SEARCH

In this issue of The Institutional Risk Analyst, we feature a great comment by Brian S. Wesbury and Robert Stein of First Trust Advisors . We are often baffled by the frequency with which otherwise savvy observers predict the demise of the dollar as the global reserve currency. In fact as the authors confirm, the global usage of the dollar in commerce and finance is increasing as other nations of the world slide into war and economic malaise. Neither Russia nor China nor even the European Union have the combination of liquidity, free markets and the rule of law that could displace the dollar's leading role in the global economy. Dollar Remains World Reserve Currency By Brian Wesbury & Robert Stein July 14, 2022 How many times have you heard that the US dollar will collapse because of Fed and fiscal policy? According to the pessimists, this will bring the loss of reserve currency status, and possibly the rise of China. Replace China with Russia, and it sounds like the 1970s. Inflation is out of control, energy prices have surged, geopolitical tensions are rising, and Presidents (then Nixon, lately Trump) were replaced by widely perceived weak leaders from the opposite side of the aisle. Though all these pessimistic forecasts are related, there is one very important distinction. The dollar is not weakening, as it did in the 1970s, the dollar is surging. Yes, in absolute terms your dollars are worth less every day due to rising prices. However, when comparing the dollar to other major currencies (in other words looking at the relative value of the dollar) the story is the exact opposite. The dollar has soared over the past twelve months and currently sits at a 20-year high according to the Bloomberg US Dollar Index . The Euro just fell below parity with the US dollar for the first time since 2002. Sure, you may not be able to buy baby formula, but at least it’s a good time to start planning that European vacation. This is the opposite of what happened in years leading up to Paul Volcker’s tenure at the Federal Reserve. From the late 1960s to the early 1980s, the dollar was collapsing in international markets, falling roughly 30% peak to trough. The dollar was at risk of losing its reserve currency status. Why? The US Government decided to use the dollar’s strength to monetize the debt from Vietnam War spending and President Johnson’s huge expansion of the welfare state through the Great Society programs. (They called it “Guns and Butter”). These dollars started accumulating abroad, and the Europeans (and others) saw the writing on the wall and asked for gold. At the time, the global financial system still operated under a gold standard. This led President Nixon to close the gold window and devalue the dollar. And, voila, the fiat currency era was standardized. The bottom line is that this was terrible for the dollar’s reputation internationally, precipitating its collapse in foreign exchange markets and creating even more inflation. Inflation clearly played a role in the Volcker Fed’s decision to send short-term interest rates to a record high of nearly 20% in the early 80s. However, saving the US dollar’s reputation and reserve currency status was also a priority, even if it meant sacrificing the real economy to do it. Today, while the US is dealing with plenty of economic problems, bailing out the dollar’s reputation thankfully isn’t one of them. Moreover, there is no potential shock like the end of the gold standard that could happen today. You can only go to fiat once. So, why has the dollar performed so well recently? First, the US economic recovery has been stronger than pretty much anywhere else in the world, owing to the ability of states to manage much of the response to COVID which allowed certain regions to remain relatively open. Second, the war in Ukraine has caused a flight into US currency. We are the security umbrella for Europe and have the best defense companies in the world, a resource that now seems to be carrying a much bigger priority abroad. The US energy sector also looks set to displace Russia’s market share in Europe as well. Finally, the Federal Reserve is raising rates while our biggest competitors in the currency space, Japan and Europe, continue to be remarkably dovish despite the global nature of the inflation problem. While there is plenty of negative news to focus on, the collapse of the US dollar thankfully isn’t on that list. If anything, reserve currency status looks stronger than ever. Once again the US is coming out of a global crisis as the cleanest dirty shirt in the laundry.

July 13, 2022 | Premium Service | For the past several weeks, we have watched as credit default swap (CDS) spreads for Ally Financial (ALLY) have widened out, to the point where the implied CDS is close to 280bp over the curve. While many readers of The Institutional Risk Analyst have been watching crypto fiascos like Silvergate Financial (SI) and Signature Bank (SBNY) , the prospect of financial problems for the 23rd largest bank holding company (BHC) and a large ABS issuer is cause for concern. But have any of the US bank regulators noticed? Back in September 2020, we profiled ALLY (“ Bank Profile: Ally Financial Inc ”) and focused especially on the bank’s still high funding costs relative to its peers. We also noted that the yield on the loan portfolio is low vs the risk, especially given the large consumer exposures at ALLY. Since that time, ALLY has improved its financial performance and has evolved into a stand-alone consumer lender operating via an online (aka “wholesale”) funding platform. With earnings expected on July 19th of this month, the market action in the stock, options and related debt is decidedly bearish. Source: Bloomberg (07/13/22) The put/call ratio on ALLY is almost 10:1, Bloomberg reports. More, the bank’s debt is trading 250bp over the Treasury curve, roughly 3x the OAS spread for large banks. The 5-year CDS spreads for ALLY were trading 280bp over the swaps curve compared with 120bp for Citigroup (C) and 150bp for CapitalOne Financial (COF) . What gives? We suspect that the large (> 50%) consumer loan exposure of ALLY is the chief reason that the $180 billion bank is attracting the attention of short-sellers. The sharp upward skew in loss rates in Q1 2022, both for COF and ALLY, was not helpful. COF, let us recall, has a gross yield near 10% and a yield on its credit card portfolio in the mid-teens. Loans to individuals at ALLY accounted for almost 60% of total loans in Q1 2022, making for a decidedly bad position for the bank going into a recession. C&I loans accounted for 20% and real estate loans were just 20%. Indeed, ALLY’s exposure to individuals is among the highest in Peer Group 1, with the bank ranking in the 97th percentile. Source: FFIEC While ALLY has tracked the other large banks down in value since June, the change in spreads on the CDS and bonds caught our eye. Simply stated, ALLY is trading more like a nonbank finance company than a bank, a function of the fact that the bank has more loan exposure than its mainstream peers. Yet the funding profile of ALLY is quite solid, with better core deposits than when we looked at them in 2020. Over 90% of the bank’s debt has maturities over five years, among the best in Peer Group 1. But bottom line, ALLY has some of the most expensive funding among large banks even compared to Citi and COF. Source: FFIEC On the credit side, ALLY is well-reserved against credit loss, but its loss rate is 4x peer because of the nature of the bank’s consumer lending business. Likewise, part of the reason that ALLY has been able to grow core deposits is because the bank pays up for money, with interest expense at 0.91% of average assets vs 0.2% for Peer Group 1 and less for the money center banks. ALLY has far more large time deposits than do banks of similar size, a component of the funding equation that regulators view as a red flag. The bank also has lower capital than its peers, another fact that may weigh upon the credit in the context of a deep recession. The spike in the bank’s loss rate in Q1 2022 may have served as a catalyst for negative sentiment. Source: FFIEC ALLY had a gross loan yield of 5.7% vs less than 4% for Peer Group 1 and 5.32% for Citigroup. By achieving higher loan yields, ALLY has been able to push next interest income above 4% of average assets vs a bit below 3% for Peer Group 1, a reflection of the higher default rate target for the bank’s business model. The skew in ALLY’s loss rate in Q1 2022, however, suggests a degree of volatility and unpredictability in results that is an obvious concern since most other banks continue to show benign credit performance. In a recession, some investors clearly believe, the bank will likewise be subject to higher loss rates. We agree. ALLY has adequate but costly funding and liquidity, but too little spread on its loan book. We think that in a recession the bank will come under growing pressure in the equity markets and may need to be sold. As we've noted in past missives on ALLY and in our testimony before SIGTARP, the ALLY business model is not sufficiently subprime a la COF to generate enough income to offset potential credit losses in a deep recession. We suspect that is why the stock, debt and CDS of ALLY are under growing 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. 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.

