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November 25, 2022 | As we watch the collapse of the offshore crypto empire of Sam Bankman-Fried and FTX, America’s consumer obsessed media will focus on the victims of the fraud. Long, sympathetic feature pieces will be published in the NY Times and Washington Post about the victims. Tears will be shed. Yet the bigger picture beckons. Despite all the hyperbole, the great crypto fraud was an insignificant game, like the small stakes poker many crypto enthusiasts share as a common background. Crypto was the aspirational nonsense atop the fringe of nonbank finance, enabled by techno hype and encouraged by the Fed’s decade long pursuit of higher inflation. Unbridled speculation in crypto (and money laundering) was one of the downsides of quantitative easing but certainly not the only or largest negative impact of QE. Now that the “commoditized fraud” of crypto, to quote one observer, has met the proverbial kitchen torch of rising interest rates, we can turn our attention to the true message of the collapse of the broader sector of new technology: Fintech is dead and mainstream nonbank finance is an endangered species as interest rates rise and originate-to-sell loan volumes fall. The Motley Fool recently commented that the decline in names such as Block (SQ) , Affirm (AFRM) , and Upstart (UPST) over the past week is due concerns about crypto. All of these firms and others to one degree or another facilitated or encouraged customers to invest in crypto frauds. There is clearly unrecognized legal, compliance and financial risk now associated with crypto, especially for banks that participated in this tawdry speculation. Prudential regulators are still behind-the-curve on crypto fraud involving banks, but expect that to change quickly in 2023. Source: Google Finance The larger drivers of value for the entire fintech universe can be found in more basic concerns. If you look at the difficulties facing nonbanks such as Carvana (CVNA) , the reason for the constraint is certainly not the crypto fraud but rather funding costs. Ally Financial (ALLY) and other near-banks dependent upon unstable brokered deposit are seeing funding costs rise faster than anticipated. We believe that the most significant headwinds facing the fintech sector are rising interest rates, credit spreads and related market volatility. The benevolent credit environment, both in terms of credit default risk and cheap funding, that enabled these firms to grow is now gone, forcing many of them to make significant changes in business models and funding sources. Many fintech firms have migrated to a depository model, but without the benefit of a retail core deposit base upon which to build a LT franchise. SQ, for example, owns a UT based industrial bank. Private players such as Cross River Bank and Evolve Bancorp have catered to the fintech and crypto communities. Let’s ponder some of the Q3 2022 results for some of the leading public players. SOFI Technologies SOFI Technologies (SOFI) , for example, had an investment operation that facilitated crypto purchases for members of the platform. Did SOFI perform know-your-customer (KYC) and anti-money laundering (AML) assessments on all of these participants? We’ll find out. Same question applies to Silvergate Capital (SI) , which we have previously profiled. SOFI’s student loan business is expected to see an upsurge in new origination and refinance activity in 2023. Piper Sandler estimates that SOFI could do over $5 billion in new loan originations vs just short of $3 billion in 2022. Of note, the Biden Administration has been forced to extend the moratorium on student loan repayments due to a court decision voiding the pre-election loan forgiveness announced by the White House earlier this year. SOFI continues to report GAAP losses due to the massive scale of the insider stock awards being made to management. In the nine months ended Q3 2022, SOFI reported a loss of $391 million and, by no coincidence, some $312 million in stock-based compensation expense. There was also a $36 million down mark on the company’s servicing book. To give you a sense for just how far out of line SOFI is with its bank peers, overhead expenses for all of the 132 banks in Peer Group 1 was 2.2% of average assets in Q2 2022. JPM was 1.9%. SOFI’s overhead as a percentage of average assets in Q2 was 16% or more than an order of magnitude above peer. How does management justify such grotesque looting of shareholders? Fintech. Here’s our question: How long are federal bank regulators going to allow SOFI to run GAAP losses to fund stock-based compensation at these levels? In theory, regulators could let SOFI generate GAAP losses forever. The stock-based compensation just dilutes shareholders not the capitalization of the bank. Yet the disclosure is truly ugly. The organization chart for SOFI is shown below. Notice that the group now includes a UT national bank, a broker dealer which is the SOFI transaction platform for securities issuance, and various other entities used for crypto and investment activities. Source: FFIEC While the managers at SOFI obviously see no problem awarding themselves huge equity compensation that drives the company into loss , SOFI is a $15 billion asset bank holding company now and the performance metrics look just OK -- if you ignore the stock-based compensation. Imagine the uproar if an established bank like JPMorgan (JPM) drove itself into loss quarter after quarter to fund insider stock awards. Sadly, there are many such examples of corporate excess in the fintech sector. Source: FFIEC So far, interest expense for SOFI is keeping pace with interest earnings, but the future may not be so kind. Net non-core funding dependence was 37% of total assets vs 3% for Peer Group 1 in Q2 2022. The gross yield on the SOFI loan book was 7.3% in Q2 2022 vs 4% for Peer Group 1. The yield on total earning assets is just over 6%. Funding costs were 1% of average assets for SOFI vs 0.22% for Peer Group 1 as of Q2 2022. Source: FFIEC SOFI has $5 billion in deposits and $8 billion in debt funding its balance sheet at the end of Q3 2022. As you can see, SOFI lives in the same neighborhood in terms of funding as ALLY, but has 200bp more gross yield on its loan book. These positives aside, the outsized executive compensation at SOFI and resultant GAAP losses result in an efficiency ratio of 126 vs 60 for JPM. Originations and purchases of loans was $11.6 billion in the first nine months of 2022, an impressive 24% increase. Loan sales by SOFI inexplicably fell to just $6.6 billion, a 30% decline, in the same period. Where did the other $5 billion in loans go to? Could it be that SOFI is starting to warehouse loans that it cannot sell? That brings us to UPST. Upstart Holdings A more serious situation is faced by UPST, the poster child of the fintech world that was crushed earlier this year when management disclosed that they had been forced to retain loans that were originally intended for sale. UPST has seen revenues and profits fall significantly as volumes have fallen and interest expense rising. Indeed, UPST is the worst performing name YTD on our fintech surveillance list, but don’t hold your breath waiting for a Sell Side analyst to break the news. Upstart (Q3 2020) In addition to declining profits, another risk factor facing UPST and other fintech lenders is increased state and federal regulation. We hear that the FDIC is conducting a horizontal examination of state-chartered banks that have been acquiring loans from UPST and other fintech issuers. Cross River Bank, a private NJ state-chartered bank that was a key leading partner of UPST, perhaps is an institution of interest as well. Remember that the regulators are still at least a year behind the curve on things like crypto and fintech lending platforms. At least one lender believes that the FDIC exam is just an opening volley and that the agency is likely to return next year to focus more attention on assets acquired by banks from fintech lenders. Is this interest from regulators in fintech loans a precursor to criticizing the entire asset category (and thereby increasing capital risk weights)? We shall see. There is also a strong assumption among bankers interviewed by The IRA that the CFPB and state authorities will be getting into the game as well, focusing on fair lending compliance. The up-front pricing on some of the UPST and Lending Club (LC) loan products is quite aggressive, so we think the possibility of CFPB enforcement actions should not be discarded. Recall that the CFPB likes to shoot first, then maybe ask questions when it suits them . But here’s the question: Does the CFPB go after the fintech platform that acquired the lead even if a bank like Cross River, Evolve or others documented and funded the loan? Block Inc The company formerly known as Square reported good earnings in Q3 2022 on traditional business lines, but lost ground on bitcoin revenue. A big increase in administrative, product development and other expenses drove the company into loss for the first nine months of 2022. Assuming that bitcoin revenue continues to ebb, we expect to see some serious cost reductions at SQ or more read ink. As we’ve noted previously, the decision to rename the company Block and move into crypto currencies was a poor decision by management and now exposes SQ to the risks detailed above. In addition, at the end of 2021, SQ was sued by H&R Block for trademark infringement. The lawsuit alleges that the SQ’s rebranding to Block, Inc. and use of a green square logo in connection with the Company’s Cash App Taxes product infringe HRB’s trademarks and are likely to cause consumer confusion. HRB demands that the Company stop using the Block name and associated branding, and further demands that the Company stop using the green square Cash App logo. In addition to the missteps regarding the change of name, the quality of SQ earnings has deteriorated because of gimmicks related to crypto tokens and offshore acquisitions, customer cash flows and loss recognition. Much of the information presented by SQ to investors is modeled rather than actuals, including: “Accrued transaction losses, contingencies, valuation of loans held for sale, valuation of goodwill and acquired intangible assets, determination of allowance for loan loss reserves for loans held for investment, determination of allowance for credit losses for consumer receivables, pre-acquisition contingencies associated with business combinations, allocation of acquired goodwill to segments, assessing the likelihood of adverse outcomes from claims and disputes, accrued royalties, income and other taxes, operating and financing lease right-of-use assets and related liabilities, and share-based compensation.” We view the use of modeled results rather than actuals as a troubling development that warrants caution by counterparties. SQ is still a relatively young company and an even younger near-bank, that is now acquiring foreign assets and liabilities. The adjustment to GAAP reporting that increased cash and cash equivalents for SQ by 50% in Q3 2022 likewise warrants attention. Source: EDGAR Of note, SQ is already starting to attract the attention of state and federal regulators. In 2022, SQ received Civil Investigative Demands (“CIDs”) from the Consumer Financial Protection Bureau, as well as from Attorneys General from multiple states, seeking the production of information related to, among other things, SQ’s handling of customer complaints and disputes related to its Cash App. Over the next few quarters, nonbank financial firms of whatever description will face an extremely challenging environment as interest rates rise, credit spreads remain wide and lending volumes fall. Unlike during QE, nonbanks no longer have an advantage over commercial banks. The good news for the nonbanks is that investor appetite for paper remains very healthy and issuance of new loans is dwindling so rapidly that secondary market sales may stop entirely. If nonbanks can navigate the twin risks of funding and regulation, then there may be clear sailing in 2024. But more than anything else, we hope to see all of the survivors in the fintech sector put the mirage of crypto currencies behind them and focus instead on building real businesses. 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.

