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October 12, 2022 | On the eve of bank earnings for Q3 2022, we take a look at one of the best performing banks in the US, both in terms of financial results and the performance of the stock. Readers of The Institutional Risk Analyst know that we have long admired Bank OZK (OZK) and its management for delivering consistent earnings and managing commercial credit on a national basis. How will this above-peer performer from Little Rock do in a Fed-induced recession that rivals 2008 in terms of market losses? We also provide our latest thoughts on Q3 earnings as the large banks guide down due to the collapse of Wall Street trading and new issue volumes, but Main Street lenders are positioned to benefit. Lower for longer on funding costs as loan coupons and securities yields rise is a recipe for upside surprises from lenders from U.S. Bancorp (USB) on down in asset size. When we talk about a recession that usually means credit losses a la 2008. But this time it’s different. In 2022, many banks are also fighting a rising tide of market losses on loans and securities created during QE in 2020-21. Indeed, we hear that there are literally dozens of community banks that will lose access to the Federal Home Loan Banks this quarter because mark-to-market (M2M) losses have rendered them book insolvent. In a reprise of the S&L crisis, solvency not book capital is what matters at the FHLBs. For the same reasons, the Federal Reserve System is insolvent to the tune of about $1 trillion or roughly 15% of its SOMA securities portfolio. We all know that “other comprehensive income” or OCI consists of revenues, expenses, gains, and losses that a firm recognizes but which are excluded from net income. How long can auditors and investors ignore accumulating OCI, especially in a rising interest rate environment? End of Q4. Think "impairment" and about the totality of M2M losses in banks and nonbanks in Q3 2022, losses that will increase as the year goes on and into 2023. OCI only works if the value goes up and down. As we noted in National Mortgage News , the M2M on billions in defaulted loans bought out at a premium from Ginnie Mae MBS pools is just as nasty as the mark on those Ginnie Mae 1.5s in the SOMA portfolio. Think about the little depositories that went to sleep during 2021 and neglected to sell or hedge that toxic low coupon paper guaranteed by Uncle Sam. Fortunately, neither of our subjects today made that mistake. So let’s compare OZK and USB and see what the numbers tell us. OZK is a $26 billion total asset lender focused on the national commercial real estate market. OZK is an AR state-chartered, unitary bank with no parent holding company, meaning that the FDIC and state regulators are the primary supervisors. While there is no Fed performance report on NIC, the uniform bank performance report produced by FFIEC has many of the same metrics we use below. Half of the balance sheet is commercial real estate loans secured by the asset, but more than half of the balance sheet is core deposits. OZK has a loss rate close to zero, almost 14% Tier 1 capital leverage, and an efficiency ratio that is twenty points (20 pts) below U.S. Bancorp, the most efficient of the large bank lenders. We start by comparing the operating efficiency of USB, OZK and Peer Group 1. Notice that OZK has an efficiency ratio almost half that of the larger banks and USB, which again is the most efficient of the top five banks. OZK shares this hyper-efficiency with NexBank Capital , which we profiled earlier this year. Source: FFIEC The superior operating efficiency of OZK is typical for smaller banks, which averaged 54% for Peer Group 2 and almost 60% for Peer Group 1 in Q2 2022. But the secret to OZK’s consistent above-peer performance is not only a story of operating efficiency. The pricing on the bank’s loan book is also excellent and consistently above its smaller and large peers as shown in the chart below. Source: FFIEC Even before COVID, OZK was pricing its loans more than a point better than USB and significantly above Peer Groups 1 & 2. One reason for this stellar performance is that OZK basically avoids 1-4 family loans (< 10% of total loans), meaning that the bank was able to dodge the worst effects of QE. Yet even on 1-4s, founder George Gleason and his team manage to price loans above the 90th percentile of both Peer Groups 1 & 2. Price discipline is the bottom line with OZK, which means loan yields at least 200bp above the top four money centers. Note in the chart below that OZK is not far from Citigroup (C) and its subprime consumer book. Source: FFIEC Even when other banks were seeing returns crushed by QE, OZK maintained its focus on commercial lending and thereby increased its pricing for loans. Yet in addition to gaining better pricing on its loan portfolio, OZK has managed to keep losses low or even negative, as was typical for many better managed banks during QE. Notice during 2020-21 that OZK managed to push realized losses down even more than USB and Peer Group 1. But here is the big question about OZK, USB and all large banks: Will the volatility seen in global markets now also push credit costs back up to pre-COVID levels or higher? Our answer to that question is yes. Thus investors need to focus on banks with a history of effective credit management as winter comes to lending after a decade of QE. Source: FFIEC The answer to the question of credit in Q3 2022 and beyond is essentially answered by our previous comment (“ Will the Fed Pivot or Pause? “), where we contrast the idea of a “pivot” with a pause. We think that as reserves run out of the system and, more important, the FOMC sets a new effective floor under interest rates, credit costs will revert to the ST mean and then go higher. Remember, the FOMC has done QE for almost 12 years and has suppressed credit costs during that whole period. As shown in the chart below, loss given default (LGD) is now negative (-35%) for bank owned real estate loans. The 50-year average LGD for bank-owned real estate loans is 71%. Source: FDIC/WGA LLC The net result of superior efficiency and asset pricing at Bank OZK is more revenue finding its way down to the bottom line. But one important piece of the puzzle to consider is funding costs, as shown in the chart below. OZK does not have a big advantage over the larger banks in terms of funding. Indeed, as the chart illustrates, the funding costs of the banks large and small basically have converged, but this process is about to be reversed. Source: FFIEC The summation of all of the factors we have discussed above is net income vs average assets, one of the more important performance measures for a bank. The rate of return on assets for USB, OZK and Peer Group 1 is shown below. Source: FFIEC Q3 2022 Earnings Since we put out our quarterly look at the top banks (" Large Banks: QT Winners & Losers "), the larger banks have continued to guide down down in terms of investment banking and capital markets. We continue to expect improving loan growth and NIM, but the benefits of cheaper funding will not be felt universally by the larger banks. Citi and Goldman Sachs (GS) , for example, will continue to see increases in funding costs, as will all nonbanks raising funding from market facing sources. These banks are simply not competitive with JPMorgan (JPM) or Wells Fargo (WFC) . Of note, WFC contacted us this week and said that they are not exiting mortgage warehouse lending as part of a larger pullback from residential mortgages. History buffs will recall when WFC exited residential lending once before in the early 1990s, before the "acquisition" by Norwest. But the ghost of Norwest has now left the building at Wells Fargo HQ. We think it is notable that WFC has slowly crawled back to #6 among our bank surveillance group, now down just 15% YTD vs more than 30% declines for JPM and Bank of America (BAC) . We also think that USB, Truist Financial (TRU) and PNC Financial (PNC) may benefit more from rising yields than the top-four money centers. Our colleague Dick Bove thinks BB&T may have finally emerged from the long and painful merger process with SunTrust. We'd sure like to have Truist back in the game, especially with that half trillion asset category getting crowded. Bottom line: Earnings growth numbers for the major banks are generally negative due to the expected collapse of new equity and debt underwriting activity. Trading results may be highly variable among banks, but this is hardly reason for joy since hedging market volatility is nigh impossible at present. Ask a lender, any lender, about loan pricing today. JPM, for example, is estimated to see earnings fall 30% for the year. We expect similar results for GS, Morgan Stanley (MS) and other investment focused banks. Asset gathers such as Charles Schwab (SCHW) and Raymond James (RJF) should suffer modestly from falling assets under management, but will benefit from funding costs. At the end of Q2 2022, SCHW's cost of funds was just 8bp vs total assets compared with 26bp for JPM. And Charles Schwab is now the 7th largest bank in the US. 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 10, 2022 | For the past several months, the asset gathers in the world of finance have been trying to turn the economic narrative of fighting inflation to the concept of a “pivot,” meaning a return to artificially low interest rates and perhaps even new bond purchases for the Fed’s system open market account (SOMA). This is a narrative that has appeal to residents of Washington, where the Biden Administration is largely dead in the water when it comes to the economy. Two-thirds of likely voters say that inflation is their top issue as the November election approaches. The big issue in the minds of equity investors seems to lie with the assumption that the world of quantitative easing between 2009 and 2021 is a normal time to which we can return. Or in other words, the increase in interest rates towards 5% for federal funds may turn out to be permanent for several years, especially if inflation in wages, necessities and housing remain in mid-to-high single digits or more. Mohamed A. El-Erian summarized the anxiety of the asset gatherers nicely in his Bloomberg column: “On the surface, investors would appear to have only themselves to blame for this whipsaw, given the sharp contrast between their romancing, yet again, the idea of a Federal Reserve “pivot” and what, for once, has been consistent messaging from central bank officials that no such policy change is in the offing. Below the surface, however, the situation gets more complicated.” One big complication is that the Fed is trying to regain credibility without actually addressing the central bank’s failure. "The Fed could do more on the communication side,” notes former Fed of New York President William Dudley . “Specifically, officials would do well to be more forthcoming about what went wrong, and why they now must raise short-term rates by more than 400 basis points in just 9 months." While the Buy Side community continues to fret about rising interest rates, most observers still do not appreciate the impact of current short-term market rates on sectors such as housing. For example, if the premium Fannie Mae MBS for November delivery is now a 7%, how high does the loan coupon need to be to generate a positive gain-on-sale for the lender? Try 8.5%. Today the on-the-run TBA contract is a 6.5% MBS soon to be a 7%. Think of what an 8.5% loan coupon will do to home prices in 2023 and beyond. As we noted in out latest column in National Mortgage News , volatility is the enemy for markets not inflation. The sharp rise in interest rates has imposed huge losses on holders of loans and securities created during QE. We wrote: “In the wake of QE, volatility in loan prices has exploded. Billions in low coupon delinquent government loans bought out of pools (a.k.a. EBOs) 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.” The Fed has swung from indifference toward inflation a year ago to an almost maniacal focus on killing inflation. Equity markets assume an immediate pivot when inflation statistics fall. Obviously taming both the reality and the psychology of inflation will take more time, thus our view that the pivot is going to evolve into a pause in rate increases once we get to 5% on federal funds. The difficulty for the equity markets is that we could be looking at higher rates for longer for at least the next year or two. Even when visible inflation starts to respond to tightening by global central banks, the US may not see a 2% yield on MBS for many years to come. This suggests a long-term valuation reset for many high-beta stocks and other asset classes that thrived during the Fed’s massive asset purchases. It also suggests billions in eventual mark-to-market losses on loans and securities created during QE. When it comes to higher interest rates, get used to it.