July 11, 2022 | A reader of The Institutional Risk Analyst shared this great tweet from @MacroAlf about the duration of reserve currencies over the centuries. As we noted in our 2010 book, " Inflated: How Money & Debt Built the American Dream ," the British Empire tossed the ball to the US after WWI. Notice that even in the Middle Ages, when China was a great empire, it’s currency was not exported abroad nor was it expansionist. China in the 1400s was largely self-sufficient and had no need of predatory trade tactics as today. Sometime in the mid-1400s, the Hongxi emperor ended symbolic trade with the west in order to save money and focus on internal threats. Immanuel Hsu wrote in his classic "Rise of Modern China": "The Chinese attitude towards foreign trade was an outgrowth of their tributary mentality. It postulated that a bountiful Middle Kingdom had no need for things foreign, but that the benevolent emperor allowed trade as a mark of favor to foreigners and as a means of retaining their gratitude." Six centuries later, little has changed in terms of Beijing's attitude to foreigners and domestic security. The country remains hobbled by an authoritarian government whose chief aim is continuance, making it economically vulnerable and socially unstable. As the Chinese Communist Party employs ever more harsh methods to retain power, the day of reckoning inevitably approaches. As in the 1400s, the chief concern of the occupants of Beijing is security from rising domestic social unrest. Most recently, the shift away from an outward-focused economic orientation in China came about because Xi Jinping , who has systematically eliminated political rivals, turned his attention to power centers in the business community. Along with a more general purge of “corrupt” cadres in corporate suites under the party’s “United Front” effort , Xi’s nation prison now features smart phone apps that can instantly downgrade a Chinese citizen's status or even cut off access to money, travel and health services. Party control over private business is increasing in China. Xi has sought to “integrate the Party’s leadership into all aspects of corporate governance” and “clarify” its legal status within the corporate governance of private companies. The aggressive reassertion of communist control over private enterprises in China is a problem for many western companies and for many reasons. The decision by the European Union to name China as a strategic threat is only the latest in a series of actions to highlight the predatory nature of the Chinese state. Many foreign companies have been forced to leave Vladimir Putin’s nation prison since the start of the Russian war with Ukraine. But there are a large number of foreign companies that are being quietly pressured by the US and other nations to relocate significant productive assets outside of Beijing’s sphere of control, this on the assumption that relations with China could deteriorate in a similar fashion to the break with Moscow. Major Taiwan semiconductor makers, for example, are building new production facilities in Japan, Europe and the US. One of the most visible foreign companies operating in China is Tesla Motors (TSLA) , creation of global business mogul Elon Musk . Like domestic Chinese business leaders, Musk has been forced to praise Beijing in his public comments , imitating the groveling seen by Alibaba (BABA) founder Jack Ma and other Chinese business leaders in response to Xi Jinping’s crackdown. As the mirage of globalization slowly fades and relations between the US and Beijing inevitably deteriorate, Musk will eventually be forced to make a decision about continuing to do business in China. If readers of The Institutional Risk Analyst take a moment to examine TSLA’s filings with the SEC, Musk is entirely silent about the risk of being forced to leave the Chinese market. While the latest TSLA 10-K details scores of loans provided by state-controlled Chinese lenders and tax breaks granted from the Chinese government, there is no hint in TSLA’s public disclosure that Musk may eventually be forced to abandon the China because of a political break between Beijing and Washington. Thus we come to Musk’s abortive takeover attempt for Twitter (TWTR) , a half-hearted effort that was never really possible financially or politically. The fact that Musk spent his credibility pretending to have an interest in acquiring TWTR illustrates how little he understands the precarious position he occupies between China and the US. Why do we say this? Because the US government would never actually allow Musk to control TWTR or any other US media company. “By dominating the supply of multiple components critical to the fortunes of Tesla, the Chinese government holds so much leverage over chief executive Elon Musk’s wealth that his planned acquisition of Twitter should concern national security leaders,” a dozen current and former officials involved in reviewing foreign investments told The Washington Post in June. As we noted last year (“ Update: New Residential Investment, Fortress & Softbank ”), if the US Committee for Foreign Investment in the US (CFIUS) would not allow SoftBank Group (SFTBY) to take full control over Fortress Investment Group , there is no way that Washington would allow the foreign-born Elon Musk to take operational control over TWTR or any US media property that has access to consumer data. Remember, in the world of global trade and investment, it’s all about the data. China’s financial participation in TSLA is so extensive that Musk arguably should register as an agent of the Chinese government. But the irony is that despite the sway that the Chinese Communist Party has over TSLA, the firm is still seen as an outsider in the Chinese market and a possible security threat because of fears of spying for the US! "There's a very strong incentive for us to be very confidential with any information," Musk told an influential Chinese business forum in 2021 . "If Tesla used cars to spy in China or anywhere, we will get shut down." His comments came in response to reports that China's military had banned TSLA cars from its facilities. Naturally, once the Chinese have stolen as much technology and know-how as possible from TSLA, the firm will be marginalized in favor of state-supported competitors in the world of electric vehicles. And as the pretense of globalization fades and the level of confrontation between China and the US grows, Elon musk will be forced to make a choice. Questions: When will Elon Musk inform his TSLA investors about the real and growing risk of being forced to exit China? Why did Elon Musk ever pretend that he was able to acquire TWTR, a transaction the US government would never allow? Today, Republican candidates are falling all over themselves to ingratiate themselves with Musk, but a military conflict with China over Taiwan will change that narrative very quickly. Will Musk's close ties to China's communist government eventually threaten his control over TSLA as well as SpaceX? Stay tuned.

July 7, 2022 | Premium Service | What are the best banks for investors seeking to weather the storm of consumer price inflation and equity deflation that currently grips global markets? For long-time readers of The Institutional Risk Analyst , this is a simple question to answer. In times of market volatility and suddenly ended delusions of easy money, the prudent path is to fly to quality . Below we take a look at how some of the best performing US banks did through the end of the first half of 2022 and what to expect next from some of the exemplars among the group. By far the best performer in 1H 2022 has been Raymond James Financial (RJF) , which is down roughly 10% so far this year. At 2x book value the regional bank and advisory business has managed to hold its ground better than its larger peers. With just $72 billion in total assets, RJF ranks 42nd in the US among bank holding companies (BHCs). The St Petersburg, FL, BHC, however, has $1.1 trillion in private client group assets, 56% of which are in fee-based accounts. RJF makes 4x as much profit and revenue from its advisory activities as it does from the bank. Notice that RJF has significantly out-performed Morgan Stanley (MS) in the first half of 2022, largely due to the larger organization's market exposures. Next on the list after RJF is Discover Financial (DFS) , the credit card issuer that is also the 37th largest BHC at $107 billion in total assets. DFS is down just 15% YTD and most of that in the past month. DFS is currently trading at 2.2x book while the larger monoline card issuer, CapitalOne Financial (COF) is trading at 0.8x book. What gives? Both are consumer lenders with gross loan spreads near or above double digits. The major difference between DFS and COF is profitability. DFS is twice as profitable as COF measured by net income vs average assets. DFS has a higher default rate and a higher gross loan yield than COF, and a higher cost of funds than its peers. Yet the management of DFS delivers significantly better financial performance quarter after quarter. One big reason: Asset turns. DFS manages its balance sheet far better, with over 100% of average assets deployed in earning assets. COF, by comparison, had just 91% or ten points below DFS deployed in earning assets. Readers of The Institutional Risk Analyst will recall that DFS for many years has been one of the best performing US BHCs in terms of asset and equity returns. It’s constant companion in this regards is American Express (AXP) , another high performing card issuer that reached 6.5x book value during the QE stock price inflation. Indeed, DFS and AXP frequently trade first place in terms of market value and overall financial performance. At almost $200 billion in assets, AXP is the 20th largest BHC in the US and often the top performer among large banks in financial terms. AXP reported net income of 4.5% vs average assets in Q1 2022 compared to 4.6% for DFS and just 1% for Peer Group 1. Now you know why few of the top-four US mega banks are highlighted in this report. The difference between AXP and DFS seems to be the greater consistency of the former in terms of earnings, which shows up in a 20% higher market multiple. Next on the list are two names our readers know when, Wells Fargo (WFC) and Toronto Dominion (TD) . Both names attract attention because they are large cap stocks and because they are relatively cheap compared to the group. We previously wrote about WFC (“ Bank Earnings Setup: JPM, USB, WFC, BAC & Citi ”) and TD (“ Profile: Toronto Dominion Bank ”). WFC is a down-on-its-luck story that some equity managers find attractive, much in the same way that some investors like underperformers such as Bank of America (BAC) . These larger names have poor equity and asset returns, and but offer the comfort of liquidity. TD is a large, mediocre asset manager and lender that has the same characteristics as BAC and WFC, but with little exposure to the global capital markets. The $520 billion asset US arm of TD is one of the worst performers financially in Peer Group 1. In Q1 2022, TD Group US Holdings reported net income to average assets of 0.71%, significantly below the Peer Group 1 average. Finally, we come to U.S. Bancorp (USB) , which at this writing was down 16% at the end of June 2022 but has outperformed JPM and the other large money centers. USB has above peer financial performance, a very large domestic payments business and little exposure to the capital markets. But the fact is that JPM has fallen twice as much as USB has in the first half of 2022. At 1.5x book, USB is not particularly cheap, but we own the preferred and may start nibbling on some of these better performers in coming weeks. Given the current rate of inflation, many stocks are cheap by definition. That said, all of the financials that we track could move significantly lower in coming months as the FOMC desperately tries to regain some measure of credibility when it comes to inflation. Banks are, after all, 100% correlated to interest rates. Disclosures: EFC, CVX, CMBS, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC 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.