November 19, 2022 | Premium Service | The Institutional Risk Analyst has published a new report, "Outlook for U.S. Residential Mortgage Finance 2023," which is available for subscribers to our Premium Service . Non-subscribers may also buy a stand alone copy of the report in our new online store . Questions? Comments? info@theinstitutionalriskanalyst.com In the latest WGA report on the housing market, we discuss trends including: Home Prices : Home prices are expected to fall by double digits in 2023 with the largest decline in prices above the 300k average loan size. High-priced assets are already experiencing compression Lending : Bond market indicators suggest that the US could see double digit mortgage rates in Q1 2023, with the premium contract for Fannie Mae MBS in December at 6.5% Risk : Banks and REITs face mark-to-market losses on loans and mortgage backed securities (MBS) that could be far larger than the visible mark-to-market (AOCI) losses we have discussed in past issues . Liquidity : Falling mortgage lending volumes and record low issuer profitability data from the Mortgage Bankers Association suggests rough waters ahead for issuers. Default : Signs of rising cash advances on delinquent loans in the government loan market suggest that 2023 may be the return of the distressed loan trade as a strategy for institutional investors. Subscribers to the Premium Service login to access the report.

November 17, 2022 | No matter how many books we read, there is really no single quotation that sums up the modern state of affairs in the US in 2022 better than Charles Dickens in “A Tale of Two Cities.” “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair.” Most people never read or see more that the first line of this famous passage, but it is in the entirety of Dicken’s genius that the fundamental human condition is revealed. Many people are simply born to be cheated and robbed, as we now see with the very long list of financial advisors, celebrities and media who were taken in by the great crypto fraud. From a reader, consider this from FTX’s new CEO John Ray in his declaration for the company’s Chapter 11 bankruptcy petition: “I have over 40 years of legal and restructuring experience. I have been the Chief Restructuring Officer or Chief Executive Officer in several of the largest corporate failures in history. I have supervised situations involving allegations of criminal activity and malfeasance [ Enron ]. Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.” If your bank or financial advisor encouraged you to “invest” in crypto assets, now is the time to look for a new relationship. Any supposed professional that could not see that the crypto wave was a temporary redux of the speculative froth seen in the US a century ago, albeit for different reasons, should be dismissed. John Kenneth Galbraith described the “innocent fraud” of the Roaring Twenties, but there is nothing innocent about crypto fraud. How can any fiduciary, officer or director do business with the likes of Bank of New York Mellon (BNY) or Signature Bank (SBNY) unless and until these federally insured depositories see wholesale changes in management and board members? As we write these lines, a new copy of the fabulous book by Daniel Gross, “ A Banker’s Journey: How Edmond Safra Built a Global Financial Empire ,” sits on our desk. What would Edmond Safra say to us about crypto? Safra’s whole life was devoted to accumulating and preserving wealth for his clients. The crypto craze was just the opposite, a period of wealth dissipation driven first and foremost by our friends on the Federal Reserve Board. When you tell the inmates that the dollar has no value as collateral via zero interest rates, we make new games to play. That is the human condition, to chase the shiny object. Yet crypto was the result of far larger forces than mere greed. The recent conclave to consider the shrinking liquidity in the Treasury market, for example, never discussed the role of the Fed and other agencies in reducing market liquidity over the past decade. Treasury Secretary Janet Yellen , who is the architect of the liquidity problems in the Treasury market c/o “Operation Twist” and quantitative easing (QE), now offers us a solution. But everyone on Wall Street knows that it is the Dodd Frank law and the Volcker Rule that hurt market liquidity first and foremost. QE and its aftermath only compounded the problem. Below we show bank securities holdings and accumulated other comprehensive income (AOCI), which was negative $250 billion in Q3 2022. For the same reason that the Fed itself is losing money on payments it makes on reserves, US banks face billions in market losses on QE era loans and MBS with low coupons. Source: FDIC The $6 trillion in bank owned securities are entirely passive. Before the London Whale and the Volcker Rule, banks made active, two-way markets around these portfolios, providing ready liquidity and, important, valuations to the Street and small issuers. Now this huge block of securities, including $1.5 trillion in Treasury paper and $3.3 trillion in MBS is entirely inert. The Fed’s $3 trillion in legacy MBS is likewise entirely passive and unhedged. The solution to market risk a la Paul Volcker and Senator Elizabeth Warren (D-MA) is to dispense with the market entirely. We turn large banks into walled islands of cash and then wonder about ebbing market liquidity. In his latest contribution to The New York Review of Books , Professor Cass Sunstein of Harvard reviews “The Tragic Science: How Economists Cause Harm (Even as They Aspire to Do Good) by George F. DeMartino ( no relation to Danielle ) . Sunstein writes: “DeMartino points to the distinction, drawn by Frank Knight and John Maynard Keynes, between ‘risk’ and ‘uncertainty.’ For example, consider the suggestion from some economists that there is a greater than 50 percent chance of a recession in 2023: a recession is a risk, and we might be able to assign a number to the likelihood that it will occur. But in circumstances of uncertainty, we do not know enough to assign probabilities at all; consider the likelihood of a war in Europe in 2100. As Keynes once put it, on some topics ‘there is no scientific basis on which to form any calculable probability whatever. We simply do not know.’ DeMartino thinks that economists often find themselves in that situation but pretend otherwise.” The embrace of “quantitative easing” by the Fed going back a decade to 2012 is the root cause of the inflation seen in the financial markets ever since. The amount of stupid money that is still sloshing around the financial markets and still over-paying for all manner of assets is enormous, even after wiping out trillions of dollars in paper wealth in the stock market since January. The fact that the dollar swaps curve is inverted from 15s to 50 years tells you all that you need to know about the future direction of US interest rates and, by connection, the dollar. Dollar Swaps vs Treasury Yields Source: Bloomberg The sudden end of the crypto craze, added to the collapse of foreign investing in Xi Jinping’s communist prison in China, is forcing liquidity into other sectors and, yes, US stocks. But the real question is, how “credible” are those published book value numbers from JPMorgan (JPM) et al in the banking world? Even as the world clamors for dollar assets and issuance of all manner of securities falls, the destruction of wealth c/o the FOMC goes on apace. In that first chart about we showed the components of the bank securities portfolio and accumulated other comprehensive income (AOCI). But if we drill down to the composition of the bank portfolio, the discussion becomes even more interesting and illustrates the culpability of Yellen and Fed Chairman Jerome Powell in the approaching bond market and banking system correction. In the chart below we consider the actual securities holdings of banks. Notice that banks own a lot more MBS than Treasury debt, 3x as much in fact, or over $3.4 trillion at the end of Q2. The trouble is that a lot of that paper was originated during the period of QE on an initial duration of say 3-4 years. Source: FDIC/WGA LLC Today the duration of bank-owned MBS is in double digits, 12-15 years. The adjusted MBS series above crudely approximates the financial impact of extending maturities on the overall market risk facing the banks and other holders of MBS and whole loans. The cost of hedging these exposures is enormous, thus the surge in AOCI. But the coming mark-to-market on bank MBS and whole loans could make the AOCI number pale in comparison. Source: FDIC The true “risk weight” of the bank MBS portfolio is closer to $10 trillion or 3x US banking industry equity capital. The entire $13 trillion in notional unpaid principal balance of all residential mortgages has a risk-weight closer to $30 trillion. Or to put it another way, when Fed Vice Chair Lael Brainard says that the FOMC should slow interest rate hikes, she is right, but for the wrong reasons. As we noted in our last missive (" Loan Delinquency, EBOs & Ginnie Mae MSRs ") , the only way current book value of MBS and related servicing assets works is if we assume negative prepayment rates. Fortunately, the FOMC has not figured out a way to push cash into our bank accounts – yet. That’s why we are building “FedNow” – the new face of Big Brother. In the meantime, look for some truly ugly QT-related disclosure from banks, REITs and mortgage companies in Q4 2022 and thereafter. There are literally dozens of banks in the US made insolvent by the policy moves of the FOMC over the past year. Somebody ought to ask Chairman Powell about this. 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.