October 6, 2022 | Premium Service | In 1998, Buddy Van Horn directed “ The Dead Pool ” starring Clint Eastwood , Liam Neilson , Patricia Clarkson and Jim Carey. The film told the tale of the curator of a macabre list of soon-to-be-dead celebrities. The Guns & Roses soundtrack was a memorable backdrop for Eastwood’s last “Dirty Harry” film, which featured this timeless line from Inspector Callahan: “Well, opinions are like assholes. Everybody has one.” With that important caveat, below follows our view of the walking dead and soon-to-be kaput players in the world of nonbank finance. With the Fed doubling down on rate increases, the pressure on all manner of nonbank finance companies and fintech platforms is growing. The gentle souls in the economic community talk about a “break” but have no idea about the details. When you are long loans and short Treasuries, and both positions move against you, and the margin calls start coming, that is a “break” that leads to the failure of a nonbank firm. With volatility off the scale and the MBS market shutting down, the real surprise would be if a few nonbank firms did not fail between now and New Year’s Day. Angel Oak (AOMR) is not part of our mortgage equity surveillance list, largely because of our astonishment when this issuer of non-QM mortgage securities decided to go public in 2021. The mortgage REIT currently trades at 0.8x book value, which is not the worst in the group by any means and the equity is down a mere 30% YTD vs say -60% for Chimera (CIM) or Blend Labs (BLND) at -80% YTD. But it is notable that the mortgage REITs have not participated in recent equity market rallies. Source: Google Finance AOMR is an externally managed REIT controlled by Angel Oak Capital Advisors, LLC , which is an alternative credit manager and vertically integrated mortgage origination platform for private mortgage loans. Sreeni Prabhu , co-founder, Managing Partner and Chief Investment Officer of Angel Oak Capital Advisors, just took over as CEO of the REIT. He replaced CEO and President Robert Williams , who helped take the company public last year. Inside Mortgage Finance reports that late Friday AOMR disclosed it had received a two-week extension on a warehouse financing facility it has with Barclays Bank for its loans. The new termination date is Oct. 14, 2022, after which we assume the firm will shut-down new loan purchases unless a replacement warehouse line is found. As we noted above, when you see you long loan position crater and are also losing money on your hedge, that is when your lenders start making margin calls and eventually shut you down. Next on our list of firms to watch is United Wholesale Mortgage (UWMC) , the spiritual reincarnation of Countrywide Financial that has exploded from relative obscurity a few years ago to being the top aggregator of wholesale loans in the US. UWM has been deliberately overpricing its loan purchases to drive other lenders out of business, a novel business strategy concocted by CEO Mathew R. Ishbia . We have noted Mr. Ishbia’s tendency to make bizarre public statements and take other actions that erode investor confidence in UWMC. UWMC is down 45% over the past year, has a 12% dividend yield and is trading +200bp in credit default swaps. While UWMC has a reasonably positive reputation in the market in terms of operations, its decision to meet or beat any bid in the wholesale channel is not good for earnings. More, UWMC continues to provide evidence that Ishbia and his team are a little light on capital markets savvy as well as the way that public companies manage disclosure. For example, on September 30, 2022, UWMC dropped an 8-K announcing that it “entered into the Amended and Restated Loan and Security Agreement (the “MSR Loan Agreement”), as borrower, with Citibank, N.A. (the “Lender”), as lender, providing UWM with, up to, a $1.5 billion facility to finance the origination, acquisition or holding of certain mortgage servicing rights (the “Citi MSR Facility”).” Ishbia continues: “The Citi MSR Facility is collateralized by all mortgage servicing rights owned by UWM that are appurtenant to mortgage loans pooled in securitization by Federal National Mortgage Association or Federal Home Loan Mortgage Corporation that meet the criteria set forth in the MSR Loan Agreement. Availability under the Citi MSR Facility is calculated based on the market value of the collateral. The Citi MSR Facility is uncommitted.” The fact that this facility is uncommitted means that this is not news. Yet for some strange reason, UWMC decided to go through the time and trouble to issue a press release. What this tells us is that Mr. Ishbia is more concerned with managing appearances to his retail shareholders than he is about looking ridiculous to credit professionals and institutional investors. An uncommitted line from a bank is like a handshake. It is meaningless. Moreover, the fact that UWMC does not have term financing for its MSRs makes the announcement all the more perplexing. Next on our list of members of the Dead Pool is Ally Financial (ALLY) , the bank holding company that funds itself like a nonbank with hot money from the brokered deposit markets. We illustrated the weakness of ALLY’s funding in our last missive (“ Large Banks: QT Winners & Losers ”). The $185 billion asset ALLY has among the highest cost of funds in Peer Group 1, 4x the large banks; an equally high credit loss rate; and overhead expenses that are significantly higher than its larger peers. In an environment with rising defaults, we believe that ALLY’s business model could come under significant liquidity stress. Another nonbank platform that is suffering from the rapid withdrawal of liquidity from the market is Upstart Holdings (UPST) , the poster child for nonbank liquidity risk. The stock cratered last quarter after management disclosed that UPST had been surreptitiously warehousing consumer loans on balance sheet. As with the case of Angel Oak and other lenders, when the liquidity leaves the market the originate-to-sell model disintegrates. First, investors back away from the market for loans and ABS, and second, the bank lenders pull back in terms of credit lines. UPST is down 92% over the past year and is trading +250bp in CDS, a nose bleed level of default risk that is comparable to other wounded nonbanks such as Affirm (AFRM) , which is trading over 300bp in CDS. By comparison, U.S. Bancorp (USB) is quoted this morning +60bp over the Treasury curve in CDS. The high probability of default reflects the uncertain funding environment, which directly impacts the ability of fintech lenders to do business. The Street has negative estimates for revenue and earnings for the rest of the year. This list is just a sample of the carnage that is forming in the world of fintech lenders, a sector that was encouraged and made real by the open market operations of the FOMC. Now that the tide is going out on many of these speculative platforms because the conditions that allowed them to thrive and raise capital have been sharply reversed. If the FOMC continues to raise interest rates through the end of 2022 and then maintains an elevated federal funds rate for 2023, then we look for many of these platforms to shut down or be sold for recovery value. Welcome to the brave new world of quantitative tightening or "QT" c/o the FOMC. Disclosure: CVX, CMBS, NVDA, WMB, JPM.PRK, BAC.PRA, USB.PRM, WFC.PRZ, WFC.PRQ, CPRN, WPL.CF, NOVC, LDI, SWCH 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 3, 2022 | Premium Service | A number of readers have asked us to talk about the winners and losers among large banks in the current interest rate environment of quantitative tightening (QT). Below we do just that and more. But first we want to give a big shout out to Dr. Judy Shelton , who asked during a CNBC interview why the FOMC thinks cratering the economy with policies she compares to medieval practice of bleeding is a good way to deal with inflation. The ways and means of the FOMC are ever more statist and authoritarian in nature, a direct threat to free markets and America's civil liberties in general. If you look around the financial markets, the many fingers of the hand of Uncle Sam including the FOMC seem to be doing their best to foster asset price deflation and general market contagion. The Fed is determined to raise the rate for the mythical market known as Fed funds through the rest of the year. This implies a Fed funds rate above 5% by Christmas. Will the FOMC then stop, look and listen to the results of its actions? Chairman Jerome Powell's stairway to heaven is shown below. The Fed has ended purchases of Treasury bonds and mortgage backed securities, creating an updraft in terms of yields that has taken the markets back to 2008 levels. Meanwhile, bank regulators at the Fed and OCC are forcing the top 50 banks to raise capital, sell risk assets and/or reduce lending on real estate generally. The top 10 banks could be sellers of a couple hundred billion in 1-4 family exposures in 2022. How is this helpful? Across the Mall in SW Washington, the folks in the normally quiet agency known as Ginnie Mae are preparing to finalize a draconian capital rule. The new issuer eligibility standards could force a sudden, 20% reduction in the fair value of MSRs held by independent mortgage banks, call it $15 billion in round numbers. Several large issuers are said to be planning big bulk sales of Ginnie Mae MSRs that could crater the $2 trillion government loan and MBS market. The fact that the Biden White House is largely unaware of the impending change by Ginnie Mae should concern members of the FOMC. As we noted in our recent deep dive into the world of government mortgages (“ The Bear Case for Ginnie Mae Issuers ”), the new GNMA capital rule could accelerate the collapse of correspondent and wholesale channels across the residential mortgage industry. And this inexplicable action by the Biden Administration will only make worse the deteriorating liquidity situation in 1-4 family loans. Both Fannie Mae and Freddie Mac , for example, are said to be greatly increasing loan repurchase requests to conventional lenders. One insider reveals that these put-backs are a means of getting rid of low-coupon loans that were caught on GSE balance sheets by the Fed's rate hikes. Against this grim backdrop, we ponder the winners and losers in the world of banking as the Fed ramps up interest rates to the highest levels since 2008. The Institutional Risk Analyst details which banks have stable core deposit funding and those that do not. These banks are seeing deposit rates barely move vs the market facing banks that are seeing funding costs rise faster than anticipated. Two charts illustrate the growing dichotomy