July 4, 2022 | Today America celebrates its liberation from British tyranny two and a half centuries ago. Then as now, we face new threats at home and abroad, but these hazards spring largely from hubris. As the winner of WWII and the Cold War, American became entirely assured in all respects. Jeffrey Sachs describes the American surrogate war in Ukraine as a success for the neo-conservative movement going back decades, long before Presidents George W. Bush and Barack Obama : “The war in Ukraine is the culmination of a 30-year project of the American neoconservative movement. The Biden administration is packed with the same neocons who championed the U.S. wars of choice in Serbia (1999), Afghanistan (2001), Iraq (2003), Syria (2011), Libya (2011), and who did so much to provoke Russia’s invasion of Ukraine. The neocon track record is one of unmitigated disaster, yet Biden has staffed his team with neocons. As a result, Biden is steering Ukraine, the U.S. and the European Union towards yet another geopolitical debacle.” The Federal Reserve Board, for its part, pretended to be in control of the US economy up until the end of last year. With the shattering of the low-inflation illusion, however, the pretense of managed stability of markets that goes back 50 years also is discarded. The Fed now has seemingly set up the US markets for a very hard landing. Think of a hard landing for the US economy as the Fed deliberately inducing a recession sufficient to lower equity valuations and home prices 20%. For those not familiar, this is like an autorotation in a dead helicopter from about 5,000 feet. You shut the engine down and land using the rotor as a wing. The great video from YouTube provides step-by-step instructions. Please don’t try this at home. https://www.youtube.com/watch?v=X5vA3OqnVuc By manipulating the $12 trillion mortgage market via QE, the Fed not only disrupted the enormous housing sector, but has also clotheslined (h/t Tim Rood ) the entire financial community and bond market, and thereby caused corporate credit spreads to blow out. Leverage is now the enemy instead of your friend. The result is a growing list of distressed financial companies and investments. Banks are hoping for higher loan yields, but with the yield will come sharply higher credit defaults. Q: Do we all still believe that “QE” is a form of economic stimulus? The collapse of First Guaranty Mortgage last week probably was not a surprise to readers of The Institutional Risk Analyst . The PIMCO -controlled nonbank lender was mostly third-party origination, which in this market is an excuse to lose money in large chunks. But the rapid move in interest rates is what killed this independent mortgage bank and will kill many more. Lenders are often down cash when they close your mortgage loan, but losing money selling the loan into the bond market is fatal. When the on-the-run TBA contract is trading at a discount, that means that you lose money on the sale of the loan. The 400bp increase in US mortgage rates over the past six months is the proximate cause of the failure of FGMC and huge capital losses in the secondary loan market. The Friday-close screenshot from Bloomberg last week shows that the on-the-run contract for loans deliverable into a FNMA MBS for July is 5.5%, but the TBA 5s have rallied back to a premium in the past several weeks with the rebound of the 10-year Treasury note. In particular, notice that the 10-year Treasury moved 21bp in yield on just Friday, a direct result of volatility caused by the FOMC’s market manipulation. Source: Bloomberg The fault for the failure of FGMC lies directly with the Fed, so let’s all please dispense with the handwringing about the risk of nonbank finance. The Fed and its’ increasingly reckless open market intervention are the chief risks to all forms of financial intermediation. Indeed, the social phenomenon called crypto is the result of QE and, despite the happy talk from US officials led by Federal Reserve Chairman Jerome Powell , is a threat to the US financial markets. It takes one pebble to start an avalanche. Notice that the financial media finally has taken note of some infamous names very familiar to our readers (“ Profile: Silvergate Capital Corp (SI) ”). Signature Bank (SBNY) and Silvergate Capital (SI) are perhaps the most visible examples of real banks diving into the surreal world of crypto tokens – we won’t call them “currencies.” These FDIC-insured banks (as well as many others) got caught in the trap of “lending” on crypto as “collateral,” a clear act of idiocy that fully deserves federal prosecution. When you as the officer or director of a federally insured bank cause a capital loss by lending against nonexistent collateral, that is called bank fraud. And there are some very interesting names from Wall Street, sports and celebrity behind some of these bank crypto projects. Stay tuned. “Signature Bank uses an Ethereum based payments application to serve its customers,” noted Damian Mark on SeekingAlpha in February . “The bank is materially growing its crypto deposits and has been recognized by Forbes as a top 50 blockchain company (2021).” Obviously, this would not be a flattering description in July 2022. Q: Is Ethereum an asset or a receipt for cash? Both SNBY and SI have deep roots in the world of secured lending, but this legacy has not prevented the managers of these institutions from risking their depositories on what seems a pretty clear example of “unsafe and unsound” banking practices, to borrow the language from 12 CFR Part 337 . Few of the players in the world of crypto even know that transactions that disadvantage a bank can be construed as felonies under federal law. Fortunately for the crypto community, federal bank regulators are still largely clueless about the risks of crypto to US banks. It’s not the sheer size of the crypto Ponzi that matters, but instead the potential for surprise, that key ingredient for a systemic event. Like if SBF , founder of Alameda Research and Bahamian crypto exchange FTX , backed away from rescuing foundering crypto ventures. That would be a surprise for many, but not for all. Putting dollar leverage under crypto tokens – that is to say, under nothing – makes for infinite dollar risk. Yet as we noted on Twitter last week, there are actually some fools in the global bank regulatory community that think allowing banks to invest 1% of total assets in crypto is acceptable. After a few months of QT from Chairman Powell, people talking seriously about crypto will be laughed from the room. Meanwhile, the wreckage in the world of private equity is building into a mountain of disappointment that could easily rival the crypto bust. “Over 140 VC-backed companies that went public in the US since 2020 had market capitalizations as of mid-June that are less than the amount of venture funding they raised,” according to PitchBook News . Add some leverage to that analysis and the PE market is yet another surprise waiting to happen. When the Fed gunned the bond market in April 2020, they set in motion an upward shift in short-term credit ratings and a related move in the equity markets, perhaps best illustrated by the flourishing of the market for special purpose acquisition corps or SPACs. Since the duration of QE was obviously finite, the SPAC offered an accelerated pathway to the public markets. Or put another way, when SPACs are popular, FOMC members should worry. But of course, we’ve seen this movie before. If we harken back to January 2021 (“ A Tale of Two Frauds: Bitcoin & GSE Shares “), via QE the Fed increased the bezzel to gigantic size, allowing all manner of frauds like crypto tokens and NFTs to blossom in the name of full employment. In the 1920s, investors traded fractional shares in FL real estate. In 2020, they traded pretend real estate visualized on a screen. Go figure. Now with the threat of QT, the “bezzle,” what John Kenneth Galbraith described as the “inventory of undiscovered embezzlement ,” is contracting – this even as the cash flow from financial assets has been reduced via QE. It would be difficult to imagine a risk management situation in the global capital markets more likely to generate anomalies and surprises. Happy holiday. Next in the Premium Service of The Institutional Risk Analyst, we look at some of the top-performing banks in our surveillance group and position our subscribers for the upcoming Q2 2022 earnings reports for financials.

