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June 6, 2022 | Updated | One of the downsides of the era of technology is that people tend to lose the ability to discern when a data point displayed on a screen is clearly wrong. We don’t code or compute by hand any longer, instead we have automated tools that display metrics. The world of finance, with all manner of derived metrics, derivatives and outright frauds, is a forest of opaque indicators and misleading signs. As a result of the adoption of "artificial intelligence," the 21st Century investor is mostly a victim in waiting. We bide our time before the next convulsive shift in politics or monetary policy turns the idealistic speculation of today into tomorrow morning’s road kill. No amount of warning or protestation prevented millions of people around the globe from losing big in crypto or aspirational stocks. And there were no metrics visible to retail investors to warn of the reversal. The risk is lost in the fog of complexity. Leaving aside the surreal but rapidly fading world of pretend currencies, the supposedly “real” work of investing in stocks and bonds also is rife with problems of definition and transparency. Vendors such as Bloomberg LP and S&P's Capital IQ provide investors with lots of data and metrics, but they rarely display how the metric was calculated from, say, a public company’s financial statement. Most vended financial data, let’s keep in mind, is hearsay evidence that has been consumed and “adjusted” so that the vendor may claim ownership, breaking the fidelity with the public record. The result of errors in calculation and/or presentation, however, can also allow issuers of securities to mislead investors. Just because the presentation of the data is allowed under GAAP or industry convention does not mean that it is not misleading. Whenever you simplify a piece of data by aggregating it into a derived metric like a P/E ratio or price multiple, fidelity and context is lost. And all too often the presentation of value is incorrect because the global providers of financial data are ignorant of context and the always moving target of GAAP accounting as interpreted by accountants and lawyers. Let’s take the question of calculating a very basic metric, namely the book value of equity. This is one of the most important measures in the global equity market but also one where changes in convention and presentation can mislead investors. One of the more significant issues we’ve noticed in our work of late at The Institutional Risk Analyst is the “non-controlling interest,” a once de minimis line item that has become more and more relevant in recent years as private equity investors defend their entitlement to double-digit equity returns. If you search on the SEC’s EDGAR portal , the term “non-controlling interest” appears in quarterly (10-Q) and annual (10-K) reports more than 10,000 times over the past five years, in most cases appropriately so. The convention in the world of data and analytics is to exclude this item from the definition of equity and that is mostly the correct approach. The result in some cases, however, is understating the actual capital of the enterprise and overstating all of the metrics derived from capital. Take, for example, Rocket Companies (RKT) , the owner of Quicken Mortgage. If you look at Yahoo! Finance , the market capitalization is shown as $1.1 billion and the price to book value multiple is shown as 1.85x. But this is clearly wrong. Not only is RKT trading at a discount to recent values like the rest of the mortgage industry, but it is trading at a steep discount to the 30x book value shown on Bloomberg . Let's see, $16.8 billion MVE / $8.7 billion BVE = 1.93x book. We asked one of the leading Sell Side research analysts in the sector to explain why the metrics shown on Yahoo! Finance and Bloomberg are wrong: ”The issue is that Bloomberg doesn’t include the “non-controlling interest” line item in total equity which distorts the price to book value multiples. For example, RKT has $8.7B of total equity but $8.2B of it is ‘non-controlling interest’ so Bloomberg uses $0.5B of equity as the denominator which increases the price-book value multiple.” Likewise in the case of United Wholesale Mortgage Corp (UWMC) , the 46x price-to-book value multiple shown on Bloomberg is clearly wrong. Let's see, $6.4 billion / $3.1 billion = 2x book. But the real issue is the distortion caused by the GAAP accounting. The relevant section of UWMC’s most recent 10-Q is shown below. Notice that of $3.2 billion in total equity underneath the company, 99% of UWMC’s capital is somehow considered a “non-controlling interest.” And do notice all of the different classes of preferred and common stock in the UWMC capital structure. UWMC Obviously the derived calculation on Yahoo! Finance of 2.6x book value is in error. The same number on Bloomberg , BTW, is 45x book for UWMC, again very obviously wrong. But how could these two big time data shops fail to get this right? Easy. It is not just the calculation but the business context that matters. The challenge for Bloomberg , Capital IQ and other data providers and also the SEC, is more subtle in this case than simply accounting. In the age of QE, the accountants, lawyers and bankers have contrived a structure for public offerings whereby you hide the majority of the equity of an issuer behind a legal façade of “non-control.” This legal fiction obscures the true economic capital of the enterprise. The presentation of non-controlling interests found in many SEC filings today is the functional equivalent of Jim Fisk and Jay Gould manipulating a stock with a hidden investment pool 150 years ago, but it is permissible under GAAP. If you are the head of analytics at Bloomberg , for example, how do you decide when a company’s use of a “non-controlling interest” classification in its equity account that is allowable under GAAP is nonetheless misleading to retail investors? Let’s look at another example, namely Switch Inc (SWCH) . As of Q1 2022, the company reported $338 million in total Switch, Inc. stockholder equity , a $287 million non-controlling interest, and total stockholders equity of $625 million. Bloomberg shows SWCH at 14x book value vs an $8.3 billion market cap. Is this right? If Bloomberg was true to form and used the $338 million for the book value calculation, then the answer is no. Half of SWCH's equity is hidden from view. In fact, the “non-controlling interest” is created from the inception of the corporate structure, and is true equity in the business and should be included in total equity for calculating all metrics for investors, particularly retail investors. But the needs of the private equity community have distorted the world of capital finance to the detriment of retail investors in public equities. A retail investor looking at the metrics for RKT, UWMC or SWCH might conclude that these stocks were outperforming other companies in the sector, when it fact the opposite is the case. The fact that Bloomberg, Capital IQ and other data vendors post these erroneous metrics and the derivatives therefrom should draw the attention of regulators and members of the trial bar. Part of the reason that many public companies have chosen to misstate their financials via “non-controlling interests” is the use of the umbrella partnership - C corporation structure (“Up-C”). This is an indirect way for an operating partnership to conduct an initial public offering (“IPO”), notes a 2019 Mayer Brown comment . Essentially fund investors use the non-controlling interest strategy to boost short-term share valuations by concealing the true float of the issuer. “Private equity-backed and venture capital-backed companies generally favor the Up-C structure because these financial investors often use flow-through entities to hold their interests in portfolio companies. The Up-C structure is a convenient tool to offer the portfolio companies’ shares to the public through an IPO,” notes Mayer Brown. Up-C derives its name from the Up-REIT structure, widely used by real estate investment trusts since the 1990s. An Up-C is composed of two entities: the parent company, which is organized as a C Corporation), and a subsidiary usually structured as a limited liability company or a limited partnership. By manipulating the presentation of the equity interest in the public company, the private partnership can make the public entity look more attractive to investors than its true fundamental performance dictates. That seems to be the explicit intention of the owners of RKT, UWMC, and SWCH; to conceal the true equity capitalization of the enterprises to make metrics such as price-to-book and return on equity appear superior until the private investors cash out. Naturally the Up-C structure has been particularly popular among private equity investors in recent years, who seek to maximize short-term equity returns over long-term performance. By allocating capital to early investors and advisers higher up in the capital structure via different classes of common or preferred stock, the partnership can manipulate the timing and size of equity returns taken by insiders in the public markets. And all of this is permitted under GAAP and SEC regulation. Remember, there are literally dozens of other examples of public companies that have used the rules of GAAP and the SEC’s Reg SX to distort their financial statements under the canard of non-controlling interests. Since the SEC long ago mandated XBRL data tagging for Form 10 filers, all that SEC Chairman Gary Gensler needs to do is ask the question. How many filers of Form 10’s have reported a “non-controlling interest” that is > 10% of the total stockholder equity of the enterprise?

