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"For the first time in more than two decades, some of the world’s most risk-free securities are delivering bigger payouts than a 60/40 portfolio of stocks and bonds." Bloomberg March 2, 2023 | Premium Service | This week , Goldman Sachs (GS) CEO David Solomon as much as agreed with our analysis of the past several years and suggested that the loss-leading consumer banking business may be sold. Some observers are suggesting Solomon may likewise head for the door, but with $25 million in compensation for 2022. Going through the investor materials from GS this week, the amount of actual substance in the documents seems to have declined to a new low, while marketing hype and general statements now predominate. There is little actual objective information for investors in much of the GS marketing materials. As Solomon and his colleagues admitted at the investor day, GS is a securities dealer first and foremost and has no comparative advantage as a bank. Funding costs are too high. Meanwhile, as discussed below, even as Solomon backs away from the retail strategy and related credit expenses, GS is adding new C&I exposure in residential mortgage and Ginnie Mae. Rocket Mortgage (RKT) just confirmed that the market for residential mortgage lenders is becoming extremely difficult, reporting a nearly $500 million GAAP loss. The unexpected departure of CEO Jay Farner puts a big question mark over RKT and the entire industry, which uses RKT as an important comp in valuation models. Notice in the table below that in 2022 RKT took a $1.2 billion negative mark on its mortgage servicing rights (MSR), net of the hedge , which was clearly ineffective. Rocket Companies Volumes for 2022 were down over 60% for RKT, much like the rest of the industry. GAAP income was likely down sharply, with adjusted net loss of $136 million vs a profit of $4.5 billion in 2021. Earnings before interest, depreciation and amortization (EBITDA) was just $59 million in 2022 vs $6.2 billion in 2021. Likewise, wholesale market leader United Wholesale Mortgage (UWMC) reported a $62 million loss in Q4 and a sharp decline in EBITDA, as shown the table below. Notice that UWMC does not pick up much ground with its adjusted net income. Despite being in the midst of a price war that has cut margins in half, UWMC predicts expanding gain-on-sale margins next quarter. Is the price war in wholesale lending over? United Wholesale Mortgage Corp In our previous note (“ The Return of Credit Risk ”), we highlighted the warehouse lenders and other liabilities of PennyMac Financial (PFSI) , which holds all of the Ginnie Mae exposures in the group. The REIT, PennyMac Mortgage Trust (PMT) , holds the conventional assets and is managed externally by PFSI. GS is shown as a relatively small lender to PFSI. PennyMac Financial Services Given the low volumes in the industry, it is likely that the group of lenders shown above will be pared back in 2023. Wells Fargo (WFC), for example, is likely to exit the mortgage market this year. But the most important question is what happens to PFSI as the MSR financings that are covered by the variable funding note facility of Credit Suisse (CS) and Citigroup (C) roll off? GS is already involved in the new financing that was completed by PFSI last month with GS involved as administrator and standby lender. The question comes as to how large is GS willing to take its exposure to PFSI and also Rithm Capital (RITM) . The firm completed the acquisition of a residential lender, Genesis, from affiliates of Goldman Sachs in 2021, as well as an associated portfolio of loans originated by Genesis. RITM is a REIT that is also the largest owner of Ginnie Mae MSRs and excess servicing, as well as many other assets. Subsequently, RITM reportedly moved their MSR financing business from CS to GS, this in apparent anticipation of the exit from the market by CS and the sale of that bank’s structured finance group to Apollo (APO) portfolio company Atlas . APO apparently was willing to manage but not buy the $20 billion or so in Ginnie Mae related loans and other assets. CS also owns a $250 million non-agency MSR managed by servicer Select Portfolio Servicing (SPS) . GS does not mention the words “Ginnie Mae” at all in its latest 10-K nor did they speak about the expansion into lending to Ginnie Mae issuers during investor day. RITM mentions GS only twice in their most recent 10-K and then only in connection with the Genesis transaction. The summary of the outstanding debt of RITM is shown below. Roughly half of RITM’s debt ($4.8 billion) is MSR financing that was structured and facilitated by CS. Will GS pick up the slack? Rithm Capital The RITM MSR financing includes $3.0 billion of MSR notes which bear interest equal to the sum of (i) a floating rate index equal to one-month LIBOR or SOFR, and (ii) a margin ranging from 2.5% to 3.3%; and $1.8 billion of capital market notes with fixed interest rates ranging 3.0% to 5.4%. The outstanding face amount of the collateral represents the UPB of the residential mortgage loans underlying the MSRs and MSR Financing Receivables securing these notes. As you can see, the rate on the RITM floaters has gone up substantially since issuance, but how and at what rate this debt can be refinanced even at current yields is up to question. Also, notice that the notes are not secured by the MSR, which can evaporate as was illustrated by the default of Reverse Mortgage Funding . The entire RITM MSR was valued at 165bp at year-end 2022, roughly 5-5.5x cash flow. Big picture: For the past decade, CS was the advisor to and facilitator of the market for financing Ginnie Mae MSRs, including providing a bank to back the crucial standby financing facility for these deals that satisfied the concerns of Ginnie Mae. Now the baton is being passed to GS and/or Citi to some degree or another, but it remains unclear just how much of a commitment the $1.5 trillion asset Goldman Sachs can or will provide. At the same time, however, C&I lending grew over 40% at GS in 2022 and we suspect a good chunk of that represents new exposures to Ginnie Mae issuers. Morgan Stanley (MS) , which has historically been involved in financing mortgage assets such as conventionals and jumbos does, not seem at all interested in banking independent mortgage banks in the Ginnie Mae market. Citibank might seem a logical choice, but they have neither the operational team nor the support from the CSUITE to dive back into the world of financing Ginnie Mae assets beyond their current level of involvement. As we’ve noted before, GS has no comparative advantage as a bank lender because of the high funding costs for the organization. This shortcoming includes lending on government loans and MSRs, a high-risk activity. Yet GS says in their 10-K that the FICC group lending: “Includes secured lending to our clients through structured credit and asset-backed lending, including warehouse loans backed by mortgages (including residential and commercial mortgage loans) , corporate loans and consumer loans (including auto loans and private student loans).” The strange nature of the government mortgage market means that you cannot create a perfected security interest in either the mortgage notes or the attached MSR, meaning that as a lender you rely solely on the credit of the obligor. Thus the GS loans to RITM, PFSI and other Ginnie Mae issuers are, in fact, unsecured. Without a substantial lending and servicing operation behind you, like those found at large depositories like the Flagstar unit of New York Community Bank (NYCB) , we have significant doubts about whether any bank should be involved in lending against Ginnie Mae assets. Perhaps this is why GS has reportedly found few other banks willing to accept syndications on these new Ginnie Mae exposures. Other lenders can see the mounting delinquency in Ginnie Mae pools and are preparing accordingly. Stay tuned. Disclosures: L: CS, CVX, NVDA, WMB, JPM.PRK, BAC.PRA, USB.PRM, WFC.PRZ, WFC.PRQ, CPRN, WPL.CF, NOVC, LDI 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.

February 23, 2023 | God does have a sense of humor. President Joe Biden is campaigning for a second term. He moved Fed Vice Chair Lael Brainard to the White House to beef up the economic team. This is not so much a sign of strength as profound weakness, running scared , in fact. As the US economy heads into the worst period of credit loss since 2008, the primary victims will be lower income Americans, the core constituents of the Democratic Party. The Federal Open Market Committee minutes released Wednesday state that the “credit quality of households also remained strong, on balance.” Well, not all households and not all businesses. The lower-income households that got the worst of COVID are about to be clobbered by the Powell FOMC, along with much of the world of secured finance. Most people think first about residential mortgages, the largest sector in secured finance. But this time around commercial assets play a starring role. Because of the sharp increase in short-term interest rates, nonbank lenders from mortgage companies to commercial real estate conduits are facing negative carry on their assets. Many firms are simply choosing to liquidate positions and shut-down. This hardship is a direct result of the fact that the Federal Open Market Committee models monetary policy vs GDP, and not based upon the impact of the Fed's actions on the private economy. Dr. Brainard participated in and endorsed this policy by the FOMC. In the world of dynamic stochastic general equilibrium (DSGE) models, where FOMC members spend most of their time, the real world is an abstraction. It may seem reasonable to FOMC members to move short-term rates 500 basis points in 12 months, but in the world of secured finance, which is governed by short-term interest rates, such a magnitude change implies a disaster. Bloomberg recently reported, for example, that issuance of commercial mortgage-backed securities (CMBS) is down 80% YOY, an indication of mounting liquidity problems. Fed bank stress tests don't assume a swing in credit expenses of several standard deviations. When you see new, non-Treasury and agency debt issuance come to a halt in Q1 2023, that is the signal the sun-dried credit soretes are about to hit the economic fan blades. “A Brookfield fund delivered a small shock to the US CMBS market last week after it defaulted on two top-tier office towers in Los Angeles,” IFR reported . There are many more actual and maturity defaults coming in CMBS as issuers are unable to roll maturing debt. The decline in new asset-backed securities (ABS) issuance shown in the chart below includes all types of asset-based financing other than mortgages. The MBS series includes residential and CMBS. Source: SIFMA Across the world of credit from commercial real estate, delinquency in auto loans and credit cards is climbing back to pre-COVID levels, a function of the interest rate shock that the FOMC has administered to the US economy over the past year. Loss given default on bank credit cards has been rising since the end of 2021. We expect to see this key indicator back to pre-COVID levels by June. Delinquency on the $1 trillion in bank credit cards is likewise rising, especially among younger consumers. Source: FDIC/WGA LLC Across town from the Federal Reserve Board, the Federal Housing Administration has just announced a cut in the insurance premium for government loans. This is an amusing development since it harkens back to similar late-stage efforts to pump up housing going back to the Presidency of Bill Clinton . But of course, President Clinton long ago left the building in favor of woke socialism and foreign wars under Joe Biden. The good news is that the default rate on FHA loans was back into double digits in December. The bad news for President Biden and his team is that the default rates on the bottom 20% of borrowers in the subprime FHA market are in the mid-teens and climbing. Neither the big media nor their economist brethren know of what we speak, but a bad credit tsunami is heading for the Biden White House. The table below is from the MBA and the FDIC. Notice that the average delinquency of FHA loans jumped 200bp in Q4 2022. Extra credit question: If FHA defaults are over 10% today, where will they be in June of 2023? December 2023? From a top-level perspective of an economist working for the Board of Governors in Washington, the housing industry looks OK, but if we sift into the different strata of loans, the picture quickly starts to darken. Ponder the world of 1-4 family loans from the perspective of one wizened industry veteran, who spoke to The IRA after the servicing conference in Orlando, FL. Source: MBA, FDIC The top $10 trillion in terms of credit quality is basically the bank portfolio and the upper distribution of GSE loans. On the surface, credit is still good and loss-given default for bank owned 1-4s is still negative. Credit costs are increasing, however, as home prices fall. The top half of the $2 trillion government market features default rates about 3x the GSE market and growing, but still no crisis – yet. In the bottom $1 trillion of the Ginnie Mae market, however, default rates are soaring into the teens and new low-FICO loan product is being added every day. Figure that loans made since 2020 will be underwater in the next downturn, notes the veteran operator and lender. And, of note, the period of ultra-low interest rates allowed hundreds of thousands of FHA borrowers to migrate into the conventional loan market. When the default rate on a Ginnie Mae MBS portfolio goes above 6%, the cost of loss mitigation generally consumes 100% of the servicing income on the portfolio. We are there now. By the end of the year, the Biden Administration is likely to be facing a growing financial crisis in the government mortgage market focused on lower-income households. Unlike 2008, there is no bank capital or subordinate debt in private MBS to stabilize sagging credit markets. Thanks to Senator Elizabeth Warren (D-MA) and the other woke socialists in Congress, the largest banks led by JPMorgan (JPM) and Wells Fargo (WFC) have largely withdrawn from direct exposure to the government market. As we have discussed in the Premium Service , Credit Suisse (CS) , is headed for the door, leaving the government market financed by a shrinking group of lenders. So far, JPM and WFC remain committed to the mortgage sector even though they have largely withdrawn from purchasing loans from correspondents. The table below shows the warehouse lenders to PennyMac Financial (PFSI) from the new 10-K. Ask yourself a question: How many of these banks shown above will even be doing warehouse lending on government assets at the end of 2023? And if CS exits the mortgage sector, who will pick up the slack with Citibank, N.A. on the PFSI warehouse line? Hmm? We will be describing the latest doings in the world of wholesale mortgage finance in a future issue of The IRA . Even as financing capacity falls, the backlog of defaulted loans is growing inside government guaranteed MBS. Many servicers cannot afford to buy the delinquent loans out of the pools. Unlike two years ago, when early buyouts of defaulted government loans were a source of industry profits, today these same loans are a growing burden on limited liquidity. The portion of FHA loans below 650 FICO is becoming a serious problem in the industry, with no sign of support or financing for loss mitigation coming from the Biden Administration or the Fed. Some industry leaders, in a meeting this week with Ginnie Mae President Alanna McCargo , reportedly suggested government-guarantees on financing for defaulted, government insured loans. This is a good idea but impossible given current law. Today delinquent government loans must be financed privately and usually at a significant cash loss to the servicer. Residential loan servicers are paying SOFR plus two for default advance funding. The liquidity crisis in housing will only get worse so long as the FOMC keeps rates at or above current levels. McCargo and her team at Ginnie Mae will need a lot more attention from the Biden White House and the Powell Fed if disaster is to be averted. Once Dr Brainard is in the saddle at the White House, you can bet that she will talk about how well the economy is doing despite the substantial increase in interest rates -- an increase that she supported over the past several years. Fact is, Dr. Brainard has primary culpability in the growing economic pain being felt around the country. When all is said and done, Joe Biden might have done better to pick an economic champion who was not one of the architects of our shared misery. 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.

