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May 15, 2023 | Last week we participated in the Thirteenth Annual Bank Dinner sponsored by Nomura Securities (NMR) . The event focused on the commercial banking, credit and mortgage sectors and featured some important discussions. Former FDIC Chairman Sheila Bair discussed the three major bank failures so far this year and made perhaps the key observation: the FOMC should have sold bonds over the past year rather than simply raise the level of short-term funds over 5%. As readers of The Institutional Risk Analyst know, the excessive interest rate increases by the FOMC have left many banks and nonbanks insolvent. The lack of balance in Fed monetary policy is strange on a number of levels, but not surprising. By lowering interest rates and manipulating the bond market through massive open market purchases of securities, the FOMC pushed interest rates down to zero and pushed asset prices up dramatically. Now we are going the other way, with asset prices falling and credit costs rising fast. The FOMC pushed the effective duration of mortgage securities to near-impossible low levels in 2020-2021, creating the circumstances for the failure of Silicon Valley Bank two years later. As we told the Nomura audience, SIVB was dead by the end of 2021 because of the massive position in mortgage backed securities (MBS). The Fed's rapid interest rate hikes in 2022 ensured that SIVB would fail. When the FOMC began to unwind this policy of "abundant reserves," however, the Fed hastily raised the target for fed funds without any active sales of bonds. This asymmetrical policy choice not only caused three large banks to fail, but left the Treasury yield curve looking like an inverted salad bowl, with short-term interest rates well-above long-term rates. By avoiding bond sales, the Fed is trying to conceal a major policy error -- without great success. Today, like the banks, many bond investors are also insolvent because of the Fed's insensitivity to how its policy actions would impact markets. Had the Fed raised fed funds to say 3.5% and aggressively sold bonds from the portfolio, longer-term interest rates would be higher and the banking industry would not be under attack by short-sellers armed with various types of exotic derivatives. “The deposit flight dynamic is not a ‘bank run’ out of fear—it is a totally logical one which the Fed continued to perpetuate last week,” noted veteran Nomura analyst Charlie McElligott . “It’s a rational decision from depositors everywhere who are now even more aware that instead of sitting in bank savings account at 0.1%, that they should continue reallocating instead into Money Market Funds or Treasury Direct Account in T-Bills and earning ~5.0%” In the asymmetrical world of Fed Chairman Jerome Powell and the FOMC, banks with a market beta > 1.5 are targets. Banks with a price to book value (p/b) below 0.5x are targets. PacWest (PACW) and Western Alliance (WAL) just happen to be the relatively small stocks where the short trade was able to get traction. The folks doing the short-trade are big institutional firms. It’s not merely short-selling of regional bank stocks that is causing bank failures, but a deliberately orchestrated assault designed by some of the biggest Wall Street derivatives houses. As the market beta for names such as PACW rises, the swings in stock price, up and down, grow and eventually the beta is over 2x the 6m SP500. The growing pendulum swings of the stock flow into the credit-default swaps models, the institutional counterparties back away and then the bank is doomed. The only limit to the short regional bank trade is the lack of short-side liquidity. The long mega banks/short regional banks trade described by McElligott last week is getting very crowded. As regionals fall, the exotics desks of the major dealers are taking on huge technical/market risk to maintain the spread positions, essentially equal weight long big banks, short regional banks. Since the regional banks are far smaller than the largest depositories, dealers are using derivatives to force down the price of regional banks even more. In order to maintain the equal weight of the trade, desks are adding lots of “vega” as prices fall for regionals. This is all done vs KRE index, which is not really liquid enough to take the massive institutional flow into this short regional bank trade. McElligott notes that “Deeply underwater long-duration Treasury and mortgage securities portfolios along with outsized CRE exposure which means awful marks for potential acquirers” of regional banks. The price volatility injected into markets by the Fed is a primary reason why the FDIC cannot easily find buyers for smaller banks. What is the fair value of a bank that has zero tangible capital, falling earnings and an indefinite price for its assets? As we wrote this week, net interest margin (NIM) for US banks in Q2 2023 will get crushed as banks double or treble deposit rates in order to retain liquidity. As noted above, all banks are competing with 90-day bills and Fed RRPs. After PACW and WAL get annihilated, perhaps then we'll then move on to Ally Financial (ALLY) and Capital One (COF)? Think that will get the Fed's attention? We assume that bank interest expense/average assets will be north of 3% in Q2 vs ~ 1% at 12/31/22. But even if the better managed regionals reprice deposits and otherwise restructure, many banks will still fail because of the excessive rate hikes by the FOMC . And all of this is unnecessary. The Fed’s lack of sensitivity to how policy will impact banks and markets is stunning and it is about to get a lot worse. The impact of the Fed’s asymmetrical policy is being felt in the broader world of credit beyond banks. Howard Marks , founder of Private Equity Giant Oaktree Capital Management, told the FT last week that “The worst of deals were made during the best of times.” When rates were near-zero during the 2020-2021 period of QE, private credit was extended with fierce competition which meant that the rates offered were low and the terms often relaxed (e.g. covenant lite). Today the world of credit is strewn with dozens of busted issuers that cannot function at prime rates approaching 10%. Think of selling that $90 billion whole loan portfolio of First Republic Bank with a 3.25% average coupon in today’s market. The same price analysis is applicable to commercial loans originated in 2020-2021. While everyone is distracted with the troubles facing regional banks and credit investors, there is a lot of value being created in the process of restructuring housing from the COVID boom. Roughly half the people who worked in housing finance in 2021 will lose their jobs in 2023. The process of down sizing from QE is painful for the victims and profitable for the winners. Mr. Cooper (COOP) just bought what was left of HomePoint for a 20% discount from fair value just a quarter before. The HomePoint MSR, which was booked at 6x cash flow at year-end, went for just shy of 5x last week. COOP looks to be rolling up the residential mortgage space on its way to $1 trillion in mortgage servicing AUM. Meanwhile, as we wrote for our Premium Service readers last week (“ Update: Rithm Capital ”), Softbank/Fortress spawn Rithm Capital (RITM) is about to jettison its mortgage business to focus on commercial restructuring. By no coincidence, a lot of the smart money on Wall Street is focusing on the world of credit and commercial loan restructuring. When Oak Tree’s Howard Marks and RITM CEO Mike Nierenberg are both calling the bear trade in commercial credit, that is called a big hint. If all of this is not enough worry on your risk dashboard, the folks at the Fed have managed to screw up the Treasury bond market so that the cash and the futures are no longer tracking. TBAs and MSR hedges are not performing as expected. Or in plain English, the off-the-run Treasury bonds are now the cheapest to deliver against your short position. Send your thank you notes to Jerome Powell c/o the Board of Governors of the Federal Reserve System in Washington. 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.

May 10, 2023 | Premium Service | Key risk indicators visible in the world of credit are not exactly confirming the rosy scenario coming from Buy Side managers and their enablers in the economics profession. Congress is playing chicken with the debt ceiling, for example, but we think the amount of US debt already demands a credit downgrade. Just the increase in debt service costs is enough reason for a ratings action. When will Moody’s, KBRA et al admit that S&P is right and downgrade the US Congress to “AA+”? Besides the dysfunctional behavior of the federal government, another reason for a sovereign downgrade of the US is the equally skittish behavior of the central bank. The Fed’s use of “abundant reserves” from 2019 onward looks an awful lot like a subsidy for the Banco de Mexico circa the 1980s. The US Treasury is, after all, the main beneficiary of QE. Looking at the accumulating ill-effects of this deliberate Fed policy (i.e. QE) of enabling ridiculous fiscal behavior in Washington, we think an explanation is in order. Not only did the Fed monetize trillions of dollars in Treasury debt since 2008 and especially since 2019, but it also taking billions in cash flows from trillions more in mortgage bonds, diverting income from private investors to the benefit of the US Treasury. This is the sort of dissolute behavior that traditionally has been observed among the more decrepit societies of the developing world. Indebted nations that threaten credit default should be marked accordingly – if the rating agencies have any value to investors. That is, of course, the real question raised by the lack of action by the credit rating agencies. Bill Nelson of Bank Policy Institute notes even more aberrant behavior at the Fed as even more piles of sovereign debt accumulate due to failed banks: “Yesterday the Fed released its always excellent biannual financial stability report (available here ). The report includes an entire section on the Federal Reserve’s actions in response to the recent banking turmoil pp. 53-54. The section discusses regular discount window lending (primary credit) and lending through the Bank Term Funding Program. In the section and in the entire report, there is no mention of Fed lending to bridge banks or to the FDIC as receiver even though such lending currently accounts for 73 percent of Fed lending in response [to] the banking turmoil.” Essentially, the FDIC now must assess new deposit insurance fees on large banks to take the Fed out of its loan to the three FDIC receiverships created since March. FDIC will also get $50 billion from JPMorgan (JPM) when the financing for the First Republic Bank (FRC) failure matures. The Fed is always an expense to the Treasury, keep in mind, unless the banks pick up the cost of now three large bank failures. That deal Jamie Dimon did buying First Republic Bank from the FDIC does not look so great now, yes? Meanwhile in the world of credit and banking, the interest rate hikes by the FOMC have left trillions of dollars worth of bonds and bank assets trading at a sharp discount to par. We noted previously that First Republic Bank boasted a gross yield on its loan book of about 3.25% at year end. The Real Deal reported this week that FRC had been making below market loans to all sorts of borrowers on New York City residential properties below $1.4 million. As the bank neared failure, it tellingly began to run away from this market. “It was clearly First Republic trying to get out of these loans because no one wants them,” Barbara Ann Rogers told The Real Deal about loans approved but never closed. “No one wants to buy a portfolio of 30-year fixed mortgages at 3.25 percent.” Ditto. We begin to perceive yet another benefit of the Fed’s QE medicine, namely a tendency to underprice risk on a systemic basis. FRC was really a whole bank full of underpriced loans that pretended to manage money. Now, in a “normal” interest rate environment, whole sectors of the world of banking and finance are trading at a sharp discount to book value. When any company trades below 0.7x book value, it suggests that the fair value of the firm is overstated. Update: Rithm Capital One of the leaders in the world of nonbank finance is Rithm Capital (RITM) , the largest nonbank owner of Ginnie Mae mortgage servicing rights (MSR). Formerly controlled by Softbank unit Fortress Investments , RITM changed its name a year ago to showcase its move back to the future and a multi asset strategy. Over the past decade, RITM has opportunistically accumulated a number of other businesses and portfolios, as shown in the table below. At the end of April 2023, the price of RITM was cut in half when the company missed analyst expectations. Since the high of $18 in June 2018, RITM has experienced several sharp declines in valuation, particularly the downward move in February of 2020. In a sense, RITM illustrates a