June 2, 2022 | Back in June of 2021 , we noted that the nonbank lending platform Upstart Holdings (UPST) was not so new after all. The originate to sell model crafted by this band of former Google employees had the same risk characteristics as the non-banks that caused the 2008 crisis, namely exposure to market risk. The fact of UPST using “AI” to make lending decisions only made us more skeptical given our experience in the world of decision engineering for loan underwriting. "AI" is simulated cognition, not intelligence. Wind the clock forward 12 months and our worst fears have been realized. UPST is in the tank in terms of the equity market value, down 65% in the past year due to the changes in the credit markets. More, a growing crowd of trial lawyers are suing the company for securities fraud. Yet the company's earnings are up compared to Q1 2021. What's the problem? The table below comes from the most recent UPST earnings report. After restating financials and moving loans from “held for investment” to “available for sale,” UPST recorded a negative $19 million fair value mark and essentially had to come clean about warehousing loans on balance sheet. Has the originate-to-sell model that seemed to allow UPST print money and pass the risk on to "partner" banks become extinct? And, please tell us, why are the CSUITE at UPST providing forward guidance to the Street? Total losses due to adjustments to fair value and other factors was $38 million, this on top of a $24 million fair value adjustment in Q4 2021. More, UPST has $675 million in variable interest entities (VIEs) that it claims are unconsolidated and for which UPST has disclosed a net exposure of just $15 million. If the nonbank lender was quietly hiding unsalable loans on balance sheet, what does this say about the investors? As we all recall from the collapse of Citigroup (C) in 2009, off-balance sheet can become on-balance sheet risk in a few hours once investors start demanding their money back. As delinquency rises, UPST will be in danger of triggering ABS thresholds that will require accelerated payoffs for senior tranches of deals. In that scenario, the juniors simply have to wait until the senior investors are paid, all this while the FOMC is raising interest rates. “The average loan pricing on our platform has increased more than 300 basis points since October,” UPST CEO Dave Girouard told investors on May 9th. “In addition to increasing rates for approved borrowers, this also has the effect of lowering approval rates for applicants on the margin.” The other big issue facing UPST is the credit performance of its loans. As we have written previously in The Institutional Risk Analyst , the positive impact of COVID loan forbearance on visible default rates is ended. We now expect to see loan delinquency rates for UPST and other lenders rise above pre-COVID levels, reflecting the lending volumes possible due to the gold-rush mentality that prevailed in the capital markets between Q1 2020 and today. “The unprecedented level of government stimulus caused the majority of these post-COVID vintages to overperform significantly,” says Girouard. “The abrupt termination of these stimulus programs has caused some of the more recent vintages to underperform. And finally, we're confident that our models are currently well calibrated to the latest consumer credit conditions, performing in line with expectations and are more accurate than at any time in our history.” UPST CFO Sanjay Datta summarized the market risks that have sent UPST into a tailspin in the equity markets: “Net interest income was a negative component of net revenue this quarter as the loan assets on our balance sheet which we mark-to-market each quarter sustained declines in valuation due to the rising interest rate environment.” One of the big problems we see for UPST is their seemingly obsessive habit of providing forward guidance to investors, a decision which is only creating risk for the company. Obviously the dozen or more analysts that follow this volatile stock want and certainly need guidance, but given the volatility of the UPST business model, perhaps another strategy would be advisable? We see the big risk facing UPST and similar originate-to-sell shops is the loss of investor appetite for unsecured consumer loans. UPST notes that loans in the company’s ecosystem have risen 300bp in recent months, reducing pull-through for new loans. More, the company’s statement during the Q1 2022 earning call that rising delinquency levels has “stabilized” in recent months seems fanciful. As we note in The IRA Bank Book for Q2 2022 , the positive impact on credit caused by QE has only begun to reverse. ABS investors are extremely sensitive to changes in interest rates and delinquency. Our fear is that UPST is going to eventually lose access to the ABS investors that have powered the company’s growth, an extreme eventuality that could badly hurt the prospects for UPST. “I think that with respect to our large ABS deals, I don't think there's much concern of breaching triggers,” Datta told investors. “We do some smaller monthly sort of pass-through issuance. And there is a possibility that those triggers will be breached.” Simon Clinch at Atlantic Equities asked a key question during the earnings call: “I'm kind of surprised to hear that you're using your balance sheet to put some loans on there, which aren't just for R&D purposes. And it strikes me as it's just not a normal course of business for you given you're a platform business for. So I was just wondering what kind of message that might send to your bank partners or to others in the system. Just curious about that.” If UPST is being forced to use its limited balance sheet to warehouse loans, then this may be the beginning of the end of the story. If investors and partner banks don’t want to buy UPST loans at current market rates, then the game is over in an originate to sell model. Thus we move to the other half of the originate-to-sell binary with UPST, namely Cross River Bank in Fort Lee, NJ. Cross River Bank Back in January of 2022, we tempted readers to ponder the fact that Cross River Bank (CRB) was one of the best performing banks in the US. Exploding from $1 billion in total assets to over $12 billion a year ago, CRB was one of the largest PPP lenders during the COVID lockdown. And these pioneering souls are also the largest bank partner for UPST, documenting, funding and closing many of the loans that are originated by this AI-based loan acquisition funnel. Since Q1 2021, CRB has shrunk by a third as its portfolio of government-guaranteed assets has run off. With $9 billion in total assets as of Q1 2022, CRB has risk weighted assets one quarter of this amount, allowing the bank to function with $800 million or so in capital. The bank has a concentration in commercial exposures and non-core funding that is breathtaking for a bank of this diminutive size. But, again, most of the assets are guaranteed by Uncle Sam. CRB is a subprime lender, with an average gross yield on its loan book of 7.41% as of Q1 2022 vs 4.14% for Peer Group 3. The bank’s income to average assets is 2x the Peer average, an indicator that suggests that CRB is an outlier in terms of risk. For example, CRB reported a yield of 17% on its MBS book, 10x the average return for Peer Group 3. All of the bank’s treasury investments for liquidity are in private commercial and residential MBS, of note, with no Treasury or agency MBS securities reported. Treasurer Dushyant Abhyankar just departed CRB to join Spencer Savings Bank . The above-peer yield on the CRB loan book is needed because the loss rate on the bank’s loans, which are 84% of total assets, is 0.18% or 5x the average of Peer Group 3 calculated by the FFIEC. The bank’s past due loans of 6.55% is astronomical and puts CRB in the 99th percentile of Peer Group 3. These PPP loans have US guarantees, but the high level of delinquency may still raise concerns. The bank has already been the focus of congressional attention because of the size of its PPP business. While the bank’s current income is strong and in the top decile of the group, the unusual business mix and funding profile are concerns. For example, CRB has 51% net non-core funding dependence. The good news is that the bank is shrinking at mid-double digit rates, including a 42% drop in new loans and leases since Q4 2021. CRB looks to be exiting the market and shrinking the balance sheet as quickly as possible. Reading between the lines of the UPST disclosure, one wonders if CRB is still closing and selling loans. CRB took $61 million to the net income line in Q1 2022, a far cry from the $372 million reported in Q4 2021. Loans held for sale almost doubled in Q1 2022 to $1.3 billion. The bank has cut back on its brokered funding in the latest quarter, but borrowed funds still account for half of liabilities. CRB reports no hedging or derivatives positions, making us wonder how or if the bank hedges its available for sale book. We expect to see CRB continue shrinking its business back down to the base of $2-3 billion in risk assets. The C&I exposures that currently comprise 70% of total assets will run off over the next year. The big question for the bank and also for UPST is how the loans originated, closed and sold to investors perform in what looks to be the worst credit environment in a decade. 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.

Each summer a number of our friends go fishing in Downeast Maine at Leen's Lodge . Leen's is a half century old fishing camp located on West Grand Lake , which is one of the most beautiful natural lakes in the United States. Our friends in the Grand Lake Stream community raised millions of dollars to protect the area around the lake and created the Downeast Lakes Land Trust to manage this responsibility for the benefit of the community. West Grand Lake from Leen's (2018) The "Camp Kotok" fishing trip in August was created by David Kotok , Chairman & Chief Investment Officer of Cumberland Advisors in Sarasota, FL. More recently, two fully social but distanced trips in August have been sponsored by the Global Interdependence Center in Philadelphia. The Labor Day trip is somewhat less structured and harkens back to the early days of Camp Kotok, held at a small hotel in downtown Grand Lake Stream. The June trip is transitory and depends upon the elasticity of demand for pre-Father's Day fishing, which usually is quite spectacular. David Kotok arrives on Katahdin Air As befits the generous character of trip founder Kotok, these excursions are about enjoying the natural beauty of Maine, catching fish and good conversation. The water in West Grand Lake is never more perfect than on Labor Day Weekend and the fishing in the many lakes and streams in the area is always excellent. By the end of August, the bugs are gone but the fish are still biting, making for a perfect way to end the summer. Lunch at Ray's Camp (2018) Most important, the hospitality of the people of Maine, from Portland in the south to the northeastern region known as Acadia that lies between Bangor and the St. Croix River, is always welcoming. Henry David Thoreau wrote in "Walden, or Life in the Woods" about this scenic area of rivers and small hills: “We need the tonic of wildness...At the same time that we are earnest to explore and learn all things, we require that all things be mysterious and unexplorable, that land and sea be indefinitely wild, unsurveyed and unfathomed by us because unfathomable. We can never have enough of nature.” The inhabitants of the rural region that includes Washington County primarily make their livelihoods outdoors via forestry, tourism and sporting activities such as camping, fishing, hiking and hunting. The season from May through October provides much of the economic activity for the community during the entire year in Downeast Maine. The trips we take each year to Leen's helps to support the community and a traditional way of life unknown to many Americans. The Maine Guides focus first and foremost in our safety, but also give us a priceless gift by making this stunning part of the American wilderness accessible to all. Guides transport the "sports" to and from the fishing ground, handle lunch and get you home safe and sound. Veteran Maine Guides such as Ray Sockabasin , Steve Schaefer , Dale Toby , Randy Spencer and many others have taken care of us for three decades of fishing and enjoyment. Steve Schaefer & Nicole Boutmy Ray and the other members of the The Passamaquoddy Tribe live in a nation that extends on both sides of the border between Maine and New Brunswick, Canada. The native word for this area is "Dawnland" since it is the easternmost point in the region. One of our favorite trips is to float down Toma Stream in the nation and lunch at Ray's camp looking west over the water towards Princeton. The Passamaquoddy have welcomed us into their homes and their lives for many years. Click on the photo below if you want to contribute to rebuilding Ray's Camp on Toma Stream along the border with Canada. Better yet, come fishing. Ray Sockabasin This year the two August trips sponsored by the GIC are sold out, but we have a few spots left on the Labor Day trip. This time of year, the gating issue on the size of the group is guides. By September many of our friends have already switched to hunting birds, moose and bear. The dates are September 1-6, 2022. If you'd like more details, please contact us or Scott Weeks at Leen's scott@leenslodge.com Some photos follow below. Kotok at Breakfast (2018) Guide Potato Chips Megan Greene, David Kotok & Michael McKee (2018) Toma Stream John Silvia & Dale Tobey (June 2015) Randy Spencer, Mitchell and Aisha Kotok (2018) Nolan Turner (June 2015) Three Generations of Flansbaums Kotok & Whalen (June 2019) Maine Guides from left: Les Williams, Bob Gagner, Dave Irving, Mike Hegarty, Jerry Richardson, Gary Santerre Long Lake (2021) Michael Lau & Steve Schaefer (June 2018) Kotok with Pickerel (June 2018) Big Lake

