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"Without price stability, the economy really doesn't work for anybody." Jerome Powell May 4, 2022 | Premium Service | In this issue of The Institutional Risk Analyst , we return to the topic of interest rates, credit and mortgage assets. For the past several years going back to April of 2020, the housing market has been turbo-charged by quantitative easing or QE, pushing interest rates and loss-given default (LGD) down to negative levels. BTW, we just updated our latest paper on Ginnie Mae mortgage servicing assets . With the increase in interest rates now set in motion by the FOMC, which moved by unanimous vote this month, our assumption is that credit default expenses for banks and bond holders will begin to revert to the mean. This repricing of risk will take time, perhaps several years. But if we assume that the FOMC means to wring the inflation out of the system, then the outlook for short-term rates – and credit over the medium term -- is decidedly bearish. When LGD on a mortgage loan or secured bond is negative, that means that after a default, the proceeds generated upon liquidation exceed the original amount of indebtedness. In 2009, LGD on the average 1-4 family mortgage was 80-90% vs the 40-year average of 65%. Twenty three years and 5 QEs later, LGD on prime bank owned 1-4s is essentially zero and inflation is in double digits. As the FOMC raises interest rates significantly for the first time since 2008, we see major inflection points coming in credit as well as interest rates. The chart above from Bloomberg illustrates how strongly the FOMC has been holding down the short end of the curve. This chart also symbolizes the degree of inflation in asset prices that the Fed has facilitated, an important relationship that is now about to change. Since default rates were muted during the entire decade of the 2010s, the mean reversion could be far larger than expected. As the FOMC raises the target rate, the short-end of the curve will adjust accordingly. But everything from 2-year Treasury notes on out is above 3%. Obviously, the FOMC is behind the curve both figuratively and actually. This is perhaps one reason why St Louis Fed President James Bullard and others on the Committee are calling for faster action by the FOMC. Consistent with his strategy, Chairman Jerome Powell continues to move deliberately. We interpret Powell’s caution as a recognition that the US market cannot tolerate a very significant upward move in short-term interest rates. This caution is reflected, we believe, in the average structure of the infamous dot plots, which show Fed Funds rising to less than 3.5% through 2024. Listening to the press conference, it seems pretty clear that the "transitory" view of inflation is alive and well. Powell is slow walking inflation fight to avoid a market meltdown. Even the modest pace of change, however, suggests much higher long-term interest rates and a recession ahead. Even as Powell signals willingness to take interest rate targets higher, he has put off a decision on the Fed's balance sheet until June. That is perhaps one of the most important take-aways from this Fed meeting. Mortgage Servicing Rights The table below shows the mortgage servicing rights (MSR) results for JPMorgan (JPM) , Wells Fargo (WFC) , Mr. Cooper (COOP) and New Residential (NRZ) . With the Fed’s 50bp rate hike this week, you would think that the owners of MSRs would be cheering. After all, because MSRs are negative duration assets with cash flow, when interest rates rise and bond and loan prices fall, the value of MSRs goes up. The marks on the MSRs are raising a lot of eyebrows as well, on Wall Street and also in Washington. Mortgage Servicing Rights Source: EDGAR Looking at the strong upward increases in fair value (FV) for MSRs in Q1 2022 earnings the sky seems to be the limit. But not all MSRs are created equal and not all buyers have a good understanding of the risk involved. Over the past several months, officials at Ginnie Mae have actually approached a number of issuers, asking for pricing and methodology details on past MSR purchases. The response reported from issuers universally has been “November Foxtrot Whiskey.” Why would the folks from Ginnie Mae’s risk function feel the need to make such a request? The short answer is that loan delinquency is rising and regulators are starting to worry that Buy Side investors and smaller independent investment banks are not sufficiently well-capitalized to navigate an increase in loss mitigation activities. While players such as JPM are highly selective in their purchases and prefer conventional or jumbo assets, the same cannot be said for the rest of the industry. As we noted in the revisions to our Ginnie Mae paper, the factors affecting the value of mortgage loans and MSRs are highly varied and also, thanks to QE, extremely volatile. We note: During 2020-2021, the embedded option to refinance was one of the chief valuation metrics employed by secondary market participants as MSR prices neared record levels. Some leading issuers were selling MSRs are a premium in 2021, on the one hand, but then paying top prices for other MSRs that were thought to have high potential for loan refinance. The same market factors in 2020-2021 encouraged issuers to buy delinquent loans out of GNMA pools in the hope of remediating the delinquency and selling the modified loan into a new pool, capturing a 3-4 point gain-on-sale. Another adverse factor that is not always recognized in valuations of MSRs is the probability of default of the underlying loans, an important factor that can quickly change and thereby impact the profitability of an MSR. Valuations for MSRs tend to be overstated (and capitalization rates are therefore too low). Over the past several years or record MSR valuations, the embedded default risk in the asset was understated due to future default risk. Yet it is possible to lose money on one’s investment in a GNMA MSR through the economic cycle. One way to view the suppression of default risk due to low interest rates is loss given default (LGD) on 1-4 family mortgages. Chart 5 below shows LGD for $2.6 trillion in bank-owned 1-4 family mortgages, a mostly prime population of fully documented, above-average size residential mortgages. Notice that the series skewed deeply negative during the period of the largest quantitative easing by the FOMC vs the long-term average LGD in the 60% loss range. Source: FDIC/WGA LLC As interest rates rise and the US economy slows, we expect to see the rate of delinquency in bank portfolios and bonds begin to normalize. In the case of 1-4 family loans, that would put default rates in the 25-50bp range and delinquency in the 2-3% range, but that process of normalization could take months or even years. If we adjust current rates of default and delinquency for the degree of extraordinary ease provided by the FOMC, that could imply credit loss rates that are above the average levels for the past decade. “Our tools don’t work on supply shocks, they work on demand,” Chairman Powell noted in his press conference. Powell intends to focus on the demand side of inflation and also price expectations, this this suggests to us that interest rates could remain elevated for some time to come. That said, Powell is in no hurry, looking for no more that 50bp at a time. And perhaps most important, Powell recognized the uncertainty of shrinking the balance sheet. He wants the rate of interest to be the primary tool of policy, thus the FOMC seems to be using the symbolism of rate increases and not the reality of balance sheet shrinkage. As Michael Pak at TCW summarized: “Given the relative insensitivity to the Fed’s policy rate of the supply side factors impacting inflation, the central bank is left with the uncomfortable choice of weakening the demand side of the economy thus risking recession in the process.”