between core funded money center banks and market funded dealers and fintech firms that happen to own an insured depository. First we show interest expense for the core group of top five banks, but without Citigroup (C) , which we include with the dealer banks. Citi has a cost of funds more than twice that of the other top banks, so we exclude them to better observe the differences among the other four: JPMorgan (JPM) , U.S. Bancorp (USB) , Bank of America (BAC) and Wells Fargo (WFC) . Source: FFIEC As you can see in the chart above, three of the top-four depositories have a cost of funds below that of Peer Group 1, a remarkable statistic given that smaller banks tend to have very stable, cheaper funding. More, notice that funding costs for these banks are barely moving. JPM is seeing funding costs rise more than their large asset peers due to the fact that half of the bank’s business is investments and capital markets. When we look at the capital markets facing institutions, however, the difference is quite striking. Source: FFIEC The chart above shows that Citigroup has seen its funding costs rising since Q4 2021, but since the start of 2022 the large subprime lender has been overtaken by Goldman Sachs (GS) in terms of funding costs. Among the large asset gatherers of US banks, GS is generally the highest cost in terms of funding. As was once the case with Bear, Stearns & Co., GS is now the most vulnerable of the top dealer banks when it comes to funding followed immediately by Citi. Other market facing banks that experience similar magnitude increases in funding costs include Ally Financial (ALLY) , which has seen interest expense rise to almost 1% in Q2 2022. CapitalOne (COF) is also seeing funding costs rise “faster than expected,” causing Sell Side analysts to reduce estimates for net-interest margin (NIM) and forward earnings. Discover Financial Services (DFS) , One Main Holdings (OMF) , Lending Club (LC) , and Synchrony Financial (SYF) are likewise seeing funding costs rising faster than asset returns. Kevin Barker , Managing Director at PiperSandler, put the situation into perspective in a recent note: “The rapid rise in Fed funds combined with outsized loan growth has led to a significant increase in funding costs for digitally-based depositories, such as ALLY, COF, DFS, SYF, LC, amongst others. After tracking weekly changes in advertised rates, we estimate deposit betas have already reached 60%+ on savings accounts since the Fed started increasing rates six months ago.” Source: Piper Sandler Notice that all of the market-facing “digital depositories” are paying deposit rates that are roughly 3-4x the rate paid today by retail funded depositories. The $13 billion bank holding company, SoFi Technologies Inc (SOFI) , also saw interest expense as a percentage of average assets rise to 1.16% in Q2 2022. We've added SOFI to our bank surveillance group. Yeah, that’s right, the nonbank formerly known as SOFI Finance now files a form Y-9 with the Fed and therefore has a nifty BHC performance report. The gross yield on SOFI’s loan book was 7.29% in Q2 2022, a mere 300bp above Citi and in roughly the same neighborhood as COF, which was over 9% gross loan yield in the same period. SOFI has reported losses in its first two Y-9s. Thankfully SOFI has 35% capital to assets, but 50% dependence upon noncore funding makes us a little nauseous. With a 126% efficiency ratio, SOFI is reporting operating losses and needs to grow revenue another 50% or so to catch up with the bank’s overhead expenses. With half the portfolio in loans and the other half in securities, it is small wonder that the company is not profitable. Yet the yield on earning assets at 5.5% is twice the rate achieved by most large banks. This company needs to get bigger. Size aside, the financial problem to be solved by SOFI is how to get earning assets from 70% of total assets up into the high 80s or low 90s percentile. The same measure for USB, for example, is 92%. If you strip SOFI of the hype associated with fintech, this new bank is a distinct underperformer with a dependence upon volatile market funding. In fact, SOFI’s cost of funds went up more in percent in Q2 than JPM paid for all funding in the same period. No surprise, SOFI is the worst performing bank in our surveillance group. Source: Bloomberg Understanding the haves and the have nots in banking as 2022 ends begins with funding costs, but then quickly ripples through the rest of the income statement. Next we consider net credit losses vs average assets, yet another category where GS leads the way among the asset gatherers. Since embarking on its journey to organically grow a retail bank, GS has demonstrated a surprising amount of operational problems, made clear by the high credit losses and low operating efficiency. Source: FFIEC Notice that GS “only” wrote off 25bp in losses this quarter vs total assets, but the firm is a clear outlier among this group. Even more, the bank’s loan book is less than 10% of total assets! GS manages to lose more money than its asset peers among the money centers even with a smaller loan book. In terms of the other asset gatherers such as Morgan Stanley (MS) , you can see that these firms have low or no credit losses. The green line at the bottom of the chart is Charles Schwab (SCHW) , for example, which basically has zero credit losses, making the GS outlier position even more remarkable. When we look at the large banks in terms of credit losses, we keep Citi in the mix this time to illustrate the difference between the retail focused money centers such as BAC, WFC and USB, and the universal banks such as JPM and C. Note that Citi’s loss rate is more than 2x the other banks and the average for Peer Group 1, followed by USB and JPM. BAC and WFC in order of greatest mediocrity at present. The average loss rate for Peer Group 1, reflecting the smaller banks in the group, is at the bottom of the chart. Source: FFIEC The fact that BAC and WFC have low loss rates is admirable, but what both banks need is to prudently take more risk via more lending volume and yield. Sometimes loss rates, as with USB, can be a sign of a profitable lending business. Indeed, even though Citi has a gross yield on its loan book that is 200bp above USB, the latter takes more profit down the net income line due to superior operating efficiency – two points better than Citi in Q2 2022. Source: FFIEC Notice in the chart above that BAC has the worst loan yield of the top five money centers, hardly a ringing endorsement. JPM is pretty much dead on the average for Peer Group 1, a remarkable testimonial to the pricing discipline of the House of Morgan compared to the average for the top 132 banks. Citi, because of its subprime consumer lending and credit card portfolio, has far higher yields than the rest of the group. Yet of the $2.3 trillion in average assets at Citi in Q2 2022, less than $700 billion was loans. The vast majority of Citi’s balance sheet is low-earning securities and deposits with banks, one reason the performance of the bank under Jane Fraser remains mediocre. But as Citi seeks to increase returns, the danger remains that this only partly core-funded bank could again get into a liquidity trap. Generally smaller banks have 100-200bp better pricing on their loan books than their large peers. When we look at the loan pricing for the asset gatherers, however, the picture changes dramatically. Source: FFIEC Notice that SCHW, RJF and MS are at the bottom of the chart in terms of loan pricing, but GS is chasing the Peer Group 1 average, a clear illustration of the business model differences between GS and the rest of the asset gatherer group. Lending is generally a secondary activity for the universal banks, yet notice that the pricing on their portfolios is actually better than that of BAC and WFC. Once we consider funding costs, credit loss rates and credit spreads, the next factor to examine is income. First we inspect the asset gatherers and find, to no surprise, that Raymond James Financial (RJF) is top of the heap when it comes to net income vs total assets of the bank holding company. As we’ve written previously, RJF is the best performing bank in our surveillance group when it comes to equity market valuations. Source: FFIEC While the bank side of RJF is a little idiosyncratic in terms of credit loss experience, a fact we attribute to the bank’s small size relative to the business of the broker dealer unit, the overall financial performance of RJF is very solid. Remember, the form Y-9 is a consolidated look at the whole firm, bank and dealer, as one entity, but does not show the entire advisory book controlled by RJF. The firm has over $1 trillion in advisory assets, including $800 billion in assets under management in proprietary mutual funds and annuities. GS, on the other hand, is at the bottom of the group in terms of income vs total assets. We attribute this to the large size of the dealer within the GS organization and the relatively small size of Marcus as a bank, which must compete for funding on the Internet bulletin boards with weak players such as ALLY. At the end of Q2 2022, GS had a yield on earning assets of just 1% vs an average over 3% for Peer Group 1, a striking metric that speaks to the continued dependence of GS on non-interest income such as trading and investment banking to support revenue. Source: FFIEC Notice that USB is basically even with the smaller, more profitable banks in Peer Group 1 while the rest of the money centers are still stuck below 1% ROA. JPM and USB have the best operating efficiency of the top-five banks, but note in the table below that the average efficiency for Peer Group 1 is 59. Over the next year, all of these larger institutions need to get near or below 60% efficiency in order to survive in the winter of QT. Source: FFIEC Bottom line for us is that there are two groups of banks, core funded depositories and market facing dealers and finance companies. These two groups then fall into three sub-categories: The large majority of US banks fall into the first category, including BAC, WFC, USB and JPM, but the House of Morgan is only half bank. JPM will see its funding costs rise faster than the other money centers. The market facing institutions such as GS, COF, DFS, SOFI, LC and ALLY are far more vulnerable to rising interest rates and periods of market liquidity stress. The asset gatherers such as RJF, MS and SCHW are largely sheltered from the storm because of big balances of bank core deposits generated by the advisory business and low credit exposure. Disclosure: CVX, CMBS, NVDA, WMB, JPM.PRK, BAC.PRA, USB.PRM, WFC.PRZ, WFC.PRQ, CPRN, WPL.CF, NOVC, LDI, SWCH 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.

