed previously and which remains is whether the asset management side of GS is really creating value. GS reported $4.6 billion in fees in the first half of 2023 on $2.7 trillion in assets under supervision (AUS), which translates into 34bp annually. If you compare GS with the $1.8 trillion wealth management arm of Morgan Stanley (MS) , the latter generates far more income vs AUS. The $1.4 trillion investment management unit at MS performs roughly in line with GS. Without a banking strategy, we question whether GS is really viable as a stand alone business over the longer term. We have long advocated that GS consider a merger with a large regional bank as a way to consolidate its position as a global competitor of MS and UBS AG (UBS) . Indeed, all of the “asset gathers” that we follow from MS to Charles Schwab (SCHW) to Raymond James (RJF) have superior funding and credit loss profiles compared with GS. In an environment where credit costs are again a primary concern for banks, GS would likely be an outlier in the asset gatherer group and would have net credit losses closer to mainstream lenders such as JPM. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

June 21, 2023 | Premium Service | The segment of the banking world that we refer to as “asset gatherers" is predominantly involved in the investment advisory world, either facilitating investment or acting as advisor and dealer in the global capital markets. The group starts at the top with UBS Group AG (UBS) , then goes to Morgan Stanley (MS) , Goldman Sachs (GS) and Charles Schwab (SCHW) , and ends with Raymond James Financial (RJF) and Stifel Financial (SF) . Most of the group is up over the past year with the notable exception of SCHW, which we profiled earlier in the year (“ Update: Charles Schwab (SCHW); Sagent Presentation ”). The chart below shows the huge decline on SCHW in March, which has since moved sideways. If you agree with our view that the short-selling of the stock was mistaken, then the discount for SCHW is unwarranted. Source: Google Readers of The IRA are aware of the auction of a non-agency servicer owned by Credit Suisse, SPS, a sale process that apparently failed for a second time last month. It will take years for UBS to work through the issues it has acquired in CS, including a portfolio of money losing mortgage businesses in the US that nobody seems to want. CS/UBS was just sued by a group of bond holders in the Eastern District of New York. The case is Star Colbert v. Dougan, 23-cv-04582 , US District Court, Eastern District of New York (Brooklyn). The first test for our group is net credit losses and as you’d expect, SF and SCHW have loss rates around zero because the banks take little principal risk. Next is Morgan Stanley and RJF and then the average of the 140 banks in Peer Group 1. Well about the rest is GS, which reported over 40bp in net losses in Q1 2023 or a “BBB” bond equivalent. Citigroup (C), by comparison, reported 77bp of net credit losses in the first quarter. GS is really in the wrong neighborhood of credit compared with MS and SCHW. But this is nothing new. Source: FFIEC The volatility visible in the GS credit performance is just the beginning of a story that features striking volatility in assets and income. For example, in Q1 2023 GS reported a gross spread on loans and leases of 9.6% – 500bp above the level reported at year-end 2022. Of note, the income and revenue figures for Q1 do not show nearly this degree of volatility, but the payoff for Goldman may lie ahead in Q2. We’ll see. Source: FFIEC The sheer movement illustrated by the GS spread data is remarkable, but the public market valuation for GS not compelling. Back in Q1 2023, a lot of people were hyperventilating about Charles Schwab, but we said no big deal. SCHW has continued to shrink its bank unit, now down to just $535 billion in balance sheet assets or the 10th largest bank in the US. At the end of Q1 2023, SCHW still had among the lowest cost of funds in the industry at 0.88% vs average assets compared with 1.52% for Peer Group 1 and over 3.5% for GS and MS. Source: FFIEC Notice that the cost of funds for MS and GS rose by hundreds of percent year-over-year, but we think that funding costs could double again in Q2 2023. Recalling that there were only a couple of weeks in March following the collapse of Silicon Valley Bank, the impact on funding was relatively muted. The increase in deposit rates during the full period of Q2 2023 could see some of the largest increases in bank funding costs in recent memory. When we look at the bottom line, the two smallest members of the group, Raymond James and Stifel, turn out to be the best performers looking at income vs average assets. Going back five years, the returns from the broker dealer have driven earnings for both of these banks. Source: FFIEC Notice that the asset returns for GS are the worst in the group, but the smaller players lead the pack. RJF, for example, did $9 billion in non-interest income in 2022 vs $1.6 billion in net interest income. Stifel was more than 2:1 fee income vs interest earnings. SCHW, on the other hand, still made more money on interest than fees, but not by much. The announcement last month by James Gorman that he will step down as CEO of Morgan Stanley sets a well-earned victory lap. MS generates 4x the fee revenue vs income from the group's two banks. All of the key performance metrics place MS dead center of Peer Group 1 in terms of financial performance. The major criticism is the relatively higher overhead expenses, as shown in the table below. Notice that JPMorgan (JPM) has the best efficiency in the group. Source: FFIEC You could argue that SCHW is the most undervalued name in the group given the strong funding and profits. It is down small for the past year, yet still trades at a much higher multiple to book value than the rest of the group. We expect that SCHW will continue to run down the size of the bank and that the investment business will predominate in the future. Source: Bloomberg (06/20/2023) The Institutional Risk Analyst 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.

