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August 25, 2022 | Premium Service | In this issue of The Institutional Risk Analyst , we take a look at two of the more depressed equity market valuations in the world of mortgage lending and servicing and ask a basic question: Is there value in some of these companies far beyond what the markets recognize at present? Some simple arithmetic suggests that the answer is yes. First on the list is loanDepot (LDI) , a name we mentioned last week in the context of industry-wide cost cutting. We noted at the time that the new CEO Frank Martell needs to cut operating expenses in half and we believe that he will, regardless of whether the endgame is a sale or salvation. To us, even in a sale, the LDI stock should be north of $6 instead of $1.65. The market capitalization of LDI as of yesterday’s close was $510 million or so, but at the end of June 2022 the company owned mortgage servicing rights in excess of $2.2 billion fair value plus almost $1 billion in cash. If we net out the loans in pipeline and the secured bank lines, half of the debt goes away. To us, LDI looks to have substantial value whether in a sale or positioned for a rebound when the FOMC reduces interest rates. The LDI financials from the latest 10-Q are shown below. loanDepot Obviously this situation has considerable execution risk, but we have added some LDI to our portfolio as a speculative investment on the likelihood that the intrinsic value of the servicing book will be recognized one way or another. At $1.60, LDI is down ~80% YTD, but has considerable value in either a sale or rebound scenario. We see a great deal more upside potential in LDI than in some of the mortgage names that are down single digits after the recent rally. How do we measure success? If we see new CEO Martell get LDI into positive territory in terms of EBITDA by the end of Q3 2022, that will be your signal that a turnaround has begun in earnest. LDI is paying down debt and canceling unneeded bank facilities to adjust expenses to a much lower floor in terms of operating volumes. Stay tuned. Blend Labs Inc. Next on the list is Blend Labs (BLND) , the point-of-sale (POS) startup that went public in 2021 above $20 per share and is now trading around $3.00 as of yesterday’s close. In 2021, BLND acquired a Title365 from Mr. Cooper (COOP) at a crazy multiple of book value in order to add some revenue to the platform pre-IPO. Very expensive revenue. We view the Title365 transaction as public evidence that these folks at BLND have no idea about value other than consuming shareholder value with both hands. A year later, BLND has written down the goodwill associated with the Title365 business, pushing the company into $550 million loss in the first six months of Q2 2022. Title365 is now about half the revenue of BLND, a bad business in a declining residential mortgage market. The revenue segments from the Q2 2022 BLND earnings presentation are shown below. Notice in the table above that mortgage segment revenues at BLND were down seven percent in 1H 2022 while the market was down 35% on volume. We suspect that the direct revenues from the mortgage segment and the Title365 business will both decline further in 2H 2022. Mortgage transactions for BLND went from 380,000 in Q1 2022 to 348,000 in Q2 2022. Note too that the incumbent managers of BLND awarded themselves an additional $52 million in stock options in 1H 2022, one of the most bizarre examples of corporate pillaging we can ever recall. How does a management team at BLND award themselves $50 billion in stock options after flushing half a billion in shareholder funds down the toilet? The Title365 acquisition was made just a year ago. If you back out the goodwill impairments and restructuring charges, BLND “only” lost $90 million in the first six months of 2022. But it is important to recall that these “extraordinary” charges are a reflection of the general incompetence of the BLNB management team in acquiring Title365 at 4x book value in the first place. Title companies generally trade at or below book value. We do not see any catalyst for value creation in this company until there is a wholesale change in the board and management team. The message of industry change and innovation contained in the BLND investor materials does not really square with the operating environment in the channel. CEO Nima Ghamsari seems to be living in a parallel universe: “We remain optimistic in our ability to execute and delivered another solid revenue quarter as we continue to grow market share. We plan to continue to optimize our cost structure, streamline our support functions and prioritize products that generate near-term ROI such that we can generate free cash flow under a prolonged market reset. And we are positioning ourselves as a category creator as we continue to drive innovation through our software solution for digital banking.” Ghamsari then addresses the issue of expenses: “Since April, we have eliminated over 400 positions or 25% of our workforce, including the elimination of backfills. We should see the full impact of these actions by Q1 2023. In aggregate, both actions are expected to reduce our annualized expenses by approximately $60 million. We will continue to monitor and adjust this cost base as market conditions warrant. We have also significantly limited hiring, focusing on the most important positions for the company.” We view the whole strategy of BLND, both in banking and mortgage lending, as marginally additive to the customer experience, but there is no transcendent improvement in loan acquisition or time-to-close. To us, aside from selling the well-worn fiction of “transformation” in the markets addressed, the incumbent managers at BLND seem more interested in personal gain than in building shareholder value. Chief Finance Officer Marc Greenberg describes the company’s financial performance, but fails to mention the more significant equity award to the incumbent managers: “As you can see in our financial supplement, our non-GAAP loss from operations was $39.5 million versus $26.3 million in the prior year. This quarter, we also recognized approximately $392 million noncash charge to reflect impairment of Title365 goodwill and intangible assets, driven by a decline in the fair value of the Title365 reporting unit.” Of interest, during the Q&A, Greenberg suggests that business volumes from defaulted loans serviced by COOP will make up for a decline in purchase mortgage business at Title365: " So the outperformance on the Title365 side is really because they have built in countercyclical offsets, right? They have the default business as well as the home ability business. So that's where you're seeing the outperformance on the Title365 side. Otherwise, Mr. Cooper transition is going great. They've been a wonderful partner for us, and we're ready for the increase in volume in the second half of the year ." The bad news for current shareholders is that there is little real value in the BLND POS business, whether you look at the mortgage segment or banking, the latter of which has suddenly become the focus of management attention. More, we do not see any potential acquirors on the horizon for BLND or some of the other startups in the mortgage POS space. POS tools are increasingly ubiquitous and available, allowing most issuers to develop in-house POS solutions at little costs. Indeed, if the merger of Black Knight (BKI) and Intercontinental Exchange (ICE) goes through, you can expect the expanded ICE monopoly in mortgage tech and data applications to simply give away POS tools to destroy the remaining incumbents other than Sagent Lending Technologies. L: CVX, CMBS, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC, LDI The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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.

In this issue of The Institutional Risk Analyst , we feature a discussion with Scott Olson , Executive Director of the Community Home Lenders of America ( CHLA ), which reflects the recent merger of the Community Home Lenders Association and the Community Mortgage Lenders of America. Olson now represents the largest DC trade association focused on independent mortgage banks (IMBs), which is CHLA's single largest membership block. Olson worked for 20 years on Capitol Hill and served on the House Financial Services Committee as Housing Policy Director under Chairman Barney Frank (D-MA). The IRA: Scott, there is a lot going on in Washington that impacts IMBs very directly, including new capital requirements for nonbank mortgage companies from the Federal Housing Finance Agency (FHFA) and Ginnie Mae and the prospective merger of Black Knight (BKI) and Intercontinental Exchange (ICE) . What are the issues that are top of your agenda for your members? Olson: Our core members are small to medium sized independent mortgage banks. We run the gamut from the small correspondent lenders that are taking their loans to the big aggregators to larger firms that are getting their seller/servicer ticket in conventionals or maybe even becoming a Ginnie Mae issuer and building a servicing portfolio. Individual things or policy changes affect each part of the secondary market in a different way. We don’t represent the larger issuers. FHFA and Ginnie Mae just came out with new financial requirements. We’ve been saying for some time that there needs to be a distinction between the small and large IMBs. The IRA: Well, especially if both agencies and especially Ginnie Mae are going to pretend that IMBs are federally insured banks. No matter how many times we explain to Ginnie Mae, for example, why the concept of risk based capital is a complete non-sequitur for nonbank finance companies, they continue to mimic the Federal Reserve and OCC supervision functions rather than develop a truly relevant risk framework. But we must remember that this is Washington. How do we get the approach you want for smaller issuers, one that recognizes that the large aggregators and the banks have the risk? Olson: There has been an extensive amount of public comment and research that suggests that virtually all of the risk in the market is with the top-20 issuers. If one of our members that is a Ginnie Mae issuer goes out of business, we will be saddened to see that, but it will have no impact on the market for government loans. The IRA: Precisely. The public record for the past half century suggests that insolvencies of IMBs are resolved in the normal course, often without even a bankruptcy filing. This is not a surprise because even when a bank fails, the FDIC takes over the depository and the parent company is usually liquidated informally, without a bankruptcy. Yet somehow the FHFA and Ginnie Mae, and also the Financial Stability Oversight Counsel (FSOC) , see some colossal systemic risk arising from residential mortgage servicing. Given your experience on financial policy, how do you explain the strange obsession that FHFA and Ginnie Mae have with bank regulatory models? Olson: CHLA did a paper on Ginnie Mae a few years ago and it is difficult to see the risk. Ginnie Mae made money in 2008. They make money every year. They are basically reinsuring government insured loans, so there is essentially no risk. We have hammered away at the idea that having a broad range of Ginnie Mae issuers, large and small, has been a huge benefit to the Federal Housing Administration program as well as the Veterans Administration and US Department of Agriculture. Yet the policies coming from the leadership at Ginnie Mae could end up forcing out some smaller issuers and concentrate the market more on two dozen or so large aggregators and servicers. We don’t think such a strategy actually protects Ginnie Mae or the taxpayer. We are the only trade association in DC making the argument on behalf of smaller issuers. The IRA: Wells Fargo (WFC) is exiting government lending and servicing. At some point the leadership of Ginnie Mae and HUD perhaps need to admit that they are doing something wrong. Markets require diversity to function. CHLA is fighting for smaller issuers, but the other trades are conflicted on FHA and Ginnie Mae. The larger banks basically see smaller banks, IMBs and other financial institutions as commercial customers and the GSEs and large Buy Side funds like PIMCO and Black Rock (BLK) as the real competition. Large banks are government sponsored enterprises after all, as you know very well from working on these issues on Capitol Hill. The government loan market was designed with the assumption of liquidity support from commercial banks, which have now left the market. How do you get fairness for your smaller nonbank members when the deck is stacked with policy options that are really only appropriate for large depositories? Olson: It is a battle. Take an example. The FHFA wants to impose a liquidity reserve on smaller issuers that don’t retain any servicing. Originally they wanted to add a 2% surcharge on TBA hedging, now it is 50bp. This doesn’t make sense to us. The IRA: We have raised the increased margin issue with the FHFA. They do not seem able to discuss their approach, whether the tax will be imposed on net or gross exposures, or even what exposures are covered. At Ginnie Mae, likewise, we cannot find anyone who can discuss the details of the Risk Based Capital (RBC) requirements included in the joint-proposal. Small wonder that commercial banks have left the government market. Now Ginnie Mae seems bound and determined to drive the IMBs out of government lending as well. Olson: One of big revelations I had after leaving the House Financial Services Committee was realizing after six months of talking to smaller lenders that there was much I didn’t know about mortgage finance. I had worked in residential and commercial finance early in my career, but going to head CHLA was a baptism in the reality our members face every day. The latest issuer/seller-servicer proposals present a challenge for federal policy makers in communicating the details to our members. Take another example: indemnification. Our members must be prepared to repurchase delinquent loans, but when I worked on Capitol Hill, I did not know mortgage lenders had that liability. We thought Uncle Sam covered everything, but that is not how it works for Ginnie Mae issuers. The IRA: Ginnie Mae servicers can lose thousands of dollars on an FHA loan foreclosure. There is little risk to Ginnie Mae in terms of payments to bond holders. The custodian banks make the payments directly to the bond administrator, which is another bank, thus no counterparty risk. The real world risk to Ginnie Mae is operational and financial risk from default servicing. Why? Because GNMA provides no liquidity to the market. Policy makers tend to see risks that don’t really exist, but miss other risks that are hiding in plain sight. Remember in 2009, people were talking about Ginnie Mae being “the next shoe to drop,” but it never happened, as you’ve noted. But we digress. Talk about some of the priorities for CHLA in the coming year. Olson: First and foremost, if we are going into a market correction in residential mortgages, then it is incumbent on FHFA and Ginnie Mae not to overreact. Increasing capital and liquidity requirements for conventional and government issuers now may just end up being a countercyclical drag on the economy and the housing market. We’ve been pushing back against changes in the issuer rules that we don’t think make sense in the real world and have also been pushing for a cut in the FHA insurance premium. The IRA: The FHA should have cut the premium for low income home buyers years ago, but somehow the Biden Administration could not put a $3 billion earmark in the budget last year or this year? Really? FHFA should have reduced the 2008-era loan level pricing adjustments (LLPAs) by the GSEs on low-income buyers, but that did not happen either, somehow. What other issues are top of mind as we head into the end of 2022? Olson: This is a time when the mortgage industry needs a thoughtful, sensitive approach from regulators, not some capital plan borrowed from bank regulators with no implementation framework for the industry to follow. We should remember what happened with the S&Ls in the 1990s when I was working in private real estate. By placing limitations on new loans, the regulators made the problem worse and ultimately pushed up the cost of resolution. We told banks and S&Ls not to make any more construction loans or mortgage loans, and we made the losses worse and caused more banks to fail. If we’re seeing difficult times, we need to be careful with initiatives to regulate risk because these measure will hurt access to credit among the most vulnerable people in our society. The IRA: FHFA Director Sandra Thompson worked at the Resolution Trust Corporation in that period if we're not mistaken. But we should all remember that regulation is a coercive progressive tool that by definition is countercyclical. Regulation is about government imposing constraints and authoritarian controls on private markets. We have to somehow fight back so that our constituents can stay in business. Thank you Scott.