May 30, 2022 | Over Memorial Day weekend, we released the latest edition of The IRA Bank Book with our review and outlook of the banking sector for Q2 2022. As we analyze the ebb and flow of earnings in the financials, in many respects the patterns visible in bank results are also visible elsewhere. We all have the same problem: rapidly repricing asset values under the weight of threatened Fed tightening. Market risk realized today becomes credit risk tomorrow. Look at ad revenue for Twitter (TWTR) , Snap (SNAP) and the company formally known as Facebook, Meta (FB) (h/t to Variety ), and you see the same manic pattern as is visible in financials. Sadly we cannot share the really cool chart in VIP+ earlier this month. Suffice to say that Q2 of 2021 was a good time to sell online ads. But the more important point is that the asset value of all of these companies has been cut in half or more. A sharp spike in online advertising activity was caused by COVID and followed by the latest episode of social engineering from the Federal Reserve Board. Now that the COVID contagion has seemingly (but not in fact) moderated, we see an equally rapid collapse in demand in many sectors. The JPM index of global developing debt is down 15% so far this year. Will the FOMC come back to the rescue if the patient begins to flatline? Like most potions conveying unnatural life, the side effects of ending the Fed’s purchases of securities via QE is an equally powerful snap in the other direction. People are no longer cloistered at home staring at their cell phones, thus no surprise that ad revenues have fallen back to pre-COVID levels at TWTR and FB. When you pull tomorrow’s sale into today, tomorrow ends up being light. The power of the Dark Side of inflation wielded by the Fed is most felt in the leveraged world of finance. The 120% increase in the ad revenue for SNAP, for example, is as nothing compared to the three-fold rise in operating income orchestrated by the Fed for banks, this as net interest revenue was falling rapidly. The FOMC ultimately sliced $40 billion per quarter out of bank interest earnings, a loss that may never be restored. Source: Quarterly Banking Profile If you examine the price movements of TWTR, SNAP and FB, all began to crater as ad revenues fell at the end of Q3 2021. Likewise, banks started to roll over as investors started to understand that the 340% spike in operating income seen in 2021 was an anomaly. Market risk realized today becomes credit risk tomorrow. Let’s consider another example c/o Joe Garrett at Garrett McAuley & Co in San Francisco and the Mortgage Bankers Association. When lending profits were 1.5%, mortgage companies actually seemed investable. What a difference a few months makes. Suffice to say that we’ll test the lows of 2018 in terms of lending profits during this up cycle in interest rates. No matter how many times we explain to investors that the earnings surfeit at banks was a mirage caused by GAAP, many refused to accept the data. More did not sell bank stocks at record levels and rode them down. And many today are sitting with low coupon loan exposures that are likely to move lower in the near term as the downward sloping trend in bank earnings unfolds. Likewise mortgage lenders dependent upon fat gain-on-sale margins are now fighting the Fed. But perhaps the largest banks face the most risk in the near term. Consider, as we noted in The IRA Bank Book , that the gross yield on the loan portfolios of the large banks in Peer Group 1 averages 4% as of Q1 2022. Some of the larger, more profoundly mediocre names such as Bank of America (BAC) are closer to 3% gross yield, according to the FFIEC. Figure BAC's gross yield at year-end was 3.25%, minus overhead of 2% of total assets and funding cost of 0.16%. What remains is net operating income. Notice that we did not include credit provisions in the analysis in the previously paragraph, not meaning to upset the more impressionable members of the reading audience. Provisions for loan losses were still negative in Q4 2021. Add 15-20bp vs average assets for normalized loan loss provisions in 2022. So the hypothetical reckoning for BAC's loan book looks like this: Gross yield: 3.4% SG&A 2.0% Funding costs: 20bp Provisions expense: 15bp Net income ~ 1% It does not take an astrophysicist to see that a small increase in funding costs and/or credit expenses will be enough to drive many banks into loss. If our fishing pal Danielle DiMartino-Booth is correct about a Paul Volcker style rate increase regime this year, say 50bp per meeting, then many banks could find themselves underwater a la the 1980s and the S&L crisis. But of course, Chairman Volcker moved faster and bigger than this crowd on the FOMC today. He not only attacked inflation, but also called out fiscal dishonesty in Washington . Volcker destroyed a lot of banks, home builders and investors by fighting inflation in those politically difficult years. As all manner of companies struggle with the increase in interest rates this year, many investors find themselves holding paper that was created during 2020-2021 that is now profoundly under water. The secret of QE is that the Fed’s machinations embedded big losses on the balance sheets of banks, pensions and other savers, the latest and largest manifestation of Financial Repression in this cycle. “The Fed’s May meeting minutes contained few revelations, leaving our Fed Minutes Sentiment Indicator little changed and remaining relatively hawkish,” Bloomberg Intelligence strategists Ira Jersey and Angelo Manolatos wrote in a note. They continued that a “number” of FOMC members thought sales of agency MBS could be necessary after runoff was “well underway,” according to the minutes “We wouldn’t be surprised if the Fed were to embark on sales in 1H23 after getting some feedback from market participants and allowing about six months of full runoff to occur before making a final decision,” the analysts wrote. We certainly hope so because any attempt to sell large portions of the Fed portfolio will badly distort interest rates and especially mortgage rates. As we’ve noted, the mark-to-market on the Fed’s $2.7 trillion portfolio of mortgage backed securities is easily minus $500 billion, a sum that is actually a loss to the taxpayer. When we said a while back that the Fed’s actions with QE are illegal, we refer directly to the fact that the Federal Reserve Board is spending money in a market speculation without authority from Congress. Robert Eisenbeis of Cumberland Advisors told The IRA back in December of 2017 (“ The Interview: Bob Eisenbeis on Seeking Normal at the Fed .” “The Fed almost by definition cannot make a profit. It baffles me how people inside the system can fail to see the accounting reality here. The Fed issues short term liabilities to buy Treasuries taking duration out of the market. The Treasury makes interest payments to the Fed who takes out its operating costs, including interest payments on reserves and returns the remainder to the Treasury. If this intra governmental transfer were settled on a net basis like interest rate swaps, there would always be a net payment from the Treasury to the Fed.” And the Fed now also stands to lose money for the Treasury on QE, a fact we think is rather remarkable. Since the national Congress has chosen to treat the remittances from the Fed as a “profit” for the purposes on the federal budget, perhaps it does not matter in Washington. It certainly matters for lenders, investors and risk managers around the world. As our friend Alan Boyce opined previously, the MBS that the Fed purchased for 102 with a duration of 4 now trade in the low 80s with a duration of at least 12. As interest rates rise, the duration of the Fed’s MBS portfolio will extend further, increasing taxpayer losses and creating a vast obstacle to normalizing policy because these low-coupon mortgage bonds are essentially unsalable. To understand the scope of the problem, instead of $2.7 trillion in MBS, imagine that the Fed actually owns $10-12 trillion in MBS that is lengthening in duration and falling in price as interest rates rise. Welcome to the risk of negative mortgage convexity , BTW. But as private investors see large portions of the gains they thought were real over the past several years eviscerated, they can take some comfort in the fact that Fed Chairman Jerome Powell feels their pain, sort of. And again, market risk realized today becomes credit risk tomorrow.

May 29, 2022 | Premium Service | With this issue of The Institutional Risk Analyst , we introduce a new format for our quarterly review of the US banking industry. By popular demand, we are now publishing The IRA Bank Book in PowerPoint, making the charts easier to read and forcing your dutiful publisher to be very concise. Subscribers may share the IRA Bank Book within your organization. In this issue, we describe the migration of the banking industry back to 2019 levels of operating income. Why did bank stocks out-perform perform in 2021? Because the banking industry spent much of the year repatriating $60 billion in loan loss reserves taken in 2020 back into income. Why did financial stocks soar in 2021? Due to GAPP adjustments to income because of COVID and the FOMC's radical asset purchases which suppressed credit costs. Now we go the other way on the financial roller coaster. The special adjustments to GAAP income are behind us and many asset classes remain rather considerably over-valued, like loans and mortgage servicing assets. This prepares the world of financials for a year of rising funding costs and credit expenses, falling asset prices and eventually, hopefully, higher asset and equity returns after the nuclear winter of quantitative easing or QE. Source: FDIC Subscribers please log-in to download your copy of The IRA Bank Book for Q2 2022 The IRA Bank Book (ISBN 978-0-692-09756-4) is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, 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 IRA Bank Book. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Book are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Book represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Book is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Book 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 IRA Bank Book. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

May 25, 2022 | Premium Service | In this issue of The Institutional Risk Analyst , we start with a general market comment and, from that vantage point, then slide into the earnings reports from PennyMac Financial Services (PFSI) and United Wholesale Mortgage (UWMC) . The general comment is fairly simple to summarize: a massive surfeit of cash sloshing around the financial system and growing as stocks sell off, threatening to inundate the Fed with cash seeking a risk-free home. In theory interest rates are rising c/o the FOMC, but in fact risk-free collateral remains scare and rates seem more inclined to fall than to move higher. At the end of last week, reverse repurchase agreements (RRPs) with the Fed of New York grew to over $2 trillion while the Treasury’s General Account (TGA) has soared to almost $1 trillion due to strong tax payments. As the TGA rises, bank reserves at the Fed fall 1:1. This illustrates why the Powell FOMC is going to find it very difficult to manage a reduction in the system open market account or SOMA. This fact will directly impact the financial performance of mortgage banks and all financials, especially issuers of securities. “Treasury is still decreasing bill supply and that seems to be driving the market firmly into the arms of the RRP facility as the only place of refuge,” said Gennadiy Goldberg, a senior US interest rates strategist at TD Securities, Alexandra Harris of Bloomberg News reports. “The big implication is that with RRP usage remaining high, QT will drain reserves from the system rather quickly at the start of runoff.” It is managing the “runnoft,” to paraphrase the film " O Brother Where Art Thou ," which is the task facing Jerome Powell . Last week, as the TGA was rising on the back of stronger than expected tax payments, total reserves at the Fed fell by almost half a trillion dollars. “As a result, outstanding bank reserve balances dropped by $466 billion in the week ended April 20,” reports Harris, “the largest weekly decline on record.” This outflow of bank reserves has the impact of forcing investors and banks back into the market for T-bills, which is already under downward rate pressure due to the Treasury’s large cash position and lack of new issuance. Observe that the 10-30 year complex in Treasury securities seems to want to rally in the worst way. Net, net, the dynamics in the market are actually forcing interest rates down even as the FOMC pretends to raise the