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March 21, 2022 | Last week, Federal Reserve Board Chairman Jerome Powell said that he was pleased with FOMC’s balance sheet discussion, Ian Katz of CapitalAlpha Partners reports. “We made excellent progress toward agreeing on the parameters of a plan to shrink the balance sheet,” he said. Powell then went on to say that the framework for shrinking the balance sheet is going to look “very familiar to people who are familiar with the last time we did this. But it will be faster than the last time, and of course it’s much sooner in the cycle than the last time.” Powell’s comments ought to be troubling to readers of The Institutional Risk Analyst on several levels, but mostly because they suggest that the Fed has not learned from past mistakes. The chart below shows the S&P 500 vs the Fed’s almost $9 trillion system open market account (SOMA). Both Powell and other Fed officials reflect a level of confidence in the process for reducing the size of the central bank’s balance sheet that belies the failures of April 2020, September 2019 and December of 2018. In each case, a lack of appreciation of the magnitude of the failure of public policy remains a major blind spot for the Fed. One of the single biggest errors in judgement by the Fed was the decision, together with the Bank of England , to kill the LIBOR market. The general point is that Dodd-Frank and particularly the Volcker Rule has made dealers reluctant to deploy capital, especially dealers inside large banks. As a result, in times of market stress, the major dealers and warehouse lenders led by JPMorgan (JPM) have folded their arms and refused to provide additional liquidity to meet market demand. Into this already constrained market for liquidity, the Fed has introduced another variable: kill LIBOR. Instead of asking Congress to fix the liquidity problem, the politically cowed members of the Fed’s Board of Governors have instead created a standing repurchase facility (SRF) to correct earlier policy errors led by the Volcker Rule and the Liquidity Coverage Ratio (LCR). The SRF will, in theory, enable the Fed to provide liquidity directly to the markets, reflecting a significant departure in terms of market structure that was not authorized by Congress. The Fed’s forward and reverse repurchase facilities represent an additional nationalization of the US money markets, this atop the confiscation of the market for overnight funds (aka “Fed funds). This once private marketplace has been transformed into a policy instrument by unelected economists, rendering the US markets more and more a copy of the authoritarian states of Continental Europe. David Andolfatto and Jane E Ihrig of the Federal Reserve Bank of St Louis made the very practical case for a SRF in 2019 . Having started quantitative easing after the 2008 market correction, the FOMC eventually found “fine tuning” monetary policy impossible with a now $9 trillion balance sheet. Powell and his predecessor, Janet Yellen , have stretched the “necessary and proper” clause of the US Constitution to the breaking point when it comes to interpreting the intent of Congress. The authors noted that due to the constraints of Basel and Dodd-Frank, large banks understandably prefer cash reserves held at the Fed to Treasury securities, which bear market risk and require higher capital allocations. They noted an earlier discussion by the Fed of New York that large banks might need the ability to liquefy up to three quarters of a trillion in Treasury paper during times of stress. The authors concluded in 2019 before the Fed’s September liquidity snafu: “Even though balance sheet normalization is well underway, we think it is never too late to introduce a repo facility. The FOMC would learn over time whether the facility is working to reduce the demand for reserves. The FOMC could do so, for example, by permitting reserves to run off organically with the growth of currency in circulation while remaining confident that interest rate control would be maintained through the repo facility.” Taken to its bureaucratic extreme, SFR would reduce the amount of reserves held by banks to some minimal amount since banks could get actual cash for Treasury obligations upon demand. Combined with a floor underneath interest rates in the form of the Reverse Repurchase Facility, the two new appendages of the central bank would essentially corner the market in short-term interest rates, forcibly if need be. But the SFR also suggests that if the markets ever turn away from the US Treasury, the Fed will be the buyer of last resort. Having the Fed push the largest banks out of the way in the market for overnight funding brings the US into alignment with Europe, where the central banks are the center of a largely state-sponsored market for secured finance. In plain terms, the Fed is killing the private bond markets in the US to control volatility and thereby make life more convenient for Fed bureaucrats. The SFR also serves another, unstated purpose, namely to keep the market for Treasury debt open. In this decidedly anti-market and also anti-democratic formulation, US investors have been reduced to the role of the residents of Locker C18 at Grand Central Terminal. Don't worry, the "Men in Black" from the Fed will save the world. Chairman Powell is obviously Will “Jay” Smith , while Tommy Lee Jones is played by former “Chair” and now Treasury boss Janet Yellen . Note who is in charge. Unfortunately, happy endings only occur in Hollywood, while in the real world agencies like the Federal Reserve Board make it up as they go through time. This is hardly a formulation that adherents to the free enterprise model of American political economy would recognize. Like the European Central Bank or even the Bundesbank in Frankfurt, the Fed now has the front row seat (singular) on the floor of the virtual exchange that is the US bond market. Keep in mind that during the liquidity hiccups of the past five years, the Fed was busily destroying LIBOR, the chief global rate for funds from overnight to more than a year. The replacement created by the Fed, SOFR, barely trades and does not follow LIBOR, forcing market participants to pad the rate to adjust. SOFR has no term structure and seems to have no correlation to other benchmarks. How is this helpful? Of note, the Fed has already removed the historical LIBOR data from its servers so that the public cannot compare the two series. Our bet is that the zombie SOFR “market” will likely die a well-deserved but natural death and other private measures such as the Treasury swaps curve or CBOE’s Ameribor will replace it. Q: What is wrong with the graph below? A: SOFR is a zombie, does not trade, lingering at 0.3%. LIBOR is at 0.9% this morning while Ameribor is 0.58%. How can Chair Jay seriously expect to reduce the Fed’s balance sheet when he has so perfectly screwed up the market for short-term secured finance?? The chart above shows overnight SOFR, 3 month LIBOR and the 3 month Ameribor contract traded by the CBOE. The Fed’s zombie SOFR index does not really trade significantly beyond overnight. Notice that the two new measures SOFR and Ameribor, which lack a significant market follow, are barely moving after the FOMC’s latest policy action. The disruption caused to the secured financial market by the Fed’s ill-considered decision to terminate LIBOR may come back to haunt the US central bank later this year. The good news is that markets such as Fed funds and the too-be-announced (TBA) market for agency and government mortgage securities trade against the Treasury yield curve. Everything else in the world of asset backed securities, however, has historically traded vs. LIBOR and now trades against, well, nothing. SOFR is not a market or even a benchmark. It is a not quite wet dream created by the Fed’s staff that like most economist musings, has no real substance. When markets get volatile, the trillions of dollars in ABS that have traded vs LIBOR historically will effectively be cast adrift without a basis for valuation. As one veteran trader reflected in Twitter over the weekend with respect to the above chart: “Something is going to break.” The point about LIBOR is not merely to illustrate the Fed’s lack of sensitivity to the cost of its policies. The folks at the Fed are really good at destroying markets, but less skilled when it comes to creating new markets, as with SOFR. Being a New Deal (aka “socialist”) institution, the Fed pursues the goal of “full employment” to the exclusion of all other goals – including price stability -- but never bothers to notice or acknowledge when it makes a policy “misjudgment.” Followers of the Church of Rome take solace in the fact of a loving and forgiving God, but there is one sin that God will not forgive: arrogance. It is time for Congress to help the Fed. In order to introduce better decision making into the Fed’s complex deliberations, we need to make Fed governors more accountable for the consequences of their decisions so as to better align economic policy and the real-world results. That is, should the Fed cause another liquidity crisis as it ends QE and shrinks the balance sheet, then Chairman Powell should immediately resign.