When you wish upon a star Makes no difference who you are Anything your heart desires Will come to you "When You Wish Upon a Star" (1940) Cliff Edwards May 2, 2022 | Last week, it finally began to dawn on a number of analysts that the gains seen in many part of the US economy during the period of extraordinary ease by the Federal Open Market Committee in Q1 2020 were transitory, to borrow the now famous phrase. With the mere suggestion of an end to quantitative easing or QE, stocks are swooning, down the most since 2008. Bond bond prices too are falling as real interest rates revert with astonishing speed to the very mean. The scene makes us recall a favorite observer from antiquity, Charles Mackay , who wrote in 1841 (h/t Edward Chancellor ) in the Extraordinary Popular Delusions and the Madness of Crowds : “Is it a dull or uninstructive picture to see a whole people shaking suddenly off the trammels of reason, and running wild after a golden vision, refusing obstinately to believe that it is not real, till, like a deluded hind running after an ignis fatuus , they are plunged into a quagmire?” No matter how humans may think that we govern our own actions, in fact we are animals hard-wired to chase the shiny object. Whether it is crypto or top-performing banks in 2021 like Silvergate (SI) or Western Alliance (WAL) or Tesla Motors (TSLA) , the movement draws our attention irresistibly. We all are just small mouth bass in June hitting anything that touches the surface of the water. Leen's 2020 Those “wish upon a star” names in the magical world of fintech, stocks that could only ever thrive and issue public securities under QE, are headed south fast, back to something approximately fundamental value + a growth premium. We’ll be writing about some of these magical names in the Premium Service of The Institutional Risk Analyst in coming weeks. Our surveillance list for Fintech stocks is shown below. Source: Bloomberg, Google This list of fallen angels may be tough for some investors to view, but the roll call of wannabe fintech names that did not make it out of the proverbial birth canal is a lot longer. Names like RobinHood (HOOD) , WISE PLC (WISE) and Marqueta (MQ) have been hammered for the past year, but recently stabilized near 52-week lows. Yet there are some more substantial names such as PayPal (PYPL) and SoFi Technologies (SOFI) that have performed even worse, evidencing the more general market angst as the FOMC prepares to change directions and in a dramatic fashion. The question about value in these stocks is to a large degree a function of the Fed, which is likely to raise interest rates sharply and at least stop reinvestment of portfolio redemptions. Much of the exuberance that took payments plays such as legacy provider Fiserve (FISV) and new arrival Block Inc (SQ) to highs in 2020 and 2021 is now gone, thus the entire sector has given up roughly half of its value. Notice that crypto enabler Coinbase Global (COIN) is now trading at just 8x earnings, surely a bargain until you see the slowdown in crypto volumes as well as prices. The shark must swim or die. As we have noted with respect to the banking sector, the higher beta stocks in the fintech sector have returned to more or less 2020 levels for the stocks, with names like SQ again below $100 vs $281 last August. Indeed, if you lay these names onto a single graph, the sector looks remarkably homogeneous. Source: Google When we first purchased SQ five years ago, we took the rule of the shinny object as our operative thesis. Our investment strategy included the likelihood that the thundering herd of equity managers would eventually discover this relatively new payments (aka "fintech") platform. It was not so much about blockchain or new markets, merely the fact that the swarms of wealth managers out there really want, no, desperately need to own fintech stocks. Many managers who follow the "deep value" school of Cathy Wood and the ARK Innovation ETF (ARKK) have, in fact, been riding the wave of momentum driven by COVID and the response from the Fed and Congress. Now that this wave of fiat cash has subsided, what do managers who held onto ARKK or these individual stocks all the way down do? Double down on fintech? We may need a larger trash container on the virtual trading floor. After all, the two is more important that the twenty when it comes to equity investment managers. Use as an operative benchmark the fact that ARKK's value has been cut in half since the start of 2022. Now that the great liquidity water balloon inflated by the FOMC in April 2020 is starting to shrink, the aspirational stocks must necessarily suffer. Many of the names on our fintech surveillance list have specific reasons for declining, but the common element in the narrative is the retreat of the speculative hoard, the same crowd that pushed up crypto currencies, fintech stocks and fix-and-flip homes and, yes, even mortgage servicing assets. We’ll be writing about the FOMC-induced train wreck in residential housing in the next edition of The Institutional Risk Analyst . But here is the question: Are the more substantial fintech names like PYPL and SQ a value at these levels? For us, we first recall that both companies have growing businesses that deliver true value to their customers. Yet in the post QE era, managers may need to significantly recalibrate the measure of value. Does SQ deserve to trade on 300x trailing earnings? Without QE, probably not. SQ reports Q1 2022 financial results on May 5th. PYPL, on the other hand, at just 24x trailing earnings seems a more reasonable value when compared to other financials. Take the financial performance and add some unicorn dust in terms of innovation to the mix and perhaps a double-digit PE ratio for PYPL makes sense. But the key thing for investment and risk managers to appreciate about fintech stocks and pleasant derivatives such as crypto is that the valuations of the past 24 months had more to do with COVID and QE than with the specifics of a given investment. Notice in the chart below from PYPL's Q1 2022 earnings release that payment volumes have plateaued in the past few quarters. Of course, if blaming the collapse of fintech stocks on the end of QE makes you a tad uncomfortable when speaking to clients, then you can always seek comfort in the war in Ukraine or the fact that the US economy is stalling. Just remember that the swoon in names like PYPL, SQ and the rest began in Q4 2021, four months before the fighting began between Russia and the Ukraine. Naturally the thundering herd of equity managers will now run for cover in risk free assets, thus many of the fintech names could get a great deal less pricey in the days ahead.

April 28, 2022 | Premium Service | Looking at the financial results for Flagstar Bancorp (FBC) , you can see the pain being felt by the entire industry devoted to manufacturing and selling residential mortgages. “A Trifecta of Bad Mortgage News for Flagstar: Lower Volumes, GOS and Layoffs,” declared Inside Mortgage Finance quite accurately. BTW, GOS means “gain on sale,” the most important three words in lending. Then we turn to Annaly Capital Management (NLY) , a REIT that buys agency mortgage backed securities (MBS), and the situation is remarkably different. How do we parse this tale of two very different mortgage players? Source: GOOG Flagstar Bancorp First we start with FBC, a company we profiled this time last year (“ Profile: NYCB + Flagstar Bancorp ”). In 2021, FBC was one of the best performing banks in the US, as we noted in our profile of NexBank (“ Profile: NexBank Capital, Inc. ”). FBC is also among the larger subservicers of residential mortgage loans and also the second largest warehouse lender to other banks and nonbank mortgage companies. A year later, FBC is seeing revenue and earnings slow after a torrid 18 months of mortgage banking activity. Of note, the progressive mafia led by Senator Elizabeth Warren (D-MA) is still holding up the regulatory approval of the FBC merger with New York Community Bank (NYCB) . The chart below from the FBC earnings report shows how FBC’s performance has changed with the sharp increase in interest rates during Q1 2022 and the continued decline in earning assets. Notice that the GOS income and thus pretax income for FBC were down sharply in Q1 2022, a reflection of the adverse change in pricing that has occurred in the secondary loan market since the end of 2021. More, while net interest margin increased 15bp to 3.11%, utilization rates measured by the volume of loans held for sale and also warehouse loans to mortgage lenders declined. That is going to be the story for most of 2022, falling volumes and slowly rising NIM. Also note that FBC’s average deposits decreased 9%, driven by a decline in custodial deposits. The bank’s cost of funds edged up to 0.26% vs 0.31% in Q1 2021. Total revenue for FBC fell to $325 million in Q1 2022 vs $513 million in Q1 2021, again due to the sharp decline in mortgage related activity. Net GOS revenue was just $45 million in Q1 2021 vs $227 million a year ago. The GOS margin of 0.58% contrasts with the 1.84% in Q1 2021, when the residential mortgage industry was experiencing record volumes and profits. The chart below from the FBC report shows trends in NIM, which rose above 3% for only the second quarter since 2019, even as earning assets have fallen for three consecutive quarters. Annaly Capital Management We purchased a position in NLY at roughly half of book value in April of 2020, when there was blood in the streets and a number of REITs were near the tipping point due to margin calls. By “going big” with securities market intervention, the Fed of New York moved forward TBA rates down in yield by couple of hundred basis point in 30-days, forcing issuers with short positions to essentially give dealers all of their cash for a month. Wind the clock forward two years and NLY is trading at 0.8x book value and has managed to survive the past two years of QE madness and actually thrive. The traditional investor in agency MBS has diversified into mortgage servicing rights (MSRs), a move we applaud and now accounts for 10% of capital. MSRs are negative duration assets with cash flow, similar to a Treasury interest only (IO) strip but with more volatility due to the idiosyncratic nature of prepayments on residential mortgages. No amount of computer power can really, really enable you to predict when Fred and Wilma are going to sell or refinance their home. Family decision cycles, for example, vary with geography and income. But with skill and a lot of data, issuers can certainly encourage and facilitate such blessed events, which in good times generate substantial income. Today, as we noted in our last Premium Service comment in The Institutional Risk Analyst , many conventional issuers are losing money on every conventional loan they close. NLY benefits when there are few prepayments on mortgages, which impacts both the MBS and also the MSR. In a rapidly rising rate environment, prepayments on MBS you bought at a premium are painful. But NLY now hedges that basic dynamic by owning MSRs and benefitting from the extension of maturities on mortgage portfolios. We also applaud the sale of the middle market loan portfolio in Q2 2021, focusing NLY on the residential asset. NLY’s NIM rose slightly in Q1 2022, but so did the cost of funds due to the dramatic shift in the Fed’s interest rate narrative. Even though the FRBNY has continued to purchase securities through the month of April, interest rates have backed up dramatically. In fact, Q1 2022 was one of the worst periods ever for the bond market and fixed income investors, yet NLY managed its position quite well. The table below is from the NLY Q1 2022 earnings presentation. NLY is positioned nicely to manage its portfolio in a rising rate environment. The new issue market for residential loans is going to slow dramatically in 2022, with volumes moving to the relatively safety of the FHA and Ginnie Mae assets, on the one hand, and non-QM loans on the other. Comparisons with the 2006 period are entirely appropriate, albeit for different reasons. Net mortgage spreads are near or above 5-year highs, thus we believe that the environment for REITs like NLY is promising, especially with the added benefit of the MSR portfolio in the mix, which increases in value as rate rise. The major risk factor, as in 2020, is whether the end of FOMC purchases of MBS is going to impact market liquidity and thus the cost of funds. The chart below from the NLY Q1 2022 earnings presentation shows the MBS current coupon vs the average yield for 5-10 year Treasury paper. With most industry MSR valuation models using high-single digit assumptions for prepayment rates going forward, there is a great deal more visibility on future cash flows than NLY and other REITs have enjoyed in many years. Liquidity remains a potential risk, but as reserve assets decline and bank purchases of government MBS return to normal levels, we think that the agency REITs like NLY will have the wind at their backs for a change. Sadly, lenders and issuers such as Flagstar will not have the same degree of visibility on future volumes and earnings. 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.