September 29, 2022 | Premium Service | This week, The Institutional Risk Analyst takes a look at the battered fintech space. Most of the names on our surveillance list are down double-digits for the year. But one name, Switch (SWCH) , a provider of “colocation space and related services to global enterprises, financial companies, government agencies, and others that conduct critical business on the internet,” is up double-digits so far this year. But is SWCH really a fintech company? And why is it going private? In November 2021, SWCH approved the pursuit of a real estate investment trust (“REIT”) conversion with a target of electing REIT status for the taxable year beginning January 1, 2023. We have a position in SWCH. As with other industry sectors, the providers of enablement to the fintech sector such as SWCH may have better prospects than some of the participants. The slide below shows some of the recent metrics from SWCH. While SWCH has good financial performance, it lacks the hyperbolic aspects of many fintech business models and related high market betas, a measure of volatility. The basic play here is providing servicers for a variety of customers with somewhat of a focus on the financial sector. The fact of the REIT conversion, however, gives you a good way to think about the opportunity, namely stable cash flow based upon a growing customer base. SCHW has delivered double-digit revenue growth between 2015 and 2021. Computer hardware, and finance and banking, each provide about 30% of top contracts, while the other sectors are smaller and more diverse. The guidance provided by SWCH to investors is for continued growth in revenue and EBITDA, a far cry from many of the new entrants to the fintech space. While the costs and revenue of SWCH are relatively stable, many of the resident of Fintech are experiencing significant volatility in terms of interest rates and revenue. SWCH is trading at a lofty multiple to earnings, but given the rate of investment a growth, this is not surprising. While the market value of equity has risen 32% over the past year, the stock is still at a 0.6 beta vs the S&P. This is not a racy hyperbolic story like so many of the names in the fintech space. It is, however, a way to benefit from the growing need for colocation and other services to support financial and other firms that value state-of-the-art capacity. Our fintech surveillance group is shown below. Source: Bloomberg (09/28/22) While at present SWCH has only a 0.62% dividend yield, we expect to see that number grow in absolute terms and relative to revenue over time. That is, after all, the point of the conversion to an equity REIT effective at the start of 2023. We liked SWCH for the same reason we entered Block Inc. (SQ) years ago, namely a new entrant that is plying an established route but with better strategy. But sadly now SWCH is being taken private by DigitalBridge Group, Inc and an affiliate of global infrastructure investor IFM Investors. Ultimately, SWCH is not a fintech play and should be compared to other specialized operators of industrial and logistics facilities in the equity REIT sector. SWCH is performing above the rate of total returns for the data center REITs, according to Nareit . That portion of the equity REIT space that avoids legacy urban office and multifamily assets and focuses instead on commercial, industrial and specialty applications such as finance and technology is in our view an ideal sector for growth in the near term and income medium to longer-term. And that is precisely why this attractive company is being taken private. 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.

September 27, 2022 | This week, The Institutional Risk Analyst is visiting Washington, DC, to speak with some folks on Capitol Hill about the evolving credit situation in the government loan market. We wrote about the impending implosion of the market for FHA and VA loans in our last comment (“ The Bear Case for Ginnie Mae Issuers ”), but we were fascinated by a comment on CNBC to the effect that the market was having "trouble" getting the VIX above 30. The 30-year peak for the VIX Index was just shy of 60 in October 2008. The next major peak for the VIX was, strangely enough, March of 2020 over 53. In 2008, the assets of the Federal Reserve System was just shy of $1 trillion. Today the Fed’s assets are about $8.8 trillion, down from a peak just shy of $9 trillion. Yet the VIX has been strangely subdued even as actual volatility in the fixed income market has exploded. We felt fully gratified by Fed Chairman Jerome Powell’s comment that the Fed would not be selling Treasury collateral or MBS from the SOMA. We’d reported the FRBNY research papers that said as much several months ago, but the frantic Buy Side mob continues to fret about whether Chairman Powell is going to wake up one morning and hit the bid. But we don't think Powell and FOMC members are looking to add to market volatility. When the Fed of New York says “no realized losses,” we take that as biblical writ. Pay attention folks. The answer is there for the taking. We wrote back in July (" Questions for Chairman Powell ") : "Importantly, the paper assumes that the Fed will not realize any market losses on the SOMA. This suggests that there will be no outright sales of either mortgage-backed securities or Treasury paper in the SOMA. Is this now Fed policy? Somebody should ask Chairman Powell." Truth is, the low coupon paper held by the Fed is pretty much unsalable. The Fed owns most of these GNMA 1.5% and 2.5% coupons, MBS that are so volatile and thus costly to hedge that even were the FRBNY to solicit bids, the market price would be weak and for very small size. Nobody wants these securities, either for the MBS or the servicing strip behind the security. Owning GNMA 1.5s is an excuse to lose money. Take an example. If a loan in a GNMA 1.5% MBS goes into delinquency, the servicer must advance interest, principal, taxes and insurance until the distressed borrower gets back on track or the house goes to foreclosure. The advance on the Ginnie Mae security will cost at least SOFR +150bp, but the FHA will reimburse the servicer at the 1.5% debenture rate of the MBS. Great deal, huh? For the same reason, the Federal Reserve is losing billions on the interest rate mismatch between what it earns on its portfolio and what is pays on reserves. As interest rates rise back to normal levels, the several trillion dollars in low-coupon MBS created by the FOMC constitute a ghetto of abnormal securities with low cash flows and commensurately elevated volatility. These securities may not be in the money in terms of refinancing the underlying loans for years, meaning that they will be a low-return, high risk portion of the MBS complex. Remember, the par GNMA MBS today is over 6% for October delivery. If the on-the-run Fannie Mae MBS for delivery in October is yielding 6.25%, how high does the loan coupon need to be for the lender to make money selling the loan? Try a 7.5% coupon rate for the borrower. One of the major negative factors in quantitative easing or QE is that lower yields mean higher price volatility for bonds, money market instruments and even whole loans. As interest rates rise, the rate of volatility in the markets will hopefully decline, but don’t be fooled by whether the VIX has risen above 30 or not. The visible rate of volatility in stocks and bonds is higher today than when the VIX reached almost twice current levels. Until the FOMC raises interest rates to more “normal” levels, we don’t expect actual volatility to decline. Indeed, as we proceed with quantitative tightening or QT, we believe that the large body of abnormally low coupons will increase actual volatility and cause substantial market dislocation in the process.

September 22, 2022 | Premium Service | A couple of years ago in The Institutional Risk Analyst , we predicted the impending collapse of the mortgage industry due to COVID. In “ The Bear Case for Mortgage Lenders ,” we described how the true risk to mortgage lenders is not insufficient capital but the cost of default servicing, when consumers cannot pay and the servicer is required to advance principal and interest payments to bond holders. But then the Fed rode to the rescue. By May of 2020, the banking industry had put almost $70 billion aside for credit losses and mortgage lenders were preparing for Armageddon as millions of Americans were given loan forbearance. By the end of the year, however, even as COVID lockdowns started to seriously damage the global economy, the problem went away. By June 2020, the mortgage industry was in the midst of a boom caused by a 300bp decrease in lending rates thanks to the FOMC. The Fed's quantitative easing or QE made the problem of financing loan delinquency go away -- until now. As lending volumes soared into Q4 of 2020, the vast surge of cash flows moving through custodial accounts floated the liquidity needed for funding COVID loan forbearance and essentially made bank warehouse and advance lines unnecessary. The chart below from the Mortgage Bankers Association shows actual and projected lending volumes for 1-4 family loans. We wrote back in 2020: “The extraordinary boom in the US residential mortgage market has pushed up volumes for new issuance of mortgage backed securities to over $440 billion per month through August. Even as commercial banks face years of uncertainty due to the credit cost of COVID and its aftermath, nonbank mortgage lenders are today's golden children for Wall Street – at least for now.” In Q2-Q4 of 2020, the US mortgage industry originated over $1 trillion in residential mortgages. The profitability of this production was unprecedented, but now the FOMC’s QE bond purchases are at an end, mortgage rates are north of 6% and volumes are falling to 1/3 of 2021 levels. Taken together, the mortgage industry is headed for a serious crisis in 2023. Without the vast amounts of liquidity provided during the lending boom of 2020-21 c/o the Fed, and with loan delinquency rapidly rising, the mortgage sector and specifically government lenders appear to be in serious trouble. Source: MBA, FDIC One of the basic rules about the government loan market is that lenders are overpaid for selling government loans into Ginnie Mae mortgage-backed securities but then lose money servicing. During times of high loan delinquency, Ginnie Mae servicers can experience operating losses once the rate of past-due loans goes above 5-6%. The servicer must advance cash to cover P&I payments to Ginnie Mae bond holders and taxes and insurance (T&I) to protect the value of the house. Servicers are not fully reimbursed for expenses in the government loan market. Kaul, Goodman, McCargo, and Hill (2018) wrote an excellent