February 20, 2023 | Premium Service | Looking at the constituents of our FinTech Surveillance list, the top performers in the past year include a combination of old and new, but virtually none of the high-flying names from the 2020-2021 period. What a difference a year makes. But a battle ranges between hungry buyers and reluctant sellers in the world of private fintech capital finance. In particular, should budding private fintechs trade at a premium to the public comps? And what about the selective disclosure of financial data? Source: Bloomberg The top performers in our group include legacy payments platform Fiserve (FISV) , Latin American e-commerce platform Mercado Libre (MELI) , cross-border money transfer service Wise plc (WISE) and Envestnet (ENV) , the provider of wealth management software and services in the United States and internationally. The rest of the group have only begun to enjoy any lift from the rally in equities since Q4 2022. Here's the question: If public comps like Block Inc (SQ) are down by two thirds vs last year, what is a cash eating private fintech like Stripe worth? Beneath this high-level distinction about public vs private discounts, however, there are additional layers and nuances for understanding valuations among emerging financial technology companies. Although there are some significant differences between the players, the headline is that QT is crushing the aspirational stocks and forcing many to take shelter in a bank license. Among the more important points for readers of The Institutional Risk Analyst to consider, however, is whether being a bank is good or bad for forward fintech valuations. Check out the chart of MELI vs SQ below. Source: Google Finance The changing tenor of the high-yield debt markets have contributed to the sharp reversals suffered by once high-flyers like Affirm (AFRM) and Upstart (UPST) . AFRM continues its strange journey of value destruction, reporting a $359 million operating loss on just shy of $400 million in revenue. The $300 million in stock-based compensation and warrant expense at AFRM is a big part of the problem. The chart below comes from the AFRM Q2 2023 earnings report since, in keeping with the outlier profile of the firm, the company reports on a June 30 fiscal year. Clearly the market does not seem to like the AFRM story at present, but the insiders don’t seem to care about the ugly optics. Perhaps there are so few fintech opportunities in the market today that such behavior makes sense? Funding expenses and credit loss provisions at AFRM have doubled year-over-year on modestly higher revenue. AFRM likes to present its financials net of credit provisions, as though this canard will make us feel better about deteriorating trends in the credit markets. Marvelous. A number of the firms in our group have become depositories over the past several years, leading one veteran fintech manager to opine last week that the banks in the group are no longer attractive. “Once a FinTech becomes a bank, it has essentially surrendered the possibility of a tech multiple,” the veteran manager told The IRA . True enough. Fintechs morphing into banks can be seen as an expensive act of surrender, but many PE managers look forward hopefully to an eventual IPO by Irish-American payments provider Stripe, Inc . Is either AFRM or Stripe a good bet to survive the next year in nonbank finance? We'll see. With sectors from commercial mortgage backed securities (CMBS) to HY debt going into hiding, where do investors look for exposure to new technology in finance? Stripe Valuation Sinks Goldman Sachs (GS) and JPMorgan (JPM) are reported to be leading a new capital raise by Stripe on a $55 billion valuation, in part to cover the cost of expiring stock options for employees. The sharp increase of interest rates has cut off the IPO hopes of firms like Stripe and left employees with big tax bills on stock awards. “In the case of payments group Stripe,” reports FT , “[restricted stock units] worth millions of dollars will start expiring from 2024 and risk being forfeited unless the company buys them out, changes the terms of the awards or launches an IPO.” The Stripe CSUITE, which operates from offices in South San Francisco, is shown below. During the hyperbolic days of the 2020-21 period, Stripe apparently raised money at valuations near or above $100 billion, thus the $55 billion headline being used in marketing materials is a significant concession and perhaps not the last. Q: If Stripe does a down round at half of the previous 2021 valuation, what happens on the next round? GS is said to be working to orchestrate the raise for Stripe, which is apparently unprofitable and is expected to need multiple future funding rounds, according to Bloomberg . Somehow, having GS fronting for this transactions does not give us a warm feeling inside . The choice of banker says a great deal about the issuer. While Stripe does not disclose financial information, it has reportedly raised $2 billion in almost two dozen funding rounds since the company’s inception in 2011. Stripe was also an active venture investor in other startups, but we suspect that there will be fewer such flutters in the future. Stripe volume was reported to be north of $800 billion in 2022, but there is no public confirmation of the firm’s revenue or profitability -- unless you have special access to the company. Given the sharp decline in revenue across the fintech space, no surprise that industry publications say that Stripe burned through hundreds of millions in cash in 2022 . Bloomberg (2/16/23) reports that Stripe lost $80 million in 2022, but CEO Patrick Collison is guiding investors and the media to a $200 million profit in 2023. Really? Selective disclosure of material financial information ring a bell? Stripe currently employs around 3,500 worldwide, but this figure varies depending on the media source. If we use the fintech premium average cost per full time employee (FTE) (~$240k) in line with SQ and GS, you’re looking at a billion annually in direct personnel costs alone. Like many tech firms, Stripe was frantically hiring in 2020-2021, but that process ended in November when co-founder Patrick Collison laid off 14% of the company’s staff. Again, reports of the scale of the pre-Christmas slaughter at Stripe vary. Of note, Stripe apparently engages “in SMB lending,” an activity like that of AFRM and UPST with a very different funding and risk profile to merely facilitating payments. We can’t wait to see some financials for this company. If Stripe is dumb enough to compete with ABS customers, they deserve the same fate. More, should Stripe in fact require several rounds of additional funding to get from unprofitability to profits and stability, that is a worry. The focus of recent fintech entrants to ensuring the profitability and convenience of insiders, makes these firms less attractive as investments. In the present financing environment, Stripe would be lucky to get a deal done at $55 billion. But let us not be too harsh just yet. On the one hand, Stripe is the plat de jour among early-stage funds. These funds need a “next thing” in payments to go into the portfolio and Stripe fits the bill. Stripe figures in breathless descriptions of the industry opportunity that include SQ, Visa (V) and PayPal (PYPL) . Yes, the barriers to entry in payments, especially owning and operating your own rails, are high. So is the level of competition from nonbanks such as Stripe, newly minted banks such as SQ and PYPL, and legacy moneycenter banking firms. Many of the newbies in fintech like SQ, for example, are still trying to grow into true profitability and stability. None have a significant bank deposit base or the sort of low funding costs that true retail deposit funding provides to managers and shareholders. Notice that Stripe just announced a new scheme to partner with WPP (WPP) to “to develop new commerce and payments solutions on behalf of joint clients.” Really? Whenever we see operators of new businesses spending happy time with public relations firms, we take that as a sign of weakness and coming instability. 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.

