SEARCH

December 9, 2022 | As we watch the world of crypto tokens slide into the recycle bin of history, it is more than a little amusing to see Goldman Sachs (GS) CEO David Solomon and former UK PM Boris Johnson both out shilling for blockchain, a technology with no discernable value save wasting billions of dollars in investor cash. At least with crypto tokens, what JPMorgan (JPM) CEO Jamie Dimon likens to pet rocks, you had the possibility of speculative gain. GS is said to be among the largest investors in blockchain, the supposed enabler technology for bitcoin. The list of banks wasting billions on a technology meant to disintermediate banks is long and storied. And all of these "investments" could be a complete loss. Just as the notion that we need “independent” currencies was a bogus enabler for crypto fraud, the tripe that said we need “independent” verification of transactions was likewise the grease for billions in lost investments in blockchain. The true use case for bitcoin, keep in mind, is money laundering and funding criminal enterprises. Legitimate users were purely decorative. Leaving aside the criminality, blockchain as used in bitcoin is a retrograde ledger technology that consumes stupid amounts of energy. "Trusted ledgers" really only make sense in offline applications that are not transaction intensive. A ledger that stores every turn of a loan underwriting model, for example, is relevant. Even in those use cases that have some utility, what we are talking about as “blockchain” is unremarkable. Blockchain is basically a write-only Excel spreadsheet with layers of permissions on top. The bitcoin variant of blockchain has been hacked so many times that it seems almost silly to discuss security in the context of “immutable blocks.” Remember, there is no file that cannot be altered. The only people who get real value from blockchain are the consultants and media that promote it for their own personal gain. Same goes for ESG. The blockchain/ESG crowd are a perfect example of the “conflicted agents” that our colleague Alex Pollock loves to describe in his writings. When Blackrock (BLK) decides to vote the shares of clients in support of acts of idiocy like ESG, for example, that is a conflict. He wrote in the Financial Times : “BlackRock represents a giant and profound principal-agent conflict. It should not be voting any shares at all without instructions from the real owners, whose money is really at risk… The real owners whose own money is at risk are the owners of the mutual fund and exchange-traded fund shares and the beneficiaries of pension funds, not their hired agents.” For risk professionals, the fact of crowd-funded, consultant-driven manic phenomenon like crypto currencies, ESG and blockchain underscores the danger that policy makers are going to get something very big very wrong in 2023. Our prime candidate for the big risk is liquidity. The lesson of the bankruptcy of Reverse Mortgage Funding (RMF) , which we profiled last week (“ RMF Bankruptcy Signals Systemic Risk in GNMA Market ”), is that liquidity is fleeing from the ABS markets, even for FHA-guaranteed loans. That is a hint. In a rising interest rate environment, falling asset prices inevitably lead to lenders stepping away from markets – even markets with explicit US government credit support. Thus, when RMF could no longer sell the FHA-guaranteed notes from reverse mortgages, the choice was bankruptcy. The process of price discovery or not is going on all around the financial markets, with residential and commercial mortgage exposures. The fact of so much worthless crypto detritus littering the floor of the financial markets only makes finding the bottom that much more difficult. Look, for example, of the prices for Manhattan apartments since the end of COVID and now a couple of months into the crypto bust. Source: Miller Samuel/Douglas Elliman Our friend Kurt Kasun asks in a recent missive: “What if October was not the bottom for stocks?” No, October was a pause, a bit of a short-covering rally both for stocks and housing. Notice however that financials are underperforming the broader market. Source: Google Finance The false narrative on Wall Street says that rising interest rates are good for financials, but the recent market carnage caused by the FOMC suggests otherwise. Rising funding costs and falling asset valuations are bad for bank stock and bondholders. Dick Bove reflected on this challenging question of whether higher interest rates are good for banks last week: “When I started covering bank stocks, it was generally believed that interest rate increases were not good for banks. That theory was driven by the view that when rates went up real book values went down and, therefore, the value of the enterprise was less. Valuation was based on book values which represented the base of a bank’s earnings power.” Rising interest rates are also bad for housing finance. The primary-secondary spread had reached over 2.25% a couple of weeks back, but the intense desire of lenders to make loans pushed rates down for a while. Remember, lenders set loan coupons, markets set bond yields. Loans being bought via correspondent channels last month actually made a profit, but November and December are short months in terms of actual business days. During the supposed rally from the October lows, financials did show some signs of life, but only a little. The same individuals that find value in crypto currencies or blockchain are not especially picky about the asset class of the moment. They are simply looking for the next shiny object to chase. And again, we warn our readers to ponder whether that book value on the Bloomberg screen won’t be 10 or 20% lower in a year’s time. Sad to say, whether we are talking about corporate credit exposures or housing, the short trade may be the place to be over the next year. Once the Fed declares victory over inflation, then a short but intense rally will ensue, followed by an equally intense but much larger down correction in home prices around 2026 or so. In that sense, the larger scenario is unaffected by what the FOMC does or does not do in the next year. Have a great weekend. 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.