June 28, 2022 | Premium Service | As we approach the end of the second quarter of 2022, let’s set up the top-five commercial banks for readers of The Institutional Risk Analyst . JPMorgan (JPM) , Wells Fargo (WFC) , U.S. Bancorp (USB) , Citigroup (C) and Bank of America (BAC) remain the largest commercial lenders in the US, but the top ten US banks now include Charles Schwab (SCHW) , PNC Financial (PNC) and Truist (TRU) . BNN Bloomberg 06/28/2022 As you can see from the list below, the top US bank holding companies have changed significantly over the past decade, with several large asset managers now among the larger depositories. There are three groups with lots of overlap, including commercial banks, universal banks and advisory businesses. The big issue facing US banks in Q2 2022 is the collapse of operating earnings after the end of GAAP adjustments to income in 2021. First banks reserved $60 billion for COVID. Then the Fed took $40 billion per quarter in interest earnings out of the US banking system via quantitative easing or QE, pushing the return on earning assets below 3% for large banks vs almost 4.5% in 2019. The chart below shows return on earning assets for the top five commercial banks and Peer Group 1. Source: FFIEC In 2021, the banking industry took that $60 billion in loss provisions back into income, further distorting the sequential and YOY comparisons for revenue and earnings. Stocks soared last year on the artificial boost of bank operating income caused by these GAAP adjustments. Notice that Peer Group 1, which includes 134 banks above $10 billion in assets, considerably outperforms the larger banks, followed by USB. JPM has the worst ROEA of the top five for the second quarter in a row, largely due to the grotesque size of the bank’s $3.9 trillion balance sheet. Accounting adjustments aside, the decline in earnings power inside all US banks is a direct result of the market manipulation of QE implemented by the FOMC, both in terms of inflating the deposit base and reducing asset returns. QE essentially confiscated earnings on Treasury bonds and mortgage-backed securities (MBS) from bank shareholders and transferred the proceeds to the US Treasury. This is what the folks inside the Federal Reserve Board call “stimulus.” Source: FDIC Now that the FOMC is moving in the direction of QT, however, the benefit to the Treasury is ending and banks will see asset returns improve as they did in 2017-2019. The key questions in this regard are 1) the magnitude and 2) the duration of the upward move in interest rates. The longer interest rates are elevated, the more opportunity banks have to repair the damage done to their balance sheets by the successive efforts of the FOMC under Fed Chair Janet Yellen and Chairman Jerome Powell . It is unlikely that banks will recoup interest income back to 2018 levels, which are half again higher than Q1 2022 results as shown in the chart below. Source: FFIEC As with the chart above showing asset returns, JPM, Citi and WFC were the laggards in terms of net income vs average assets. USB actually outperformed all of the other banks and also Peer Group 1, in part because of the bank’s refusal to grow above present levels. Even as it digests the acquisition of MUFJ retail branches in the West, USB CEO Andy Cecere sounded a very positive note during a June 14th conference call: “Our deposit balances are still well above pre-COVID levels. Spend levels are strong. Our credit card spend is up 35% versus pre-COVID, 15% above last year. There is a little bit of a shift from discretionary and non-discretionary spend. And credit is really good. We are not seeing any early indicators of any weaknesses. So there is – if you look at the here and now, it’s very good. But while we all have a base case, I think the range around that base case is pretty wide and we are prepared with those scenarios because of the uncertainty given inflation and the war and COVID and all those things.” Disclosure | L: EFC, CMBS, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC We own the USB preferred but are not tempted by the common, much as we like Cesare and his management team. The Street has USB growing revenue 10% in 2022 and 15% in 2023, metrics we find plausible given the bank’s acquisition and overall financial performance through COVID. USB is down just 16% YTD vs -27% for BAC and -26% for JPM. And to remind our readers of one of our favorite asset managers, Raymond James Financial (RJF) is down less than 10% YTD. After profits, the next place to turn is credit expense, which remains very benign at present despite a lot of predictions about bad times to come. We remain concerned that one of the side effects of QE was to skew credit costs downward, a factor that now seems destined to reverse and to the same degree. As the chart below illustrates, credit costs have fallen along with asset returns, but the former is likely to rebound faster and to a larger degree. Source: FFIEC Even the modest swing in credit expense back into positive territory, this after seeing credits to earnings from reversals of loan loss provisions in 2021, has dampened investor enthusiasm for banks. Most of the banks in our surveillance group are down between 10% and 30% so far this year, but none of these are particularly cheap as yet. The artificially boosted earnings in 2021 were a pretext for sharply higher market valuations, but now that process has been reversed and then some. Analysts are showing basically no revenue growth for JPM in 2022, for example, and then mid-single digits in 2023. Another factor that comes into play now as a headwind instead of a tailwind is the cost of funding, which still remains near record low levels but is starting to rise with market rates. Interest expenses vs average assets was just 17bp in Q1 2022 compared with 19bp for all of Peer Group 1. Source: FFIEC As interest rates slowly rise, the big question facing the industry for the future is when we’ll see spread expansion for loans. Bond spreads have moved significantly in the past 90 days, implying that banks will find greater pricing power in the future. The industry did see some loan growth in Q1, a positive trend driven by the exodus of credits from the bond market. Actually generating net growth in terms of bank loan portfolios, net of annual redemptions, however, will require higher growth rates. New high yield issuance is running at a quarter of last years levels, good news for yield hungry banks marginalized during QE. Many PE firms are already complaining about tightening loan terms from major banks for leveraged buyouts. The chart below shows the gross yield on all loans and leases for the top five BHCs, with Citi obviously far about the pack and Peer Group 1 because of the higher default target rate and accompanying loan spread. Notice that in Q1 2022 Citi was already starting to evidence significant lift in terms of gross yield before its asset peers. Source: FFIEC BAC continues to track at the bottom of the group in terms of loan pricing, one reason why the bank is competing with WFC for last place among the top five banks in many instances. Next in terms of pricing is USB, then JPM and Peer Group 1. The smaller banks in Peer Group 1 have far better loan margins than larger peers, making the performance of JPM remarkable. Morgan Stanley (MS) , Goldman Sachs (GS) , BAC) and WFC hiked their dividends this week after the U.S. banks cleared their annual stress test exercise. JPM and Citi made no change. The increase in dividends is logical because the banks as a group have excess capital and are unable to originate loans sufficient to utilize their deposit base. They might was well return the excess capital to shareholders, either via dividends or share repurchases, but the latter category is likely to be muted compared with 2019 and 2021. The chart below shows share repurchases as reported to the Fed on form Y-9. Source: FFIEC One of the most important measures of bank performance is operating efficiency, which is defined as: Overhead expenses / Net Interest Income + Non-Interest Income. The lower the number, the better able the bank is to take revenue down to the income line. No surprise that smaller banks are more efficient than their larger brethren, but note that JPM is below the average for Peer Group 1, a testament to the strong operating rules inside the House of Morgan. Source: FFIEC BAC, Citi and WFC are well-above average, a basic indicator that management is not addressing the cost side of the equation. The Street, for example, has BAC growing revenue by single digits in 2022 and 2023, yet listening to CEO Brian Moynihan on the most recent conference call, you might think that BAC was leading the large bank group in terms of financial performance. Part of the reason for the poor performance is the low asset returns already mentioned, which translate into an elevated efficiency ratio. Moynihan bragged in the Q1 2022 earnings call: “We reported $7.1 billion in net income or $0.80 per diluted share. We grew revenue, we reduced costs, and we delivered our third straight quarter of operating leverage coming out of pandemic. Net interest income grew 13% and is expected to grow significantly from here. We saw a strong loan growth. We grew deposits. We saw a strong investment flows. We made trading profits every day during the quarter. We grew pretax pre-provision income by 8%. We had a return on tangible common equity of 15.5%.” One of the big ideas of Moynihan in recent months was to swap the bank’s $200 billion Treasury portfolio into floating rate, but BAC will need more aggressive ideas to move the needle on asset and equity returns. The bank’s held-to-maturity residential loan portfolio contains another $500 billion in low-yielding assets. CFO Alastair Borthwick noted recently that $15-20 billion in prepayments come off the book each year, meaning that the low-yielding assets created in 2020-2021 will be with BAC shareholders for years to come. With WFC, the situation illustrated by the high 70s efficiency ratio is relatively problematic. The bank needs to cut its overhead expenses by about 8-10% in order to get back into line with its peers. The Street analysts have WFC revenue falling by single digits in 2022 as the bank continues to shed businesses. We’d discount any estimates for WFC next year as entirely speculative. This bank has great potential, but WFC is now less than half the size of JPM and is likely to get even smaller in the near future. 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.

June 27, 2022 | For many readers of The Institutional Risk Analyst , the past few months have been a bundle of contradictions, with interest rates rising at the start of Q2 2022 and now falling as the quarter concludes. Note the widening gap between the 10-year Treasury note and 30-year residential mortgage rates. With this in mind, we come back to JPMorgan (JPM) , one of our favorite large banks but one that is never particularly cheap because of the bank’s massive institutional following. The Q1 results were probably the best for this year and featured numerous cautionary statements from CEO Jamie Dimon . The big question for the money center banks, which as a group tend to be at most 50% core deposits, is about how the eventual imposition of quantitative tightening or QT will effect bank deposits. At $19.9 trillion as of Q1 2022, US bank deposits are about $3-4 trillion above normal levels. Steven Chuback of Wolfe Research asked the key question during the JPM analyst call: “In the past, you've spoke about the linkage between Fed balance sheet reduction and deposit outflow expectation for yourselves and the industry. And with the Fed just outlining a more aggressive glide path for balance sheet reduction, how should we be thinking about deposit outflow risk?” CFO Jeremy Barnum proceeded to answer the question in a thoughtful but overlong fashion. He noted that “industry-wide loan growth outlook is quite robust and that should be a tailwind for system-wide deposit growth.” He then continued: “Then you just have to look at what's going to happen in the front end of the curve particularly in bills. So the Treasury has to make decisions about weighted average maturity and what makes sense there. There's obviously a little bit of shortage, of short-dated collateral in the market right now. So, that might argue for wanting more supply there. The Fed has to make decisions about portfolio management. They talked in the minutes about using bill maturities to fill in gaps and so on and so forth. And so those things are going to interact in various ways.” Dimon, who warned shareholders earlier this year that the market is underestimating the number of Fed hikes that might be needed to curb inflation, then clarified the issue of QT and bank deposit runoff. “So the answer is we don't know, okay. And you guys should read economists' reports, but the fact is initially it probably won't come out of deposits. Over time, it will come out of wholesale and then maybe consumer. We're prepared for that. It doesn't actually mean that much to us in the short run. And the beta effectively, we don't expect to be different from what it was in the past. There are a lot of pluses and minuses. You can argue a whole bunch of different ways, but the fact is it won't be that much different, at least the first 100 basis point increase.” So now here we are at the end of June and JPM and the rest of the industry have already seen a 100bp move in market rates, but the Fed has still not clarified its intentions with respect to the SOMA portfolio. So if you are Jamie Dimon or the head of any of the major banks, you are not exactly getting clear guidance from Fed Chairman Jay Powell and the FOMC. Dimon advises that liquidity will drain from the system starting with wholesale balances, but this is hardly glad tidings from the biggest repo counterparty in the market. Since the Fed has not yet been able to convince most banks to utilize the standing repo facility, JPM remains a significant chokepoint in the institutional market for funds. And, in fact, deposit growth in the US banking system is already starting to slow, as shown in the chart below. Source: FDIC While total deposits in the US banking system continued to grow in Q1 2022, the rate of increase was the lowest in several years. More important, Q1 2022 is probably the peak in US bank deposits for this cycle, suggesting that the runoff described by Jamie Dimon may be occurring sooner and more rapidly than was anticipated in early April of 2022. Source: FDIC We anticipate that over the course of the next year, total bank deposits could shrink by several trillion dollars as the Fed’s balance sheet begins to run off. As the chart above suggests, a "normal" level for US bank deposits would be closer to $15-16 trillion than $19.9 trillion today. And as the FOMC begins the process of shrinking the balance sheet, look for growing volatility in the funding markets.