February 16, 2023 | A reader of our friend Rob Chrisman recently chastised us for being “wrong” about double digit mortgage rates . In fact, when mortgage rates peaked in October of 2022, the loan coupons on high-LTV, low FICO conventionals and jumbos were well into double digits. As the headline rate for a FHLMC 30-year fixed coupon loan peaked over 7%, lenders were losing money on almost every loan. And they still are, but hold that thought. As we’ve noted previously in The Institutional Risk Analyst , thanks to the machinations of the Federal Open Market Committee, some two-thirds of the $13 trillion in agency and government mortgage-backed securities have coupons between 2% and 4%. Rates have to fall a lot from present levels before any of the loans inside these MBS are in the money to refinance. Given the impact of QE on the distribution of existing residential mortgage loans, you can appreciate that mortgage lenders currently have a stronger bias that normal toward lower interest rates. Thanks to the Fed's manipulation of the mortgage market during 2020-2021, lenders are going to continue to set rates below economic levels for months to come. The FOMC-induced movement of short-term and long-term interest rates over the past year has left the term structure of interest rates a complete mess. Normally the note rate on an MBS is a point below the mortgage loan coupon that the consumer pays. The difference pays for servicing, other fees and maybe a small profit for the lender to recoup some of the expenses incurred making the loan. In today’s market, however, lenders are setting coupon’s below 6% on those prime, 20% down loans, and then selling these mortgage notes into a 5.5% MBS for delivery in the too-be-announced (TBA) market next month. Many smaller lenders who do not have access to term financing must also sell the mortgage servicing right (MSR) to recoup some of their cash losses. As you can see in the snapshot below from the Bloomberg , a 5.5% TBA for March delivery is trading near par. During COVID, the on-the-run MBS was trading at 103-104. So when you as a lender sell that ~ 5.875% loan into a TBA 5.5%, you mostly lose money. Instead of writing loans in the high 5s, lenders should be writing loans with 7% coupons. Source: Bloomberg The negative impact of the Fed’s action on housing finance and the larger corporate debt market cannot be overestimated. Bloomberg reports that “a wall” of $6.3 trillion in debt is coming due by the end of 2025. Much of this “debt” will be turned into equity via restructuring. The same volatility that has left many banks insolvent on a mark-to-market basis has also left a number of corporate borrowers in similar circumstances, with refinance levels hundreds of basis points above the coupon on existing debt. The ebb and flow of interest rates, as a result, has become the primary directional indicator for stocks with exposure to interest rates, either directly or indirectly. When interest rates peaked in Q4 2022, the financials proceeded to rally and spreads on everything from corporate debt to mortgage loans eased. Just as mortgage lenders continue to dream of rates in the low 5s, corporate treasurers likewise are hoping for a chance to refinance liabilities at lower cost. The fly in the proverbial ointment is credit, both individually and collectively. The Treasury is headed for a default by mid-year if the Biden Administration and Congress cannot agree on a budget deal. More important, credit costs are rising pretty much across the board as consumers and corporate issuers run out of COVID cash. Banks have begun to re-price assets that were created during the pandemic. Emerging companies are now submerged in terms of access to new credit or even repricing existing debt. In addition, the impact of COVID on the reality and the presentation of GAAP earnings is a big negative eroding investor sentiment in terms of credit. The YOY comparisons for many financials, for example, are truly ghastly. Whereas Fannie Mae received a $5.1 billion benefit to earnings from returning COVID credit reserves back to income in 2021, last year Fannie Mae put aside $6.3 billion for future credit losses and related expenses. Fannie also reported $300 million in losses on “significant decrease in the market value of single-family loans that resulted in valuation losses on loans held-for-sale as of December 31, 2022, as well as lower prices on loans sold during the year.” Look for this number to go significantly higher. Like many banks and corporate issuers, the GSEs have significant unrealized losses on low-coupon assets created during COVID. The narrative on Wall Street continues to focus on the pace of Fed short-term rate increases, yet in fact interest rates beyond four years continue to fall. Beyond ten years, dollar swaps continue to move lower. The bond market rally pushed stocks higher and some credit spreads lower through the end of January, but the short-end of the curve has lifted since that time as the reality of higher for longer sinks in for equity managers. The big surprise for the Buy Side will come when the FOMC breaks with the “soft landing” narrative and pops a couple more 50bp rate increases to get SOFR closer to 6% than 5%, where the consensus currently sees the rate hike pain ending. When Cleveland Federal Reserve Bank President Loretta Mester said that there was a “compelling” case for a 50bp hike in January, the markets trembled. “At this juncture, the incoming data have not changed my view that we will need to bring the fed funds rate above 5% and hold it there for some time,” Mester said. The Cleveland Fed President will make a great Fed Chairman one day. Everyone from President Joe Biden to the CEOs of a lot of heavily over-leveraged corporate debt issuers are betting Mester is wrong. But fact is, if the Fed continues to hike short-term interest rates and eventually forces longer maturities higher, the cost in terms of credit will be as outsized as was the move lower in rates during COVID. Source: FDIC/WGA LLC Bottom line: As the FOMC moves short-term rates towards 6%, we expect to take another run at double-digit rates for prime residential mortgage loans. At some point, the survivors in the world of lending are going to have to start pricing loans to make money rather than defend market share. This process is already underway in corporate debt markets, where banks are making life and death decisions about corporate issuers that are now cut-off from the bond markets. Stay tuned. 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.

February 13, 2023 | Premium Service | The continuing battle in Washington over the proposed acquisition of conventional servicing software monopoly Black Knight (BKI) (k/n/a Loan Processing Services ) by Wall Street data monopoly Intercontinental Exchange (ICE) seems to be drawing growing scrutiny. Just imagine putting two legacy technology monopolies , one in housing finance and the other in global markets, in a single value-killing burrito ! Politico reports that Federal Financial Analytics managing partner Karen Petrou, one of the most respected banking consultants in Washington, has a new paper urging the Federal Trade Commission to block Intercontinental Exchange’s acquisition of Black Knight, citing potential systemic risks. We worry more about the 50-year old technology. FedFin disclosed that the paper was funded by an unnamed entity “for which this transaction has raised competition concerns” but said it retained full editorial control over the work. Karen’s book on the Fed is an important read BTW. ICE has said the deal would lower costs for lenders and improve the homebuyer’s experience. If you believe that, then we have a couple of bridges to the multiverse decorated with hot new NFTs we’d like to sell you. A BKI spokesperson said the new FedFin paper was inaccurate, adding that it was funded by competitors. That sounds an awful lot like Warburg Pincus portfolio company Sagent Lending Technologies . We published a discussion of the ICE+BKI transaction with former FHA Commissioner and Mortgage Bankers Association head David Stevens (“ David Stevens on GNMA Capital Rule & ICE + BKI ”). Our view is that the BKI purchase is a horrible deal for ICE shareholders, a value killer of epic proportions for one of the most highly valued utility stocks on Wall Street. BKI trades on a 9 price-to-earnings ratio. ICE trade over 40 P/E today. Any questions? Next! The concerns raised by Stevens and others about operational risk was just illustrated by the market outage at the New York Stock Exchange , a unit of ICE. But ICE has been reportedly lobbying regulators by saying that they will improve the consumer experience in mortgage lending. Again, looking at the goals for cost-savings and earnings post-close in ICE's public disclosure, we cannot see how there will be any money -- or people -- left to drive change in BKI's antiquated platform. “Black Knight is reportedly placing the Empower loan origination system up for sale in order to gain antitrust approval for its acquisition by Intercontinental Exchange,” reports National Mortgage News . “From the day the deal was signed, most expected that Black Knight would have to divest the LOS, the No. 2 most used system behind acquirer ICE Mortgage Technology's Encompass.” In our latest column in NMN , we note that it is financial instability in depositories and not systemic risk from nonbanks that poses the biggest the biggest threat to the housing finance sector. The fact that the Financial Stability Oversight Counsel (FSOC) frets about nonbank risk, but ignores the growing insolvency of the banking system due to QT, is a national scandal. Speaking of key bank mortgage lenders servicing the government market, on Friday Credit Suisse (CS) finally closed "part" of the sale of its Structured Products Group (SPG) to Apollo Global Management (APO) . While the media is focused on the larger restructuring of CS into a gentle asset gatherer, the disposition of the US mortgage business will determine whether the process succeeds or fails. “The full sale is expected to be completed in the first half of 2023,” reports Inside Mortgage Finance . “Credit Suisse expects to book a pre-tax gain of $800 million from the full sale of its securitized products group. Apollo will operate its new SPG as Atlas SP Partners.” But what about the rest of the sale of the CS US mortgage business? The completion of this transaction is important for a number of reasons, but first and foremost because it advances the objective of restructuring the struggling Suisse lender. But there are significant implications for the mortgage sector and especially the world of Ginnie Mae servicing assets. We picked up some CS shares earlier in 2023 on premise that the bank will eventually be fixed and neutered into an asset gatherer a la UBS AG (UBS) . We can recall years ago during a fishing trip when UBS Chairman Alex Weber promised to "de-risk" the bank. He did. But our worry: What happens to the market for Ginnie Mae assets if CS simply exits the space? Disclosure: L: CS, CVX, NVDA, WMB, JPM.PRK, BAC.PRA, USB.PRM, WFC.PRZ, WFC.PRQ, CPRN, WPL.CF, NOVC, LDI For example, there is as yet no word on the sale of CS unit Specialized Portfolio Servicing or the purchase on certain assets from Rushmore Loan Management Services. These transactions were previously announced by CS at the end of 2022. Consider the remarkable message to customers on the Rushmore web site. Notice the first word in the paragraph: "Possibly" Our surmise is that CS informally approached the Fed and other regulators for permission for SPS, a wholly owned unit of Credit Suisse Holdings (USA) Inc . , the top-tier parent for CS in the US, to buy the Rushmore assets. The answer from the Fed apparently was negative. When a bank holding company is not in good graces with the Fed, then permission to expand any activities is unlikely to be forthcoming. Archegos Capital , living wills, capital levels and other supervisory issues suggest that CS is no more likely to get an OK to acquire the assets of Rushmore than Deutsche Bank (DB) was to acquire the loan administration business of Wells Fargo before COVID. For the record, we'd like to be proven wrong. Last week Mr. Cooper (COOP) announced the acquisition of the Rushmore business sans the servicing assets, which are supposed to be going to SPS. In the event that a sale to SPS does not occur, another buyer may need to be found for these non-agency mortgage exposures. Clip from COOP earnings presentation below. The more important point is that the “other part” of the US mortgage financing assets inside CS still do not seems to have a home. The importance of the CS business not taken by APO et al is not fully appreciated by investors in government-insured loans and MSRs. These exposures include assets related to mortgage servicing advances on GNMA MBS that cannot easily be replicated at other lenders. What happens or not regarding these Ginnie Mae exposures inside CS and the issuers dependent upon them is perhaps the most important question in mortgage finance. Much of what remains of the world of correspondent lending, for example, may be destroyed if CS exits the commercial lending space without finding a replacement. Several large Ginnie Mae issuers, in the event, would be forced to downsize significantly. In the post 2008 period, all of the big warehouse lender banks led by JPMorgan (JPM) and Citigroup (C) worked diligently to make sure that nonbank issuers were not dropped from funding books without first finding another warehouse and MSR lender. Wells Fargo (WFC) stepped into the market in those dark days, but now the fourth GSE is exiting the correspondent loan market. Unless a large US depository steps up to buy SPS and, more important, the Ginnie Mae advance portfolio of CS, we have a hard time constructing a happy ending for this story. Biden Taxing MSRs? Last week at the Southern Secondary sponsored by the Texas MBA, a comment made during a panel got a lot of people riled up about another run by the Biden Administration to tax MSRs at inception. After several discussions this week, we have begun to understand the continued concern about future risk of taxes on MSRs expressed at TX MBA session last Monday. Bottom line is that the ruckus was caused by poor drafting in the Inflation Reduction Act, as discussed below. Two years ago when the Mortgage Bankers Association and the mortgage industry fought off up-front tax on MSRs at inception, they were forced to educate MCs about how mortgages work. For Senator Elizabeth Warren (D-MA) et al, this was a revelation. This led Senate Democrats to insert language in tax bill mandating Treasury to adjust "reasonable compensation" standard for servicing MSRs if appropriate. A rule making process by Treasury is expected. The increased data on and official awareness of excess servicing strip (ESS) trades comes into play here. If the industry is selling half or more of the strip to finance MSRs, then what is the reasonable compensation? The answer is that historically the whole strip was meant to be available to support loss mitigation through the cycle, especially for GNMA. In a falling interest rate environment, however, rising asset prices tend to push down gross and net credit losses, allowing for ESS. Of note, the risk function at GNMA is thinking of imposing a bank like provision on all existing and future ESS trades allowing the issuer to suspend payments if loss mitigation expenses rise above a certain amount. See the standard template for bank preferred securities as an example. This was an important part of the industry discussion with GNMA last September. Six months later, ESS may be the only way to raise capital for the GNMA market. Given the above, additional education may be needed to prevent another attempt to tax new MSRs, which would destroy the value of servicing assets and might include all payment intangibles. Such a tax might exclude NOLs, BTW, which is another pet project of Senate Democrats in their endless effort to raise taxes. All of this said, it is important for issuers not to overreact, says one insider. Defining “reasonable comp” for tax purposes is in play largely because of the way the provision in the Inflation Reduction Act was drafted. “Congressional intent on MSR taxation has been made clear twice recently with The Tax Cuts and Jobs Act ("TCJA") and now The Inflation Reduction Act IRA,” he notes. “We don’t want to make a bigger deal of this with Treasury. They simply need to codify the safe harbor from the 1990s.” 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.