December 7, 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: Rising interest rates caused accumulated other comprehensive income (AOCI) for the US banking industry to rise almost 40% in Q3 2022 to $347 billion or roughly 25% of total tangible capital. Year-end AOCI could hit $500 billion depending upon the rate of interest rate increases by the FOMC, asset sales and the movement of available-for-sale assets into portfolio (HTM) Rapidly rising interest rates in Q3 2022 pushed down the tangible capital for the US banking industry to negative $1.9 trillion under a moderate stress scenario. The big area of danger for the banking industry in 2023 continues to be market risk generated by rising interest rates. Market risk is effectively becoming outsized credit risk that threatens the solvency of banks and nonbanks alike. Source: FDIC Copies of the IRA Bank Book for Q4 2022 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 Q4 2022:

December 2, 2022 | Premium Service | Reverse Mortgage Investment Trust and several affiliates filed bankruptcy in Delaware this week, beginning one of the more problematic events of default in the government loan market in many years, even decades. While a declaration has been filed by restructuring firm FTI, the debtor has obtained an extension of the deadline to file financial schedules until February 2023. RMIT is sponsored by three-funds managed by Starwood (STWD) and represents about 40% of the $61 billion market for home equity conversion mortgages or HECMs, reverse mortgages that are guaranteed by the FHA. As of October 31, 2022, RMF managed reverse mortgage loans with an unpaid principal balance of approximately $25.57 billion. And this is not the only bad thing happening in mortgage land this week. A tour through the bankruptcy filing is instructive. The majority owner is a group of three Starwood SPVs, which acquired Reverse Mortgage Funding in 2021. As in the case of First Guaranty Mortgage and PIMCO , there is no indication as yet that the sponsor intends to support the debtor or even bid for the assets. Why STDW made this purchase on behalf of its clients is something for the history books to ponder. Nutter Financial closed down its reverse business earlier this year. The other public issuer of private reverse products, Finance of America (FOA) , withdrew from forward lending to "focus on reverses." Like Reverse Mortgage Funding, FOA also issues private label reverse mortgage products that have become illiquid in the past several months. About 8% of RMIT's portfolio is private-label reverse mortgage loans. The secured lenders include Credit Suisse (CS) , Nomura Securities (NMR), Barclays Bank, Texas Capital Bank (TCBI), TIAA Bank. The table below outlines the capital structure of RMIT. The largest creditor of RMIT is Compulink dba Celink, one of two subservicers in the HECM sector. Celink is said to be for sale, but that has been true to one degree or another for years. Celink is the monopoly subservicer in the reverse space and has a reputation for poor operational performance and controls. The fact that the claim filed by Celink is labelled as “contingent, disputed and unliquidated” is no surprise. We suspect that RMIT has not been paying Celink for some time. The debtor stated in a press release : “ The Company is in ongoing, productive discussions with its Mortgage Servicing Rights (MSR) secured lender and other industry players, including Ginnie Mae, to achieve an agreement that ensures a smooth landing for the Company's servicing portfolio, as well as other obligations. In the meantime, RMIT has already begun work to transfer the remaining loans in its pipeline to other lenders in order to support seniors looking to unlock value in their homes.” The first obvious reason for the bankruptcy of RMIT and its affiliates is the interest rate environment. The funding mismatch on HECMs is never good and in the current environment is horrendous. The owner of the reverse-MSR must advance cash to the elderly home owner and, at the end, buy out the loan from the pool prior to conveying the asset to HUD. It can take weeks or even months for HUD to process the reverse. The second reason for the EOD appears to be the same reason for earlier defaults by independent mortgage banks (IMBs), namely non-agency exposures. Our colleagues at Ginnie Mae fret about the risk from servicing assets on government loans, but in fact it is the non-agency loan exposures that caused the implosion of First Guarantee Mortgage and now Reverse Mortgage Funding. As the market for non-agency reverse products dried up