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November 28, 2022 | Watching the Buy Side Pivot Platoon rev up for a new surge of asset allocation into large cap bank stocks, we remind readers of The Institutional Risk Analyst that US depositories currently are not particularly cheap, in nominal or real terms. In fact, in a stressed scenario, the liabilities of banks exceed the value of the assets by over $1 trillion, the classic definition of insolvency. Once you adjust reported book value for the asset price inflation & now deflation of the QE/QT roller coaster ride, it is fair to ask: Just where is the value? If we told you that the capitalization of the industry was negative by over $1 trillion at the end of Q2 2022, would you still buy bank stocks for your clients? Let’s have a look at industry paragon JPMorgan Chase (JPM) just for giggles, but first we’ll start off with the industry view. At the end of Q2 2022, the US banking industry had $2.2 trillion in total capital. That is, book equity. But much of total capital is not tangible, which is why regulators use Tier 1 Capital as the base measure for solvency. The legal definition of Tier 1 Capital, which excludes many items we discuss below, is found at 12 CFR Part 324 of the federal banking regulations. Specifically, the law: “requires that several items be fully deducted from common equity tier 1 capital, such as goodwill, deferred tax assets (DTAs) that arise from net operating loss and tax credit carry-forwards, other intangible assets (except for mortgage servicing assets (MSAs)), certain DTAs arising from temporary differences (temporary difference DTAs), gains on sale of securitization exposures, and certain investments in another financial institution’s capital instruments. Additionally, management must adjust for unrealized gains or losses on certain cash flow hedges.” Of note, when adopted in 2015, CFR Part 324 allowed all non-advanced approach institutions (aka little banks) to make a permanent, one-time opt-out election, enabling them to calculate regulatory capital without AOCI . At the time, accumulated other comprehensive income was a minor entry on bank balance sheets and income statements, minor as in the footnotes. In the age of QE, however, AOCI is now a much bigger deal, but still is dwarfed by how QE has caused unrealized losses on bank balance sheets. So, let’s begin the fun with the fire-sale calculation we perform using the aggregate data from the FDIC. We start with total capital, the broadest definition of bank equity. We then subtract the goodwill and all of the intangibles. (H/T to Jake for catching error in earlier edition.) U.S. Banking Industry Source: FDIC Notice that tangible capital dropped by several hundred billion in three quarters since Q4 2021. As we’ve noted earlier, the large banks led by JPM plateaued in Q3 2022 in terms of AOCI, mostly through sales of assets and transfers into portfolio to be "held to maturity." But the risk remains. MSR prices have likewise softened since June. Regulators refer to “assets” rather than rights because sometimes mortgage servicing can become a liability, particularly in the government market. Thanks to QE and now QT, all sorts of assets have become negative return propositions for banks and nonbanks alike. If the coupon pays less than the funding costs, you’re losing money. Just ask Jerome Powell about the return on the Fed’s SOMA portfolio. Below we take the analysis through adding the net gain or loss reported in AOCI. U.S. Banking Industry Source: FDIC So just subtracting the basics for Tier 1 capital leverage, including taking out the AOCI, we have almost cut Q2 2022 industry capital in half. And we have not even arrived at the fun part, which involves estimating the mark-to-market losses on loans and securities held in portfolio caused by the rapid increase in interest rates by the FOMC. Even if the bank holds these low-coupon assets created during 2020-2021 in portfolio to maturity, cash flow losses and poor returns could eventually force a sale. This is why people who prattle on about how well capitalized are US banks are just showing their ignorance. The table below shows our conservative M2M adjustment for the last three quarters on the almost $12 trillion in total loans and leases owned by banks. We adjust Q4 2021 by 2.5%, Q1 2022 by 8% of total loans and leases, and 15% of total loans and leases in Q2 2022 to approximate the low-end of M2M losses due to the rapid increase in interest rates in 2022. U.S. Banking Industry Source: FDIC As you can see, the industry is already insolvent in Q2 2022 with the adjustment to the loan portfolio, which may be significantly underwater by next year. GAAP allows owners of assets held to maturity to ignore mark-to-market losses so long as they have the capacity and the intent to do so. So, do you sell the 2% and 3% coupon loans and securities at a loss and buy some 8% and 9% loans coupons? Yes you do, eventually. This is how M2M becomes available for sale (AFS) “gradually, then suddenly” to recall Ernest Hemingway’s 1926 novel, The Sun Also Rises . The final part of the analysis is to apply the adjustments above to the $5 trillion bank securities portfolio. The result is another $700 billion in potential M2M losses as of the end of Q2 2022 and a picture of the US banking industry that is a good bit less positive than the conventional wisdom. U.S. Banking Industry Source: FDIC The value of the FDIC data is that they track all of the AOCI even if the banks do not need to add or subtract the balance from regulatory capital. The fact that the US banking industry had $1.3 trillion more in potential M2M losses that capital at Q2 2022 should put to rest any doubts that QE was too much funny money for too long. Notice that none of the economics reporters who cover the Fed ever ask about the impact of QE on the banking system. So now if we turn to JPM, which is one of the better managed banks in the US, the results are better than the industry as a whole but the bank still had a negative capital position at the end of Q2 2022 to the tune of -$16 billion in capital. The capital deficit increased to -$58 billion when we increased the M2M adjustment to 17.5% haircut in our stressed scenario. JPMorgan Chase Source: FDIC, Edgar Don't hold your breath waiting for Fed Chairman Jerome Powell to address the issue of bank solvency at the next FOMC press conference. First QE and now QT has injected such excessive levels of volatility into the prices of assets -- all assets -- that the value of capital has been compromised. Suffice to say that if the FOMC continues to raise interest rates above current levels, then we think that the issue of bank solvency may be front-and-center by next summer. 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.