July 15, 2023 | Premium Service | A quick note to our Premium Service subscribers about Q1 2023 bank earnings so far. We’ve seen the best of the large bank group with JPMorgan (JPM) , which as we wrote earlier is leading the top five money center banks by a wide margin. The mainstream media narrative says that banks are “benefiting from higher interest rates," but in fact funding costs rose less rapidly than feared. We'll take good news of whatever description. The first key takeaway is that the rate of increase in funding costs has slowed, taking pressure off of the banks and also members of the Federal Open Market Committee. Looking at Citigroup (C) , for example, the bank actually managed to push its gross loan yield to 8.6% while the gross cost of its deposits rose over 3%. Interest income overall rose 11% vs Q1 2023, while funding costs overall at Citi rose 17% vs Q1 2023. YOY, Citi’s funding costs are up over 400%, but Citi’s IR team thinks this statistic is not meaningful. The table below is from Citi’s Q2 2023 earnings presentation. Citi’s credit expenses went down in Q2 2023, but operating expenses rose and revenue fell, resulting in a 37% drop in earnings vs Q1 2023, which is usually C’s best quarter of the year. A $1.5 billion drop in principal transactions was somewhat offset by lower loan loss reserves, but the bottom line was another disappointment for Citi shareholders. Interest expense at JPM overall rose “only” 22% in Q2 2023 while interest income rose 13%, again showing the uphill climb against funding costs banks still face. JPM easily beat the other four money centers and seemingly maintained the 10 point operating leverage advantage over Peer Group 1. Again, low default rates allowed JPM to reduce loan loss provisions in Q2 2023, another significant tailwind for banks this quarter. Credit expenses may increase through the year. Notice in the JPM earnings that deposit related fees rose 11% in Q2 2023, a reflection of the vast amount of funding that moved to the bank after the three bank failures in Q1 2023. One of our readers notes that the .01% PPI headline this month was totally dependent on the +0.2% contribution it got from Services. In turn, Services was supported by something called “Deposit Services” which posted +5.4% month-over-month. JPM saw strong +26% growth in income from the mortgage sector, including the bank’s growing book of mortgage servicing rights. As we note in our latest column in National Mortgage News (“ The chaos wrought by the FOMC keeps unfolding ”), JPM is well-positioned to buy conventional MSRs from nonbank mortgage firms. JPM ranks #2 after Wells Fargo & Co (WFC) in owned mortgage servicing at just below $900 billion in unpaid principal balance (UPB) of loans. Most of the top-ten owners of MSRs are nonbanks, but Bank of America (BAC) is #9 at $300 billion in UPB. The table below shows the results for JPM and the impact of First Republic Bank broken out. Of particular note, JPM took $900 million in losses on investment securities in Q2 2023 as the bank continues to aggressively clean house of COVID era exposures. This expense was easily offset by the accounting gains from the purchase of First Republic Bank. We expect to see continued strong performance from JPM, but we do expect them to focus on shrinking the bank balance sheet as the Fed continues to roll off ~ $75 billion per month in reserves and even more cash from roll-off of Reverse Repurchase Agreements. One reason that JPM and other large banks will be looking to reduce assets is because regulators are preparing to impose new capital requirements and other levies on large banks. In this regard, JPM provided three key points of guidance for 2023: 1) Expect FY2023 net interest income excluding markets segment of ~$87B, market dependent; 2) Expect FY2023 adjusted expense of ~$84.5B excluding the FDIC special assessment; and 3) Expect FY2023 Card Services NCO rate of ~2.60 Point 2 reflects the fact that the FDIC is preparing a special assessment to replenish the bank insurance fund that will be paid entirely by the largest banks. This assessment seeks to cover the $15 billion cost of covering the uninsured depositors of Silicon Valley Bank and Signature Bank will be a significant financial expense for JPM and other large banks. Perhaps the most improved of the large banks Friday was WFC, which saw total revenue up $3.5 billion vs Q2 2022. ROE rose to double digits for the second quarter in a row and operating expenses fell. WFC took twelve points out of its efficiency ratio, pushing this key indicator down to 61. Efficiency is one of the key criteria we identified previously as needing improvement for the bank to be attractive to investors. Note that JPM's overhead ratio was 49 in Q1 2023. WFC’s deposit base fell 7% in Q2 2023 and we expect to see more shrinkage as the year progresses. Interest expense rose 27% in Q2 2023, the most of any large bank so far this quarter. Mortgage banking revenue fell 13% as WFC continues to withdraw from correspondent loan purchases and related commercial lending. Just the end of third-party mortgage purchases could see the bank shrink assets and commercial deposits significantly during the rest of the year. WFC managed to boost net income nicely in Q2 2023, but the driver was noninterest revenue. NIM for WFC actually fell in Q2 and the outlook is for the bank to continue shrinking the balance sheet and running off the $900 billion UPB mortgage servicing book. Indeed, if we include First Republic's $100 billion in MSR, JPM is officially even with WFC now. We think that bulk sales of MSRs could make JPM the largest bank owner of residential servicing assets by next year. (Note: Of course, as a reader notes, there is $250 billion in UPB of originated mortgage loans inside JPM already, but WFC also has a huge internally originated loan book where the MSR is never capitalized.) Bottom line: JPM has an impressive lead in earnings and growth over WFC and C, neither one of which is positioned to catch up with Jamie Dimon in 2023. As Jim Cramer noted on CNBC last week: "JPM is a growth stock." We look for better results from USB, but the jury is still out until July 19th. Bank of America (BAC) , on the other hand, is one of our bigger concerns because of the mediocre performance in Q1 2023 in terms of funding costs and net losses. Disclosure (07/15/23) 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.

July 17, 2023 | On Friday we described some of the bigger takeaways from bank earnings for Premium Service subscribers, but one huge headline goes against the narrative of rising rates helping bank earnings. In fact, the rate of increase in both deposit costs and loan yields is slowing compared with 2022. The FDIC reported in Q1 2023: “The average yield on loans increased 32 basis points from the prior quarter to 6.08 percent. The increase in average loan yields represents a sizable deceleration over the 73 and 65 basis-point increases reported in fourth and third quarters of 2022, respectively. Average loan yields increased for all QBP asset size groups relative to the previous quarter.” The popular narrative in the Big Media says that banks are benefiting from higher interest rates. In fact we all dodged a bullet in Q2 2023 because the repricing of assets and deposits slowed from the crazy levels seen at the end of March. Big h/t to Fed Chairman Jay Powell and other regulators for providing ample liquidity to get everybody to calm down. The mark-to-market problem remains, however. The mark-to-market losses facing banks still tally into the hundreds of billions of dollars. But at least we are making money on deposit fees. In this regard, a reader named Joan of long acquaintance writes about the latest producer price data: "The .01% PPI headline was totally dependent on the +0.2% contribution it got from Services. In turn, Services was supported by something called “Deposit Services” which posted +5.4% m/m. So of course, I had to look that up. As you can see, the jump in the cost of 'Deposit Services' happened in March which coincides with the bank failures. What gives?" Our take on the numbers is that a LOT of institutional money moved around in Q2, part of the reason that fees rose 11% at JPMorgan (JPM). The House of Morgan did add 1.75% to its gross loan yield in Q1 2023, yet the increase in Q2 was half that amount looking at the GAAP disclosure. Overall, the rate of improvement in deposit rates and loan yields for the industry as a whole is slowing markedly. The folks on the FOMC need ponder whether this changes after one or two more fed funds target hikes. The other big eye opener we’ve seen with several banks is that lending fell in Q2 2023 as bank treasurers more than tapped the brakes on new lending in order to let portfolio runoff naturally build cash. Banks receive payoffs and prepayments every day or some 20% of the balance sheet annually on average, so if you take your foot off the gas in terms of new loans and renewals, cash accumulates quick. The fact that Wells Fargo (WFC), for instance , is exiting correspondent lending, will cause the bank to generate a lot of cash. But WFC is not typical for the industry. Consider the example of Washington Federal, Inc. (WAFB) in Seattle, a $22 