over the past few months, firms like RMIT were essentially stuck with non-agency reverse products that the firm could neither fund now sell. Spreads widened and the execution on HECM residuals, when the loan is repurchased out of the GNMA pool, went from 104 a year ago to par today. It is interesting to note that GNMA has been pondering making changes to the rules for HECMs that would allow issuers to securitize the residuals into GNMA securities. This would be a great help, but unless that change can become actualized by early next year it is unlikely to help issuers that are being crushed by bad execution for new loans and crazy funding costs for cash advances. We are concerned that FOA may meet the same fate as RMIT. As investor appetite for first private label and then HECM residuals disappeared, RMIT was likely stuck with non-agency paper on warehouse lines, forcing a fire sale to come back into conformity with warehouse lending rules. Meanwhile, the poor execution for new HEMCs made continuing in business impossible. Thus, RMIT is selling reverse loans from its pipeline to other lenders but the fact of new ownership will not improve the painful secondary market execution. The bigger story is layered risk that is not recognized. Relying on the securitization market for the take-out for the private reverse mortgage loans was a problem waiting to happen. But the more profound point about risk is that the government RMSR asset has negative value in current market conditions, thus it is difficult to envision who among the two remaining players in reverse mortgages will take possession of the RMIT book, even for nothing. If there are no buyers or even takers for the RMIT business, then GNMA may be forced to ask the Financial Stability Oversight Counsel (FSOC) to create a conservatorship for the group. The likely scenario in that extreme event would be for the Treasury to invoke Dodd-Frank and hire the Federal Deposit Insurance Corp to manage the assets until RMIT and its affiliates are liquidated. But again, we do not think another servicer will take the RMIT portfolio unless they are compensated and indemnified. In a market where funding is both increasingly expensive and declining in terms of availability, the assets of the RMIT estate are likely to have few buyers. More important, the two incumbent nonbank lenders, Nomura and Credit Suisse (CS) , are unlikely to remain in the picture long term. Earlier reports that CS was going to sell its structured products group (SPG) to Apollo (APO) and PIMCO have apparently not been realized. We hear that PIMCO has now backed away from the SPG opportunity, raising a question for the mortgage industry as to what is going to happen to the CS financing book. While APO was willing to buy the non-GNMA exposures from CS, the GNMA footings were apparently not acceptable and would remain with CS. The assets and liabilities of the CS SPG business have yet to find a home, including the potential contingent liability from the GNMA MSR securitizations led by CS over the past five years. The uncertainty with respect to the eventual disposition of the CS MSR financing business and particularly the GNMA exposures is an open question looming over the US mortgage industry. Both with respect to specific obligors such as RMIT and the government market more generally, the unresolved fate of CS may ultimately discourage investors in these assets and reduce the liquidity in a government loan market that is already operating under stress. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

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

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

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

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

November 10, 2022 | Watching the collapse of the FTX crypto fraud pyramid, we are reminded that most financial stocks trade on tangible book value (TBV). When there is nothing tangible, well, then there is probably little value. Occasionally value hides in plain sight, waiting for the accountants to fashion a new rule and recognize same for GAAP purposes. The gain-on-sale income from mortgage servicing assets, for example, is a case in point. But in the instance of crypto fraud (or what our pal Nouriel Roubini wonderfully dubbed “shitcoins”), the value was only in the eye of the credulous in finance and the media. News reports suggest that FTX Chief Executive Sam Bankman-Fried misappropriated billions in investor funds, which he lent to his Alameda Research firm to the tune of about $10 billion. We have a