August 22, 2022 | Premium Service | In the almost 20-years that The Institutional Risk Analyst has been published, we can rarely recall a scenario for national finance that is more likely to end in tears. Market interest rates are rising and the Federal Open Market Committee has begun to shrink the system open market account (SOMA), some $9 trillion in Treasury debt and mortgage-backed securities (MBS). Dick Bove of Odeon Capital summarized things nicely last week: “This week the Federal Reserve reduced the size of its balance sheet by a net $29.4 billion. This brings the 4-week total decline to $49.4 billion. These numbers indicate a serious intent to reduce the money supply. This is being done, I believe, because the Federal Reserve now understands that simply raising interest rates will not kill inflation. Shrinking the money supply will.” Even as the investment community ponders whether Chairman Powell is really serious about inflation and, therefore, prepared to impose consecutive down quarters on the equity markets , the housing sector is cooling and more. Why diverting the income and gains from $3 trillion in MBS to the Treasury stimulates the economy is beyond us. Maybe somebody will ask Fed Chairman Jerome Powell at the September FOMC presser. We’ve already talked about how the prudential regulators are forcing large banks led by JPMorgan (JPM) to raise capital and/or reduce risk weighted assets. Readers of The IRA no doubt noticed the announcement by Wells Fargo (WFC) that they are withdrawing from correspondent lending entirely. Banking aficionados will appreciate that the ghost of Norwest Bank has left the building, a reference to the aggressive merger partner of Wells Fargo & Co in 1998. The decision by WFC to stop buying third party mortgages is a sesmic event for the housing market. It could take down the bank’s risk weighted assets significantly, more than $100 billion, but represents a huge decrease in market liquidity for 1-4s. Note that Bloomberg has current coupons in MBS at 4.35 as of Friday’s close, suggesting 5.5% as a breakeven loan coupon rate in conventionals. This is a full point lower in loan coupon rate than 45 days ago, a remarkable swing in price. We expect to see more banks exiting the warehouse and correspondent space, including most of last year’s late arrivals. Source: Bloomberg Meanwhile, the Federal Housing Finance Agency and the Government National Mortgage Association (Ginnie Mae) issued new eligibility requirements for issuers. Overall, the new rules are a pleasant surprise for the mortgage industry, which is fighting for its life as rates rise and volumes fall faster than operating expenses. There is, however, some bad news, namely an area where the two proposals are not aligned. The Ginnie Mae proposal includes a risk-based capital (RBC) rule that would impose a punitive 250% capital charge on government mortgage servicing rights (MSRs). This is effectively a declaration of war on the non-bank issuers with large Ginnie Mae servicing books such as Mr. Cooper (COOP) , Lakeview, Rithm (RITH) and Freedom. But should the industry sound battle stations and go to war? Maybe not quite yet. The good news, of sorts, is that Ginnie Mae staff do not seem able to discuss the risk based capital rule at all. We hear that risk function head Greg Keith , for example, told one issuer during an all hands meeting that "we don't have to discuss that now," this in response to a question about RBC. This seems a very odd comment for a senior official of Ginnie Mae. Even makes us wonder if this RBC proposal is more decorative than substantive. Much of the joint-proposal between FHFA and Ginnie Mae is aligned, a big win for FHFA Director Sandra Thompson and Ginnie Mae President Alana McCargo . But the strange, Basel-style risk weighting for MSRs in the Ginnie Mae proposal makes no sense and requires a detailed explanation from McCargo. The RBC scheme doubtless will increase visitor traffic into the office of M cCargo and HUD Secretary Marcia Louise Fudge . Did anyone in the Ginnie Mae risk function, we wonder, review the proposal with McCargo? It appears that the answer is no. One MBA official noted: “The Ginnie RBC stuff is stupid. They are keeping an RBC standard for monoline institutions with a punitive risk weight on MSRs that has driven banks out of the servicing business. Dumb.” Fortunately, the effective date of the yet-to-be-defined risk based capital rule is many months away. Many mortgage firms may simply go out of business due to horrendous market conditions, where most issuers are losing money on every loan they underwrite. The chart below contains data from the latest Mortgage Bankers Association performance survey: Source: Mortgage Bankers Association Suffice to say that the velocity of change in the money markets combined with the difficulty involved in reducing expenses as quickly as interest rates have risen has pushed many mortgage lenders into operating loss in Q2 2022. loanDepot (LDI) , for example, reported a loss of $0.51 per share and a sharp decline in volume. As usual, bank consultant Joe Garrett puts it well in a client note: “[S]ources of revenue are not steadily moving upward a little every year. So, what does this mean? It means that you have to be disciplined in managing your overhead. Period.” LDI will exit the partner (wholesale / non-delegated correspondent) channel, but will fulfill the $1 billion still in pipeline by the end of October. We’ll see. The execution in the channel remains depressed due to the beggar-thy-neighbor approach taken by United Wholesale Mortgage (UWMC) , which has already chased several weaker players out of the wholesale channel entirely. According to the earnings disclosure, LDI expects to be run-rate profitable exiting 2022, but they are assuming continued slowdown in volume through 2023. We think many weakened firms will either be put up for sale of shut-down entirely. Inside Mortgage Finance writes: “The word on the street is that loanDepot hired industry veteran Frank Martell early this spring to trim the fat at the nation’s seventh largest lender and make sure it survives. The end-game? A sale or merger perhaps…” We agree. Martell better hurry. The interest rate rally since mid-June may help some lenders in Q3 2022, but we still think that pricing remains an issue due to industry overcapacity. And to address that very issue, UWMC is clearly preparing for a war of attrition in the wholesale channel: KBW featured this little financing note recently: “United Wholesale Mortgage, LLC, which is indirectly minority owned by UWM Holdings Corporation (NYSE: UWMC), entered into a revolving credit agreement with SFS Corp. as the lender. The agreement provides for, among other things, a $500mm unsecured revolving credit facility with an initial maturity date of August 8, 2023. UWMC has an “Up-C” organizational structure whereby United Wholesale Mortgage, LLC is the operational subsidiary of UWM Holdings, LLC. As of June 30, 2022, UWM Holdings, LLC’s common units were 5.8% held by UWMC as Class A common units and 94.2% were held by SFS as Class B common units which are convertible into Class D common stock of UWMC, providing SFS with 79% of the voting power of UWMC’s common stock. Mat Ishbia , CEO and Chairman of UWMC, is President and sole director of SFS and indirectly controls all of its voting stock.” You won't see a lot of other mortgage companies taking down unsecured financing this year. The cost of revolving bank lines for mortgage lenders and other non-bank finance companies is rising fast, putting additional pressure on an industry that is already operating in extremis . The money market summary above from Bloomberg shows that 30-day benchmark rates are closing in on 2.5%, so figure that rates for most secured advance and warehouse lines for non-banks lenders is around 3.5% to 4%. Meanwhile, the total cost of funds for JPM is still inside 40bp vs average assets as of Q2 2022. Source: FFIEC Back in June we reviewed Upstart Holdings (UPST), the once high flying partner of Cross River Bank (“ Update: Upstart Holdings & Cross River Bank ”) that has lost 80% of its market value since last year. UPST was sued by the class action law firms after revelations about surreptitious warehousing of unsold loans shattered the company’s veneer of invincibility. A large group of hedge funds selling the stock short certainly helped in the devaluation process. When banks and non-bank lenders like mortgage companies and UPST had a cost of funds approaching zero, then it was easy to pretend that non-banks could compete with insured depositories. Likewise, zero returns on risk-free assets made crypto tokens seem reasonable. But non-banks fund off the market, while banks have funding called deposits. Big difference, especially when the FOMC moves federal funds hundreds of basis points in a quarter. Now that market interest rates are starting to become very positive, but bank deposit rates are barely moving, the pretense of fintech as bank killer is over. The rising real costs of funding for non-banks is the chief risk in 2022 and beyond, one reason that the Ginnie Mae proposal to increase the capital charge for government MSRs is so completely ridiculous. As we move through 2022 and prepare for another year of down debt and equity markets, all of the market funded, market facing lenders in fintech, whether operating in mortgages, auto loans or unsecured IOUs, are going to be at the mercy of lender banks and an ABS market that has suddenly grown a good bit more picky. That is one reason why UPST is down 81% YTD, but they have a lot of company. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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.