stock that did very well during the early period of Fed intervention in the fixed income markets, but has been sliding since the Fed ended its open market bond purchases. If you perceive a strong correlation, we agree. Rithm Capital Q1 2023 RITM currently trades below 0.7x book value, which is a nice way of saying that the market does not believe the stated book value. The company reported income of $164 million before taxes, with losses on origination like much of the rest of the industry. The reason that you follow RITM is because CEO Michael Nierenberg is a smart asset manager. He is not at all reticent about calling the end of the residential mortgage trade and the dawn of the commercial credit cycle. He stated in the earnings call: “Cash and liquidity sits in and around $1.5 billion, putting us in a great position to take advantage of the market dislocations we're seeing. We do expect plenty of assets to come out for sale into the marketplace as a result of some of the market dislocations. Our third party fund business continues to be a major focus as we transition to growing our business as an alternative asset manager. With that in mind, we are evaluating alternatives for our mortgage company and will likely file an S-1 in the coming months. This will allow us to create other pools of liquidity to the extent we create a public entity and further diversify our business model.” The idea of spinning off the mortgage business is not new, but it carries with it great significance. First, the spinoff must include all of the Ginnie Mae exposures of RITM because a REIT cannot be a government issuer. The predecessor of RITM originally acquired Shellpoint and later Caliber in order to qualify as a Ginnie Mae seller/servicer, but now must include all Ginnie Mae exposures and MSRs with the licensed entity. The unresolved scandal at HUD involving Michael Drayne turned around RITM's efforts to obtain a Ginnie Mae issuer license for the REIT, an effort that was unsuccessful. While RITM is sending the Ginnie Mae assets off in an IPO for the New Rez lending business, it will probably also contribute the rest of the residential MSR portfolio to the vehicle and thereby shed most or all of the for-profit business assets that have operated as an appendage of the REIT. The mortgage company servicing represents 75% of RITM’s full MSR portfolio. The diagram below shows the MSR portfolio of RITM from the quarterly supplement. Rithm Capital Q1 2023 The key takeaway from the table above is that RITM, like Mr. Cooper (COOP) , is happy to see the weighted average coupon (WAC) of the portfolio well-below 4%. This is an important distinction. Other firms in the industry such as PennyMac Financial Services (PFSI) prefer a higher note rate on their servicing books because of potential refinance events when interest rates fall. We think that RITM and COOP have it right. RITM notes: “98% of our Full MSR portfolio is out of the money to refinance, with a portfolio WAC of ~3.7% significantly below current new production.” The focus on the lower coupon rate of the MSR is important because of the leverage that RITM uses to finance its MSR. Nierenberg told investors: “When you look at [MSR] multiples, a multiple right now is roughly 4.9 times, that includes all of our seasons. MSR is essentially roughly unchanged in the quarter. Again, 4% to 5% CPR for the full portfolio, unlevered returns, give or take something between an 8% and 10% right now is what we're seeing in the marketplace.” Interest expenses for RITM were up 123% YOY, forcing the firm to shed overhead expenses at a rapid clip. The importance of the breakup with Fortress is made apparent by looking at the income statement and the absence of the $25 million management fee in Q1 2023. The table below shows income and expenses for RITM. Rithm Capital The concern for the future is that RITM faces a protracted period of high interest rates with weak lending volumes and rising credit costs. The decision to spin off the mortgage lending business is obviously driven by the prospect of rising cash flow needs as default rates on residential mortgages rise and financing costs normalize. Also, RITM are smart traders and they recognize that the next opportunity is coming from the mounting train wreck in commercial real estate. Again, the fact of QE enabled some truly regrettable transactions in commercial real estate. RITM w/o the residential mortgage business might be an interesting story, but a story much like the beginning of the journey a decade ago. Slide 13 in the RITM earnings presentation is shown below. Given that RITM is now reported to be relying primarily upon Goldman Sachs (GS) to finance its MSRs and mortgage operations, any large increase in default activity could add instability to the mix. Our view is that GS does not have the funding base to provide competitive financing to nonbank mortgage firms. Overall funding costs for GS are roughly 2-3x those for JPMorgan (JPM) . Net, net, RITM seems to have come to the conclusion that monetizing the mortgage business is a better alternative than retaining the lender as a for-profit appendage of the REIT. RITM does not disclose its principal and interest (P&I) advances on its large portfolio of Ginnie Mae servicing, but the cost is likely comparable to other leading issuers. And down the road, when and if interest rates fall significantly, RITM and other issuers will face margin calls on financing for MSRs as prepayments on new production soar. The 5x multiple on the RITM MSR portfolio may seem reasonable at a distance, but putting new loan production with 6 plus percent coupon on at a 5x capitalization rate for the MSR is a tad aggressive in our view. RITM notes that “Newly originated MSRs this quarter had a weighted average mortgage rate of 6.37.” Now you know why Mike Nierenberg is so interested in spinning off his mortgage business. Truth is, new production MSRs ought to be capitalized at 3x multiples or half the levels seen at many issuers. When interest rates eventually fall, perhaps in 2024, those late vintage mortgage loans with 6% coupons will evaporate like spring snow in the sunshine. 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.

May 8, 2023 | A number of readers of The Institutional Risk Analyst have asked whether the banking crisis of 2023 is over. The short answer is no. The massive shift in interest rates, asset values and funding costs caused by the Fed's actions during and after the Wuhan Flu pandemic left many banks, pensions and other investors with significant capital deficits of unprecedented size. This party is just getting started. In the next Premium Service issue of The Institutional Risk Analyst, we’ll be updating our readers on Rithm Capital (RITM) and its possible plans to spin off its residential mortgage lender. With the 10-year Treasury note at 3.5% and SOFR at 5%, the mark-to-market picture is not as bad as Q3 2022. Yet the basic mismatch between cash flows, asset prices and funding costs remains. The chart below shows one-year T-bills vs the Reverse Repo rate paid by the FRBNY. Notice how yields on T-bills fell sharply in March and April. Ponder the weight, emotionally and financially, of the market shock caused by three large bank failures since the first week of March, when brokered deposit rates were in the 3s. Today, teaser deposit rates from some of the largest banks are above 5% annualized, reflecting the fact that effective cost of funds is basically rising to meet yields on Treasury bills and the Fed's reverse repurchase facility. Given that the gross yield on all loans and leases owned by large US banks was not quite 5% at the end of Q1 2023, you can see that we have a problem. The weighted average maturity of a large bank is generally measured in mid-single digits, meaning 20% or so of the average bank balance sheet may be repriced each year. Yet somehow Federal Reserve Chairman Jerome Powell is able to look into the TV camera and tell the public that US banks are safe and sound. Really? One Year Deposit Rates Last week was one of the worst weeks in the markets in awhile. We also got a strong jobs number Friday that largely let the air out of predictions of a Fed pivot on interest rates in the near term. The banks bounced Friday after a difficult week, with Western Alliance (WAL) closing at 0.58x book vs 0.71x a month before. PacWest Bancorp (PACW) finished the week below 0.3x book value. Generally speaking, banks trading below 0.5x of book are either state-supported zombies or for sale. Our view is that the change in the market environment for banks since the collapse of SIVB is likely going to result in a reduction in credit availability for the US economy. Banks are looking to raise cash and the easy way to achieve this is to slow lending. Most of the better-managed banks we follow already have put their deposit rates in the 5% range or double the rate at the end of February. We look for some truly ugly earnings results in Q2 2023. For example, the cost of wholesale bank financing for new commercial loans is now SOFR +3% or more (h/t J. Kohan ). Needless to say, the volume of new commercial loans flowing through the system is down year-over-year. Of note, Wall Street banks have become comfortable with the idea that interest rates are unlikely to go much higher. By coincidence, the cost of interest rate caps on floating rate financing is suddenly falling. Go figure. But commercial loans with 8 or 9 handles is now the norm. Plug that into your DSGE model Chair Jay. We expect that liquidity for banks and nonbanks will remain a serious issue in Q2, but the joke is that credit costs are also going to rise through the remainder of the year. So long as the 10-year Treasury remains at or below 3.5% (currently 3.41%), the situation is tolerable. If the 10s widen out to 4%, then the banks have a very ugly disclosure problem on M2M and the shorts sellers (who've been starving for a decade, to be fair) will feast. Besides the ongoing, on-the-fly repricing of $19 trillion in bank deposit liabilities, the commercial lending sector also can look forward to sharply higher credit costs. Of course, this time it’s different. In 2008, we all fussed about residential mortgages, but this time commercial real estate exposures will lead the parade. Fact is, the loss given default (LGD) for $2.5 trillion in bank-owned residential mortgages is still negative, but the $500 billion in multi family and $1 trillion in commercial office exposures are already above the long-term average. Source: FDIC/WGA LLC If we combine the asset-liability mismatch facing the banks, with a sudden reduction in credit availability as lenders seek to raise cash, the end result could be a significant uptick in credit defaults later this year. Given the velocity of change we have already witnessed since the Fed began to tighten policy more than a year ago, we think that preparing for sharp upward moves in credit default rates at banks is probably a prudent move. But the real whammy that faces US banks and levered investors is what happens to net-interest margin when the rate of change in funding costs doubles or more in a single quarter. Below we show the components of net interest income for all US banks. The rate of growth in interest costs has been galloping along at a multiple of interest income, part of the normalization process from the Fed’s QE program. Interest expense for US banks is up 10-fold since the near-zero lows of 2021. But while the rate of increase in funding costs for all US banks was decelerating gradually at the start of 2023, since the failure of Silicon Valley Bank in the first week of March the rate of increase in bank funding costs has jumped . The bank deposit rates we can all see online suggest that the US banking industry could see declining net interest margins in Q2 2023. If we use U.S. Bancorp (USB) as a surrogate for the industry data that will be released by the FDIC at the end of May, Q1 2023 funding costs rose almost 40% and interest income rose 16% sequentially. The year-over-year comparisons are even more striking. But there are only three weeks of data post-SIVB in the USB results for Q1 2023. This begs the question as to what happens in Q2 2023 and beyond given the shock of three large bank failures in March and April. Our best guess about Q2 2023 for the whole US banking sector is shown below. Source: FDIC/WGA LLC Let’s say that banking industry interest income rises another 20% in Q2 2023, but bank interest expense surges higher and rises 100% vs the ~ 40% Q1 2023 baseline we take from U.S. Bancorp. The chart above shows the projected results for all US banks in Q2 2023, which will be released by FDIC at the end of August. Total interest expense exceeds net interest income by almost $14 billion, an unprecedented development in a year that promises to set more records. After all, it’s not even Memorial Day and we could easily see a couple more commercial banks fail in coming weeks. 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.