couple of questions. First, when are state and federal prosecutors going to start prosecuting the crypto shills in finance, politics and media for fraud? Second, when will CNBC , Bloomberg and other financial media stop talking about and advertising for crypto schemes? At what point do the general counsels at media firms say enough and end the public promotion of crypto fraud? Consider two examples: Silvergate Capital (SI) and Signature Bank (SBNY) . We warned our readers that these two crypto banks would soon come to a bad end. Back in February of this year, we profiled the former mortgage bank from Costa Mesa, CA (“ Profile: Silvergate Capital Corp (SI) ”). The fate of the remarkable but tiny SI is a matter of indifference to us compared with SBNY, a $118 billion asset regional bank with a proud legacy that stretches back decades to paramount private banker Edmond Safra and Republic National Bank. We wrote in July : “While many readers of The Institutional Risk Analyst have been watching crypto fiascos like Silvergate Financial (SI) and Signature Bank (SBNY), the prospect of financial problems for the 23rd largest bank holding company (BHC) and a large ABS issuer is cause for concern. But have any of the US bank regulators noticed?” A year ago this week, we warned our readers that the Fed’s “pivot” away from encouraging inflation would result in lower valuations for crypto tokens and stocks, especially the aspirational stocks that followed the crypto upsurge. Crypto has gone from a sort-of juiced up equity strategy to a distressed credit story in just hours. But now that the collective idiocy of crypto and, yes, blockchain too are hopefully falling by the wayside, let’s take a look at how financials are navigating the world of rising interest rates. Roaring Financials Over the past month, our bank surveillance group has rallied on hopes of moderating inflation, with Raymond James Financial (RJF) leading the group higher. The basic explanation for this rebound is twofold. First, the higher-beta stocks in technology and new media are getting hammered, forcing managers to seek shelter in less volatile names in order to preserve and protect that all-important assets under management (AUM). Second, the banks are seeing expansion of new interest margins even as the FOMC pushes ahead on interest rate hikes. We expect to continue to see improvement on the lending/NIM side of the equation, but the market side of the universal banks will continue to suffer weakness in absolute terms and in YOY comparisons. Loan growth will likely slow in 2023 as the economy slows, but notice that the Fed is now being criticized by both Democrats and Republicans. The table below shows our bank surveillance group as of the market close yesterday sorted by price-to-book value. The numbers are hardly distressed and are, in fact, quite normal. JPMorgan (JPM) at 1.5x reported book value is hardly cheap. Bank Surveillance Group Sources: Bloomberg, Yahoo Finance But with the huge swings in interest rates and asset valuations, the real question is what is true book value, net of mark-to-market adjustments c/o the FOMC and underwater loans and securities. Piper-Sandler writes: " GAAP Equity has been negatively impacted as rates have risen. Unrealized losses in AFS securities are included in AOCI (and therefore GAAP Equity), and as bond losses remain unusually large, the hit to equity is likewise bigger than anticipated for most financial institutions." While the fundamental view of financials may be neutral to slightly negative in the next year or so, don’t expect Buy Side managers to be shy about buying banks regardless of the outlook for earnings. So long as credit costs remain muted, the appetite for bank stocks should only grow as investors become convinced of an approaching pause in rate hikes by the FOMC. If credit expenses continue to rise, however, then the bull thesis around bank stocks may start to weaken appreciably. Not only are the equity market valuations of banks and nonbanks overstated coming out of QE, but credit costs remain far below average levels, suggesting that a mean reversion will occur recession or no, simply because of the reset in the floor for interest rates. We temper our generally positive view of lenders with the knowledge that there is no free lunch and that state TBV may fall just as it rose in 2020-2021. Next week we will be reporting on the discussion at the the 8th annual IMN MSR East conference in Lower Manhattan. What does or does not happen to the value of mortgage servicing rights (MSRs) in the next year will be top of the agenda. We have more questions than answers, sorry to say. Click this link to read our latest column in National Mortgage News . The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