November 15, 2022 | Premium Service | The annual migration of industry professionals to the IMN MSR East conference in lower Manhattan was well-attended and instructive, though not without some intense debate among participants. The longs are getting a tad bloated as valuations rise, but the shorts in the equity markets are spending a lot of capital to prove they’re right. We'll see. One of the more amusing impressions from the meetings were reports that our friends at Ginnie Mae continue to search for the magic formula that will encourage depositories to return to government lending and particularly servicing. Given the risks facing depositories from both mortgage securities and loans, don’t hold your breath. Banks will happily originate high-FICO FHA loans with 7s and 8s and retain same in portfolio, but will never return to the Ginnie Mae MBS market because of the high cost of servicing government loans. Another entertaining snapshot came when a representative of the Council of State Bank Supervisors essentially threw Ginnie Mae under the bus, noting that the CSBS aligned its recommendations for nonbank capital with the Federal Housing Finance Agency . The CSBS representative then repeated concerns about possible mark-to-mark losses for MSRs owned by banks and nonbanks alike arising from implementation of the Ginnie Mae risk-based capital rule. A number of participants at the IMN event echoed these concerns . It seems obvious that the reported book value metrics coming from many commercial banks, REITs and mortgage banks are a tad inflated, but not to the Buy Side community. Watching Two Harbors (TWO) completing a 1:4 reverse stock split only adds to the aspirational atmosphere in the sector as layoffs accelerate each month. Leading non-QM loan shop Angle Oak (AOMR) has exited the retail channel and Finance of America (FOA) has likewise retreated from the forward loan market. Annaly Capital Management (NLY) is trading near 0.9x tangible book value and Rithm Capital is (RITM) is just above 7x, but how much more should these valuations be adjusted down to account for overvaluation of mortgage servicing assets? NLY’s $1.7 billion in all conventional MSRs are booked at a 5.4x multiple as of Q3 2022. In a forced secondary market sale, these MSRs would likely go for a full multiple below these levels. Here’s the problem. With prepayment rates now below 5% CPR, there is not a lot more room for MSR values to expand. As owners of MSR try to increase the collateral value of the asset, one CEO tells The IRA , you need negative prepayment rates to make the numbers work. Meanwhile, Ginnie Mae is threatening to drive leverage ratios back a decade to 50% on the fair value of MSR, a move that all of the participants agree will end in tears. Meanwhile, some of the more aggressive third-party valuation shops are backpedaling on assessment as the Treasury market rallies more than it has in years. Volatility is no one’s friend in this market, with shifts in the Treasury yield curve accounting for the lion’s share of the market risk. “The Fannie Mae 30-year current-coupon spread to the 5/10-year blend tightened 25 basis points to +141 as the US Treasury 10-year yield fell 28 basis points to 3.81% and volatility was little changed,” Bloomberg reported this week. “The spread decreased the most in more than two years. Yields on Treasuries saw the biggest decrease in more than two years.” We’ve noted before that this sort of market volatility renders attempts to hedge securities or loans effectively useless. But the big takeaway from the IMN conference were the reports of lenders, banks and IMBs alike, that are still coming to grips with what the FOMC has done to the mortgage markets. As one Ginnie Mae issuer asked on a government blog: “Does the FHA expect us to take a 20-point loss selling a reperforming 3% loan?” The answer to that question is most definitely yes. There are a surprising number of banks and nonbanks that are holding early-buyouts (EBOs) of delinquent loans that are in process of modification. Once these loans are again performing, they must now only be held for three months of seasoning before the loan can be sold into a new GNMA pool. But a 3% loan sold into a Ginnie Mae 6.5% MBS could result in a 20-point loss. No surprise that EBOs activity has slowed dramatically over 2022. And now you know why banks want nothing to do with Ginnie Mae servicing. Source: FDIC While many holders of EBOs are not yet selling these QE era loans, it is a pretty good bet that sales will begin in Q1 2022 from smaller issuers. When buyers return with allocations and EBOs become eligible for pooling into MBS, the proverbial decision on loss realization will be forced. In that sense, the worst possible outcome for a large holder of EBOs is timely resolution. Our friend Dick Kazarian of MIAC reminds us that there are two components to the pricing of a loan: Loan Spread : The primary loan rate vs the secondary market rate for whole loans, which has tightened dramatically during 2022 to just 0.87% vs 1.4% in 2020. The primary-secondary spread, excluding the gfee, can be considered the retail markup over the wholesale cost of mortgages or the secondary rate. Swap Spread : The swap spread is the difference between the benchmark Treasury yield and the MBS debenture rate. As mentioned earlier, this shows the difference between the maturity on the Treasury yield curve and the premium MBS for a given market. “In contrast to the primary/secondary loan spread,” Kazarian notes, “we expect significant volatility in the secondary swap spread.” Ditto. We have already highlighted the issue of mark-to-market losses on the books of banks and REITs in low-coupon securities, but another potentially larger risk awaits in the form of EBOs that are financed at 98 cents on the dollar by warehouse lenders but have a current market value in the low 80s or high 70s. It will take only one event of default that reveals this pricing disparity to cause a fundamental re-pricing of delinquent government loans and the related servicing asset. Source: MBA The issue of the collateral value of EBOs and MSRs is important because the rate of cash advances on government loans continues to grow. While the reported levels of delinquency are still falling, in fact cash advanced on delinquent government loans is rising fast, suggesting that loan delinquency will start to rise as well. But add the prospect of the new Ginnie Mae issuer eligibility rule in 2023 and issuers and investors will likely see lower prices for MSRs in the New Year. As we noted during the IMN panel yesterday, banks and nonbanks alike are currently planning their business strategy and operations for 2023 and beyond. Nobody has the time to wait to see what the folks at Ginnie Mae decide to do with their abortive risk-based capital rule. And it is important to remember that the Ginnie Mae rule does not distinguish between government and conventional MSRs. If Ginnie Mae really intends to forcibly lower the leverage allowed on government MSRs, then we expect to see selling pressure across all servicing assets in Q1 2023. Strategic sales of MSRs in 2023 could overwhelm demand from normal portfolio allocations. It is interesting to note, for example, that public marks for Ginnie Mae MSRs are in the mid 4s times annual cash flows, but the private market bid is in the 3x range. How long will banks lend on EBOs and MSRs that are 20% overvalued? More ominously, the prospect of adverse mark-to-market events on MSRs coming at the same time banks are trying to offload underwater loans and MBS could push some bank and nonbank Ginnie Mae issuers into insolvency. Between the FOMC under Jerome Powell and Ginnie May under President Alana McCargo , all mortgage issuers face a perfect storm in 2023. When interest rates do eventually decline, we'll be talking about margin calls a la 2020 on these same assets. 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.