August 17, 2022 | One of the more amusing tasks we have at The Institutional Risk Analyst is explaining to readers, old and new, why the government sponsored entities (GSEs), Fannie Mae and Freddie Mac , will likely sit in conservatorship indefinitely unless and until Congress acts first. It has been almost 15 years since the Treasury retook explicit control over the GSEs, yet the $7 trillion in conventional MBS guaranteed by these two “private” issuers is still not included in the national debt of the United States. There are well-intentioned people in Washington who continue to believe that, given the right political alignment, the GSEs will be recapitalized and released from conservatorship and the U.S. Treasury will recoup its full investment. Yet getting from here to there is a lot more complicated than most Washingtonians appreciate, one reason why former Treasury Secretary Stephen Mnuchin ultimately did nothing at the end of the Administration of Donald Trump . The first thing to understand about the GSEs is that, post 2008, post-Dodd-Frank and multiple amendments to the Basel capital guidelines, we can no longer pretend that these federally chartered corporations are sovereign credits once they leave government control. Under conservatorship, Fannie Mae and Freddie Mac are “AAA/AA+” credits, referring to the sovereign rating for the United States from Moody’s & S&P , but once they leave conservatorship, the rating drops. Under Basel capital rules, Ginnie Mae obligations have a zero percent risk weight for banks and the obligations of the GSEs have a 20% risk weight or $2 per $100 of risk exposure. In the world of Basel capital rules, 100% risk weight equals $8 of capital per $100 of exposure. As the GSEs exit conservatorship, the risk weight for GSE risk could rise to 50% or $4 of capital per $100 of risk. Private corporate exposures are 100%. Why would Fannie Mae and Freddie Mac be downgraded? Because the criteria used by Moody’s and S&P for sovereign ratings makes it impossible for a “private” obligor to achieve a “AAA/AA+” rating. No matter how much private capital an issuer possesses, even with a contingent $250 billion credit line from the U.S. Treasury, you are still not a “AAA” issuer. This means that the conventional mortgage backed securities issued by Fannie Mae and Freddie Mac would be downgraded as well. Hold that thought. During her first testimony before Congress, Federal Housing Finance Director Sandra Thompson noted that once the GSE have raised the required $300 billion or so in private capital, they would need to have a conversation with Treasury about the preferred equity position held by the government. If the GSEs exit conservatorship, will the Treasury get par value for its investment? Another good questions you never hear discussed on Capitol Hill. Rep. Blaine Luetkemeyer , R-MO, asked Thompson about the capital requirement under the amended regulatory enterprise capital framework put in place by FHFA. “Do you think $300 billion is the point at which the conservatorship can end?” Thompson did not answer the question directly, but rather listed some of the things that need to be done once the GSEs have retained $300 billion in private capital. She said (h/t to Inside Mortgage Finance ): “When the enterprises meet their capital targets, that’s one component of exiting conservatorship. There are other factors that need to be taken into consideration. Certainly, conversations with Treasury about its senior preferred shares. Conversations with the Federal Reserve about certain policy issues, like single counterparty and what happens if the enterprises exit and what’s other significant institutions’ exposure to Fannie/Freddie stock.” What Thompson did not say, however, because it would be too shocking to members of Congress, is that long before the US government begins to move towards removing the GSEs from government control, the Treasury must agree to continue guaranteeing the existing and future MBS issuance by Fannie Mae and Freddie Mac. Imagine how that change in the business model of the GSEs will impact the value of the private equity. With, say, a “A+” rating from S&P for the two now “private” GSEs, the spreads on conventional MBS will widen, the market prices of the MBS will fall, and the cost of conventional loans to consumers will rise proportionately. Just call our colleague Warren Kornfeld at Moody’s and ask him what happens if the GSEs simply exit conservatorship with $300 billion in private equity capital (and zero corporate debt, BTW). Allowing $7 trillion in conventional MBS to be downgraded by the major rating agencies would be a catastrophic event for the Treasury and the US housing market. As a result, most serious analysts who have looked at the GSEs understand that prior to release, Fannie Mae and Freddie Mac would essentially have to transfer full responsibility for the conventional MBS market to the Treasury. Instead of earning 50bp+ in insurance fees on MBS, the GSEs would need to pay the Treasury around 20bp annually to guarantee the secured mortgage debt. Now, you are probably thinking, charging 50bp or more to consumers and giving Treasury 20bp is not a bad business. But here’s the rub: Who’s going to care about a guarantee from Fannie Mae with a “A+” rating? A: Nobody. Even at “AA,” the GSEs would be marginally competitive with the large banks, private mortgage insurers and also nonbank aggregators like Rocket Mortgage (RKT) and PennyMac Financial (PFSI) . Keep in mind that the GSEs are nowhere near as efficient operationally as these private counterparties. Source: Bloomberg You see, there is this guy named Jamie Dimon . He’s got a bank named JPMorgan Chase (JPM) with a lead depository with a strong “AA” rating. He’s just below sovereign in credit terms. Why? Because rating agencies automatically give large, systemically significant money center banks a full notch of uplift in credit ratings. Why? Because JPM has access to the Fed’s discount window. In addition, Dimon has got over $2 trillion in core deposits. The GSEs have no internal liquidity, and no access to the Fed and by 2030 will have zero term debt in their capital structure. Source: Bloomberg Once the corporate debt is redeemed in 2030, the GSEs will basically be conduits with just enough working capital to buy loans and sell MBS. If you take the GSEs out of conservatorship without federal legislation, then the Treasury must cover all conventional MBS. The original issuers, Fannie Mae and Freddie Mac, become superfluous. More, as and when the Treasury puts a public price on a federal credit wrapper for conventional MBS, why can’t JPM issue its own conventional deal, pay the Treasury 20bp and keep the rest? And that is precisely what will happen. Tell us again how the GSEs will make money post-conservatorship? Going back to the inception, Fannie Mae always depended upon the federal guarantee for its debt to function in the capital markets. When it was created by Congress in the 1930s, Fannie Mae was essentially a federally chartered thrift owned indirectly by banks, a utility. In the 1970s, the Administration of Lyndon Johnson pretended to privatize the GSEs, but only in name. The government retained “dominion” over the assets, to paraphrase the US Supreme Court, voiding true sale and forever tainting the IPO of Fannie Mae and Freddie Mac as a monumental act of fraud by Congress. In a perfect world, Congress would transfer responsibility for guaranteeing the conventional MBS market to Ginnie Mae and extinguish Fannie Mae and Freddie Mac, without any compensation to holders of common or preferred. The Uniform Mortgage Backed Securities (UMBS) platform would be opened to all issuers of conventional mortgages, aligning the conventional market with the market for government loans and Ginnie Mae MBS. Any issuer could sell conventional loans into an MBS without a federal guarantee in good times, but fall back on a Treasury credit wrapper in times of market stress. Many of the operational and human resources at the GSEs could be migrated to the Federal Home Loans Banks , which become the liquidity backstop for the industry in a post-GSE mortgage market. As we noted in our latest column in National Mortgage News (“ Washington is the problem in mortgage finance ”), Director Thompson needs to reopen access to the FHLBs for independent mortgage banks (IMBs) that are helping to achieve the mission of the conventional market before the Fed induced recession overwhelms the secondary mortgage market. Of note, some of our readers may have seen a press release a while back from an organization calling itself the “Capitol Forum” saying that Fannie Mae General Counsel Terry Theologides was leading a crusade against the acquisition of Black Knight (BKFS) by Intercontinental Exchange (ICE) . We wrote about the deal in May in our Premium Service (“ Does ICE + Black Knight = Shareholder Value? ”). We hear from the highest levels that the Capitol Forum statements about Theologides and Fannie Mae “were a complete fabrication.” Such is life in the swamp called Washington. But in June, Scott Olson of the Community Home Lenders (CHLA) did send a letter to the Department of Justice seeking an antitrust review of the proposed purchase of Black Knight by ICE – citing concerns about the impact on consumers and smaller IMB lenders. As we never tire of reminding our readers, whether we speak of GSEs, zombie banks or large private monopolies, the public interest is rarely served but the private interests on and around Capitol Hill always benefit.