June 20, 2022 | Q: Is the Federal Open Market Committee preparing to sell mortgage-backed securities (MBS) from the system open market account (SOMA) via that most notorious (and useful) of all products, the CMO or collateralized mortgage obligation? Is this a good idea? Yes it is, but hold that thought… During the most recent FOMC press conference on June 15, 2022, Federal Reserve Board Chairman Jerome Powell described the mounting carnage in the house industry with considerable detachment. Maybe the folks at the Fed’s Board of Governors in Washington think they are playing with a science experiment in high school and not an industry that impacts every American. Said Powell: “Recent indicators suggest that real GDP growth has picked up this quarter, with consumption spending remaining strong. In contrast, growth in business fixed investment appears to be slowing, and activity in the housing sector looks to be softening, in part reflecting higher mortgage rates. The tightening in financial conditions that we have seen in recent months should continue to temper growth and help bring demand into better balance with supply.” Headline: The housing sector is in recession and accelerating down in terms of volume and headcount. Of course, it was the FOMC that encouraged an increase in supply of mortgage loans by dropping interest rates several hundred basis points in March of 2020. The industry increased headcount and operating expenses by 50% in response. Now in 2022, the residential mortgage industry is downsizing as falling revenue and operating expenses converged in Q1 2022. We described the unprecedented change in the secondary loan market last month in The Institutional Risk Analyst (“ FOMC vs TGA; PennyMac Financial & United Wholesale Mortgage ”). Message to Chairman Powell: How is this helpful? We also commented last week on some related matters in National Mortgage News (“ Mortgage industry liquidity risk returns ”). What should investors and risk professionals focused on the mortgage industry expect in coming months? Something like 2019, the worst year for secondary market profitability in a decade, only a bit worse in terms of the speed of change. Large issuers will survive, small issuers will become canon fodder for the Fed’s decidedly idiosyncratic policy machine. First, the latest up and down cycle in mortgages is more extreme than the 2002-2006 bubble, as shown by the historical data from the MBA. In 2020 and 2021, we saw larger lending volumes but fewer, bigger loans. Average loan size has grown more than a third since 2008 and this increase has accelerated over the past five years, but drew little notice from the FOMC or the Fed’s staff in Washington. Home prices are up more than 200% since 2008. Below are the MBA’s historical annual production number going back to 1990. Source: Mortgage Bankers Association Because of the magnitude of the Fed’s error in terms of running QE purchases too long and at too high a level, the mortgage market ran very hot in 2020 and 2021, leading to bigger peak lending volumes than in 2005. Again, in real, inflation adjusted terms, the 2002-2006 bubble is bigger and, significantly, was comprised 50% of private label loans. Today’s residential loan market is 99% government-insured and conventional loans. Another way to think about the problem created by the FOMC is home prices. The average purchase mortgage is now $450,000 today vs less than $300,000 a decade ago. The chart below from FRED shows the Case-Shiller Index going back to before the crisis. In nominal terms, the most recent skew upward is bigger, but adjusted for inflation it is actually about the same magnitude increase as the 2002-2006 housing bubble. The next question to ask is about profitability. There are many ways to show this, but the bottom line is that production profits in 2022 will be about a tenth of the peak rates seen in 2022-21. The weak profitability is a function of the fact that refinance loans will drop sharply. The two charts below tell the story. First is the MBA’s production profit and the second is the MBA’s forward production estimates. Below is MBA’s “Chart of the Week” . As you can see, production revenue is about equal to expenses. Many firms are losing money. Joe Garrett of Garrett McAuley in San Francisco said in a note: “2022 is about costs more than revenue. Put another way there’s a limit to what you can do about revenue. There’s a lot you can do about costs." The MBA’s Marina Walsh and Jenny Masoud put the surge in production costs in perspective: “While lower production revenue contributed to scant profit margins, the primary driver was cost. Total loan production expenses – commissions, compensation, occupancy, equipment and other production expenses and corporate allocations – increased to 345 basis points in the first quarter, from 315 basis points in the fourth quarter. On a per-loan basis, production expenses ballooned to a new study-high $10,637 per loan in the first quarter, up more than $1,000 per loan from the fourth quarter and more than $2,500 per loan from one year ago.” Again, the inflation of lending costs since 2008 speak to a secular inflation that ought to be of interest to the Fed and the research community. The MBA’s actuals and projections for 2022-2023 are shown below. The MBA has production cratering this year and bouncing in 2023 as capacity runs off and pricing power begins to be restored. Likely the FOMC will also be lowering interest rates in 2024 before the presidential election. Source: Mortgage Bankers Association At present, there are a number of marginal lenders making loans in competition with healthy companies. Just as thrifts doubled down in the 1980s, independent mortgage banks (IMBs) facing extinction will fight to the bitter end. The marginal lenders must exit the business before the healthy lenders can restore profitability. That is the harsh reality of the mortgage business, but amplified thanks to the FOMC and quantitative easing (QE). The dying among lenders will make loans until they are completely dead, preventing the industry from re-pricing efficiently until next year. In general, the annual loan coupon paid by a consumer is 1% higher than the debenture rate on the MBS that will eventually finance the loan. With the industry moving to 5% or 5.5% coupons for future MBS issuance, implying loans with at least 6-7% annual percentage rates, lenders that have been writing loans in the 5s will take losses when the loan is sold. The TBA swaps page from Bloomberg as of the close on Friday is shown below. Notice that the 4.5% contracts for Fannie Mae MBS for delivery in July are already trading three-quarters of a point below par. Source: Bloomberg Stronger lenders can lose money on a new mortgage loan at close and at the point of sale, but recoup by collecting servicing fees and the occasional refinance opportunity. IMBs without servicing portfolios are not long for this brave new world fashioned by the FOMC. The plummeting production levels due to higher interest rates and the spread compression caused by industry overcapacity will require a one-third reduction in lending capacity in 2022. Our view of home prices, which is informed by conversations with some of the smartest operators in the industry, is that sharply falling lending volumes are unlikely to affect home prices initially. Sticker shock will slow demand in some cases, but pent-up demand for homes remains powerful and yet to be even partially satiated. Home prices will plateau for a few years, then pop up again when the Fed drops interest rates ~ 2024, followed by a macro reset for the housing market a la 1988 and 2008 in 2026. Home price cycles tend to run about 20 years. That reset in 2026 could force down home prices to 2019 levels – but again inflation may change this calculous. Finally, both stock prices and bond yields for the mortgage industry suggest that the 1-4 sector is headed for a serious restructuring in 2H 2022. Mortgage issuers with term debt are trading at the widest spreads in years. We expect to see some forced sales and bankruptcy filings in the next several months. The big issue facing the IMBs and the mortgage industry as a whole in 2023 is loan delinquency, which we expect to rise significantly as the economy slows and dips into a recession. As usual, Chairman Powell saved his best comment on the housing sector for last: “[T]he supply of finished homes, inventory of finished homes that are for sale is incredibly low, historically low. So it's still a very tight market. So prices may keep going up for a while even in a world where rates are up, so it's a complicated situation. We watch it very carefully. I would say if you're a home buyer, somebody or a young person looking to buy a home, you need a bit of a reset. We need to get back to a place where supply and demand are back together and where inflation is down low again and mortgages rates are low again so this will be a process whereby we ideally we do our work in a way that the housing market settles in a new place and housing availability and credit availability are at appropriate levels. So, thank you very much.” Listening to Powell, it’s as though we all live in Superman’s Bottle City of Kandor , which sits on a shelf at the Fed’s HQ on Constitution Avenue. Of note, Chairman Powell had nothing to say about providing liquidity to the market for government loans and Ginnie Mae MBS as the economy slides into recession. As we’ve noted several times in past comments, credit costs for 1-4s are likely to spike significantly higher as the economy slows. Neither was there any discussion in the press conference of sales of MBS from the Fed’s system open market account or SOMA and how this might further adversely impact the already reeling mortgage market. Nobody in the Big Media thought to ask Chairman Powell about the most important factor in US monetary policy, namely the SOMA portfolio. That omission, however, may be quite significant. The Federal Housing Finance Agency (FHFA) just announced what may seem a purely technical change to the pricing for collateralized mortgage obligations (CMOs) issued by Fannie Mae that contain Freddie Mac MBS and vice versa with Freddie Mac as the issuer: “Effective market-wide July 1, 2022, Fannie Mae will begin charging a new fixed upfront fee to create certain Supers® and real estate mortgage conduit (REMIC) securities that have Freddie Mac Uniform Mortgage-Backed Securities (UMBS) collateral underlying those Supers and REMIC securities. A fee of 50 basis points will apply solely to the portion of the Supers and REMICs that are Freddie Mac UMBS collateral. This fee is a one-time fee applying to Freddie Mac UMBS collateral that has never incurred such a commingling fee from Fannie Mae in the past.” In other words, if the FOMC wants to sell some of its low coupon MBS now in the SOMA via a comingled Super CMO containing Fannie Mae and/or Freddie Mac collateral, then the pricing is in place to cover the cost of the insurance and other expenses. Since both Fannie Mae and Freddie Mac are in runoff in terms of their own balance sheets, they are unlikely to be issuers of CMOs on their own account. And these could potentially be very large, investment grade deals. By allocating part of the duration risk among investors with progressively longer investment timeframes, the stand-alone CMO that we described in the book Financial Stability actually "kills" part of that duration risk. Issuing CMOs via the GSEs could help the FOMC out of its trading mess, but represents a monumental irony. By entering the CMO market in order to hide growing losses on low-coupon MBS, bonds acquired during the latest round of QE at 103-104 but now trade in the low-80s, the Fed will concede the reckless nature of its policies.