November 10, 2022 | Watching the collapse of the FTX crypto fraud pyramid, we are reminded that most financial stocks trade on tangible book value (TBV). When there is nothing tangible, well, then there is probably little value. Occasionally value hides in plain sight, waiting for the accountants to fashion a new rule and recognize same for GAAP purposes. The gain-on-sale income from mortgage servicing assets, for example, is a case in point. But in the instance of crypto fraud (or what our pal Nouriel Roubini wonderfully dubbed “shitcoins”), the value was only in the eye of the credulous in finance and the media. News reports suggest that FTX Chief Executive Sam Bankman-Fried misappropriated billions in investor funds, which he lent to his Alameda Research firm to the tune of about $10 billion. We have a couple of questions. First, when are state and federal prosecutors going to start prosecuting the crypto shills in finance, politics and media for fraud? Second, when will CNBC , Bloomberg and other financial media stop talking about and advertising for crypto schemes? At what point do the general counsels at media firms say enough and end the public promotion of crypto fraud? Consider two examples: Silvergate Capital (SI) and Signature Bank (SBNY) . We warned our readers that these two crypto banks would soon come to a bad end. Back in February of this year, we profiled the former mortgage bank from Costa Mesa, CA (“ Profile: Silvergate Capital Corp (SI) ”). The fate of the remarkable but tiny SI is a matter of indifference to us compared with SBNY, a $118 billion asset regional bank with a proud legacy that stretches back decades to paramount private banker Edmond Safra and Republic National Bank. We wrote in July : “While many readers of The Institutional Risk Analyst have been watching crypto fiascos like Silvergate Financial (SI) and Signature Bank (SBNY), the prospect of financial problems for the 23rd largest bank holding company (BHC) and a large ABS issuer is cause for concern. But have any of the US bank regulators noticed?” A year ago this week, we warned our readers that the Fed’s “pivot” away from encouraging inflation would result in lower valuations for crypto tokens and stocks, especially the aspirational stocks that followed the crypto upsurge. Crypto has gone from a sort-of juiced up equity strategy to a distressed credit story in just hours. But now that the collective idiocy of crypto and, yes, blockchain too are hopefully falling by the wayside, let’s take a look at how financials are navigating the world of rising interest rates. Roaring Financials Over the past month, our bank surveillance group has rallied on hopes of moderating inflation, with Raymond James Financial (RJF) leading the group higher. The basic explanation for this rebound is twofold. First, the higher-beta stocks in technology and new media are getting hammered, forcing managers to seek shelter in less volatile names in order to preserve and protect that all-important assets under management (AUM). Second, the banks are seeing expansion of new interest margins even as the FOMC pushes ahead on interest rate hikes. We expect to continue to see improvement on the lending/NIM side of the equation, but the market side of the universal banks will continue to suffer weakness in absolute terms and in YOY comparisons. Loan growth will likely slow in 2023 as the economy slows, but notice that the Fed is now being criticized by both Democrats and Republicans. The table below shows our bank surveillance group as of the market close yesterday sorted by price-to-book value. The numbers are hardly distressed and are, in fact, quite normal. JPMorgan (JPM) at 1.5x reported book value is hardly cheap. Bank Surveillance Group Sources: Bloomberg, Yahoo Finance But with the huge swings in interest rates and asset valuations, the real question is what is true book value, net of mark-to-market adjustments c/o the FOMC and underwater loans and securities. Piper-Sandler writes: " GAAP Equity has been negatively impacted as rates have risen. Unrealized losses in AFS securities are included in AOCI (and therefore GAAP Equity), and as bond losses remain unusually large, the hit to equity is likewise bigger than anticipated for most financial institutions." While the fundamental view of financials may be neutral to slightly negative in the next year or so, don’t expect Buy Side managers to be shy about buying banks regardless of the outlook for earnings. So long as credit costs remain muted, the appetite for bank stocks should only grow as investors become convinced of an approaching pause in rate hikes by the FOMC. If credit expenses continue to rise, however, then the bull thesis around bank stocks may start to weaken appreciably. Not only are the equity market valuations of banks and nonbanks overstated coming out of QE, but credit costs remain far below average levels, suggesting that a mean reversion will occur recession or no, simply because of the reset in the floor for interest rates. We temper our generally positive view of lenders with the knowledge that there is no free lunch and that state TBV may fall just as it rose in 2020-2021. Next week we will be reporting on the discussion at the the 8th annual IMN MSR East conference in Lower Manhattan. What does or does not happen to the value of mortgage servicing rights (MSRs) in the next year will be top of the agenda. We have more questions than answers, sorry to say. Click this link to read our latest column in National Mortgage News . 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.

November 7, 2022 | As mortgage interest rates climb to the highest levels in 25 years, the financial services industry has seen a dramatic increase in demand for adjustable-rate mortgages and second-lien mortgages. Second-lien mortgages are a way for home owners to extract capital from the home without selling the house or disturbing an existing first-lien mortgage loan. But not all second liens are the same and these loans present unique risks for borrowers and investors. Home equity loans and home equity lines of credit (HELOCs) are common examples of second mortgages. Both products are traditionally issued and retained in portfolio by banks or other end investors. Why? Because a second-lien mortgage is not eligible to be sold into a Ginnie Mae or conventional mortgage-backed security (MBS) issued by Fannie Mae or Freddie Mac. As a result, the secondary market or “take out” for the second mortgage is essentially comprised of banks and cash investors and is thus limited. Some second mortgages are “open-end” loans, which means that you can continue to take cash out up to the maximum credit amount. As the loan balance is paid down, the obligor can draw principal again up to the maximum loan limit. A bank HELOC is an example of an open-ended loan and is essentially a revolving credit line that is secured by a second lien. But is a HELOC really secured? Other second-lien mortgage loans are “closed-end,” which means you receive the entire loan amount upfront and cannot redraw principal paid after that time. Most home equity products have a maximum maturity, after which the borrower must repay or refinance the loan. Closed-end mortgage loans are far less popular than HELOCs. The chart below shows used HELOCs, undrawn HELOCs and also used closed-end second lien mortgages. Notice that drawn HELOCs fell from a peak of almost $700 billion in total assets in 2009 to below $300 billion today. Likewise close-end second liens peaked around 2009 and have fallen to below $50 billion today. The portfolio totals for banks are rising again, but only just because the runoff on older loans is running in high single digits annually. Source: FDIC The risk to consumers from HELOCs and other home equity products is that these loans typically charge interest based upon a variable rate market index, thus the monthly cost of the loan will rise and fall with market interest rates. Below is an example of the terms for an open-end second lien from loanDepot (LDI) : “loanDepot.com’s home equity line of credit (HELOC) is an open-end product where a minimum draw amount of the greater of seventy-five percent (75%) of the requested line amount (minus the origination fee) will be drawn at the time of origination. No additional draws may be taken for 90 days following the closing date. As you repay the balance on the line, you may make additional draws during the draw period. If you elect to make an additional draw, the interest rate will be based on an Index, which is the Prime Rate published in the Wall Street Journal for the calendar month preceding the date of the additional draw, plus a fixed margin. After the draw period ends, you will no longer be able to obtain credit advances and must pay the outstanding balance over 240 months. During the repayment period, payments will be due monthly. Your minimum monthly payment will equal the greater of (a) $100 or (b) 1/240th of your unpaid outstanding balance at the end of the draw period plus all periodic finance charges that accrued on the outstanding balance during the previous month plus other fees, charges, and costs.” For lenders, the biggest risk from all mortgage loans is interest rate volatility. As interest rates rise and home prices fall, the "equity" in homes also retreats. Or to put it another way, those low-coupon first and second lien mortgages made during the period of quantitative easing (QE) are likely to be underwater by next year. If the first lien loan on a home purchased in 2021 with 20% down at close is underwater next year, what does that say about second liens? If a borrower defaults on an underwater first mortgage, the second is likely to be worthless and represent a total loss to the lender and/or investor. The nightmare scenario for a lender is that the value of the house falls 20% from peak price levels, wiping out any visible equity in the first lien loan. The borrower then pulls on the unused credit in the second lien home equity loan (which the bank also owns in portfolio) and files bankruptcy. This is a catastrophic loss that can quickly cause a bank to fail. The first lien mortgage is likely to cause a modest loss to the lender, but the second-lien is basically unsecured and likely to be a total loss to the bank. The way to understand this risk from a Basel capital perspective is exposure at default or EAD, which measures the risk a bank faces from unused but committed bank lines. The chart below shows exposure at default for all US banks on home equity products. EAD shows unused but committed lines vs used lines as a percentage. Source: FDIC/WGA LLC So if the home owner has drawn half of the available credit on a HELOC, for example, the exposure at default or EAD is 100%. This means the bank could lose the total used and unused amount of the home equity line in the event of default. Now you know why so many lenders do not allow unused credit lines, especially for consumers. As one lender quipped to The Institutional Risk Analyst last week, "there are no net worth requirements for consumers." The old rule in the banking industry is that anything about 50% loan-to-value (LTV) for either consumer or commercial loans is 100% risk exposure through the economic cycle. As the chart above suggests, US banks currently have record credit risk exposure to holders of home equity lines as a percentage of used lines. As the economy slips into recession and the Fed seeks to drive down inflation and, of necessity, home prices, the credit risk on 1-4 family loans will surge. This growing risk is one reason why the Federal Reserve and other prudential regulators are pushing banks to raise capital and sell 1-4 family loans. Source: FDIC Banks are not the only lenders to be concerned about volatility in interest rates, home prices and the resultant credit risk. The GSEs, Fannie Mae and Freddie Mac , are furiously demanding that lenders repurchase performing first-lien mortgage loans because of the reality of credit risk implied by the FOMC’s manic interest rate policies. Simply stated, the GSEs do not have sufficient capital to navigate through a prolonged recession and elevated credit costs. These loans being put-back by the GSEs are performing loans with no apparent defects, but no matter. The GSEs are trying to force lenders to buy them back before falling home prices inevitably push loan default rates higher. Falling loan volumes, and the requirement to redeem the remaining unsecured corporate debt issued by Fannie Mae and Freddie Mac, could force one or both of the GSEs to seek another government rescue. And the repurchase event may sink many mortgage banks. One reader noted after the original post: " Borrower equity is irrelevant when you have an immediate 25 point paper loss on the repurchase of a performing, above water, 3% rate mortgage. Hidden tail risk from contingent liabilities is a far bigger and more insidious threat because of the discount required on the balance sheet for those repurchases. The more volume an IMB did, the more they are exposed." Depending upon how long the FOMC keeps interest rates elevated and how far home prices fall, the GSEs and banks alike face historic levels of risk c/o the FOMC. And has anyone noticed that GSE credit risk transfer (CRT) deals have been trading at a discount of late? Hmm? Remember, for bank lenders running at 15:1 leverage or the GSEs with infinite leverage and dwindling capital, it’s all about exposure at default on all types of mortgage loans. For consumers, the FOMC’s reckless policies of manipulating market interest rates presents a huge risk of default on a home mortgage that is underwater. And rapidly falling home prices present the first true credit risk to consumers and lenders alike since the 2008 financial crisis. Doesn't the triple mandate in the Humphrey-Hawkins law that directs FOMC policy say something about "reasonably stable prices?" 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.