February 9, 2023 | Premium Service | This week The Institutional Risk Analyst was in Houston for the Southern Secondary Conference sponsored by the Texas MBA. Below we discuss some of our insights from the conference and then take a look at the earnings results for Rithm Capital Corp. (RITM) and PennyMac Financial (PFSI) . As we’ve noted for some time, things are very difficult in the mortgage finance channel, but the world is not ending just yet. There was a combined $75 billion in new CUSIPs issued in the Fannie/Freddie/Ginnie market in January, well-below the run rate needed to hit ~ $1.9 trillion in production in 2023. Yet while lending activity in TX is down overall, immigration from CA, NY, IL, strong employment growth and overall lack of regulation and zoning restrictions should continue to be positives for new purchase business in Texas. The context for the Southern Secondary is an industry in retreat, with banks and non-banks alike cutting back expenses and exiting the market as industry capacity painfully right-sizes to volumes. In Q4 2022, home lending at Wells Fargo (WFC) was down 57% YOY, one reason the bank is withdrawing from correspondent lending. A number of other lenders have exited correspondent lending and vendors such as Blend Labs (BLND) are shrinking headcount accordingly. Better.com is likewise treading water as special purposes acquisition corp (SPAC) Aurora Acquisition Corp (AURC) is seeking yet another extension to complete its merger with BetterHoldco, Inc . We view the latest move as mostly theatrics because there seems to be no way for AURC to buy Better.com without provoking litigation over the valuation. News that key BetterHoldoco shareholder SoftBank Group has reported yet another massive loss makes us view the Better.com situation as problematic. Last May, Better.com CEO Vishal Garg disclosed that he was personally liable for part of the $1.5 billion that SoftBank committed to Better.com in anticipation of an IPO. The deal never happened and SoftBank advanced only $750 million to Better.com. What happens next? In a recent filing, AURC disclosed that its bankers had largely resigned, this apparently due to the threat of delisting by NASDAQ and further action by the SEC and other regulators against SPACs as an issuer class. Fact is, SPACs have gone from the flavor of the month back in 2020 to a shunned asset class today with ample headline risk. AURC might be well-advised to allow the extension effort to gently fail and return the funds held in trust to investors. PennyMac Financial reported on February 2nd and the results were about what we expected. Volumes are down, but servicing assets and book value are up. The flow of early-buyouts (EBOs) from Ginnie Mae MBS pools are slowing dramatically as dwell times for delinquent assets extend. Notice the surge of EBO revenue in Q4 as the bond market rallied 100bp and execution improved accordingly ( Earnings Presentation Pg 15 ). Notice too the 10-fold increase in expenses related to EBOs. Every mortgage lender in the US is dealing with the impact of the deeply inverted yield curve. Carrying spreads are negative and the execution in the TBA market is likewise badly skewed. Issuers are avoiding the expense of buyouts of delinquent loans and are simply leaving the notes in the pool as they work with the borrower. Advance lines from banks are being priced today at SOFR +200bp or higher on agency and government assets, thus the negative carry facing mortgage lenders is measured in points. For PFSI, however, the key to survival has been aggressive management of operating expenses as volumes have declined and earnings from the servicing book slowly rise. PennyMac Financial Services The earnings report by Rithm Capital, the largest nonbank owner of MSRs, were supported almost entirely by servicing income as new loan originations have dried up. The valuations of the RITM MSRs is near a 5x multiple, including for new production. Over 98% of RITM’s MSR portfolio is out of the money to refinance, with a portfolio weighted average coupon (WAC) of ~3.7% significantly below current new production. The same metric for PFSI is 4.3%. The chart below shows the valuation multiple for RITM’s MSR portfolio. Rithm Capital The Street is pounding the table on both PFSI and RITM, both of which rallied substantially in Q4 2022. The real issue with both of these names, however, is future credit costs. It is interesting to note that neither PFSI nor RITM provide a statement of cash flows with their earnings release. As delinquency reverts to the historical mean in terms of loss given default, we expect to see all issuers come under growing liquidity pressure. If these pressures grow sufficiently, then you will see RITM, PFSI and other large government issuers start to sell MSRs to raise cash. When the periodic income and escrow earnings from MSRs are insufficient to keep large government issuers solvent and they are forced to sell assets, that is the signal that we are entering a true liquidity crisis in housing finance . We suspect that the IMBs will be sellers of conventional assets to defend their Ginnie Mae MSRs. Meanwhile, we look for commercial banks to be buyers of conventional servicing assets. The general view of most attendees at the Southern Secondary is that the market exits by WFC and New York Community Bank (NYCB) will not result in a huge rush to sell MSRs. Calls to WFC by several issuers have been met with responses that indicate that the process of down-sizing will take years. The 2017 sale of the 1-4 business by Citigroup comes to mind as a model for the WFC process. That said, in 2023 there will be some very motivated sellers of MSRs going forward, especially if the FOMC keeps rates at or above current levels for all of 2023. Both Housing Wire and Inside Mortgage Finance are banging the drum publicly for doom and gloom due to lower MSR prices, but markets say otherwise. The lack of earning assets across the fixed income spectrum, we believe, will continue to drive investors into MSRs even as issuers come under growing liquidity pressure. The bond market rally in Q4 took some bank MSR marks down just as AOCI also fell, but we may swing up in valuations in Q1 as negative AOCI balance rises again. Of note, while we are not yet at record nominal MSR valuations vs the 1990s, one veteran commented on our panel that the difference between today and 1990s is in the greater values of escrows thirty years ago. If we equalize for the change in interest rates over the past three decades, the valuations may actually be higher. The BIG question looming over all of these discussions about MSR valuations and credit concerns for larger issuers is home prices. The chart below shows the progression of home price appreciation since the high-inflation years of the 1980s, when Fed Chairman Alan Greenspan first turned up the gas on inflation. The home price appreciation of the 2001-2007 period caused by the FOMC under Greenspan set the stage for today's inflation. While the valuations for MSRs today are greatly helped by rising interest rates, as 2023 continues weaker prices for homes may start to increase negative pressures on MSR valuations. The sharply rising cost of loss mitigation activities in 1-4s. will eventually start to offset rising interest rates as a factor in MSR valuations. Historically the value of escrow balances has accounted for as much as 20% of MSR valuations, according to an analysis prepared for WGA LLC by MIAC. But as we leave behind the market distortions of QE and see credit loss metrics normalize, look for the embedded cost of credit in MSRs surge. At the end of the day, loss given default in 1-4 family mortgages is a function of home prices. Source: FFIEC Final thought. Keep your eyes on the FHLBs in next few weeks as they prepare to announce open ended forbearance for banks that are book insolvent due to QT. Like the banks, the FHLBs and the GSEs also have capital impairment issues due to QT. Regulators like to beat on the IMBs over capital or MSRs, but then they give the banks a free ride -- even if some of these institutions end up failing due to M2M losses. The Q4 numbers for accumulated other comprehensive income (AOCI) for the US banking industry will look better, but rising market interest rates in Q1 2023 may be quite ugly in terms of AOCI and the M2M on the retained book. Notice that many banks reported lower deficits in terms of AOCI in Q4, but MSR valuations also declined. These two relationships -- MSRs and AOCI -- are essentially linked via market interest rates. As funding costs rise, banks which lack large negative duration positions in MSR will come under pressure to sell low-coupon exposures that are underwater. Source: FFIEC 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.