billion asset bank we rated when we worked at Kroll Bond Ratings . WAFD has grown assets 10% in the past year and has seen steady deposit growth through the first two quarters of 2023. WAFD is a strong performer within Peer Group 1 and typifies the type of super community banks above the key $20 billion asset regulatory threshold that have caused Peer Group 1 to grow to 140 institutions over the past year. WAFD is known for having steady profitability and a strong credit culture, with most of the bank’s loans secured with real estate. Yet the bank deliberately throttled back lending in Q2 to less than $1 billion compared with $2.7 billion in Q1 2023, a stark indication of how even strong banks such as WAFD reacted to the sudden failure of Silicon Valley Bank . Commercial loans represented 63% of all loan originations during the second quarter and consumer loans accounted for the remaining 37%. “After nine consecutive years of net recoveries, during the last two quarters we have experienced net loan charge-offs. It is clear the rapid rise in interest rates is causing some stress for a limited sub-set of borrowers, but taken in its entirety, credit quality remains a positive differentiator for the Bank,” WAFD told shareholders. WAFD notes that commercial loans are preferable as they generally have floating interest rates and shorter durations. “Over 85% of our loans are secured by real estate with an estimated average current loan to value ratio under 45%. While there will likely be further stress for certain segments, we believe the Bank's conservative underwriting will accrue to our long-term benefit.” WAFD reported an efficiency ratio of 52% in Q2 2023, below the average for Peer Group 1 and just behind the hyper-efficient JPM at a stunning 48% overhead ratio in the second quarter. One of the things that we like about WAFD is that their overhead costs are significantly below Peer -- 65bp below their peers in fact. The bank is in the bottom 20% of Peer Group 1 in terms of overhead costs vs average assets and in good company with the likes of Bank OZK (OZK) . Like many banks, WAFD has doubled cash on hand over the past six months and has also seen a steady migration of deposits into time deposits and out of uninsured transaction accounts. And over the past six months, WAFD has increased deposits and also added $1.5 billion in additional debt liquidity to support growth. The table below is from the Q2 2023 earnings release from WAFD. So what does WAFD tell us about banks during the rest of 2023? Holding more cash with less market exposure is the wave of the future, which with T-bills over 5% is fine for now. In fact, WAFD had positive accumulated other comprehensive income (AOCI) over the past couple of years! You see, not all banks are dumb. The positive AOCI at WAFD, a key measure of overall balance sheet duration, fell 70% in Q2 vs Q1 of 2023, but at least the number was still positive. Big h/t to CEO Brent Beardall and his team. This means that the management of WAFD, who are primarily real estate lenders, has more than a clue about market risk and duration . JPM, by comparison, had a negative $14.6 billion mark in terms of AOCI at the end of Q2 2023. Source: FFIEC This $22 billion super community bank only has 6% of assets in long-duration securities. Sabe? The average securities holdings of large US banks is 16% of total assets which is really too high. Anything over double digits makes us want to walk the treasury team out of the building. When you are in a secular interest rate tightening, there is no reason for a bank to be long duration and especially long MBS or whole mortgage loans. Selling loans and investing treasury proceeds in swaps and mortgage servicing assets is the proper strategy. If US regulators want to get a handle on the risks that caused three major bank failures in 2023, then the answer comes down to characterizing bank business models. How does the bank fund and deploy its assets? If the answer is like Silicon Valley Bank, where we put more than 40% of assets in MBS, then it’s time to call in the FDIC and maybe bring the FBI along for good measure. Call us severe, but bankers who deliberately run an insured depository into the ground are imprudent and deserve prosecution. This is about more than simply clawing back personal compensation. Have a good week. 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.

July 11, 2023 | We start this issue of The Institutional Risk Analyst by noting the latest comments from the Federal Reserve Board on how to make banks more resilient to the risks that caused the collapse of three good size regional banks, accounting for almost half a trillion in banking assets. As our colleague Dennis Santiago noted on Twitter last week: "Entropy doesn’t care who is right or wrong. The only thing it sees is someone disturbed the equilibrium." The outsized wave of market volatility unleashed by the Fed has not made the agency any more forthright in its public statements. “Events over the past few months have only reinforced the need for humility and skepticism, and for an approach that makes banks resilient to both familiar and unanticipated risks,” Michael Barr , the Fed’s vice chair for supervision, said in a speech, The Wall Street Journal reports. The only problem with Barr’s statement is that his solution entirely avoids the problem. The definition of “risk weighted assets,” as defined by US regulators for the purposes of Basel capital rules, does not include government bonds, including Treasury debt and Ginnie Mae mortgage backed securities. Both have zero risk weights, but still caused SVB to fail. Under Basel capital rules, 100% means $8 in capital per every hundred dollars in assets. Conventional MBS backed by Fannie Mae and Freddie Mac have 20% risk weights. This compares to 50% capital for well-underwritten whole mortgage loans or 100% for corporate credit exposures. Bottom line is that Barr’s capital increase will lower bank earnings, but will not address the factors that caused Silicon Valley Bank to fail in March of 2023. Not at all. Source: FDIC So what should Barr do? Forget the general capital increase for banks. Instead, immediately impose a 50% minimum capital weight on all MBS to acknowledge the market risk contained in these securities . Barr should lead this discussion within the US regulatory community, but does he have the courage to speak up? Because of the borrower’s open-ended right to prepay, holders of MBS are always short duration, both in terms of market price and relative spreads. Barr should dispense with the childish nonsense about "capital" and make bank managers address that real risk. Look at the number of stocks that have been downgraded in recent weeks because of the impact of unrealized securities losses on the balance sheets of banks and REITs. The public record is filled with relevant examples for Barr and his colleagues to ponder. If you bought whole loans or MBS during COVID and were not smart enough to shed this risk in good order, then today you are at least 10-15 points under water on price and 5-6% underwater on funding for these assets. Moving right along in the grand parade of value destruction, the bankrupt parent of Silicon Valley Bank filed a lawsuit against the FDIC last week seeking to recover $2 billion in funds deposited with the defunct bank. Good luck. Long-time readers of The Institutional Risk Analyst will recall a similar litigation involving the 2008 failure of Washington Mutual FSB . The WaMu failure spawned numerous derivative lawsuits with JPMorgan (JPM) , Deutsche Bank (DB) and other parties . When the former parent of WaMU eventually won in court, the FDIC turned around and sued the officers and directors for the additional loss to the bank insurance fund. The failure of three regional banks in Q1 2023 is just part of the larger wreckage caused by the policy failure of the FOMC over the past five years. There are literally hundreds of billions in losses working through the US financial system as a result of the outsized market risk caused by the FOMC’s decision to “go big” with reserves starting in 2019. Now Barr and his colleagues will impose inappropriate new capital rules on banks at a time when regulators should be seeking to boost bank profitability in order to absorb current mark-to-market and future credit losses. If we take note of the fact that the Fed is likely to keep rates at or above current levels, then all financial institutions face a period of dramatic readjustment to this new reality and lower earnings in the meantime. Large US banks already have 11% common equity tier 1 capital / total risk-weighted assets (RWA). Just how much more capital does Mr. Barr think that banks need to prepare for the next wave of market volatility ℅ the FOMC? The sad fact is that even with another 2% capital to RWA, most US banks are arguably insolvent thanks to the Fed “going big.” Just wait for some of the juicy disclosure in Q2 2023 earnings around unrealized losses. Join us tomorrow on SiriusXM Business Radio at 9:00 AM ET for our monthly discussion with Janet Alvarez, Executive Editor at WiseBread, CNBC & Telemundo Contributor and Harvard Visiting Nieman Fellow. 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.