Through its expansion of credit policies, the Fed has effectively engaged in fiscal policy actions that more appropriately belong to Congress. Congress, as well as the Fed, have taken actions that violate at least the spirit of the 1951 Accord. Taken together, these actions undermine the independence of monetary policy decision-making by the Fed and open the door to political and fiscal abuse of the central bank’s balance sheet. Thus, it is important to strengthen Fed independence through the appropriate assignment of decision-rights and accountability required of the institution in a democratic society. "Federal Reserve Independence: Is it Time for New Treasury-Fed Accord?" Charles Plosser March 15, 2022 | There is a fairly brisk debate ongoing in the fixed income markets over how much the Federal Open Market Committee will reduce the size of its balance sheet over what timeframe. A key component of this discussion is whether or not the Federal Reserve Bank of New York will be required to actually sell agency and government mortgage-backed securities (MBS) next year in order to meet the Committee’s targets. The basic issue driving this debate, a question that will not be resolved when the FOMC meets this week, is whether the slowdown in mortgage refinance transactions will force the Fed’s hand and compel outright sales of MBS next year. As prepayments slow, the effective maturity of an MBS extends, creating what denizens of the bond market lovingly refer to as “extension risk.” The sudden change in effective duration of securities has been responsible for numerous financial crises over the past 50 years. Extension risk means that as the effective maturity or duration of a residential mortgage security extends, the pricing becomes more volatile, mostly on the downside, and the investor is deprived of the opportunity to re-invest at higher rates. The S&Ls of the 1980s, for example, were decimated when short-term interest rates rose but the duration of loan assets extended, making it impossible for thrifts to manage interest rate risk. US banks face a similar risk today, but hold that thought. Source: FDIC/WGA LLC The history of Wall Street liquidity crises going back 50 years has often included investors who thought they owned an MBS or collateralized mortgage obligation (CMO) with a four- or five-year average life, but awoke one morning to find that the bond now has a 10-year + effective maturity. Hello. The FOMC owns about half of all MBS issued since 2020, several trillion dollars in total. As one analyst noted last week, the Fed will own these bonds for a long time barring outright sales. Yet the line coming from the Fed is steady as she goes in terms of denying the possibility of outright sales of MBS. Lori K Logan , EVP of the Federal Reserve Bank of New York, set the stage for the withdrawal of accommodation in an important conversation with David Beckworth this past January: “At the conclusion of the large-scale asset purchase programs after the global financial crisis, the committee did undertake balance sheet normalization that lasted about two years. So in terms of the mechanics of that process, balance sheet normalization was conducted in a gradual manner and a predictable manner. I think those are the two key themes there. And there were two implementation elements to that. First, principal payments from our maturing securities were no longer reinvested and that reduces the balance sheet size. And in other words, it was an organic process. We didn't sell assets. And then the second mechanical feature was that caps were set on these monthly redemption amounts to ensure a steady decline.” The war in Ukraine adds another layer to the usually domestic analysis of Fed monetary policy. Most of the economist chorus in the US almost never talks about the rest-of-the-world, but in fact offshore demand for dollars and, equally important, demand for risk-free collateral denominated in dollars is a factor as well. Watch the likes of Softbank of Japan circling the drain of credit and liquidity, then you understand why Asian investors are selling stocks with abandon this week. In the chart below from Bloomberg , the green line is the Treasury yield curve and the blue line is the bid side of dollar swaps. Notice that the portion of the swaps curve between overnight and 7 years is very well bid. Think anybody on the FOMC will talk about this tomorrow? While the Russia war of extermination against Ukraine may remove Putin’s kingdom from the global economy, we think the crisis will actually strengthen the dollar’s role as the default means of exchange. Dollars, euros and yen are the only global currencies, managed by free and democratic societies, that matter. And the distinction between onshore and offshore will increasingly divide markets and economies. Yeah, the dollar will “never be the same” because we’ve chased all of the oligarchs and associated crime organizations back to Moscow. Down the road, Ukraine will become a copy of Austria circa 1955 (h/t John Dizard), sorta an EU member, but outside of NATO by international agreement . Given the table that has been set for the FOMC, we think the first question is when will the 10-year Treasury peak and maybe touch 2.25%? But our bias remains lower rates because of the persistent foreign demand for liquidity and risk-free assets. Given the chart above, we see 1% on the 10-year Treasury as a likely target. The FOMC remains months behind the proverbial risk curve in terms of ending extraordinary purchases of securities and will be in the midst of tightening policy even as the global economy heads into recession later this year. Leading the way into an economic slowdown will be housing, which benefitted enormously from QE but is now paying the price for the party via layoffs and a serious deterioration in operating profits. US banks also must now struggle with rising funding costs and sluggish asset returns, reversing the benevolent environment when funding costs fell faster than asset-yields. As we note in The IRA Bank Book Q1 2022 : “We expect to see banks make progress in terms of building back interest income that was suppressed by QE, yet investors and risk managers need to be mindful that Q1 2019 is the real benchmark. The noise and adjustments to GAAP earnings during 2020 and much of 2021 make these years a throw-away analytically. If the Fed sticks to its guns and raises the target for federal funds a couple of percentage points during 2022, then residential mortgage rates will be at 5% by 2024 and the great mortgage correction of 2025 will be well in sight. Add to that picture the price inflation of war in Europe and 2022 becomes a year of growing credit risk.” Besides the question of monetary policy and the economy, the key question facing the FOMC is when and how the extraordinary ease of the past several years will cause a serious correction in the affected markets, particularly stocks and real estate assets. Even a slowdown or cessation of double-digit price increases in these asset classes will present a serious challenge for investors and risk managers. But add the additional risk of unexpected credit losses and volatility will likely grow. “There are currently two narratives - one focuses on a housing crash coming soon due to interest rate rises, and another on prices increasing in line with inflation,” Tim Thomas of the Wealth of Geeks Network wrote on Bloomberg this week. “Consequently, it's tough to know which conclusion individual investors will reach, and there's likely to be some diversity of opinion. Some may consider real estate a hedge against inflation, but others may get spooked and pull out, completely dampening demand further.” Or as our friends at SitusAMC commented last week in a discussion of the market for mortgage servicing assets, sometimes as the risk free rate rises, the option-adjusted spread (OAS) goes down. To review, OAS is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, adjusted to take into account the embedded optionality. Given the volatility in terms of market risk and credit exposure flowing through the global economy, calculating OAS, let alone setting a coherent path for US interest rates going forward, will be a challenge indeed. WEBCAST | Chris Whalen: Rate Hike(s): Market Risk Rising