April 26, 2022 | Last week, The Economist proclaimed the failure of the Federal Open Market Committee when it comes to managing inflation, causing quite a fuss among American economists and investors . The Economist correctly identifies the political corruption of the Federal Open Market Committee, first lurching headlong into progressive inflationism during COVID, then swerving into what passes for Austrian School austerity described by St Louis Fed President and Uber Hawk James Bullard . The Economist goes on to blame the current bout of wage and price inflation on the fact that Congress spent that last $2 trillion in COVID stimulus in 2021. No, say we to our friends in London, the inflation is not caused by surging demand due to the last bit of fiscal benevolence from Washington. Instead the inflation today is caused by war in Ukraine, the effects of COVID in China and a lot of external factors like shortages of products from silicon chips to single family homes. Truth to tell, The Economist has missed the point about markets and inflation consistently since Walter Bagehot reported for them in the 18th Century. The operative model for the global economy is not banking in the City of London circa 1861 but rather Adam Smith . Bagehot's famous notion of charging "punitive rates" to punish speculation during a crisis, for example, has destroyed the British economy and, more important, a financial system based on the pound sterling. US benevolence after WWII created the dollar system. Where would the world be today had John Maynard Keynes not contributed his essay, "How to Pay for the War," after the Battle of Britain began and before the US entered the conflict? The US and Britain raised marginal tax rates, sold lots of debt to pay for the war effort and created a safety net for the soldiers who fought and died. The allies beat the Nazis and eventually won the cold war with the Soviet Union because of benevolence, not Bagehot-style austerity. The US and its allies in Europe and Asia must use the same approach taken in WWII to stop the deflation set in motion by Vladimir Putin's dictatorship in Russia. If the Great Wheel stops circulating (and the US economy stops growing), then we are all in deep trouble. This is the key insight that has guided the FOMC's at time clumsy actions over the past decade. One of the supposed authors of the Fed’s excesses in terms of inflationary bond buying and low interest rates was then Fed Chair Janet Yellen , who has moved from strength to strength now as Treasury Secretary. Yellen recently declared that inflation has peaked, her imitation of the famed economist Irving Fisher , the first celebrity economist. To recall, just nine days before the Great Crash of 1929, Fisher confidently declared the bloated US stock market had reached "a permanently high plateau." In fact, the US was about to go through the horrors of debt deflation for the next decade. He wrote in his classic essay, " The Debt Deflation Theory of Great Depressions" : "While any deviation from equilibrium of any economic variable theoretically may, and doubtless in practice does, set up some sort of oscillations, the important question is: Which of them have been sufficiently great disturbers to afford any substantial explanation of the great booms and depressions of history?" In a strange way, Yellen is right about inflation, but not for the reasons that the Secretary and members of the Biden Administration probably hope. May of 2022 may indeed mark the peak of the post-COVID price bubble, but it may also be the start of a deflationary down leg in a global economy that has lost a couple of trillion dollars in economic output in the past three months. The real GDP projections by the International Monetary Fund are shown below. We expect to see a lot more red on this map by the end of 2022. Source: IMF The threat to the global economy comes not from the Fed, but from the fact that the world faces a huge output gap and thus a lack of productive endeavors that can absorb capital and drive growth. Thus as consumer prices are soaring, stock prices are falling and investors are fleeing to the apparent safety of government debt. Readers of The Institutional Risk Analyst will recognize the chart from FRED. Note that high-yield bond spreads have reached almost 500bp over risk-free assets, a major danger sign for the US economy. "The effect of Russia's invasion to stimulate inflation has been enormous," notes Fred Feldkamp , our co-author in Financial Stability: Fraud, Confidence and the Wealth of Nations . "The 10-year Bund has gone from a low of -35 bps late last year to +97 bps recently. Russia may have 'cured' the EU's problem with negative interest rates." Significantly, both Xi Jinping in China and Putin in Russia have decided to turn their backs on the global economy and embrace authoritarian terror in order to maintain power, Feldkamp argues. Both nations are now a drag on global growth and a potential source of serious instability in the future. The color for China ought to be red in the above map, but the IMF persists in using bogus official economic data from the Chinese government. Without quick action to offset the yawning canyon of missing economic output that stands before the global economy, we may indeed see hyperinflation and deflation at the same time. As global capital flows into the remaining investment opportunities away from China and Russia, prices are likely to rise even faster than dictated by supply chain blockages. Look at the swarm of investors buying single family homes and commercial real estate in the US at the top of the market. Of note, the price of interest rate caps for commercial loans rose by an order of magnitude in the past 60 days. In 2008, the US had to offset $30 trillion in acts of stupidity accumulated in the bond market between 2003 and 2006. The Treasury supported the banks, the Fed supported the financial markets, and the US economy did the rest, outperforming the rest of the world in terms of growth by a large margin. Today the question comes down not to fighting demand-led inflation, which is transitory and will subside, but to create a financial counterweight to the deflationary wave caused by the Ukraine war and the COVID lockdown in China. The authoritarian turns of both China and Russia can be explained by the relatively poor economic performance of both societies since that time. Putin invaded Ukraine not due to worries about NATO, but because Russia is a failed society politically and economically. Kyiv is the economic center of a prosperous nation that boasts many transformational industries. Moscow is a military citadel that rules a nation that makes a living selling commodities and third-rate military hardware. Like Venezuela, Russia is largely dependent upon imports for most technology, manufactured goods and even food. China likewise is a failed state politically and economically due to communist misrule. Xi Jinping fears COVID as a random, idiosyncratic event of the sort that has in past centuries driven dynastic change in China. The simple fact is that the ineffective response to COVID by China is now a threat to continued communist rule. Massive waves of infections and death could literally result in social upheaval in China, thus Xi locks his people behind fences guarded by soldiers and lets them starve to death. Between Congress and the Fed, America marshalled the cash necessary in 2009 to keep the global economic system from tipping over. Fed Chairman Ben Bernanke understood that the sudden drop in economic output that occurred after 2008 had to be offset, otherwise we end up in a classic debt deflation described by Fisher in 1933. Today the sources of deflation are different, but the threat remains deflation rather than inflation. While many analysts argue about a century old narrative defined by hard money, on the one hand, and tolerance for inflation on the other, perhaps its time to recognize that keeping the economy liquid and functioning is really the common goal. When a large part of the world suddenly is taken offline from the global economy, the result must be a decline in aggregate economic activity, rising events of default and a gradual slide into debt deflation. When times change, people need to change their minds. Fed Chairman Jerome Powell is said by some members of the media to be “losing control of the inflation narrative,” but we think otherwise. Powell, like Bernanke, understands the lesson of the 1930s and debt deflation. “Global growth is projected to slow from an estimated 6.1 percent in 2021 to 3.6 percent in 2022 and 2023,” reports the International Monetary Fund. “This is 0.8 and 0.2 percentage points lower for 2022 and 2023 than projected in January.” We suspect that growth estimates for the US and the world will be falling over the rest of this year and next. Given that scenario, a slow approach to raising interest rates and reducing the size of the central bank’s portfolio is the optimal strategy at present. But the real challenge facing Secretary Yellen and the US government is how to marshal the resources of the G-20, minus totalitarian China and Russia, to combat the true threat to global economic stability, namely the deflationary wave that now threatens to engulf the world.