February 6, 2023 | Last week our friend and fellow Lotosian William Cohan suggested in the FT that Goldman Sachs (GS) ought to combine forces with Bank of New York Mellon (BK) , a marriage that strikes us as less than compelling. Cohan correctly identifies the growing problem: Goldman Sachs under the current team led by CEO David Solomon is stuck between being a traditional securities dealer and a commercial bank, and at present does neither well. The chart below shows funding costs for GS and some high-cost peers from the FFIEC. Notice how quickly funding expense at GS was rising compared with some of the higher-cost banks and Peer Group 1 even before Q4 2022. Source: FFIEC Goldman is too big to hide in the treacherous world of global dealmaking but too small to survive as it is. As we have discussed at some length, funding is the Achilles Heel of Goldman Sachs . This judgment is informed not by asset size but rather two factors: 1) the sources of funding and 2) the stability of the business. Says Cohan: “The perfect merger candidate for Goldman has long been Bank of New York Mellon, which operates in 35 countries around the world and has $1.8tn of assets under management and another whopping $44.3tn of assets under custody or administration.” Well, no. BK has a pile of assets under management and also a vast pool of global assets in custody for which it is paid slices of pennies to safekeep. But we must say at the outset that BK is an amalgam of utility businesses that more astute organizations have long since shed and abandoned. An apocryphal tale will illustrate the point. Once upon a time, we were happy retail customers of The Bank of New York . But one night we were sold to JPMorgan (JPM) in a swap of retail assets by BKNY for the clearing and custodian businesses Jamie Dimon discarded. The private bankers and other lovely aspects of the old BNY quickly disappeared in a cloud of continuous cost cutting. Now we have the Chase web site. Dimon got core deposits and the better end of that trade. Cohan is correct, of course, that the Federal Reserve Board and other prudential regulators would be unlikely to give Goldman Sachs the keys to the US clearing system by allowing them to acquire BK. Along with the Depository Trust and Clearing Corp (DTCC) , BK is the center of the US financial system. Indeed, BK is not a great fit for GS or anybody else – other than Uncle Sam. The equity returns at BK in Q4 2022 were modest (5.7%), growth and alpha are pretty much non-existent, and operational and counterparty risk is infinite. One day, we could see a government-sponsored merger of DTCC and BK simply to cut costs. If there is one depository in the US that is very definitely too important to fail in a systemic sense, it is BK. But that also means that nobody is going to buy it. For example: “On November 21, 1985, the Bank of New York (BoNY) suffered a software failure that left it unable to redeliver securities it had received from other institutions as an intermediary,” wrote Huberto M. Ennis and David A. Price of the Richmond Fed . “The result of the failure was that the bank sought and received $22.6 billion in discount window lending from the New York Fed, a record-setting amount.” In the mid-1980s, BKNY was a rounding error compared with BK today, but te example is important. Just as GS is mostly a $1.5 trillion asset investment bank with a small depository attached, BK is a global clearing, custody and data processing business with a “small” $450 billion asset depository attached. BK is a “bank” in name only and has few profitable loans on its balance sheet. BK has the lowest gross spread on loans and leases in Peer Group 1 at 2.37%, which is half a point below the banks overhead expenses. Fortunately, BK is about assets under management or in custody instead of credit risk. The cost of funds for BK is slightly above the average for Peer Group 1 and operating proficiency is poor, with an efficiency ratio in the mid-80s vs 59% for JPM. BK’s operating expenses were more than 75% of adjusted operating income, 20 points above the average large US bank. Nearly 60% of the bank’s operating income comes from fiduciary activities, necessary and vital services that are entirely relevant and completely undifferentiated. BK is the Bayer Aspirin of banking. GS, which survives based upon being the outlier among global investment banks would find the old Wall Street culture of BK toxic, even today. So how does BK survive given these dreadful operating metrics? Lots of non-interest income. While the average bank in Peer Group 1 earns less than 1% of assets from non-interest services such as trust, BK’s non-interest income is more than 3% of total assets. Do banking assets even matter when discussing BK? No and yes. The core BK business is really about processing and safekeeping data, yet the ability to act as custodian for financial assets and payment agent is a unique function of a regulated bank. To have a fixed address on the global payments system, you got to be a bank. To perform the fiduciary and payments functions of BK, you need to be a large federally insured depository institution with a master account at a Federal Reserve Bank. At mere $500 billion in assets, BK is arguably far too small. BK’s loan book was just $70 billion at year end, mostly real estate loans and other odds and ends with horrible pricing. Remember, the gross yield on BK’s loan book is less than the cost of the bank’s SG&A, so fewer loans is better. The rest of the balance sheet is held in securities, which means that BK had a substantial negative mark on its available for sale assets and retained portfolio at year-end. The accumulated other comprehensive income (AOCI) reported to regulators in Q3 was -$6.6 billion. BK’s Tier 1 capital position is low, below 6% of total assets at year end, but in terms of Basel IV and "risk-weighted capital," the bank appears adequately capitalized. But if we recall the unlimited operational (and counterparty) risk the bank faces, no amount of capital is adequate. Did we mention the $47 billion in intangible assets? How about the 120% double leverage (Equity investment in subsidiaries / Equity capital )? In terms of the impact of QT on the bank's tangible net worth, we combine the BK disclosed AOCI ($-6 billion) with a conservative 10% negative mark on the bank’s retained loans and securities (-$20 billion) and subtract $20 billion in goodwill and intangibles, BK was book insolvent at year-end. We performed this same analysis for JPM at the end of 2022 (“ Is JPMorgan Insolvent ”). BK claims $193 billion in core deposits, including over $100 billion in foreign deposits, but these are wholesale placements that could and would disappear in a matter of days. Should the US Treasury suffer a debt default, for example, we’ll see how many of those foreign deposits at BK, C and JPM will loiter. Foreign deposits are nor insured by the FDIC, of note. And BK has over $150 billion in non-core funding. Rather than slamming Goldman Sachs together with BK, a business that is ultimately doomed by the advance of technology, we repeat our view that GS would be better advised to consider combining with a more mainstream lender like KeyCorp (KEY) , U.S. Bancorp (USB) or even Citigroup (C) . The latter has far more “core deposits” than BK. Remember that Bank of New York Mellon does not have a Main Street retail banking business to support the mammoth global custody business. Frankly, putting BK and GS together would not help either business and might result in a sum of the parts that is lower than the two banks separately. GS is a highly levered, high-risk business that is overly dependent upon non-core funding. BK is a sleepy, low-margin but very high-risk business at the center of the global financial system. That $40 something trillion in custody assets represents much of the dollar equity investments globally. The clearest way we can say it is that the risk-adjusted return on capital for BK is negative and probably lower than Goldman, which overall is the highest risk large bank in the US. BK should pay David Solomon and GS to take over this problematic basket of low growth, high-risk businesses. The operational risk of BK is simply impossible to quantify or offset. And note in the chart below that the derivative position of BK is 4x the average for Peer Group 1 and is 2/3rds foreign exchange contracts. Bill Cohan is right about one thing. Would the Fed and other regulators allow the most important bank in the world of custody and clearing to combine with the highest risk player among the top-ten banks? NFW. A far better fit would be to put Citi together with Goldman Sachs, give the puny Marcus to Citibank NA and eliminate an investment banking and capital markets competitor. The resulting global institution would have sufficient size to operate as a universal bank and could then afford to combine with a larger asset gatherer. Problem solved. 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.

“Disneyland is over, the children go back to school. It’s not going to be as smooth as it was the last 15 years... All these years, assets were inflating like crazy… It’s like a tumor, I think is the best explanation.” Nassim Nicholas Taleb Bloomberg Television February 3, 2023 | Premium Service | There are two economic narratives in America. The first narrative is obviously false, but largely controls the financial media and the political conversation. This narrative reflects the conflicted, long-only view of the major investment advisory firms and is supported by the Fed and Treasury. Fed Chairman Jerome Powell says that 2% inflation is the minimum requirement for economic stability. Why? On the assumption that a little inflation will lift all or at least some boats. This leads to the second narrative, the actual story for the vast majority of Americans. These are people who work to live and are being killed by double digit inflation every year. The Americans in the real narrative have no interest in or knowledge of the financial markets. The tens of thousands of Americans who have been laid off in the past ninety days understand that the US economy is slipping into recession. The credit markets are reacting accordingly. After 12 years of pro-inflation QE, the post-COVID reset is going to hurt, as Nassim Taleb suggests above. Many emerging companies that we wrote about in 2020-21 as equity plays are now credit stories. In the real economy, households that lose a wage earner must often choose between paying for the car, the house and/or food. The second narrative resides in the world of credit and fixed income securities. No surprise then that the big take away from Q4 2022 earnings is that credit expenses are headed higher and at a brisk pace. Watching the announcements of layoffs that have blossomed since the New Year, it seems striking that the unemployment rate is at just 3% yet the levels of delinquency visible in low FICO, high loan-to-value (LTV) subprime mortgages (aka “FHA/VA/USDA”) are in the mid-teens and rising back to pre-COVID levels. DQ rates on sub-600 FICO government loans are rising roughly 1% per month and are now in the mid-teens. This is a stunning statistic that nobody in the first narrative seems to have noticed. While the average FICO score in the US has risen into the low 700s since 2008, more than one-third of all Americans have scores below 600. Thus when we see that the overall level of delinquency on Ginnie Mae 3.5% MBS is already above the level of gross income on the servicing strip, this begs the question of liquidity. As we discuss below, funding the growing pile of delinquent government loans is becoming more problematic as interest rates rise. The fact of large depositories stepping back from the mortgage market is also not helpful. Speaking of liquidity, there is growing evidence that the artificial market benchmarks led by the Secured Overnight Funding Rate (SOFR) are starting to become unstable. It seems that the Alternative Reference Rates Committee — the Federal Reserve-backed industry body known as “ARRC” that rubber-stamps the central bank's shaky transition from dollar Libor — has created a potential systemic problem by over-regulating the market for short-term cash. William Shaw and Alexandra Harris of Bloomberg reported earlier this week that Scott Peng , one of the early voices to call out the scandal-ridden London interbank offered rate (LIBOR) during his time at Citibank , is now sounding the alarm over its successor. Peng says guidelines designed to limit who can use derivatives tied to the Secured Overnight Financing Rate are inadvertently heaping risk onto banks’ balance sheets, echoing warnings from TD Securities and JPMorgan Chase & Co. Left unchecked, he says, it could pose a significant risk to the smooth functioning of financial markets. “Banks and issuers are just starting to come to grips with this — we are at beginning of a reckoning,” said Peng, chief investment officer of Advocate Capital Management . “At the present time it’s an annoyance, but as that risk position become bigger and bigger at some point it becomes a systemic issue.” The rapid decline of market liquidity presents a threat to the economy on multiple levels, yet Fed Chairman Powell does not yet see a problem. Raising interest rates 400 bp in nine months has created huge problems in housing finance, commercial real estate and other sectors, problems that are still not visible to much of the mainstream media. The bond market rally in Q4 2022 took some short-term pressure off of banks and the credit markets, but a new period of rising yields could literally blow the wheels off of the proverbial wagon a la December 2018. Announcements by Wells Fargo (WFC) and New York Community Bank (NYCB) that they are withdrawing from mortgage lending is a huge blow to the liquidity of the housing market. Credit Suisse & Ginnie Mae MSRs As the accelerating reduction in “free” reserves in the banking sector may bring the entire rate hiking process to an end, liquidity is a growing problem in the housing sector. While many observers and media worry that mortgage lenders are preparing to sell government MSRs, in fact the opposite may be the case. One issuer told The IRA this week that the recent announcement by the Federal Housing Finance Agency (FHFA) that it is considering modeling the valuations for mortgage service rights (MSR) is a defensive reaction. “Ginnie Mae is sucking all of the capital out of the market,” the issuer laments. “When things get tough later this year, issuers will sell Fannie Mae and Freddie Mac servicing to protect their position in Ginnie Mae assets. There is no choice.” The issuer worries that the cost of advancing cash on delinquent loans is already above the monthly cash flow from the performing loans behind the MSR, begging the question as to how this delinquency will be financed. As we noted in a research paper in 2020, the FHA/Ginnie Mae market requires issuers to provide liquidity to the government market, especially in times of recession. The GSEs such as Fannie Mae and Freddie Mac provide liquidity to issuers, but offer inferior execution to the government market and other hazards such as repurchase claims and definitional games. For example, the GSEs are taking the position that COVID was not a “natural disaster” when it comes to sunsetting liability for representations & warranties on conventional loans. Specifically, Freddie Mac is stating that COVID does not meet its definition of a disaster and so forbearance offers made to customers for COVID will NOT be considered as having made on time payments. Despite the fact that the government and both Fannie and Freddie required servicers to offer the forbearance plans, they are now changing the rules after-the-fact. When a large issuer confronted Freddie Mac over this policy decision, the officials seemed almost embarrassed to admit that they weren’t following the same protocol for COVID as in other natural disasters. Of note, FHFA has yet to put out a public statement on this position. If this is in fact the stance taken by the GSEs, the next time servicers are requested to offer up solutions for events similar to the COVID pandemic, they are going to say “No Thanks.” A more serious situation is festering over at Credit Suisse (CS) , where the bank has been struggling to sells its Structured Products Group (SPG) since the middle of last year. CS most recently announced plans to move its asset management arm into a revived First Boston spinout, an ironic end to the banks earlier efforts to build its investment banking business. CS had previously indicated that a deal to sell SPG and its unit, Select Portfolio Services (SPS), to APO would be finalized in Q4 2022 but there was no announcement. Credit Suisse announced in early November an exclusivity agreement to transfer “a significant portion” of SPG to an investor group led by Apollo Global Management (APO), reports Inside Mortgage Finance . Apollo and PIMCO were said to be negotiating to acquire most of the securitization group’s assets and “hire the SPG team to the new platform.” No close was ever announced and the remaining bankers at CS are not talking. SPS serviced about $166 billion in unpaid principal balance (UPB) of loans at the end of 2022, mostly non-agency exposures. More important, there reportedly are advance and warehouse credit exposures related to Ginnie Mae MBS and MSRs that APO and PIMCO were not willing to purchase. APO was reportedly willing to manage these assets on behalf of CS, but there has been no further mention of these assets nor confirmation of the transaction closing this year. To give you some idea of the complexity involved in breaking up the CS business in the US, the link below downloads an CSV file from The National Information Center that contains the full hierarchy of Credit Suisse Holdings (USA) Inc ., the top-tier parent for CS in the US. Under Basel, CS is required to maintain the capital of its US business on a stand-alone basis, thus shifting the Ginnie Mae exposures as part of the SPG sale is essential. CS has been a key advisor to a number of the larger Ginnie Mae issuers and the architect of the several MSR financial transactions issued for Penny Mac Investment Trust (PMIT) , Rithm Capital (RITM), Freedom Mortgage and other GNMA issuers. If a stable and liquid new home cannot be found for the Ginnie Mae exposures inside the CS SPG unit, then it is hard to construct a scenario for 2024 where these MSRs deals are refinanced. More likely, we believe, is that these deals will be extended or redeemed. In the PMIT Series 2017-GT1 financing for Ginnie Mae MSRs, for example, the Cayman Islands branch of Credit Suisse AG provided the variable funding notes (VFN) and separately provided an uncommitted MBS Advance VFN to get these deals done five years ago. Is there a lender today that would step into the shoes of CS to roll these deals for another five years? Given the reaction of APO and other Buy Side shops to the opportunity to acquire the CS Ginnie Mae book, we think the answer is no. Of note, RITM moved much of its warehouse and Ginnie Mae MSR financing business to Goldman Sachs (GS) last year, seemingly anticipating the dysfunction at CS. Citi reportedly has also been willing to provide VFN financing for MSR financings, but it remains to be seen whether these banks or other mortgage-focused shops such as Morgan Stanley (MS) will pick up the slack. With the demise of the financing market for Ginnie MSRs, we may see a renewed emphasis on bank lines and excess servicing sales as a means of financing for Ginnie Mae servicing assets. That said, it is hard to think of a likely buyer for the CS mortgage exposures to Ginnie Mae assets. Requests for comment to APO and CS were not answered by press time, but we will update this report in the event. The irony of course is that Ginnie Mae’s leadership had been leaning toward the capital markets execution and away from bank lines and excess servicing sales (ESS) as a way to finance the MSR. With the apparent demise of CS as a factor in the mortgage finance market, we think that the leadership of Ginnie Mae and FHFA need to become more open to and encouraging of creative means to raise equity capital. We recently asked Ginnie Mae if they have come to a view of using ESS in the risk-based capital framework finalized last year. No response yet, but we have a feeling that the Ginnie Mae leadership will be looking for multiple ways to get Buy Side money into the world of mortgage finance. The only difficulty is that QE not only pulled many loans from tomorrow into today, but it left precious few loans for mortgage bankers to make in the future. The table below shown the distribution of $2.2 trillion in GNMA loans by coupon. Notice that 75% of all GNMA MBS have coupons between 2% and 4% thanks to QE and the FOMC. The 10.8 million loans inside these MBS may not be in the money for refinance for many years to come. Source: Ginnie Mae The incentive to put capital behind a Ginnie Mae portfolio in tough times was always the prospect of making money on new loans when interest rates fall and the sun begins to shine. Now thanks to the Fed, the future earnings potential for mortgage lenders may be significantly curtailed for many years to come because three quarters of the mortgage market is out of the money. 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.