March 9, 2023 | Updated | Premium Service | On February 28, 2023, Kroll Bond Rating Agency (KBRA) put six classes of notes on Watch Developing issued from three transactions collateralized by subprime auto leases originated by an affiliate of RAC King, LLC . The rating action came following various news articles citing the fact that American Car Center (“ACC”) was ceasing all operations and closing its headquarters in Memphis, Tennessee on February 25, 2023. The shutdown came after the reported failure of an ABS securitization led by Atlas, the new vehicle created by Apollo (APO) to acquire the structured products group (SPG) from Credit Suisse (CS) . Why this first ABS deal for Atlas was allowed by APO to fail is unknown, but this is another negative development in the unwind of CS. It also confirms the poor market conditions in the ABS sector more generally. A number of readers have asked why KBRA and other agencies are not taking more aggressive action given the situation in the ABS market. There has been no bankruptcy filing as yet for ACC, but that seems a distinct possibility. Westlake is reportedly taking the servicing book from ACC. CS still has the warehouse assets apparently, but no word on how the transfer of the servicing will impact the bank. https://news.bloomberglaw.com/bankruptcy-law/westlake-to-take-over-servicing-of-american-car-centers-leases Will Silvergate Survive? Meanwhile, Silvergate Financial (SI) continues to attract more attention from short-sellers, this despite the fact that most of the supra-normal returns have been squeezed out of the stock. We profiled SI back in February of 2022 , when the bank was “only” trading at 2.4x book value vs 12x in March 2021, at the height of the crypto craze. The stock peaked at $219 in November 2021. How did we know that SI was probably a time-bomb for counterparties and investors? First obvious risk indicator was legal and regulatory risk of know-your-customer (KYC) and anti-money laundering (AML) compliance for a depository facilitating crypto transfers. At least with similar stories like Robinhood Markets (HOOD) and Interactive Brokers (IBKR) , the crypto trades occur away from the broker-dealer. Ian Katz at Capital Alpha Partners notes that “there’s now an open discussion in the industry about whether the bank and its holding company, Silvergate Capital, are more likely to file for bankruptcy or be forced into FDIC receivership.” So long as the subsidiary bank of a bank holding company (BHC) is solvent, it is possible to recapitalize the bank. If, however, the bank is insolvent or has other regulatory issues that affect solvency, then the State of California and/or the FDIC can declare the bank insolvent and place the depository into a federal receivership. In the event, the BHC loses 100% of the investment in the bank and often files bankruptcy. The reason we were suspicious of SI going back to 2020 was that the equity of this small mortgage bank was following the market progression of crypto stocks rather than banks, always a bad sign. Banks are designed and regulated to be boring underperformers. When a bank evidences market performance that is dramatically different from other banks, that is usually a sign of something being amiss. Besides SI, perhaps the greatest example of the outlier rule was Lehman Brothers Bank FSB , the non-bank affiliate of Lehman Brothers. In the years leading up to the great financial bust in 2008, Lehman Brothers Bank was the best performing bank in the US with equity returns over 50% annually. The bank was used as the conduit for MBS issuance by Lehman and was shut down in 2009. Does Ginnie Mae Threaten Government Lenders? A recent article in National Mortgage News asked a popular question: “ Are shaky nonbanks putting Ginnie Mae at risk? ” The answer to that question is no. In fact, for a number of reasons Ginnie Mae is a source of risk to independent mortgage banks (IMBs), depositories and the financial markets more broadly. The idea of IMBs as a source of risk to the US government is accepted doctrine in Washington. In fact, Ginnie Mae and the federal agencies that it serves, including the FHA, USDA and VA, take liquidity from the private financial markets and create the very liquidity problems that so vex housing agencies and the Financial Stability Oversight Counsel Chaired by Treasury Secretary Janet Yellen . Since the 2008 financial crisis and the National Mortgage Settlement in 2012, the cost of servicing residential mortgage assets soared several-fold, making it impossible for less efficient depositories to service government loans. Punitive fines and concerns about reputational risk helped further to drive virtually all large banks such as JPMorgan (JPM) out of the government market, mostly recently Wells Fargo (WFC) . As a result of the exodus of banks and even some nonbanks from the government market, a growing proportion of GNMA servicing assets are controlled by finance companies, real estate investment