April 22, 2022 | Premium Service | With this edition of The Institutional Risk Analyst , we return to a couple of interesting banks with roots in the mortgage industry, but that’s where the similarities end. Silvergate Capital (SI) and Western Alliance Bancorp (WAL) were two of the best performing bank stocks of 2021, but both are now following the bank group lower and for different reasons. The former is being hurt by flagging interest in crypto assets, the latter by the nuclear winter in housing caused by the lurch in Fed interest rate policy. Where is value for these two names and the broader banking sector? Source: Google Western Alliance Bancshares (WAL) We profiled WAL early last year , just as the bank had closed its acquisition of AmeriHome from Apollo Global (APO) portfolio company Athene (ATH) . In those happy days, AmeriHome was raking in the profits from QE, with gain-on-sale margins for conventional loans in the 3-4 point range. There are virtually no conventional lenders in the US today that are profitable when they sell a loan into the secondary market. Why? Because forward prices (yields) in the too-be-announced (TBA) market are galloping higher and faster than the advertised annual percentage rates for residential mortgages. This is significant for WAL and AmeriHome because they are among the largest aggregators of conventional loans along with PennyMac (PFSI) . Specifically, instead of trading at 3-4 point premiums to par, TBAs for current production are at a 1-2 point discount. This means that every loan being sold into a conventional MBS today is a dead loss for lenders . Notice in the screenshot below from Bloomberg that the only TBA shown above par are FNMA 4.5s, meaning that many lenders are losing money on every loan sold into the secondary market. This past week we saw several conventional loan pools with 700+ FICO scores on average and weighted average coupons (WACs) above 6%, in some cases near 7% coupons. These pools were sold into 6% FNMA securities for delivery in May, a TBA contract that is not yet even shown on the Bloomberg screen. We also saw two pools of non-QM jumbos that priced above 101.87 with WACs above 7.5%. What is suggests is that mortgage rates are already above 6% effectively, but the insane competition in the shrinking market for conventional loans is holding down prices and annihilating a market with 50% over-capacity. WAL saw net down slightly in Q1 2022 vs Q4 2021 at $240 million, with net interest margin of 3.3%. The bank continues to be one of the best performer in Peer Group 1 measured by metrics such as efficiency and credit. WAL reported zero charge offs in Q1 2022 and showed delinquent loans at just 0.15% of total loans. Shareholder equity rose by $1.3 billion YOY, a reflection of the bull market in housing assets that is now sadly a fast fading memory. We don’t have any stability concerns for the $55 billion asset WAL as we enter a period of uncertainty over interest rate policy and great market volatility. The bank’s held-for-investment loan portfolio has grown enormously (43%) YOY, but deposits have also increased by 36% due to the massive mortgage escrow balances controlled by AmeriHome. The impact of the AmeriHome acquisition is clearly visible and largely in a positive way, but we look for loan volumes at WAL to fall sharply in 2022 along with the rest of the mortgage industry. At 1.6x book value at the close today, the stock is not cheap but it is down from 2.6x a year ago when it outperformed most large banks. Silvergate Corp (SI) We profiled Si back in February of this year , but much has changed in the past several months with interest rates up and crypto valuations falling. SI was trading at 12x book value at the end of Q1 2021, but today the stock is trading around 2.5x, a significant drop YOY, but SI is up sharply from a month ago. Note that SI has a beta of 2.5x the average market volatility, a function of the crypto component in the stock’s audience. WAL by comparison, has a beta of 1.5x and the KBW Bank ETF has a beta of 1.3x. There are clearly some investors who are still bullish about the SI crypto business. For us, the big change in the mix is the declining attractiveness of the crypto trade as the FOMC raises interest rates dramatically, providing a tangible alternative to crypto assets as a shelter from financial repression. If you think of SI, Tesla (TSLA) and all of the MEME stocks as a reflection of real interest rates, the timing of the down move in SI begins to make some sense. Or to put it another way, a year ago SI’s market valuation was inflated by expectations regarding the profit potential of crypto, but today such expectations are greatly reduced. While the bank continues to grow income and its customer base, the flow of crypto transaction across its proprietary SEN network fell dramatically in Q1 2022, as shown in the table below from the SI Q1 2022 earnings presentation. Given the small size of the depository, SI is obviously not of interest to investors because of its community banking or legacy mortgage business. With $16 billion in total assets (vs less than $2 billion in 2019) and an unusual liability structure, SI’s bank unit is idiosyncratic to put it mildly. As and when the blown falls off the crypto rose entirely, we suspect that the bank could shrink back down to ~ $2 billion in assets. The continued attraction of SI for investors is clearly crypto, but we still don’t see the profits to support the risk of crypto involvement. The swooning volumes in the world of crypto currencies is an important factor for investors and risk counterparties to consider. The table below is from the latest SI earnings presentation. We have previously expressed concerns about SI’s business model, both in terms of the composition of the bank’s balance sheet and the risk to the bank posed by extensions of credit with crypto assets as collateral. The torrid growth rate for the bank’s assets, which are mostly invested in agency securities, is another obvious red flag. The non-interest income side of the ledger is clearly the point of attention for investors, yet this metric declined in Q1 2022. The chart below is from the SI earnings presentation. With the explosion of the war in Ukraine and related sanctions against Russian nations and institutions by the US and other nations, counterparty risk must also be considered when assessing the risk profile of SI. Suffice to say that anyone involved in crypto trading and other services in the US, onshore or offshore, must have a know your customer (KYC) and anti-money laundering (AML) regime in place to avoid violating US sanctions or face serious legal repercussions. This tiny community bank in Southern California may be along the casualties of the latest convulsive lurch in FOMC interest rate policy. 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. Disclosure: L: EFC, NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC

April 20, 2022 | Updated | Earnings season for financials ended almost as soon as it began as results for JPMorgan (JPM) on down the list disappointed the rosy expectations of Buy Side managers. As we noted on Monday in our Premium Service edition of The Institutional Risk Analyst , the results for Goldman Sachs (GS) confirm our view that this firm is in trouble long-term. Funding costs at GS are too high, credit expenses are elevated even now compared with its peers, and the dependence on trading and investment banking sets the firm up for trouble down the road. The proverbial stool at GS has only two legs. Keep in mind that the Fed has been suppressing bank credit costs via QE, thus the poor GS credit experience vs average assets is truly remarkable. Source: FFIEC Meanwhile, James Gorman and his team at Morgan Stanley (MS) have created a large, liquid universal bank with three strong legs – investment banking and capital markets, wealth and investment management, and commercial banking. Thanks to half a trillion dollars in core deposits and $1.5 trillion in AUM, the cost of funds for MS is a fraction of that paid by GS. Game over. All of these thoughts of investing and business models are a pleasant distraction, however, compared to the real human suffering being endured by the people of Ukraine and other nations. The vicious attack on Ukraine by Russian dictator Vladimir Putin positions Europe and much of the developing world for a period of economic depression and political instability for many years to come. And much of the blame for this disaster belongs to officials in Washington and the EU. The fact that members of the Biden Administration encouraged Ukraine to seek NATO membership eventually will be recognized as a stunning miscalculation by Washington. Russia was falling behind the west economically long before the war began, but the inept actions by US and EU leaders provided Putin with a perfect domestic pretext for war. The inflation and economic costs caused by this horrible conflict in the center of Europe will torment the world for many, many years to come. With the grain growing regions of Ukraine and Russia consumed by conflict, millions of people in Africa, India and other nations face the prospect of hyper-inflation of prices for basic necessities, eventual starvation and related political upheaval and geopolitical tumult. Industries from technology to transportation to energy will be disrupted for decades. The true economic cost of the ill-considered actions of US and EU officials with respect to NATO membership for Ukraine will take many years to reckon. The clumsy performance of Russian military forces has also been noticed by Xi Jinping’s China, which like Russia also faces economic malaise due to authoritarian rule. China covets Manchuria as a source of food and other commodities. Never forget that the largest battles of WWII occurred in the Far Eastern regions of Russia and China, between Japanese forces, the Soviet army and the Nationalist Chinese. Thanks to global warming, you can now grow wheat in Manchuria. As Putin’s Russia fails economically and politically under the weight of western sanctions, the tendency toward military conflict between Russia, the US and China will grow. It is worth recalling that the surprise attack on Pearl Harbor in December of 1941 came about due to Washington’s successful efforts to cut off energy supplies to Japan's military government. Economic sanctions are a weapon just like tanks, missiles and jet aircraft. Just imagine how global markets will react when Putin deploys tactical nuclear weapons in Eastern Ukraine to avoid a conventional military defeat. Meanwhile back in Washington, there is an almost complete lack of recognition that the global economy is headed for serious trouble due to the Ukraine conflict. Since we now live in the age of the dilletante, appearances naturally trump substance. Celebrity policy makers seem more interested in making television appearances than in truly serving the national interest. The cacophony of voices coming from the FOMC, for example, illustrates this systemic dysfunction. St Louis Fed President James Bullard leads the hawkish tendency on the Federal Open Market Committee, thundering away on television that the central bank needs to raise interest rates to truly impossible levels to fight inflation. But wasn’t the inflation that so worries Mr. Bullard the result of the reckless policies pursued by the FOMC under Chairman Jerome Powell and former Fed Chair Janet Yellen ? Do we hold any of these officials accountable for their actions? We wonder, do Mr. Bullard and the other members of the FOMC understand that raising interest rates dramatically after two years of artificially low interest rates is perhaps a bad idea? If Bullard’s policy suggestions on television over the past week that we need to get the federal funds rate to 3-4% were actually to become reality, many US banks would see themselves underwater on assets created during 2020-2021. As we noted during our discussion with Jack Farley on Blockworks earlier this week, the benefit the Fed gave to banks in Q1 2020 may now become an equal burden as the FOMC seeks to reclaim credibility on inflation. Thirty-year mortgage rates are likely to hit 6% by June or double the rate of one year ago. Given the rhetoric from Bullard and other hawks, mortgage rates are likely to move even higher as the year progresses. Because of the ineptitude and lack of focus we see from many policy makers, our expectation is that the financial markets in the US and globally face a long-period of adjustment and volatility. As market and geopolitical risks surge back into view after years of managed, but artificial, economic stability, investors will be forced to change their risk appetites and time horizons. Take an example. Thirty-day interest rate locks have disappeared from the residential mortgage industry, forcing borrowers to price loans on the closing date. So too, global investors are being forced into a short-term mindset that is going to add to market volatility and make asset allocation even more difficult. As we noted this week in National Mortgage News , with TBAs trading at a discount to par, this instead of a four point premium last year, mortgage lenders are losing money on every new loan they close. As this issue of The Institutional Risk Analyst went live, a colleague reported a new pool of conventional mortgages with a weighted average coupon (WAC) of 6.8% and intended delivery into a 6% Fannie Mae MBS in May. This suggests that we could quite easily see a 7% mortgage by June . With much of Europe and China now off the menu for global investors, the wave of liquidity chasing returns will now focus on a reduced set of opportunities. Many of these remaining investment situations will be distressed due to the economic disruption of the Ukraine war. Look at Citigroup (C) trading at 0.5x book value today and you see the fear of unknown risks in the minds of investors and counterparties. It is not impossible that Citi or another large global bank will need official support due to credit defaults arising from the Russian invasion of Ukraine. The FOMC managed to suppress credit costs during the past several years, but now as shown by bank earnings, credit costs are becoming very real once again. Over the next twelve months, we look for bank credit costs in the US, Europe and Asia to revert to the mean and then rise to elevated levels that will shock many complacent investment professionals and policy makers. In 2022 and beyond, we are truly headed into the new age of credit and geopolitical risk.