November 4, 2022 | Premium Service | As the week comes to a close, there is much news in the world of banking and mortgage finance. The Teachers Insurance and Annuity Association of America-College Retirement Equities Fund (TIAA) , a $1.3 trillion insurance and investment conglomerate, is selling TIAA FSB (f/k/a Everbank). And as Q3 earnings grind on, there is lot’s more news from the world of mortgage finance, good and bad. Subscribers to the Premium Service of The Institutional Risk Analyst read the details below. The big news this week starts with the poor showing by Rocket Companies (RKT) , reporting a loss for Q3 2022 and a big decline in volumes. “Like most home lenders, its production volumes were decimated by rising rates and evaporating refinances,” writes Paul Muolo at Inside Mortgage Finance . “In 3Q, Rocket funded $25.6 billion, down 25.9% on a sequential basis. For comparison purposes, the company originated $75.9 billion in the fourth quarter of 2021, when rates were still comparatively low.” As of September 30, RKT’s mortgage servicing portfolio included 2.5 million clients with $531 billion in unpaid principal balance. At the end of the third quarter, the value of RKT’s mortgage servicing rights was $7.3 billion, an increase of $1.9 billion or 26% year-to-date. In '20 and '21, nearly 50% of the mortgages that RKT originated came from were clients that were in firm’s servicing book, meaning there's virtually no cost to acquire the new asset. During the quarter, the value of the RKT MSR asset increased by $600 million, including a $400 million positive mark-to-market adjustment, yet the company still lost money. Why? Because RKT is slow-walking expense reductions due to the firm’s significant excess capital and liquidity position. “The decision-making, of course, is not based on the profitability of a day, a week, or a month,” said Rocket CEO Jay Farmer . “The decision-making is based on the metrics that will tell us that the investments we're making are going to pay off in the long run.” In other words, RKT is not going to chase United Wholesale Mortgage (UWMC) as it buys market share at the cost of profitability. UWMC reported earnings this AM and, as noted above, the company is buying market share with both hands. UWMC originations of $33.5 billion in 3Q22 compared to $29.9 billion in 2Q22 and $63.0 billion in 3Q21. Purchase originations were $27.7 billion in 3Q22, the best purchase quarter in UWMC's history, a 24% increase compared to $22.4 billion in 2Q22 and a 5% increase compared to $26.5 billion in 3Q21. Of note, even as mortgage profitability has been cut in half, UWMC has been offsetting dwindling production income with MSR sales. “Through the first nine months of 2022, UWM transferred $85.5 billion in MSRs to other shops,” according to Inside Mortgage Trends . “Transfers reflect MSR sales.” In sharp contrast to the volatility shown in RKT and UWMC results, Guild Mortgage (GHLD) reported another profitable quarter, confirming our earlier view that this mortgage issuer is one of the best managed businesses in the industry. The press release says it all: GHLD generated GAAP net income of $77.4 million, or $1.26 per diluted share, compared to $58.3 million, or $0.95 per diluted share, in 2Q22 Adjusted net income was $24.1 million, or $0.40 per share, compared to $13.9 million, or $0.23 per share, in 2Q221 Net revenue totaled $261.2 million compared to $287.5 million in 2Q22 GHLD’s adjusted EBITDA totaled $32.9 million compared to $22.0 million in 2Q221. And total originations were $4.4 billion or 91% purchase loan volumes. The announcement that TIAA is selling the $33 billion savings bank (f/k/a Everbank) into a club deal led by Warburg Pincus is hardly a surprise. TIAA never knew what to do with the bank and now, five years later is selling the bank in a down market. TIAA will remain a minority investor, but intends to spin the trust business into a new regulated bank. As in the case of past successful WP bank investments (Varo, Citizens, National Penn), Warburg is a very credible lead. No investors will "control" the bank per se, but will have substantial influence on the deal via the board. Investors will include Stone Point Capital, Warburg Pincus, Reverence Capital Partners, Sixth Street and Bayview Asset Management. The bank will be renamed and operated independently of TIAA and its investment affiliate Nuveen. The bank will, however, have an arms' length relationship with all investors per Reg W. Bayview is an investor in the deal, but that will not really help them fund the mortgage business even if they deposit escrows in the bank. Only by owning 100% and merging Bayview’s mortgage operations into the bank would any real benefits be realized. TIAA FSB bank is a peer performer, but loan yields are low and there is a large slug of non-core funding. The bank’s low efficiency ratio (37%) may change on a standalone basis once the parent-bank connection with TIAA is ended. Virtually everything on the balance sheet is held-to-maturity, so there may be some surprises in the portfolio awaiting the buyers. TIAA FSB has a surprising amount of foreign exchange exposure and also $10 billion in footings held off balance sheet. At the end of Q2 2022, TIAA FSB reported an over $100 million deficit in terms of accumulated other comprehensive income (AOCI), but that number magically turned into a profit in Q3 2022. It will be very interesting to see how this bank looks once the transaction closes. 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.

November 2, 2022 | Former Fed Chair and now Treasury Secretary Janet Yellen is said to be monitoring the ebbing liquidity in the Treasury market “closely.” Since the author of “Operation Twist” and other acts of idiocy by the FOMC during Yellen’s tenure is now the cause of illiquidity in the market for government debt, it is good to know that she is still on the case. In our view, Secretary Yellen should be sent into well-earned retirement to spare the nation the cost of more of her good works. So badly have the Federal Reserve Board under Jerome Powell and the Yellen Treasury screwed up the term structure of interest rates in the US that the Treasury may now be forced to buy-back low coupon debt to set things right. By manipulating the Treasury bond market, Yellen and Powell have created yet another problem. The ignominy of the US taxpayer exchanging low-interest bonds for current coupons merely to suit the convenience of institutional investors should provoke outrage in Congress, but not a sound is heard from the world's only permanent criminal class. Members of Congress are largely clueless about the ways of means of the FOMC. As readers of The Institutional Risk Analyst know, the Treasury debt and MBS issued in 2020-2021 comprise an illiquid ghetto that nobody wants to own save a few unfortunate central banks. The hedging cost on GNMA 2% MBS is 3x current coupons and, even then, may not be effective. Similar problems are seen with low-coupon US Treasury debt. No surprise, the Fed is now running a negative funding spread, paying out more in interest on reserves than it earns from those low-coupon bonds it created during QE. Some central banks may be needing some liquidity rather soon. Over the weekend we were struck by a report in the Financial Times that suggests that the EU is finally unravelling, with the stronger fleeing the weaker credits. German Finance minister Christian Lindner says it is cheaper for many countries to raise their own debt rather than borrow jointly to address energy subsidies. Why? Because the growing pile of unsecured EU debt is trading at higher yields than the debt of the member states. “The financial advantage the commission, and many member states once hoped for from common European debt, as opposed to issuing debt on a national basis, no longer exists,” Linder said. With EU debt trading just shy of 3% and Germany close to 2%, Linder made the obvious calculation. The table below shows yields on various government debt. Source: Financial Times Part of the reason for the poor performance of EU debt is the fact that ECB Governor Christine Lagarde is foundering badly in the growing political storm in Europe. Her comments about inflation “appearing out of nowhere” made her a laughing stock in European financial circles, but few people in Europe are laughing in public. With total EU debt now approaching 100% of GDP, Lagarde has dug a financial hole that may eventually fracture the EU. The more basic problem faced by the EU and Japan is that the US is headed for a 5% fed funds rate by year-end. The U.S. yield curve and swaps remain inverted, however, with 10-year Treasury notes above 4%. The 30-year Treasury bond is below 3.75% and 50-year swaps below 3%. The inverted yield curve is not so much a signal for impending domestic recession, but rather highlights the entrenched belief by investors that U.S. interest rates will soon fall. Demand for dollars, as evidence by the deeply inverted curve for dollar fixed-to-floating rate swaps, remains brisk. A swap collateralized by US Treasury debt is the functional equivalent of the collateral, less fees of course. The inverted yield curve also displays the rather serious bias of economist surveys, which see the fed funds rate reaching 5% by February 2023 and remaining elevated through December of next year. The consensus survey of economists then sees fed funds falling to ~ 3.5% before the November 2024 general election. This is called a "soft landing" in the parlance of the Buy Side asset gatherers. Most of the economists surveyed, of course, work for Buy Side firms that earn a living by gathering and managing assets in a predictably mediocre fashion. Yet like Pavlov’s Dog , investors are now hard-wired to buy stocks when they fall by a certain amount. No additional conditioning is required. Edward Chancellor writes in The New York Review of Books : “Professional investors, who fear that clients will leave them if they underperform, may be forced to buy overpriced stocks to preserve their jobs—that is, they rationally choose to make seemingly irrational decisions. This problem becomes acute when investment performance is measured over the short term; as Keynes observed in his General Theory, most money managers are concerned ‘not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.’ Such behavior makes markets inherently unstable.” Do Buy Side investment managers and their pet economists cause market volatility? Former Treasury Secretary Larry Summers said as much in a Bloomberg interview, calling out the “growing chorus” of the “consensus of economists who have a track record, since COVID, of being dismally wrong on inflation. I believe this advice is badly misguided.” The cult of ever falling interest rates goes back 50 years and spans the terms of Fed chairs back to Alan Greenspan and Paul Volcker , who only fought inflation after President Ronald Reagan was elected in 1980. Neither the economists nor the advisors they serve would ever recommend that clients move to cash, as illustrated by the equity market selloff in 2022. The faithful expectation of a Fed-induced rally in both stocks and bonds drives the projections of an impending pivot. Like earnings projections, the purpose of projecting falling interest rates this side of the Fed event horizon is to convince investors to go back into equities early, before the actual fact. This strategy is easily predicted because all of us have seen that same movie before, with the FOMC coming to the rescue of a swooning economy. Most of the pundits and prognosticators are basically following the consensus view, with interest rates falling in Q1 2024. Exhibit A is the rally in financials over the past month, with Raymond James Financial (RJF) leading the group and such dogs as Deutsche Bank (DB) and Bank of America (BAC) galloping at 20-30% annual rates. But is this the time to be buying financials? It is fair to say that few of the managers buying these bank names for client portfolios has any idea about the risk that lies ahead. Specifically, the FOMC has kept fed funds artificially low since the 2008 financial crisis. The conflicted consensus view says fed funds will eventually settle back to 2019 levels of 3%, this after the Fed slays the inflation dragon. Mortgage rates, in this view, will fall back into the 5s. But what if the “reset” in interest rates is more like 4-5% fed funds, as was the case prior to 2008? And what does a 4-5% terminal rate say about future credit costs? One big reason why we think that any interest rate ease will be modest and grudging is the issue of volatility and related losses to investors and financial institutions. The growing clamor by investors for the US Treasury to repurchase low coupon bonds is a very real concern driven by real market realities like volatility and hedging costs, which directly impact new securities issuance. But the cost of fixing the handiwork of Janet Yellen and Jerome Powell may be very high indeed. Both because of concerns about inflation and also the FOMC’s growing awareness of the extent of the damage to markets done by QE, we expect the Fed to move very slowly to change interest rates once the necessary increases have been made. We expect the “ease” in FOMC policy to be merely a cessation of rate increases. That could be quite a surprise to the comfortable and entirely biased Wall Street economic consensus. 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.

October 28, 2022 | Updated | As we near day-30 since the close of the third quarter, the pain being felt across most markets is palpable and growing. Not a lot of fun for operators or analysts or even bank regulators. The FOMC is coming dangerously close to causing a repeat of the S&L crisis among smaller depositories. In this spirit, The Institutional Risk Analyst checks in on two important players in the world of mortgage and structured finance, PennyMac Financial (PFSI) and Credit Suisse AG (US) . Credit Suisse AG Credit Suisse is a Zurich-based bank that does a global investment banking and wealth advisory business. CS is the final holdout among the Swiss private banks in terms of exiting the transactional world more than a decade since 2008. A decade ago this month, UBS AG (UBS) fired 10,000 investment bankers and exited the world of fixed income investment banking forever. Today UBS is the largest private bank in Switzerland and by a wide margin, while CS is a laggard. In the wake of the $5.5 billion in losses and reputational damage caused by the hedge fund Archegos Capital Management , CS has decided to spin off the investment bank as a resurrected “First Boston.” CS also just settled a long-standing claim from the 2008 financial crisis to the tune of $500 million. Bloomberg reports that Apollo Management (APO) and PIMCO are in negotiations for a club deal to finance the spin-out of the CS structured finance group. No sign of Citigroup (C) or the Fortress Investment unit of SoftBank . Did our friend Charles Gasparino of Fox Business really really , suggest TD Bank (TD) or Canadian Imperial Bank of Commerce (CM) as prospective buyers for the CS investment bank? We cannot imagine a more frightening possibility. CS is a relatively small global bank, with roughly $700 billion in total assets and less than 50% deployed in loans. At the end of Q3 2022, the bank had 6.5% capital to assets and $370 billion in customer deposits. In the US, of note, CS operates as a broker-dealer rather than a commercial bank, a pattern followed by many EU names. The corporate taxonomy of the US operations of CS is below: The bank is said to be raising an additional $500 million in equity to bolster its balance sheet, which is well-below required Basel III levels. As of the date of this report, CS was trading at 0.27x book value and + 250bp over the curve in credit default swaps, roughly mapping to a “BB-” ratings equivalent. CS is down 56% YTD while the close comparable, UBS AG, is down just 11% and is still trading above book value. As we’ve documented over the years in The Institutional Risk Analyst , the asset gatherers tend to have higher market valuations and lower volatility than the universal banks with transactional risk. Thus CS trades on a beta of 1.5x the average market volatility vs 1.0x beta for UBS. End of story. We suspect that Swiss regulators and other private bankers will be very pleased to see CS exit the world of investment banking and structured finance for good. PennyMac Financial PennyMac Financial Services (PSFI) reported earnings yesterday. Like COOP, volumes are down dramatically from 2021 but MSR values and cash flows from servicing are rising, providing collateral to fund advances or operations. The key caveat is that issuers must manage expenses very aggressively. In times of rising interest rates and falling lending volumes, lenders with substantial servicing books generally fare better than lenders that sell loans servicing released. The chart below is from the PFSI earnings release. Like COOP, PFSI is well-above the capital requirements for the new risk-based capital regime from GNMA and had more than adequate access to liquidity. Both of these firms control a servicing book measured in the millions of loans to feed leads to a consumer direct lending platform, the lowest cost way to originate a new loan asset. The rising value of the MSR provides a natural hedge for the declining production income of the lending business. While there have been some hyperbolic reports in the media about the impending collapse of PFSI and other large issuers, in fact the liquidity situation for the large players is improving even as loan delinquency rates return to pre-COVID levels. Note in the slide below the history of advances on PFSI’s half trillion dollar servicing book. How is this possible when aggregate advances in the industry are rising 30% YOY? Because mortgage lending remains a very fragmented business with wide dispersion in operating models. The true situation at present with respect to liquidity for PFSI and other large GNMA issuers is that cash flow requirements are continuing to decline even as interest rates rise to 20-year highs. This is the lingering effect of the Fed’s QE, which drove loss given default (LGD) for conventional and bank-owned 1-4s negative over the past two years. How is this possible? Ask Fed Chairman Jerome Powell . “Servicing advances outstanding decreased to approximately $397 million at September 30, 2022 from $506 million at June 30, 2022,” PFSI reports. “No P&I advances are outstanding, as prepayment activity continues to sufficiently cover remittance obligations.” In other words, PFSI has more than sufficient internal cash flow to finance any default advances without pulling on bank lines – a situation that has existed for several years, of note. Short-sellers drinking the tea of hyperbole beware. The indicators of liquidity for a large seller/servicer such as PFSI are not immediately apparent to market observers, in part because large lenders with equally large servicing books generate enormous amounts of free cash flow. As volumes fall and issuers are able to recapture the equity component of advance lines, cash grows but uses for this cash in terms of lending are limited. To paraphrase the exchange in the 1982 John Milius film “ Conan the Barbarian ,” what is best in life? What is best in mortgage lending? Piles of ready cash and committed sources of liquidity from large banks. When PFSI CEO David Spector tells you he has not needed to draw on advance lines to pay principal and interest on defaulted loans, that is a good sign that belies the predictions of imminent disaster. Below is the table showing PFSI’s adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). Some readers have expressed confusion over our past warnings regarding mounting delinquent loans, particularly in the government sector, due to the high cost of default resolution. Those warnings remain very much in effect and, indeed, have been broadened. Fact is the total amount of cash advanced on delinquent loans (including COVID forbearance is still rising, but not apparently at PFSI. Like any financial company, you cannot really tell what is going on inside a bank or nonbank based upon GAAP financials. The operating dynamics and financial flows inside a bank or a nonbank issuer with substantial owned or third-party servicing assets are far more complex than outside observers in the financial community appreciate. The cash flows generated by loan prepayments, for example, are largely invisible but very definitely an operating benefit. So what is best in life when interest rates are rising? A big servicing book. Is future loan delinquency going to be a substantial expense for PFSI, COOP and the other leading government issuers in 2023 and beyond? Yes. But we worry more about the market risk facing lenders in the TBA markets. Our recent comments about future margins calls as and when interest rates fall are the real risk facing the industry as MSR valuations march ever higher. The table below shows the MSR disclosure from PFSI's Q3 earnings. PennyMac Financial Services The Fed, after all, is the single biggest risk to the world of bank or nonbank finance. But the destabilizing effect of mark-to-market losses on loans and MBS due to rising interest rates is front of mind for prudential regulators and the Federal Housing Finance Agency. We hear increasing concern about the Ginnie Mae risk-based capital rule from investors, lawyers and regulators as we head to the end of the year. Could Q1 2023 be the great flushing away of M2M losses by U.S. banks? Indeed, we think there is a growing chance that prudential bank regulators, worried about already insolvent depositories and the prospect of a 20-30% markdown in $120 billion in MSRs in Q1 2023, will pressure HUD, Treasury Secretary Janet Yellen and the Biden Administration to withdraw the Ginnie Mae RBC rule entirely. In any event, PFSI, COOP and other large issuers easily meet the Ginnie Mae RBC rule today, in fact, several times over. But they cannot control what happens to the MSR market. If Ginnie Mae’s astounding insensitivity to market risk and the rules of finance causes a wholesale markdown of MSR valuations, everyone loses. You might think the larger mortgage issuers would like to see many smaller players exit the market, but no. Only fools believe you can encourage an industry consolidation and reduction in leverage on MSRs in the current rate environment without courting disaster. 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.