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

November 4, 2022 | Premium Service | As the week comes to a close, there is much news in the world of banking and mortgage finance. The Teachers Insurance and Annuity Association of America-College Retirement Equities Fund (TIAA) , a $1.3 trillion insurance and investment conglomerate, is selling TIAA FSB (f/k/a Everbank). And as Q3 earnings grind on, there is lot’s more news from the world of mortgage finance, good and bad. Subscribers to the Premium Service of The Institutional Risk Analyst read the details below. The big news this week starts with the poor showing by Rocket Companies (RKT) , reporting a loss for Q3 2022 and a big decline in volumes. “Like most home lenders, its production volumes were decimated by rising rates and evaporating refinances,” writes Paul Muolo at Inside Mortgage Finance . “In 3Q, Rocket funded $25.6 billion, down 25.9% on a sequential basis. For comparison purposes, the company originated $75.9 billion in the fourth quarter of 2021, when rates were still comparatively low.” As of September 30, RKT’s mortgage servicing portfolio included 2.5 million clients with $531 billion in unpaid principal balance. At the end of the third quarter, the value of RKT’s mortgage servicing rights was $7.3 billion, an increase of $1.9 billion or 26% year-to-date. In '20 and '21, nearly 50% of the mortgages that RKT originated came from were clients that were in firm’s servicing book, meaning there's virtually no cost to acquire the new asset. During the quarter, the value of the RKT MSR asset increased by $600 million, including a $400 million positive mark-to-market adjustment, yet the company still lost money. Why? Because RKT is slow-walking expense reductions due to the firm’s significant excess capital and liquidity position. “The decision-making, of course, is not based on the profitability of a day, a week, or a month,” said Rocket CEO Jay Farmer . “The decision-making is based on the metrics that will tell us that the investments we're making are going to pay off in the long run.” In other words, RKT is not going to chase United Wholesale Mortgage (UWMC) as it buys market share at the cost of profitability. UWMC reported earnings this AM and, as noted above, the company is buying market share with both hands. UWMC originations of $33.5 billion in 3Q22 compared to $29.9 billion in 2Q22 and $63.0 billion in 3Q21. Purchase originations were $27.7 billion in 3Q22, the best purchase quarter in UWMC's history, a 24% increase compared to $22.4 billion in 2Q22 and a 5% increase compared to $26.5 billion in 3Q21. Of note, even as mortgage profitability has been cut in half, UWMC has been offsetting dwindling production income with MSR sales. “Through the first nine months of 2022, UWM transferred $85.5 billion in MSRs to other shops,” according to Inside Mortgage Trends . “Transfers reflect MSR sales.” In sharp contrast to the volatility shown in RKT and UWMC results, Guild Mortgage (GHLD) reported another profitable quarter, confirming our earlier view that this mortgage issuer is one of the best managed businesses in the industry. The press release says it all: GHLD generated GAAP net income of $77.4 million, or $1.26 per diluted share, compared to $58.3 million, or $0.95 per diluted share, in 2Q22 Adjusted net income was $24.1 million, or $0.40 per share, compared to $13.9 million, or $0.23 per share, in 2Q221 Net revenue totaled $261.2 million compared to $287.5 million in 2Q22 GHLD’s adjusted EBITDA totaled $32.9 million compared to $22.0 million in 2Q221. And total originations were $4.4 billion or 91% purchase loan volumes. The announcement that TIAA is selling the $33 billion savings bank (f/k/a Everbank) into a club deal led by Warburg Pincus is hardly a surprise. TIAA never knew what to do with the bank and now, five years later is selling the bank in a down market. TIAA will remain a minority investor, but intends to spin the trust business into a new regulated bank. As in the case of past successful WP bank investments (Varo, Citizens, National Penn), Warburg is a very credible lead. No investors will "control" the bank per se, but will have substantial influence on the deal via the board. Investors will include Stone Point Capital, Warburg Pincus, Reverence Capital Partners, Sixth Street and Bayview Asset Management. The bank will be renamed and operated independently of