June 22, 2022 | Premium Service | In this issue of The Institutional Risk Analyst , we comment on the announcement last week by New Residential Investment (NRZ) that it is rebranding and, more significant, finally saying goodbye to Softbank affiliate Fortress Investment Group . We have long advocated putting a good bit of distance between NRZ and the notorious Japanese fund, so we view this as a big positive for shareholders. The big news is that NRZ is saying goodbye to Fortress and is migrating to an internally managed model. NRZ paid Fortress over $100 million annually in management fees. The surprise news, though, is that CEO Michael Nierenberg has decided to bid farewell to residential lending and turn the largest nonbank owner of mortgage servicing rights (MSRs) into a multi-asset manager. More, NRZ has also adopted a new name, Rithm Capital (RITM) , which will take affect August 1, 2022. Source: Google The company’s stock has fallen sharply since June 7, 2022, suggesting that news of the material announcement made on Friday was in the market at least two weeks before the release. Of note, the announcement comes on the heels of a number of analysts downgrading the stock because of poor visibility on future earnings. While many managers are circling the wagons in the residential market, Nierenberg has decided to harken back to the antecedents of NRZ such as Newcastle and take the firm in a new direction. When he says that NRZ “will evolve into a more diversified asset manager,” Nierenberg is telling you is that returns in 1-4s are likely to be under pressure or even negative for an extended period. Likewise, NRZ’s leader several times alluded to reducing the $800 million in capital inside the lender and diversifying elsewhere. But with the stock trading at 0.7x book value, buying back stock for a 30% plus return may be one of the best uses of cash at NRZ. NRZ must pay $400 million to Fortress to end the relationship with the external manager, a final act of squeezing NRZ shareholders after years of extracting very full fees from the externally managed REIT. Of note, when Kevin Barker at Piper Sandler asked Nierenberg how long the negotiations between NRZ and Fortress for the separation had been underway, NRZ’s CEO pled ignorance of the special committee process of each firm’s board. He subsequently told Barker that the process had been ongoing “for months.” The end of the relationship with Fortress will reportedly save NRZ $60-65 million in fees, net, a fact that highlights the timing of the change as the residential housing market sinks into a period of retrenchment. Nierenberg is always focused on driving returns for shareholders, thus we interpret these changes as being mostly defensive and focused on cost reduction. As we noted in our last comment, expenses are the only thing at the moment. Why is cost a factor? First, revenues are falling from lending. Second, NRZ has not yet integrated the several lenders within the company, meaning that operating costs will be difficult to manage lower in the near-term. Despite a lot of talk about “operating efficiencies,” NRZ reportedly has yet to begin the long as costly process of combining Caliber, Shellpoint and other lending operations. Achieving operating efficiency gains always seems to be a future project. Perhaps most surprising was Nierenberg’s assertion that there will be further expansion of the multiple on the firm’s MSR. “We pulled back from lending rather than simply deploy capital for the sake of doing that,” he told one analyst. “We have $630 billion [in UPB of MSR] so we don’t need any more.” Nierenberg confirmed that the current MSR mark is 4.86x annual cash flow and the weighted average coupon (WAC) is 3.68%. Of note, NRZ has reportedly migrated its financing for GNMA MSRs to Goldman Sachs (GS) , an interesting choice given that Goldman has “become the largest warehouse provider for random stuff,” in the words of one prominent analyst. Given that NRZ is explicitly guiding the Street to a higher MSR mark, the move to GS may be counterproductive since Goldman is known for being tough on credit haircuts. Given that the 10-year Treasury note has been rallying as the month of June ends, it may not be easy to deliver another sharp up valuation in MSR without breaking the bones of some third-party valuation providers. Nierenberg told analysts that book value per share will remain stable, meaning that the upcoming mark of the MSR in Q2 will be big enough to cover the cost of the internalization and a dividend. PiperSandler’s Barker wrote in a note earlier today: “We are also encouraged to see NRZ disclose book value will remain near $12.50 for the quarter as a large mark-up in the MSR offsets the $0.25 dividend and $0.75/share impact of the internalization. However, we still expect significant headwinds for GAAP earnings going forward due to origination gain on sale pressure. In addition, we see little additional room for the MSR to mark higher and, therefore, see greater downside risk for book value.” We think that the decision to separate from Fortress is a positive move for the company and for shareholders, and gives the Nierenberg and his team the freedom to manage the company. The move to a multi-asset strategy and the name change are, to us, mostly about repositioning the firm defensively to survive and grow in a world where residential lending is no longer an attractive use of capital. We continue to have concerns about NRZ and other residential lenders with heavy exposure to Ginnie Mae as the US economy heads into a Fed-induced recession. 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.

June 15, 2022 | Premium Service | As markets wait to find out how high the FOMC will jump in fighting inflation and pursuing credibility, we are going to focus on some obvious opportunities in the markets presented by rising interest rates. Big picture, a lot of assets that traded at a premium a year ago are now at a discount. “Negative-incentive Ginnie paper prepays faster than does negative-incentive conventional paper,” First Horizon Financial (FHN) SVP Walter Schmidt wrote in a June 14, 2022 report. “And since the market is now clearly in a negative incentive position with almost every asset priced at a discount to par, faster-prepay assets should perform better.” In other words, you can buy GNMA MBS at a discount and profit from prepayments at par. Schmidt notes that the largest non-banks service roughly three quarters of the unpaid principal balance of the Ginnie Mae sector while only 14% is serviced by the five largest commercial banks. “This leads to more aggressive servicing tactics, particularly along the lines of cash-out refinancings,” he concludes. Approximately 44% of the conventional market is serviced by “aggressive non-bank servicers,” FHN adds. Yeah, and those aggressive nonbank servicers will keep prepayment rates elevated as a matter of survival. Meanwhile, Signature Bank (SBNY) got a 2x4 in the mouth earlier when concerns about the demise of the crypto market caused the equity market value of this $120 billion asset unitary bank to crater. The SBNY common is down more than 40% YTD. SBNY just came off of a strong Q1 2022 earnings report, thus the down move caught many investors by surprise. Net income in Q1 2022 increased $148.0 million to a record $338.5 million vs $190.5 million in Q1 2021. What's not to like? Crypto. "The stock was suffering from the selloff in bitcoin as many on Wall Street see it as a cryptocurrency play , as the bank has a digital payments platform, named Signet, and because it offers a loan product collateralized by cryptocurrencies," Marketwatch reports. SBNY management needs to explain to investors just why they decided to risk the bank’s excellent reputation on something as absurd as lending on crypto tokens. Taxi medallions, an asset class where the bank was once active, would be a superior speculation. When you recall that SBNY traces its lineage back to Republic National Bank , the obvious question is this: What would Edmond Safra say? Large bank leader American Express (AXP) has given back just 10% YTD in terms of its equity value, one of the best performances among financials. Next on the list is the low-beta Toronto Dominion Banks (TD) , which is down 11% so far in 2022. The leader in our large bank group is HSBC (HSBA) , which is up almost 20% YTD in a larger flight to perceived quality. Our bank surveillance group is shown below c/o Bloomberg. June 15, 2022 What is remarkable but not surprising is looking at where the market’s volume is concentrated. Aside from HSBA, other volume leaders include Bank of America (BAC) , Wells Fargo (WFC) and Citigroup (C) , which is now trading less than half of book value. How does anyone explain this seemingly irrational behavior by investors? Big is better than quality in times of market uncertainty. Other names that are out performing the group that we have highlighted in the past include Raymond James Financial (RJF) and U.S. Bancorp (USB). As the market deflates a lot of aspirational stocks in coming weeks, we are looking to add to our holdings of preferred and possibly even some common. That said, we are in no hurry and are more inclined to add to positions in energy and technology. Truth to tell, even with the selloff to date, the financials are not particularly cheap. AXP at 5x book value is cheaper than it was in January, but not yet compelling for our money. USB and JPMorganChase (JPM) are still trading well above book value. Our basic view is that the whole banking complex will trade lower on credit fears arising from a recession, but lackluster financial performance will add to worries. Meanwhile over at Citi, the noise regarding the Ukraine war and sanctions have pushed the stock down to what seem silly levels. We are less worried about the possible credit risks to the bank and more concerned by the army of consultants from McKinsey that are swarming the Citi operations. Even by past standards, the consulting expenditure at Citi on various risk remediation projects has become massive and will likely show up in operating expenses as the year progresses. As the bubble created by the Fed’s QE exercise collapses, we expect more substantial names in the financial sector to come back into vogue. We do not anticipate a bounce in pre-tax income for banks, adding to downward pressure after 18 months of artificially enhanced results. The fact of more aggressive action by the FOMC may push funding costs up faster, making our earlier prediction of a narrowing of net interest margin come to pass. A lot of Street peeps have been caught off guard in financials, in particular our Twitter buddy Jim Cramer , who has made us a lot of moolah over the years. On banks, however, the Street has largely refused to accept the magnitude of Jay Powell’s impact on NIM and pre-tax earnings, which remain down $40 billion per quarter vs the end of 2019. Even as the FOMC raises interest rates, we are dubious that asset returns will keep pace in the near term. Thus we caution our readers to be prepared for disappointment from banks in the near term. 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.