August 15, 2022 | Premium Service | In this issue of The Institutional Risk Analyst we focus on the world of universal banks, institutions that have a depository but are primarily involved in the investment business, including advisory, capital markets and investment banking activities. We exclude the top-four money center banks from this group, but include some of the best performing stocks in the industry, both in terms of operations and also market performance. Note to our subscribers: We shall be changing the pricing and terms of our Premium Service after Labor Day. Take advantage of low annual rates today! We published a profile on Raymond James Financial (RJF) last November and the company has outperformed much of the bank group since that time, both up and down. Financials generally have rallied in the past month on hopes that inflation will moderate, but we’d point out to our readers that the FOMC won’t start shrinking the Fed’s balance sheet until next month. The advisory income that RJF and other members of the universal bank group generate will enable them to outperform many money center banks in the uncertain and likely volatile period of adjustment ahead. In this report, we feature: All of the firms above are bank holding companies with large broker dealer subsidiaries, but that is where the similarities end. Goldman Sachs (GS) and Morgan Stanley (MS) are more traditional brokerage and investment management models, married to significant trading and investment banking lines. Charles Schwab (SCHW) and Raymond James (RJF) are far more focused on the advisory business and building both client assets and related bank deposits than trading or investment banking. SCHW is also a sponsor of money market funds and exchange traded funds (ETFs), as well as offering third-party managers to its advisory clients. RJF and SF have significant investment banking arms, but these businesses are smaller than the advisory businesses of these firms. Of the two, Stifel Financial (SF) is a more traditional securities firm with substantial principal and investment banking activities, but also boasts almost $400 billion in wealth management assets. We have written positively about MS in the past because we believe that CEO James Gorman created a goal of building a diversified universal bank and executed on that strategy. Gorman had to pay a significant price to acquire some of the businesses absorbed by MS over the past several years, including E*TRADE (2020), Eaton Vance (2020) and FrontPoint Partners (2006), but there was no real alternative. Likewise, SCHW, RJF and SF have made significant acquisitions and also paid and today pay top dollar to attract advisors onto their platforms. SCHW acquired TD Ameritrade in an all-stock transaction valued at approximately $26 billion that closed in 2020. Both RJF and SF have been gradually rolling up brokerage firms and advisory businesses for much of their existence. The 130-year old SF has a storied history of acquiring other brokerage business from its base in St Louis. It became a bank holding company in 2007 when it acquired First Service Financial and now has two national bank units. Many years ago, SF floated a loan for Bolivia. GS has a large investment management business, and a consumer and wealth arm, and the fees reflect the fierce competition for assets. If we compared $4.4 billion in investment management revenue with $2.495 trillion in assets under supervision, the gross is just 17bp. Throw $7.1 billion in revenue at MS vs $5.6 trillion in assets managed or in wealth advisory accounts, and the result is 12bp. Yet the sheer size of these business allows them to contribute to profits with ~ 10% ROE for MS in recent years from the asset side of the business. The exception to the rule of growth by acquisitions in the group has been GS, which has refused to make a transformative acquisition of a bank for fear of losing control over the overall business. SCHW, for example, paid to grow into the 7th largest bank in the US by spending money to acquire advisors. We have argued that Key Bank (KEY), with over $100 billion in core deposits and a focus on financing and servicing commercial real estate would be a good fit for GS, but prudential regulators would force the resultant bank holding company into a very different business model than the present-day Goldman Sachs. Eschewing acquisitions, GS instead has chosen to grow organically, particularly with respect to the banking side of the business and with decidedly mixed results. Below we go through the key indicators that we use for all banking groups, namely credit loss rates, the gross yield on loans and leases, funding costs and finally profitability vs total assets of the parent company, which is how the Federal Reserve Board looks at these companies. Source: FFIEC As the chart above suggests, GS is a good bit above its peers in terms of loan losses. We can take comfort from the fact that the GS loan portfolio is relatively small, just $250 billion, but it is now big enough to hurt the firm if credit conditions deteriorate to a degree equal to the benefit lenders received from QE during 2020-2022. Note that the other members of the group including MS and Peer Group 1 are well below the outlier GS. The loan book at GS has grown 140% over the past five years, of note, 5x the growth rate of the firm’s capital. Next stop is the pricing on the loan book, an important indicator of operational efficiency and management control. Note in the chart below that the gross spread for Peer Group 1 is near 4% while larger banks have seen spreads compressed to 3% during QE. GS is next above 3% gross yield, but the rest of the group are below 3% yield before SG&A. Note the way that GS was forced to give ground on loan pricing during QE in 2020 and 2021. Source: FFIEC The question of loan yield is crucial to all of these banks, however, because market interest rates are rising faster than loan yields. GS saw interest income rise 35% over the year ended June 2022, but interest expense rose 56% over the same period. The next key factor after loan yields to consider with this group is funding costs, shown in the chart below as interest expense vs average assets. Note that SCHW had the lowest cost of funds in the industry at just 8bp in Q1 2022, a position unchanged in Q2 2022. Source: FFIEC Through the end of Q1 2021, GS had a cost of funds that was 2x the rest of the group and, significantly, above the average for Peer Group 1. MS, on the other hand, has a funding cost that is below the average for the top 134 banks in the US above $10 billion in assets. RJF has a relatively high cost of funds, while SF has a cost of funds below all of the other names in this report other than SCHW. At the end of Q1 2022, MS had $340 billion in core deposits comprised almost entirely of retail funds from its advisory clients. MS has no jumbo deposits in its liability structure, zero. GS, on the other hand, has a significant proportion of deposits in jumbo CDs, foreign deposits and other forms of “hot” money that can depart immediately. GS had $200 billion in federal funds borrowed at the end of Q1 2022 vs just $74 billion for MS. Total noncore funding at GS was over $700 billion at the end of Q1 2022 vs $321 billion for MS. Despite the efforts at diversification, MS and GS remain dependent upon investment banking and principal trading for a large portion of profitability. The table below shows the total derivatives positions of the top banks as a percentage of average assets. Note that MS and GS have the largest notional positions in derivatives, literally thousands of percent of total assets, higher than JPMorganChase (JPM) or Citigroup (C) . These positions are about 80% interest rate contracts, but are many times the total capital of both firms. The other names in this report have little derivatives exposure and are more focused on third-party business for clients. SCHW, for example, has less than 5% of total assets in gross derivatives positions. Total Derivatives/Total Assets (%) Source: FFIEC The last key indicator to inspect is net income, one of the most important performance benchmarks for any financial institution. More than capital, banks survive because they can generate sufficient earnings to offset credit costs and continue to operate profitably. When a bank has to rely upon capital to offset credit losses, then you can be pretty sure that the Federal Deposit Insurance Company is already marketing the bank for sale. Since the enactment of Dodd-Frank, the FDIC now has the legal authority to place the entire organization into conservatorship and to then sell the enterprise intact without resolving the subsidiary bank. Source: FFIEC As the chart above illustrates, the two smallest members of our universal bank group have the best financial returns measured against total assets. RJF and SF, which have both performed well during the recent market downturn and rebound in Q2 2022, also have consistently better financial returns on assets overall. MS did 1.02% ROA in Q1 2022, but RJF and SF were close to 2% or 2x the 1.2 average for Peer Group 1. Q2 2022 Earnings The results for most of the universal bank group were weaker in Q2 2022, if for no other reason than the modest selloff in equities reduced assets under management (AUM) across the industry. GS saw results fall sequentially and YOY, but asset management was up almost 100%, an illustration of the volatility that attaches to this particular line item at Goldman. Total net revenues in the first half of 2022 were down 23% vs the previous year, again illustrating the volatility in the GS income statement. Likewise MS saw weakness in Q2 2022, both sequentially and YOY. Institutional securities took the brunt of the decline, but all three of the main business segments showed weakness due to market conditions. Provisions for credit losses also rose to $101 million in Q2 2022, the highest level seen at MS since 2020. SCHW, by comparison, reported record revenue in Q2 2022, with revenues up 6% for the first half of 2022. SCHW is a far simpler business than either MS or GS and it shows in the fact that the summary of advisor activity takes up the entire financial supplement. SCHW CEO Walter Bettinger makes clear in his Q2 2022 comments that client engagement, not market conditions, is the chief metric that SCHW uses to measure success. Remember, while SCHW has lower nominal income than its peers, the risk-adjusted returns are far higher. SCHW has total nominal assets of $648 billion for the purpose of the basic regulatory leverage ratio, but the risk weighted assets component for Basel capital purposes is only $154 billion. The bank reported ROE of almost 20% in Q2 2022. RJF saw revenues and earnings up in Q2 2022, which is Q3 in the bank’s fiscal year for purposes of GAAP reporting. The bank holding company still files quarterly financials on a December year-end for regulatory purposes. Revenues were down slightly on a sequential basis, but up 16% for the past nine-months. Provisions for credit losses were up 66% YOY, reflecting the normalization of credit across the markets. RJF had 8,600 advisors at the end of June 2022 and is aggressively recruiting in the channel. SF saw revenue and earnings down in Q2 2022, with both commissions and principal transactions under pressure due to market conditions. SF in many ways has more in common with GS than with RJF. We think of RJF as a smaller version of the giant SCHW, which is now the largest platform for RIAs and also a dominant provider of tools and solutions for independent advisors. SF is a classic investment bank with deep roots in the Midwest community and a fierce devotion to client service. They have literally rolled up dozens of other firms over the past century and, more recently, several banks. The $35 billion bank holding company reported solid results with net revenues of $1.1 billion, the second highest second quarter in its history, driven by higher net interest income and asset management revenues. Bottom line: We like the universal banks as a group because of the stability of earnings and low risk, but MS and GS are obviously outliers due to the trading and market risk taken by both firms. SCHW is the low-risk player in the universe of US universal banks, serving as the enabler and finance provider for independent advisors. But for us, RJF and SF may offer the most interesting opportunities in the universal space as each firm continues to grow its advisory business and related bank deposit base, but without the outsized market risk taken by GS, MS and the top-four money center banks led by JPM. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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.

August 10, 2022 | One of the goals of The Institutional Risk Analyst is to help our readers see the rocks in the water ahead before we hit the prop on the brand new Yamaha outboard motor. We try to do this by highlighting the exemplars among banks, finance companies and aspiring fintech issuers in our Premium Service . Last year, we helped several readers avoid the downturn in financials, positioning them to go shopping today. We recently featured Block Inc. (SQ) and Guild Mortgage (GHLD) , in our last issue (“ Update: Guild Mortgage & Block Inc. ”). West Grand Lake August 2022 We also focus on the those increasing instances where the speed of change in the macro markets is adding more noise than signal to the common narrative of investors and risk managers. In that regard, we were more than a little amused when the notorious SoftBank of Japan announced that it was dumping shares of SoFi Technology (SOFI) after reporting a more than $20 billion loss on its portfolio. Bloomberg News reports: “SoftBank Chairman and Chief Executive Officer Masayoshi Son earlier Monday said he plans widespread cost cutting at his Tokyo-based company and the Vision Fund, following a record 3.16 trillion yen ($23.4 billion) loss. The Vision Fund has been hammered by a selloff in global technology stocks this year, and SoftBank also reported a $6.1 billion foreign exchange loss because of the weaker yen.” As we predicted last year, SoftBank has been forced to put Fortress Investment Group up for sale. “SoftBank announced its acquisition of Fortress, one of New York real estate’s more active lenders, in February 2017. The deal came out to $8.08 per share, or $3.3 billion overall,” reports The Real Deal . Price talk for FIG is now said to be around $1 billion. Remember, the end of QE means asset price deflation . Q: If SoftBank needs to take a 70% discount on the sale of FIG and other assets, what does this say about the sustainability of Masayoshi Son ? More than any other global hedge fund, SoftBank represented the one-way trade created by the Federal Open Market Committee during the past decade. Its most radical adventure in quantitative easing or QE was merely the finale of a decade of inflationism. The most recent round of “large scale asset purchases,” as QE is known internally at the Fed, caused stocks and bonds to move higher in a nearly 100% correlation, a fundamental change in how private markets operate. By nationalizing the short-term money markets, the FOMC created the appearance of control. Just as SoftBank seemed to be minting money with every investment it made over the past decade, the Fed suspended the laws of economic gravity. QE was essentially a free long call option on the equities markets for global investors, especially those fueled by leverage. Now, however, that long-call position has suddenly migrated into a short-put position , with equity managers desperately trying to avoid another down quarter as clients take losses. As short-term rates rise but medium-duration exposures fall in yield, the FOMC is confronted with one of the more profound aspects of QE: namely that having inflated asset values to a grotesque extent, the central bank is now compelled to embrace and even encourage debt deflation. Not only does this suggests a prolonged period of economic contraction equal to the expansion under QE (read: a recession), but it also suggests that we’ll experience above-average credit defaults after a period of artificially benign credit. Source: FFIEC The reality of the construct above is revealed by the decidedly bearish views spilling out of the bank regulatory community. When the Fed directed JPMorgan (JPM) and other banks to raise capital buffers in preparation for the “hard landing” dreaded by economists, what they are really saying is that the conclusion of extraordinary policy may be a significant uptick in bank credit losses. If deflation takes hold and asset prices for stocks and homes weaken, then banks will take a significant hit after two years of negative credit costs. If you believe that the FOMC is going to stick to its guns and force down prices for residential homes, then you must also believe that all manner of credit investor will also take significant losses in the process. This is not a reference to losses on crypto tokens or other pieces of the financial fringe, but rather a mark-down in the value of real assets with real cash flows. Whereas the 2008 financial crisis was about the excesses of Wall Street in selling private-label residential mortgages, the deflation of 2023 is about marking down all types of real assets to the price level that equates with a non-QE world. As the FOMC now attempts to reduce the size of its portfolio, it will be a net-seller of Treasury debt and mortgage-backed securities (MBS), putting pressure on the dealer community even as issuance volumes fall. As bank reserves fall, banks and other investors will be forced back into the market for Treasury debt and MBS, pushing interest rates lower in the process. Lower reserves means lower deposits held at banks, eventually pushing down assets for the entire industry. Bank funding costs will remain suppressed for the next 12-18 months, however, giving banks a significant advantage in the money markets. Source: FFIEC And as the FOMC raises short-term interest rates and, with it, the cost of borrowing Treasury and MBS from the Fed’s reverse repurchase (RRP) facility, money market funds will be forced to buy Treasury debt and MBS in the open market, again putting downward pressure on medium and long-term interest rates. Banks, meanwhile, will be net sellers of assets as they comply with regulatory edicts to raise capital, putting upward pressure on interest rates as they sell loans and MBS. For all of you members of the Buy Side community who have been talking about rising bank lending volumes as interest rates rise, forget it. As the FOMC normalizes policy after several years of radical QE, banks will be forced to shrink risk assets and build liquidity, a counter-cyclical aspect to the scenario that is not addressed in most economic models. Banks will be net sellers of risk, putting downward pressure on loan prices and bank earnings for 2022-2023. Bottom line is that the Fed has created a scenario whereby the central bank and commercial banks are net sellers of risk. The structural aspects of this decidedly Fed market may force rates lower in the near term. As reserves disappear and the bid for Treasury paper and MBS rises in a market with dwindling supply of collateral, medium-term and long-term rates may fall significantly. Chairman Jerome Powell and his colleagues on the FOMC want you to believe that they can manage this complex process without market disruption and without taking the Fed’s balance sheet down below ~ $6 trillion. Sure. Have a great summer.