October 26, 2022 | Premium Service | As earnings season grinds on, readers of The Institutional Risk Analyst are coming to appreciate just how contorted are Q3 2022 earnings results vs last year. As we told Liz Claman on Fox Business last week, you can just throw the past two years of financial data into the trash from an analytical perspective. We note in our last comment (“ AOCI: The Winter of Quantitative Easing ”), that the stress visible in banks and nonbanks is rising. This is due to the huge price volatility injected into markets by the reversal of the Fed’s pro-inflation policies. More, the price risk in committed but undrawn lines from banks is another area that may soon color a number of credit profiles. In this issue, we look at the results from Mr. Cooper (COOP) , one of the earlier filers among publicly traded nonbank lenders and servicers. The story is what you’d expect, with declining lending volumes and a rising mark on the owned mortgage servicing rights (MSR) to 162bp or over 5x annual servicing income. The table below from the COOP Q3 presentation shows the growth in total book value of equity and the decline of deferred tax assets (DTAs) as a portion of capital. Yet more than half of COOP’s servicing book owned by third parties, a fact that enhances income while reducing operational risk to COOP shareholders. The market for MSRs continues to be supported by interest rate trends. The new discloser this quarter is where COOP books servicing on “base servicing.” Assuming that is 25 bps per year of gross spread, they are booking at-the-money servicing at over 6x and apparently augmenting GAAP earnings with large amounts of excess servicing, also at rich valuations. Yet valuations may go higher still as the Fed pushes rates higher. “Servicing assets have experienced significant YTD 2022 price increases across all four sectors and both vintages, with a UPB-weighted increase of 1.17 multiple (or 30.0%),” notes Mike Carnes , MD of the MSR Valuations Group of MIAC . “Within conventional products, pricing increased substantially more for 30-year than for 15-year, in both absolute (1.37 vs. 0.68 multiple), as well as relative (32.5 vs. 19.1%) magnitude.” Carnes notes that the uptick in MSR valuations comes with the move in 30-year spreads: “This is primarily due to the less negative 15-year option-adjusted durations (OADs) at the start of 2022 vs the substantially more negative 30-year OADs (-13.1 vs. -20.1),” he reports in the Fall 2022 Perspectives . A number of traders have been short the COOP common for months, this on the assumption that the markets would punish this nonbank in the same fashion as smaller seller/servicers. But size matters as does management. The scale of the COOP balance sheet and the discipline shown with respect to operating expenses makes this firm one of the best in class. The table below shows COOP operating expenses. While there may be some tough quarters in 2023, we expect COOP to continue to lead the mortgage issuers in terms of profitability, even during periods when the whole industry is reporting losses. A big piece of the analysis on COOP, PennyMac (PFSI) and Rithm Capital (RITM) is the value of the MSR. You could argue that all of the owners of MSR are already at peak levels, but that depends upon your view of interest rates next year and, indeed, for the next five years. If, for example, the FOMC sets an effective floor for interest rates at say 3% for federal funds, then the value of MSRs could easily reach 6x annual cash flows. The peak valuations seen for MSRs in the 1990s, for example, were considerably higher than current levels – 7s and 8s were seen three decades ago. And as we’ve noted previously, many of the loans originated in 2020-2021 would still be points out of the money for refinance. The cash flows will extend, but the refinance options will decline. While some lenders think that mortgage rates will retrace back down to the 5% range, we disagree. The entire mortgage sector is going to suffer mightily over the next year as lending volumes fall to two-decade lows. We expect COOP to ride out the storm and be ready to capture volumes as and when interest rates decline. The market of 2024 is going to look a lot smaller, with fewer, bigger seller/servicers positioned to harvest refinance events off of giant servicing books. Indeed, industry consolidation will help to grow’s COOP’s book for owned and third-party servicing even higher. Despite the outlook for the industry, COOP continues to be one of the better performing names in our mortgage surveillance group. Those readers operating in the investment world should anticipate that COOP and other owners of MSR will continue to accrete the value of the asset as interest rates and particularly bond spreads continue to widen. Even if the Fed pauses increases in the Fed funds target rate at year-end, we’d anticipate some further expansion of MBS spreads into 2023. Our surveillance group is below. 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.

October 24, 2022 | Equity investors have spent the past nine months watching as trillions in supposed paper wealth was destroyed. One of the weaker near-banks, Ally Financial (ALLY) , just took its lumps on an ill-considered investment in Better.com . The loss is due to a $136 million impairment charge “on a nonmarketable equity investment” related to its mortgage business, Inside Mortgage Finance reports. Some readers of The Institutional Risk Analyst may wonder if time is not running in reverse. Instead of creating wealth from the ether during 2020-2021, now the FOMC is destroying wealth with even larger effect on markets and companies. Is the damage being caused by the end of quantitative easing or QE over? Not even close. The wealth destruction visible in the REIT sector, for example, is massive and continues each and every day. The negative mark on the trillions in mortgage-backed securities and loans on the books of all manner of REITs is mounting and is likely to put pressure on many of these issuers as they seek to replenish capital losses in the equity markets. Consider the travails of the banks holding committed loans to Elon Musk for his alleged acquisition of Twitter (TWTR) . The best thing that could happen to these banks is for the deal not to go through, in part because the lenders involved will be forced to retain the loans. Musk at least locked in some of his financing costs for the $40 something billion acquisition, but the loans are now points under water and will probably need to be written down to fair value before being buried in a portfolio by the lenders. And what happens to the loans to buy Twitter if, for example, Musk is forced to retrench in China as communist dictator Xi Jinping doubles down on tyranny and wrecks the economy. Force majeure ? Of course the economists continue to focus on the “tough” job facing Jerome Powell and his colleagues on the Federal Open Market Committee. Little attention is being paid to the collateral damage being done by the FOMC to the debt capital markets and, by connection to the banking system, under the Fed’s tightening strategy. Quantitative easing is a public policy disaster, yet the FOMC remains silent about its missteps over the past three years even as market losses grow. US banks had $4.2 trillion in unused loan commitments in Q2 2022 or 2x CET1 capital levels. How many of these commitments are now deep under water? Source: FDIC The chart below shows the accumulated negative "other comprehensive income" or AOCI for the US banking industry through Q2 2022 to the tune of -$250 billion or 10% of the CET1 equity of the entire industry. This chart illustrates the huge volatility injected into the financial markets by the FOMC. Source: FDIC Based upon Q3 2022 earnings, the mark-to-market deficits for the industry are likely going to increase significantly, but fortunately the top banks seem to have plateaued since Q2 2022. If you think of the downward skew in prices for the fixed income markets over 2022, the chart above begins to make sense. Ponder, however, how much of the “pain” in terms of mark-to-market losses has been hidden by banks in held-to-maturity portfolios. Indeed, one big reason that JPMorgan (JPM) and Bank of America (BAC) are not showing big increases in AOCI in Q3 is that the losers on the available for sale book are being hidden in the held to maturity portfolio or sold. JPM has almost cut its AFS securities book in half since March. BAC has also cut its AFS book by $50 billion but its held-to-maturity book is essentially unchanged. Our bet is that BAC CEO Brian Moynihan is burying his failure to manage interest rate risk deep in the bowels of the bank, with a commensurate negative impact on future earnings. We expect the large banks to use hedging and transfers to held-to-maturity to shield themselves from further negative marks, but the banking and nonbanking sectors remain very vulnerable to additional losses as the FOMC continues its rate hikes. As we note in National Mortgage News this week, two more rate hikes of 75bp and we could see high-priced conventional loans above 10% by Q1 2023. Just imagine the accumulated AOCI for all financial investors by the end of 2022. The negative mark-to-market on $9 trillion in government and agency MBS could exceed half a trillion dollars by Christmas. But the bigger risk lies ahead, when the FOMC finally drops interest rates and the margin calls on MBS and leveraged mortgage servicing assets crush those firms that managed to survive the Winter of 2023.