cost of credit. The impact of the conflicting flows between the Federal Reserve and Treasury is visible in terms of the uncertainty in the markets. Bond spreads and primary lending rates are soaring, but benchmarks such as the 10-year Treasury note are displaying a reluctance to move higher. The result is a flattening yield curve and a primary market for residential mortgages that is going to be more challenging as the year progresses. The difference between 30-year mortgage rates and the 10-year Treasury is widening, yet industry profits are falling fast due to chronic overcapacity. PennyMac Financial Services The story with PFSI is similar to that facing the entire industry, namely falling production volumes and not as rapidly falling production expenses. Some firms are actively reducing headcount, others are trying to redeploy valuable people to servicing and loss mitigation. In either case, cutting volumes in half has focused the entire industry on cost. The bottom line is a draconian cut in operating profits as the industry slowly manages down operating costs to fit ~ 50% of the $4.4 trillion in new origination volume seen in 2021 in 2022. The table below from the PFSI supplement shows earnings before interest, depreciation and amortization (EBITDA). Note that the upward adjustment to the MSR in Q1 2022 was 2x PFSI’s reported income. The decline in operating income is relatively easy to see, but what is more troubling and less easy to see is the sharp deterioration of the net production revenue less loan officer (LO) compensation. In Q1 2021, PFSI reported $585 million in production income with production expenses of $222.6 million or 38% of production revenue. In Q1 2022, in sharp contrast, PFSI reported $235.6 million in revenue and production expenses of $226.3 million or 96% of production revenue. This shocking collapse in profitability is visible across the industry and shows how difficult it is for the mortgage industry to manage operating expenses. Of note, net production income for the industry has fallen from 124bp in Q1 2021 to 5bps in Q1 2022, according to the most recent survey from the Mortgage Bankers Association. The table below from the PFSI Q1 2022 earnings supplement shows the production results for the firm. The increase in interest rates has also taken much of the profitability out of purchasing delinquent government loans out of Ginnie Mae pools (aka “EBOs”), a big part of PFSI earnings in 2021. In Q1 2021, EBO revenue added $283 million to the bottom line, more that total servicing revenue for PFSI in that period and roughly 25bp per loan. The same line item in 2022 saw revenue of $95 million or just 7.4bps earned on each resolved delinquent loan. Provisions for loan losses rose 50% to $30 million in Q1 2022. The sharp upward mark in the value of the PFSI MSR helped reported earnings significantly, as shown in the chart from the PFSI Q1 2022 earnings presentation. Notice the interaction between the changes in valuation for the MSR, production income and the results from the PFSI hedging operations. In 2020 when the firm reported 60% equity returns, it was net of a $1.1 billion negative markdown of the MSR due to mid-double digit mortgage loan prepayments. Half of the $12 trillion mortgage market was refinanced in 2020 and 2021. PFSI's common equity is down 30% YTD, reflecting investor concerns with the plummeting equity returns for this leading mortgage issuer. In 2020, PFSI generated 60% equity returns, but in 2021 just half that amount and only 21% in Q1 2022. Through the balance of 2022 and beyond, PFSI will be forced to tighten operating expenses to keep pace with declining revenue and industry volumes. Upward valuations may continue to be a positive for the rest of 2022, but servicing assets are overvalued today vs the likely NPV of the asset. United Wholesale Mortgage If PFSI is a good example of the broader mortgage industry, UWMC is an outlier and one that displays a good deal more volatility than do other issuers. The common equity of UWMC is off 60% in the past year, even though the SPAC transaction is still showing a premium multiple to book value. But with firms like UWMC, what is book value? Piper Sandler wrote on May 19th: “We are downgrading UWMC to Underweight from Neutral and adjusting our price target to $3.00 from $5.00. In our view, UWMC will struggle to generate earnings that exceed the current dividend run rate of $0.10/share as production revenue declines at a rapid pace due to lower demand. UWMC should experience an incremental decline in expenses, but we think the pace of expense reductions would be slower and therefore, UWMC would experience operating margin compression.” Like PFSI, volumes fell and expense less so at UWMC, generating a squeeze in operating results. The table below from the UWMC earnings report illustrates key operating metrics. Note that GAAP income was “only” cut in half because of a $390 million increase in the value of the MSR vs Q1 2021 and $170 million sequentially, an adjustment that is non-cash. When asked during the earnings call about his rosy view of the outlook, Ishibia said: "Right. That's why you sit there and I sit here. So, that's the reality is $170 million of our $450 million was fair value markup, not $450 million of it. So, understand our business is extremely profitable as I told you guys last quarter. It's going to be extremely profitable in the second quarter. So, you just have to be confident that I sit over here and I run the show and we're doing a great job. And once again, 2018, I referenced it earlier in the call, was the last time this happened. Most companies didn't make money. We did. I've seen this before. This isn't like my first day on the job. I've been here 19 years. I built the company. We're doing pretty well. I think you'd understand that and agree with that." As a result of falling lending volumes, adjusted EBITDA was just $128 million in Q1 2022 vs $711 million in Q1 2021, including a negative mark on the MSR. UWMC, of note, derives its own valuation for the MSR – a Level 3 asset under GAAP -- using internal models and assumptions. It is fair to say that UWMC could not sell its MSR in today's market for anything like the reported value. UWMC has stated that it will not be laying off employees, thus it remains to be seen how CEO Matt Ishibia will manage expenses going forward. Ponder the logic of Mr. Ishibia in his Q1 2022 earnings conference call: “Well, we're still hiring people. So, we're different than these other guys and gals, companies, however you want to say it. So, we're hiring and we look for great people to join our company all the time. And so, will attrition affect you? Of course. When you have so many team members, there always some people leave, some people move out of town, things happen.” Expenses at UWMC were basically unchanged in Q1 2022 vs the previous quarter. Rhetoric aside, we expect to see some rather aggressive cost cutting from UWMC in Q2 2022 and beyond. The big concern with UWMC is the rate of growth in the company from 2020 to today. The firm now has $2 billion in “non-funding debt,” meaning corporate borrowing that is not directly contributing to revenue and profits, but likely underpins the MSRs. One interesting comment from Ishibia on the Q1 2022 earning call concerned his focus on the wholesale channel, arguably UWMC’s strongest suit and a consistent #1 ranking for the firm. He describes why top performing LOs would rather be independent brokers in a tough loan market: “You know, we saw a huge pick up in the first quarter from the fourth quarter, and I see the momentum continuing. It's like a snowball going downhill. It's always better for a loan officer to be at a mortgage broker shop. They can offer better rates and have better technology and better processes than they have at retail. That's just fact. And so, for consumers to go there and the realtors to follow those loan officers, that's happening. And so, it's just a matter of how fast it happens. And I think a lot of data out there is showing that the speed is picking up because, as I think I said last year, a bunch of times, when the market is so busy, you know, a loan officer closing 25 loans a month, it's hard to pick up and leave a retail shop.” Will the snowball of LOs migrating to the higher ground of the broker channel come to the rescue for UWMC? We hope so, but like the folks at Piper we remain skeptical. Winter has come in mortgages and its likely to be the longest, nastiest winter in residential assets since 2008. The issue this time is not credit at first, but market risk and the bizarre reality of trillions in conventional and mortgage paper that is 200bp or more out of the money in terms of refinance. In this vast pool of new mortgages with LTVs averaging close to 50% lies a good deal of hidden credit risk that will emerge during the approaching recession. With a recession and higher loan defaults will come repurchase claims from the GSEs. 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.

May 23, 2022 | Last week, JPMorganChase (JPM) CEO Jamie Dimon was rebuked by shareholders unhappy with the bank’s recent performance. JPM is down 25% YTD and was trading at 1.3x book value at the close on Friday, hardly a disaster. But Americans as a group are unwilling to accept such a poor short-term showing, this even though much of the apparent wealth creation of the past two years was entirely surreal. In 2020 and 2021, the FOMC removed $8 trillion in duration from the markets, forcing up asset prices for all manner of equity in the process. Now that very act of asset price inflation is being reversed and threatens to destroy a large chuck of virtual wealth accumulated in the equity markets. Chinese tyrant Xi Jinping has already destroyed several trillion in equity value via the communist crackdown on Chinese tech firms, but the US is preparing to add a zero to that total of value obliteration in coming months. American’s accumulated an addition $35 trillion in paper wealth between Q1 2020 and the end of 2021, writes Ben Steverman of Bloomberg News . But Americans have lost $5 trillion in the selloff so far, JPM estimates in a research note, and may lose as much as $10 trillion by the end of 2022, the bank reports. This downward adjustment in paper wealth tracks the estimate we published earlier, that Americans would have to give back at least 25% of the paper gains created by quantitative easing (QE). Watching the unhappy reaction of Americans to slumping prices for stocks and crypto assets, it is almost as though they feel entitled to continuous share price appreciation. The FOMC, of course, tells us that inflation expectations have not yet become hardened among the broad public. Yet when people complain about the impact of rising interest rates on public company valuations it seems like they don’t understand why stock prices were rising in the first place. Truth to tell, Jamie Dimon is not responsible for seeing JPM reach $172 per share last October and he is not responsible for the fact that the bank’s equity is nearing $100 as of Friday’s close. Financials are simply tracking the ebb and flow of liquidity into the financial markets. Share prices are falling as expectations for short-term appreciation fall and concerns about credit costs are rising in the minds of the more astute members of the audience. Our bank surveillance matrix is shown below: Source: Bloomberg Notice that crypto bank Silvergate Capital (SI) is the worst performer in the group, now below 2x book vs 12x book last March. Western Alliance Bancorp (WAL) is likewise under pressure due to plummeting residential lending volumes. More important, sector leaders such as American Express (AXP) and Raymond James Financial (RJ) are outperforming the rest of the group when it comes to downside risk. Perennial underperformer HSBC (HBA) is the only name that is still up for the year. The market gods do have a sense of humor. Is this the re-entry point for US banks? Not for our money. We are pondering several fintech names as we noted in our comments last week, but we’ll let the banks ride for a while in terms of common equity exposure until the magnitude and timing of the swing in credit costs becomes more clear. Just as US equity valuations will now give back ground, other asset prices including real estate are likely to follow as the great reset gathers pace One reader of the Premium Service of The Institutional Risk Analyst said last week: "I am a very satisfied subscriber and appreciate and value your reports. Quite frankly, it has been your writing that has kept me from investing any of my clients wealth into bank stocks." Now to be clear, it is not that we dislike bank stocks per se , but we are very cautious about investing in financials when the open market intervention of the FOMC, or lack thereof, is the key determinant in bank results. The Fed boosted short-term earnings with QE and suppressed credit expenses for lenders by boosting asset prices – all asset prices. Now we are reversing this process, but bank interest earnings remain 30% below 2019 levels. It is an open question when or even whether banks will be able to rebuild these revenues. Source: FFIEC As we assess whether or not to re-enter certain names in financials, the key calculous involves first determining how run-rate revenues and earnings are likely to look as the FOMC raises interest rates and allows