June 13, 2022 | First a big thank you to readers of The Institutional Risk Analyst who liked our post regarding non-controlling interests in the disclosure of public companies (“ Memo to Gary Gensler: Beware the “Non-Controlling Interest ”). None of the media companies that are in the business of aggregating and re-selling financial data have yet been willing to report on the issue. We remain hopeful. Perhaps the Securities and Exchange Commission and FINRA eventually will look into the obvious disclosure and GAAP presentation issues this anomaly raises. One wonderful technical supporter at Bloomberg commented that he couldn't change the calculation of equity to include non-controlling interests since it would "affect too many people." Well, you are affecting them right now. Tens of thousands of shareholders of hundreds of public issuers are impacted by this false presentation of equity. We are hoping for a new series including the non-controlling interest. Not only does the characterization of equity as a “non-controlling interest” strike us as inaccurate in many (but not all) cases, but the question of inaccurate data and derivative metrics raises a lot of nasty questions for the world of “artificial intelligence” or AI and credit. If the inputs into an automated system are wrong, then the output is garbage. Garbage in, garbage out as they say in Silicon Valley. But then, technology companies would never accept the error rates that are considered normal on Wall Street. Q: Can a new era broker dealer like Robinhood Markets (HOOD) use AI to power retail investment recommendations without checking the accuracy of the data? There are hundreds of issuers that utilize “non-controlling interests” in their public company financial disclosure, for example, yet the data vendors do not inspect the presentation of the data. In the world of investment banking, you cannot use vendor data for fairness opinions or other materials, for example, because of such anomalies. So, is a typical 2-3% error rate for financial data and metrics OK for retail investors? The issue of data quality and fidelity is crucial not just for consumers, but because it goes to the very heart of risk in the fast approaching credit cycle. All of the "new" loan approval systems that were developed after 2008 and during the period of quantitative easing (QE) are biased down in terms of the cost of credit. These are systems primarily designed to originate an asset to a minimum level of confidence and sell it to an investor while minimizing the legal liability of the issuer. Loans held in portfolio by a bank, for example, are subject to far more scrutiny and thus incur more cost of origination. As we’ve documented in The IRA Bank Book Q2 2022 , the cost of credit in bank owned 1-4 family mortgages has been negative for five years. As default rates normalize in this pool of large, mostly prime mortgage loans, what do you suppose will happen to the less prime mortgage exposures that were sold into an ABS? FHA exposures, for example, could reach the high teens in terms of delinquency in this cycle -- before home prices actually crack a couple of years from now. Source: FDIC/WGA LLC Of interest, last week the Consumer Financial Protection Bureau (CFPB) issued an order to terminate Upstart Network (UPST) from its list of approved “no-action letters.” The CFPB granted special regulatory treatment to Upstart by immunizing the lender from being charged with fair lending law violations with respect to its AI-based underwriting algorithm, while the “no-action letter” remained in force. Upstart requested an amendment to the “no-action letter” that effectively seeks immediate termination. “Loans originated by Upstart are either held, sold to institutional investors, or retained by bank partners,” notes the CFPB. “In 2021, Upstart’s bank partners originated 1.3 million loans, totaling $11.8 billion.” It will be interesting to see how the various vintages of UPST production perform in a rising interest rate environment. The CFPB, of note, is taking increased interest in technology that supports lenders and the vendors that provide these systems of record. The CFPB granted UPST a first “no-action letter” in September 2017 and a second letter in November 2020, just when the utopian frenzy of nonbank fintech AI-enabled lending caused by QE maxed out. “No-action letters” typically grant individual companies special regulatory treatment, on certain specified matters, where an agency agrees to not take action for violations of law. Remember, making good loans is about making good underwriting decisions, not machine learning. As the head of non-QM lending at a top-four bank said of using AI for automated post-close due diligence prior to sale: “No, I know what we are dealing with. Open the door and loan quality will degrade.” The idea of modifying an automated credit model at the end of a decade of QE may strike some of our readers as significant. We agree. Our skepticism toward the world of automated credit originations is similar to our view of automated appraisals for residential mortgages. They work until they don’t, especially at major economic and market inflection points. The reason why lenders continue to spend big dollars on data consumption and validation is the need to limit the process errors to a certain level so as to avoid spikes in credit costs. But it is axiomatic that the production that is sold to investors is always inferior to the production retained. Thus the big risk to originate-to-sell lenders is repurchase claims. As we noted last week, it was the retention on balance sheet of UPST production that spooked investors (“ Update: Upstart Holdings & Cross River Bank ”). When investors see a nonbank issuer like UPST and its partner banks retaining exposures that were meant for sale to investors (aka, the “victims”), then you can understand the natural feeling of consternation. In the world of retail, this is what is known as "expired stock" -- especially when interest rates are rising. Falling market liquidity in the private markets for asset backed securities (ABS) adds a certain urgency to news that UPST has decided to make significant modifications to its credit model. Given the way UPST handled its involuntary foray into warehousing unsecured consumer loans, we look for more revelations in the future. But the big picture facing the ABS markets is of greater concern. New issue volumes for ABS actually rose sharply in May 2022, but the absolute value of $35 billion in new issuance remains well-below 2019 levels. Since January of 2020, ABS issuance has been throttled, a decidedly negative indicator for liquidity risk and the U.S. economy. Likewise the bid for non-QM mortgage loans is also moderating after a torrid 2021, raising more operational issues for residential lenders. Notice that total mortgage issuance of all asset types is now below $200 billion per month, as shown in the SIFMA data below, half of levels a year ago. The May data for Treasury issuance, added to the record tax receipts, pushed the government’s cash balances over $1 trillion in May, but is now trending lower. Meanwhile, the crowd looking for risk-free returns at the Fed’s reverse repurchase window (RRPs) is growing toward $2.5 trillion. Notably the crowd does not include the dealers and banks that were the intended participants. The negative stigma of borrowing from the Fed remains too powerful as disincentive. The RRP facility is now a policy challenge for the FOMC. We suspect that the usage of the RRP facility is going to become a problem because the crowd of money market funds looking for risk-free returns is only going to grow as rates rise. The only way to reduce the level of utilization in RRPs, it seems, is to push down the awarded rate and literally force participants back into Treasury bills. The chart below shows 30-day T-Bills vs the award rate for overnight RRPs. This desire for higher risk-free returns may only be a transient problem, however, since we fully expect the 10-year Treasury note to start falling back towards two percent yield in short-order. Even as the FOMC forces up the front of the Treasury yield curve, the back end is more likely to rally. Could we see a rally in bonds and some down marks on servicing assets in future even as mortgage rates rise? The 4x growth in the duration of the Fed’s MBS portfolio since last June describes the magnitude of the credit risk which resides inside all fixed income assets. The FOMC moved loss rates on 1-4 family loans down by an order or magnitude over the past four years. Given the huge amount of credit exposure embedded in private financial assets over a decade of QE, and the closely related demand for safe assets, the true risk free rate is probably less than zero. Ponder that as Chairman Powell tries to wind-down QE. 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.