monograph on these costs for Urban Institute. “Servicing FHA Nonperforming Loans Costs Three Times More Than GSE Nonperforming Loans,” they found. This is why the FHA lenders receive 44bp for servicing vs. 25bp for conventional loans guaranteed by Fannie Mae and Freddie Mac. But even the higher servicing fee for FHA loans does not cover all of the expense of servicing Ginnie Mae loan defaults. With default rates rising back to pre-COVID levels, most Ginnie Mae servicers are losing money and the tide of red ink is rising. At the start of 2020, just prior to COVID, FHA delinquency was at 17% vs the current rate of 8.85% as of Q2 2022. Looking at the rate of growth in advance rates, which measure the amount of money being paid on behalf of delinquent borrowers, delinquency is rising. The table below shows some of the larger government seller/servicers in the government loan market. The column on the far right shows the level of advances made on behalf of defaulted borrowers through August. Servicer Advances What the table illustrates is that the amount of cash being advanced by large Ginnie Mae servicers has generally been increasing since April, an indication that reported levels of loan delinquency are likely to rise in the future. Of these top servicers, only Freedom Mortgage has been reducing advances as it resolves its backlog of early-buyouts or "EBOs" of defaulted government loans. Data from Black Knight (BKI) reportedly suggests that re-default rates for loans modified during COVID forbearance are running at about 11 percent. But significantly, the BKI data excludes large Ginnie Mae issuers including PennyMac (PFSI) , Freedom Mortgage , Mr. Cooper (COOP) , and Carrington Mortgage . With these issuers included, we believe based upon anecdotal reports from servicers that the redefault rate is closer to 15-17%. The risk for the future in the mortgage market is that higher levels of delinquency will force servicers into larger operating losses, especially in the government loan market. While the GSEs reimburse conventional issuers for expenses after four months, in the government market servicers must finance all loss mitigation activities until the loan is either re-pooled into a new MBS or goes to foreclosure. Ginnie Mae servicers tend to lose $5-10k per loan that goes to foreclosure, adding to the overall expenses. With half a million people still in COVID loan forbearance, the actual delinquency rate for FHA loans is already above 10% and is growing fast. Home foreclosures are now underway after the end of COVID moratoria. As one veteran operator told The IRA last week: “We may have reached a new normal for mortgage markets. It is characterized by forbearances settling in at around half a million mortgages and around 2 million delinquent mortgages, with foreclosure starts around 30,000 per month. Fortunately to date, most of the 8.9 million borrowers who took up forbearance during COVID have exited successfully.” The wild card in the equation is the proposed issuer eligibility rule from Ginnie Mae, which we described in detail in National Mortgage News (“ Government Lenders Await the McCargo Rule ”). The prospect of lower leverage and thus profits for government lenders has drawn a negative response from warehouse lenders, who rightly view the Ginnie Mae action as hurting the credit standing of independent mortgage banks. The prospective rule from Ginnie Mae has also hurt liquidity for government mortgage servicing rights (MSRs), an ominous development as the industry heads into a period of low volumes and consolidation. The nightmare scenario now approaching in the government loan market is that FHA loan delinquency rises into the teens and the resultant drop in cash flows from performing loans force servicers to advance cash until they reach the point of insolvency. Without the flow of profits and liquidity from new loans, government seller/servicers are basically consuming capital until the FOMC drops interest rates. And the McCargo Rule at Ginnie Mae may accelerate the outflow of cash from government seller/servicers and so make a systemic event in the government loan market more likely in 2023. Our mortgage equity surveillance group is shown below: Source: Bloomberg We expect to see the firms with larger servicing portfolios perform well in this difficult environment, in part because the low prepayment rates and high cash flows from these portfolios will serve as a source of support in 2023 and beyond with volumes less than half of 2020-21 levels. But more important, the government seller servicers with proficiency in buying MSRs and recapturing prepayments will find a ready source of liquidity with the larger banks. Like the larger independent mortgage banks (IMBs), the traditional providers of warehouse financing such as JPMorgan (JPM) and Flagstar (FBC) are seeing a thinning out of the competition as volumes fall and recent arrivals head for the exits. A number of large regional and foreign banks that jumped into warehouse and MSR lending last year are going to be leaving the sector in short order. And most significant, Wells Fargo (WFC) is exiting 1-4s in terms of correspondent lending and warehouse. Another significant development in the market is the restructuring of Credit Suisse (CS) and its investment bank, including the possible shutdown or sale of the bank’s structured products group. Bloomberg reports that the group, which has been involved in a number of MSR financing transactions, has been looking for outside capital. In another transaction, Select Portfolio Servicing Inc. (SPS) has struck a deal to acquire certain assets of Texas-based Rushmore Loan Management Services LLC , reports Housing Wire . One leading government lender has gone from $20 billion in warehouse capacity this time last year to just $6 billion today, a stark illustration of plummeting industry lending volumes. In coming months, however, the demand for advance lines for delinquent and forbearance loans is likely to grow, presenting a real danger to the industry as opposed to the false alarm in 2020. Whereas the threatened liquidity crisis in 2020 was saved by the massive liquidity from the FOMC, today the Fed is out of the market and JPM and other major banks are net sellers of 1-4 family loans and MSRs. We expect to see many smaller IMBs with smaller servicing portfolios forced to sell and/or close their doors over the next 12-18 months. While some of the larger public companies in our surveillance group have debt yields in the teens and credit default swaps (CDS) spreads above 200bp, the fact is that mortgage companies generally pay double digit rates for equity capital. The application of a couple of turns of leverage to the business of making and servicing 1-4s can be quite lucrative and far lower risk than a bank or broker dealer. But more to the point, the IMBs that are likely to survive in the government loan market are going to be those firms that understand not only the value of the MSR in terms of periodic cash flow, but the more important optionality of the potential to refinance loans in the portfolio. Unlike investment assets that can move with a phone call, loan servicers that own MSR have the proverbial cake and get to eat it too. They control the asset but also control the optionality of a refinance event, which can represent several years’ worth of servicing income. The firms in the government loan market that will be able to deal with a surge in loan delinquency will be those firms that will retain the support of the larger warehouse lender banks, even when running at a net operating loss. The banks will lend not because the IMBs have a certain amount of capital or because of the low credit risk of government assets. The large warehouse banks will lend because they understand that the value of the owned MSR, including the unrecognized value of the refinance option, is well in excess of fair value assigned to the MSR under GAAP and is thus the most important capital asset owned by an IMB. 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.

September 19, 2022 | Last week in the Financial Times , Frederick Mishkin made an important comment about our departed friend and fellow member of The Lotos Club , Paul Volcker. The former Fed Chairman and President of the Federal Reserve Bank of New York was both a good economist and an astute politician. Truth is, every Fed chief since Governor Charles Hamlin needed to consider political trends and events, but especially since the end of WWII. Mishkin wrote: “Paul Volcker is considered to be a GOAT (greatest of all time) central banker because he and the US Federal Reserve broke the back of inflation in the early 1980s. However, less talked about is the serious policy mistake that the Volcker Fed made in 1980. The result was a more prolonged period of high inflation that required even tighter monetary policy, which then resulted in the most severe US recession since the second world war up to that time.” The fateful mistake Mishkin describes was the decision by the FOMC to reduce interest rates in May of 1980 even though inflation was still rising, a situation not unlike today. Those who now call for the Fed to slow rate hikes, at least before last week's inflation data, would do well to recall this period. “This action was taken despite the fact that inflation reached a peak of 14.7 per cent in April,” Mishkin recalls nearly half a century later. Fact is, Paul Volcker blinked and Ronald Reagan won the White House in 1980. By dropping interest rates, the FOMC seemingly helped President Jimmy Carter , a fellow Democrat, but in fact the election of Ronald Reagan was already done by mid-year. Inflation, related interest rate hikes over the previous year and the Iran hostage crisis sealed Carter’s fate, a historical parallel that many Americans ought to ponder as the mid-term election approaches and memories of COVID fade. Volcker knew that Reagan was the likely winner, in large part because of the political advice he received from Richard Whalen , who had been a confidant and speech writer for Reagan going back to 1976 and for candidate Richard Nixon before that. Whalen eventually became a special advisor to Secretary of State William Rogers and sous-chef in the early Reagan kitchen cabinet. He also remained a loyal friend and political confidant to Volcker and his successor, Alan Greenspan . In 1983, Whalen and NV Senator Paul Laxalt engineered the reappointment of Volcker to a second term as Fed Chairman. Richard Whalen & Ronald Reagan (1982) Once President Reagan won the election, Volcker turned back to fighting inflation at the end of 1980, sending the US into the worst recession in the post-WWII era. We remember Volcker for his later actions, not for blinking in May 1980. Even as we lionize