March 12, 2022 | This week Guild Holdings Co (GHLD) reported results for Q4 2021 and the full year. GLHD is one of the older independent mortgage banks (IMBs) in the US and also one of the more stable and better managed shops. The proof of this statement is seen in the financial results of GHLD, which in 2022 illustrated that not all IMBs are the same. GHLD focuses on purchase mortgage business and does so in a way that delivers more stable volumes, more consistent gain-on-sale (GOS) margins and more even financial results through the economic cycle. Subscribers to the Premium Service of The Institutional Risk Analyst read on to find out why. One of the first things to notice about GHLD is that the company has very close control over operating expenses and did not “overshoot” revenues as 2021 ended. While many issuers large and small allowed expenses to run ahead of business volumes, GHLD managed down expenses with revenue. Source: EDGAR GHLD is largely a purchase mortgage lender that has a strong retail channel. Retail mortgages are the most expensive channel in residential finance, thus GHLD has always needed to be sensitive to operating expenses given the ebb and flow of interest rates and mortgage volumes. This focus on expense management and retail production has resulted in less volatility in operating results and more stable margins that the industry average of 228bp in Q3 2021. In Q4, GHLD earned a gain on sale margin of 3.47% based on in-house originations and 3.94% based on pull-through adjusted locked volume. Source: GHLD “I am pleased with the results Guild delivered during the fourth quarter and full year of 2021 despite a more challenging second half of the year for our industry,” said Mary Ann McGarry , Chief Executive Officer. “In originations, we funded $37 billion of mortgage loans last year at higher gain on sale margins relative to those typically generated in the wholesale or correspondent channels. Much of our resiliency can be attributed to our purchase-focused mortgage business that sets us apart, as well as industry volumes increasingly shifting toward purchase loans." In addition to managing the decline in earnings, GHLD continued to build its servicing book with relatively low leverage, growing the unpaid principal balance (UPB) of its book. Some highlights from the GHLD earnings presentation are below. Note in particular the relatively low leverage on the mortgage servicing rights (MSR) portfolio, which was marked at 95bp at year end after a small downward adjustment: Net income for the servicing segment totaled $27.3 million compared to a loss of ($24.5) million in 4Q20, In-house servicing portfolio increased 18% to $71 billion from 4Q20; retained servicing rights on 80% of loans sold, Servicing portfolio leverage ended the quarter at 37% with $250 million of borrowings and a fair value of $675 million, and Recaptured 61% of refinance opportunities, highlighting the power of Guild’s business model As the residential mortgage industry goes through a tough period of cost-reduction in coming months, we expect GHLD to continue to outperform the industry. “We think that there's going to be continued pressure on margins, but now starting to see some of these companies' final shed some excess capacity will help, but the natural volume drop, and the competitive nature and the volatility of the market is pushing those down right now,” McGarry said on the GHLD call. Like most other mortgage banks, GHLD has given up a good deal of ground since its second IPO in October 2020 but less than some of its peers. Notice in the table below, for example, that GHLD has the lowest market volatility (beta) in the group and is trading at 0.75x book. Source: Bloomberg Bottom line is that, in our view, Guild is one of the highest quality lending and servicing businesses in the residential mortgage space. McGarry and her team have spent the past several decades building value in their business, from the relationships in the retail channel to a growing book for mortgage servicing rights, that will feed future originations even as many other players in the industry are forced to retrench. Disclosures: 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. 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March 7, 2022 | In this Premium Service issue of The IRA Bank Book for Q1 2022 , we review the trends in the US banking sector as we head to the end of the first quarter of 2022. This report will be available to all of our readers through March 10th. The good news is that the skew in bank financial results caused by COVID and the response by the Federal Open Market Committee is nearly at an end. The bad news is that Russia's attack on Ukraine is creating new credit default events all over the world even as it pushes global prices higher. As the chart below illustrates, the contribution to bank earnings from negative loan loss provisions has just about run its course. In many ways, Q1 2022 is an inflection point for markets, inflation and risk. Source: FDIC As US interest rates have risen over the past several months, net interest income for all US banks has started to recover from the nuclear winter of quantitative easing or QE. While this is welcome news, the industry has a long way to go to return to the $180 billion in total interest income reported in Q1 2019. Meanwhile, domestic credit costs are building after a two year hiatus on loan payments c/o the Consumer Financial Protection Bureau and many states. Source: FDIC As NIM recovers from the lows of 2019-2020, asset and equity returns for the industry are actually falling. Assets and equity have continued to grow faster than bank income, a reflection of the strange dynamics at work in the banking sector as COVID quickly slips into memory. Part of the decline in the reported ROA and ROE stems from the end of the return of credit loss provisions back into income as shown in the first chart. Source: FDIC/WGA LLC The decline in public valuations for banks coincides with the drop in equity returns and a related drop in dividend income from banks. Cash dividends in Q4 2021 were almost $15 billion below the $54 billion in Q3 2021, as shown in the chart below. We continue to see evidence that the industry is headed back down toward 2019 levels of pretax income in 2022 even as credit costs again become an expense. Factor that into your thinking about future bank dividends and share repurchases. Source: FDIC Industry income, after all, dropped $20 billion in the past four quarters to just $77.6 billion in Q4 2021 vs a tad under $100 billion in Q1 2021. During the same period, public market valuations were bid up to near record levels. As we’ve noted in recent reports, several crypto banks such as Silvergate Capital (SI) soared to valuation multiples usually associated with the most speculative technology assets. Now that the industry has seen 25% of pretax income disappear into the black hole of QE, investment managers seem to have finally taken notice. Again, we are headed for a landing around Q1 2019 levels of pre-tax income for US banks in 2022, but operating expenses sadly are not affected by QE. “Noninterest expense rose $7.8 billion (6.2 percent) year over year, led by an increase in “all other noninterest expense” and salary and benefit expense,” FDIC reports for Q4. “Higher marketing and data processing expenses drove the increase in the “all other noninterest expense” category. Average assets per employee increased from a year ago to $11.5 million.” How have US banks managed to build reserves, pay earnings and repurchase stock even as interest income has fallen 25%? Because the Fed has stepped on funding costs with the full weight of the United States. “Average funding costs declined 2 basis points from the previous quarter to a new record low of 0.15 percent,” the FDIC reports in the latest Quarterly Banking Profile . One big reason to look for an expansion of bank earnings in coming months is the fact that funding costs will lag the rise of yields on earning assets. But that said, the starting point for the climb back in terms of bank earnings is Q1 2019. Source: FDIC/WGA LLC Last week Federal Reserve Chairman Jerome Powell suggested a three-year timeframe for reducing the Fed’s balance