May 4, 2023 | Premium Service | The Federal Open Market Committee committed another significant error yesterday by raising interest rates a quarter point. The symbolism here is more important than the 25bp, since much of the US banking sector, as well as insurers and pension funds, are already insolvent on a mark-to-market basis. The concentration of risk caused by the FOMC’s massive open market bond purchases in 2020-2021 now threatens the US with a 1930s style financial collapse. This situation is caused first and foremost by hubris and insensitivity by the US central bank as to how its actions impact markets and financial institutions. This AM we had a chance to speak with Hugh Hendry of Eclectica on Bloomberg Radio about what happens next . Hugh is a thoughtful guy who has seen this movie before. He suggested that US authorities may need to erect formal gates to prevent bank depositors from accessing their funds. We completely agree. Welcome to Brazil or Mexico circa 1970. The idea that the Fed could let things get so bad that it must impose limits on bank deposit withdrawals shows how serious the situation in Washington is becoming. Idiotic discussions about suspending short-selling of bank stocks also illustrate where things are headed. Imagine how President Joe Biden will react if Chair Powell needs to announce formal limits on access to US bank deposits. The Fed’s actions have undermined confidence in US banks as well as the government in general, but the only response from official Washington is to make things worse. The studied incompetence displayed by appointed officials at the Fed and other agencies stands in sharp contrast to the alarm and dismay expressed by career staff at the Treasury and Fed. Given recent developments, a couple of points for our readers: Banks : With the short sellers attacking PacWest (PACW) and Western Alliance (WAL) this AM, we sold our WAL position and are reviewing our large bank preferred exposures. While we still have a position in New York Community Bank (NYCB) , we’d tell our readers to avoid taking risk positions in banks until the FOMC relents and drops short-term interest rates. Until the Fed accepts that its policies are the problem, we see most smaller banks as targets for short-sellers and not suitable for any investor. The only way that the Fed can end the run on banks is to offer to finance 2020-2021 vintage assets at par indefinitely. If not, then the run continues. Once the smaller banks are gone, then we’ll move up the list to larger outliers such as Ally Financial (ALLY) and Capital One (COF) . Remember, this situation is not about large banks vs small, but all banks vs the Fed and Treasury in the short-term funds market. The short sellers will continue to attack smaller banks, but then will turn to the larger depositories. We do not believe that the Fed Chairman can survive politically if more banks fail in coming weeks. Economy : As banks and other market participants step back from lending in order to reduce risk exposures and/or raise cash, the impact on the economy will be to accelerate the normalization of credit and push loss mitigation costs sharply higher. We expect to see a sharp deceleration in economic growth over the next couple of months as credit tightens, with the rate of change mimicking the volatility seen in other quarters. Again, since the Fed itself is a major source of market volatility, any solution requires a change in Fed interest rate policy. Source: FDIC/WGA LLC Credibility & the Dollar : Perhaps the biggest issue we see created by the latest Fed interest rate move is about the credibility of the US. When Fed Chairman Jerome Powell gets up in front of the cameras and says that the banking crisis is over, but the markets continue to sell bank shares, he is eroding the credibility of the central bank and the entire US government. We don’t believe that the Fed will be able to maintain its interest rate policy for more than a few months, but that may be enough to badly damage the banking system, and the market position of the Treasury and the dollar. As we’ve noted in The Institutional Risk Analyst , after 2008 the market for dollar interest rate swaps moved to a discount because of heavy demand for dollar assets. Today, that demand and the Fed’s massive bond market intervention have kept long-term interest rates artificially low. When the market for dollar interest rate swaps returns to a premium, then the special role of the dollar will be ebbing for the first time since 2008. Chairman Powell may be responsible for making that momentous change a harsh reality. 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.

May 1, 2023 | Watching the collective train wreck around the failure of First Republic Bank (FRC) over the weekend, we take a moment from book editing to ask five questions about the common (and largely false) narrative surrounding this event. 1. Did a lapse in management and/or prudential regulation cause the failure of FRC? No, the Fed’s excessive open market intervention from 2019 through 2022 was the primary cause of the failure of FRC as well as Silicon Valley Bank and Signature Bank . Specifically, starting in 2019 the Federal Open Market Committee deliberately manipulated the bond market down to zero and thereby concentrated massive amounts of risk in a narrow band. The FOMC then raised interest rates more than 500bp starting in 2022, rendering most banks in the US insolvent on a mark-to-market basis by the end of Q3 2022. 2. How large is the capital deficit of US banks due to the Fed’s actions? Last year, in Q3 2022, all US banks reported a mark-to-market deficit of almost $1 trillion on available for sale (AFS) and held-to-maturity securities. The chart below from the FDIC illustrates the aggregate position of all US banks. If you include the loan portfolio of US banks in the capital calculation, then most US banks today are insolvent on a fair value, mark-to-market basis because of the FOMC’s actions. The general surrogate for the M2M losses of US banks on securities holdings is the 10-year Treasury note. In Q3 2022 when the M2M losses of US bank securities positions approached a trillion dollars, the 10-year was over 4%. Our general measure for gauging the M2M loss is the GNMA 3% MBS, which currently trades around 90 cents on the dollar. 3. Why did the Powell FOMC decide to massively expand open-market purchases of securities in 2019, a year before COVID? We have attributed the decision by the Fed to “go big” with providing additional reserves after the December 2018 money market collapse to both Chairman Powell and his predecessor, Treasury Secretary Janet Yellen . But perhaps we are too hard on the old girl. Lee Adler of Liquidity Trader writes: “Everybody blames Yellen, but Powell was the one who went big. Yellen shrank the Fed's balance sheet. She started the "normalization" policy. Powell was the one who panicked and reversed course when they had a problem in the money markets because of it. And Chairman Ben Bernanke knew he was setting a trap for anyone who would dare to try to reverse his money printing. He's a financial war criminal.” Lee continues: “The villains are Greenspan, Bernanke, and Powell. Yellen is the only one who tried to do the right thing. Yet the rabid right loves to lump her in with the real bad guys. They even make her the primary villain. It's wrong. You're better than that, Chris. You have the ability to sift through the facts to get at the underlying truth. Don't let your bias cloud your vision.” Point taken. Claudio Borio , Head of the Monetary and Economic Department of the Bank for International Settlements , recently rebuked the Fed on its use of abundant reserves : "Since the Great Financial Crisis, a growing number of central banks have adopted abundant reserves systems ("floors") to set the interest rate. However, there are good grounds to return to scarce reserve systems ("corridors"). First, the costs of floor systems take considerable time to appear, are likely to grow and tend to be less visible. They can be attributed to independent features of the environment which, in fact, are to a significant extent a consequence of the systems themselves. Second, for much the same reasons, there is a risk of grossly overestimating the implementation difficulties of corridor systems, in particular the instability of the demand for reserves. Third, there is no need to wait for the central bank balance sheet to shrink before moving in that direction: for a given size, the central bank can adjust the composition of its liabilities. Ultimately, the design of the implementation system should follow from a strategic view of the central bank's balance sheet. A useful guiding principle is that its size should be as small as possible, and its composition as riskless as possible, in a way that is compatible with the central bank fulfilling its mandate effectively." 4. Is it wrong for JPMorgan to buy FRC? No, the progressives led by Senator Elizabeth Warren (D-MA) as usual don’t understand banking. JPM CEO Jamie Dimon really had to buy FRC because he had enabled this odd business to flourish in the first place. The analogy here is Bear Stearns, where JPM was the clearing bank. Nobody else could or would buy either business. FRC had made much of its money selling private label jumbo mortgages, production financed by JPM as warehouse lender, even as FRC pretended to be an asset manager. As we wrote earlier (“ Who Killed First Republic Bank? ”), FRC really did not make much money off of that $280 billion in assets under management (AUM). Investment banking fees were a significant source of income for FRC. It is poetic justice that JPM has to actually pay money for branches it probably does not want and AUM and deposits that will probably walk out the door in the next year. The loan portfolio, even with the loss-sharing agreement, may still end up costing JPM money. Looking at the growing traffic jam in the secondary market for mortgage assets with stories, the FRC portfolio does not strike us as particularly good value. Critics of big banks should instead become critics of stupid and self-serving monetary policy. Were it not for the massive balance sheet inflation caused by the FOMC after December 2018, US banks like JPM could be a third smaller than they are today. And given that the banking system is running off at $50-100 billion per month thanks to the latest gyration in Fed monetary policy, JPM and other banks will get smaller -- whether they like it or not. 5. Will More Banks Continue to Fail? Yes is the short answer. Until Chairman Powell comes clean with the Congress and the American people about QE, more banks will inevitably fail. The huge swing in asset prices caused by the actions of the Powell FOMC basically has left US banks and bond investors like pension funds and insurance companies holding the bag on $5 trillion in losses. If you haircut the $25 trillion in loans and securities priced during 2020-2021, that is the conservative estimate of loss. Since US banks only have about $2 trillion in tangible equity capital, you can see that we have a problem. Outliers among bank business models will fail first, followed by more mainstream banks on up the food chain. Until the Fed 1) admits that going “big” with open market intervention was a mistake and 2) drops federal funds 100bp, more banks will fail. The sad truth is that buying $9 trillion in securities not only left the banking industry insolvent, but it now ties the Fed’s hands in terms of fighting inflation. Powell et al at the Fed don’t want to admit that they have a problem with monetary policy, but they are more than willing to throw federal bank regulators under the bus for now three major bank failures and over $100 billion in losses to the FDIC's bank insurance fund. Some media wondered at the Fed’s willingness to quickly take the blame for these bank failures, but wonder no more. The Fed is more than willing to take a beating on Capitol Hill for bank regulatory lapses. Yet the Fed’s Board of Governors will watch several more large US banks fail before Chairman Jerome Powell takes the blame for his intemperate monetary policy actions following December 2018 and resigns. 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.