August 8, 2022 | Premium Service | Earnings season continues to roll along, with some notable surprises and also disappointments. This week, The Institutional Risk Analyst looks at Block (SQ) and Guild Mortgage (GHLD) , two story situations that have important messages for investors in financials. Both were punished in the first half of 2022 but both names have significant value outside of the current noise in the financial markets. With SQ, we see the negative impact of the deflation of crypto as the FOMC raises real interest rates, but the core business continues to grow. We think the Street is dead wrong about an impending pivot by Fed Chairman Jerome Powell and remind one and all that a sea change has occurred at the central bank. While the threats and bullying from the progressives in Congress is tough to take, restoring credibility in terms of inflation is now the Fed’s focus. Investors in the credit markets ought to consider how some of these platforms and strategies will look when the Fed goes into 2024 and into the general election with short-term interest rates still elevated. Housing costs, for example, are going to continue rising into 2023, thwarting hopes for an early pivot by the Fed. And across the universe of financial assets, the upward demand pull on valuations by investors is striking. The evidence of systemic inflation abounds. While it is “different this time,” the basic cycle of employment and inflation that has governed US financial markets remains intact, albeit with much higher volatility. We expect the FOMC to maintain elevated interest rates through to 2024, a dire message for equity managers that are betting the house on a pivot by the Fed before year-end. We look for many credit metrics to normalize over the next year as volumes remain low and default rates are rising. Guild Mortgage The volatility caused by the FOMC's shift to fighting inflation was very much in evidence in financials and particularly mortgages in Q2 2022, thus we were pleased to see GHLD deliver a strong quarter in terms of managing loan production expenses and other costs. The fact that rates rallied into the end of the quarter provided a bit of lift for GHLD and many other mortgage lenders and issuers. The first thing to notice about GHLD is that while the industry is down 60-70% on volumes, the purchase mortgage lender is only down less than 40%. GHLD has smartly reduced expenses 30% YOY, keeping this traditional retail lender solidly in the black while continuing to grow its servicing book, now $76 billion in unpaid principal balance (UPB) or about 315,000 loans. Source: EDGAR Likewise gain-on-sale volumes fell very modestly, again attesting to the strength of the GHLD model and their focus on retail purchase mortgage volumes. Total in-house originations of $11.8 billion compared to $17.9 billion in the first six months of the prior year. In addition, net revenue of $769.3 million compared to $820.3 million in the first six months of 2021. Net income of $266.3 million compared to $169.5 million in the first six months of 2021. “We delivered solid financial results for the second quarter of 2022 despite higher interest rates, excess capacity and limited inventories,” said CEO Mary Ann McGarry. “Despite shifting market conditions, our tenured management team has a proven track record across cycles and our differentiated purchase-focused business model positions us well, as refinancing volumes continue to weaken. In fact, purchase loans accounted for 84% of our total origination volumes in the second quarter.” GHLD has obviously given up a lot of ground since the end of 2021, but it has outperformed all of its mortgage peers save Mr. Cooper (COOP), as shown in the chart below: GHLD is down 17% YTD, a better performance than many other stocks in the mortgage group with the exception of COOP. The next year is going to be challenging for mortgage issuers, but we look for GHLD to continue to out-perform the group and perhaps even be a buyer of struggling mortgage firms. If you want upside exposure for the next Fed rate easing, names like GHLD and COOP ought to be part of your basket. Block Inc. (f/k/a Square) The results for Block were actually good in Q2 2022, but for the distraction of the crypto market. With the Fed raising interest rates, MMT and its techno hell spawn bitcoin are being deflated by rising real returns. Crypto tokens, NFTs and other collectibles only made sense in a zero rate environment. So long as central banks were removing trillions of dollars in duration from the markets, humans created new games from which to profit. The same crypto cachet that made SQ soar during the past two years has now become a bit of a headwind in the near term. As SQ stated in its shareholder letter: “Total net revenue was $4.40 billion in the second quarter of 2022, down 6% year over year, driven by a decrease in bitcoin revenue. Excluding bitcoin, total net revenue in the second quarter was $2.62 billion, up 34% year over year. Gross profit was $1.47 billion, up 29% year over year and up 47% on a three-year CAGR basis, and included $18 million in amortization of acquired technology assets.” We were involved in SQ early, but exited at the end of 2018 after returns went into double digits. The stock then proceeded to double and more during COVID. Since January of 2022, however, SQ has been cut it half, making us wonder if now is not an opportune time for re-entry based upon the core payments business as opposed to crypto fluff. Names such as Visa (V) , Mastercard (MA) and Fiserve (FISV) are better comps in our view. We were more than a little disappointed when SQ co-founder Jack Dorsey got involved with crypto and even changed the name of the company to give the firm a blockchain flavor. We think such short-term behavior detracts from the excellent results that Dorsey and his team have delivered on the core business. As we’ve noted in previous missives, we got into SQ half a dozen years ago because we knew that the roving hoard of equity managers seeking fintech would eventually find the stock. And they did. We loved the new approach to vendor transaction clearing for small business and that aspect of SQ remains the most attractive part of the business. Now, however, we think that a more constructive way to think about SQ is in comparison to the other credit card and payments players, which is hardly a bad thing but not quite so hyperbolic as the fintech sector has been in the past several years. The chart below shows SQ's results through Q2 2022. Source: EDGAR We like the positioning of the company and the fact that they are growing their business on larger accounts. CFO Amrita Ahuja addressed this issue: “We have obviously a diverse base of sellers, millions of sellers. From a vertical perspective, we span a range of verticals. So, 40% of Square GPV comes from a range of services verticals in 2021. The remaining 60% is across some of those discretionary areas like food and beverage, retail and other smaller, but growing verticals where we've continued to see stability from a three-year CAGR perspective. From a seller size perspective, as I said, continue to grow upmarket. In the second quarter, two-thirds of our volume in the Square business is from larger sellers, $125,000 in annual GPV or more. And historically, those larger sellers have been more resilient through downturns. And as we've said, larger seller, broader retention within the Square business, even including our smaller sellers, has been positive across GPV and gross profit in the second quarter and into July.” The major negative with SQ is the childish dalliance with crypto and the equally ill-considered name change. There does not seem to be any appreciable contribution to Block's business from blockchain technology. More, Square is how the firm is known inside the company and in the consumer payments community. Since Block has not yet changed its ticker symbol, perhaps Mr. Dorsey will eventually change the company's name back to Square and slowly distance himself from the crypto world and the equally unimpressive blockchain morass. While SQ is down 45% YTD, it rallied over 30% in the past month, along with names such as PayPal (PYPL) , SoFi Technologies (SOFI) . We suspect that concerns about the economy and the intentions of the FOMC with respect to interest rates are going to remain a drag on many consumer finance stocks. But we are impressed by SQ's progress in building its core business and think a long-term perspective that de-emphasizes the crypto component may be appropriate. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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.