July 8, 2023 | Premium Service | If we told you that a bunch of mortgage companies and specialty banks focused on housing were outperforming much of the rest of financials in the public equity markets, even as interest rates rise, would you believe it? Oh, and home prices are rising too. Most readers of The Institutional Risk Analyst know that some members of our mortgage equity group have outperformed the large-cap banks. Whether this evolution is warranted or sustainable is not even debatable, as discussed below. You perchance noticed that Fifth-Third Bancorp (FITB) pulled out of mortgage warehouse lending last week, this after less than a year in that channel. Suffice to say that FITB is not considered a particularly serious player in the world of secured finance. The Comerica (CMA) exit was another matter entirely. Skittish behavior by large regional banks fleeing commercial loan markets is further evidence suggesting that Q2 2023 earnings may hold more than a few surprises for banks and nonbanks alike. Funding costs and changes in the composition of deposits are the first data points for analysts following banks in Q2 2023 earnings. As we noted in our pre-earnings comment on JPMorgan (JPM) , the ability to raise the yield on your book while managing perhaps 100-200% increases in funding costs is how banks will be measured in Q2 2023. For nonbanks in the mortgage sector, the question is why are we even here. Funding costs for nonbanks are SOFR +1-2% and rising even as new loan volumes touch decade lows. More, the prospect of short-term interest rates remaining above 5% indefinitely has big implications for the economics of the mortgage market. For this reason, the fact that some names in the mortgage complex are actually outperforming banks and fintech firms is remarkable and may offer an opportunity for the risk oriented. Equity Surveillance List Source: Bloomberg, CapIQ First on the list is Arch Capital (ACGL) , a multi-line insurer that also writes private mortgage insurance (MI) on conventional loans. AGCL hit a 52-week high in May, but the sophisticated financial group remains popular with the analyst community. It offers exposure to the mortgage space without direct operating risk of an issuer and is No 2 on the Insurance industry group of Investors Business Daily . Like the entire group, ACGL benefits from some upside exuberance that is fading as expectations regarding interest rates evolve. Next on the list is United Wholesale Mortgage (UWMC) , the dominant player in the wholesale channel that has grown its footprint significantly in recent years. Comparisons to Countrywide Financial are entirely appropriate. UWMC is tied with PennyMac Financial (PFSI) in purchase mortgages and we suspect UWMC will pass them in Q2 2023. Both PFSI and UWMC trail behind Rocket Companies (RKT) in terms of refinance transactions, but all have the same challenge: low lending volumes, high loan originations costs and negative secondary market spreads. UWMC completed 2 bulk loan servicing sales as well as 2 excess servicing strip sales in Q1 on servicing assets with a total UPB of approximately $98 billion, and also completed 2 additional mortgage servicing rights (MSR) sales subsequent to quarter end. Net cash proceeds approximated $650 million from MSR and excess sales in Q1 2023 or 66 bp on the UPB. UWMC reported an operating loss of $138 million in Q1 2023 and a negative mark on the owned MSR over $330 million. Source: Bloomberg So obviously the question comes, why is UWMC up 40% over the past year, more than many, far larger banks and fintech firms? The first answer is that the stock is very tight, with most of the shares held off-market in “non-controlling” interests. This is why Bloomberg cannot seem to calculate the correct market value of equity or price-to-book value for UWMC (“ Memo to Gary Gensler: Beware the “Non-Controlling Interest ”). Notice in the table above that Bloomberg reports the price/book for UWMC is 67x. Just remember it's a $5 stock. The second reason is that UWMC is one of the market leaders in conventionals and amassed a large enough pile of cash during COVID to bully other lenders for much of 2022. Now that pile of cash is gone and so is the aggressive, beggar-thy-neighbor approach to buying loans from CEO Matt Ishbia . The company is monetizing half a billion in MSRs per quarter to cover operating losses. We think selling MSR today is not a bad decision, but it is always best to retain your own servicing if possible -- especially when the industry faces an existential change in the nature of the mortgage business. It seems that a number of Buy Side analysts moved investors into names such as UWMC and PFSI on the theory that the FOMC would pivot this year, ushering in a benevolent period of lower rates and coupons around 5.5% instead of over 7% today. Look for the glib analyst in the Q1 UWMC earnings call who prattles on about 5% mortgages and the end of Fed rate cuts. Meanwhile, home prices are again rising and the Fed and other central banks are being backed into a corner in terms of maintaining current interest rate levels indefinitely. The more optimistic souls in the mortgage industry seem to have misjudged the timing of an actual interest rate decrease by the Fed, especially given the latest economic data. We also worry about 2024, when large, aggressive conventional issuers like UWMC are likely to be waist deep in repurchase claims from Fannie Mae and Freddie Mac. Putback claims will come even as volumes are subdued and loan execution in the secondary market may still be negative. UWMC originates 75% conventional loans and with $15 billion in Q1 volume is the market leader over PFSI and RKT, Inside Mortgage Finance reports. Western Alliance Bancorp (WAL) unit AmeriHome and U.S. Bancorp (USB) are fifth and sixth in conventionals. UWMC’s portfolio has a weighted average coupon of 3.6% or half of current coupon rates, making them an ideal target for the GSEs to make putback claims. A snapshot from UWMC’s Q1 financials follows below. Of course, EBITDA is not particularly relevant for a bank or finance company. What the table above doesn't show is that UWMC’s overhead expenses were $300 million in Q1 vs $161 million in net revenue. Like many large issuers in the mortgage sector, overhead has simply not fallen as fast as revenue, driving these companies into operating losses. UWMC has seen revenue fall by 80% year-over-year. Likewise PFSI had net revenue roughly equal to operating expenses in Q1 2023, resulting in a small GAAP profit. PFSI had better results than UWMC primarily because of the larger servicing book, as shown in the slide from PFSI's Q1 earnings presentation below. PFSI did a better job of hedging interest rates in Q1 2023 than did UWMC and thus reported a small profit. As PFSI noted in Q1, mortgage delinquency rates decreased from the prior quarter and remain below pre-pandemic levels. Significantly, servicing advances outstanding for PFSI’s MSR portfolio decreased to approximately $427 million at March 31, 2023 from $520 million at December 31, 2022. While a number of rather optimistic analysts and investors continue to talk about returning to 5.5% mortgage loans in the near term, we think they ask the wrong question. Rather, if the period of hyper-low interest rates that the industry has seen since 2008 is truly over, how do mortgage lenders like UWMC, PFSI and RKT look in terms of business models? Veteran mortgage executive Bill Dallas provided some insight into that question in National Mortgage News : “What's interesting is almost none [of my clients] have a lot of perspective about the mortgage business. A lot of them have never been in an environment that is predominantly purchase. I was raised in that environment. I spent my first 20 years in an environment where we didn't have refinances really. Everything was a purchase. I think they're struggling with that. And then the second shoe that hit them all is margin compression, and product compression, which they weren't expecting. Almost everybody's business model that I saw underestimated the amount of compression on the gross revenue side of their business.” If we summarize the points from the interview with Bill Dallas, the message is that the future facing mortgage lenders is a purchase market with very high expenses per loan and resulting downward pressure on revenues . Purchase loans cost over $12k to originate vs $3-4k for a refinance loan. Negative economics will persist, both because of origination expenses and the backwardation of the TBA market due to the actions of the FOMC. Most lenders are losing money on every loan they close and sell, leaving the servicing strip as the only potential source of income long term. Source: MBA As a result, the “winners” in the mortgage sector will be those larger players with equally large servicing books that can access funding from the dwindling number of banks that are focused on the sector. We think that the valuations for some of the larger issuers discussed in this report are excessive and likely to be corrected as investors come to appreciate that 7% loan coupon rates in a largely purchase loan market could be with us for years. 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.