the system open market account (SOMA) to run off. Given that the Fed still has yet to start that latter process, we think that JPM’s estimate that we give back $10 trillion in paper wealth this year may be a tad low. Why? Because magnitude of the Fed’s folly is large enough to force a general price reset for many assets, this as living expenses are rising. A number of readers were appreciative of the post we published about the mechanics of QE and, the opposite, quantitative tightening or QT (“ Chairman Powell's Duration Problem ”). Yet we still don’t think most analysts understand what the end of this “extraordinary” policy implies for equity market valuations. This confluence of open-market manipulation by the FOMC and falling asset prices suggests that deflation, not rising prices, is now the chief concern. “Duration of UMB 2.5s was 4 when they were originated at 102,” notes mortgage veteran Alan Boyce . “Now they trade at 90 and the duration is 12.” Extend that comment from Boyce to the entire housing complex of some $15 trillion in residential and commercial assets, and you begin to understand the scope of the adjustment problem created by QE. The extension of the duration of the Fed’s $2.7 trillion in mortgage-backed securities illustrates the dilemma facing the FOMC. As interest rates have increased, the “weight” of the duration on the markets has grown three-fold in just the past year. This change is forcing down securities prices and creating huge losses on the books of the central bank as well as investors in loans and MBS. The Treasury yield curve and swaps are shown below. Source: Bloomberg Note that dollar swaps are still trading inside of Treasury yields, a slight improvement over the past six months. Demand for dollar assets remains brisk, but notice that short-term swaps are at a premium, suggesting an excess of demand for risk-free collateral. This has implications for the economy and credit conditions. Analysts have taken to comparing the present period to the 1980s, when former Fed Chairman Paul Volcker took up interest rates dramatically. The Federal Reserve board led by Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. But this time is very different because of the grotesque size of the Fed's balance sheet. Zoltan Pozsar is reported to have said : “Fed won’t be intimidated by asset price corrections, but rather emboldened by them to do more.” If that is the case, then we look to see a far deeper correction in asset prices as the Fed's pushes $30 trillion worth of mortgage risk exposure, measured by duration , down the throats of depositories and non-bank lenders. The lenders that created residential loans in 2020 and 2021, for example, are short a put option to the owner of the home. The holder of the mortgage may pay off the loan at any time and without penalty. During the past two years, just about every mortgage loan in the US was in the money for refinance. The big question is whether the rush for safety will accelerate the timing of the reset in residential housing, which we still see as being at least 24 months off. Since interest rates are rising, the mortgage loan made in 2020 is no longer in the money for refinance, so no problem. Right? But the lender is also long credit exposure to the borrower. As interest rates rise and asset prices eventually fall, these QE-era loans will trade at a sharp discount and the true credit profile of the borrower will come back into view. All of those FHA borrowers that migrated into conventional loans, for example, will show their true credit characteristics in a recession in 2023 and beyond. Many loans made during 2020 and 2021 on the strength of rising asset value will now be re-priced to adjust for falling asset prices, whether we are talking about a home or crypto or margin loans on shares in Softbank (SFTBY) or Tesla Motors (TSLA) . The reduction in the Fed's balance sheet is the largest ever margin call on equity exposures of all descriptions. And the FOMC has not even begun to shrink the SOMA, suggesting that calls last week about the end of the bear market may be a bit premature. The mere suggestion of an end of growth in FOMC securities purchases has caused equity markets to crash. The FOMC “intends to reduce the Federal Reserve's securities holdings over time in a predictable manner primarily by adjusting the amounts reinvested of principal payments received from securities held in the System Open Market Account (SOMA). Beginning on June 1, principal payments from securities held in the SOMA will be reinvested to the extent that they exceed monthly caps.” As the QT process begins in a week’s time, we expect to see the global money markets slowly tighten, especially when the Treasury returns to the markets for the next refunding operation. Production of mortgage-backed securities is likely to continue to fall as mortgage interest rates rise, thus the end of Fed purchases is likely to be a non-event in a dwindling market for risk-free collateral. The return of duration to the money markets, as represented by the opportunity to earn a return via rising interest rates, has provided an alternative to stocks, real estate and other speculative assets. The opportunity to take returns off the table and exit into risk free assets at positive yields is likely to continue to attract additional flows out of equities in the near term. Medium to longer-term, look for signs of a correction in high-end home prices as a signal that a housing price correction has begun. More reading: Fear and Loathing in Mortgage Land National Mortgage News https://www.nationalmortgagenews.com/opinion/fear-and-loathing-in-mortgage-land Regulators Add to Rising Market Risk Zero Hedge https://www.zerohedge.com/news/2022-05-11/regulators-add-rising-market-risk

May 18, 2022 | Premium Service | As the Federal Open Market Committee raises interest rates and ends the massive purchases of securities under quantitative easing or QE, the liquidity is running out of the global capital markets. Readers of The Institutional Risk Analyst know how this movie ends. Bond spreads are widening and new issue volumes are falling like a rock. The vast output gap in global GDP caused by the Ukraine War is being exacerbated by the FOMC’s actions, only confirming our view that deflation remains the key risk to the US economy as 2022 progresses. Even as new bond issuance volumes are falling, spreads on high-yield securities are rising, a danger sign for the US economy and also the equity markets. Once HY credit spreads rise above 500bp over the Treasury curve, this indicates that the capital markets are not functioning properly. The sharp increase in credit spreads since January 2022 has resulted in a decline in equity valuations, wiping out trillions of dollars in aggregate paper wealth. The 3.5 trillion yen (about $27 billion) loss by the Softbank (SFTBY) Vision Fund illustrates the losses being taken by many investors that foolishly deployed cash into various crypto frauds and aspirational stocks, both public and private. Below we discuss how these negative trends are likely to affect specific sectors as the year progresses. Crypto Assets We will dispense with any analysis of specific crypto assets. The key thing for investors to appreciate is that crypto made sense as a tactical speculation only so long as interest rates were at or near zero. Due to the actions of the FOMC and global central banks, rising interest rates are again creating competition for short-term assets. Both crypto and speculative stocks will now suffer. “Crypto’s an innovation that seems likely to be dead before FASB can determine their proper accounting procedure,” notes Fred Feldkamp . “As mortgage derivatives were the mass destruction devices of 1985-2008, crypto looks like the candidate for that distinction in the decades of a 0-bound Fed.” Once interest rates began to rise, the zero carry crypto schemes began to collapse like any Ponzi-type speculation. The illusion that bitcoin and/or the various other coins could serve as a payments medium has also evaporated once Ether's stable coin fraud broke down. Incredibly, some members of the crypto crowd are now looking for a federal bailout. The post below from Twitter pretty much summarizes the situation. Fintech Our general thesis about the process of QT and reducing liquidity in the financial system is that the stocks and assets that benefitted the most from QE and the investor mania it caused will now see similar price reductions. The mark-to-market on the Softbank (SFTBY) portfolio, to take an example, begins to approximate the mark-down required in similar pools of assets. Q: What do Elon Musk and Masayoshi Son have in common? Gigantic margin loans tied the the equity of their respective firms. SFTBY bottomed at a 52-week low, but bounced to finish the week just below $20. Given that the FOMC has only just started the tightening process, we’d be reluctant to add this name to our portfolio at this stage. The same dynamic that made SFTBY soar in past years is now dragging the heavily leveraged firm down as the value of it’s portfolio falls. “The risk was magnified in mid-March when shares in Jack Ma’s company dropped to $73, the lowest level since 2016. On that day, SoftBank came ‘insanely close’ to a $6bn margin call on the loan borrowed against Alibaba’s shares, according to one person familiar with the situation,” reported the FT last week. It is interesting to note that the Chinese authorities rescued Son and SFTBY, illustrating the close ties between Son and Beijing. This illustrates one big reason why the US government does not trust this organization. In that regard, we continue to wonder whether Masayoshi Son will be forced to sell Fortress Investment Group , which is the manager of mortgage giant New Residential Investment (NRZ) . As we noted earlier, the Committee for Foreign Investment in the US (CFIUS) blocked SFTBY from integrating FIG when it was acquired in 2017. Founder Wes Edens has effectively retired from FIG, making any sale a difficult proposition given the slowdown in the mortgage sector. We just spent the past four days at the Mortgage Bankers Association Secondary Market Conference in New York City. Suffice to say that much of the industry is for sale, but there is no obvious candidate to roll up the sector. Aspirational mortgage tech names such as Blend (BLND) and Better.com are literally dead in the water with no practical acquiror in evidence. Market leaders like Rocket Companies (RKT) have lost any pretense of a tech valuation and the entire sector is under intense operating pressure. There is a growing problem in the mortgage industry with depositories, mortgage banks and funds choking on loans and servicing assets that are mispriced. Loans produced in Q4 2021 and Q1 2022 are now trading at steep discount. We continue to hear troubling reports of buyers and third-party valuations shops using "cross-sell" opportunities to justify sky-high valuations for mortgage servicing rights (MSRs). Servicing assets likewise are trading at a discount to the official valuations seen in Q1, with several bulk deals now languishing in the secondary market. Names such as PennFed credit union are frequently named as among the more aggressive buyers of 1-4 family loans, including high-risk loans for solar conversions in residential properties. JPMorgan (JPM) has been among the most aggressive buyers of MSRs, but from a very selective perspective in terms of price and composition. Most of the assets are either jumbos or large balance conventionals. TIAA has been among the most aggressive sellers. A host of foreign and regional banks have recently entered the sector to finance MSRs, never an encouraging sign. We sold our position in REIT Annaly (NLY) last week and have been adding to our position in Nvidia (NVDA) as well as some of our bank preferred positions, since many of these names are now trading below par. Our view of the tech world is that companies with real profits and revenues are going to weather this storm far better than the aspirational names. The situation with Twitter (TWTR) is a case in point since the stock peaked three times in the past six weeks, apparently as discussions with Tesla Motors (TSLA) founder Elon Musk began to leak out, as suggested by the movement of the stock. We continue to wonder as to Musk’s true motivation in launching a bid for TWTR, which like most acquisitions announced in the past several weeks is mispriced. Could be simply be attacking TWTR and the large population of bots in the user base? And we agree with Jim Cramer on CNBC that Musk may be compelled to follow through on his agreement with TWTR unless he can demonstrate fraud regarding the number of bots in the social media’s firm’s user base. Our surveillance group for the fintech financials is shown below. We are pondering re-entering names like payments providers like Block (SQ) and Fiserve (FISV) , but we believe that the macro downdraft in terms of the reality of and fears regarding the Fed’s future actions is likely to make all of these names cheaper in the near term. We are going to be patient as the crowd comes back to earth in terms of valuations and earnings expectations. Fintech Group Question? Comment? Do you have a name you'd like to see profiled in a future comment? info@theinstitutionalriskanalyst.com Disclosure: L: EFC, CVX, 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.