April 18, 2022 | Premium Service | Last week Goldman Sachs (GS) and Morgan Stanley (MS) reported Q1 2022 earnings. Both firms managed the return to “normal” reasonably well in terms of overall results, but the former continues to evidence a high degree of volatility in line items that ought to be stable. Dick Bove put the situation well last week, saying that Goldman Sachs needs to demonstrate “to what degree can it control its destiny?” That is the right question for readers of The Institutional Risk Analyst to ask as the FOMC is prepares to end QE, significantly raise interest rates and normalize credit costs along with it. Both MS and GS essentially have three business lines: Institutional Securities , including capital markets and investment banking Wealth Management , including advisory and brokerage services for individuals, and Investment Management , including institutional investment services and funds GS further breaks down its institutional securities business into global markets and investment banking, a revealing choice that illustrates the firm’s dependence upon trading the markets and other transactional business. The stable periodic income generated by the MS wealth and investment management lines stand in sharp contrast to Goldman's volatility. Neither firm breaks out commercial lending as a separate business line, but in the case of GS, credit may be a future vulnerability. In terms of AUM, MS had $1.6 trillion in assets under management in proprietary mutual funds and annuities at the end of 2021 vs just $595 billion for GS, according to the FFIEC. MS generated $1.6 billion in fees from this AUM vs $1.3 billion for GS, suggesting that Goldman Sachs clients are paying significantly higher fees for the privilege. The first observation to make in comparing MS with GS is that the latter has far greater volatility in its financial results. What GS labels “Asset Management,” which is the firm’s institutional investment business, swung from $4.6 billion in Q1 2021 to just $546 million in Q1 2022, an 88% decline YOY and a 81% decrease sequentially. The chart below shows the net revenue by segment for Goldman Sachs from the firm’s Q1 2022 results. MS reported a modest increase in net revenue YOY and a 24% decline sequentially, but Wealth and Investment Management lines were relatively stable. Consumer and Wealth Management at GS, by comparison, grew 21% YOY and rose 7% sequentially. These two GS revenue line items are relatively small compared with Global Markets and Investment Banking, which tend to account for the lion’s share of revenue. At MS, by comparison, Wealth and Investment Management regularly account for roughly half of firm revenue, as shown in the table below from the MS quarterly results. MS has made the progression from independent investment bank before 2008 to universal bank and asset manager in the years that have followed. GS, on the other hand, pays lip service to growing its banking business, but continues to focus its financial and human resources chasing high-risk investment banking revenue. The result at GS is a more volatile business model than MS, with a smaller core deposit base and, significantly, higher credit losses than the 130 members of Peer Group 1. At the end of 2021, MS had $329 billion in core deposits vs less than $200 billion for GS. Both firms have been focused on growing banking deposits, but MS has been willing to grow liquidity via acquisitions while GS has preferred to grow organically. The result is that, at the end of 2021, MS had a cost of funds of just 12bp vs average assets or well-below the 23bp average for Peer Group 1. GS was at 41bp in Q4 2021 or 2x the peer average. Amazingly, GS generated the lowest net interest margin of Peer Group 1 at just 48bp at the end of 2021. Source: FFIEC One of the big concerns we have about GS is credit. Despite the fact that GS is a tiny commercial bank in terms of total assets, the firm regularly reports credit losses that are higher than the average for Peer Group 1, which is comprised mostly of smaller commercial banks. Keep in mind that the Fed has muted loss given default via QE, so the fact that GS is experiencing poor credit performance is remarkable. Net loans and leases were just 16% of total assets for GS at the end of 2021 vs 23% for MS, but the credit performance of the GS loan portfolio is poor compared to MS. The gross credit losses of GS loan book are an order of magnitude higher than MS or Charles Schwab (SCHW) , for example, which barely report credit losses at all. Notice in the chart below that both GS and Raymond James (RJ) reported large, idiosyncratic credit losses related to COVID at the end of 2020. Peer Group 1 also showed above-average losses at the end of 2020. Source: FFIEC Given that credit expenses are likely to rise in a secular fashion back to normal levels over the next several years, we believe that the credit performance of GS ought to be monitored carefully by investors and risk professionals. But perhaps even more of a concern than the bank's credit is the firm’s industry leading derivatives exposure. At the end of 2021, GS had the highest gross derivatives position of the top US banks, followed by MS, Citi and JPM. These positions are predominantly interest rate swap contracts, but notice that the oversize derivative position of Goldman Sachs has little impact of the firm’s above-peer funding costs. Source: FFIEC One area where GS excels when compared with the other large banking groups is operating efficiency, where the firm has the lowest efficiency ratio of the top-ten depositories. At nearly five points below JPM in 2021, GS’s efficiency ratio is where it needs to be given some of the disadvantages that face the smallest universal bank in the US market. In fact, GS is in the bottom quartile of Peer Group 1 in terms of efficiency ratio, an impressive showing given that there are some regional banks with efficiency ratios in the 40- and 30-percent range represented in the unweighted peer average generated by federal regulators. Source: FFIEC The bottom line for us when comparing MS with GS is that the former is 20% smaller than Goldman Sachs in terms of total consolidated balance sheet assets, but generates more net revenue with less risk. Simply stated, Morgan Stanley has a much more diverse and sustainable business model than Goldman Sachs At times GS has “killed it,” to paraphrase one hyperbolic headline from CNBC , with outsize investment banking or trading results. Yet the firm’s business model lacks a solid third leg for the proverbial stool in terms of a large banking business and/or wealth management business. The dependence upon investment banking and trading results creates inherent instability in the GS business. MS can always depend upon the more stable wealth and investment management lines to pay the bills in times of market volatility or global upheaval as we see due to the war in Ukraine. For this reason of business model stability, we have long advocated a merger with a large regional bank. Acquiring a large advisory business would also make sense, but SCHW and MS already have largely captured most of the attractive candidates. Sad to say, GS does not have a currency to acquire a large advisory business like SCWW or even RJ, which trade at higher multiples than GS. When you need to swing for the right field fence on every pitch in order to make next quarters’ earnings, this makes GS vulnerable to large swings in the markets and operational risk events such as the continuing 1MDB scandal in Malaysia. MS is a more stable, lower risk business that naturally has higher risk adjusted returns. As the Fed ends QE and begins to run off its balance sheet, we expect GS to resume its traditional place at a modest discount to book value. MS should trade at a small premium to book, reflecting its more stable business, but we would not buy either stock at current levels. Disclosure: L: EFC, NLY, 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.