July 5, 2023 | As is customary over the period leading up to long holidays, a good bit of interesting news and commentary emerged last week. The big news globally is the slowdown of the Chinese economy. Witness the frantic efforts by Beijing to address a deflation led by a collapsing real estate market. Much of China's malinvestment in housing, as well as the "belt & road" boondoggle, was funded in cheap dollars. But overinvestment in housing is not a situation unique to communist China. If China has created too much housing stock, the US has too little, resulting in rising prices for existing homes. As we noted in our last issue , prices for existing homes started to rise again in 2023, defying efforts by the FOMC to calm inflation by crushing the US housing market. Rising home prices, however, may not be your only problem if you own a home in Florida. Last week our friend John Dizard , formerly of the Financial Times and now a free man in Paris , described the building train wreck involving residential property insurance in Florida and GOP Governor Ron Desantis (“ RON DESANTIS AND THE FLORIDA HOME INSURANCE UPRISING ”). John writes: “A fair number of homeowners will have extreme difficulty finding affordable property insurance. No home-owners insurance means no access to mortgage financing supported by the US government’s housing agencies. This is a real wake-up from the Florida Dream. Reasonable people might say this set of problems was not created by Governor DeSantis, but he happens to be Governor right now, this year and next year, when the reckoning is coming due.” So say, for example, that a homeowner gets subsidized homeowner's insurance from the State of Florida, but the insurance lapses after six months and the homeowner cannot afford market rates. What happens to the loan? This is a question you can be sure is attracting the attention of Sandra Thompson , Director of the Federal Housing Finance Agency and regulator of Fannie Mae and Freddie Mac. A conventional loan with lapsed property insurance on a home in Florida is a perfect candidate for a putback claim to the issuer. But will those conventional issuers still be answering the phone a year from now? As we’ll be discussing in our next Premium Service issue of The IRA , there are a few names in the world of housing finance that have run up double digits in the past year but may disappear in the next twelve months. “Mortgage fintech Better.com — which still clings to the hope of becoming a public company — lost $89.9 million in the first quarter of 2023, according to updated financials filed with the Securities and Exchange Commission,” Inside Mortgage Finance reported on July 3rd. “In 1Q22, the New York-based lender lost $328.9 million and spilled (combined) red ink of $1.19 billion in 2021 and 2022, the amended S-4 filing states.” The world of secured finance is still coming to grips with the idea of several more increases in the federal funds rate this year. Higher for longer seems to be the consensus in the world of mortgage finance and the market for US Treasury paper. Accordingly, MUFG Securities is revising its 30-year current coupon basis target for the end of 2023 upward to 120-130 basis points from an original December 2022 forecast of 100 basis points,” Bloomberg reports. “[T]he FDIC liquidations of the failed banks’ agency MBS portfolios has gone well leading us to conclude an underlying strength in the demand for agency MBS relative to anemic net supply,” wrote Glenn Schultz , head of mortgage prepayment & strategy at MUFG, in a June 22 report. This suggests that the Federal Open Market Committee has ample room to sell mortgage backed securities (MBS) into market strength. But what about deflating China? Even as the Fed and other global central banks fret about inflation, a collective problem created by years of sovereign bond purchases, few in the analyst community have noticed that higher interest rates are creating a largish recession in secured finance. Driven by the short end of the yield curve, secured finance is the part of the economic complex where jobs are created and economic growth occurs. One hint of a growing problem is securities issuance. Private new issuance levels are falling as banks ratchet-up the sale of loans and securities, and build piles of cash, a dangerous recipe for global deflation in 2024. If you take out the Treasury (green) and agency (yellow) issuance from the SIFMA chart below, the remaining mortgage, corporate and ABS issuance is weak. Source: SIFMA US bond issuance is falling due to rising interest rates. Chinese demand for dollars is falling due to deflation in housing and inflation in US interest rates. Bloomberg reports that “Chinese firms’ dollar-bond issuance hit the lowest level in a decade during the second quarter, and there are few near-term catalysts to reverse the trend as cheap onshore borrowing costs and economic uncertainty persist.” Fewer bonds in the offshore dollar market means less demand for dollars? Specifically, Bloomberg claims that dollar debt issuance by Chinese firms has fallen almost 80% year-over-year as Beijing cuts borrowing rates to counteract a severe deflation in the property sector. Since peaking near ¥6.6 per dollar, the Chinese currency has depreciated rapidly as shown below. If Beijing supports internal demand with further domestic monetary emissions, will the dollar strengthen further, hurting Chinese imports from nations around the world? Even as bond yields in the US are struggling higher, and expected cap rates are extending accordingly, the bid for private assets is weakening. Investors will seek shelter in risk free Treasury and agency exposures, forcing yields even lower, but a larger opportunity beckons to institutional investors, both short and long. As banks and even the GSEs regurgitate low-coupon assets, will prices fall further? The Buy Side crowd is talking bank stocks up on the belief that this time is like last time, but maybe not. Maybe stagflation is the next leg for the global economy, led downward by China. President Xi has indicated that bolstering domestic demand is the priority for China in 2023 and beyond, but China’s leadership is still reeling from the policy errors during COVID and demand shows little signs of recovery. “If Chinese consumers stay home and the property rebound stalls,” China Beige Book notes, “Beijing will probably support the economy through policy, still giving investors what they have long wished for.” Such happy sentiments may please the vanity of Buy Side global equity managers, but underestimate China’s capacity to choose very badly when it comes to economic policy. Robert Shapiro writes in The International Economy : “Apart from the unknown, there is one clear, potential threat to China’s growth and progress: President Xi’s determination to concentrate all important decisions in himself and a loyal coterie while building an advanced surveillance state to identify and eliminate any nascent challenge. The combination deprives Xi and his government of the broad array of information and analysis that prudence and experience require for cogent decision making… Xi’s irrational approach to the pandemic suggests that he is not immune from terrible decisions that would imperil China’s economic prospects.” During the period of low interest rates in the US, China used dollar financing to fund the absurd belt & road demand creation initiative, Xi Jinping's version of Mao's Great Leap Forward. Now with higher dollar interest rates, China is stalling. Can lower costs for local currency financing catch the falling knife in the Chinese property sector? And if the FOMC keeps interest rates at or above current levels, will prices for US residential housing fall? In the next Premium Edition issue of The Institutional Risk Analyst, we’ll review the world of mortgage lenders and servicers as the markets get comfortable with the idea of higher interest rates for longer than just 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. 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.