trusts (REITs) and private funds, which lack internal liquidity or the ability to retain significant capital. Banks still finance government lenders, even if they are no longer willing to take direct risk lending to low-income consumers. While Fannie Mae and Freddie Mac provide liquidity and other support to conventional issuers, Ginnie Mae takes liquidity from the government market and creates other unnecessary obstacles that prevent IMBs from accessing vital bank financing. For example, due to budget snafus and internal disfunction, Ginnie Mae is unable to process requests for new acknowledgement agreements in a timely fashion. Backlogs stretch back more than a year. Meanwhile, funding requirements are growing with the level of defaults. Given that government issuers are required to fund loss mitigation activities from the buyout of the loan to resolution, a process that sometime takes years, the fact that Ginnie Mae cannot assist issuers in expanding financing arrangements to support loss mitigation is tragic. But this striking example of the disfunction and indifference of Ginnie Mae is only the beginning. Late last year, a senior HUD official, Michael Drayne , resigned suddenly, leaving members of the mortgage finance community scratching their heads. In the intervening months, more information emerged, including a lawsuit brought by a small mortgage firm against Softbank subsidiary, Fortress Investment, and its former affiliate, New Residential Investment, now known as Rithm Capital (RITM). The lawsuit ( 360 Mortg. Grp. v. Fortress Inv. Grp., 19 Civ. 8760 (LGS) (S.D.N.Y. Mar. 30, 2022 ) alleges that Fortress, which managed and controlled the RITM REIT at the time, conspired with at least one Ginnie Mae official to put 360 Mortgage out of business. 360 Mortgage and Fortress had a previous business dispute and relations between the two firms were strained. While claims made in civil lawsuits are often disproven, the US government has now seemingly confirmed the allegations made by 360 Mortgage in an official report. Early this year the Office of Inspector General (OIG) for the U.S. Department of Housing and Urban Development (HUD) posted a heavily redacted report that explains the back story to the litigation against Fortress and the departure of Drayne. https://www.hudoig.gov/reports-publications/investigation-summary/investigation-alleged-misconduct-ginnie-mae-senior-vice The complaint alleges that an official of Fortress/RITM threatened to put 360 Mortgage out of business. Subsequent to the threat, Ginnie Mae EVP Michael Drayne reportedly took the unusual step to accuse 360 Mortgage of fraud and place the firm into default. The narrative suggests an agency that is out of control, with a large issuer using the most senior civil servant in Ginnie Mae to purse a private vendetta against a smaller Ginnie Mae issuer. The names of the Fortress/RITM representatives have been redacted from the report. The ID for 360 Mortgage in the OIG report is “Issuer 1.” The complaint states: "On July 16, 2018, Defendant's in-house counsel called Plaintiff's counsel and threatened to put Plaintiff out of business if it did not pay the disputed amount, and warned that Defendant had a close relationship with GNMA and that it was meeting with GNMA the next day.” In addition, the OIG report goes on to recount other machinations by Fortress/RITM representatives and Ginnie Mae officials led by Drayne. Most significant, Fortress/RITM allegedly tried to convince Drayne to default another servicer, Ocwen Financial (OCN) , after it was sued by the CFPB in 2017. The ID for OCN in the HUD OIG report is “Issuer 2.” HUD’s OIG reports that Drayne communicated about OCN with Fortress/RITM representatives as early as 2016, sharing material non-public information about OCN and essentially discussing the sale of OCN’s assets to RITM. An excerpt from the OIG report is below. The reference to “IC” appears to be RITM: “OIG’s review of Drayne’s emails showed that Drayne solicited IC Representative’s thoughts about Issuer 2 as far back as a year prior to its April 2017 distress. Specifically, in an email dated March 1, 2016, Drayne asked IC Representative if he could get his “thoughts about [Issuer 2] sometime in the next couple of days. Drayne told the OIG that Issuer 2 serviced a “pretty substantial amount of [Investment Co.’s] assets,” that IC Representative was in a position to “take steps that would have . . . somewhere between harmed .. . or . . . ended [Issuer 2’s] business, really,” and therefore “we would have been strategizing about . . . what might happen here and is there anything we can do to be prepared.” The passage above suggests that the Ginnie Mae official and Fortress/RITM were discussing the termination of OCN’s status as a Ginnie Mae issuer. Given that RITM was seeking a Ginnie Mae issuer license from Drayne at the very same time these discussions occurred makes the situation even more conflicted. Of note, HUD took the unusual step