TIAA and its investment affiliate Nuveen. The bank will, however, have an arms' length relationship with all investors per Reg W. Bayview is an investor in the deal, but that will not really help them fund the mortgage business even if they deposit escrows in the bank. Only by owning 100% and merging Bayview’s mortgage operations into the bank would any real benefits be realized. TIAA FSB bank is a peer performer, but loan yields are low and there is a large slug of non-core funding. The bank’s low efficiency ratio (37%) may change on a standalone basis once the parent-bank connection with TIAA is ended. Virtually everything on the balance sheet is held-to-maturity, so there may be some surprises in the portfolio awaiting the buyers. TIAA FSB has a surprising amount of foreign exchange exposure and also $10 billion in footings held off balance sheet. At the end of Q2 2022, TIAA FSB reported an over $100 million deficit in terms of accumulated other comprehensive income (AOCI), but that number magically turned into a profit in Q3 2022. It will be very interesting to see how this bank looks once the transaction closes. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

November 2, 2022 | Former Fed Chair and now Treasury Secretary Janet Yellen is said to be monitoring the ebbing liquidity in the Treasury market “closely.” Since the author of “Operation Twist” and other acts of idiocy by the FOMC during Yellen’s tenure is now the cause of illiquidity in the market for government debt, it is good to know that she is still on the case. In our view, Secretary Yellen should be sent into well-earned retirement to spare the nation the cost of more of her good works. So badly have the Federal Reserve Board under Jerome Powell and the Yellen Treasury screwed up the term structure of interest rates in the US that the Treasury may now be forced to buy-back low coupon debt to set things right. By manipulating the Treasury bond market, Yellen and Powell have created yet another problem. The ignominy of the US taxpayer exchanging low-interest bonds for current coupons merely to suit the convenience of institutional investors should provoke outrage in Congress, but not a sound is heard from the world's only permanent criminal class. Members of Congress are largely clueless about the ways of means of the FOMC. As readers of The Institutional Risk Analyst know, the Treasury debt and MBS issued in 2020-2021 comprise an illiquid ghetto that nobody wants to own save a few unfortunate central banks. The hedging cost on GNMA 2% MBS is 3x current coupons and, even then, may not be effective. Similar problems are seen with low-coupon US Treasury debt. No surprise, the Fed is now running a negative funding spread, paying out more in interest on reserves than it earns from those low-coupon bonds it created during QE. Some central banks may be needing some liquidity rather soon. Over the weekend we were struck by a report in the Financial Times that suggests that the EU is finally unravelling, with the stronger fleeing the weaker credits. German Finance minister Christian Lindner says it is cheaper for many countries to raise their own debt rather than borrow jointly to address energy subsidies. Why? Because the growing pile of unsecured EU debt is trading at higher yields than the debt of the member states. “The financial advantage the commission, and many member states once hoped for from common European debt, as opposed to issuing debt on a national basis, no longer exists,” Linder said. With EU debt trading just shy of 3% and Germany close to 2%, Linder made the obvious calculation. The table below shows yields on various government debt. Source: Financial Times Part of the reason for the poor performance of EU debt is the fact that ECB Governor Christine Lagarde is foundering badly in the growing political storm in Europe. Her comments about inflation “appearing out of nowhere” made her a laughing stock in European financial circles, but few people in Europe are laughing in public. With total EU debt now approaching 100% of GDP, Lagarde has dug a financial hole that may eventually fracture the EU. The more basic problem faced by the EU and Japan is that the US is headed for a 5% fed funds rate by year-end. The U.S. yield curve and swaps remain inverted, however, with 10-year Treasury notes above 4%. The 30-year Treasury bond is below 3.75% and 50-year swaps below 3%. The inverted yield curve is not so much a signal for impending domestic recession, but rather highlights the entrenched belief by investors that U.S. interest rates will soon fall. Demand