January 30, 2023 | Premium Service | On January 23, 2023, the Lex column of the Financial Times carried a shameless public endorsement of the stock of Ally Financial (ALLY) , a $200 billion asset wholesale funded bank that focuses on auto lending. Suffice to say this is one of those instances when we wonder why journalists that make specific stock recommendations to retail investors are not subject to FINRA regulation. Now a century old, ALLY was the captive finance unit of General Motors (GM) and over the decades mutated into a mortgage issuer within GM, ultimately leading to the spinoff of what is today Ally Bank in 2010 and the bankruptcy and liquidation of Residential Capital in 2012. Some twelve years later, ALLY is still more finance company than bank and really has no core deposit base worthy of the name. If you acquired ALLY tomorrow, a discriminating buyer would pay no deposit premium and might even ask for a discount. We last wrote about ALLY in July (“ Update: Ally Financial (ALLY )”), when we noted that the bank has a yield on its loan book that is too low and a cost of funds that is too high. ALLY is forced to compete for funding with some of the largest market facing banks including CapitalOne (COF) , Goldman Sachs (GS) and Barclays Bank (BCS) . Notice that all of these banks are paying at least 3.3% for funding compared with SOFR closing in on 4.5%. Meanwhile, the average interest expense for the largest US banks is still below 1% None of these public facts prevented the FT from engaging in hyperbole that really begs the question as to why they wrote this column at all. Could the team of reporters that so courageously tracked down the Wirecard AG fraud really get a simple analysis of a $200 billion consumer bank so badly wrong? Yes they can. Consider this perfect regurgitation of ALLY’s IR twaddle: “Ally has in recent years increasingly relied, sensibly, on consumer deposits to fund its lending. To do so it offered high saving rates. Last year, to remain competitive, Ally had to boost savers’ yields even as its loan book returns were locked in. Net interest margins have since waned, towards 3.5 per cent, a figure the company believes will mark the bottom.” Consumer deposits? Not only is this statement factually incorrect, but it suggests erroneously that ALLY actually has a retail deposit base like JPMorgan (JPM) or Bank of America (BAC) . In fact, ALLY is exactly comparable to GS, which has a base of “core deposits” that are very yield sensitive and will walk out the door if the bank does not keep pace with the bulletin boards for brokered deposits. But then the FT concludes their little stock pitch with the following drivel: “Ally very much offers a role model for what Goldman Sachs wanted in consumer finance. With sufficient scale in lending, plus some good fortune on the economy, Ally’s return on shareholder equity can easily bounce back into double-digit percentages again.” No, actually GS has done a better job building its admittedly flawed Marcus than ALLY has done building its online bank. We have some significant issues with the GS business model, but the ALLY model is clearly a monoline consumer finance business with no real reason to exist. There is no competitive advantage for ALLY occupying the funding killing field between the large banks, on the one hand, and the more aggressive bank and nonbank consumer lenders on the other. Let’s take a look at some quantitative comparisons between ALLY and its peers in the world of narrow banks using the data from federal regulators. Notice that we choose as our comparable firms the usual suspects – GS/C/COF and have also added the $180 billion asset US unit of Barclays Bank PLC (BCS) , Barclays US LLC , which is a monoline issuer of credit cards. All of this FFIEC data is public and has a consistent accounting taxonomy in terms of presentation, but few members of the media or Buy Side analyst ratpack ever bother to look. They are too busy. First let’s take a look at net loss rates, the proof of the pudding for any bank. We’ve commented in the past about the relatively high loss rate of GS compared to the other large banks. The net loss rates in Q4 were up across the board for these consumer facing lenders. Somehow the folks at the FT did not notice that ALLY’s net charge-offs are up 270% YOY, more than any of the other comps in our group. Source: FFIEC Notice that ALLY’s loss rate is below that of Barclay’s US business, Citi and COF, but well above that of Peer Group 1. We’ve already noted the brisk increase in net charge offs (Page 15 of the ALLY Supplement). Next let’s take a look at the gross spread on the loan book, which is a key component of the analysis. The first thing to notice is that the spread for ALLY’s loan book is pretty stable compared with other consumer facing banks such as COF and Barclays. But at the same time, ALLY’s gross yield on its loan book is far lower than these other lenders. Source: FFIEC At the end of 2022, ALLY reported a net margin of almost 8% for auto loans, but then there is a lot of the book that is in mid-single digits. The best yielding assets for ALLY are unsecured consumer via Ally lending (11%) and Ally credit card (22%), but these loan categories are relatively small. Yet the bank’s exposure to individual consumers at 40% of total loans puts ALLY in the 96th percentile of Peer Group 1. Of note, ALLY is about 70% loans to assets, with the remainder in securities. At the end of 2022, ALLY had a negative balance of accumulated other comprehensive income (AOCI) of $4.1 billion or roughly 1/3 of total capital, a far larger percentage of capital impaired by unrealized losses than larger banks. This fact is due to ALLY having $136 billion of loans and finance receivables held available for sale at December 31, 2022, one big reason for the large negative AOCI balance. Also, the fact the ALLY has no retained portfolio is significant and speaks to the question of funding costs . ALLY really is more of a finance company than a bank, with virtually no loans held to maturity in portfolio. Next on the list is funding costs, an important piece of the puzzle that illustrates the fundamental weakness of the ALLY business model. ALLY has made progress reducing the funding differential with other banks during QE, but that is not really notable. What is important is the rate of change in ALLY’s funding costs profile as interest rates rise. Source: FFIEC Notice that ALLY’s funding costs are galloping higher, above all of the other members of our group except Barclays US. And do please notice where funding costs were for Barclays in December 2018, when the FOMC almost ran the US financial system aground. Ally was right behind Barclays and 1.5x the funding costs for Citi, COF and GS. In Q4 2022, ALLY’s Interest Expense/Average Assets was 2.5%. Below we decompose the gross yield and interest expense of the group as a percentage of average assets. As you can see, COF, Barclays and Citi are the best performers, but ALLY actually outperforms Goldman Sachs. Readers will recall that we have consistently called out GS for poor credit portfolio performance, both in terms of the loan yield and net credit expenses. Keep in mind that the Net Spread shown below is before SG&A and taxes. Source: FFIEC More important than the relative distribution of the net spread among our comps, note that ALLY is just a point above the average for Peer Group 1, arguably too little spread given the risks on the book. At 300bp of gross charge offs (vs < 1% for large banks), ALLY’s production is basically “BB” bond equivalent, not hideous but not prime. If net losses revert to the pre-COVID mean ~1%, then ALLY will have a hard time expanding earnings. How does ALLY survive given our view? First, they benefit from the relatively cheaper funding costs of being a bank, even if they must pay brokered deposits spreads for cash. ALLY basically uses deposit funding as a replacement for warehouse finance for an originate-to-sell nonbank finance model. Second, the bank has kept operating efficiency tight, with an efficiency ratio in the high 50s. Pushing operating costs down to get closer to 50% efficiency would be among the few ways the bank can grow earnings. More significant, over the past decade ALLY has not demonstrated any ability to grow its loan spread – contrary to what you read in the Financial Times . Simple fact is that ALLY cannot expand its loan spread without sacrificing volumes, hardly a strong position. IOHO, the Financial Times owes their readers an apology for misstating the financial situation of a publicly traded bank. 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.