July 3, 2023 | Premium Service | The 2023 Federal Reserve stress test results released this past week demonstrate that large banks in the U.S. are highly resilient to a severe stress scenario imagined by economists. This says nothing about the soundness or profitability of these banks, however, especially given recent market volatility. In such an environment, no surprise, JPMorganChase (JPM) is outperforming its asset peers while smaller banks stumble. Higher levels of capital would not have changed the outcome for Silicon Valley Bank or the other casualties of rising interest rates. With that caveat in mind, below follows our setup for Q2 2023 earnings for financials. The first comment to make is that banks generally are getting smaller and are looking to shed problematic credit exposures sooner rather than later. These disposals, coupled with a general decline in lending volumes across the board, is likely to put downward pressure on assets and in some cases bank earnings in Q2 2023. Some observers think that bank loan prices remain stable, but in fact the flow of loans and related servicing assets being sold by banks already has become a torrent. The decision by Comerica Inc (CMA) to suddenly exit mortgage warehouse lending after 110 years in the business, without even attempting to sell the business, illustrates the point about panicked shrinkage of balance sheets and overhead costs. Securities holdings and deposits are down high single digits year-over-year, but other borrowed funds is up 100% to $1.9 trillion or 10% of total industry assets. Fact is, things in the bank channel are a bit confused and likely to get worse in the near-term as banks take assets to the curb. We expect to see funding costs at least double in Q2 2023, putting additional pressure on banks to increase loan rates and/or reduce assets . Source: FDIC During Q1 2023, loan balances across the industry actually grew while securities holdings fell over 10%. This suggests that banks are not only selling unattractive assets, but are buying newer, higher coupon assets to bolster earnings and stay ahead of galloping funding costs. Banks with shorter durations on their assets are at a big advantage over other institutions. This leads us to the second general trend that banks are adding to the gross spread on lending products at a brisk pace. The pace being set by some of the better performers in our surveillance group will put a great deal of pressure on the public equity securities of the laggards. Note in the chart below that the better financial performers are also leading the way in terms of valuation. Source: Google In Q1 2023, Citigroup (C) added more than 2% to its gross loan spread, pushing this key metric to almost 8.5%. Right behind Citi was JPMorgan, which took up its gross yield 1.75% in the past quarter. The average yield for the 140 banks in Peer Group 1 moved over a point to 5.6%. Wells Fargo (WFC) and U.S. Bank (USB) saw the least improvement in gross yield but had much lower increases in funding costs. Notice that USB has suffered in market value since March 2023, a direct result of being below $1 trillion in total assets. Source: FFIEC The reason for the herculean efforts to raise revenue is that interest expenses are rising even faster. No surprise that Citi saw funding costs double to 2.6% of average assets in the quarter. Right behind C was Bank of America (BAC) , which saw its funding costs rise 3x in Q1 2023 to 1.83% even as it wallowed at the Peer Group 1 average loan yield. WFC saw the smallest increase in funding costs, yet another notable area of improvement for the $1.8 trillion asset bank. Source: FFIEC In terms of credit, Citi has seen a relatively sharp increase in credit costs since 2022, leading the top five bank group higher after several years of below-average loss rates due to QE and COVID loan forbearance. The rest of the group is seeing only gently increasing credit expenses across most portfolios, with commercial real estate showing the fastest rate of increase in defaults. Source: FFIEC Top of mind, naturally, is the degree of commercial exposure on the lending book. JPM CFO Jeremy Barnum said in the Q1 earnings call: “[T]he large majority of our commercial real estate exposure is multifamily lending in supply-constrained markets. And I think it’s quite important to recognize the difference between that and sort of higher-end, higher price point, non-rent-controlled, not supply-constrained markets.” According to the IR narrative, JPM has also worked to minimize exposure to office buildings outside of the “A” class space located in central urban locations where the return to work narrative has legs. More important, only about 30% of JPM's $3.7 trillion in total assets were in the $1.1 trillion in net loans and leases at the end of Q1 2023. There's another trillion in bank deposits and repurchase agreements, and $500 billion or so in trading assets. JPM is really a large mutual fund with a bank attached, as shown in the table below. Source: FFIEC Of note, rising coupon rates do not seem to be slowing down impatient consumers. With lenders writing mortgages with 7% coupons for agency and government loans, and in double digits for private jumbo paper, you’d think that the market would be slow. But persistent demand is still helping lenders fill pipelines with purchase mortgages. “Housing is in short supply in America,” noted JPM CEO Jamie Dimon in Q1. “So, it’s not massively oversupplied like you saw in 2008.” Consider the startling fact that after dropping in nine previous months, the national median home price accelerated 10.2% to $350,000 from $317,496 between the first and second quarters this year, according to market data provider Attom . Inflation and a lack of new home construction is keeping asset values high, even though some speculative markets in the south and west have clearly cooled. The chart below from FRED shows the Case-Shiller index for the US and major markets. Notice that progressive New York is the worst performing market of the group. In the world of commercial real estate, San Francisco, Houston and even blessed Austin are correcting. Several direct lenders we follow in the commercial space have basically said no to new opportunities in Houston and are starting to slow purchases across the state of Texas. And by no coincidence, China’s real estate sector is also slowing dramatically after years of pump-priming by the Chinese Communist Party. One big reason that the top five banks are still reporting reasonable earnings is the fact that credit default rates remain subdued and well-below levels seen prior to 2020. “The net charge-off rate of 0.41 percent increased 5 basis points from the prior quarter and 19 basis points from the year-ago quarter,” the FDIC noted in Q1 2023. “The annual increase was led by higher credit card net charge-off balances. Despite the increase, the industry’s net charge-off rate remains below the pre-pandemic average of 0.48 percent.” The biggest threat to bank earnings remains market risk rather than credit. As the chart below illustrates, the leader of the group in terms of asset returns is JPM followed by Wells Fargo, of note. WFC may be the most improved member of the top-five banks after years in regulatory purgatory. Notice that Citi continues to significantly underperform the group, one reason why the stock is trading at half of book value. Source: FFIEC In terms of operating leverage, JPM continues to lead the group first in asset returns and also by maintaining an efficiency ratio in the 50s vs the 60% or 70% range for other members of the group. Efficiency ( Overhead expenses / Net Interest Income + non-interest income ) is a key measure of the management in a bank. The other key measure is loss given default, a fancy way of saying net credit losses. But operating efficiency is ultimately what separates the very good banks from the rest of the industry. Note that BAC is next in our group at 61% efficiency, 10 points above Jamie Dimon! Source: FFIEC Notice that Charles Schwab (SCHW) has the best operating efficiency in the group after JPM and almost even with Peer Group 1. The clear message from the Q1 2023 results is that JPM is extending its lead over its asset peers, while smaller banks such as Citi and USB are struggling to keep pace. Wells Fargo continues to improve and may be worthy of attention, while BAC's performance remains mediocre and USB has lost a step vs JPM. The sharp increase in funding costs for the $3.1 trillion BAC was a surprise and is reason for concern going forward because of the bank's poor asset returns and credit performance. BAC's loss rate is right behind JPM and USB, both of which have higher yields on the book to offset credit losses. All of the top five banks need to keep operating efficiency in the low 50s to be competitive long-term as credit costs steadily rise into 2024. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