of making an appearance in the 360 Mortgage litigation as an "interested party," apparently because Drayne and perhaps other parties as yet unnamed clearly acted outside the scope of their employment at HUD. For the same reason, the redacted OIG report was subsequently made public by HUD. One industry CEO who reviewed the OIG report told The IRA that “I have lost all confidence in Ginnie Mae and their ability to protect non-public, confidential information. This is a huge problem for the industry." Of note, representatives of the Department of Justice, 360 Mortgage, HUD, Ginnie Mae, and RITM did not respond to written requests for comment. Fortress responded but had no comment. We suspect that this incident and the lawsuit are going to get greater attention, both from investors and also in Washington, in the weeks and months ahead. More than six years have gone by and HUD and Ginnie Mae have yet to resolve the matter or to formally notify Congress of these disturbing events. Ginnie Mae officials learned of Drayne’s action in May 2017, but the HUD OIG was not notified until January of 2018. Drayne did not leave Ginnie Mae until the end of 2022. Incredibly, Ginnie Mae officials have refused to confirm that Drayne has left the agency and have made no comment despite several requests. It is SOP at The Institutional Risk Analyst to take allegations from lawsuits with ample seasoning, but in this case the complaint brought by 360 Mortgage against Fortress/RITM appears to be largely confirmed by the report from the HUD OIG. We suspect that this incident and the lawsuit are going to get greater attention, both from investors and also in Washington. Five years have gone by and HUD Secretary Marcia Fudge has yet to resolve the matter or to notify Congress of these events. More, there is no mention of this lawsuit in the latest RITM 10-K. 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 27, 2023 | Watching the debate over interest rates and the economy, it is a point of fascination to The Institutional Risk Analyst that virtually nobody in the economic profession or media talks about the Fed’s balance sheet. Indeed, by expanding its balance sheet via quantitative easing or QE, the Federal Open Market Committee arguably lost control of monetary policy and has placed America's banks in grave risk. Since the start of the Fed’s tightening, the nominal size of the system open market account or SOMA has declined, but the duration-adjusted value of the portfolio and the entire mortgage finance complex has exploded several-fold. Mortgage-backed securities (MBS) with sub-5% coupons have seen loan prepayments slow to low single digits, extending the effective maturity of the Fed's mortgage hedge fund by 3-4x. The chart below from FRED shows Treasury debt and MBS on the left scale and reverse RPs on the right. By facilitating the mortgage lending boom in 2020-2021 during the Fed’s most extreme period of open market operations, the Fed has captured and effectively sequestered more than $12 trillion in duration represented by the $2.8 trillion notional in MBS held by the SOMA portfolio. The chart below shows the distribution of Ginnie Mae MBS by coupon: The effective duration of all outstanding MBS from 2020-21 is roughly 3x the original duration when these securities were created. This upward surge in duration represents the extension in the average life from low single-digit years to more like 12-15 years. And the duration of the entire mortgage market, including whole loans owned by banks, also expanded by a similar amount. The fact that 75% of all MBS are now between 2% and 4.5% coupons shows how the Fed’s actions have concentrated risk on the balance sheets of banks. Since the Fed does not hedge the market risk on its vast securities portfolio, the long MBS position is essentially isolated from the market. Selling pressure on 10-15 year Treasury paper and swaps is reduced. Likewise the Volcker Rule prohibits trading by large banks around their massive Treasury, MBS and corporate bond positions, thus selling pressure on long-term yields is reduced. In effect, the long-MBS position in the SOMA is in direct conflict with the FOMC’s desire to raise the cost of credit, especially long-term interest rates. But does the Fed really want long-term rates to go up and stay up? The lack of selling pressure from the MBS owned by the Fed also tends to impact the swaps market and the dollar. Thus we come to the real question: Would the negative spread in dollar swaps that has existed since 2008 remain if the Fed were to start actively selling its long MBS position? In June of 2022, we asked whether it wasn’t time for the Fed to engage the Federal Housing Finance Agency (FHFA) under Director Sandra Thompson to fix the growing duration trap facing the Fed, the GSEs (all three, btw), many REITs and the banking industry (“ The Fed and Housing ”). Thompson, who has extensive experience at FDIC and Resolution Trust Corp dealing with bad assets and