January 25, 2023 | Watching the markets in recent days, it occurs to us that the fascination of the F ederal Reserve Board with employing “confidence” as a mechanism of monetary policy begins to backfire. Consider the righteous indignation of the mob denied the right to gamble their worthless fiat currency on crypto tokens and other products of the imagination. The anger is most pronounced among the losers in the group, those sitting in the audience not sufficiently clued in to sell in mid-2021, when speculative icons like Silvergate Capital (SI) traded at many times book value. Source: Goggleh One especially savvy colleague in the advisory community reports that some clients are positively outraged by the growing official focus on SI and other insured depository institutions, banks that were foolish enough to touch crypto tokens. For financial professionals, crypto always has been an AML and KYC train wreck waiting to happen. Advisors also report being incredulous at the desire of some clients to double down on the crypto mirage, even as the various crypto "exchanges" go bust, as though confidence and faith were all that is required to breathe life into these barren possessions. Crypto, of course, is not an asset as much as a bad idea that was given life by the Fed via Quantitative Easing. Like the shareholders of the GSEs, who have finally been put out of our misery by the courts, the crypto faithful are now full-fledged American victims. Crypto faithful really believe that people are way too bearish on crypto. We are reminded of the crowd in the classic 1956 Cecil B.DeMille film "Moses," with Edward G. Robinson playing Dathan, who encouraged the idolators to turn away from God and worship the Golden Calf. The basic view of Silvergate among the faithful, including a number of prominent people in the religious community, is that the bank was doing a legit business and FHLB bailout was "kosher." No, it was not. Seeing a bank need to fund one third of its assets at the FHLB is a sign of impending default and resolution. Hello. Kate Berry of American Banker nailed this story last week . Once upon a time, Silvergate was actually in the mortgage business , providing warehouse finance for jumbo lenders in Southern California. After shooting most of the personnel on the well-regarded mortgage team at the start of 2023, CEO Alan Lan e is now left with a small bank that apparently has pledged all of its salable assets for a loan with the Federal Home Loan Bank of San Francisco . Once the $4 billion repo transaction unwinds, we assume that the bank shuts down. Looking at the bank’s Q4 earnings results and the actions of Lane and SI management over the past year, we have a hard time understanding why the State of California and the Federal Deposit Insurance Corp have not closed institution to protect the remaining depositors and the bank insurance fund. Book value of the SI common has fallen from $46.55 at the end of 2021 to below $13 at 12/31/2022. Tier one capital has fallen from 11% of assets at the end of 2021 to below 5.5% today (including $200 million in negative AOCI), a serious red flag for regulators. Deposits are down by more than 50% over the past year and the bank reported a $800 million loss in Q4 2022. The $4.3 billion in short-term borrowings from the FHLB shown at year-end, up from $700 million in Q3 2022, represents the last desperate effort by Lane to save the bank. And yes, having 1/3 of bank assets financed with the FHLBs is another moral hazard red flag for regulators. Beyond the ugly financials, however, it is important to understand that the fall of Silvergate is a larger story about the end of the “theology of prosperity” that was a key driver of the crypto confidence game. Think of SI as evangelical Christianity and Opus Dei meets party poker/FX trader, with a dash of millennialism thrown in for added flavor. Many players in the world of crypto believed that their focus on this pretty standard form of financial fraud would actually bring them wealth and economic freedom. Instead, the holders of crypto are likely to be disappointed, over and over again. The larger and possibly more significant mess involving crypto and Signature Bank (SBNY) in New York is another case of confidence c/o QE causing real world damage to banks and investors. Unlike SI, which is too small to care in a systemic sense, SBNY is a $110 billion asset commercial lender that is systemically important. The fact that SBNY’s management team would allow this valuable banking franchise to be put at risk by involvement in crypto fraud demands attention from regulators, shareholders and policy makers. As lenders like SBNY back away from crypto exchanges and their “affiliates,” the wreckage among the community of faithful grows. CoinDesk reports that SBNY is refusing to process transfers on its crypto platform of less than $100,000 for Binance , effectively cutting off the giant crypto casino from the Fedwire. Given the still unknown risk to SBNY and other banks in terms of KYC and AML violations, this move is probably the first step toward an exit by all US banks from facilitating cash transfers for all crypto. Last week Jemimah Kelly wrote in the Financial Times that some of the worst offenders in the world of crypto fraud are busily building a new game even as many financial regulators around the world continue to, well, do nothing. Su Zhu and Kyle Davies, co-founders of the bankrupt crypto hedge fund Three Arrows Capital , are apparently erecting a new vehicle for crypto fraud called GTX, Kelly reports. Yet despite these efforts by hardened crypto grifters to steal yet more money from credulous retail investors, the faith in crypto assets is slowly wanning. Of greater concern than the end of crypto is the risk to market confidence more generally as QE becomes quantitative tightening or QT. Investors believe as an act of faith that the FOMC is going to reduce inflation and put the markets back to a happy place something like Q1 of 2020 before COVID. The only trouble is that the Fed has essentially lost control of its own balance sheet, leaving open the question whether the US central bank can continue to tighten for much longer and how global markets will react to this public failure. Bill Nelson of Bank Policy Institute asks precisely this question in a recent missive, wherein he notes that the failure by the FOMC to force down the use of reverse repurchase agreements (RRPs) by money market funds and banks has created a structural problem. RRPs are effectively a form of T-bills created by the Fed without Congressional authorization to subsidize money market funds and banks. Now the Fed cannot take away the duration it provided with these ersatz T-bills. In order to shrink the Fed’s balance sheet, RRPs need to decline – a lot – from the current level over $2 trillion. The chart below from FRED shows the major assets in Fed’s portfolio of Treasury debt and MBS on the left scale and liabilities in terms of RRPs on the right. Or maybe another way to put the Fed's dilemma is that those MBS on the NY Fed's balance sheet need to repay before the balance sheet shrinks significantly. During a recent conclave at the Council on Foreign Relations, Federal Reserve Governor Christopher Waller said roughly $2 trillion of reserves could be taken out of the banking system without disrupting banks . Waller, an academic economist with no financial markets experience , does not address when and how the FOMC is going to tell money market funds to exit RRPs. Keep in mind that those MBS on the Fed’s balance sheet have fallen to low single-digit levels of prepayments annually. The problem is that the Fed via RRPs has essentially decided to issue $2 trillion in T-bills without explicit fiscal authority from Congress. The MM funds and banks certainly prefer holding RRPs with the Fed and will not exit unless forced to do so. But given the current issuance schedule for the US Treasury, forcing MM funds and banks out of RRPs will have the effect of lowering short-term interest rates as investors scramble to buy a limited supply of T-bills. Nelson notes: “In September 2022, Patricia Zobel, the acting System Open Market Account Manager, gave a speech (available here) in which she stated “Overall, as the Federal Reserve’s balance sheet declines, I expect money market interest rates to rise relative to the ON RRP rate, and for market participants to shift investments away from the facility moderating the decline in reserves.” Nelson reports that the FOMC seems to believe that as the Fed’s balance sheet gets smaller, money market rates will rise relative to the interest rates it pays on reserves and ON RRPs. But sadly the markets are not cooperating. He continues: “As rates on repos with non-Fed counterparties and treasury bills rise relative to the ON RRP rate, money funds should switch from ON RRPs at the Fed to other investments. However, so far, the process is barely working. On September 8, when Zobel gave the speech, the market repo rate was 2 basis points below the ON RRP rate and the ON RRP facility was $2.2 trillion. Currently, the market repo rate equals the ON RRP rate and the ON RRP facility is $2.1 trillion.” When it becomes clear that the FOMC is unable to significantly shrink its balance sheet, investors are going to surge back into the equity markets. Stocks are, after all, one of the few true havens from inflation unlike crypto tokens. But if inflation in housing costs and other key areas of consumption do not decline, then what? When the Fed cannot force down housing prices, then QT has failed. If the Fed cannot reduce its balance sheet back down to pre-COVID levels, then the inflation in stocks, home prices and other tangible assets is going to become permanent. Consumer will go from chasing happy dreams of free money c/o crypto and QE, to being crushed by continued inflation in key asset classes like housing and financial investments. As the shrinking population of equity investors ride the updraft up, consumers will increasingly ask “what’s in this for me?” As and when the American political process produces a candidate able to frame the policy failure on the part of the Fed regarding inflation into terms understandable to consumers, then the faith in the entire system will come into question. We will not destroy the dollar system because of the resurgence of gold or the evil machinations coming from Beijing and Moscow. We will destroy the dollar system because of hubris on the part of central bankers, who think that they can control the workings of the world’s largest economy by playing God with the Fed’s balance sheet. 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.

January 23, 2023 | Premium Service | As we navigate through bank earnings, one trend clearly visible through the fog of QT is that bank funding costs are rising faster than asset returns, an arithmetic relationship that defies spin. In the case of Bank of America (BAC) , for example, interest expense rose over 400% in 2022 vs the previous year. Interest income, on the other hand, rose just 52% vs 2021. Overall, BAC saw net income fall 14% YOY vs 2021. Although net interest income rose, non-interest income fell almost $4 billion. Notice that credit loss provisions shown below swung from a $4.6 billion GAAP benefit in 2021 to a $2.5 billion expense in 2022, a stark illustration of the income statement volatility caused by the FOMC’s open market operations . BAC’s results continue to trail the other members of the top-five money center banks. This tale of glorious mediocrity is illustrated by the rising headcount and related expenses, and an efficiency ratio that is six points above JPMorgan (JPM) and the average for the 132 banks in Peer Group 1. We are fortunate to have the standardized data from the Fed for making such comparisons, however, because BAC consistently uses non-standard terms and presentation for its financials. The table below is from the Q4 2022 BAC results. For example, as of the end of Q3 2022, BAC reported accumulated other comprehensive income (AOCI) to the Fed and other regulators on Form Y-9 of -$12.7 billion, but in the GAAP financials just released the Q3 2023 AOCI number is shown as -$4.3 billion. For year end 2022, BAC shows AOCI of -$16.1 billion. Does this mean that the number reported to the Fed for Q4 will be 3x higher than the GAAP number? We’re not sure. BAC reported lower asset returns in 2022 than in 2021, a remarkable statistic that again separates the Bank of Brian from its peers. The chart below from the FFIEC shows the results for the top banks through Q3 2022. Note that all of the large banks are trailing the average of Peer Group 1, which includes all banks above $10 billion in assets. BAC is somewhere between Wells Fargo (WFC) and Citigroup (C) in terms of asset returns, even based upon the Q4 2022 results! Note too that U.S. Bancorp (USB) is just below Peer Group 1. Source: FFIEC BAC’s asset returns were down in Q4 2022, this as the rest of the industry saw earnings and asset returns expanding. Long-time readers of The Institutional Risk Analyst will not be surprised by these poor results, yet members of the financial press and the analyst community refuse to criticize BAC’s consistently mediocre performance. When Gerard Cassidy asked Brian Moynihan about BAC’s future loan loss reserve build, the BAC CEO danced beautifully: Gerard Cassidy: Alastair, on the loan loss reserving, and Brian just talked about the adverse case being about 40%. Can you guys share with us how much of the reserve building is what might be referred to as management overlay relative to what the models are specifically dictating on reserve building? Brian Moynihan: We don't disclose that. But you might assume that there's a fair amount -- 3 components to this: one is what the models say; two is basically uncertainty, imprecision and other things we overlay and then a judgmental, and you might think that there's a fair amount of that right now with the uncertainty. But -- so the model piece of that would be a portion of it. Both Moynihan and JPM CEO Jamie Dimon spent a lot of time talking about uncertainty during the earnings calls, especially when it comes to future capital requirements. We see less uncertainty in the numbers and more evidence that mean reversion is occurring with full force and more quickly than the operators or analyst community want to admit. All of the top four banks need to downsize 25-35% of assets in order to get back into line in terms of performance. One key area of “uncertainty” is future provisions for loss, but we hear in the channel that regulators are making their views of future loss probabilities very clear in guidance to the top banks. This is significant to investors and risk managers because future reserve build reduces earnings 1:1. Add on top of this the “overlay” from regulators for a significant blood letting during 2023 due to mark-to-market losses. The chart below shows net losses through Q3 2022. The results for Q4 for these banks are all up significantly, even if the absolute numbers are still low by historical standards. Source: FFIEC Total net charge-offs for BAC in Q4 2022 were $689 million or 26bp vs total loans and leases, double the previous year. Notice that three quarters of BAC’s losses come from the consumer book. The steep rate of change is where regulators are focused, one reason why Dimon has been so cautious in comments about future capital requirements. BAC added 75bp to capital in 2022 and is arguably above the new requirements. Regulators, however, expect credit losses to rise back to 2020 levels or higher during 2023. BAC CFO Alastair Borthwick framed the issue between the regulators and potential dividend and/or share repurchase increases: “I think the difficult part with Basel III endgame right now is we don't have the rules. So we got to wait, I think, until we see those. They'll go through a comment period. At that point, we'll offer much more perspective. But I'll say the obvious, banks have got plenty of capital. We were asked to take 90 basis points more in June. There's a lot of procyclicality already in things like the stress test and stress capital buffer and in CECL. And I think, look, we've shown our ability to perform and build capital, in this case, 75 basis points in 2 quarters. So we'll deal with whatever the ultimate rules come out with.” While it is great to see BAC building capital for a potential storm, we’d like the team to focus a bit more on improving earning asset returns (2.2% in Q4 2022) and lowering the bank’s efficiency ratio. Until that key operating metric efficiency starts with a “5” handle, Brian Moynihan is not in the game in terms of boosting the share price. If you want to be measured against JPM and USB, not underperformers like WFC and Citi, then BAC needs to boost asset returns and loan yields, and start cutting expenses aggressively. BAC reported an efficiency ratio of almost 65 in Q4, but JPM and USB are in the low 60s or high 50s. Source: FFIEC Disclosures: L: CS, CVX, NVDA, WMB, JPM.PRK, BAC.PRA, USB.PRM, WFC.PRZ, WFC.PRQ, CPRN, WPL.CF, NOVC, LDI 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.