June 28, 2023 | One of the banks that has raised the most questions with investors since the start of 2023 is Comerica Inc. (CMA) , a $90 billion asset commercial lender based in Dallas, TX. CMA was originally from Detroit, but fled the city in search of growth to the south. To answer the queries from several readers, below is our profile of CMA in the style familiar to subscribers of The IRA Premium Service . “Comerica, originally called Detroit Savings Fund Institute, opened its doors on August 17, 1849, to a city bustling with shipyards, river trade, sawmills, horse drawn carriages and dirt roads,” the company history relates . But the City of Detroit, which spawned Henry Ford , Thomas Edison and many other American entrepreneurs of the day, no longer has a real economic purpose in the 21st Century. The first thing to say about CMA is that the bank is a solid financial performer, with most significant financial metrics lying dead center of the fairway in terms of comparisons to Peer Group 1 and market leaders like JPMorgan (JPM) . Even more than the dead banks f/k/a Silicon Valley and Signature, there is nothing obviously wrong with CMA as a bank and a business. And yet since 2022, the bank has been shrinking as deposits have run off and headed out the door. Because of the eroding funding base, CMA is one of the weaker stocks in our surveillance list, trading just above Western Alliance (WAL), KeyCorp (KEY) and PacWest (PACW) . We currently own New York Community Bank (NYCB) . We exited WAL in April 2023 due to a lack of conviction in the stock. While we do believe that the risk equation is shifting in 1-4 family mortgages, our only holdings in the mortgage sector are LT stakes in NYCB and Guild Mortgage (GHLD) . The IRA Bank Surveillance List Source: Bloomberg (06/28/23) The first thing to note about CMA is that the bank’s credit performance is strong. When you see a bank with a minus sign on net-losses, that indicates a strong credit culture. The efficiency ratio in the mid-50% range likewise indicates that CMA management is focused on delivering operating leverage. Source: FFIEC As you can see in the chart above, CMA’s credit performance is stellar compared with some of the regional players such as U.S. Bancorp (USB) . So if CMA is getting things like credit and operating efficiency right, why is the stock under pressure? Because in the world of huge reserves of Fed Chairman Jerome Powell and massive fiscal deficits of Treasury Secretary Janet Yellen , all banks are targets. The macro environment for banks generally is uncertain. As the chart below shows, Treasury cash balances held off-market at the Fed are rising, while bank deposits for now are stable. Yet at the current rate of runoff from the System Open Market Account, at least $750 billion in bank deposits will disappear from the US banking system over the next year. After net losses, the next factor to examine when assessing CMA is the pricing on the bank's loans. Again, not only is CMA at Peer Group 1 levels, but the bank is actually leading our comp group higher with the notable exception of Ally Financial (ALLY) . Notice that in both net losses and gross spread, ALLY is headed “to da moon” as it reprices its balance sheet, which is essentially a loan conduit for eventual asset sales to investors. All of the major banks are showing strong, even desperate increases in gross loan yields as they struggle to keep pace with funding costs. Source: FFIEC The big question facing CMA, however, is deposits. Looking at the chart below showing funding costs vs average assets, again CMA leads the pack. The bank’s funding costs are below all of the banks in our comp group and Peer Group 1. But that may not be a particularly good thing right about now. Core deposits have fallen 20% in the past year, leading the bank to make some painful decisions about its business that have drawn sharp criticism from informed observers. Source: FFIEC Michael McAuley , Principal of Garrett McAuley, among the most respected consultants in the banking and mortgage space, provided this scathing assessment of CMA’s sudden decision to abandon warehouse lending : “In perhaps the most shocking and boneheaded move of the year in the mortgage industry, Comerica Bank senior management has decided to exit the warehouse lending business (which it's been doing since 1913!)... Credit quality wasn't the issue as the Comerica warehouse lending group has always been very smart and conservative. Size wasn't the issue as it has $1.1 billion outstanding and $400 million in deposits supporting it, which (despite senior management's and uninformed Street analyst claims) is an excellent ratio of deposits generated from a commercial lending line of business. It's not that they haven't made good money in the business as during the recent mortgage boom, warehouse lending made so much money that it was regularly addressed in the bank's earnings calls. It's not likely that the group is losing money now as warehouse lending (unlike mortgage banking) is always profitable but particularly so in a low-rate environment, and particularly during a recession when it and the mortgage banking line of business generate the large profits that fund the substantial loan losses on commercial real estate and C&I lending. No, it's probably that Comerica Bank is desperate to appear to be doing something to address its relatively high level of uninsured commercial deposits and its large underwater investment portfolio, and exiting warehouse lending is the easy way to reduce loans and those deposits quickly without taking big losses.” What is really odd, McAuley notes, is that CMA is apparently not trying to sell the warehouse business. "They apparently think (or did poor research) that they’d have to sell the portfolio at a discount," he tells The IRA , "but warehouse lending portfolios sell at a premium of 25 bps to 37.5 bps of outstandings as of the date of closing." We agree with the assessment of our friends at Garrett McAuley, but we note that the shrinkage in the deposit base outside of mortgage escrows goes back two years and may have forced the bank’s hand. "They could have realized some value," notes one competitor who wonders at the announcement. "It would have been better for their customers and the warehouse team to sell. Seems like they’ve acted in haste." When you look closely at the performance metrics for CMA, what you see is a bank that actually fluctuates a good deal below the period-end assets and liabilities. While CMA is only about 50% loans to assets, in our view the shrinkage in the core deposits of the bank is behind the weak share performance and mounting volatility. In addition to deposit runoff, the accumulated other comprehensive income (AOCI) at CMA shows a 50% impairment on capital at the end of Q1 2023. The $15 billion in MBS owned at the end of Q1 2023 is 17% of average assets or 50% higher than the 11% average for Peer Group 1. CMA illustrates in graphic terms how the Fed’s decision to “go big” by providing excessive reserves into the banking system has now essentially rendered a solid commercial lender effectively insolvent. The last factor to consider with CMA is profitability. Again, CMA leads the comp group and Peer Group 1 in terms of asset returns, leading to the obvious question: what’s not to like? The answer, sadly, is that the bank’s outsized portfolio of mortgage backed securities may have shot a hole in the proverbial Grand Lake Canoe. Source: FFIEC If bank regulators and policy wonks want to understand why large depositories like Silicon Valley and Signature were caught wrong-footed by Fed interest rate tightening, it comes down to one word: duration. The long-duration position illustrated by the large MBS holdings of CMA was clearly a mistake given the accumulation of AOCI. Once investors realized that the bank’s balance sheet was misaligned given the rate environment, the deposits left the building. At 0.9x book value, CMA is hardly in trouble today, but the real question is what is book value? If the Fed keeps interest rates at or above current levels, banks like CMA may be forced to sell MBS at a loss and reduce capital, a path that is unlikely to lead to positive results for equity investors. In the meantime, CMA is raising cash and reducing assets, hardly a recipe for stronger earnings down the road. If the Fed is eventually forced to sell MBS from the SOMA to normalize market interest rates, then the losses on MBS will grow. The Fed has applied a tourniquet to the bank liquidity problem via the Bank Term Lending Facility (BTLF), but this latest band aid from the central bank does not deal with mounting losses on MBS in a rising rate environment. If the FOMC raises the target rate for fed funds further, then banks like CMA are likely to come under renewed selling pressure. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