troubled depositories, understands why time is the most precious aspect of managing risk. In simple terms, the financial world has been massively long bonds (a/k/a duration) in a rising rate environment, a troubling scenario that has left many banks insolvent on a mark-to-market basis. Note that nonbanks and broker-dealers like Goldman Sachs (GS) don’t have this problem. We urgently need to find a way for banks to sell this low-coupon paper, reinvest at a higher rate and buy the time needed to repair the damage to bank capital done by QE and now QT. Last week, the Financial Times profiled Silicon Valley Bank (SIVB) , one of our favorite specialty lenders focused on the technology space. When we worked years ago banking some of the suppliers in the world of semiconductor capital equipment, SIVB was the key relationship for startups and venture investors. But what the bank has in credit sense for lending to early-stage companies it lacks in capital markets expertise. The FT notes that the bank’s market capitalization has been cut in half over the past year: “But some analysts, shareholders and short sellers point to another problem of its making: a move to put $91bn of its assets into a poorly performing bond portfolio that has since amassed an unrealized $15bn loss.” At year-end SVB had negative accumulated other comprehensive income (AOCI) of only $1.8 billion, representing available for sale (AFS) loans and securities, and the net mark-to-market on hedges and other market facing exposures. Yet like the Fed, the GSEs and the banking system, the negative mark-to-market on the retained portfolio at SVB are 10x the AFS book and now threatens to wipe out the bank's actual capital. Remember, the agency and government MBS with 2% and 3% coupons are trading in the low 80s today or 20 points below where they were valued 18 months ago. And these securities are far-beyond the point of being underwater in terms of net carrying cost. Nobody wants to own a Ginnie Mae 2% MBS. This cash negative reality affects most of the banking industry and represents a ticking time bomb that Chairman Powell need defuse pronto. Under GAAP, if a bank buys an MBS and marks it as “held to maturity” or HTM, it can account for the security at cost. However, when an investor loses the 1) ability and/or 2) intention to hold an asset to maturity, it is forced to mark all such HTM securities to market . This is the danger that is approaching the GSEs and many banks, which may eventually be forced by rising short-term interest rates to sell assets that were once meant to be held to maturity. The FHLBs hold hundreds of billions in seasoned low-coupon loans that are underwater vs the 5% coupons on new system debt. The Fed, the prudential regulators, the FHFA and the GSEs need to sit down together and fashion a comprehensive program that will allow banks, REITs and the GSEs themselves to repackage low-coupon loans and MBS into CMOs and sell this paper into the market. The FHFA needs to re-open the doors of the GSEs to securities and seasoned loans older than six months. Once the selling process begins, prudential regulators will need to give banks forbearance in terms of the recognition of losses and the impact on capital. We need to buy time so that banks and the GSEs are not forced into involuntary sales. The good news is that by using the power of the GSEs as underwriters, we can restructure the cash flows from the existing MBS and create attractive “AAA” rated income producing securities and deep-discount zero coupon securities. Banks and other investment grade investors can buy the relatively short-duration front tranches of these CMOs, while long-term investors and insurers will find the longer-duration paper attractive. Since new issue activity in the bond market is dropping, the Fed and banks should create some new duration to offset the market shortfall. If we take a page from the playbook of Jesse Jones , Chairman of the Reconstruction Finance Corp in the 1930s, we should use the superior credit of the federal government to solve a massive duration problem created by the FOMC via QE. The solution to the problem, as it was a century ago, is to buy time. If you don’t have time, then there is no liquidity and no deliberate action possible. Deflation then ensues. Federal Reserve Board Chairman Jerome Powell needs to lead a process to help banks and the GSEs extend maturities and timelines for loss realization. We need to do this before banks are forced to explain to investors later this year why they are reporting gigantic losses on assets they once intended to hold to maturity . And after we get the process started, the Fed itself should engage the GSEs to help slowly sell the SOMA MBS and return this duration to private hands. The GSEs need the business. Once the Fed sells its MBS portfolio, it will once again have control over the size of its 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.

"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.