April 29, 2023 | Premium Service | As we watch yet another large regional bank head for failure with First Republic Bank (FRC) , we return to the relatively blissful world of mortgage lending and servicing. There is not much lending at present in the world of 1-4 family mortgages, so most firms are relying on servicing income to carry the load on earnings. The big concern: future mortgage delinquency rates. Penny Mac Financial (PFSI) and Mr. Cooper (COOP) reported and both firms managed to deliver good results despite the dismal state of the secondary mortgage industry. Estimates of production for 2023 continue to fall, although Q1 2023 will hopefully be the low for this cycle. Our mortgage surveillance list is shown below: Source: Bloomberg The good news for both of these leading mortgage issuers is that they are using their significant servicing books to ride out the famine of 2023 in the mortgage lending space. The bad news is that one issuer, PFSI, has seen a major change in its management team that may be significant to market participants and investors over the course of the next year. “PennyMac Financial Services Inc. (PFSI) and PennyMac Mortgage Investment Trust (PMT) announced Thursday that Vandy Fartaj is stepping down from his position as senior managing director and chief investment officer of both PFSI and PMT, “in order to pursue other interests,” reported National Mortgage Professional in March. “He is being replaced by William Chang .” Since March and the departure of Fartaj, there has been a discernible change in the market behavior of PFSI, with the leading aggregator of conventional loans now taking several steps back in terms of pricing behavior. Leading conventional shops such as the AmeriHome unit of Western Alliance Bank (WAL) and other issuers are taking market share as PFSI retreats. One competitor told The IRA that AmeriHome and rising issuers such as Planet Mortgage essentially had the conventional market to themselves in March and April. Some issuers found themselves overpaying for loans, not realizing that PSFI had backed away from the conventional market. This fact helped several issuers turn in strong production volumes in March and April. More to the point, the highly regarded Fartaj reportedly played an important moderating role at PennyMac, balancing the natural tendency to wave through all production with an astute view of valuation and pricing, both for loans and mortgage servicing rights (MSRs). Given that most loans underwritten since 2020 will be underwater in the next down cycle in residential home prices (say 2026-2027, for now), paying up for conventional loans may not be the best choice. The table below from the PFSI earnings presentation shows total industry mortgage production and interest rates in the secondary mortgage market. Over the past year, PFSI has steadily increased the average note rate on its servicing book, from 4.4% in Q2 2022 to just shy of 6% in Q1 2023. A higher note rate provides for better recapture opportunities in the event that interest rates fall, but it also means that the MSR will run off more quickly. The question remains, however, whether PennyMac will continue to drive average note rates higher. In the event of a sharp decline in interest rates, prepayments could jump and force PFSI to meet margin calls on MSR financing. PFSI claims over 17% market share in correspondent lending, citing Inside Mortgage Finance , through Q1 2023. Where will that number be in Q2 2023? The fact that PFSI did not take questions from analysts at the end of the company’s Q1 2023 earnings presentation is not likely to inspire great confidence. Given market trends, we wonder if PFSI will still be able to claim market leadership in conventional correspondent in Q2 2023. In this regard, note that PFSI intends to increase correspondent purchases from its REIT affiliate PMT in Q2 2023. The table below shows trends in the PFSI servicing book. Notice that prepayments were only $10 billion in Q1 2023. Of note, PFSI reported an increased valuation for its MSR at the end of 2022, but a decrease of $90 million in Q1 2023 before the effect of hedge results. The rally in the bond market since Q3 2022 caused some issuers such as COOP to take successive negative marks on the MSR, but PFSI did not do so until Q1 2023. If the 10-year Treasury note were to rally back toward 3%, MSR valuations would likely fall from current levels and force PFSI to take larger negative marks. Of particular note, on Page 16 of the PFSI presentation, the issuer states: "No P&I advances are outstanding, as prepayment activity continues to sufficiently cover remittance obligations…” Like the rest of the industry, mortgage delinquency rates for PFSI decreased from the prior quarter and remained below pre-pandemic levels. Mr. Cooper At COOP, originations rebounded from a dismal Q4 for the industry and have moved higher along with many other issuers, who reported strong profits in February and March of 2023. Unlike PFSI, COOP’s production leads with direct to consumer (DTC), with correspondent a close second. The focus on DTC has enabled COOP to expand origination margins at a time when much (but not all) of the industry is seeing margins. The table below from COOP’s earnings presentation shows origination results. Mr. Cooper COOP continues to drive toward $1 trillion in total loans serviced in terms of assets under management (AUM) with several acquisitions during the quarter. Of note, the COOP MSR valuation trends and multiples are relatively conservative. More, unlike PFSI, COOP seems more focused on how much of the MSR book is out of the money (and therefore unlikely to prepay) than generating refinance events . The table below is from the COOP earnings presentation. Mr. Cooper Of interest, COOP is carrying just shy of $1 billion in advances on delinquent loans at the end of Q1 2023 vs zero for PFSI. COOP has only a bit more Ginnie Mae exposure in terms of delinquency than does PFSI, thus the fact that the latter continues to report zero advances is even more remarkable. One veteran banker notes that when delinquent loans are 2x prepays on a Ginnie Mae pool, that means that the custodial account is empty and the servicer must use corporate cash to fund advances. COOP has plenty of borrowing capacity for advances or MSR acquisitions, and has largely hedged its MSR position against falling interest rates. “Our goal is to bring down the capital ratio over time, primarily by investing in MSR acquisitions and our own stock,” COOP CEO Jay Bray told analysts. “The quickest way for us to re-leverage the balance sheet would be to issue high yield notes, but we don't view the trading levels for our bonds as consistent with our strong credit profile. So we'll wait for a more opportune time to tap that market.” Bottom line: Both PFSI and COOP are navigating the current market well, but we have questions about where the former is headed. With COOP, the direction is clearly to build AUM for the servicing book and use superior funding to extend the lead over other issuers. The DTC channel combined with a rational approach to correspondent seems to be delivering good results for COOP. At some point, however, PSFI must address the twin issues of the team and market strategy going forward. To us, there is quite a difference between the two strategies. COOP takes comfort from relatively low note rates, but PFSI has been pushing the note rate up to catch future refinance events. The structural changes in the industry with 3/4 of all loans below 4.5% suggest that the MSR-centric view of COOP is the correct strategy. Even a significant rate decrease may not move the needle in terms of originations. Disclosure 4/28/2023 BAC.PR, CPRN CVX GHLD JPM.PRK NOVC NVDA NYCB USB.PRH WAL WFC.PRQ WFC.PRZ WMB WPLCRF 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.

April 26, 2023 | Q: Who killed First Republic Bank (FRC) ? A: Janet Yellen and Jerome Powell . Q: When did bankers and regulators first know they had a problem with QE and the banks? A: The middle of 2022 . Going back more than five years, The Institutional Risk Analyst described the existential market risk created by the Federal Open Market Committee’s massive purchases of securities. The recent movement of the bond market has reduced the visible unrealized losses on securities owned by banks, but the fundamental problem of mispricing of risk remains unresolved. Trillions of dollars worth of low-yielding assets are festering on the books of all US banks. Ponder the remarkable idiocy of the Financial Stability Oversight Council , which just published a long list of recommendations for identifying risk among nonbank financial firms like Black Rock (BLK) . The FSOC document never mentions the impact of quantitative easing or “QE” on financial institutions and markets. Chaired by Treasury Secretary and former Fed Chair Janet Yellen , one of the architects of the “go big” policy behind QE, the FSOC sees risk lurking in every corner but the one that actually matters. It is clear today that the Fed's decision to start manipulating the bond market early in 2019 was a serious mistake, yet Fed Chairman Jerome Powell and Secretary Yellen are silent. The Treasury and Fed cannot admit fault for fear of bringing the whole house of cards crashing down, especially now that President Joe Biden has announced his reelection campaign. How big is the risk created by Chair Yellen and her successor, Fed Chairman Powell, as a result of going “big” on QE in 2019 and then full throttle after March 2020? Let’s start with the data from the Securities Industry and Financial Markets Association (SIFMA) , which shows that about $25 trillion in fixed income securities were issued in 2020-2021. If we adjust these securities by a conservative 12% haircut vs current pricing for say Fannie Mae 3% coupon MBS, you’re looking at $3 trillion in unrealized losses on COVID era securities. The same price adjustment on trillions of dollars in whole loans priced during 2020-2021 gets you another couple of trillion in unrealized losses. We express the losses as a discount to par value, but the real problem for banks and other investors is the low levels of income coming from these COVID-era securities. Those Fannie Mae 3s issued in 2020 at 104 are trading at 89 today, but SOFR is just shy of 5% as are three-month T-bills. Anyway we cut it, the US financial markets need to absorb about $5 trillion in securities losses to get clear of the cost of QE. This process of loss recognition must occur at the same time that banks and leveraged investors are forced to reprice their funding costs. As the process of repricing of liabilities moves forward, more banks will likely fail. Looking at Q1 2022 to Q1 2023, for example, First Republic Bank (FRC) saw its funding costs go up 20x or twice as fast as JPMorgan (JPM) and other large banks. This violent change led to FRC’s near-failure in Q1 2023, leaving the institution today a function of support from other banks. The enormous rate of change seen in FRC’s funding costs has to do with those risks that Secretary Yellen and other members of the FSOC don’t quite see. This is a qualitative risk that defies easy quantification and thus eludes “data dependent” regulators and economists. For example, FRC’s unrealized loss position over the past year was not large enough to warrant mention. What was the chief risk facing FRC? Liquidity risk from the bank’s wealthy customers. The type of fully entitled, high-net-worth customers that were attracted by the “high touch” (and low profit) model of FRC had zero loyalty to the bank. Compare the experience of Bank OZK (OZK) , which we profiled in our last Premium Service comment, with FRC. OZK actually knows its customers, commercial and retail. When the bank raised deposit rates and asked their customers for support, the depositors of OZK responded and even grew deposits in Q1 2023. The customers of FRC, by comparison, took the money and ran. Wealthy clientele such as the affluent individuals that banked at FRC have no loyalty to any particular financial advisor. First Republic was one of many advisers and service providers to their wealthy customers, people who find products like interest only mortgages attractive. These same products helped the bank to retain assets in normal times, but when liquidity risk arose the wealthy clients ran away. The Main Street business model of OZK was far more durable, it seems, than the asset gatherer model of FRC. The structure of the FRC portfolio featured a high reliance on non-core funding, which was used to grow the bank’s loan book. Net-loans and leases at the end of 2022 equaled almost 100% of deposits vs 62% for Peer Group 1. When deposits started to leave the bank, the portfolio almost immediately ran into trouble as runoff forced asset sales. And it was the affluent and mobile nature of the FRC client base that enabled them to run. Aside from the dependence upon non-core funding, FRC also suffered from poor profitability – even with $280 billion in client assets under management. The bank was generally below Peer Group 1 in terms of net income and the gross yield on its loans. A significant portion of the bank's income came from investment banking fees. Yet the bank’s non-interest, fee income as a percentage of average assets was actually below its smaller peers. FRC was more broker dealer than bank. The bank had a pristine credit history, but the lack of basic profitability was telling through year-end 2022. FRC had an efficiency ratio in the 60s, in line with the larger banks but hardly challenged. The Q1 2023 earnings reported by FRC basically shows a bank that has failed in all but name, with almost $100 billion in non-deposit funding holding up the $200 billion asset bank. During the trading day yesterday, FRC indicated that it was looking at strategic alternatives, including the possible sale of $100 billion in assets – likely whole real estate loans. But given the slow pace of asset sales by BLK for the FDIC, getting a bid for a $100 billion block of whole loans is unlikely – especially if those assets are underwater. FRC had a 3.24% gross yield on its loan book at year 2022 end vs over 4% for its larger bank peers. The fact is that FRC and its assets may not be attractive unless the FDIC first takes over the crippled bank to cleanse the assets of any contingent liabilities. In the event, FDIC would likely retain the legacy 2020-2021 loan portfolio in the Receivership as it did with the securities book of Silicon Valley Bank. FDIC will then sell the bank’s asset management business, the deposits and selected assets, and the bank charter. FRC is a unitary bank with two valuable bank charters. Optimists who believe that the bank can be salvaged need to know that the business model will be very different in a new First Republic Bank. A banking business that is stable and profitable must start with a Main Street focus, which includes traditional business and consumer business lines. The days of running an investment advisory business for high net worth clients, with a jumbo mortgage business alongside, from inside an under-performing bank are probably at an end. But the more significant point may be that as the Fed drains trillions of dollars out of the system, it will necessarily force losses on 2020-2021 era securities. These losses could easily stretch into the hundreds of billions or even trillions of dollars, and may force the sale or failure of a number of banks along the way. The US banking sector, which stands in first loss position behind the Federal Deposit Insurance Corp and in front of the Treasury, may be forced to pick up the bill for QE. 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.