June 8, 2022 | Premium Service | A number of subscribers to The Institutional Risk Analyst have been asking about different regions of the mortgage and asset management complex. Creators and servicers of loans are currently in disfavor, but some investors are beginning to nibble on the real estate investment trusts (REITs). We’ll be looking at a number of asset gatherers and managers in upcoming issues of the Premium Service . Here’s the key questions: First, do you expect the yield on financial assets and particularly mortgage-backed securities (MBS) to rise faster than funding costs? And second, how do you feel about mortgage servicing rights (MSRs), which seem to be the plat du jour among the REIT community in this cycle? As the housing market rolls over and asset prices begin to fall for the first time in a decade, credit costs will reappear in at least equal measure. Interest Rate Volatility The big worry we see ahead is the fumbling approach of the Federal Open Market Committee to normalizing monetary policy combined with the rapid pace of change in the markets. Bill Nelson , Chief Economist of The Bank Policy Institute , illustrates the problem faced by the FOMC compared to the Bank of England: “The BoE plans to set the interest rate on its collateralized loans equal to Bank Rate, the rate it pays on deposits (reserve balances). It then plans on shrinking its securities holdings at least until borrowing picks up, which should happen at roughly the unknown structural short-run level of reserve demand,” Nelson noted in a missive earlier this week. He continues: “By contrast, the Fed’s plan is to stop QT ‘when reserve balances are somewhat above the level it judges to be consistent with ample reserves.’ At that point, the Committee will let currency growth reduce reserve balances until the balances are ‘at an ample level.’ The New York Fed is basing its balance sheet projections (available here ) on an assumption that that minimum ample level is 8 percent of nominal GDP (the level in December 2019) and will be reached in 2026 when reserve balances are $2.3 trillion.” In other words, the FOMC staff in Washington is modeling the demand for total reserves based upon GDP and the BoE is going to let the markets decide. Obviously we give the latter policy course a higher chance of success. Speaking of bad models, the FOMC continues to buy mortgage-backed securities even as new issuance of agency MBS is plummeting. The chart below shows dollar swaps vs the Treasury yield curve, which is essentially flat now from 2 years out to 30 years. Source: Bloomberg Given that new issuance is falling across the board in the fixed income markets, buyers of assets such as New Residential (NRZ) and Annaly (NLY) are going to be part of a much larger crowd that is chasing a shrinking pool of opportunities. The change in new issuance in areas such as high-yield and MBS is large in relative terms, thus we will be watching for signs of expansion in bank yields when the Q1 2022 bank peer data is released by federal regulators next week. Mortgage Issuers & Servicers The elevated velocity of change we alluded to with respect to interest rates is evidenced in the housing sector, with new mortgage applications at a 22-year low and aspirational prices for high-end dwellings softening. The fact that sales volumes are falling on the high-end properties is partly driven by lean inventories and provides little relief to low-income households, who face continued shortages of homes in many markets. “There is a massive shortage of housing in Arizona and California,” notes Alan Boyce in an email earlier this week. “Imperial County has 40 homes for sale with a population over 200,000 people.” With the shortage of housing assets for sale and falling lending volumes, it is difficult to paint a rosy picture of rising yields for investors in loans, servicing and MBS. This is not to suggest that astute managers cannot make money in this market, but the fact remains that bellwethers such as NLY and NRZ have been going sideways in the equity markets since the COVID selloff in March of 2020. NRZ has suffered the most severe decline, but since 2020 has clawed back about half the ground lost due to COVID and the FOMC’s response. Source: Bloomberg We sold our position in NLY earlier this year. While we continue to like the diversification of the NLY balance sheet into servicing assets, the outlook for the agency REIT market overall in terms of the FOMC is so unclear that we are just not comfortable holding the stock. We see an at least equal chance that margins will get squeezed for agency and MSR investors before they expand in response to higher benchmark interest rates. The flat yield curve and tight swaps curve both speak to a general scarcity of assets, yet the bid for non-agency loans and even MSRs has fallen away in recent weeks. Investors are running away from risk and back into Treasury and agency assets. The velocity noted above also applies to credit exposures, meaning that returns on GNMA mortgage servicing rights may start to be impacted as short-term interest rates rise. When we talk of interest rate spreads and credit, this all gets boiled down to net-interest income. As with banks, REITs such as NLY and NRZ have seen an erosion of net interest income since 2020. Now, as credit costs rise and lending volumes fall, some investors are starting to look at nonbank mortgage lenders as a distressed asset class. Given the clumsy behavior of the FOMC, we honestly do know when credit investors will once again see NII expansion. This is another reason why we and also the market remain circumspect on the bank, nonbank mortgage and agency REIT sector. The components of NII for NLY are shown below. Note the volatility of the results as market swings have hurt returns, in part by driving up the cost of hedging MBS 3x compared to pre-COVID. NRZ has actually out performed NLY since 2020, particularly over the past year, and added significant operating assets and MSRs with the acquisition of Caliber. Now the largest non-bank owner of MSRs, NRZ took a $575 million positive mark on its servicing asset, accounting for most of the increase in servicing income for Q1 2022. With lending volumes falling like a rock, NRZ will be under a lot of pressure to replace revenue and is reported to be employing unconventional valuation methods to boost the fair value of MSRs. Meanwhile, NRZ's once successful trade in Ginnie Mae early buyouts (EBOs) has reportedly turned sour and could be the source of losses later in the year. Overall, the EBO trade could cost the mortgage sector billions in losses in Q2 2022 with Ginnie Mae 2.5s trading at 90 and change in the TBA market. Along with JPMorganChase (JPM) , NRZ is reportedly using assumed revenue from cross selling opportunities to customers acquired via MSR purchases. A number of other banks have been purchasing conventional MSRs at multiples approaching 6x and, again, are referring to cross selling opportunities to justify MSR valuations. We find these reports troubling but not surprising since the flow of credit into MSRs is only increasing marginal demand. Of note, Bank of Montreal (BMO) and BNP Paribas (BNP) have jumped into the market for lending on MSRs. A breathtaking number of conventional issuers are plunging into the opportunity for non-QM loans, a shift that is unlikely to bring relief to lenders fleeing the carnage in the conventional loan market. Many issuers are losing money on secondary market execution, a situation which is a function of overcapacity. Our mortgage equity surveillance group is shown below and is sorted by dividend yield. The big concern in the near term is that market volatility and rising demand for risk-free assets will pressure residential and agency REIT returns even as new lending volumes fall. More important, we see growing pressure in the seller/servicer channel as debt prices fall to multi-year lows. RKT 2 7/8s of 2026, for example, traded above par as recently as December 2021 but are now trading in the mid-80s. If there is a credit event in the world of nonbank issuers, bank lenders will step back from this sector. PennyMac Financial (PFSI) 4 1/4s of 2029 are trading at 79 and a spread of 500bp over the Treasury curve. A winning strategy for survival is said to be one leg down in Ginnie Mae and the other in non-QM, leaving the conventional market out of the calculous. But we worry that the large and growing crowd in non-QM is going to drive the execution in that market into loss as well. Meanwhile, some of the bigger non-bank issuers have been leaning into large loan and MSR trades to capture assets, this in response to the reappearance of banks in the market for Ginnie Mae MSRs. Outlook In the background of the discussion of US interest rate policy and housing markets, there is a continued debate as to whether the FOMC will actually try to sell MBS from the system open market account or SOMA. It is important for investors and risk managers to understand that the flat yield curve imposed on markets by the FOMC, together with the threat of outright sales, is having pernicious effects. So long as the FOMC needs to absorb $2 trillion in cash via reverse repurchase agreements (RRPs) and the Treasury is awash in cash, managing the process of reducing the size of the SOMA is going to be problematic – especially if the Fed is using a GDP-based model to guide its actions. The chart below shows some of the major factors impacting the supply and demand for risk-free assets in the near term, including SOMA holdings of Treasury paper and the Treasury's General Account. If the FOMC wants to end all purchases of Treasury securities and MBS for the SOMA, then the Committee must also manage the availability of RRPs and slowly allow market rates to force investors out of RRPs. At the same time that the Fed is forcing money market funds out of RRPs, banks will be migrating out of reserves and back into coupons and T-bills. Funds and offshore buyers have been outpacing last year’s pace of purchases of Treasury notes and bills even as new issuance has fallen. Dealers have been taking down significantly less paper at 10-year Treasury auctions than a year ago. Any way you cut it, demand for risk free assets and MBS is likely to keep the yield curve flat to inverted for 2022 and beyond. The FOMC may indeed get the fed funds rate to 3% or higher, but the yield on the 10-year Treasury note may be considerably lower. The financial implications of such an environment for leveraged lenders and investors is not very pleasant to consider. 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.