May 16, 2022 | In this issue of The Institutional Risk Analyst , we feature a discussion with Dan Sogorka , CEO and President of Sagent Lending Technologies . Payments provider Fiserv (FISV) in 2018 sold a majority stake in Sagent, which includes the Fiserv mortgage servicing business, to Warburg Pincus . We spoke to Dan last week just as New York Stock Exchange-parent Intercontinental Exchange (ICE) announced that they will acquire mortgage software and data monopoly Black Knight (BKI) for $13.1 billion . But the big news at the Mortgage Bankers Association Secondary Conference this year is how lenders will navigate an environment with rising interest rates and also rising levels of loan delinquency. Dan Sogorka The IRA: Dan, thanks for taking the time to speak to us in a very busy week. Let’s start with the obvious and talk about the announcement of the acquisition of Black Knight by ICE. A lot of people were surprised by the deal due to anti-trust questions and the ambitious price as well. But several observers also suggest that the Sagent deal with Mr. Cooper (COOP) played a part in making this marriage come to pass. Do you take this deal as a compliment to Sagent? Sogorka: The COOP transaction did generate a lot of inquiry from Buy Side investors about Sagent and the servicing sector more broadly. The ICE transaction with Black Knight also helps to raise the profile of the sector. I must say, after two years it feels good to be able to report that we have won some big pieces of business. We have state-of-the art technology, a fantastic team and a process to actually meet customer asks. We also have important partners like Warburg Pincus, COOP and other large issuers that want a better solution. The IRA: COOP has a reputation for being savvy investors in technology, but having Warburg Pincus and FISV behind you is also a great endorsement. Of just about any PE firm in the business, Warburg Pincus is known for its success when investing in banks and other financial companies. Most recently they partnered with Varo Bank . We featured a discussion with former Warburg Pincus Vice Chairman Bill Janeway in 2018 (“ William Janeway on Capitalism and the Innovation Economy ”). In terms of highlighting the sector and the need for new solutions for manufacturing and servicing loans, in a way the ICE deal seems fortuitous for Sagent. Sogorka: Our customers as well as both partners and competitors in the fintech space are asking how the ICE deal may play out and whether Washington will delay, kill, or require divestitures. The deal announcement said this will play out into 2023, so time will tell in the coming quarters. Regardless of what happens, Sagent remains committed to the industry and our customers. We are focused on two things (1) executing alongside our customers in the trenches every day to build stable, future-proof platforms for them, (2) staying in the lead on homeowner-first innovation for our industry. Our vision for data-first, cloud-native platforms that connect consumers and servicers in real time across the performing and non-performing loan lifecycles is accelerating each week. As we integrate 200 new Mr. Cooper mortgage fintech specialists into Sagent’s 600-strong team of mortgage innovation experts, we have the best team in the industry. The IRA: We thought the $400 million breakup fee that BKI has to pay ICE in the event was of particular interest. Both ICE and BKI are hyper-acquisitive, heavily levered credits that grew more valuable during the upswing in mortgages, say 2016 on through 2022. Call it half a decade of rebound and then overperformance. Since we are on the backside of the interest rate cycle, don’t these names and the whole mortgage sector come under pressure? The public names in the industry are getting pounded in the options markets. How do you talk to clients and investors about the operating environment and also the financial markets going forward? Sogorka: As I noted, we’re all about being in the trenches with our customers to do the precise work of innovating in this complex sector – which is as much about smart technology as it is about intimately knowing the needs and challenges of servicing operators and their customers. Marrying modern fintech with in-the-weeds operational expertise is Sagent’s special sauce, and it’s our unwavering commitment to servicers. This is how banks and lenders thrive even in acute market cycle adjustments like this. And the more we help them thrive – and operate in a way they see fit rather than forcing them into black-box solutions – the more they can seize on market consolidation opportunities as this cycle plays out. The IRA: Sadly the changes at Ellie Mae since being acquired by ICE have not brought happy news for issuers used to a degree of customization. Can you deliver a hosted, cloud-based service for issuers that is robust and enables them to customize their version of the tool? Much like COOP contributing technology to Sagent? Giving lenders control and accountability over these key tools is crucial. We can see that many large issuers still maintain their own proprietary POS, LOS, etc. How do you deliver this level of custom service and at reasonable cost? Sogorka: Sagent is all about the cloud-native, open-API model giving servicers optionality and cost control. That fintech development mindset is still new for our industry, but it’s the future. It’s how we deliver ongoing, fast innovation at a lower cost without surprises, and without charging customers for tools they do not use. Also, It’s worth noting here that the new technology that powers the Sagent-Cooper vision for servicing is already proven in the market. Mr. Cooper generates customer retention that’s two times the industry average. This clear performance doesn’t just lead to better experience, it also has significant implications for cost savings by not having to re-acquire lost customers. The IRA: As we go through 2022 and the next several years, it seems pretty clear that interest rates are going to be higher for longer than in the post 2008 period. This suggests some pretty big operational and financial challenges in servicing. How does Sagent take advantage of this coming test for distressed servicing across the industry? Does the focus on expense management and loss mitigation help you further grow your share in the industry? Sogorka: The simple answer is yes. We will continue to talk about the need to change the paradigm from merely servicing a loan as a debt collector into something that is more sympathetic and responsive to the consumer – again, it’s all about a customer retention mindset. We think that the need to manage expenses and better interact with consumers will make the industry ask whether they have the right technology for that job and the right technology partners. It is not just about efficiently dealing with troubled mortgages and offering the best options for consumers, but how do we get ahead of the process to give servicers and consumers more time to consider options. The IRA: We learned years ago that keeping the family in the house and helping them to get back on track is always the best course for the consumer, the note holder and ultimately for the US taxpayer, who backs the credit risk on most residential mortgages. While investors are protected, servicers often lose money on foreclosures, even with record high home prices. How does Sagent address this pain point for servicers? Boathouse Row Want to join The Institutional Risk Analyst this Labor Day for fishing and fun at Leen's Lodge in Grand Lake Stream, Maine? Email: info@rcwhalen.com Sogorka: No one wants extended foreclosures. Giving consumers options earlier in the process and making sure these are the right options is, to us, the key to effective loss mitigation. If you don’t have electronic tools that can effectively engage with consumers, then you lose precious time. These are human beings that are going through difficult circumstances. Being able to engage with them, understand their situation and intent, is the key. Doing this via the web or a smartphone is mandatory. Sagent was first to enable digital hardship care as the CARES Act rolled out, and it's because of our digital-native, cloud-native platform. This lets our servicers maintain real-time compliance and customer care during rapidly evolving market and policy changes – this is the world we live in, and Sagent is meeting the moment. The IRA: Tell us a little bit about why Warburg Pincus got interested in mortgage servicing. How did you convince one of the premier private equity firms and investors in financials to dive into residential mortgages? And does FISV stay a minority but still significant investor? Sogorka: Fiserv is still a partner but Warburg Pincus is the primary capital partner. As you know, they’re one of the world’s elite investment organizations, and an ideal partner because they understand the scale and speed required to power America’s $12 trillion housing market. They enable us to think big and execute on our visions to lead innovation in this space. We often say modernizing servicing is the last frontier of the fintech era because it’s the biggest, most complex operationally, and the most regulated. Having a lead partner like Warburg Pincus who truly understands this means we can keep going fast on making innovation a reality. The IRA: For FISV, it obviously is a huge plus to have a credible partner like Warburg Pincus and now COOP in the mix and helping support the investment required, especially as the industry goes through a down period. As we go through this year and 2023, what is the message to the mortgage industry from Sagent as we approach the MBA Secondary? Sogorka: With the recent transaction with COOP, we have a lot more tools to talk about with clients, tools that are highly relevant to an environment where credit and compliance only grow in importance. We’ve also brought on a lot of deep industry talent in the servicing space to support client implementation and execution. We are not going to hand you a proprietary tool and tell you to figure it out yourself. As I’ve said, we’re in the trenches with you to help you redefine how you perform servicing and actually make it a profitable business for your organization. We have found that consultative approach is what the industry wants and it is central to how we approach the market. The IRA: And you are fully committed to an open source architecture? This is an industry that builds its own tools. Sogorka: Yes, completely. We’ll show you what is possible today, what new products we’re delivering shortly and how you, the customer, can decide how to create your servicing and loss mitigation process to your specifications. The industry hasn’t had this before, and with Sagent, now they do. We start with a very different perspective, which is to listen to the client and tell them how we can build and maintain the platform that they want today and tomorrow to be cost effective and compliant. If they want a certain set of third-party tools added to the mix that they believe are best-in-class, we make it happen in a cost effective way. The IRA: As Henry Ford said about the Model T, you can have any color you want as long as it is black. Thank you for your time Dan. Enjoy the MBA.

May 12, 2022 | In this issue of The Institutional Risk Analyst , our friend and co-author Fred Feldkamp talks about Paul Volcker, volatility, inflation and honesty. Fred is a retired Partner of Foley & Lardner in Detroit , where he spent decades advising clients in the world of secured finance. Fred is a veteran securities counsel who was "in the room" for the salvation of General Motors in the early 1990s and many other significant transactions. He acted as counsel for the first private securitization of residential mortgages in the early 1990s is responsible for helping to define the modern concept of true sale. Many years ago, I spent a couple hours with former Fed Chairman Paul Volcker (1927-2019). I doubt he’d remember it. During the conversation, I explained how much I appreciated the path he chose to stop inflation in the late 1970s. He was surprised. Few people, it seems, had so openly thanked him. During our conversation, I explained that the US was facing an accumulation of inflation pressures dating to the 1942 decision to spend “whatever it takes” to win WW II by producing materials under “cost plus” contracts with suppliers. That policy was correct. It led to victories over: (1) totalitarians in Germany, Japan and Italy and (2) deflation generated during the Great Depression. What led to inflation was our national lack of willingness to “stop” when a “good” idea became stupid. Inflation arose by our unwillingness or inability to end the “sugar high” created by government expenditures, spending funded with borrowings rather than by the imposition of responsible taxation. As conditions worsened, those responsible refused to “come clean” and change course. Volcker’s commitment to honesty forced recognition of our flaws. He refused to continue to “hide” nearly three decades of political failure and raised interest rates into double digits to force a change of course for an entire nation. I thanked him because raising interest rates forced homebuilders to create more efficient ways to fund home mortgages. The nation’s commitment to honesty weakened after Volcker retired. We went on a mortgage binge in the mid-2000s to give everyone a home while hiding the increased debt “off balance sheet.” We spent “whatever it takes” to end the Great Recession that started when the US “subprime mortgage crisis” became a Global Financial Crisis. In 2001, George W. Bush committed to spend “whatever it takes” to fight terrorism, but refused to raise taxes to pay for that commitment. President Barack Obama deserves no flak for spending what W forced on him after missing all the pre-2008 signals of the impending crisis. By 2007 (6 years into W’s admin), the best folks at FASB agreed with me that fraudulent accounting had accumulated more than $30 trillion of unreported systemic bank liabilities globally. During that time, I advocated a need to resolve that threat long before a collapse of capital would force stock markets over the “cliff” as in fact occurred in 2008. Through the years of President Obama, American financed domestic spending and a global war on terror with debt. Political infighting again precluded responsible taxation to cover the accumulated costs. In 2017, President Donald Trump actually lowered taxes despite higher US expenditures at home and abroad. President Trump battled to close the door on immigration, this in a mistaken belief that immigrants “take jobs” from “us.” Incredibly, Trump would have us all believe that immigrants do not spend what they earn within the domestic economy. In 2020, after Trump refused to listen when COVID could have been slowed by steps that have worked since the mid-1300s, he triggered an epidemic that required spending “whatever it takes” to prevent another depression. We added trillions more to the federal debt. In total, "W" and Trump borrowed and wasted more than $15 trillion of taxpayer money to finance domestic priorities and foreign wars. GOP leaders now seek to blame President Joe Biden because he used roughly $1 trillion to rescue the nation from the disaster Trump left behind due to COVID. Benevolence, as Chris and I noted in our book " Financial Stability: Fraud Confidence and the Wealth of Nations, " always gets you more bang for the economic buck than being miserable. In the early 1980s, rising interest rates forced homebuilders to spend for the creation of stand- alone collateralized mortgage obligations (“CMOs”). Since 1983, that innovation has changed the world of finance. When the Global Financial Crisis hit in 2007-8, that model allowed the US bond market to create a system for financing all forms of investments without reliance on credit support from entities insured by the government. As a result, I told Mr. Volcker that his “honesty made my legal career.” When I met with Mr. Volcker, we also discussed abusive derivatives of CMOs that were partly responsible for numerous crises after 1983. Most notable was the “Companion Class” CMO debacle that bankrupted Kidder Peabody and threatened General Electric (GE) in 1994. Fed Chairman Alan Greenspan replaced Paul Volcker in 1987. In 1994 he decided to raise rates to “discipline speculation” and almost caused a recession. By the nature of their structure, Companion Class CMOs immediately extended in maturity and, of course, collapsed in value when the Fed raised interest rates. Any debt supported by the instruments collapsed in turn. Kidder Peabody had loaned holders of the securities a lot of money on security of pledged Companion Class instruments. The loans could not be collected and, within a year, most Kidder Peabody employees worked elsewhere and the firm’s name ceased to be used. General Electric owned Kidder, but avoided reporting its loan losses by putting the impaired assets in an investment portfolio that was not “marked to market.” CMO technology is now applied to all sorts of markets around the world. That has eliminated a lot of “systemic risk” among insured depositories. But undisclosed losses are still losses. The Fed now has the same problem as faced Kidder Peabody decades ago. By the impact of market losses by Rivian (RIVN) , we are now seeing Ford (F) and Amazon (AMZN) being forced to recognize loss on those investments . Does that mean market losses of the past week will be reported as further write-downs among firms that invested in the firms that suffered loss? If so, could this trend generate a chain reaction of still more losses as past investment losses are reported? Not if we remember the rule of benevolence. Investors and advisors should support a measured approach to taming today’s inflation, as recommended to Fed Chairman Jerome Powell by this Sunday NY Times editorial. https://www.nytimes.com/2022/04/29/opinion/inflation-interest-rates.html Chairman Powell has made clear that the FOMC is not entirely sure how to wind down the extraordinary accommodation of recent years. If honesty of valuation increases the volatility of markets, the losses may accelerate a reversal of inflation expectations. Inflation is a very significant problem today, and better disclosure and higher risk spreads may “self correct” inflation pressures. The best course for the Fed to pursue today would seem to be a measured pace that allows for change and adjustment.