April 11, 2022 | The market for too-be-announced (TBA) mortgages closed last week at a discount, something of a change compared to the 3-4 point premiums seen in 2020 and 2021. Winter has come to mortgage land, this according to industry sage Joe Garrett in San Francisco. Below c/o Joe’s firm, Garrett McAuley, are the profit per loan numbers for some of the best and worst years in recent memory in the residential sector. Joe has a great way of reminding readers of The Institutional Risk Analyst of the context in data. Profit per Mortgage Loan (bp) Source: MBA When the front contract in TBAs is trading below par, that means that lenders are losing money on every loan they close, a circumstance that will only go on for so long before headline rates and spreads move higher. Yes, the servicing is worth good money, but what TBAs are telling you is that mortgage rates are headed north. MBS are now sporting 4% and 4.5% coupons vs the 2s and 2.5% MBS of 2020. If you add a point in fees to those MBS coupons, that gives you residential mortgage loan APRs in the 5.5% range. TBAs tell us that, barring some unforeseen hiccup, we'll see a 6% residential mortgage by summer if not sooner. That 5.5% mortgage is what you might call sticker shock, maybe. But in fact, even as mortgage interest rates rise, the purchase market for homes continues at a brisk pace. We wonder if consumers have reached the same conclusion as many institutional investors in rent-to-hold models, namely that the Fed’s inflation of real estate values is not transitory. As a result, the Fed is likely to need to push interest rates much higher before buying activity slows in real estate. We could easily see consumer mortgage rates at 6% by June as all manner of lenders try and restore pricing power. Meanwhile, new issue volumes are falling dramatically in most categories other than US Treasury debt. Source: SIFMA We were pleased to be the only dissenting voice in the celebration of the Life of Brian Moynihan , CEO of Bank of America (BAC), published last week by the New York Times . Just for the record, BAC's stock price languished from 2009 through 2017, then galloped when the agony of mortgage crisis woes finally ended. This caused SG&A to drop at BAC from a $70 billion annually expense down into the $50s, yet the bank’s financial performance remains decidedly unexceptional. Make no mistake, Brian Moynihan avoided more revenue at BAC over the past decade than the $100 billion plus he paid out in fines and losses due to the 2008 mortgage crisis. BAC is down less than some of its peers YTD as financials flee the specter of rising interest rates. Can bank asset returns keep pace with rising market rates? Probably not, suggesting that a 1980s-style margin squeeze may lie ahead as the FOMC seeks to earn back credibility on inflation. We commented in our pre-earnings comment (“ Top Five US Banks: USB, JPM, WFC, C & BAC”) : “In terms of net income, Citi is at the bottom of the group followed by BAC, WFC and Peer Group 1. JPM and USB are the best performers in the group. Notice that USB has been the top performer in the top five banks going back five years and maintained that position through COVID. Why do investment managers prefer temples of mediocrity like BAC to USB? Because the former is bigger and a more liquid stock, and relatively cheap. But BAC is cheap for a reason, namely the weak management and lack of focus under CEO Brian Moynihan.” Some Buy Side managers get testy when we so publicly disrespect Brian Moynihan, but hey, we don’t make up his financial results. If you want to see the definitive view of BAC, pull up the most recent Bank Holding Company Performance Report from the FFIEC. What you find is that BAC is in a race with Citi and Wells Fargo & Co (WFC) for last place among the top five banks. And all of the larger banks look pedestrian vs the smaller names in Peer Group 1. Watching the Sell Side analysts reducing their estimates and price targets for Q1 2022 bank results, we get the feeling that the Street has figured out that there is a large chunk of bank gross interest revenue missing compared with year-end 2020. With investment banking also looking a tad light and the Street focused on other comprehensive income losses on low-coupon Treasury and MBS, bank earnings season is shaping up to the quite the train wreck. The table below shows a subset of our bank surveillance group, which illustrates that the leaders of 2020-2021 are now leading the group lower. Some of the stronger names such as American Express (AXP) and Charles Schwab (SCHW) are resisting the increased gravitational pull from rising interest rates. Notice too that Morgan Stanley (MS) is trading at a 50% better book value multiple than Goldman Sachs (GS) , which along with CapitalOne (COF) is reverting back to a discount to book. Citigroup (C) continues to suffer from concerns about exposure to the Ukraine War. Source: Bloomberg, Yahoo Finance If you like financials, the good news is that common shares and lower risk securities such as preferred equity are getting cheaper by the day. This movement lower is likely to persist until markets get a better handle on just how high and how quickly US interest rates are likely to move. But the more profound question that occurs as rates rise is how quickly will credit expenses normalize and again become an expense drag on bank earnings. Falling prices for all manner of loan collateral, from plain vanilla 1-4s to complex structured notes tucked inside collateralized loan obligations (CLOs), are weighing on the minds of institutional money managers. When he Fed pushed asset prices higher, visible credit costs also fell. Now that process is reversing across the credit complex, led first and foremost by residential mortgages. “CLO collateral metrics have stayed resilient despite the recent volatility in markets but more forward-looking market indicators such as asset prices and declining equity NAVs shouldn’t be ignored, says Bank of America’s Alexander Batchvarov . “Defaults remain low, but given the macro picture, their uptick in the foreseeable future cannot be ruled out,” Bloomberg reports. Asset prices for homes and commercial property are not weakening just yet, but we expect to see a more general softening in asset prices in 2023 and beyond. The quantity of happy juice injected into the US economy by the FOMC's experiment in QE is massive and still enduring, but the end of QE and the move to tightening of policy suggests a correction in asset prices across the board. For every dollar that runs off of the Fed's balance sheet, markets must shoulder $2 in new duration. The BIG question facing analysts and policy makers is what happens if the FOMC goes for 50bp at the next meeting, then the stock market rolls over and cuts 10% off the value of the national pastime. Will Fed Chairman Jay Powell fold in terms of further rate hikes if the S&P 500 falls 1,000 points in a day? We continue to believe that the US stock market has limited tolerance for higher interest rates, in part because of what rising interest rates imply for asset prices and credit. Put it all together and we think bank stocks will be a lot cheaper in June than they will be on this Good Friday.