Volcker, history has been unkind to former Fed Chairman Arthur Burns for doing too little on inflation during the term of President Richard Nixon. Nixon and his thugs bullied Chairman Burns in a despicable fashion . The fact was, the worry about the economy and unemployment, and possible social unrest following the 1968 riots, took precedence over inflation in the early 1970s. We wrote in Inflated: How Money and Debt Built the American Dream : “In early August, at the insistence of Treasury Undersecretary Paul Volcker, Nixon held a secret meeting at the Camp David retreat to discuss the crisis affecting the economy. Congress had given Nixon broad powers over wages and prices in 1970 via the Economic Stabilization Act, and Nixon was determined to use them. Treasury Secretary John Connally, who Nixon recruited for the Cabinet in 1970, laid out the plan to the assembled staff, including the wage and price controls, an import surcharge, and closing the gold window. Nixon admitted at the time that he was not sure of the impact of the decision to close the gold window. Fed Chairman Burns was against closing the gold window, but was in agreement with the other aspects of the Nixon NEP. Connally would say after the summit meeting that when Nixon announced the unilateral United States departure from Bretton Woods: ‘We have awakened forces that nobody is at all familiar with.’” Those forces referred to by Secretary Connolly are the precursors of inflation. The secular explosion of inflation over the past half century, despite the heavily doctored statistics to the contrary, is illustrated very well by the rate of growth of the assets of the US banking system and, more recently, the erratic management of the Fed’s balance sheet under Janet Yellen and Jerome Powell . The sharp increase in the Fed’s securities portfolio in response to COVID represents an institutional failure by the Fed, which caved into political pressures in the same way as Paul Volcker did 40 years earlier. History makes too much of our friend Chairman Volcker when it comes to monetary policy and not enough about his careful treatment of the big banks. He was, after all, a Democrat from New Jersey, a state know for its special love of large banks. Volcker and his colleagues at the Federal Reserve Board permitted the largest banks to hide exposures “off-balance sheet” and thus laid the groundwork for the 2008 financial collapse. Citigroup, Wachovia, Lehman Brothers, Countrywide and Bear Stearns failed in the collapse of the private mortgage market that began in 2006. When we asked Chairman Volcker why he and FDIC Chairman William Issacs (1981-1985) allowed the big banks to inflate their leverage after the Latin debt crisis, Volcker said over lunch in 2017: “They were broke. What else was I going to do?” Lunch at 30 Rock (2017) Hidden off balance sheet leverage led to the failure of half of the large banks and nonbanks in the US in 2008, a deflationary catastrophe. Fortunately, the FOMC recalled Irving Fisher , did the math and realized that they needed to substitute demand from the central bank for several trillion dollars in suddenly absent private demand to avoid a 1930s style debt deflation. Chairman Ben Bernanke et al picked benevolence instead of Bagehot-style deflation and won the day. In “ Deflation, Not Inflation, is the Threat ,” we discussed why quantitative easing or QE was the right choice in 2009. But then the FOMC under Janet Yellen and Jerome Powell made the same mistake as Volcker in 1980 and played politics with QE. The result is a far worse inflation problem than would have existed without an extra year of QE and several trillion in unnecessary fiscal stimulus. Just as Volcker made inflation worse in 1980 by hesitating to attack immediately, Yellen and Powell erred by pretending to know how and when to fine tune. Yellen and then Powell did too much for too long, and bought way too many bonds. Those Ginnie Mae 1.5% and 2% MBS will still be sitting in the Fed's portfolio long after Powell and Yellen retire from public life. Even today, Powell and the FOMC admit that they cannot quantify the value of QE vs a given decline in federal funds, thus what was the basis for this public action? Externalities like Ukraine were the accelerant for global prices, but QE provided the fuel for the inflation fire seen today in US stock valuations and home prices. We described the political pressure on Chairman Burns in "Inflated": “In 1972, Fed Chairman Arthur Burns kept monetary policy sufficiently expansive to help Richard Nixon win reelection by a landslide, taking 60 percent of the popular vote. The quid pro quo to Burn’ s easy money posture had been Nixon's imposition of price controls the year before, which made inflation at least appear to be low compared to the official statistics. But the economy was weak, no matter what the figures suggested and Americans knew it.” In the period leading up to the appointment of Paul Volcker as Fed Chairman in 1979, Congress passed the Humphrey Hawkins law, an attempt to legislate an economic reality, namely full employment, that could not really be achieved in practice. The legislation started in 1974 as a proposal to make the U.S. government the employer of last resort, but was altered and amended to compromise with Republicans and also President Carter, who was uncomfortable with this explicitly collectivist jobs-for-all mandate. Over the four plus decades that have passed since Volcker’s appointment to the Fed, the central bank has done what Congress would not do in 1978, namely socialized economic growth. Freed from the restraint of a gold backed dollar after Nixon closed the gold window in 1971, America’s love for inflation and debt bloomed and, of necessity, the role of the Fed in the US economy has also grown. The Fed has nationalized the short-term money markets in the US and is about to extend this web of state economic control to the payments system via FedNow . Down the road, the Fed will eventually be able to see into every financial institution and even individual bank accounts via the control over the payments system. None of the expenditure of public funds for FedNow has been authorized by Congress. More, FedNow looks a lot like the deterministic system of control used by the dictator Xi Jinping in communist China. In 1980, the assets of the Federal Reserve System were a rounding error compared to the $9 trillion in Treasury debt and mortgage backed securities that sit on the books of the central bank today. The Fed is starting to let this portfolio slowly run off, but the FOMC only plans to allow the system open market account (SOMA) to run off down to about $6 trillion. This suggests that much of the asset and home price inflation encouraged by Chairs Yellen and Powell is probably permanent. The kids may never own a home thanks to Janet Yellen. The 2% inflation target explicitly adopted as policy by the FOMC speaks to the abandonment of the legal mandate from Congress for "price stability." As George Orwell said in Nineteen Eighty-Four, 2+2=5. The fact that price increases during 2020-22 are unlikely to be reversed marks a major difference with the experience with inflation under Paul Volcker, as we highlighted in "Inflated": “In a 1982 memo from Paul Krugman and Larry Summers , who were both then working in the Reagan White House, to William Poole and Martin Feldstein , the two economists predicted that inflation would again begin to accelerate because the reduction in inflation engineered by the Fed was only temporary. But Summers, Krugman, and many other liberal economists were wrong. In fact the relentless rate squeeze by the Fed and a lot of positively coincidental and mostly external trends broke the inflation in the United States, but did not really instill fiscal sobriety. But Paul Volcker broke the momentum of inflation and also took sufficient demand out of the economy to give the crucial impression of price stability.” The natural human tendency to accede to immediate demands for jobs and growth has led the US down a path where future inflation is a given, especially with Congress unwilling to balance the federal budget. When we praise or chide Chairman Volcker or Yellen or Powell, we should remember that they are first and foremost political figures. Volcker rebuked Bernanke and Yellen in an essay for Bloomberg (" What's Wrong with a Two Percent Inflation Target ") before his death in 2019: “Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk. The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the ‘easy money,’ striving for a ‘little inflation’ as a means of forestalling deflation, could, in the end, be what brings it about. That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of those requirements inexorably lead to the responsibilities of a central bank.” The Fed has largely failed in the legally mandated focus on "price stability" because Americans love inflation and debt. Instead, the Fed is slowly taking over the internal financial machinery of the US economy. The nationalization of the money markets, the demise of LIBOR and soon FedNow, concentrate vast new power in the hands of Jerome Powell and the FOMC. The political imperative for short-term gratification is overwhelming in a democracy, especially when the levers of policy are in the hands of progressives like Janet Yellen, who really don’t mind some inflation. As the cost to the Treasury of interest rises, pressure from Congress on Powell to back off on fighting inflation will grow even as we pay homage to the memory of Paul Volcker. Everyone in the investment world wants to believe there is intelligent design in monetary policy and across the street at the Treasury, but evidence suggests instead a lack of focus. We desperately want to believe that Powell and his colleagues on the FOMC can manage a process with rising market interest rates and federal debt, while deliberately shrinking private market liquidity under quantitative tightening or QT . The curse of Humphrey-Hawkins is that ever more radical policy moves by the Fed to achieve the impossible dream of full employment are slowly destroying the private marketplace. As the scale of Fed open market operations has grown since 2008, market volatility has increased, rendering the adjustment process from QE to QT ever more problematic for private market participants. The on-the-run forward mortgage contract in TBAs, of note, swung 150bp in the past two weeks. The Fed has now ended purchases of agency collateral and has begun QT in earnest. Year-end 2022 promises to be more of the same volatility and lack of liquidity we’ve seen before. We hope and pray the Fed will do a better job managing bank reserves than they did in September 2019, but perhaps this expectation is unreasonable?