sheet. Brean Capital published a note saying that this would require some outright MBS sales in 2023 and 2024, Bloomberg reports. Recall that as the Fed's portfolio shrinks, bank deposits are destroyed on a 1:1 basis with the reduction in reserves. As reserves shrink, banks will shift back into T-bills and Treasury coupons, and Ginnie Mae MBS, for reserve assets. Given these mechanics, we doubt that the Fed will be able to raise rate targets more than a couple of times without sparking a liquidity crisis. While the rate paid on deposits is unlikely to move in the near-term, it is important to note that the relative slowing of QE has already started to evidence itself in a slowing of bank deposit growth. Once the Fed ends new investments and even starts to taper reinvestment of principal repayments, the rate of change for US bank deposits will slip into negative territory. Source: FDIC/WGA LLC But perhaps the most important news for the US banking industry in Q4 2021 was that bank loan portfolios finally started to grow after several years in negative territory. Most of these loans were acquired from correspondents or in bulk, not made by the reporting bank, but no matter, the numbers are headed north and may auger higher asset returns in future quarters. The key question is how fast the pricing for commercial loans will recover. Source: FDIC While the loan growth seen in bank portfolios is welcome, the big area of balance sheet expansion remains securities and particularly Treasury bonds. As the Fed seeks to shrink its balance sheet in coming months, and available reserves decline, banks will become ever more aggressive in terms of debt purchases. This also implies increased market risk on bank balance sheets, and hedging expenses, as risk free reserves are exchanged for Treasury coupons and bills. “Growth in U.S. Treasury securities (up $175.7 billion, or 13.9 percent) continued to drive the quarterly increases in total securities,” the FDIC reports. “Loans and securities with maturities greater than three years now make up 39.4 percent of total assets, up from 36 percent in fourth quarter 2019.” Basically, banks are increasing long duration as interest rates rise, never a good combination. Look for hedge losses in Q1 2022 earnings for banks and nonbanks alike. Credit Charts Total Loans & Leases The $11.2 trillion in total banks loans has started to grow, as shown in the chart above. Loss and recovery rates, which have long been distorted by QE and COVID loan payment moratoria, are starting to normalize. Loss given default (LGD) has rebounded from the 50-year record low of 56.7% and now seems likely to rise back into the 80s (the LT average is 79%, BTW). Indeed, we expect to see LGDs rise above the LT average as the economy sorts out the losses due to COVID and the Russia-Ukraine war. The latter factor is exogenous and will defy efforts to quantify, but most US banks have no direct offshore exposure. Source: FDIC Source: FDIC/WGA LLC Total Real Estate Loans The $5.2 trillion in real estate loans on the books of US banks, roughly a quarter of total assets, is perhaps the most heavily skewed asset class when it comes to bank loans and QE. The fact of low interest rates boosted residential and commercial asset values, pushing down loss given default to low and even negative levels. The loss rates on 1-4s, for example are deeply negative, suggesting that home lending has no risk. The Fed effect is most pronounced in residential assets, where record low rates have driven growth in outstanding mortgage debt and a repricing of more than half of the stock of existing loans. But the repricing of residential mortgage assets since Q4 2021 has also created a lot of unrealized losses on the books of banks, REITs and funds that were caught asleep at the switch by the change in inflation expectations and price data, and thus Fed monetary policy. Source: FDIC Source: FDIC/WGA LLC 1-4 Family Residential Mortgages With mortgage rates closing in on 4% vs below 3% a year ago, the dynamic in the market for quality residential loans and mortgage servicing rights has changed from originate to sell to buy and hold. Scores of regional banks, for example, have suddenly decided to get into lending on MSRs in the past several months. Sales of loans are falling fast as banks retain prime loans in portfolio. The Fed is likely to end new purchases of agency and government MBS in March, suggesting that this collateral may see further erosion in prices and higher yields. The on-the-run Fannie Mae MBS, for example, is now a 3.5% coupon vs 2.5% a year ago, and probably headed to 4% in short order. By no coincidence, as volume and therefore liquidity ebbs in the secondary mortgage market, loans by banks to non-depository institutions rose $60 billion or almost 10% from Q3 2021. Source: FDIC/WGA LLC Note in the chart below that the post-default loss for bank-owned 1-4s rose from negative 130% in Q3 2021 to “only” minus 30% in Q4 2021. That means in those rare events of default in prime 1-4s, the bank sells the property, pays off the loan and pockets a profit. The magnitude of the skew in LGD for prime bank loans suggests to us that the upward price pressure caused by QE will continue for several more years. Note that the average LGD for 1-4s is still in the 50% range even though the Fed has brazenly manipulated home prices over the past decade. Source: FDIC/WGA LLC Home Equity Lines of Credit Like first lien residential loans, HELOCs have experienced an enormous skew downward in loss rates, but also an increase in volatility. Banks actually reported an intriguing anomaly in Q4: negative recoveries (that is, a loss) and also significantly higher charge-offs in Q4 2021. This caused an enormous skew in the calculation for LGD that pushed the series back into positive territory after hitting negative 216% in Q3 2021. Sad to say, there are just $265 billion in bank owned HELOCs remaining and the book is running off at double digit rates despite rising interest rates. Source: FDIC Source: FDIC/WGA LLC Rebooked GNMA Loans | EBOs Another important indicator of the state of the loan market is early-buyouts or EBOs of delinquent government insured loans. In 2021, GNMA issuers were aggressively bidding for EBOs because of the potential to profit by fixing the loan and selling it into a new GNMA MBS pool at 105 or 106. Today, many of these loans are now priced closer to par, meaning that the issuer has less potential profit to work with in helping the borrower. As a result, the banks as a group are backing away from participating in the EBO trade directly, but they continue to finance this loss mitigation activity performed by nonbank issuers. Source: FDIC Multifamily Loans The one real estate loan category that has bucked the trend in terms of the Fed’s positive impact on credit loss rates is multifamily loans. The $512 billion in bank owned multifamily loans showed positive loss rates and elevated levels of delinquency in 2021, a radically different picture than that for 1-4s and related credits such as construction loans. Indeed, it is a little scary to think what loss rates on bank multifamily loans would look like without the impact of the Fed's low interest rate regime and QE. The long-term average LGD was 59% through 2021, but the actual loss rate for bank multifamily loans was 10% above the LT average at 66.5%. Source: FDIC/WGA LLC Source: FDIC Commercial & Industrial Loans The $2.3 trillion commercial and industrial loan portfolio has also been skewed by QE and then the COVID loan payment moratoria in many states. Paycheck Protection Program loan forgiveness and repayment drove the 5.2% annual decline in C&I loan balances in Q4 2021. From January 1, 2022, however, most of the legal prohibitions on debt collection were lifted. Loss given default for the C&I book was still falling in Q4 2021 toward 50%, just below the LT average of 55% loss after default. We look for the LGD series and actual charge-offs or realized losses to rebound back toward more normal levels, a trend we expect to see shared by bonds. Source: FDIC/WGA LLC Source: FDIC Credit Card Loans Bank credit card balances reversed four quarters of decline and went back above $800 billion in Q4 2021. Consumer loans also grew strongly as ample