for dollars, as evidence by the deeply inverted curve for dollar fixed-to-floating rate swaps, remains brisk. A swap collateralized by US Treasury debt is the functional equivalent of the collateral, less fees of course. The inverted yield curve also displays the rather serious bias of economist surveys, which see the fed funds rate reaching 5% by February 2023 and remaining elevated through December of next year. The consensus survey of economists then sees fed funds falling to ~ 3.5% before the November 2024 general election. This is called a "soft landing" in the parlance of the Buy Side asset gatherers. Most of the economists surveyed, of course, work for Buy Side firms that earn a living by gathering and managing assets in a predictably mediocre fashion. Yet like Pavlov’s Dog , investors are now hard-wired to buy stocks when they fall by a certain amount. No additional conditioning is required. Edward Chancellor writes in The New York Review of Books : “Professional investors, who fear that clients will leave them if they underperform, may be forced to buy overpriced stocks to preserve their jobs—that is, they rationally choose to make seemingly irrational decisions. This problem becomes acute when investment performance is measured over the short term; as Keynes observed in his General Theory, most money managers are concerned ‘not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.’ Such behavior makes markets inherently unstable.” Do Buy Side investment managers and their pet economists cause market volatility? Former Treasury Secretary Larry Summers said as much in a Bloomberg interview, calling out the “growing chorus” of the “consensus of economists who have a track record, since COVID, of being dismally wrong on inflation. I believe this advice is badly misguided.” The cult of ever falling interest rates goes back 50 years and spans the terms of Fed chairs back to Alan Greenspan and Paul Volcker , who only fought inflation after President Ronald Reagan was elected in 1980. Neither the economists nor the advisors they serve would ever recommend that clients move to cash, as illustrated by the equity market selloff in 2022. The faithful expectation of a Fed-induced rally in both stocks and bonds drives the projections of an impending pivot. Like earnings projections, the purpose of projecting falling interest rates this side of the Fed event horizon is to convince investors to go back into equities early, before the actual fact. This strategy is easily predicted because all of us have seen that same movie before, with the FOMC coming to the rescue of a swooning economy. Most of the pundits and prognosticators are basically following the consensus view, with interest rates falling in Q1 2024. Exhibit A is the rally in financials over the past month, with Raymond James Financial (RJF) leading the group and such dogs as Deutsche Bank (DB) and Bank of America (BAC) galloping at 20-30% annual rates. But is this the time to be buying financials? It is fair to say that few of the managers buying these bank names for client portfolios has any idea about the risk that lies ahead. Specifically, the FOMC has kept fed funds artificially low since the 2008 financial crisis. The conflicted consensus view says fed funds will eventually settle back to 2019 levels of 3%, this after the Fed slays the inflation dragon. Mortgage rates, in this view, will fall back into the 5s. But what if the “reset” in interest rates is more like 4-5% fed funds, as was the case prior to 2008? And what does a 4-5% terminal rate say about future credit costs? One big reason why we think that any interest rate ease will be modest and grudging is the issue of volatility and related losses to investors and financial institutions. The growing clamor by investors for the US Treasury to repurchase low coupon bonds is a very real concern driven by real market realities like volatility and hedging costs, which directly impact new securities issuance. But the cost of fixing the handiwork of Janet Yellen and Jerome Powell may be very high indeed. Both because of concerns about inflation and also the FOMC’s growing awareness of the extent of the damage to markets done by QE, we expect the Fed to move very slowly to change interest rates once the necessary increases have been made. We expect the “ease” in FOMC policy to be merely a cessation of rate increases. That could be quite a surprise to the comfortable and entirely biased Wall Street economic consensus. Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

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