September 14, 2022 | Premium Service | In this issue of The Institutional Risk Analyst , Whalen Global Advisors LLC publishes the latest edition of The IRA Bank Book , the quarterly outlook for the US banking industry. The highlights of the new edition of The IRA Bank Book include: Income for the US banking industry surged in Q2 2022. WGA projects that industry income for US banks will continue to improve faster than expected by most analysts. Loan growth for US banks is strong and likely to accelerate in 1H 2022 even as the FOMC ends its asset purchases and allows excess reserves in the system to decline. Credit losses for US banks remain very depressed due to QE. The process of normalization of credit and funding costs represents an opportunity for better-managed lenders able to reprice earning assets to take advantage of low deposit rates. Rising interest rates and lending volumes have caused the principal balance of home equity lines of credit (HELOCs) owned by banks to rise for the first time since 2008. Source: FDIC “The same people who were telling clients to buy large cap bank stocks like JPMorgan (JPM) at 2x book value a year ago are now running away from bank stocks just as the fundamentals are starting to improve,” notes WGA Chairman Christopher Whalen . “We expect to see reasonably strong earnings for lenders in Q3 2022 as loan yields slowly rise, but the market-facing firms are likely to deliver weak results.” Copies of the WGA report are available to subscribers to the Premium Service of The Institutional Risk Analyst . Standalone copies of the report are also available for purchase in our online store. Media wishing to receive a courtesy copy of the report please email: info@theinstitutionalriskanalyst.com Subscribers login to download your copy of The IRA Bank Book Q3 2022:

September 12, 2022 | In this issue of The Institutional Risk Analyst, we feature a conversation with David Stevens , a two decade veteran of the residential mortgage market. David served as Assistant Secretary of Housing and Federal Housing Commissioner for the United States Department of Housing and Urban Development and later head of the Mortgage Bankers Association until 2018. We focus on the latest capital rule for mortgage banks from federal regulators. We also talk about the proposed acquisition of Black Knight (BKI) by Intercontinental Exchange (ICE) . The IRA: David, thanks for taking the time during a very hectic period in residential mortgages. Our friends at Ginnie Mae and the Federal Housing Finance Agency disrupted everyone’s Labor Day holiday for the second year in a row by dropping a new eligibility rule for MBS issuers in mid-August. The latest version, which we’ve dubbed the “McCargo Rule,” originates inside the risk function of Ginnie Mae. The rule is far more draconian than the Basel III treatment of residential loans and mortgage servicing rights (MSRs) for commercial banks. What is your take on this bizarre curveball from the Biden Administration ? Stevens: I have seen the numbers from several large nonbank lenders and what the new Ginnie Mae capital rule from Alanna McCargo means for their servicing books. One CEO told me last week that the one-year implementation schedule will put just about every Ginnie Mae servicer out of business. Oddly, the Ginnie Mae rule focuses on MSRs, which have never caused a single issuer to fail. Yet we don’t impose higher capital on non-QM loans or exotic residuals, which have caused firms to fail in the past. The IRA: Under the McCargo Rule, according to the work done by the trades, several large IMBs fail and most of the correspondent channel for smaller government lenders disappears. How does this serve the mission of HUD to assist low income borrowers? In the definition of "net worth," Ginnie Mae's risk function proposes to subtract the excess MSR from capital? This is totally nonsensical. We worked on the early iterations of Basel. This imitation is an embarrassment. Does Ginnie Mae want us all to get out of government lending? Stevens: The Ginnie Mae issuer rule is pretty draconian . A 20bp move in MSR valuations under even a modest stress test puts most IMBs out of compliance with the rule, which is an event of default under their warehouse and debt indentures. The IRA: Several large investors called us last week to ask if they should not be selling Ginnie Mae servicing before the McCargo Rule is made final. Without a change in the Ginnie Mae issuer rule proposed by President McCargo, we think many clients will attempt to exit investments in Ginnie Mae MSRs. A sale assumes a buyer, however. Do the people at Ginnie Mae understand how thin the secondary market is for government MSRs? You're lucky to have two bidders on most bulk sales. This proposal will kill the government MSR market. Stevens: Ginnie Mae used an outside consultant for the issuer capital proposal, so the RBC model does not make sense. If you subtract excess MSRs from net assets and get a negative number, that obviously is a problem. Your proposal in NMN earlier this week for Ginnie Mae to allow a 50% weight for excess MSRs is constructive but does not help several large issuers. President McCargo is not technical at all. I doubt she went through this model in detail, issuer by issuer. Frankly, she and HUD Secretary Marcia Fudge seems to have been sold a bill of goods by the career staff at Ginnie Mae. The IRA: Several issuers proposed an interesting idea after the NMN column was posted: Keep the proposed rule, as is, but allow two ways to meet the requirement: (1) The current rule with 6% adjusted net worth, exclude the excess MSR; or (2) require higher net worth of 9% and include the “excess MSR" and term unsecured debt with > 1 year to maturity in net worth calculation. Bank holding companies are allowed to use term unsecured debt to fund Tier 1 capital investments in bank affiliates. The table below illustrates the idea: Stevens: The implicit message from Ginnie Mae seems to be that they want net worth for government issuers closer to 10% than the 6% minimum in the rule, so let’s just raise the net worth number for the handful of big issuers that own most of the servicing and declare success. The FHFA proposal with the add-ons for pipeline hedging, for example, is the same thing. Let's put the net worth number for complex, large issuers where everyone is comfortable. The IRA: Agreed. The all-in cost of capital for most non-banks is in mid-double digits, so 9 or 10 percent minimum net worth for large issuers is fine. Moving right along from the sublime to the ridiculous, you’ve had a lot to say about the prospective acquisition of BKI by ICE. We wrote back in May of this year about the investment prospects ( " Does ICE + Black Knight = Shareholder Value? " ) , which seem a stretch given ICE’s lofty P/E multiple. BKI is a higher risk, lower P/E multiple busines than ICE. But the folks at ICE make so much money on the financial markets that taking over residential mortgages perhaps makes sense? What’s the deal? Stevens: This is one of the most high risk business takeovers that nobody is talking about. I am amazed that more institutions are not realizing what ICE + BKI implies for the industry, including OptimalBlue loan trading platform and the Encompass point-of-sale, and how much influence ICE will have on the entire mortgage finance system. Many issuers have strong views about this transaction, but the market power of ICE and BKI intimidates most into silence. There is naturally a bit of paranoia, which our industry is known for, and also some outright fear of what this combination could mean in terms of access to new technology. Lenders are intensely concerned about what could happen to them in terms of cost or service levels if they speak out against this transaction. The IRA: Well, BKI is the incumbent monopoly in the conventional servicing market for IMBs clearly. The legacy Fiserv (FISV) product still has a defensible position in banks, but some players like Flagstar (FBC) adopted BKI's MSP platform due to large correspondent and sub-servicing operations. We really won’t see the “new” Sagent product derived from Mr. Cooper (COOP) ’s IP for servicing until next year, according to the channel talk. Only the fact of some larger Ginnie Mae issuers using Sagent prevents BKI from having a pretty much total monopoly in IMBs now. How do you resist the irrational desire of the ICE octopus to own residential mortgage servicing? Stevens: When I was at MBA, I could beat up the GSEs and set some bright lines in terms of leaving the secondary market to the lenders. But with ICE and BKI, the MBA is conflicted because the head of ICE is on their board! This is one reason that Scott Olson of Community Home Lenders of America , who you featured earlier, has come out swinging. The acquisition of Black Knight by ICE could adversely impact many of his smaller members, banks and IMBs that could never afford the BKI product. The IRA: Over time, the smaller issuers represented by CHLA will have their market choices and data controlled by the ICE/BKI combination. This is more than a little ironic and also problematic for ICE. The Consumer Financial Protection Bureau, HUD and the FHFA are moving in the direction of mandating new, higher levels of data retention for lenders and servicers. We hear that Sagent will likely be able to meet the existing FHFA data retention standard by March . We hear in DC that BKI is actively lobbying FHFA to push the deadline for even the modest fair lending data required because of huge technology issues they will have coming into compliance. If ICE buys the Black Knight legacy platform, they will essentially control the mortgage business, front and back, correct? Stevens: For the smaller issuers that don’t have large servicing books, the ICE/EllieMae/BlackKnight monopoly won’t really impact them directly, but the indirect effect could be profound. MBA is conflicted as we mentioned and they would never stand publicly against an acquisition by a major member even if it adversely impacted smaller mortgage lenders. But perhaps more interesting is the silence from the policy community. The major political parties are focused on the midterm election. Fortunately, the Anne Schnare piece in Housing Wire got a lot of attention on Capitol Hill. The IRA: Do you think that the Biden Administration will challenge the transaction? After all, one of the biggest public mortgage issuers, PennyMac Financial Services (PFSI) , is suing BKI for antitrust violations. How does this transaction get approved by the Department of Justice with this civil litigation ongoing? That aside, the negative implications of BKI for the ICE stock may be the biggest negative in the equation. There is a reason why FISV ran away from mortgage servicing as a business. Likewise, Fidelity National (FIS) ran away from BKI, of note. FISV and FIS are much higher multiple businesses than BKI or the Fiserv mortgage servicing business that is now Sagent. What are we missing here? Stevens: You are correct. The ICE data business is not a people intensive business. Mortgage servicing, on the other hand, is entirely people intensive. The amount of manual effort involved in keeping clients compliant and following the rules from various agencies is astounding, even today a decade after Dodd-Frank and the 2012 National Mortgage Settlement . There are so many ways that BKI and ICE can get hung for being the owner of that platform in a recession, when loss mitigation is front and center for all issuers. The IRA: When we left Kroll Bond Ratings in 2017 and became a consultant to Ocwen Financial (OCN) , the CFPB basically told us to junk the Real Servicing platform in favor of the “better” Black Knight MSP platform. A decade later, we now have CFPB making noises around lender bias and servicing errors that seems to target BKI and other service providers for a future role as a responsible party in an enforcement action. And imagine if CFPB and/or FHFA mandate retention of all data used in the loan underwriting process. Significantly, Sagent does not see the consumer data as their property, but ICE and BKI do. Is that the bright future that awaits ICE if they acquire BKI? Stevens: It is no secret that Black Knight has a mixed reputation in the industry with customers, but so far the regulators have not targeted BKI directly for errors in the lending or servicing process. The danger I see for ICE is that they have a lot more cash and a far better reputation than BKI, making them a prime target for ambitious regulators in Washington. The operational and political difficulty of running a massive loan servicing platform is a far cry from the automated systems at the New York Stock Exchange, where the audience is primarily institutional investors. With residential loan servicing, ICE will be directly facing millions of consumers and sharing in the risk of the largest mortgage issuers and servicers. The entire mortgage industry will have a single point of failure with the ICE/BKI combination, a monopoly that will stifle innovation and competition even as it concentrates operational and regulatory risk in one firm. The IRA: It is amazing that BKI actually asserts ownership over legally protected consumer data in servicing. Most large Wall Street advisory shops that value loans and MSRs specifically avoid holding or claiming ownership of consumer specific data because of the legal liability. Just makes us want to run out and buy the ICE stock. Thanks David.