April 6, 2022 | Premium Service | Back in Q1 2020, March 24th to be precise , the FOMC rescued the markets from the shock of COVID and nearly swamped several mortgage lenders and REITs in the process. The Fed’s early open market purchases were actually focused on the wrong TBA contracts, further exacerbating the impact of “going big” with liquidity, but the Fed eventually got it right. Now two years later, we are reversing the go big liquidity trade. FRBNY EVP Lori Logan thinks that the natural “ runn oft ” from the Fed’s system open market account (SOMA) is about 15 CPR, but we think that the Fed’s got it wrong again by more than 2x. Based on the FOMC minutes released yesterday, Ms Logan and her colleagues at the FRBNY are about to inject huge volatility into the markets as they struggle to reduce the size of the SOMA. What is the next big trade in this increasingly uncertain environment? Let’s start with a few basic observations about the nature and volatility of change in the months ahead. Credit : Starting in 2020, the FOMC greatly skewed credit costs via quantitative easing, driving asset prices higher and loss-given default to record lows for many asset classes. Real estate has been the chief beneficiary of the Fed’s manipulation of LGD, but there is also a general impact on commercial assets. Over the next year, we expect to see LGD for real estate assets rapidly normalize as asset prices start to weaken, but that adjustment process could take years given tight inventory . The chart below shows loss given default (total charge-offs - total recoveries/total charge-offs) for $5 trillion in bank-owned real estate loans. Source: FDIC/WGA LLC Financials : During QE, the manager mob rushed into financial stocks, driving valuations for banks toward 2x book value and forcing valuations for nonbanks names to levels that make little sense. The shift in terms of Fed policy has taken the air out of some of the most excessive examples such as Silvergage Capital (SI) , but we think that banks will continue to trend lower as investors come to appreciate that the baseline for bank earnings is 2019, not 2021. Think of JPMorganChase (JPM) just below 1.5x book as a bellwether for bank valuations more generally. One of the unfortunate aspects of the shift in Fed monetary policy is that many banks and nonbank financials. Our friends at Piper Sandler put the situation succinctly in a note last week: “The end of Q1 2022 is a precarious time for financial institutions. Since the start of the year, we have seen a large jump in rates, while investment portfolios comprise a larger portion of the balance sheet. Strategies and messaging take center stage, as the investment portfolio mark pressures TCE ratios.” Translated into plain terms, there are a lot of depositories and nonbanks that were lulled to sleep during 2021, when the market risk was in one direction and the mortgage industry was minting MBS with 2 and 2.5% coupons. Today the on-the-run MBS is now a 4% coupon, meaning that much of last years production is under water and headed lower. We expect to see a large number of financials reporting mark-to-market losses on loans and MBS that got caught in the interest rate shift that has occurred over the past 90 days. Equity managers may see any resulting price weakness as a buying opportunity, but we repeat that the baseline for 2022 bank earnings is 2019 and not 2021. The FOMC took $40 billion from quarterly bank earnings due to QE. It will take years for banks to rebuild asset returns. MSRs : One question we hear a lot from readers is what is going to happen with mortgage servicing rights after several years of near-record pricing. The good news is that prepayment rates are falling and average lives are rapidly extending, suggesting higher net-present value for MSRs generally. Prepays for Fannie Mae 1.5s, 2s and 2.5% MBS coupons are below 20% CPR and falling rapidly, implying double digit returns for holders. The big question with MSRs, however, is credit. As the Fed raises interest rates, home prices will react as the pool of available buyers shrinks in reaction to reduced affordability. While home supply constraints are a factor in terms of home prices, the lower income homeowner is likely to be impacted disproportionately in an economic downturn. The biggest risk in the mortgage industry is low-income home owners facing financial problems. Home owners that have been able to migrate from FHA loans to conventional loans w/o private mortgage insurance may constitute a risk hotspot in the world of conventional servicing. Investors who have paid premium multiples of 5x annual cash flow may find that the assets they own are actually comprised of a large portion of FHA borrowers who will behave accordingly. In Ginnie Mae MSRs, the risk/return calculation is even more profound because of the higher natural delinquency rates in government loans and also the tendency of mortgage servicers to modify delinquent loans that came under COVID. We continue to hear reports that large portions of loans that were modified during COVID will eventually re-default, suggesting that mortgage servicers and investors with exposure to Ginnie Mae MSRs will encounter rising expenses. End investors who bought Ginnie Mae MSRs during the peak of QE may come to regret these decisions. Source: MBA, FDIC Ginnie Mae MSRs, for example, that were being capitalized at 3-4x cash flow are likely to trade sharply lower as delinquency rates “revert to the mean.” The chart below from JPM shows Fannie Mae MSR prepayment rates. Note that Fannie late vintage (2021) CPRs on 1.5s, 2s and 2.5% MBS are already in single digits. Bottom line is that we see credit as the big trade idea for 2022. How rising interest rates impact the credit exposures for banks, financials and the bond market will provide many opportunities to investors, but largely in terms of falling valuations. One of the biggest risks to financials is one name: Citigroup (C) , which is trading below half of book value due to concerns about exposure the Russia due to the war in Ukraine. Negative news from Citi could take the entire financials complex back to Q1 2020 valuations. Whereas in 2020-2021 the dominant trade thesis was long and SPACs were proliferating like flowers in Spring, now the trade is short across many sectors and asset classes. Many of the startups, investment flows and SPAC transactions that proliferated in 2020-2021 are likely to be casualties in the next several years. Disclosure: L: EFC, NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC

April 4, 2022 | In this edition of The Institutional Risk Analyst , we list the top members of our surveillance group in the world of mortgage finance, this time by the value of their public equity. Some of these names are familiar to our readers, others are new. The fact that Fiserve (FISV) is the most valuable, followed by a number of service providers and vendors that support the mortgage ghetto, is no surprise. As the 30-year mortgage rate climbs and mortgage lending volumes fall, the market value of the seller/servicer community has declined sharply. The monopoly provider of servicing software, Black Knight (BKI) and FISV appendage Sagent M&C are corporate orphans, spun out from higher multiple businesses that wanted to avoid the negative connotations associated with residential mortgages. BKI was separated from Fidelity National (FNF) in 2017. Sagent was partially spun out from FISV in 2018. Indeed, some of the best quality names in the world of mortgage finance are trading at a steep discount as Q1 2022 ends, a bond market reality we discussed in our last comment (" Why the FOMC Cannot Sell its Mortgage Bonds "). Residential mortgage finance, lest we forget, is 100% correlated to interest rates and employment. The Residential Mortgage Finance Top 27 is shown below. But the really big question facing the denizens of the mortgage ghetto this week: Who is going to acquire and restructure Blend Labs (BLND) before this newbie-fintech-something runs out of cash? " Blend Labs, the mortgage processing cloud platform that went public last year, posted a hefty $73.1 million loss for the fourth quarter, warning of tougher times ahead for its bread-and-butter residential lending clients," reports Paul Muolo at Inside Mortgage Finance . "In 3Q21, the San Francisco-based tech firm lost $76.3 million. Companywide revenues fell to $80.9 million in 4Q from $89.6 million in 3Q21." Ouch! Another similar situation faces Better.com, the five-year-old mortgage lender that prospered during the extraordinary period of QE, but now seems to be in trouble. The online lender was supposed to close an IPO via SPAC last year. Sponsor Softbank has been forced to inject capital into Better.com . It is unclear whether the transaction will ever close. " In May 2021, the Softbank-backed Better.com disclosed that it had entered a deal to go public via a merger with special purpose acquisition company ( SPAC ) Aurora Acquisition ," Forbes reported in March. "The companies are aiming to close the deal sometime before the end of the year." That is, 2022. Questions? Comments? info@theinstitutionalriskanalyst.com

March 31, 2022 | In this edition of The Institutional Risk Analyst , we return to the key topic when it comes to changes in US monetary policy, namely how will the FOMC manage the reduction in the system open market account or SOMA . Many talking heads spend time squawking about the changes to interest rate targets, but what happens to the Fed's balance sheet is far more important to investors, lenders and markets. The economists who run the central bank assume that they can actually sell the mortgage backed securities in the SOMA trove despite the change in interest rates. But maybe not. We asked the following question on Twitter this AM. What was the duration of the Fed’s MBS portfolio a year ago? And what is the duration now? The folks at FIDO have a nice summary definition of duration: “Duration is expressed in terms of years, but it is not the same thing as a bond's maturity date. That said, the maturity date of a bond is one of the key components in figuring duration, as is the bond's coupon rate. In the case of a zero-coupon bond, the bond's remaining time to its maturity date is equal to its duration. When a coupon is added to the bond, however, the bond's duration number will always be less than the maturity date. The larger the coupon, the shorter the duration number becomes.” In simple terms, you can think of duration as the weighted average time required to recoup your investment in a bond or servicing asset. But the bond or modified duration of a security shows how volatile that security is given a change in benchmark interest rates. Because most of the Fed’s $2.5 trillion in MBS are 2% or 2.5% coupons, these securities are more volatile than the broad market. Today in New York, of note, UMBS 2s for delivery in April were trading 92 26-28 at midday. The screenshot from Bloomberg shows the TBA market summary with Fannie/Freddie MBS (UMBS) at the top and Ginnie Mae MBS at the bottom Source: Bloomberg 03/31/22 TCW outlined the liquidity issue facing the FOMC in a research note: “The Fed has served as the buyer of last resort for years and suddenly removing its role in the agency MBS market will be problematic. In addition to the possibility of destabilizing the agency MBS market, it is likely to have knock-on effects on other sectors. Currently, agency MBS is already facing multiple challenges including an YTD rise in mortgage rates of over 100bps. We do not believe the Fed will want to put further stress in the market.” While we agree that the mortgage market is vulnerable to further Fed manipulation, unfortunately the damage is already done. When the FOMC purchased trillions of dollars in MBS from the markets, the average life of a mortgage loan was a couple of years. In QE, the Committee also removed huge amounts of duration from the markets, forcing investors to look elsewhere for returns. The purchase of MBS during QE also pushed down interest rates and pushed asset prices higher, depressing visible default rates. Now we are reverting back to normal. Buckle up. Unlike a regular bond, the maturity of MBS vary with the rate of prepayment of the residential mortgages behind the security. Every borrower has a free option to prepay the loan w/o penalty. When rates rise, bond prices fall and prepayment rates plummet. With effective MBS maturities now in excess of 10 years and headed higher, the FOMC wants to sell several times more duration back into the markets than was removed via QE . Hello. This change in duration of MBS is called extension risk , BTW. Not only is the dealer community unwilling to deploy capital to support these risky, low-coupon securities, but these government-insured MBS may soon be under water in terms of cash returns. As the rate of monthly loan prepayments fall down to, say, high single digits in 2022, a Ginnie Mae 2 or 2.5% MBS is not an easy asset to sell. TCW continues: “It will also be an operationally daunting task for the Fed to sell its MBS holdings. A mortgage portfolio’s paydowns are dependent on interest rates due to prepayment speeds… Over the past QE cycles, the Fed’s purchases have been focused in purchasing production coupons with the goal of matching market liquidity. For the latest QE cycle, the bulk of purchases have been focused in 30-year UMBS 2.0s and 2.5s. As a result, 70% of Fed’s 30-year UMBS holdings are in 2.0s and 2.5s. With the recent selloff in interest rates, the 30-year mortgage rate is hovering around 4% and the production has shifted to 3.0s and 3.5s.” If interest rates continue to sell off, TCW notes, “the liquidity on the Fed coupons may be thin.” This may be the understatement of the year to date. Many observers are concerned about a massive sale of off-the-run MBS by the Fed. Some believe that given the Fed’s stated schedule to return to a Treasury-only portfolio, the Fed needs to sell MBS at some point in the coming years. We have a different view, namely that the Fed will ultimately need to change its schedule for balance sheet reduction. The conditional prepayment rate or "CPR" is an estimate of the percentage of a loan pool's principal that is likely to be paid off prematurely. We think that prepayments on the Fed's portfolio of 2s and 2.5s could fall down into low single-digit CPRs. With the duration of low-coupon MBS falling and prices also plummeting, the FOMC may have to accept the natural runoff rate for the MBS in the SOMA and avoid outright sales for many years to come. Of note, most the third-party valuation firms currently use 8-10% CPR for modelling LT MSR returns, but we think those 2% MBS held by the Fed could fall down to 4% CPRs. That is, we do not think that the FOMC will be able to OK outright sales of MBS from the SOMA beyond a token amount. The only other option for the FOMC is to convince the Bank of Japan and other supranational buyers of MBS to swap the mortgage paper on the Fed’s books for Treasury securities. The good news is that prepays are down and returns on UMBS and GNMA MBS are again positive on a nominal basis after several years of negative returns. Buyers of MBS were annihilated by QE when CPRs rose to 30-40% annual prepayment rates. Is Fed Chairman Jerome Powell smart enough to call the BOJ and ask the question? As the Dutch like to say, if you don’t ask the answer is no. Trying to sell a couple of trillion in low-coupon MBS on the Fed’s current schedule will cause a market crisis in government and agency securities, an eventuality that even the folks on the FOMC will hopefully have the good sense to avoid. Given that the Fed is currently playing chicken with the markets with the abortive “transition” from LIBOR to SOFR , hopefully cooler heads will prevail. Unlike inflation and unemployment, risk is never transitory.