August 1, 2022 | This week The Institutional Risk Analyst is headed for Leen’s Lodge in Grand Lake Stream, Maine , for a week of fishing, discussion and perhaps a poker game. Topic A on the agenda items for debate will be the state of monetary policy in the United States. Big Lake (August 2020) First and foremost, let's review last week's FOMC presser. Powell declared victory and proceeded to state that the neutral rate of interest or ”r*” is somewhere close to the current nominal level of Federal Funds (FF). The incredulity in the room was palpable, yet nobody in the media dared to challenged Powell’s statement. He said: “I'd start by saying we've been saying we would move expeditiously to get to the range of neutral. And I think we've done that now. We're at 2.25 to 2.5 and that's right in the range of what we think is neutral.” The chart below shows effective FF vs the rate on reverse repurchase agreements (RRPs). In these latter transactions, the Fed lends securities and takes cash out of the market. But hold that thought. The lack of specificity in the Fed’s statement about r* provides a hint about just how little precision there is in the way the FOMC looks at variables like inflation and interest rates. This lack of clarity, in turn, trickles down into all of the policy decisions made by the Committee. Thus if Powell actually believes that FF is now at r*, then no further rate hikes are required in 2022? Bill Nelson at Bank Policy Institute rejected Powell’s statement about FF neutrality: “That is incorrect – the current level of the federal funds rate is not neutral. The neutral federal funds rate is the rate above which monetary policy is restraining the economy and below which monetary policy is stimulating the economy. The neutral rate is usually defined in term of the real federal funds rate – the nominal federal funds rate minus a measure of inflation or inflation expectations. The neutral real federal funds rate is often called r*. The median FOMC participant indicated in the June SEP (Summary of Economic Projections) that he or she judges that the nominal federal funds rate will be 2.5 percent in the long run at which point inflation will be 2 percent. That reading indicates the neutral real federal funds rate is 0.5 percent.” Fed Chairman Jerome Powell mentioned the phrase “balance sheet” twice during his remarks. None of the senior reporters and columnists in the room asked about the portfolio, which is the single most important factor in monetary policy. Putting Powell on the spot about the vagueness of the Fed's intentions on the portfolio would be seen as unconstructive. Thankfully Jean Yung of Muck Rack asked about the pace of balance sheet reduction. Powell replied: “So we think it's working fine. As you know, we tapered up into it. And in September, we'll go to full strength. And the markets seem to have accepted it. By all assessments, the markets should be able to absorb this. And we expect that will be the case. So, I would say the plan is broadly on track. It's a little bit slow to get going because some of these trades don't settle for a bit of time. But it will be picking up steam.” What Powell was saying is that reinvestment of redemptions and prepayments on mortgage securities will end in September and forward trades in the mortgage market will likewise settle by that time. Translated into plain language, the Fed will start shrinking reserves and in theory force investors out of reverse repurchase agreements in September. Dealers will also be expected to shoulder 100% of the duration of Treasury and agency MBS issuance. Powell then defined the timeframe: “So I guess your second question was getting-- the process of getting back down to the new equilibrium will take a while. And that time, it's hard to be precise, but the model would suggest that it could be between two, two and a half years, that kind of thing. And this is a much faster pace than the last time. Balance sheet's much bigger than it was. But we look at this carefully and we thought that this was the sensible pace. And we have no reason to think that it's not.” Greg Robb of MarketWatch then asked Powell a good follow-up question about the potential for a repeat of the December 2018 taper tantrum, when markets seized up after several money center banks back away from overnight funds markets. Powell’s answer was quite revealing and detracts from the idea that reserve targeting as a percentage of GDP is a good way to avoid similar market hiccups: “So I think we learned, there have been multiple taper tantrums, right? So there was the famous one in 2013. There's what happened at the December '18 meeting where markets can ignore developments around the balance sheet for years on end, and then suddenly react very sharply. So we just had developed a practice of moving predictably and doing it in steps and things like that. It was just like that's how we did it. And so we did it that way this time. We were careful to take steps and communicate and all that kind of thing. Yeah, we were trying to avoid a tantrum. Because they can be quite destructive. They can tighten financial conditions and knock the economy off kilter. And when it happens, you have to, really in both 13 and 18, really had consequences for the real economy, two, three, four months later. So we were trying to avoid that.” We noted earlier that the Fed is modeling future market liquidity requirements vs GDP. Economists love to argue about mysterious quantities like liquidity or unmeasurable notions such as r*, yet the fact is that the FOMC ultimately relates everything to interest rates or gross domestic product. More complex notions are completely beyond the comprehension of members of Congress and the investment advisory profession. The purely domestic focus of the Humphrey-Hawkins law encourages this childishly simplistic view of the dollar political economy, a view significantly that excludes the rest of the world. For example, when Chairman Powell stood up last week and spoke about the neutral rate of FF, he never once acknowledged that the 10-year Treasury note had rallied almost 50bp in yield since the last FOMC meeting. Why is this key benchmark falling in yield? Because of the global shortage of risk-free collateral created by QE. Few people among the Big Media that “cover” the Fed have any idea about the bond market, risk-free collateral or the dollar. Notice in the chart below that sellers of fixed dollar cash flows are paying up handsomely in swaps, but outside of 30 years dollar cash flows trade at far lower yields than Treasury collateral. Source: Bloomberg Jeffrey Snider , Head of Global Research at Alhambra Investments, did an important piece recently where he discussed the shortage of collateral in the context of the dollar and interest rates (“ Collateral Shortage…From *A* Fed Perspective ”). Snider noted that since 2017, Treasury bills have been trading at a premium to risk-free reserves at the Fed, a strange situation that suggests a systemic shortage of this crucial collateral. At the same time, the short-term market for dollar swaps has been trading well-outside of the Treasury yield curve, but beyond 30 years is very tight and well-through Treasury yields. Since only banks may hold reserves at the Fed, the shortage of collateral has fallen most heavily on private market participants. Snider concludes: “It’s all about the puppet show. Top-level policymakers still, to this very day, believe that they can convince the world to dance to their tune; playing the federal funds “market” as the sole instrument in the accompanying FOMC Orchestra. The intended audience for this pitiful display includes, ridiculously, collateral suppliers and multipliers. That very fact alone gives it away. No one uses nor really cares about fed funds except those in the media who then give the public a distinct monetary impression that is plainly false.” “Even now, you’ll hear it said that the dollar goes up because of rate hikes to either the FOMC’s fed funds target (pre-2009) or its range plus instruments (like RRP and IOER),” Snider relates. “The Fed does not matter. Only Euro$.” We agree. For some time now, we have tried to focus the attention of our readers on the growing influence of foreign investors when it comes to the dollar and also the rate of interest in the dollar system. The growing number of disturbances to the offshore dollar system, including the financial implosion of China’s “Belt & Road” effort, the default of HNA and other corporate failures, and the related carnage in the Chinese property market, were early signs of stress. The war in Ukraine, inflation and the rising rates have thrown the non-dollar world into another debt crisis. And yet, strangely, the FOMC managed to conduct a press conference last week where the word “debt” was never mentioned. Foreign nations and markets were barely acknowledged. All of this is part of the exceptional American perspective that our domestic debt does not matter and the impact of the dollar on other nations, most of whom are short dollars, is of no consequence. As we noted in our comment to subscribers of the Premium Service last week (" Questions for Chairman Powell "), one reason that the Fed is not willing to allow its balance sheet to fall below about $6 trillion by the end of the decade is uncertainty about how the different pieces of the puzzle – the $9 trillion portfolio, $2 trillion in reverse repurchase agreements, and the Treasury market and cash balances -- will interact. But politics also plays a role. The FOMC figures that they can manage the politics of losing money on an interest rate mismatch more easily than taking hundreds of billions in realized losses on securities held in the system open market account (SOMA). Thus the FRBNY research team last month assumed no realized losses from the SOMA at all, zero, and thus no sales. Somehow nobody in the Big Media thought this was important? The $9 trillion in paper held by the SOMA (~ $6.2 trillion in Treasury debt and $2.7 trillion in mortgage backed securities) constitutes a threat to the global economy outside the US. Why? Because when countries and private companies and banks engage in offshore dollar transactions, they need risk-free collateral to back the trade. The low coupon Treasury paper and MBS created in 2020 and 2021, however, is now a ghetto, unsalable paper that is trapped on the Fed’s balance sheet, creating a serious problem in the global market for dollars. “Given the Fed primarily holds 2.0% to 2.5% coupons on its balance sheet, the ‘Sword of Damocles’ that is active sales hangs over these lower coupons as the Fed postures to embark on this unprecedented route,” writes Gordon Li of TCW, referring to the considerable underperformance of the lower coupon MBS since last year. He elucidates: “In stark contrast to these developments in lower coupon sectors, current coupon agency MBS have seen nominal spreads widen to levels roughly 35 bps in excess of previous Fed 'Reinvestment-QT' ranges, perhaps suggesting that the ‘pricing in’ of hawkish Fed actions has been overdone this hiking cycle. Valuations in current coupons have been made even more compelling by a sharp decline in dollar prices.” Given the dichotomy between the Sell Side tendency, which has already begun to chatter about Fed rate cuts before the end of next year, and the rest of the world, which is suffering from a strong dollar, the lack of clarity with respect to the optimal level of Fed involvement in the market is striking. Specifically, should the Fed assume that it needs to aggressively lend out its SOMA portfolio as the process of shrinkage actual begins in September? Here’s a question we’ll leave with our readers until later this week, when we report on the discussions at Leen’s Lodge: Will the Fed actually be able to “force” investors out of the more than $2 trillion in reverse RPs? “Force” is one of those unfortunate terms in monetary economics. We cannot force people to lend or invest unless we turn America into a copy of Xi Jinping's Chinese prison. Some believe that the Fed lost control over its own balance sheet at the start of QE. More, how much of a discount to FF will investors tolerate in return for borrowing risk free securities from the Fed? The answer to those questions will better inform the FOMC’s consideration of optimal reserve levels than a modeled output based upon GDP. After all, the relative demand for risk-free collateral and thus liquidity is largely a function of how JPMorgan (JPM) CEO Jamie Dimon feels about risk on any given day. As we noted recently, Dimon is a seller of risk. Stick that in your model and stir briskly Chairman Powell.