September 8, 2022 | Premium Service | In this issue of The Institutional Risk Analyst , we check in on US financials after the markets essentially gave back the gains made over the summer during the month of August. The two best performers in our surveillance group remain Raymond James Financial (RJF) and Charles Schwab (SCHW) , just proving that quality is not quite dead in the land of stock investing. What’s next for financials as we head into the end of Q3 2022? In general, the mid-quarter updates from the small to medium size banking institutions are strong, with loan growth starting to appear and deposit rates remaining very low. We continue to expect the financials to report better, less volatile results in Q3 2022, but that may not impress institutional investors. The universal banks are going to suffer going forward as AUMs and new securities issuance falls sharply. The same people who were buying large caps at 2x book value a year ago are now running away from bank stocks just as the fundamentals are starting to improve for Main Street lenders. The Buy Side is generally 6 to 12 months late when it comes to the financials, in part because they focus on volatile reported earnings rather than more meaningful fundamental measures of bank profitability. We wrote about RJF and SCHW last month (“ Universal Banks | Morgan Stanley, Goldman Sachs, Charles Schwab, Raymond James & Stifel ”), but we think it is notable that some of the lowest risk platforms in the business are outperforming the largest names, by a lot. RJF is the only name on the list that is still up for the full year. Our surveillance list follows below. Source: Bloomberg (09/07/2022) The general selloff in financials starting in July tracked the increase in interest rates after the mini-rally from mid-June through most of July. The 10-year Treasury is again above 3% but the market is moving 10-15bp per day either way, adding to the cost of hedging and the general level of uncertainty about prices. On Friday September 2nd, for example, the Treasury market fell 10bp in yield going into the Labor Day holiday. Right behind RJF and SCHW in terms of recent performance is Morgan Stanley (MS) , another one of universal banks in our surveillance group that is outperforming the large money centers. With all of these names, a major positive in terms of valuations is the relatively small role that credit plays in earnings. The universal banks gather assets and occasionally make loans, creating a low-risk franchise that is being rewarded by risk averse investors. That said, we are increasingly cautious about the trading and investment banking side of the equation, one reason why MS is trailing the more focused advisory plays like RJF and SCHW. The large declines in debt and equity underwriting in 1H 2022 has led a number of analysts to issue “sell” ratings for some names, including Goldman Sachs (GS) . Dick Bove at Odeon noted with respect to MS, GS and Citigroup (C) : “These companies are facing severe problems as business dries up. Moreover, moves by the Federal Reserve to shrink its balance sheet suggests that the current tough times will extend through 2023.” With the FOMC reducing the size of the system open market account (SOMA) by $50 billion per month, the bid for Treasury debt and agency mortgage-backed securities might seem to be softening, but recession fears are likely to offset the exit of the Federal Reserve Bank of New York from the bond markets. We expect to see reasonably strong earnings for smaller banks as loan yields slowly rise, but the transaction side of the house is likely to be weak, hurting MS, C, GS and JPMorganChase (JPM) . In the chart below from SIFMA, new securities issuance through July is plummeting, good news for lenders but very bad news for the wider financial markets and the economy. Note that the Fannie Mae current coupon MBS is now +150bp to the blended yield on the Treasury 5-10 year securities, the widest spread in many weeks. Treasury yields in general are at the highest levels in 12 weeks going back to mid-June, another reason why we expect to see higher loan yields when banks report Q3 earnings. One name to watch in Q3 2022 will be Wells Fargo & Co (WFC) , which is in the process of dramatically shrinking its balance sheet. Improved earnings in Q3 2022 may be a catalyst for this long-underperforming name. As we noted in our Q2 2022 pre-earnings setup, a modest improvement in operating efficiency at WFC, which has been in the 80% range, could be quite meaningful for the stock. The alternative to common shares that we have long followed is to purchase the preferred shares of the largest banks when they are cheap, one reason why we enjoy value shopping when the markets are choppy. We have been adding to our preferred positions through the selloff and are looking to establish some new positions as market opportunities arise. We will be writing more extensively about the outlook for earnings in Q3 2022. Suffice to say that the results for smaller Main Street lenders are likely going to be a surprise, but worries about future credit losses will probably dampen the party in terms of share prices in the near term for large cap names. Disclosures | Long: CVX, CMBS, NVDA, WMB, JPM.PRK, BAC.PRA, USB.PRM, WFC.PRZ, WFC.PRQ, C.PRN, WPL.CF, NOVC, LDI The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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"Money, it's a crime Share it fairly but don't take a slice of my pie Money, so they say Is the root of all evil today But if you ask for a rise it's no surprise that they're giving none away" "Money" Dark Side of the Moon (1973) September 6, 2022 | Last week The Institutional Risk Analyst returned to Leen’s Lodge in Grand Lake Stream, Maine, for a Labor Day respite and some salmon fishing on West Grand Lake. This pristine cold water fishery now has so many healthy juvenile smallmouth bass that the daily limit is being raised next year to two fish up to 14” from the single 8-12” fish limit today. There are literally too many healthy, hungry smallmouth bass chasing too few smelts in the vast series of lakes that stretch from the heart of Downeast Maine at Grand Lake Stream Plantation on US Route 1 west toward Lincoln on I-95. Investment managers likewise face too few real opportunities in the world of asset allocation, too few smelts to chase to borrow the metaphor of the smallmouth bass. There are few asset classes that have not been impacted by demand-pull inflation from hungry investors. Take the market for legacy music portfolios. Valuations for old rock music catalogs have exploded in the past three years even as the population of listeners has declined. Looking at the prices paid for creative content of all descriptions, it seems that the proverbial horse has left the barn for the FOMC when it comes to controlling the inflation of valuations for creative assets. Keep in mind that the cash flows from music catalogs are a closely held secret, so there is zero visibility into past or future sales. Some of our most trusted colleagues in the world of mortgage finance get queasy when prices for conventional mortgage servicing assets drift north of 100bp or ~ 4x annual cash flow, yet in the world of legacy music portfolios, add a zero. Variety reports that 20-30x annual sales is the norm today. Yet none of the “prices” for these deals are public and the counterparties are under NDA. If you speak, you lose your LA privileges for life. Buy Side firms are said to be circling the Pink Floyd catalog, for example, specifically the Hipgnosis Songs Fund backed by Blackstone (BX) with an indicated price tag of $500 million. Is this a fair deal? Maybe by today’s standards, but the question is will this be a good deal for investors a decade from now? When was the last time you listened to Pink Floyd? Ask your children if they’ve every heard of Pink Floyd. Here’s a pretty comprehensive list of legacy music catalogs. “The truth behind the spate of music catalog sales are threefold,” opines composer and Emmy Award winner Michael Whalen , who spent the past few years curating legacy music portfolios. We consulted Michael back in 2017 about the evolution of the content over the years (“ The Economics of Content: Michael Whalen ”). Here’s his well-informed take: “First, names like Pink Floyd are really an ego buy. PF does well on streaming platforms but not enough to justify a $500 million check. Also, past sales say nothing about future streaming revenues. Therefore, the money will have to come from someone who wants ‘bragging rights.’ That said, no one under the age of 40 knows or cares about this music. Artists like Pink Floyd are ‘cashing out’ by selling the remaining sales of these catalogs now.” “Second, many artists were afraid that the Biden Administration was going to change capital gains taxes upward, putting pressure on making these deals before the change. This pressure now seems to be abating, of note. But people like BMG are pulling in more VC money to finance potential purchases like Pink Floyd, putting more pressure on prices and on monetizing the catalog.” “Third, record labels and music publishers have commoditized returns from streaming to the point that they can predict within a few hundred dollars a quarter what a music catalog will produce - especially an iconic catalog. In other words, the record companies have calculated NO MORE than 5-8 years to recoup their principal investments on the catalogs they have bought. There is very little risk.” While the risk of loss of funds invested may be low, we wonder about the real, long-term value of a catalog like Pink Floyd, especially adjusted for inflation. Michael notes that the sales so far are almost entirely and only legacy people. Also, the multiples negotiated are for what the artists are making NOW not what can be earned by the labels through licensing and other means. Michael Whalen “I am very skeptical of the valuations of the legacy catalogs and these latest sales have done nothing to change my mind,” Michael told us last week. “We’ve seen one of these hysterical ‘gold rush’ scenarios that Wall Street insists on pursuing, often fucking the investors in the name of management fees. Said another way, there is a LIMITED window to exploit this music. The labels might recoup but they won’t be ‘raking it in’ for decades.” With legacy music catalogs are going for 20-30 times annual cash flow, a mind-blowing statistic, recovering the initial cash outlay, especially with leverage, may be a more pressing concern. When Universal Music agreed last year to buy the catalog of Bob Dylan for a reported $300 million, our first reaction was to reject the price. As it turns out, the pricing of legacy music catalogs is about as transparent as the market for 19th Century American paintings sold in gallery sales. “Everybody lies about the size of their deals,” Doug Davis of the Davis Firm told Variety last year after he sold his catalog to Hipgnosis Songs Trust. “Anyone who’s sold a catalog wants to go around and say they got a bigger check than they got, so there’s pie-in-the-sky aspirations.” Pie-in-the-sky is a great description for many of the investment manias and speculations we’ve all witnessed over the past several years. Whether it is Bitcoin or meme stocks or legacy music catalogs, the investment community continues to display the collective discretion of a school of small mouth bass, chasing the shinny object hither and yon around the clear waters of West Grand Lake. No amount of analytics can prepare or protect investors when price volatility has reached double digit rates of change on a weekly or even daily basis. The assumption of price volatility on the part of consumers and business managers is at the heart of inflation expectations , a feature that was seen in the US economy a century ago during the Roaring Twenties following WWI. Ponder that parallel. Many ask how long it will take for the Fed to get inflation under control. We wonder, to paraphrase James Grant in “ The Forgotten Depression 1921: The Crash That Cured Itself ,” whether Mr. Market won’t take care of that problem in due course by ushering in a period of asset price deflation to match the recent asset inflation mania. No matter how much fiat money the Fed creates, the secular bias remains deflation. In that downturn 100 years ago, Grant describes eloquently how the Wilson and Harding administrations, and the Federal Reserve both followed policies contrary to current wisdom. Interest rates were raised and spending was cut. A strong economic recovery ensued. Somehow we don’t think that this next economic adjustment will end so well given the amount of leverage and government intervention in the system.