reserves are finally turning into earning assets. Like other loan categories, bank credit card portfolios have seen a dramatic decline in reported levels of delinquency as COVID loan forbearance schemes have been in operation. With the end of loan forbearance, however, we expect to see credit card portfolios quickly return to 4% delinquency or higher. Notice that LGD for credit cards fell to nearly 60% vs the LT average loss rate post default of 80%. Source: FDIC Source: FDIC/WGA LLC Auto Loans Prices for used cars due to the disruption in the semiconductor industry, COVID and other factors have driven down loss rates on bank auto loans to zero in Q2 2021. The LGD on bank auto loans rebounded into the 30s this past quarter, but suffice to say that the next stop is probably higher. Most observers expect the tightness in supply for autos to be alleviated by 2023, thus we look for bank auto loan credit metrics to head back towards the LT average of ~ 60% loss given default. Source: FDIC Source: FDIC/WGA LLC Outlook: The Return of Credit Risk The outlook for US banks as the year began was for normalization of revenue, earnings and also credit metrics as the Fed began to reduce extraordinary measures for the economy. The end of forbearance schemes at the state and federal level means that the full cost of the credit dislocation of COVID will become apparent. Roughly one third of all government loans modified and re-pooled during COVID, for example, are likely to redefault in 2022. We add a new dimension of risk to the normalization of US bank earnings with the Russian war against Ukraine. Whereas the cost of credit domestically is going to rise and assume relatively normal portion of bank earnings this year, the Russia attack on Ukraine has disrupted commercial and personal finances for tens of millions of companies and people around the globe. The primary and secondary effects of this destruction of value instigated by Vladimir Putin will be felt in credit losses to banks and commercial companies alike for years to come. Going into the end of Q1 2022, we expect to see some lift to bank earnings from loan growth and a continued boost to net income in the form of reduced credit costs. Increases in gross loan yields will come later. It is important to state, however, that US banks go into an uncertain year with robust credit reserves. As the FDIC notes: "The ALLL as a percentage of loans 90 days or more past due or in nonaccrual status (coverage ratio) increased 53.7 percentage points from the year-ago quarter to 223.8 percent, a record high, due to declining noncurrent loan balances. This ratio is well above the 147.9 percent reported before the pandemic in fourth quarter 2019. The coverage ratio for community banks is 49.9 percentage points above the coverage ratio for noncommunity banks." We expect to see banks make progress in terms of building back interest income that was suppressed by QE, yet investors and risk managers need to be mindful that Q1 2019 is the real benchmark. The noise and adjustments to GAAP earnings during 2020 and much of 2021 make these years a throw-away analytically. If the Fed sticks to its guns and raises the target for federal funds a couple of percentage points during 2022, then residential mortgage rates will be at 5% by 2024 and the great mortgage correction of 2025 will be well in sight. Add to that picture the price inflation of war in Europe and 2022 becomes a year of growing credit risk. 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.

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way—in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only. A Tale of Two Cities March 9, 2022 | One of the truths of finance is that there are big banks and then there is everybody else. Banks are “government sponsored entities” or GSEs just like Fannie Mae , Freddie Mac and the Federal Home Loan Banks . All of these entities have privileged access to government subsidized funding, liquidity, and payments. We discussed this topic and the new rules for nonbank mortgage companies in our recent column in National Mortgage News ( " Dissecting the FHFA’s issuer eligibility proposal" ) The cost of funds for the entire US banking system in Q4 2021 was just 15bp, as we note in the most recent IRA Bank Book Q1 2022 . The gyrations of interest rates since the start of the full-blown Ukraine war with Russia have turned a rising rate narrative of several weeks ago into a falling rate narrative. And nobody is more impacted by interest rate volatility than mortgage banks, which typically pay several points over SOFR or even Ameribor for funding. Source: Bloomberg Those GNMA 2.5s trading for next month in the TBA market were on a 97 handle at the end of February, but now are trading near par with the resulting drop in yields. Yet even as benchmark rates have backed up in recent weeks, most of the mortgage sector is trading at a steep discount to book value. Commercial banks, meanwhile, continue to trade at a premium. Why? Because nonbank finance is heavily correlated to interest rates. Consider the sad case of Finance of America (FOA) , a venerable mortgage shop that went public via a special purpose acquisition company or “SPAC.” Bear in mind that when you go public by SPAC, you are usually acquired by the SPAC. If the SPAC pays a premium above book value for the target, then goodwill is booked as an intangible asset. If the value of the stock subsequently declines dramatically, then a write down of the goodwill often follows. “Due to a sustained decline in the Company’s stock price,” FOA disclosed on March 2, 2022 , “the Company recognized a $1,381 million accounting impairment of the outstanding goodwill and certain intangible assets in the fourth quarter of 2021 to align the Company’s book value with a supportable control premium.” To put it in plain terms, the company reported $2.4 billion in total equity in September 2021 but after the adjustment to goodwill, now reports just $1.1 billion in total equity, having written down capital by 55%. The tangible equity of FOA at $480 million, which is all that ever mattered, rose by $40 million in the same period. That sound in the background is the trial lawyers sharpening their cleavers. Meanwhile, the folks at United Wholesale Mortgage (UWMC) deserve a big hat tip for structuring their SPAC transaction with Gores Holdings IV, Inc. in such a way as to avoid creating goodwill. The March 1, 2022 prospectus from UWMC (the “Company” below) describes the transaction: “The business combination transaction was accounted for as a reverse recapitalization in accordance with U.S. GAAP as UWM was determined to be the accounting acquirer, primarily due to the fact that SFS Corp. continues to control the Company through its ownership of the Class D common stock. Under this method of accounting, while the Company was the legal acquirer, it was treated as the acquired company for financial reporting purposes. Accordingly, the business combination transaction was treated as the equivalent of UWM issuing stock for the net assets of the Company, accompanied by a recapitalization, with the net assets of the Company stated at historical cost, with no goodwill or other intangible assets recorded. The net proceeds received from Gores Holdings IV, Inc. in the business combination transaction approximated $895.1 million, and the Company incurred approximately $16.0 million in costs related to the transaction which were charged to stockholders' equity upon the closing of the transaction.” Both UWM and FOA trade well-below the heady IPO valuations of a year ago, but the former avoided the ugly investor disclosure of a goodwill write down by structuring its transaction with Gores Holdings as a reverse merger. The clever structure of the UWMC transaction, however, has distorted the book value multiple on UWMC, currently 49x. And therein lies a tale for the future. The FOA experience is instructive, however, because it provides a yardstick to understand how much the Fed’s policies inflated the asset prices of mortgage companies in 2020 and 2021. And this is one big reason why attempts by Ginnie Mae and the Federal Housing Finance Agency to impose bank like capital requirements on independent mortgage banks can only end in tears.