July 27, 2022 | Premium Service | In this issue of The Institutional Risk Analyst , we look at the Q2 2022 results for Mr. Cooper (COOP) released today. COOP is one of the larger owners of servicing among independent mortgage banks (IMBs) and one of the first members of the group to report. Generally speaking, IMBs, fintech platforms and other members of the finance market fringe tend to hide in the weeds until the last week or two of the 45-day reporting season mandated by the SEC. United Wholesale Mortgage Corp (UWMC), for example , reports on August 9th, but COOP is always one of first out of the gate and always has some of the best disclosure in the industry. Most of the rest of the industry won't report till next week at the earliest. As Sydney Poitier said so well in The Jackal , the good guys don’t hide. COOP is the sixth largest owner of mortgage servicing and one of the largest servicers for third-parties, with over $800 billion in primary servicing. The chart below is from COOP’s Q2 2022 earnings presentation. COOP is well on its way to reach its goal of $1 trillion in mortgage servicing. The Q2 results included a $195 million, non-cash amortization on the owned-MSR, which reduces reported income 1:1. Going forward, COOP expects that lower amortization and higher interest income will benefit earnings. Indeed, COOP told investors on the call that Q2 2022 may be the worst quarter of the cycle . Significantly, the compounded prepayment rate (CPR) of COOP’s servicing book is now down to 11% and the firms projects that rate falling to high-single digits by year-end. One of the big advantages that COOP has vs. its peers is a relentless focus on operational efficiency and cost savings, illustrated by the 40% decline in operating expenses since 2018. At the same time, COOP has increased the number of loans per employee from just shy of 700 in 2018 to 850 in Q2 2022. New loan volumes in Q2 2022 were running at a quarter of last year’s levels, but the servicing book generated substantial income. Unlike most of the mortgage sector, COOP's stock is up year-to-date, reflecting the balanced business model that includes one of the largest servicing books in the industry and a state-of-the-art lending operation that is more efficient than most other issuers. COOP claims that they have a 30% cost advantage vs other lenders and servicers. Like New Residential Investment (NRZ) , COOP has slowed purchases of MSRs and, indeed, recently sold owned-MSRs to a client in order to raise cash. COOP clearly believes that there will be opportunities to acquire MSRs in the future as other IMBs encounter operational difficulties as the economy slows. As we've noted in past notes, pricing in the MSR market has been week since the start of 2022 as previously active banks have backed away and have even sold assets. The fact that COOP is telling investors that they expect operating income and cash flow to grow for the rest of the year reflects a very bullish view on the part of management. It is interesting to note that COOP continues to be a buyer of its stock. More, COOP has no significant debt liabilities maturing for the next five years, providing a clear runway for the firm to build cash and acquire MSR portfolios opportunistically. “We are in a period of very unique opportunities,” Vice Chairman Chris Marshall told investors. “We want to position to take advantage of opportunities in the markets.” CEO Jay Bray noted that there are more and more MSRs coming to market, mostly from IMBs, thus supporting the narrative that says that assets are going to be getting cheaper. The twin prospect of disruption and opportunities in the mortgage market may provide COOP with an opportunity to continue to expand the MSR portfolio. We view COOP as one of the more prudently managed IMBs in the industry. The focus on the use of technology to reduce costs, plus the capital light strategy and the move to sell assets opportunistically makes COOP one of the more nimble and more survivable firms. The move last year to sell Title365 and spin the servicing technology platform to Sagent Lending Technologies illustrate the superior strategy and implementation of COOP. Leon Cooperman , a large shareholder, asked during the call what COOP sees as the long-term capital needed to run the business, Bray indicated that the current 30% capital to assets is probably too high and the minimum target is half that amount. Cooperman then went on to suggest that Bray ought to do a more substantial share repurchase or tender offer, a luxury most IMBs cannot even consider. We agree with the assessment of COOP management by Mr. Cooperman that this firm is one of the best positioned IMBs in the industry and has the liquidity necessary to continue to build value for shareholders. The fact that Leon Cooperman is one of the largest shareholders of COOP, even after the mortgage market selloff, speaks volumes for the way that this company has performed in good markets and in bad. If the recession now before us is extended, then COOP will be well positioned to navigate through it and acquire new assets as MSRs valuations come under pressure. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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. 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July 25, 2022 | Premium Service | As the meeting of the Federal Open Market Approaches this week and, more important, Camp Kotok begins next week, we have more than a few questions for Chairman Jerome Powell and his colleagues. A careful reading of the Fed’s research provides some insights about future Fed policy. Since the May 2022 statement regarding the management of the system open market account or SOMA, there have been a couple of important pieces of research that are suggestive regarding future policy. H/T to Bill Nelson at Bank Policy Institute. Two research reports by the Fed of New York have illuminated both the history of the Fed’s SOMA portfolio and then project forward the likely losses by the Fed as the portfolio gradually shrinks. More, the second paper by Alyssa Anderson , Philippa Marks, Dave Na, Bernd Schlusche , and Zeynep Senyuz , sets some disturbing markers for the future size of the SOMA portfolio and the realized and unrealized losses that are likely to accumulate. Totto Ramen East (2019) In the second FEDS Notes paper, the authors explain how the Fed is likely to start to generate actual, realized losses because of the interest rate mismatch on the Fed portfolio. This is more than a little amusing and also terrible to behold. The FRBNY paper essentially highlights one of the biggest downside risks created by quantitative easing or “QE,” namely a gigantic interest rate mismatch across the market for banks, non-banks and other financial intermediaries including the GSEs. Thus in the final paragraph, the Fed drops a bomb: “While the expansion of the Fed's balance sheet in response to the pandemic may have increased the risk of the Fed's net income turning negative temporarily in a rising interest-rate environment, the Fed's mandate is neither to make profits nor to avoid losses. In all its actions, the Fed seeks to achieve its congressional mandate of maximum employment and stable prices. If the Fed had not taken these actions, the risk of experiencing a period in which net income turns negative would be lower than it is at present, but the economic position of households, businesses, the U.S. government, and taxpayers would be far worse off.” Of course, the Fed has the luxury of ignoring losses because, as a creature of the US Treasury, it’s resources are assured. But private financial intermediaries and banks don’t have this luxury. As this edition of The Institutional Risk Analyst went to press, there were literally hundreds of billions in unrealized losses on the books of private investors, banks, all three GSEs and money market funds, underwater paper that will likely be retained through to maturity, reducing bank net interest margins. Apparently this is precisely what the Fed intends to do, namely keep all of the low coupon paper in the SOMA until it matures, in some cases decades from now. Thus the FRBNY paper projects likely realized losses from the difference between what the Fed earns on its portfolio and what it pays out to reserve holders and participants in the Reverse Repurchase (RRP) facility reaching $180 billion in a stressed scenario. Importantly, the paper assumes that the Fed will not realize any market losses on the SOMA. This suggests that there will be no outright sales of either mortgage-backed securities or Treasury paper in the SOMA. Is this now Fed policy? Somebody should ask Chairman Powell. The other big takeaway from the FRBNY paper is that the portfolio is going to be allowed to decline to about $6 trillion by 2025 and then start to grow again back to $8 trillion by 2030. This suggests a vast increase in the Fed’s monetization of debt service costs for the Treasury as rates increase. The enormous magnitude of losses on the Fed’s interest rate mismatch may prevent the central bank from making any remittances to the Treasury for several years. We can look forward to the eventual reduction of the RRP facility by raising the rate paid on reserves but not the rate for reverse RPs. Later this year, as short term rates rise, the Fed will force banks, money market funds and other investors out of RRPs. Media note: Somebody ask Chairman Powell about the timing of the “tapering” of the RRP facility, now $2.2 trillion. Think of the SOMA and RRPs as the asset side of the Fed’s ledger, while total bank reserves are the increasingly costly source of funding. The interest rate mismatch on the Fed’s balance sheet will give economists something to talk about at Camp Kotok, but for private lenders and investors, the legacy of QE may be capital losses and bankruptcy. Importantly, Bill Nelson notes that the elevated capital requirements for banks via the Supplementary Leverage Ratio (SLR) have had the unintended consequence of driving banks into the RRP facility. He wrote last week: “Eventually, prior to reserve balances declining further than the Fed wants, the Fed will need to widen the spread between the IORB rate and the ON RRP rate to drain the facility. Seems unlikely that the Fed will take that step at the July meeting, though. Money market rates have been low relative to the target range, so raising the ON RRP by only 70 basis points Wednesday could leave them below the target range. Raising the IORB rate 80 basis points could shine a brighter light on the expense of such a big balance sheet. Better to just wait a bit longer.” These most recent posts from the FRBNY research staff have clarified earlier Fed statements about the impact of unrealized losses on the SOMA. The authors of the FRBNY paper conclude: “While an unrealized gain or loss position on the SOMA portfolio does not directly affect the Fed's net income, if a higher expected policy rate path causes an unrealized loss position, this would be indicative of higher future interest expense. [fn] A higher policy rate path means that the Fed will have to pay more on its liabilities such as reserves held by banking system and the ON RRP facility.” Of note, Bill Nelson and Andy Levin of Dartmouth will be presenting our a new paper (“Quantifying the Costs and Benefits of QE”) at a Hoover workshop Wednesday July 27. He notes that whether the Fed loses money on asset sales or interest rate mismatch, the losses will occur: “As I explained in a blast email in May here ), the correspondence between unrealized losses and expected future remittances is, in fact, pretty tight. In particular, a change in unrealized gains/losses over an interval resulting from a change in the expected policy path is approximately equal to the change in the expected present value of future remittances.” Or to put it another way, past Fed statements have made it seem that outright sales of securities were being contemplated, which in turn would result in realized losses to the Fed and massive disruption to the secondary loan market for mortgages. Instead, this most recent missive seems to confirm that there will be no outright sales of securities from the SOMA , but the Fed will realize actual losses due to the asset/liability mismatch caused by rising interest rates. Final media note: Ask Chairman Powell how he and the members of the Committee think about the interaction between the swollen SOMA, large bank capital levels and the target for Fed funds. We suspect that merely asking that question will force Powell to reveal his true thinking regarding inflation. But do any of the journalists in the audience have the courage to ask? Specifically, after a modest reduction, the Fed plans to grow the SOMA and RRPs significantly to accommodate “reserve needs” (aka the federal deficit). The chart below comes from the FRBNY paper: Once upon the time, the Fed funds rate was a private market. Today it is a tool for public policy. As the Fed continues to expand its balance sheet, albeit after a modest adjustment, the only conclusion for reasonable people is that the central bank has embraced inflation as its primary tool to finance federal deficits. The Fed will, if necessary, destroy and subsume the private financial markets in order to keep the market for new Treasury debt open and functioning. The pursuit of the 50-year old dual mandate has become a threat to the stability of the US markets and the economy, a fact illustrated by the Fed’s actions over the past decade. Each time the Fed changes policy, greater volatility is seen in markets and throughout American society, as illustrated by housing. When Congress passed the Humphrey-Hawkins law half a century ago, the America’s public debt was tiny and had little impact on Fed policy. Today, managing the Treasury’s debt is the Fed’s primary though unspoken task and explains the vast growth in the Fed's balance sheet. There has never been a better time for Congress to repeal the Humphrey-Hawkins law and refocus the Fed entirely on price stability.