June 26, 2023 | Premium Service | Developing a forward investment thesis for the world of housing credit requires first that we recognize the impact of monetary policy on both asset returns and the apparent cost of credit. Asset returns were boosted by low interest rates, while soaring asset valuations muted or even turned negative the apparent cost of credit. In January 2022, the Congressional Research Service published a handy history of the Fed’s monetary machinations, “ Federal Reseve: Tapering of Asset Purchases, ” focusing on the resumption of Fed asset purchases in 2019: “In the fall of 2019, a liquidity shortage caused repo market turmoil, prompting the Fed to begin purchasing Treasuries again. Asset purchases rapidly increased in response to financial unrest caused by the pandemic’s onset in the spring of 2020, with securities holdings increasing by about $2 trillion in two months. MBS purchases resumed then, and for the first time the Fed purchased agency CMBS (MBS backed by commercial mortgages) in relatively small amounts. Beginning in June 2020, the Fed purchased $120 billion of securities per month—a faster rate than the rounds of QE following the financial crisis. In December 2020, it pledged to continue purchases at this rate “until substantial further progress has been made toward its maximum employment and price stability goals.” When tapering was first announced, the unemployment rate had fallen from 6.7% to 4.8% and the Fed’s targeted inflation measure had risen from 1.3% to 4.3%. Since March 2020, the Fed’s securities holdings have doubled to $8.9 trillion.” The immediate impact of the asset purchases was to push down interest rates across the board, the obvious impact of the FOMC removing almost $9 trillion in securities from the Treasury and mortgage markets. Our discussion of the FOMC meeting last week with Bloomberg Television is below. Since 2022, as the FOMC raised the target rate for federal funds, the rest of the yield curve has remained suppressed while short-term interest rates have returned to something closer to normal. The chart below shows dollar swaps from the Friday close (green line) and some 15 years ago in June of 2008 (yellow line) with the spread shown below. Source: Bloomberg Since 2008, the market for dollar swaps has traded through Treasury yields, again reflecting the change in US monetary policy since the FOMC under Chairman Ben Bernanke embraced QE. Today dollar fixed/floating rate swaps (blue line) trade through Treasury yields (green line) outside of ten years, as shown in the chart below. If we look at the rate and the shape of the swaps curve, it seems to reflect the fact that the Fed still owns over $8 trillion in securities in the System Open Market Account (SOMA). Is the inverted yield curve a bad thing? And does it predict a future recession? Our answer is that the distortions in the term structure of interest rates caused by Fed open market operations and, now, no sales of securities, are bad for the economy and very bad for lenders. Erica Adelberg of Bloomberg Intelligence describes how lenders are facing absurd conditions in the bond markets, with forward contracts for mortgage backed securities trading above current spot prices. This classic “contango” market means that lenders do not earn any float on their assets and, in fact, lose money on loans as they move through the manufacturing process. She writes: "With the fed funds rate higher than the yield of most agency mortgage-backed securities (MBS) coupons, it's become cheaper to hold cash than MBS in the near term, as dollar-roll financing for TBA issues has fallen deeper into negative territory. The Federal Reserve's indications that more hikes may be on tap for 2023 could lead to persistent carry challenges for MBS." Simply stated, most mortgages backed securities are trading on yields well-below funding costs for lenders. Let’s say you are writing 7% loans this week, which you are going to deliver into a Fannie Mae 6% MBS in July, which yields in the high five percent range. Or to put it in basic terms, you are short the MBS for July and prices are rising. But for investors looking to pick the next strategy in mortgage land, some thoughts. The first obvious statement is that those 2% MBS that are causing everyone indigestion are also one of the big trades in prospect. The question, of course, is when to actually put on a trade that is 5 points underwater on funding. But as the Fed’s portfolio runs off and rates do eventually fall, the long duration Ginnie Mae MBS kamikaze trade will beckon to the wild of heart. Let’s say that the FOMC does eventually start to sell MBS or at least ensure that the portfolio runs off $35 billion each month. Does that help MBS prices? In the current low production environment, that incremental selling may not result in higher mortgage rates or MBS yields. That is bad news for lenders seeking profitability, but good news for financial investors with cash and a strong constitution. The second observation is that with credit costs starting to rebound from the torpor of QE, valuations on certain mortgage portfolios and servicing strips will come into question. We’ve already seen a huge chasm emerge in recent months between buyers and sellers of mortgage servicing rights. Higher credit costs means lower net operating income and MSR multiples, but sellers are refusing to capitulate -- yet. The higher credit costs that make MSRs and loans unattractive to some buyers will provide great value for others. Scores of investors are preparing for an increase in delinquency after a decade of QE. The increase in operating costs, however, could make some servicing portfolios unstable, leading to significant losses for investors. The cost of servicing a 1-4 family loan has trebled since 2008 and that cost increase makes mortgage servicers vulnerable to default. In a comment article published in Reuters (" Don't go chasing waterfalls: intercreditor agreements in the context of agency mortgage servicing rights "), Michelle Maman and colleagues from Cadwalader, Wickersham & Taft LLP in New York note that mortgage servicing assets depend upon intercreditor agreements that contain two key provisions: (i) "waterfall" provisions that govern the application of collateral proceeds; and (ii) "turnover" provisions that require creditors to hold proceeds in trust and then remit excess proceeds they have received in violation of the applicable waterfall provision. Maman opines: “Notably, however, the enforceability of these agreements could be called into question if the collateral at issue is insufficient to pay the secured debts of the servicer.” Translated into plain language, if the expenses of the servicing portfolio rise and it cannot meet all of its legal obligations under the waterfall, then the intercreditor agreement fails and the secured debts become general claims on the bankruptcy estate. Or if a mortgage servicer tips over and cannot pay its secured debts covered by the waterfall, upon filing bankruptcy the MSR vanishes. Laurie Goodman and Ted Tozer published a comment last week for Urban Institute (“ The Payment Supplement Partial Claim Offers a Great Vision but Is Operationally Burdensome ”) where the authors discuss efforts to expand liquidity for government issuers to support loss mitigation activities. Without expanded access to liquidity to fund loss mitigation activities, we believe that smaller government issuers are likely to fail. Larger government issuers are already under stress, as evidenced by the number of firms that have slashed dividends and other expenses. Names such as Two Harbors (TWO) have been forced to cut dividends to finance rising expenses and capital losses due to MBS spread widening. Bill Greenberg , Two Harbors’ president and chief executive officer, remarked: “The decision to reduce the dividend this quarter was not a function of downward pressure on earnings, but rather a strategic focus on enhancing book value and further investing capital into a positive Agency MSR and MBS environment.” Some REITs are migrating toward the floating phase of fixed/floating preferred instruments, one of the dumber ideas we can recall but typical of the predatory behavior of Sell Side investment banks, particularly given the amount of confusion in markets today. Preferred equity issued by Annaly (NLY) is already floating and several other REITs will soon be paying floating spreads (+500bp) over SOFR. What a great trade. H/T to Ed Groshans at BTIG. Oh, and let’s not forget the NLY reverse stock split of last year, never a bullish sign. The big picture message for our readers is that there are some compelling opportunities in fixed income securities, MSRs and operating assets. We view MBS as a potential long-trade to benefit from a Fed easing in 2024, but MSRs, levered investors such as REITs, and operating assets are likely to be trading at discounts to current marks. As we noted recently, the MSR of the lender f/k/a HomePoint were marked at 6x cash flow at year end 2022, but were sold for total consideration closer to 3x. As Q2 2023 comes to an end, we are bracing for some really astounding earnings results from banks and nonbanks alike. The distortions inserted into the money markets by the FOMC since 2019 are still not well-understood by most investors. In particular, the contango trade in the mortgage markets is profound and will continue to impact the performance of loans, MSRs and lenders. The negative economics in the loan market will drive further consolidation among lenders as the strong absorb the weaker operators. When we saw Rocket Mortgage (RKT) selling $200 million in MSRs to JPMorganChase (JPM) , we recalled the words of RKT CFO Brian Brown . “The buyers in that space, though they are big buyers, they are limited buyers,” Brown said in January, Inside Mortgage Finance reported. “It doesn’t take much pullback from an institutional buyer to all of a sudden have more supply than demand.” If we think of the first half of 2023 as the Street getting comfortable with higher interest rates for longer through 2023 and beyond, the second half of 2023 will be about business operators adjusting accordingly. Many lenders and investors that thought the Fed would relent and drop interest rates before the end of the year must now make tough choices about selling money-losing assets and reducing headcount. We look for lower prices for legacy MBS and MSRs as new allocations are used up and P&Ls sink deeper into the red under mounting financing losses and credit mitigation expenses. The Institutional Risk Analyst 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.