March 3, 2022 | Toronto Dominion Bank (TD) trades at a higher multiple to book value than JPMorgan Chase (JPM) and sports a modest 0.87 market beta, but the financial performance of the $1.7 trillion asset universal bank is not that good compared to the top US financials. Asset returns below 1% and return on equity in single digits? TD just announced the purchase of another wonderful example of mediocrity, First Horizon Corp (FHN) , at about 1.5x book, a 40% premium to market when the deal was announced. At a time when many US banks are reducing footprint in retail banking, TD is buying more. Management led by CEO Bharat Masrani is buying yet another retail bank franchise even though wealth management is the primary support for TD's public valuation. Analysts and well-wishers hail the transaction as a sign of growth for this colossus of the north. We see more value destruction in store for TD’s long suffering shareholders. The list of M&A transactions closed by TD Group is long and varied for this financial conglomerate . TD, we should recall, is known primarily as an asset manager in Canada and not a lender, but it is the largest bank by assets in the country. Instead of adding to its higher value wealth management business, TD has decided to buy another retail bank in the US. Like the other Canadian banks before it, TD has a decidedly mediocre record building a profitable banking portfolio in the US. TD acquired Commerce Bancorp for $8.5 billion in 2007, a premium valuation. TD US also holds the 9.7% stake in Charles Schwab (SCHW) that arose from the 2020 sale of TD Ameritrade. The acquisition of FHN will add another $4 billion to the intangibles of the group. In 2005, it sold TD Waterhouse USA to TD Ameritrade Holding for $2.9B, which eventually was acquired by SCHW. Even as asset peers like Banco Santander (SAN) are making a bee line for the door to exit US retail banking, those generous souls in Toronto have decided to double down. Indeed, Masrani does not even talk about wealth management when he talks about creating a new “TD brand” in the US. “Transactions that are strategically compelling, financially attractive, fit within our risk appetite and are culturally aligned are rare,” Masrani effused on a call with stock analysts. “We’ve been patient in waiting for the right opportunity, and in First Horizon we have found it.” Analysts and investors can view the US business of TD in the BHC performance reports prepared by the FFIEC for TD Group US Holdings LLC ( RSSD 3606542 ). The first thing to note is that TD US business is not very profitable, lying in the bottom decile of the 132 bank average for Peer Group 1. Funding costs are quite low, but the profitability of the $500 billion business (not including FHN) is poor, with net interest income in the bottom third of the group. Return on earning assets has been consistently below peer for the past five years. While the income of TD’s US business is low, the credit losses are 3x peer in Q3 2021. Indeed, net losses have been elevated compared with the peer group for quite a number of years. The pricing on the bank’s US loan book is dead on peer, but the operating expenses of the TD US business are above peer, including a big number for other corporate expenses. Since just 32% of the bank’s assets are in loans and the rest in low yielding securities, it is hard to make money. Yet despite the fact that its US loan book is smaller than its peers, TD US manages to lose more money as a percentage of total assets. Source: FFIEC TD US has an efficiency ratio in line with or even below Peer Group 1, but the efficiency ratio saw a spike to 66 in Q3 2021. Expenses at TD US have been growing 2-3x faster than assets for the past several years. Source: FFIEC TD US had $58 billion in total equity capital at the end of Q3 2021, but also carried $20 billion worth of intangibles from previous acquisitions in the US. TD has been buying banks in the US going back decades, including the 2006 acquisition of control of Bank North and Hudson United . FHN had been trading around book value prior to the announcement of the acquisition, not a rousing testimonial given the performance of financials over the past several years. F/K/A First Tennessee, FHN has performed well in some periods in the past, but more recently has been wallowing in the bottom half of Peer Group one in terms of net income and asset returns. The bank has over 400 retail branches in a dozen states. Interest expense for FHN is below the peer average as you would expect and credit losses are also below the peer group, but the pricing on loans is likewise weak, at just 3.5% gross yield vs over 4% for the peer average. At least FHN is reasonably well deployed in terms of loan assets, with 65% of total assets in loans and leases. Perhaps the folks from TN can teach their Canadian partners something about better managing earning assets. Like TD, FHN’s efficiency ratio (Overhead Expenses / Net Interest Income + Non-Interest Income) was over 66% in Q3 and has been above 60% going back five years. FHN has been chasing opportunities in the secondary mortgage market in recent years, one reason that compensation expenses are well above peer. Personnel expenses at FHN were more than 41% of operating income vs just 32% for Peer Group 1. Looking at the financials of FHN, it is hard to see how the purchase adds anything to the TD business in the US other than size. What is the point of Masrani buying more retail deposits if the TD bankers cannot fill the existing balance sheet with quality loans? Or to put it another way, adding a business that trades at 1x book to the existing TD franchise is unlikely to result in higher shareholder returns. The significant premium to book paid by TD for FHN is illustrated in the chart above. The most significant comparable to TD is SCHW, but for some reason TD has decided to continue to buy retail banking franchises rather than paying up for asset managers. SCHW trades over 3x book, while FHN was just barely 1x book prior to the announcement of the acquisition. To us, spending $13 billion on acquiring more SCHW makes more sense than buying FHN. If the past experience of Canadian and other foreign banks is any guide, Masrani may come to regret this investment.