April 24, 2023 | Premium Service | A reader of The Institutional Risk Analyst recently complained of seeking investment advice and specific thoughts and insights on preferred equity issued by small banks. First thought: Read our FAQs . Another thought: Ask Manny Friedman at EJF Capital how he feels about small lenders now that the fuss in financials has settled down a bit from last month. EJF was the subject of derision in the media this past March because of the firm’s focus on small financials. But truth to tell, EJF started to pare back exposures last year . We ourselves decided to migrate up the capital structure in 2020, when the Fed began to “go big” with QE. This meant dumping common equity exposures and buying preferred equities. By the end of 2021, the bloom was off the rose in fintech and the shorts were already feasting on the likes of Upstart (UPST) and Affirm (AFRM) . The dichotomy in financials is profound. Smaller banks have better financial performance and growth, but suffer from the negative risk factor of liquidity. In March 2023, when the FOMC’s intemperate actions in the bond market caused several large depositories to fail, liquidity fled from smaller banks and nonbanks, leaving many investors specializing in smaller names underwater. If you invest in smaller banks, liquidity risk is the prime concern. It’s that simple. The liquidity concerns of smaller banks are blissful, however, compared to the funding and operating profiles of nonbank financial firms operating in the world of consumer finance. Notice that UPST and AFRM continue to trade at steep discounts to our surveillance group. Source: Bloomberg Fact is, with SOFR just under 5% and the 10-year Treasury loitering around 3.5% this week, there is not a lot of juice in the nonbank consumer trade at present, especially with credit concerns weighing on more astute minds. Jumping funding costs for banks are the story of Q1 and Q2 2023, but credit will be the plat du jour by Halloween. The big concern on everybody’s worry list is commercial real estate. We fussed about some of the existential issues facing New York City and other legacy urban landscapes during COVID, but the glacial pace of change in commercial real estate is finally starting to impact credit. Konrad Putzier just wrote a sobering article in The Wall Street Journal that begins to describe the carnage heading for the world of credit in commercial real estate. “Landlords are contending simultaneously with a cyclical market downturn and with secular changes in the way people work, live and shop,” Putzier writes. “The sudden surge in interest rates caused property values to fall, while the rise of remote work and e-commerce are reducing demand for office and retail space.” We noted on Twitter recently that the slippery slope of falling lease rates, phantom occupancy and eventual flight by anchor tenants all spell doom for the equity in commercial buildings in legacy cities. The more progressive the politics in cities like New York and San Francisco, the lower the asset values. Just look at the lease rate in a given building, our friend Nom de Plumber opines, then consider how much leased space is actually occupied. Unlike the 2008 crisis, when mortgage debtors on 1-4 family homes sent lenders the keys in the mail, today it is tenants that are giving up on whole buildings. The first loss positions on the legacy office buildings typically are held by private equity and REITs. Banks and commercial mortgage backed securities typically hold the mortgage, a 50 LTV affair. But when interest rates have risen 500bp in a year and cap rates are extending accordingly, that 50 LTV of 2021 vintage means zero equity today. Bank OZK The world of property development is once again flipping to full-time restructuring. With the increasing focus on credit losses from commercial assets, it is time to check in on Bank OZK (OZK). The $26 billion asset commercial lender is considered a bellwether in the commercial real estate industry. Some 65% of the bank’s loans are secured by commercial real estate, 10x the average for Peer Group 2. Bank OZK was once a high-flyer among banks, demanding a premium valuation for many years. At the end of 2022, OZK was near the 52-week high, but subsequently slid back after the failure of Silicon Valley Bank. Yet the bank just reported record results in Q1 2023, even as the Little Rock based lender increased credit loss provisions and even grew deposits. Source: Google OZK CEO George Gleason talked about the bank’s organic deposit growth: “On the deposit side, as you saw in the quarter just ended, we had good deposit growth, 3.6% growth in deposits, not annualized. That was organically through our branch networks. Most of our deposit growth comes from our 229 branches in Arkansas, Texas, Georgia, Florida, and North Carolina. We expect those branches will continue to fund that growth going forward in the remainder of the year. We've not had any changes in our deposit gathering strategies or adjustment.” Not only does OZK gather deposits via its branch network, but the bank manages to price its loans over 6.2% on average vs 4.6% for Peer Group 2. Measured against most operating metrics, OZK ranks near the top of Peer Groups 1 or 2, depending on your preference. In 2022, for example, OZK’s net income was over 2% of average assets, placing the bank in the 98th percentile of Peer Group 2 (average at 1.2%). OZK had an efficiency ratio of 35.75% in December 2022 vs over 52% for Peer Group 2. The bank has an almost 16% capital leverage ratio and below-peer credit losses. Some 40% of the bank’s loan book is focused on construction and development loans, vs low single digits for commercial & industrial credits. Like other banks, OZK saw interest expense rise 10x over the past year, but the bank had the growth to use these deposits and actually expanded net interest margin when other banks are in retreat. Significantly, OZK managed to grow net interest income even as it put aside $35 million for future loan losses. The bank has one significant REO asset, a roughly $60 million parcel of land zoned for commercial development. The bank has the luxury of strong capital to hold the REO asset for an eventual sale. The one thing that seems to worry Gleason is that the flow of new loans may slow as the year progresses. Virtually all of the bank’s assets are originated internally. The bank’s guidance is cautious about being able to maintain past growth rates into the full year 2023. But the key takeaway for us is that George Gleason and his team at Bank OZK are building credit reserves as we go into the second quarter of 2023. We wish other banks showed the same focus on operating efficiency and loan pricing as is constantly in evidence at OZK. Banks that do not aggressively reprice liabilities and assets as OZK did in Q1 2023 may be left behind. 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.