May 10, 2022 | Premium Service | Just as the financial markets selloff gained momentum last week, the folks at New York Stock Exchange-parent Intercontinental Exchange (ICE) announced that they will acquire mortgage software and data monopoly Black Knight (BKI) . The deal values the software and data analytics firm at $13.1 billion. This price is a bit of a bump from the $1.8 billion valuation in May of 2015, when BKI was spun-out from title insurance giant Fidelity National Information Service (FIS) . The equity market value of BKI peaked at $15 billion in October of 2020 and has been sliding ever since. When Mr. Cooper (COOP) announced its strategic relationship with Sagent M&C in February 2022 , BKI’s valuation fell by $1.5 billion in a matter of days. ICE is catching the falling knife of Black Knight. To us, if this deal ever closes, the value of ICE + Black Knight may be less than the sum of the parts today. Like the mortgage market they serve, the valuation of both of these companies is likely to fall as the year progresses, putting added pressure on a deal that will not close at the earliest before Q1 2023. Recall the torment of Better.com and the IPO via SPAC , another deal that may never close. We view this transaction as ICE rescuing BKI from a rapidly swooning mortgage sector. As this issue of The Institutional Risk Analyst went to press, loanDepot (LDI) had just reported a huge loss for the first quarter, caused by a significant swing in volumes and loan production income over just 12 months. We'll be strolling in particular through the wreckage of the mortgage sector in future issues. Given the trends in interest rates, volume for BKI’s loan origination tools is likely to fall during 2022 and beyond. Lenders issued $859 billion in mortgages in the first quarter of this year, down 25% from a year ago. Every month, the MBA and GSEs are revising down their loan volume estimates for 2022. Both ICE and BKI make money on volume. BKI is the incumbent legacy provider of servicing software for the mortgage industry via the old Loan Processing Services (LPS) platform, now known as MSP. Despite a market approach optimized to defend the company’s monopoly position, BKI’s place in the industry is being eroded by new technology and the emergence of more agile competitors. These firms offer better, cheaper and faster solutions that are evolving towards a flat rate, all you can eat model. The huge financial investment needed to truly change the mortgage industry has not exactly attracted capital to the sector. This is precisely why the larger and more profitable FIS spun off the BKI business almost a decade ago. Likewise payments provider Fiserve (FISV) in 2018 sold a majority stake in its loan servicing business to Warburg Pincus . Yet notice in the chart below that BKI and ICE outperformed FIS as well as FISV in the equity markets, a situation that correlates to low interest rates that we expect to see reversed as extraordinary policy by the FOMC ends. Source: Google Finance ICE describes the BKI transaction as a bold new initiative. We see another acquisition by ICE at an excessive valuation for a business that could easily decline or even disappear over the next decade. The destruction of shareholder value at ICE, starting with the Ellie Mae transaction and now with BKI, is truly mind boggling. In both cases, the leadership of ICE is overpaying for the asset, but without a clear goal in terms of really effecting transformation in an industry that stubbornly resists change. ICE’s fascination with the mortgage industry goes back many years, but was really accelerated by the 2020 acquisition of Ellie Mae from Thoma Bravo . ICE paid $11 billion for Ellie Mae, a provider of loan origination software (LOS). Thoma Bravo had paid just $3.7 billion to acquire Ellie Mae for cash only a year earlier. ICE then proceeded to cut spending on development and other areas at Ellie Mae in order to achieve cost synergies, gradually eroding the company’s position as a trusted partner for smaller lenders. On an earnings call in 2020, CEO Jeffrey Sprecher described ICE as “building the clearing house for the mortgage industry” and said the residential mortgage market “could prove to be another important chapter in ICE’s 20-year evolution.” Other than driving earnings growth via expensive acquisitions, however, ICE does not seem to be creating a lot of value for shareholders and especially not in residential mortgages. It could take ICE a decade or more to recover its investment in BKI, assuming that the target's revenues do not deteriorate. Both ICE and BKI are very acquisitive firms that remind us of the Cisco Systems (CSCO) of old, which bought new networking companies by the dozens. In many respects, the investment operations of ICE and BKI are more impressive than the operating results. BKI has done handsomely on its stake in Dunn & Bradstreet , for example. Yet the irony of the ICE acquisition of BKI is that eventually the Ellie Mae business could be written down to zero in the rapidly evolving market for mortgage services. Whereas ICE looked for $50 million in costs savings and “synergies” from the Ellie Mae transaction, the BKI acquisition involves an estimated $350 million in cost reductions, including $200 in cost savings and $150 million in “revenue synergies.” And most of the cost at BKI is people. Antitrust Issues The first obvious objection to the acquisition of BKI by ICE is anti-trust. The transaction has "significant" risk of antitrust issues and there likely aren't any simple remedies, according to Patrick O'Shaughnessy at Raymond James (RJ) . The Ellie Mae Encompass platform is the largest provider of loan origination software (LOS), while BKI's Empower is the "clear #2" LOS, according to RJ. "Our specific concern is that U.S. regulators are already calling out the lack of competition amongst technology providers to the consumer finance area," O'Shaughnessy wrote in a note last week. Add this concern to the fact that BKI has been involved in several litigations with servicing clients, including PennyMac Financial Services (PFSI) , which include claims for anti-competitive behavior. In a similar vein, Piper Sandler wrote: “PFSI and BKI continue to have lawsuits against each other whereby BKI alleges that PFSI stole its IP when it created its own servicing system, and PFSI alleges that BKI used monopolistic business practices. Considering there are anti-trust concerns with this merger, it's possible ICE/BKI may be pressured to remove the overhang of these lawsuits in order to finalize the merger. We note BKI's lawsuit requests compensation of $300M. Ending these lawsuits could give PFSI more flexibility with utilizing its servicing technology.” Given that BKI has a monopoly on the provision of software and data to the servicing sector and the #2 loan origination software, just how does ICE expect to navigate the approval process with Joe Biden in the White House? Keep in mind that the investigators from the Federal Trade Commission and Department of Justice can easily gain access to confidential settlements between BKI and other parties, settlements that almost invariably involved releases of claims for anti-competitive behavior. Technology Issues Leaving aside the significant anti-trust issues raised by the transaction, ICE’s purchase of BKI seems to be another exercise in value destruction. Despite the huge among of time and financial resources that ICE has invested in the mortgage sector, there seems to be little to show for it save a series of expensive acquisitions of mature technology providers. “Since our founding in 2000, ICE’s simple mission has been to make analog and opaque financial transactions more digital and transparent, beginning with commodity markets, extending across a large array of asset classes, and most recently working to help streamline the mortgage industry,” said ICE founder and CEO Sprecher. So far, ICE and many other vendors have not been able to “streamline the mortgage industry,” as Mr. Sprecher declares. Acquiring mortgage registry MERs has hardly resulted in a revolution. Firms like Ellie Mae and Black Knight represent yesterday’s technology and linear manufacturing models for loans that literally stretch back in time to Henry Ford and the Model T. ICE buying the revenue streams represented by BKI is a big bet on yesterday, not a bold initiative to change the future of residential lending tomorrow. The technology platform used by BKI stretches back to the dawn of the computer era, one reason why users of BKI servicing and LOS tools report that they are unable to customize components required for tasks like distressed servicing. The lore of the mortgage industry says that BKI will not integrate any tool they do not own. But the truth is that the ancient, COBOL based mainframe computer technology employed by BKI makes customization impossible. We suspect that BKI sold themselves to ICE when it became apparent that a combination of sharply lower volumes and a renewed challenge from Warburg Pincus portfolio company Sagent, which embraces open source and will customize its tools to meet client needs. Like many legacy computer systems in the world of finance, there is no way to transition these systems to newer technology without a massive investment. This was, after all, why FIS spun off BKI and FISV spun Sagent, to avoid the capital drain and political risk of the mortgage market. Financial Factors Of the three segments at ICE, exchanges, data and mortgages, the latter is the least significant prior to the BLK acquisition. The ICE segment data for mortgages is shown below. Notice that the revenue for the ICE mortgage segment was down 13% year-over-year. With BKI, the financial outlook is even less rosy. The firm carried a lot of revenue and volume into Q1 2022, but its all down from here. Like its clients, the results of BKI are highly correlated to the movement of interest rates and the economy. BKI also goes into the transaction with $2.7 billion in debt, including $1.7 billion that is priced at +150 to LIBOR. The table below comes from the Q1 2022 BKI earnings presentation. In February 2020 BKI completed the acquisition of Optimal Blue from co-investors Cannae Holdings and investment entities affiliated with Thomas H. Lee Partners . Optimal Blue offers a relatively new marketplace platform and related data and analytics. BKI will describe the Optimal Blue investment as evidence of innovation, but in fact BKI was simply taking out a younger, more agile competitor at a very full price. Another example of this defensive, monopolistic behavior by BKI was the acquisition of eMBS. BKI acquired eMBS and two other small competitors in Q1 2022 alone. Looking at the dismal results for the mortgage industry in Q1 2022 and the outlook for even worse in Q2 2022 and the balance of the year, it is hard to put a positive face on this acquisition. We expect to see a lengthy and problematic review process by the Biden Administration, which may require BKI to sell significant assets and settle all outstanding litigation before the transaction closes. But more, as the financial results for BKI deteriorate in coming quarters, we think ICE management will come under growing criticism for tying the company’s future so closely to the mortgage industry. Until this transaction closes, both companies will be held hostage to the movements of the respective stocks. “If the Merger Agreement is terminated under certain circumstances, we may be required to pay a termination fee of $398 million to ICE and/or we may be required to reimburse ICE for its reasonable and documented out-of-pocket costs and expenses incurred in connection with the Merger Agreement and the Merger in an amount not to exceed $40 million,” BKI notes in its most recent 10-K. Stay tuned. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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May 9, 2022 | Watching the huge fuss coming from the ranks of professional equity managers, you’d think we are in some sort of financial meltdown a la 2008. In fact, stock prices have returned to pre-COVID levels, hardly a catastrophe. Considering that the FOMC has yet to actually do anything save raise the target for Fed funds 50bp, the reaction of the markets seems a tad overdone. After all, the FRBNY will still be reinvesting the redemptions and prepayments on the system open market account or SOMA through June. As we noted in our comment last week, Fed Chairman Jerome Powell’s press conference was more interesting than usual. Powell, you see, actually understands much of the financial markets subject matter that is so pressing upon the considerations of the FOMC. Sometimes he says things in person or in the Fed transcripts that are quite important, but these little gems are usually missed by the generalist media that covers the central bank. Powell said with respect to the runoff: “Consistent with the principles we issued in January, we intend to significantly reduce the size of our balance sheet over time in a predictable manner by allowing the principal payments from our securities holdings to roll off the balance sheet, up to monthly cap amounts. For Treasury securities, the cap will be $30 billion per month for three months and will then increase to $60 billion per month. The decline in holdings of Treasury securities under this monthly cap will include Treasury coupon securities and, to the extent that coupon securities are less than the monthly cap, Treasury bills. For agency mortgage-backed securities, the cap will be $17.5 billion per month for three months and will then increase to $35 billion per month. At the current level of mortgage rates, the actual pace of agency MBS runoff would likely be less than this monthly cap amount.” While the FOMC is able to plan the runoff of its Treasury portfolio with precision, the variable nature of the duration of the Fed’s MBS portfolio creates a lot of uncertainty. Thus the last sentence of Powell’s statement confirms that the natural rate of runoff of the $2.7 billion MBS portfolio is well-below the $35 billion monthly cap, suggesting to many Wall Street bond analysts that outright sales will be required next year. Since much of the Fed’s portfolio is comprised of agency and government MBS with 2% and 2.5% coupons, any sales will imply a loss of 10-15 points for the FOMC’s account. Naturally the little nuance about losses on the portfolio flew right over the heads of most journalists at the FOMC presser, who as a group prefer the vague but promising world of monetary policy to the mechanics of the financial markets. Thus when Powell told the audience that the FOMC is essentially flying blind when it comes to adjusting the three variables of policy, few journalists in the room reacted. Powell said: “So typically in a recession, you would have unemployment. Now you have surplus demand. So there should be room in principle, to reduce that surplus demand without putting people out of work. The issue will come that we don’t have precision surgical tools. We have essentially interest rates, the balance sheet, and forward guidance, and they’re famously blunt tools. They’re not capable of surgical precision.” Much like the Russian bombs and missiles being employed in the pacification of the Eastern Ukraine, Fed monetary policy is a very blunt tool. Especially when the FOMC is unsure how to calibrate changes in the SOMA with other policy tools such as rate targets and forward guidance. Forward guidance does not count for much when a crowd of equity investors is headed for the door all at once. If you think for a moment, once we dispense with forward guidance, the two remaining components of FOMC's proverbial toolkit hardly inspire great confidence. During a response to a question from no less than Michael McKee of Bloomberg News , Powell let slip the proverbial bomb that zoomed high over most heads in the room. He basically told the global markets what the readers of The Institutional Risk Analyst have known for years, namely that once you go down the dark road of massive bond purchases via quantitative easing or "QE," you cannot retrace your steps without potentially horrid consequences. Powell said: “I would just stress how uncertain the effect is of shrinking the balance sheet. You know, we, you -- we run these models, and everyone does in this field, and make estimates of what will be the -- how do you measure, you know, a certain quantum of balance sheet shrinkage compared to quantitative easing? And, you know, these are very uncertain. I really can't be any clearer. There won't be any clearer. You know, people estimate that broadly on the path we're on, and this is -- this will be taken, probably too seriously. But sort of one quarter percent, one rate increase over the course of a year at this pace. But I would just say with very wide uncertainty bands, very wide.” As we and our friends at ZeroHedge noted some years ago, the Fed has been acutely aware of the “duration problem” caused by QE since 2016. This technical issue has to do with the variable nature of the maturity of mortgage backed securities, but also in the way in which central banks manage their securities portfolios overall. We wrote in The Institutional Risk Analyst back in 2017 (“ Banks and the Fed’s Duration Trap ”): “Since the Fed and other sovereign holders of MBS do not hedge their positions against duration risk, the selling pressure that would normally push up yields on mortgage paper and longer-dated Treasury bonds has been muted. Thus the Treasury yield curve is flattening as the FOMC pushes short-term rates higher because longer-dated Treasury paper, interest rate swaps or TBA contracts are not being sold, either in terms of cash sales by the FOMC or hedging activity.” Like the big banks post London Whale and the Volcker Rule, the Fed’s portfolio is totally passive. There is no attempt to manage for duration or hedge, much less the more obvious public policy goals of regulating inflation. This is an odd situation given that Board staff has explicitly recognized the impact of changes in the size and composition of the SOMA. As we said to David Andolfatto et al on Twitter a while back, maybe the FOMC should manage the SOMA for a duration target. Publish same in the Minutes? We were the first writers in 1993 and the good works of Rep. Henry B. Gonzalez (D-TX) . Read about those years in Tim Todd's book, " A Corollary of Accountability: A History of FOMC Policy Communication ." Rather than merely selling securities for cash, an obviously painful policy choice, why not instead think about changing the duration of the Fed’s portfolio? That swap with the Bank of Japan we suggested earlier beckons. That said, any embedded loss in the Fed’s bond portfolio should not be a major concern for analysts who truly appreciate the relationship between the US Treasury and the central bank. The fact is that QE is and always was an expense to the Treasury, proof positive that the two legally separate agencies are actually faces of a single godhead. Robert Eisenbeis of Cumberland Advisors clarified the issue in a December 2017 interview (“ The Interview: Bob Eisenbeis on Seeking Normal at the Fed ”): “The Fed almost by definition cannot make a profit. It baffles me how people inside the system can fail to see the accounting reality here. The Fed issues short term liabilities to buy Treasuries taking duration out of the market. The Treasury makes interest payments to the Fed who takes out its operating costs, including interest payments on reserves and returns the remainder to the Treasury. If this intra governmental transfer were settled on a net basis like interest rate swaps, there would always be a net payment from the Treasury to the Fed.” Notice that Eisenbeis, who headed Research at the Atlanta Fed, properly identifies that the Fed has withdrawn duration from the market. But the thing that rightly worries Chairman Powell and other properly focused members of the FOMC is the uncertain calculus that attaches to attempts to manage down the size of the Fed’s balance sheet. Let’s review how this works, first with QE and then quantitative tightening or QT. With QE, the Fed of New York purchases securities in the secondary market from the primary dealers, part of the illusion of separateness between the Fed and Treasury. The Fed takes delivery of the security and credits the reserve account of the bank, which in turn records a new “deposit” either for itself or a customer. The reserves at the Fed earn interest and are cash for all purposes. As of the May FOMC meeting, the Fed has stopped buying new securities for the SOMA, but is still reinvesting redemptions of Treasury debt and MBS, including prepayments and insurance payments from the GSEs and FHA, VA, etc. In terms of cash, the mortgage related payments to the SOMA ultimately are paid by the Treasury. Importantly, so long as the Fed continues to reinvest redemptions, the Treasury does not need to refinance the bond in the private market. With QT, the Fed stops reinvesting principal and interest payments. The Treasury redeems the bond and gives the Fed cash, which reduces its balance sheet by a like amount of reserves. The deposit on the books of the bank disappears, however, because the Treasury, which is running a deficit, must now refinance that bond in the private market. The bank or a customer buys the new Treasury bond, but the deposit disappears and the bank shrinks. Part of the difficulty in figuring out how to manage balance sheet shrinkage is the fact that as the Fed’s balance sheet runs off, banks must start to migrate away from reserves at the Fed for liquidity purposes and back into Treasury debt and MBS. Banks and other investors hedge these positions, creating new selling pressure in longer-dated securities at just the moment when selling pressure is already soaring. Taking down the SOMA is a process that is, by definition, problematic. Note in the chart above that the Treasury General Account at the Fed, which is another factor in the FOMC monetary policy mechanics, is back up to just shy of $1 trillion. This account is collateralized with Treasury debt. Meanwhile, do note that the short-term money markets are still signaling deflation, with the bid on the Fed’s reverse repurchase facility falling through the market volatility last week as demand rises. "Overnight funding rates plunged below the Federal Reserve’s new target range on Thursday as cash returned, overwhelming a market that’s already short on investable assets," reported Alexandra Harris of Bloomberg News . She reports that GCF repo rates fell to just 0.6% last week. "Demand for the Fed’s overnight reverse repo facility rose Thursday, as 86 counterparties parked $1.85 trillion, just off the all-time high of $1.91 trillion reached on April 29." As the SOMA shrinks, the $8 trillion in bond market duration supported by the Fed will shift back to the banks and primary dealers, especially in longer dated Treasury paper and MBS. We worry that Chairman Powell and his colleagues are still focused on managing a difficult financial process with SOMA as though it were a monetary policy narrative. The two things are not the same, as we proved in September 2019 and December 2018. Chairman Powell’s demeanor during the press conference when he spoke with Mike McKee suggests a man who knows that he has a problem with the balance sheet. If the Fed starts to actually reduce its portfolio next month and shifts this duration back into the hands of banks and private investors, the weight of duration on the system will increase selling pressure in the bond market in ways that defy expectations. Meanwhile, buying pressure in the short end of the Treasury curve says that deflation remains the ultimate issue facing the FOMC.