October 17, 2022 | Premium Service | A number of readers asked about the reference in our last comment to banks being rendered "insolvent" on a mark-to-market basis as a result of rising interest rates. Will quantitative tightening (QT) tip over a large bank or nonbank financial firm that has not hedged its market risk? Is hedging even possible in the volatile post-QE markets? The huge shift in funding costs engineered by the Federal Open Market Committee caused an equally large downward move in bond and loan prices. Every loan or security created during 2020-2021 was mispriced, with a resulting negative “accumulated other comprehensive income” or AOCI . Remember those four letters if you invest in or have risk exposures to banks and other financial intermediaries. Note too that banks own a lot more variable duration mortgage-backed securities (MBS) than Treasury bonds. Source: FDIC As interest rates increase, changes in the fair value of debt securities that are available for sale (AFS) may negatively affect accumulated other comprehensive income (AOCI), which lowers the bank's based capital. AOCI also includes unrealized gains or losses related to the transfer of debt securities from AFS to held to maturity (HTM), which are subsequently amortized into earnings over the life of the security with no further impact to capital. So how big is the mark-to-market hit facing US banks? At the end of Q2 2022, US banks held $6.1 trillion in securities, including $3.4 trillion in AFS and $2.7 trillion HTM. These totals include $1.5 trillion in Treasury paper, $3.38 trillion in MBS and another half trillion in municipals. Depending on your assumptions about the fair value of the MBS, the unrealized loss figure stretches into the tens of billions of dollars. Keep in mind that the weighted average coupon (WAC) on bank-owned MBS probably averages around 3.5% vs today's yields of 6.5% to 7% on new issue MBS. The low-coupon MBS owned by banks and the Federal Reserve itself are trading in the 80s and 70s today. During the earnings call for Wells Fargo (WFC) last week, Morgan Stanley (MS) veteran analyst Betsy Graseck asked management how long it would take for underwater securities to accrete back to par. Betsy Graseck -- Morgan Stanley - Analyst The underwater AFS book, right? Like if rates were flat with quarter end 3Q, you got-- Mike Santomassimo -- Chief Financial Officer When do you start to accrete back the AOCI? Betsy Graseck -- Morgan Stanley - Analyst Yeah. Yeah. How long does it take to accrete back the AOCI? Wells Fargo CFO Santomassimo then explained why it will take a while for that to happen, especially if you recall that many of these securities have below-market coupons – like 400bp below current market. And many bank-owned MBS were purchased significantly above par . As Graseck notes: “it's meaningful to the capital outlook.” The chart below shows the accumulated AOCI at WFC through Q3 2022. Source: EDGAR Meaningful indeed. Declines in accumulated other comprehensive income for WFC, driven by higher interest rates and wider agency mortgage-backed securities spreads, resulted in declines in the Common Equity Tier 1 (“CET1”) ratio of 96 bps from 3Q21 and 21 bps from 2Q22. In other words, mark-to-market losses have wiped out 10% of WFC's capital in the past year. At the end of Q3 2022, JPMorgan Chase (JPM) had negative $19.1 billion in AOCI. Now you understand why the Fed, OCC et al are pressing JPM and the other large banks to raise new capital immediately. The chart below shows the CET1 capital for Well Fargo. Over the period of quantitative tightening or QT, we estimate that bank capital levels could fall 30% from the 2021 high water mark due to market risk and without any uptick in actual credit costs. Source: Edgar Due to the sharp increase in interest rates, many banks have been moving low-yielding securities from AFS to HTM, a process that normally cannot be reversed. If an institution changes its intent or no longer has the ability to hold one or more securities held to maturity, it will usually have to reclassify the entire portfolio as available for sale and mark the assets to market immediately. The migration of securities from AFS to HTM illustrated in the chart below suggests that a number of banks have been caught off base by the Fed’s interest rate hikes over the past year. While moving these securities to HTM will avoid future loss recognition and reduce hedging costs, these low yielding securities may hurt bank asset returns over time. Source: FDIC Many institutions also consider reclassification because of the Current Expected Credit Loss (CECL) rule. CECL applies to securities held to maturity but will not affect securities available for sale. As a result, some financial institutions consider reclassifying securities so they do not have to worry about applying CECL to their securities portfolio. Banks like WFC and JPM have a choice. Keep the securities in available-for-sale and risk further price deterioration or move the securities to held-to-maturity and take the hit now. The latter choice stops the accounting for additional declines in market value, but imbeds a low-yielding asset in the bank’s portfolio at a loss. Thus the question about accreting the asset’s fair value back up to break even. Now you may be wondering: What about loans? Both mortgage and nonmortgage loans classified as held for sale should be carried at the lower of amortized cost basis or fair value. If the amortized cost basis of a loan exceeds fair value, a valuation allowance should be established for the difference. However, if the loan is hedged using an active portfolio method, the loan’s fair value is not adjusted. One big area of concern for both banks and nonbanks is delinquent loans, an area that was very profitable for issuers in 2020-2021 but has now become a source of significant risk. At the end of 2020, banks held nearly $30 billion in early buyouts (EBOs) from Ginnie Mae MBS, but the number has come down since that time as the economics of buying delinquent loans has sharply deteriorated with rising mortgage rates. Source: FDIC GNMA EBOs are loans that were sold into an MBS pool by an issuer and subsequently repurchased due to delinquency. In the wake of QE, volatility in loan prices has exploded. Billions in low coupon delinquent government loans bought out of pools are now trading in the low 80s, choking both investors and lenders alike. Many of these EBOs were purchased above par, say 103, when the TBA was a 2% MBS trading at 106. But no more. At the end of September, nonbank issuers operating in the GNMA market faced billions in EBOs and far more delinquent government loans are still sitting in MBS with WACs below 4% and in some cases below 3%. These low-coupon loans created by the FOMC during QE represent a substantial burden to these issuers, both in terms of the cost of loss mitigation and the eventual loss on the loan when it is modified and sold into a new MBS. Again, the on-the-run MBS for delivery in November is a 6.5% coupon today. The table below shows the largest government issuers, the total AUM of their servicing book, the weighted average coupon (WAC) and the level of delinquency. Source: MIAC The sharp markdown of EBOs illustrates the problematic aspect of market volatility and how it impacts the value of the assets of commercial and mortgage banks in times of rising interest rates and growing illiquidity. Upward movement in benchmark interest rates during Q3 further increased the value of mortgage servicing rights (MSRs) but pushed MBS and loan valuations lower. Those Ginnie Mae 1.5s and 2s are now effectively orphaned securities that trade at distressed bids despite the government credit wrap. As interest rates have risen, the rate of purchases of EBOs has plummeted. GNMA EBOs ($) Bottom line: We have noted before that the Fed has created an embedded short-put position for investors in MBS and whole mortgage loans that could prove problematic for banks and markets in the months ahead. The huge volatility in asset values observed over the course of 2022 is clearly an enormous negative effect of QE and its aftermath. The cause is artificial low-coupon Treasury securities and MBS. We expect to see considerable pain evident in the financial results for banks and nonbanks alike due to the sharp increase in interest rates in 2022. Mark-to-market losses on the $4 trillion in MBS owned by banks could easily exceed 10-15% of face value, forcing many banks to transfer these assets to HTM in order to conceal the lapse in risk management. But can you really criticize a bank for failing to anticipate the ravages of QE and now its reverse? But burying a toxic MBS with a 2% or lower coupon in HTM does not end the problems for the bank, REIT or nonbank owner. If interest rates remain at or above current levels, negative carry on low-coupon securities could eventually damage banks and nonbanks badly enough to force a fire-sale to raise liquidity. In the event, the entire portfolio category may then be considered "available for sale" and the resulting mark-to-market could cause the failure of the bank or nonbank investor all thanks to the FOMC. 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.