March 28, 2022 | Premium Service | In this edition of The Institutional Risk Analyst , we take a look at the top-five US commercial banks – JPMorganChase (JPM) at $3.7 trillion in total consolidated assets, Bank of America (BAC) at $3.1 trillion, Citigroup (C) at $2.2 trillion, Wells Fargo (WFC) at $1.9 trillion and falling and U.S. Bancorp (USB) at $573 billion. We exclude Goldman Sachs (GS) , Morgan Stanley (MS) and Charles Schwab (SCHW) because these financial holding companies are focused primarily on investing rather than commercial banking. Do note, however, that SCHW is now the 7th largest BHC in the US and there are now five US banking groups in the $500 billion asset category. As the GAAP adjustments to bank income due to COVID have ended in 2021, US depositories start 2022 with gross interest income that is $40 billion per quarter below levels of two years ago. Loan loss rates remain quite low by historical standards, but delinquency is rising as you’d expect after a bull market in lending. The big question for 2022: Will funding costs rise faster than asset returns as the Federal Open Market Committee shifts policy to tightening. Source: FDIC The chart below shows net losses for total loans and leases vs average assets, one of the most basic measures of bank credit quality. Note that Citi’s loss rate is more than 2x the other large banks and 3x the average for the 130 large banks in Peer Group 1. Loan loss rates still reflect the downward skew caused by QE and the low absolute level of interest rates. Note that BAC has one of the highest levels of credit loss of the other large banks after Citi, a remarkable fact given the poor asset returns reported by the bank under CEO Brian Moynihan. While BAC is consistently among the most traded bank stocks in terms of volumes, its financial performance remains decidedly mediocre. WFC, on the other hand, had the lowest loss rate in Q4 2021. Source: FFIEC Once we consider the bank’s credit loss profile, the next and related question is how well the bank performs in the market in terms of originating or pricing loans acquired from correspondents. BAC, of note, has the lowest gross spread on loans and leases of the top five banks and also boasts the longest average duration on its $1 trillion loan book in excess of ten years. Source: FFIEC After loan losses and pricing, the next area of interest is funding costs. The cost of funds for US banks reached an all-time low in Q4 2021, with Peer Group 1 reaching 23 bps and JPM just 15bps. But the lowest funding costs among the top ten US banks was SCHW at just 8bp on the bank’s almost half trillion in core deposits related to its advisory business. The smaller banks in Peer Group 1 naturally pulled the average down, but Citi’s cost of funds was 2x the group at 39bps. Source: FFIEC When we consider credit expenses, loan pricing and funding costs, the result is net income vs average assets. All of these institutions have significant non-interest income as part of their business mix, but all depend upon interest income and the spread over funding to function as a business and pay returns to equity investors. Source: FFIEC In terms of net income, Citi is at the bottom of the group followed by BAC, WFC and Peer Group 1. JPM and USB are the best performers in the group. Notice that USB has been the top performer in the top five banks going back five years and maintained that position through COVID. Why do investment managers prefer temples of mediocrity like BAC to USB? Because the former is bigger and a more liquid stock, and relatively cheap. But BAC is cheap for a reason, namely the weak management and lack of focus under CEO Brian Moynihan. One way to compare the operating profiles of the top five banks is to look at the efficiency ratios calculated by the FFIEC. The table below shows the efficiency ratios for the top five banks and Peer Group 1. Notice that USB and JPM are at or near the unweighted peer average, which reflects the superior profitability of smaller banks, while the results for BAC, Citi and WFC are elevated. Efficiency Ratio (%) Source: FFIEC Another interesting perspective on operating efficiency is available by comparing the assets per employee of the major banks. While BAC has the largest assets per employee, they have the worst financial results. USB, on the other hand, has the smallest assets per employee but the best operating results. Big is not better. Assets per Employee ($) Source: FFIEC Outlook Street analysts have JPM’s revenue basically flat in 2022, but miraculously growing 6% in 2023. USB, by comparison, is estimated to see 10% revenue growth in the current year and up 12% in 2023, the best outlook for the group. The 12 Street analysts that follow BAC estimate single digit revenue growth this year and next, with earnings of $3.57 for 2022 and only $3.30 in 2023 for the Bank of Brian. Citi is expect to do $10 per share in earning this year but only $7 next year, perhaps explaining why the bank is trading at 0.6x book value at the close on Friday. Revenue growth for Citi is modest given that the bank is in the midst of jettisoning poorly performing businesses. WFC, by comparison, is expected to see down revenue in 2022, with earnings declining from $4.80 per share this year and just $3.90 in 2023. Hardly a rousing recommendation. The tail winds in 2023 are that credit costs are still subdued thanks to the FOMC’s que and funding costs remain near record lows. But with the prospect of a flat or even inverted Treasury yield curve in 2023 and beyond, banks may face a future that is as uncertain as the past few years have been assured. Funding costs could very well rise above the average yield on short-term securities held by many banks, adding to the pain already felt by the movement in interest rates. Last year, large banks were swimming in a market with robust M&A activity, a good number of low quality IPOs and strong mortgage origination volumes. Now a good number of those IPOs are busted deals and the flow of new transactions is down significantly. The non-interest income line of the universal banks will be light this quarter. Last March, banks were selling residential mortgage loans into GNMA 2 MBS, but today are more likely to be selling fewer loans into a 3% MBS or 3.5s. There are a number of banks and IMBs that are sitting on market losses on whole loan and MBS portfolios that were retained too long. The TBA market for convention and government MBS is shown below. Source: Bloomberg The war in Ukraine has closed Russia and also China to the global investment banking swarm, thus we look for disappointment in Q1 2023 earnings on that front. It is interesting to note that the Chinese government is showing concessionary signs on the question of audits for Chinese firms seeking to list in the US market. With the on-the-run 10-year Treasury note trading on a 94 handle, the message is clearly higher interest rates and less new issue market activity as a result. Volumes in the residential mortgage market in the US will likely be down 60% in 2022 vs the record year before. All that said, valuations for the top five US banks are up slightly as Q1 2022 comes to an end. Notice that USB has the highest multiple of book value for the group as the quarter comes to an end. Source: Yahoo Finance Our banking surveillance group is shown below. 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