April 19, 2023 | Premium Service | In this issue of The Institutional Risk Analyst , we review the latest earnings for banks and think about the next shoe to drop. One reader asked why JPMorgan (JPM) is paying 5% for one year deposits. The short answer is that JPM and Bank of America (BAC) are competing for funding in a shrinking market. The funding crisis affecting US banks is not over and very definitely not limited to smaller banks. CNBC World Wide Exchange (04/17/23) Every time a Treasury bond matures in the Fed’s portfolio, the Treasury refinances that piece of debt (since the US is running a massive deficit) and an investor buys that bond. A bank deposit disappears and an asset is acquired. And given the growing crowd of investors dumping commercial real estate exposures, the demand for risk free collateral is brisk. The same math does not apply to mortgage-backed securities (MBS), sadly. Since the mortgage finance industry is barely producing $400 billion in new loans each quarter in 2023, the Fed would need to sell $50-$100 billion per month just to compensate for all redemptions globally. Net, net, the mortgage ice cube is melting. The MBA estimates only $1.8 trillion in production in 2023. By not selling MBS from its portfolio, the Fed is causing distortions in the Treasury yield curve and arguably is forcing down mortgage rates and long-term yields generally. As new MBS production dwindles and the Fed sits on its growing pile of duration represented by the MBS in the system open market account (SOMA), the net effect is to make MBS scarce and drive down yields. Even with banks backing away from 1-4s, the net effect is still to make MBS collateral ever more scarce. As liquidity runs out of the system, the FOMC ought to be providing risk-free collateral to enable private counterparties to raise cash. One of the little market details that seems to always evade economists is the link between liquidity and risk-free collateral like Treasury bonds and Ginnie Mae MBS. If collateral is tight, then raising cash is also more difficult and expensive. After December 2018, you’d think that the Fed understands this connection by now. The BlackRock (BLK) sale of mortgage bonds for the FDIC could reach up to $2 billion in MBS pools and $500 million in collateralized mortgage obligations per week, close to expected levels of $10 billion a month, this according to analysts at Citigroup (C) . But since the primary market for new agency and government MBS will be lucky to produce $400 billion in Q1 2023, the obvious answer is for the Fed to join the banks as net sellers of older mortgages. This may be obvious to investors, but nothing seems to be obvious to members of the FOMC when it comes to finance and economics. The same pressures that are building on banks are also impacting all manner of buyers of assets, from insurance companies to REITs. Reports that the insurance sector is stepping back from the commercial office market is bad news that could not come at a worse time. Indeed, we perceive a run on commercial real estate that carries profound risks for the credit markets. Just because commercial real estate is a mostly private market without public prices for entirely large, disparate exposures does not mean that there is no pain. Earnings Roundup So far the earnings reported by the banks largely confirm several basic points we have discussed over the past year. Points: First is volatility. The rate of change in just about every metric is off of the scale compared with past experience. Looking at the rate of change in funding costs for JPM and BAC, for example, we see confirmation of the trend visible in the regulatory data, namely that funding costs are surging. Our estimates put C’s interest expense north of 2.5% of average assets in Q1 2023 or basically 2x Q4 2022. Again, why is JPM paying over 5% for 12-month deposits? Because they need liquidity. Note too that Citi reported that cash fell 14% sequentially and 6% YOY. One of our portfolio holdings, Western Alliance Bancorp (WAL) , saw net interest income jump 35% in Q1 2023, but funding costs rose 10x in line with JPM. Of note, WAL reported fair value loss adjustments of $147.8 million related to the transfer of $6.0 billion of loans from held-to-maturity to available for sale. Run rate revenue was over $700 million before the fair value adjustment. Meanwhile, the 43% efficiency ratio gives WAL a lot of flexibility to deal with future losses. The stronger banks are those with sufficient earnings to sell underwater assets. The fact that WAL was able to increase net-interest margin by 14% in Q1 2023 vs the year before speaks to the focus of management. With the management changes at PennyMac Financial (PFSI) , WAL’s Amerihome mortgage unit has the world of conventional correspondent largely to itself. At the end of March, Vandad Fartaj ceased serving as PFSI’s Chief Investment Officer , causing PSFI to subsequently become less aggressive in the secondary market for conventional loans. The table below shows some of the changes to the WAL balance sheet over the past year. Notice that the bank has moved 10% of assets into available-for-sale and raised cash and total assets, even while pushing down deposits. Second is the broad-based flight away from risk assets such as commercial real estate exposures. This change in lender appetite comes at a time when banks are already lightening up on commercial loans and also 1-4s, and looking to maximize liquidity. One way to immediately increase liquidity is to decrease lending. We see a flight from risk building among banks and nonbanks as concerns about the economy grow, particularly in areas such as legacy urban commercial real estate. Banks like Citi are reducing corporate exposures even as they coast temporarily in terms of allowance for future losses. Citi is also running off legacy exposures in Asia and Mexico at a 20% annual rate and putting cash into trading accounts and securities. We look for all large banks to step back from high-risk markets and maximize cash over the balance of 2023. Third and looming large for the rest of 2023 is credit costs. The fact that JPM boosted provisions 56% YOY is more significant than the fact that the bank basically made no additions to the ALLL in Q1 2023. The industry is pausing before a significant credit build – because it can. For most banks, Q1 earnings are likely to be the best of 2023 for a number of reasons, chief among them are strong top-line revenue from the banking side of the ledger and low current credit expenses. Will JPM pull another bunny from the hat in Q2 2023 in terms of a 72% surge in principal transactions? See yellow highlight below. Looking at the $470 million loss realized by GS on the sale of Marcus loans, our earlier view about the inferior credit performance of the Goldman credit book seems to be confirmed. We agree with the decision to cut the loss at Marcus, but we continue to believe that GS needs to merge with a larger player to address funding costs. In the post QE world, the shrinkage in available liquidity as the SOMA runs off will put growing pressure on high-cost depositories. Interest expense at GS was up 850% YOY and 27% in Q1 2023 vs Q4 2022. Interest income was up 365% YOY and 20% sequentially, again illustrating the vast change underway in terms of funding costs. If we replicate the calculation from the FFIEC, annualized interest expense/average assets for GS was 342bp in Q1 2023 vs 138bp in Q4 or a 150% increase in a single quarter. Notice in the table below that GS saw net interest income fall in Q1 2023, even as non-interest income provided most of the profitability. Banks large and small are feeling the withdrawal of liquidity from the markets. Again, the liquidity run on US banks is not over and it is very definitely not limited to smaller depositories. With Morgan Stanley (MS) , for example, interest expense soared 1,750% YOY, from $434 million in Q1 2022 to $8,033 million in Q1 2023. Credit expenses also increased triple digits, albeit from a small absolute amount. MS reported 1bp of net loss in Q4 2022, an excellent performance that puts them in the bottom quartile of all large banks. While the headline assets is $1.1 trillion, risk weighted assets is less than $450 million. MS got a nice surprise from the investment bank, but net interest income was flat, up 1% sequentially and 6% YOY. This again shows how hard it is for relatively short-duration businesses like MS or GS, which are still predominantly broker dealers, to generate net interest margin. Like Charles Schwab (SCHW) , MS is a large investment firm that owns a large, liquid banking business. Net interest income at MS was $2.3 billion vs over $12 billion from fees and other non-interest income generated by investment activities. The 48% increase in trading activity at MS in Q1 2023 is unlikely to be repeated in Q2 2023. The key takeaway from Q1 2023 earnings so far: Volatility on the balance sheet and in the income statement are to be expected in 2023. We look for better managed banks to get smaller and more liquid over the next several quarters. Banks that do not get the hint and wait to make adjustments when change is forced upon them will pay accordingly. The changes we see occurring at some of the largest US banks suggests to us that the tightening of credit conditions by the FOMC is affecting all banks differently and to a degree that is not well-understood by markets or policy makers. 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.

April 17, 2023 | In this issue of The Institutional Risk Analyst , we ponder the key takeaway from Q1 2023 earnings. Just by coincidence, funding cost is the same takeaway our readers considered a year ago – namely the fact that interest expense for banks, REITs and other investors is rising faster than asset returns. Bank deposit rates must rise. CNBC 4/14/23 Consider the example of JPMorgan (JPM) , which reported record Q1 2023 earnings on Friday thanks to QE. Interest income rose 139% from Q1 2022, but JPM’s investor relations team decided that the 10-fold increase in interest expense was somehow not meaningful to investors. In fact, JPM’s interest expense was up over 900% YOY. Likewise, Citigroup (C) apparently decided that investors would not find the increase in the bank's funding costs of interest to investors. In fact, Citi’s interest revenue increased 88% vs Q1 2022 but funding costs increased 377% year-over-year. After our appearance on CNBC’s Squawk Box Friday, Citi’s investor relations teams decided to complain that we had incorrectly characterized the bank’s credit loss rate. In fact, we wuz wrong. Citi’s net loss rate is actually 5x higher than the same measure for all of the banks in Peer Group 1. Years ago, we learned one of the more useful lessons in finance while working at Bear, Stearns & Co . The most important call or email from an aggrieved financial professional is often the one that is not sent. Sometimes you need to pick up the phone, dial the number and then put down the receiver before the call connects. Likewise with email. Provisions for credit losses at Citi, the next shoe to drop, were up 560% YOY in Q1 2023. This was another remarkable metric that the veteran IR professionals at Citi thought was not meaningful to investors. Fortunately, they did allow that a 49% increase in credit losses since Q1 2022 was perhaps meaningful to investors. Both managers and regulators are still fighting the last war in terms of bank risk, namely market risk due to sharply rising benchmark interest rates. The gap between bank deposit rates and that 4% yield on 90-day T-bills will close over the next year, forcing up prime bank loan rates towards low double digits. The productive economy of jobs and sales funds the necessary world of secured finance off the short end of the Treasury yield curve. A year ago, Citi took $600 million out of loan loss provisions, this as part of the great rebalancing of post-COVID credit reserves. For this reason, much of the financial data from 2021 and 2022 is useless from an analytical perspective. But the simple fact is that Citi and other consumer lenders will be building credit reserves in anticipation of an extended recession through 2023. Citi’s income was up over 80% sequentially, a legacy of the familiar pattern whereby Q1 of the year is the strongest. The fourth quarter of the year tends to be light at most large banks and especially at Citi. Thus the YOY comparison is less stimulating, with net income up just 7% vs Q1 2022. The same is true with most other banks, with Q1 being the best quarter of the year in terms of income. Most observers continue to focus on deposit runoff at smaller banks as a sign of weakness, but perhaps that focus is misplaced. We remind our readers that the whole point of tightening by the FOMC is for banks to get smaller -- 10-15% smaller on average vs average assets or about $2 trillion smaller for the entire US banking industry. The issue is not whether your bank is getting smaller, but whether credit expenses are being managed as funding costs -- and loan defaults -- inevitably rise. 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.