July 21, 2022 | A while back our friend and mentor Alex Pollock wrote an important comment in Housing Finance International , “ The government triangle at the heart of U.S. housing finance ,” which discussed the huge expansion of the role of the central bank in the US economy since 2008. He writes: “The U.S. central bank’s great 21st century monetization of residential mortgages, with $2.7 trillion of mortgage securities on the books of the Federal Reserve, is a fundamental expansion of the role of the government in the American housing finance system. In Economics in One Lesson (1946), Henry Hazlitt gave a classic description of those whose private interests are served by government policies carried out at the expense of everybody else. ‘The group that would benefit by such policies,’ Hazlitt wrote, ‘having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds to devote their whole time to presenting its case,’ with ‘endless pleadings of self-interest.’” We tend to think that the early period of Fed manipulation of the mortgage markets in 2020 and 2021 was a good idea, if for no other reason than giving the mortgage industry the cash to help millions of Americans avoid default during the COVID lockdown. The alternative would have been a 1930s style debt deflation with millions of home foreclosures that would have made 2008 seem blissful by comparison. But whereas in 2020 and 2021 the mortgage industry originated trillions of dollars in new loans, in 2022 the industry will be lucky to break $800 billion in new issuance of agency and government mortgage backed securities (“MBS”). As existing home sales fall, the issuance of MBS will likewise plummet. Home mortgage rates are over 6% and headed higher. The decline in existing home sales carries several immediate implications, writes Glenn Schultz , head of agency MBS prepayment modeling and strategy at MUFG Securities . “Issuance volume, at this point we are confident 2022 issuance will reach the mid-point of our forecasted range of $600 to $800 billion. Looking into 2023 we believe issuance will decline balancing supply/demand fundamentals.” Schultz says that MBS turnover will continue to decline and prepayments will likewise moderate. He expects the rate of home price appreciation to continue at a double digit pace through 2022, however, only moderating in 2023 as supply and demand balances. Schultz says further that existing home sales will probably decline below five million units on an annualized basis due to demand destruction caused by higher mortgage rates and strong home price appreciation. So here is the obvious question in the minds of readers of The Institutional Risk Analyst : Why is the Fed continuing to reinvest prepayments and redemptions on its $2.7 trillion system open market account (SOMA) MBS portfolio? In hindsight, the Fed should have ended all purchases of MBS a year ago, when new issuance volumes started to drop. Yet the MBS purchases continue. We appreciate the comments from various people on our recent column in National Mortgage News , (“ Faulty bank stress tests are hurting the mortgage market ”), which highlights the continuing conflict between Fed monetary policy and the central bank’s regulation of large banks. Suffice to say that the latest Fed bank stress tests are so far off the mark that we cannot even construct a reasonable facsimile of the test results for JPMorgan (JPM) using the regulatory data from the FFIEC. We wrote: “The situation with respect to the Fed and bank stress test results is more than a bit ironic. The potential losses that the Fed’s fantastic stress tests envision are the direct result of the manipulation of the housing sector and global credit markets by the Federal Open Market Committee under ‘quantitative easing’ or QE.” So when the Fed finally stops reinvesting redemptions and prepayments from MBS, the large banks regulated by the central bank will also be selling residential mortgage exposures because of the skewed results of the bank stress tests. How is this helpful? Does the Fed’s Board of Governors really want to crater the market for housing finance by having both large banks and the SOMA as net sellers? Looking from the perspective of mortgage lenders, it sure looks that way. Leaving monetary considerations aside for a moment, why save mortgage lenders in 2020 but kill them now by hiking the Fed funds rate? Meanwhile, between July 15, 2022 and July 28, 2022, the FOMC is scheduled to buy $6 billion in MBS . If annual issuance of new MBS is only running at $600 to $700 billion or one quarter of 2020-2021 levels, then why is the FOMC still buying $10-15 billion per month in MBS for the system open market account? Is this meant to offset the impact of rate target increases? If so, then it's not working. Since nobody in the media thought to ask that question at the last FOMC press conference, we do not know the answer. Maybe next week. In our last edition, we noted that the 10-year Treasury note has rallied nearly 50bp in yield since the middle of June, driving the on-the-run contract in the forward market for residential mortgages back down to 4.5% coupons for Fannie Mae MBS. If you were too short on your TBA hedge, too bad. Meanwhile the net longs are filled with joy. And all of this because of the profound lack of sensitivity of the FOMC to that most mysterious of things, market forces. The time to taper MBS purchases for the SOMA is when market demand is high. Demand for risk-free assets such as agency and government MBS is very high at the moment, largely because issuance across the board is falling. This is bad. We applaud Fed Governor Christopher Waller for urging his colleagues to resist the temptation to hike rate targets 1% next week. The real message to the FOMC is this: hike another 75bp in July and then let the Fed funds target sit for a few meetings while you let the SOMA portfolio shrink, slowly. The 10-year Treasury is heading toward 2.5%, high yield spreads are tightening and the dollar is strong. Take the gift. One of the truths of American monetary policy is that the FOMC, being a creature of politics, always does too much. The FOMC bought too much Treasury debt and MBS since the 2008 crisis and, especially, since the outbreak of COVID. When you increase the money supply w/o a proportional increase in productivity, you get inflation. Now the Fed seeks to regain virtue by over-correcting on the anti-inflation medicine, but risks recession and market contagion in the process. Just as the Fed badly needs to consider the interaction between monetary policy and large bank capital rules, the central bank also needs to better understand and articulate the trade-offs between rate target increases and changes in the balance sheet. Chairman Powell, to his credit, has admitted that the FOMC does not understand how to calibrate changes in rate targets vs changes in the SOMA. Given this uncertainty, we think that the Fed should do less not more, with a view to reducing the level of volatility in the system introduced by the Fed’s very own “go big” tactics on QE in 2020 and 2021. Market rates have already moved hundreds of basis points since January. More important, issuance of new securities is headed into the floor, a serious red flag for policy makers that want to see the US economy continue to function and grow. Maybe now is the time for the FOMC and the financial community to admit that the solution to inflation may take time and also may be beyond the power of central banks to fix in the near term. That requires political courage; the courage to say “no” to the screaming mob in the political community and the media, just as former Chairman Paul Volcker had to ignore many loud critics half a century ago. Governor Waller is right. Slow down.

July 19, 2022 | Premium Service | We start this issue of The Institutional Risk Analyst by noting that the Fannie Mae 4.5% MBS for delivery in August is now above par, a measure of the impact of the bond market rally seen since the mid-June peak of 3.43% for the 10-year Treasury note. Today the 10-year T-note opened below 3% as the yield curve is now inverted from 2s through 10s. Many analysts have still not caught up to the fact that the bond market has been in rally mode for the past month. “We think in the short term spreads have the potential to go wider and only when the risk factors start to abate would we expect spreads to turn tighter,” Bank America (BAC) analysts Jeana Curro and Chris Flanagan wrote in a July 15 client note. “Over the long term we would expect mortgages to outperform, but the timing is of course tricky.” Tricky indeed. Meanwhile, BAC reported earnings this week and the results were decidedly mediocre, as we predicted in our earlier missive. First lien originations fell but home equity lines rose. Net interest income rose by $3.5 billion, but non-interest income fell by $2 billion in the first six months of 2022. A $1.5 billion tax bill and $500 million in provisions (both items were negative last year) and BAC’s net earnings were down $4 billion in the first six months of 2022. The summary from BAC’s earnings presentation are below. BAC is currently trading at book value, which given the outlook for the company is probably about right. With 8 billion shares outstanding, BAC is one of the most widely held stocks on Wall Street and, as a result, has an army of apologists among Buy Side managers and the media. They've all made the same mistake and spend enormous time in justification. Even though the bank continues to underperform its asset peers, CEO Brian Moynihan was praised in the financial media for a strong quarter. “Bank of America revenue tops expectations as lender benefits from higher interest rates,” CNBC declared on July 18th. But Moynihan continues to fall short in terms of his bank’s performance vs its peers. The good news for BAC and other banks is that there is a discernable lift underway on the yield of bank balance sheets, with the return on earning assets (ROEA) for BAC up to 2.23% in Q2 from 1.89% in Q1 2022 and 1.79% a year ago. The difficulty is getting BAC and other underperformers such as Well Fargo (WFC) to tighten up their operating efficiency while they also build capital to meet higher requirements from the Fed. “Management [at BAC] expects to build CET1 to 11.5% by the end of 2023 in response to increasing SCB & CSIB surcharges through a combination of organic capital generation and balance sheet optimization,” writes Jeffrey Harte at Piper Sandler. “While buyback activity is likely to be subdued in the near term, management sees an ability to continue repurchasing shares.” BAC, for example, dropped its efficiency ratio down to 66% in Q2 2022 vs 68% in Q1 and almost 70% a year ago. But the bank is still not in the right neighborhood with JPMorgan (JPM) and U.S. Bancorp (USB) in the mid-60s in terms of efficiency. The chart below shows efficiency ratios for the top-five banks. Source: FFIEC, EDGAR Citigroup (C) was the big winner in Q2 2022 in terms of results, not so much in terms of the size of the increase in revenue and earnings but rather the stability of the results. The sub-65% efficiency ratio is also good news. The six percent increase in net income contrasted with the sharply lower results of some asset peers. One of the ways that CEO Jane Fraser can rebuild support among investors is to deliver results with less volatility and more consistency than BAC or WFC, which continues to be badly wounded from its regulatory problems. WFC’s revenue fell $500 million in Q2 2022 and was down 11% in the first half of the year. The bank’s loyal following among managers is being tested by the deliberate downsizing of the bank, including a double digit runoff rate for residential mortgage exposures. With Tier 1 leverage sitting at 8%, we’d not be surprised to see further reductions in assets. The annualized ROEA for WFC was 2.7% at June 30, 2022, a good bit above BAC. Most of the banks reporting last week saw slippage in residential mortgage lending and servicing. WFC saw third-party servicing assets fall below $700 billion as the bank continued to shrink. It was not so long ago that WFC's assets serviced for others was measured in the trillions of dollars. “JPMorgan Chase, the second-largest depository home lender in the nation, originated $27.9 billion of first liens in the second quarter, a 7.6% sequential decline,” Inside Mortgage Finance reported. “Compared to the same quarter a year ago, loan production skidded an ugly 59.3%.” During last week’s earnings call for JPMorgan Chase (JPM) , CEO Jamie Dimon rebuked the Federal Reserve Board and other regulators for what the veteran operator described as “ridiculous” bank stress tests. He then went on to say that JPM and other banks will be forced to reduce 1-4 family mortgage exposures because of the Fed’s poorly conceived bank stress tests. “We don’t agree with the stress test,” Dimon said. “It’s inconsistent. It’s not transparent. It’s too volatile. It’s basically capricious [and] arbitrary. We do 100 [stress tests] a week. This is one. And I need to drive capital up and down by 80 basis points? So, we’ll work on it. We haven’t made definitive decisions. But I’ve already mentioned about how we dramatically reduced [risk weighted assets] RWA this quarter. We may do that again next quarter.” What is raising Jamie Dimon’s ire? Regulators recently determined that JPM could lose $44 billion in a highly stressed economic scenario, in large part on its $250 billion portfolio of 1-4 family mortgages. As a result, JPM is curtailing share repurchases until at least 2023. Read our analysis in National Mortgage News (" Faulty bank stress tests are hurting the mortgage market "). The other interesting notes so far in this earnings season was the rebound of Silvergate Financial (SI) , the small bank located in Southern CA that was trading 12x book value in March of 2021, but then collapsed with the crypto bubble. SI has been up over 30% in the past month but is still down almost 50% YTD. Another notable name from the world of crypto, Signature Bank (SBNY) had also rebounded strongly along with SI, but then got clobbered when strong earnings results were combined in a significant run off in crypto related deposits. SBNY is still down almost 50% and has given up all of its gains of the past month. Finally, a name we highlighted recently, Ally Financial (ALLY) , came in low on earnings and high on loan loss provisions, pushing the stock lower. The bank continues to originate auto paper and, indeed, beat analyst estimates by a wide margin. The good news is that the bank is “only” trading +270bp in five-year credit default swaps, but the ALLY 5 3/4s of 2025 and 4 3/4s of 2027 are trading +250bp in terms of the mid-market spread. Bottom line on banks earnings: Higher credit provisions and taxes, and lower revenue seem to be the basic picture. Rising rates are starting to reprice bank assets, a process that promises to increase asset and equity returns in the future. But balancing this bright prospect will be continuing worries about credit after several years of great moderation by the FOMC. The fact of rising credit provisions at banks suggests that the great normalization is well underway. Next in the Premium Service of The Institutional Risk Analyst, we’ll be looking at the Wall Street universal banks and advisors – GS, MS, SCHW, RJF. Our bank surveillance group is shown below. Please keep those questions and comments coming. Source: Bloomberg (7/18/2022) The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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. 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