March 1, 2022 | A number of readers have asked our view of western bank exposure to Russia since the invasion of Ukraine. The short answer is that the EU banks bear the brunt of the risk. Citigroup (C) reports less than $10 billion in cross border exposure to Russia and most other US banks have nothing to do with Eastern Europe much less Russia. But the imposition of sanctions on Russia is not as comprehensive as some press reports suggest. "Force majeure" is a contractual term that means an unforeseeable circumstances that prevent someone from fulfilling a contract. When the markets face “force majeure” in the form of military hostilities, for example, all bets are quite literally off. The obligations of parties to make or receive contracted payments are stayed for the period of the disruption, creating a cascade of risk and non-payment that can quickly build into contagion. The performance of Deutsche Bank AG (DB) and other large European banks tells the tale. Yet the break between Europe and Russia is not complete. Source: Google Looking simply at the direct exposure of western banks to Russian counterparties does not begin to describe the risk created by Russia. Customers of global banks with business ties to Russia may also become compromised as a cascade of defaults ripples through the global economy. It will take months and years to discover the true cost of the Russian invasion of Ukraine, particularly in nations such as Egypt that are dependent upon gain produced in both nations. Food prices are likely to move higher in coming months. Russia is now being pushed into a barter relationship with China, which is unlikely to observe global sanctions on Moscow. Some observers have speculated that a Chinese-Russian payments system may start to compete with the dollar, which has 40% of global reserves and is the largest means of payment in global commerce. Such predictions may be overly optimistic, however. Trade between China and Russia in December 2021 was less than $20 billion, a three-fold increase from December 2005. In terms of global payments, the actions by the G-20 nations amount to a physical severing of ties between Russian institutions and the outside world. If we recall that the SWIFT network, for example, is simply a technical overlay that operates atop the traditional payments system of correspondent banks, the combination of sanctions and other measures will create further events of default in coming months as the backlog of failed payments grows. People’s Bank of China , the Chinese central bank, hasn’t given any clues yet about the status of Russian foreign exchange reserves or the currency swap line, Politico reports. As the number of nations cutting off economic ties with Russia grows, pressure on China will grow. Tech firms in China, for example, could be subject to huge fines for violating sanctions, regardless of the Chinese government’s official policy of opposing such measures. US officials are intent upon denying Russia access to all western technology. While a great deal of attention is focused on relations between China and Russia, in Europe the real questions comes down to Germany and its energy imports. So far, Sberbank and Gazprombank have been excluded from the SWIFT exclusion, but these banks are subject to sanctions in the US and UK. Half of Germany’s natural gas supplies come from Russia. Sberbank is the largest bank in Russia and Gazprombank is the banker to Russia’s energy sector. Vladimir Putin knows that Germany cannot do without gas imports from Russia. German politicians have made passionate speeches about the need for higher NATO defense spending, but none have yet suggested that Germany end purchases of energy from Moscow. So Putin will murder his neighbors in the Ukraine and suffer the consequences, but ultimately he knows that Germany lacks the resolve to turn away from Russia.

February 25, 2022 | With the Russian invasion of Ukraine, the financial markets will quickly become comfortable with Vladimir Putin’s naked aggression and focus anew on the Federal Open Market Committee. What the FOMC does or does not do in the next few months will have a big impact on markets and economies around the world. Besides rising interest rates, the big story in the US is the growing recession in housing finance, a dramatic reversal that could impact the macro outlook for US jobs and growth in 2022. Banks and nonbanks alike are desperately trimming expenses to right size headcount to falling revenues. Just watch the job postings for loan underwriters on the major career portals and you get an idea of the scale of the adjustment now underway. Below for subscribers to our Premium Service , we review results for several industry bellwethers and comment on interest rate trends more generally. The Bank Policy Institute just finished an important conference in Washington, “ Informal Symposium on Monetary Policy, Bank Regulations, and Money Markets .” The agenda included four timely topics: The outlook for deposit rates and deposit levels, The prospects for the Fed’s new Standing Repo Facility (SRF), How the Fed’s balance sheet and money market rates will evolve as the Fed tightens policy, and Treasury market functioning as the Fed switches from purchases to redemptions. BPI’s summary raises some interesting questions for investors and risk managers: “The participants noted that deposit rates could initially rise only slowly as the Fed raises interest rates, resulting in a large flow from banks into money funds, boosting the Fed’s Overnight Reverse Repurchase Agreement Facility and driving down reserve balances. Such flows could complicate Fed tightening and imply the Fed might choose to allow the spread between the interest rate it pays on reserve balances (the IORB rate) and the interest rate it pays on reverse repos (the ON RRP rate) to widen at liftoff. Participants generally did not think that the Fed’s new Standing Repo Facility would be free of stigma. If the SRF does not work as intended, the Fed may meet resistance shrinking its portfolio of securities as scarcity in the market for reserves materializes sooner than expected (as happened in 2018), requiring the Fed to stop redemptions and instead raise the federal funds rate more aggressively. Participants judged that as the Fed switched from Treasury purchases to redemptions, market functioning should be OK as long as there are no disruptions such as a war in Europe or a sharp rise in rates because the path for monetary policy tightening is marked up. Any such disruptions could result in flows that overwhelm the market’s capacity, which could require a difficult-to-explain reversal of quantitative tightening or worse, spark broader financial instability.” Since the conference, war has begun in Ukraine, but the FOMC seems to be focused on dealing with the internal inflation situation in the US. The discussion at the BPI event echoes some of the concerns regarding liquidity we have discussed over the past year, particularly the prospective scarcity of risk-free collateral in a scenario where the Fed shrinks the SOMA portfolio. And we continue to worry that the Fed staff in Washington has yet to accept that QE was an error in judgement and in public policy. The more important question for US monetary policy is how and whether it is possible to reduce the central bank's portfolio without again courting disaster in the credit markets, as the Fed did in 2018 and 2019. Former Treasury Secretary Lawrence Summers noted in comments last year to The International Economy Magazine . “With regard to the Fed’s balance sheet, I think there is some confusion here going back to an earlier era when the Fed did not pay interest on reserves. I think of quantitative easing as the Fed issuing reserves which are essentially floating-rate government obligations and buying longer term government instruments. I’m not sure why that is a good idea. Everybody else in the economy is turning out debt. For the Fed to turn in the debt of the government of the United States, at a time of unprecedented uncertainty and remarkably low long rates, seems to me a quite odd