April 12, 2023 | Premium Service | In this issue of The Institutional Risk Analyst , we provide a pre-earnings look at the top-five depositories – JPMorganChase (JPM) at $3.6 trillion in total assets, Bank of America (BAC) at $3 trillion, Citigroup (C) at $2.4 trillion on balance sheet, U.S. Bancorp (USB) at $670 billion and Wells Fargo & Co (WFC) at $1.8 trillion. As the quarter ends, there is good news and bad news, as we discussed in our previous comment (" Powell's Duration Trap, Banks and the US Treasury "). Yields on loans and securities are rising, but more slowly than hoped. LT yields are falling, in fact, because the FOMC refuses to sell securities from the system open market account (SOMA). Market analysts come up with a variety of clever explanations as to why long-term interest rates are falling, but the gorilla dancing in the center of the room is $20 trillion or so in option-adjusted duration festering, unhedged and passive, on the Fed’s sterile ledger. Imagine where the 10-year Treasury would be today if the FOMC mandated that the Fed of New York bond desk sell sufficient MBS each month to hit the $35 billion cap for runoff. In Q1 2023 earnings, effective hedging strategy or lack thereof will feature prominently. Fed officials have no idea how to quantify their market intervention and banks likewise are left with an insoluble risk equation. To the more attentive, since Q3 2022, the trade has been long duration, as evidenced by the decline in the fair value of mortgage servicing assets (MSRs). The fact that price multiples for MSRs continue to climb even as valuations fall illustrates the pain felt by many issuers still operating in the forward loan markets. If the 10-year retraces to 3% or lower in this cycle, margin calls on negative duration MSRs and short-TBA positions in residential mortgages will start to be a concern. Source: FDIC/WGA LLC Likewise, market volatility in March was extraordinary after the twin failures of Silicon Valley Bank and Signature Bank. The VIX traded over 25 for the first time since October 2022 and for most of the month. Q3 2022 was the start of the present rally in 10s and out for the Treasury curve. Volatility fell back below peak levels by the end of the month, but it is fair to say that modeling these markets remains a challenge. How the largest banks manage their asset-liability risk is one of the more important aspects of earnings in 2023. Look for duration smart results from JPM and USB, among the larger banks, and Mr. Cooper (COOP) and, Rithm Capital (RITM) , the REITs in 1-4s. Of note, significant personnel changes at PennyMac Financial (PFSI) have caused this once leading MBS issuer to step back in terms of pricing in conventional loans. JPM managed to shrink assets in Q4 2022, but loan growth was also low and well-below the 14% growth reported for Peer Group 1. JPM actually shed non-core funding in Q4 even as banks generally saw a massive uptick in the usage of non-core funding in Q4 2022. Was this the clue that the data dependent Fed missed? We think so. The fact that Peer Group 1 averaged a 98% change in the usage of hot money is the proverbial dog that did not bark in the night. NY Fed President John Williams says that he sees no sign of credit tightening, yet the bank data gathered by the Fed suggests otherwise. Net credit losses as a percentage of average assets have been climbing for a year, as shown in the chart below. Source: FFIEC Note that Citi with its subprime consumer lending book has a loss rate 5x Peer Group 1, which is the dark blue line running along the bottom of the chart. Because of the higher credit spread, Citi is a leading indicator. Next below Citi is USB, which also tends to track above the other money center banks in terms of loss rates. Then comes JPM in the middle of the pack. BAC and then WFC have lower loss rates but also inferior operating performance, as we discuss below. The Street has JPM growing revenue by high single digits in Q1 2023, but it is important to recall that the bank’s pretax income was down more than 20% in 2022. The comparison with 2021 was muddied by the favorable GAAP adjustments to income in that year after the huge and unnecessary provisions put aside in 2020. Even if JPM hits the Street’s growth numbers, the bank will still be way behind compared to 2021. A big reason for the difficulty that JPM and other large banks will have in growing revenues has to do with the yield on the loan book, which is only starting to recover from QE. Source: FFIEC Observe that Citi also leads the group in terms of gross yield because of the subprime consumer portfolio. Next is JPM at just shy of 5% followed by the average for Peer Group 1. The rest of the group is still showing yields below peer and just barely above 4% before funding costs and SG&A. Given that the US Treasury is paying 4% for 90-day T-bills, you can see how far banks have to go in terms of asset returns to become competitive. To get another perspective on banks and QE, the chart below shows the return on earning assets (ROEA) as calculated by the FFIEC. Source: FFIEC That the average for Peer Group 1 leads the pack reflects the diverse results of the 132 banks represented in the average. Smaller banks tend to get better pricing on loans than do the larger banks. Context matters, however. Today Peer Group 1 is still a point below the ROEA at the end of 2019. Notice that JPM and BAC are last among the top five banks, illustrating the huge, underperforming securities portfolios of these giants. USB, on the other hand, is competing with Citi for the leadership of the group even though it has a far lower gross spread on its loans. USB managed to grow assets and loans in 2022, albeit because in December it closed the acquisition of MUFG Union Bank's core retail banking operations. Unlike the other larger banks among the top-five depositories, USB is still able to pursue acquisitions. The Street has a lower revenue growth estimate for USB for 2023, but we expect that the Minneapolis-based bank will continue to perform above peer. The chart below shows the efficiency ratios (Overhead expenses/Net Interest Income + non-interest income) for our group and Peer Group 1. Source: FFIEC Peer Group 1 and JPM have the best (lowest) efficiency ratios, which you can think about as the dollar cost of revenue. USB is next, followed by BAC, Citi and WFC, which is in distressed territory above 75% efficiency. A combination of down-sizing and expenses related to remediating various regulatory problems has made WFC well-nigh distressed in recent years. Until WFC management gets that efficiency ratio down into the 60s and keeps it there, we would not take them seriously. Operating efficiency is a simple but effective proxy for the effectiveness of management. Despite the bank’s miserable performance, the Street still manages to be constructive on WFC, showing revenue growth that is seemingly in conflict with recent results. Assets fell 3.5% at WFC in 2022 while loans grew 5%, a remarkable achievement given that WFC exited correspondent lending in 1-4s last year. Only half of WFC’s $1.8 trillion balance sheet is invested in loans, yet the bank managed to keep its mark-to-market losses to less than 10% of capital in Q4 2022. Incredibly, the Street analysts are less constructive on BAC than on Wells Fargo. BAC dropped assets by single digits in Q4 and was below peer in terms of loan growth, two metrics that will not surprise readers of The Institutional Risk Analyst . BAC’s net loss rate is pedestrian, illustrating more the bank’s remarkable torpor more than a deliberate risk management choice, yet losses are rising. Historically, BAC made its earnings by keeping credit losses and funding costs down. But now interest expense is rising faster at BAC than either JPM or USB. We expect further increases in Q1 2023, even if the bank benefits from the flight to big depositories. Seeing BAC right behind JPM in terms of funding costs in Q4 makes us wonder how much different Q1 2023 will look. Source: FFIEC The fact that Citi had an overall funding cost 2x JPM and BAC at the end of 2022 is no surprise since the bank’s net non core funding dependence was over 40% vs 8% on average for other large banks. Despite the double-digit yields on its loan book, the high funding costs at C still result in a lower return on earning assets compared with the other top five depositories. On a risk-adjusted basis, the equity returns from Citi are arguably far lower than say JPM or USB. Maybe that is why the stock is trading 0.4x book. The Street has Citi growing earnings to $7 in 2023 but only $5.8 in 2024? Revenue growth is in low single digits. Given our view that credit is the next course awaiting many banks, Citi bears close attention because of its subprime credit book. In an environment of rising credit costs, Citi’s profile will not look very attractive. Even if commercial real estate exposures are among the worst pockets of risk in the banking world in 2023, banks with consumer facing exposures are likely to be punished further. The bottom line for earnings is shown in the relationship between net income and average assets. The first thing to notice is that the smaller banks are performing far better than their larger peers. This situation is likely to reverse in Q1 2023, however, as smaller banks are forced to drop loan rates and raise deposit rates in order to retain business. Source: FFIEC The good news for all banks is that the huge unrealized losses that caused the failure of Silicon Valley Bank will continue to moderate in Q1 2023. So long as the 10-year Treasury is closer to 3% than to 4% yield, the ugly disclosure of mark-to-market losses will be manageable for most banks. Capital markets activity is unlikely to rebound significantly as LT rates fall, but reduced volatility may help large bank results later in 2023. The bad news is that without active sales of securities from the SOMA, bank asset returns are unlikely to return to pre-COVID levels. As credit expenses rise in Q1 2023 and the balance of the year, banks are likely to see operating income squeezed between higher funding costs and sluggish yields on earning assets. At the end of the day, the spread between operating income and provisions for credit losses is the most important relationship in banking. The Fed's gift to banks in Q1 2023 is dismal capital markets results and constrained asset returns. The asymmetry of Fed interest rate policy between rate hikes and SOMA asset sales is going to create problems for banks until the imbalance is reversed. Source: FDIC 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.

April 10, 2023 | In the next Premium Service issue of The Institutional Risk Analyst to be published this Wednesday, we’ll provide a pre-earnings look at the top-five depositories – JPMorganChase (JPM) at $3.6 trillion in total assets, Bank of America (BAC) at $3 trillion, Citigroup (C) at $2.4 trillion on balance sheet, U.S. Bancorp (USB) at $670 billion and Wells Fargo & Co (WFC) at $1.8 trillion. But first we make a couple of general market comments for all of our readers about the state of the banking industry and the Fed itself after a year of tightening by the FOMC. America’s largest bank, JPMorgan, actually shrank in size 2% in 2022, after growing average assets 10% in 2021 and 25% in 2020 during the “go big” period of QE. In that year, the Federal Reserve Board decided to double the size of its balance sheet without considering the now apparent down-side risks. As a result of the Fed’s ill-considered actions, several large banks have failed and hundreds of billions of dollars of private equity and debt have been destroyed. The total cost of QT to investors and also the US Treasury, however, is likely to be far larger as the tightening process continues. Before the bank liquidity crisis in March of 2023, our expectation was that JPM would continue to shrink in Q1 2023, but now it's likely that the largest bank in the US actually grew in 2023. Even as the size of the money center banks increased during the period of massive bond purchases by the FOMC, the book value multiple of these stocks has declined, a grim testament to the negative impact of QE on banks and investors generally. Notice that subprime lender Citi has been punished by investors, while JPM and USB lead the group. In that sense, nothing has changed in five years. Source: Yahoo, Bloomberg A couple of general observations about the group are in order. First, the Fed’s quantitative easing (QE) policy seems to have retarded lending even as banks grew in size. As banks now shrink in the world of post-QE and higher short-term interest rates, it is unlikely that we shall see significant loan growth or spread expansion. Total loans and leases held by all US banks rose 7% in 2022, but loan portfolios actually fell over the past five years vs total assets. Source: FDIC In March 2023, the Fed expanded its balance sheet by several hundred billion dollars to accommodate the cash needs of scores of smaller depositories following the collapse of Silicon Valley Bank and Signature Bank, as shown in the chart below. This extension of credit to banks was far smaller than that provided in 2008-2009, however, and the system open market account (SOMA) is already starting to decline, at least in nominal terms. Source: Board of Governors Since the Fed’s balance sheet is theoretically running off around $90 billion per month, including $60 billion in Treasury debt and an uncertain amount of mortgage-backed securities , the Treasury will eventually need to issue new bills and notes to refinance these redemptions. Because prepayments on MBS generally are very low , the redemptions from the SOMA are running well-below the $35 billion cap. The Fed’s projections for portfolio runoff are as shown in the chart below. Notice that the MBS barely