January 19, 2023 | In this issue of The Institutional Risk Analyst , we speak to Mike Patterson, COO of Freedom Mortgage . Mike joined Freedom in 2006 when the firm acquired Irwin Mortgage and thereby became a government lender and Ginnie Mae issuer. Over the next two decades, Mike and other members of the Freedom Mortgage team have built one of the largest lenders and loan servicers in the US. The IRA: Mike, thank you for taking time to speak to us about market conditions. There are a lot of people predicting the apocalypse in the residential mortgage market in 2023. What do you say to investors and policy makers who ask about market conditions now, some nine months into a rising interest rate cycle from the FOMC? Patterson: We’ve been through these cycles before. This is nothing new. We went through this in 2008 and 2009. We went through this in the 1990s. We even went through this to some degree in 2018. For a while, we are going to have a period where if the loan is not a purchase, then there are simply very few transactions out there. I would want to be set up for this period the way we are here at Freedom, and this is not as a matter of self-promotion. If you don’t have a substantial servicing book that is going to provide consistent cash flows, then this is a very tough production environment for any mortgage bank. Leaders from ESGR-NJ presented the prestigious Seven Seals Award to Mike Patterson, Chief Operating Officer of Freedom Mortgage, and fellow employees and reservists. The IRA: Precisely. We have looked at a number of businesses in the past year. Most of them have good people but no servicing asset, so there really is no value in the business with volumes this low. All the consultants have the same message to smaller issuers: downsize to survival mode or simply shut down entirely. Is this market correction that severe for the industry? Patterson: If you are only an originator and not a servicer, in the next 12 to 24 months you risk giving back all of the profit made during COVID if you don’t have a servicing book to help from a cash flow perspective. The IRA: How does this period differ from 2008? You joined Freedom just before the wheels came off the cart in 2007 in private label mortgages. How is this correction different from 12 years ago? Patterson: In 2008, we saw a contracting credit market where LTVs and FICO scores were tightening. Now we see an opening of the credit box to some degree, where FICOs are going a little deeper into the 600s and LTVs are going higher. The box is widening a little bit instead of contracting dramatically. Debt-to-income (DTIs) are a little higher. You also see lenders originating loans that they usually don’t pursue, meaning that they are not proficient at it. These trends could end up being concerns down the road. The IRA: We know a guy named Stan Middleman who told us a while back that loans originated from now until the correction later in the decade will retrace in terms of home prices back to 2020 levels and be underwater for a while. Patterson: The loans will be underwater or the originators operating in unfamiliar territory will make these higher LTV, lower FICO loans until the music stops and there is nobody left to buy the loans. The IRA: The FOMC has moved mortgage rates 500bp or more in the past year. Most small issuers have given up on creating pools and are simply selling the loans on a best-efforts basis. How do you get people to think rationally about credit or loan pricing when they are literally fighting to keep the doors open? Patterson: One of the opportunities that an environment like this creates is that more and more flow deals will get set up between larger issuers, such as Freedom, and smaller lenders that are having trouble dealing with these volatile market conditions. To get long-term stability at issuers that do not retain loans or servicing, flow deals help to provide some measure of certainty. You help the small issuer preserve their operations and they give us more volume as an issuer of MBS. The IRA: How do you see the market for mortgage servicing rights (MSRs) in 2023. There are still some concerns about the Ginnie Mae risk-based capital rule. The tenor of the conversations at the IMN MSR conference at the end of last year were subdued, yet this is a market with shrinking supplies of new securities and extending durations. Most recently Wells Fargo (WFC) has announced an exit from all correspondent lending. Patterson: The MSR market is still very healthy, despite the attempts by some observers to paint the market as a problem. There is now a lot of supply out there that people were holding through year-end in order to get better pricing in the first quarter. They wanted to get through a strong 2022, but they are going to need cash in Q1 and this will bring out new bulk deals. The IRA: One of the interesting comments we’ve heard from a number of players is that the funds and banks essentially exhausted their cash in Q3 this year, leaving the room essentially empty in Q4 2022. With the start of Q1, however, new allocations will be available and the assumption is that volumes for bulk sales will pick up. Patterson: We think there will be a lot of GSE and GNMA MSR deals in Q1 that will give the industry an opportunity to continue to grow servicing AUM or raise cash. The conventional market has hovered in the 5-6x cash flow price multiple range and the government assets are also strong with a smaller number of buyers. Source: FDIC/WGA LLC The IRA: A number of regulators in Washington have made a great fuss about the risk from MSRs, but the defaults this year have come from non-agency exposures in non-QM forwards and private reverse mortgages in the case of Reverse Mortgage Funding . Some regulators like to make a great fuss about the fact that MSRs are often booked above the cash value in the secondary market, but these assets generally only trade once. Patterson: Some issuers carry their MSRs at a higher price than they can sell it today, but the premium is relatively small. We are in the market every day and the mark-down from carry value for a secondary sale is usually a good bit less than 10%. Some issuers that want to sell will take their losses from carry value in Q1 and then position for a good year. Maybe they booked the asset in the 150bp range but have to sell at 145bp. That is a completely normal and acceptable practice as the market adjusts. The IRA: So, come the end of January, we’ll have full numbers for the year and then look to sell the servicing asset at or near book value. A 5% discount is hardly a disaster. You book the GAAP loss and put the cash in the bank. Yet there are some folks at Ginnie Mae that are on a mission to prove that the government MSR is grossly overvalued by issuers, but the public record seems to suggest another conclusion. And, again, most MSRs trade once, if at all. Even if these were Level 2 assets instead of Level 3 under GAAP, there would still be a good bit of wiggle room in valuations depending on your interest rate outlook. Patterson: We were at a 6.75% loan market for a few weeks, then the market rallied and now we are down to a mid 5% market more or less. So, now we have an opportunity for home buyers to save a money on their mortgage payment. What is interesting is how adept consumers have become at judging market swings and timing purchases to maximize savings. People were closing on 6.75% loans a month ago and now they are going to make the call today when they see a 6% or lower and ask if they can refinance. There are many refinance opportunities that are created because of short-term market moves. We often forget that dynamic. The borrower always wants the lowest payment. That is the one rule that does not change in our industry. The IRA: Ginnie Mae is starting to get concerned about prepayments, an issue that goes back to the era of former Ginnie Mae President Michael Bright . Do you think that the industry has gotten religion when it comes to providing the maximum benefit to the consumer the first time around so that Ginnie Mae will not feel the need to penalize issuers for prepayments when interest rates eventually fall? There are a lot of Bright-era rules that were entirely focused on protecting the investor in the Ginnie Mae MBS from loan churning. Has the industry learned its lesson? Patterson: Those rules are a problem because they effectively deny the consumer their legal right to prepay the mortgage at any time without penalty. That family that closed on a 6.75% mortgage in September cannot get a refinance today into a 5.75% mortgage because of the seasoning rules. There is no question that responsible lenders need to make sure that they provide maximum benefit to the consumer and thereby manage the issue. But what does not get nearly enough attention is the ability of consumers to seek lower mortgage payments as soon as the market moves, within even hours or days. The IRA: It sounds like the winning strategy in the post-COVID world is to provide the maximum benefit to the consumer in a refinance the first time around and then retain the asset in portfolio. Instead of going for multiple bites at the apple in terms of refinancing the same loan over and over again, the responsible issuer will seek to provide maximum benefit the first time. Is that fair? Patterson: We have always sought to provide the maximum benefit to the consumer and then retain the asset. The reality, however, is that servicers have a limited ability to manage prepayments. Brokers and other parties are contacting that consumer constantly and especially if interest rates move lower. People used to manage portfolios based upon assets, but now we manage our portfolio based upon the customer. The IRA: Given the change in the market since 2020 and the number of loans that may not be in the money again for refinance, isn’t the competition for refinance loans going to be intense? How can issuers and regulators hope to have any impact on prepayments given the structure of coupons in the mortgage industry today? Patterson: It is not just a question of competing for the few loans available for refinance, but there is also a limited spread in terms of profitability. I am looking at the TBA market right now and 102.50 is the top bid shown on the screen. The premium pricing that was available in 2020 and 2021 has changed dramatically. CNBC Worldwide Exchange 1/17/2023 The IRA: There are some issuers based in Detroit that believe that they can drive everyone out of the wholesale market by overpaying for loans. How long does it take before we start to see rational pricing in the industry? Isn’t what United Wholesale Mortgage (UWMC) is doing today in wholesale just a repeat of what Provident and Countrywide did in the past? This is not a new story. When do we start to see rational pricing in the secondary market for residential loans? Patterson: We will see some rationalization in Q2 of this year. In Q1, people are going to slowly see spreads improve. Better execution will allow some of the more aggressive issuers to pull back, but this just means that the other issuers will come back into channels like wholesale. Every month, we have seen gain-on-sale getting better for the public companies. By Q2, things will improve enough that I think some of the more aggressive players will start to relax and you’ll see the other wholesale players back in the game. Again, remember the golden rule: the consumer does not know names or brands, they know payments. Give them a lower payment and good service, and you’ll win their business. Is market share or best execution and service the most important thing? I will tell you it is the latter every time. The IRA: Thanks Mike. 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.