declines. The green area shows MBS and CMBS held by the SOMA. The residential MBS have a weighted average coupon (WAC) around 3%, These same MBS have a weighted average maturity (WAM) in excess of 15 years or 5x the WAM at the time of issuance in 2020-2021. As a result, we think projections of the rate of runoff of MBS from the SOMA are still too optimistic. Actual compounded prepayment rates (CPRs) are running in low single digits vs the 6% CPR minimum assumed in most commercial prepayment models. "There is absolutely no way that homeowners are going to give up those 3% mortgages that went into UMBS/GNMA 2% 30r bonds," notes reformed mortgage banker and entrepreneur Alan Boyce . "The Fed will have to actively sell the MBS at a big loss to make the QT goals. All the regional banks have the same issue, you will lose the money now by selling or over time via negative carry," says Boyce. Boyce notes that there is almost 100bp spread between the WAC on the mortgage loan and the bond coupon. "Half is a forever annuity held by the GSEs and the rest is massively undervalued as a mortgage servicing right (MSR) held by a mortgage bank," he observes. "Ironically, Basle III treats the MSR as an intangible in the same category as tax loss carryforwards. MSRs trade at a lower CAP rate than commercial real estate! The Fed screwed the financial system, forcing them to stuff their balance sheets with low Risk Capital Weighted assets like MBS while eschewing the best cash flows." Simply stated, US banks are caught in a vice between rising short-term interest rates and the Fed’s $16 plus trillion effective long duration position in Treasury debt and MBS. How can SOMA be approaching $20 trillion in effective, duration adjusted size when the Fed’s own data show a nominal value just shy of $9 trillion today? Because of the extension risk of the MBS, risk that now resides inside every mortgage portfolio in the US. The mortgage bonds owned by the Fed, which had an effective average life of 2-3 years at the time of issuance during QE, are now closer to 20 years when measured against actual prepayment rates. CMBS, which are generally interest-only affairs, where principal is rarely repaid and refinancing is assumed, are also extremely sensitive to changes in interest rates. The cool chart below from the Bloomberg terminal shows the index of modified duration of Ginnie Mae securities over the past five years. In one striking image, we can see the true idiocy of QE and now QT as formulated by the FOMC. The huge manipulation of the duration of mortgage exposures by the FOMC caused the failure of Silicon Valley Bank and has badly damaged dozens of other banks. Source: Bloomberg Notice that after the market break in December 2018, the FOMC under Powell started to flood the markets with reserves based on the untested idea that this would preclude further market mishaps. This judgment turned out to be badly wrong, however, and forced the FOMC to spawn various band aids such as Reverse Repurchase Agreements to keep the money markets from imploding. The FOMC pushed down the effective duration of MBS from the LT average of 6 (think of duration as the average time required to recover principal) down to three by the end of 2019 via massive market purchases of Treasuries and MBS. With the onset of COVID, the FOMC doubled down, driving the effective duration of Ginnie Mae MBS further down to 1 from Q1 2020 through Q1 2021. In March of 2020, T-bill rates were effectively zero. Between Q1 of 2020 and Q1 of 2021, the US mortgage market originated over $5 trillion in new, low coupon mortgages with an average duration of say 1.5 at the time of issue. That's 40% of the entire residential mortgage market in 12 months. Those 2% and 3% MBS are now trading on average durations closer to 6 with weighted average maturities closer to 15-20 years. The average index value for new production MBS, securities with 5.5-6% coupons, is now back to a duration of 6. Let's consider the example of Silicon Valley Bank (SVB). At the end of 2019, SVB, has about 25% of assets invested in MBS with a duration of ~ 6 and a WAM of 5-6 years. By the end of 2020, SVB had taken its MBS position up to 33% of total assets, but half of the MBS portfolio had prepaid during that first big year of QE. Now the SVB MBS portfolio had a duration of ~ 3 and a WAM of perhaps three years. Source: FFIEC By the end of 2021, another 50% of the SVB mortgage portfolio had prepaid, but the bank's management had purchased even more, lower coupon MBS, to take the total position up to over 45% of total assets. This MBS position had sharply lower cash flows, duration now approaching 2 and a WAM of perhaps 2 years. The volatility of the SVB MBS portfolio had now doubled compared to the end of 2019 and the cost of hedging had likewise increased dramatically. Q: Did the management of SVB realize that they had killed the bank a year before it actually failed? It seems not. Of note, the Federal Reserve Bank of New York states in a February 2022 staff paper : “Because MBS pay fixed coupons to investors and typically have 30-year maturities, duration is high and prices are very sensitive to interest rates. A key distinguishing feature of MBS is that the duration of the security is not fixed but rather uncertain because borrowers can prepay their loans at any time.” The problem now for banks and the Fed itself is that virtually no borrowers are prepaying COVID era mortgages. The MBS that were being priced off of the 5-year Treasury note in 2021 are now priced off of the 15-year portion of the Treasury yield curve and extending. And even as the rally in the 10-year helps the mark-to-market on Treasury bond portfolios, the prepayment behavior of low coupon MBS may not change very much. The 3% jumbo we have sitting in a Fannie Mae high balance pool vintage March 2020 is not going anywhere, thank you. The table below illustrates the SOMA holdings as of April 3, 2023 and the crude adjustment by WGA LLC to illustrate the market impact of the Fed’s MBS and commercial mortgage holdings. Fed Chairman Jerome Powell told Congress in his recent testimony that the SOMA portfolio is running off, yet in duration adjusted terms, the SOMA is actually growing and is now 2x the notional amount. Source: Board of Governors, WGA LLC The 10-year T-note closed on a yield of 3.3% on Friday. The passive, unhedged portfolio of Treasury and mortgage debt on the books of the Fed is a dead weight on private markets and banks that holds yields down. QE took banks and the bond investors short duration to a massive degree. This has negative implications for bank loan yields and earnings going forward. Until the FOMC decides to actually sell MBS outright from its portfolio, it is unlikely that long-term benchmark interest rates such as the 10-year Treasury note will rise and remain above 3.5%. We see little indication that the Powell FOMC is willing to change policy. First and foremost, the Fed is already losing so much money on its own duration mismatch that it dares not entertain outright asset sales from the SOMA. Yet the markets remain short duration, so much so that even the prospective sale of almost $100 billion in Treasury securities and MBS by the FDIC Receivership is unlikely to impact market yields. New MBS origination volumes are so low that $100 billion barely moves the needle in terms of market supply. As a result, bank loan yields are unlikely to expand sufficiently to keep pace with funding costs unless the FOMC begins to sell MBS from the SOMA. The final thought is credit, the one thing that nobody has needed to worry about over the past decade because of QE. The Fed’s purchase and sequestration of trillions in duration forced asset prices up and net loss rates down, resulting in negative credit loss rates for much of secured finance. Now everything from auto loans to CMBS and C&I loans and residential MBS are rapidly reverting to long-term average loss rates. The illusion that credit had no cost, created by QE in 2020-2021, is now fading from view. Note in the chart below that net-charge off expenses for prime auto loans owned by banks bottomed out at zero in Q2 2021. Source: FDIC Cost of QE & QT to the Treasury As we’ve noted previously, both US banks and investors, and the Federal Reserve System, have two problems. The first problem is the ugliness of unrealized losses on securities that were bought during 2020-2021 and after. Even though the rally in the Treasury bond market off the lows of Q3 2022 has reduced the size of the negative mark-to-market for many banks and the Fed itself, this is more of a disclosure issue than an immediate concern. The second and more serious problem, however, is cash flow. Many banks and investors, and the Fed itself, are losing money because the coupons from those Ginnie May 2s and 2.5s from the period of QE are several points below the cost of funding in today’s market. The Fed is paying 5% on reserves and reverse repurchase agreements with cash from a portfolio of low coupon Treasury, agency and mortgage securities. Our friend Allex Pollock reflects on the Fed’s growing cash operating losses in his latest column in the New York Sun : “The Federal Reserve’s new report of its balance sheet shows that in the approximately six months ended March 29 it has racked up a remarkable $44 billion of cumulative operating losses. That exceeds its capital of $42 billion, so the capital of the Federal Reserve System has gone negative to the tune of $2 billion — just in time for April Fools’ Day. This event would certainly have surprised generations of Fed chairmen, governors, and, we’d have thought, newspapermen. The Fed’s capital will keep getting more negative in April and for some long time to come, at least if interest rates stay at anything like their current level. The Fed in the first quarter of 2023 reported losses running at the rate of $8.7 billion a month.” It is worth noting that the actual cash operating losses incurred by the Fed are, in fact, losses to the US Treasury. There are many people in Washington and particularly in the national Congress who naively assume that the remittances from the central bank represent “revenue” to the United States. In fact, much of the Fed’s revenue is merely the return of the Treasury’s own funds – less the Fed’s operating expenses. The interest and principal payments made on Treasury debt are clearly the assets of the United States held by the central bank. The Fed's confiscation of tens of billions in private interest and principal payments on MBS merely confirms the fact that the Treasury was the primary beneficiary of QE. We discussed this issue of the relationship between the Fed and Treasury with Robert Eisenbeis of Cumberland Advisors in a 2017 interview (“ Bob Eisenbeis on Seeking Normal at the Fed ”): Eisenbeis: When you look at the research on QE, the opinions are all over the map both inside and outside of the Fed. I think there is a consensus that there were diminishing returns in the additional QEs that were engaged in after QE1. Then it’s a question of what are the costs and benefits of getting out of the program. Those who suggest that QE has been a huge success are premature in my view. You don’t really know until we are completely out. It looks to me like we are going to be OK on balance, but what really bothers me is this constant drum beat inside the Fed and by some outsiders about the huge “profit” earned from QE. They have the accounting all wrong. The IRA: Well, the board is aligning itself with the idiocy on Capitol Hill, where the interest earned by the Fed is viewed as “income” for budget purposes. Most members have not read your 2016 testimony on the Fed's fiscal relationship with Treasury . But Bob, really, is it possible that PhD economists don’t understand the financial relationship between the Treasury and the central bank? We always like to remind people that the US Treasury issued the original $150 million in greenbacks directly into the market to help President Abraham Lincoln fund the Civil War. The Fed is the Treasury’s alter ego and is an expense to the government, which is subtracted from the earnings on the portfolio and then returned to the Treasury. Eisenbeis: Correct. The Fed almost by definition cannot make a profit. It baffles me how people inside the system can fail to see the accounting reality here. The Fed issues short term liabilities to buy Treasuries taking duration out of the market. The Treasury makes interest payments to the Fed who takes out its operating costs, including interest payments on reserves and returns the remainder to the Treasury. If this intra governmental transfer were settled on a net basis like interest rate swaps, there would always be a net payment from the Treasury to the Fed. It is too obvious, yet I am not privy to the sidebar conversations on this issue.” So given the costs to the banking sector and investors more generally of the Fed’s policies of QE and now QT, and given the Fed’s growing operating losses, should we worry about the Fed running out of cash? Will cash operating losses force the FOMC to sell securities to raise cash? In this vein, we have a suggestion for a question at the next FOMC press conference. Here goes: "Mr. Chairman, historically the Federal Reserve System has not presented a Combined Statement of Cash Flows as required by GAAP because, to quote the 2022 financials, “the liquidity and cash position of the Reserve Banks are not a primary concern given the Reserve Banks' unique powers and responsibilities as a central bank.” Given the Fed’s mounting cash operating losses and the cost this implies to the US Treasury as a result, will the Federal Reserve Board commit to release statements of cash flows for the years from 2020 forward?" 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. 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