decision. I wish tapering had already begun and I hope it will play out before too long.” Meanwhile, as we near the back of the 45-day reporting period for public companies for 2021, the mortgage lenders and servicers are providing a look at the rapidly changing environment in the secondary market for home loans. Home Point Capital (HMPT) , reported a tiny profit in Q4 2021 that was only made possible by the sale of the remaining Ginnie Mae servicing. With the company selling tradable assets and moving to an outsourced servicing model, we’d not be surprised to see a sale sooner rather than later. This is not an uncommon situation in the industry, but most mortgage issuers are private. HMPT's gain on sale margin dropped from over 2% a year ago to ~ 50bp now, illustrating how lender margins can fall even as primary-secondary spreads widen. Since loan originators are selling the loans, Goodman et al (2013) note , the profit margin depends on the price at which they can sell them, rather than the interest rate on the security into which they sell the loans. Industry leader Rocket Companies (RKT) saw profits drop by $2 billion in 2021 vs 2020, but with stable operating expenses. As with other players in the industry, the ramp up in operational capacity to address the record volumes in 2020 and 1H 2021 is now a glaring problem. A year ago RKT was trading over 6x stated book value, but today is trading less than 2.5x. Notice in the chart below that 2019 and 2021 are relatively “normal” years, with net profits lower than gross operating expenses. The year 2020, on the other hand, was extraordinary. Source: Edgar The situation at HMPT illustrates a broad trend in the industry, namely that many independent mortgage firms are cutting back on headcount and also reducing the utilization of credit lines from commercial banks. As is usual at the end of a bull market in home lending, a number of warehouse lenders have stepped back from certain products or repriced to fit a higher risk environment. Generally, the move in rates since January has left many smaller banks, REITs and others holding collateral that is now trading closer to 97 than 103, which is where GNMA 2.5 MBS started the year. There is a growing liquidity problem for smaller depositories due to the lack of alternatives to recover the bank's capital from seasoned loans given the shift in the Treasury yield curve. Most small banks and credit unions don't have the resources to effectively hedge loans or available for sale securities. To give an example of the volatility that many financial companies and REITs have seen in the past 18 months, consider New Residential Investment (NRZ) , an externally managed REIT controlled by Softbank unit Fortress Investment . The largest nonbank owner of mortgage servicing assets reported $964 million in profits in 2021 vs a $1.3 billion loss the year before. NRZ revenue was basically flat to down slightly year-over-year, but the firm continued to rebuild capital and liquidity after the near-miss of 2020. The difference in results was the $2.2 billion write-down of the NRZ servicing portfolio in 2020. And NRZ’s compensation and benefits were twice as high last year compared with 2020, but the firm still made more money! The volatility in corporate operating results due to FOMC policies such as QE is mind boggling and visible in public company filings such as NRZ. One bright spot in the world of consumer lending is Upstart Holdings (UPST) , the lead generation play that has partnered with Cross River Bank to originate and sell loans. The company’s revenues and income continue to grow explosively, driven by the fat fees that UPST takes out of its loans. Some consumers pay a several point upfront fee on funds raised to UPST, a margin banks can only dream about. Revenue was up 264% YOY to just shy of $850 million. Adjusted EBITDA was 27% of revenue or $232 million. This capital light originate to sell model has enormous upside leverage since much of the risk is shouldered by Cross River and the other bank partners of UPST. In 2022, UPST is focusing on the auto lending sector, a highly competitive space that has disappointed more than one new entrant. Time will tell if the UPST methodology will succeed. Even with the strong financial performance, UPST has seen its valuation cut by 60% since March of last year, when its common equity traded at a mere 31x book value. Today UPST is only 12x book at $132 per share or twice the valuation of bank exemplar American Express (AXP) . And UPST brags that 70% of loan originations are fully automated, “with minimal fraud.” Again, only time and some aging on the portfolio will tell the tale of credit. In the meantime, UPST is the only one of this group that is still up over the past year and has optimistic guidance for 2022. Disclosures | 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.

"Electricity is the thing. There are no whirring and grinding gears with their numerous levers to confuse. There is not that almost terrifying uncertain throb and whirr of the powerful combustion engine. There is no water-circulating system to get out of order -- no dangerous and evil-smelling gasoline and no noise." Thomas Edison February 21, 2022 | Updated | “An awful lot can happen in two months,” writes Spencer Jakab in his timely new book, “ The Revolution that Wasn’t: Gamestop, Reddit, and the Fleecing of Small Investors .” He writes of the ambush of Melvin Capital : “The Reddit revolutionaries despised short sellers more than the general investor population did, which is saying something… Hurting short sellers became something of a sport on WallStreetBets, and its members were about to learn how to aim for the kill shot.” Jakab’s book is not just a fascinating history of short-selling in Gamestop (GME) , but provides a canvas for understanding the behavior of investors over the past two years during the COVID mania. Hedge funds with a seemingly reasonable strategy to short GME were suddenly destroyed by social media gangs and the rising tide of liquidity from the Fed's growing balance sheet. Assets from stocks to crypto tokens all soared in a generalized mania fueled by cheap credit and a natural human compulsion for personal gain. But there was no glorious revolution for investors, no enduring prosperity or jobs created, just a temporary high followed by equally rapid deflation in asset prices and inflation in living costs. The wreckage caused by the Fed’s largely speculative monetary policy is still being tallied, including billions in losses to retail investors. GME rose during the period of extraordinary social experimentation by the Fed from 2020, even as other MEME stocks led by the likes of Tesla (TSLA) and Silvergate Capital (SI) soared . Less compelling stocks like Robinhood Markets (HOOD) languished, while other hopeful stories never got out at all. Aurora Acquisition Corp (AURC) , for example, is still pondering the purchase of money-losing mortgage lender Better.com, a deal we wager never closes. Even AMC Entertainment (AMC) , the original MEME stock, barely moved compared with TSLA, SI and GME. Source: Google Finance The general mania caused by the response to COVID is no better illustrated than with the case of Peloton Interactive (PTON) . This maker of stationary exercise bikes “went to da moon” (in Reddit speak) for a while because of the techno hype around a socially enhanced spinning class. At the end of the day, PTON is a company that makes exercise equipment with a pricey proprietary social media channel. Have you noticed the full-page newspaper ads from the PTON cult this past weekend? Hmm? In a delicious report in the FT Magazine , Peloton chief executive John Foley recounts how his board of directors told him to stop claiming that PTON would be a trillion dollar market cap company. Andrew Edgecliffe-Johnson and Patrick McGee of the FT quote Foley: “Last year, I was talking to our board and I was like, I see this as clear as day: this thing is going to be one of the few $1tn companies in 15 years,” he recalled. “And they said, ‘Don’t say that again. It makes you sound like an idiot.’” Of course, John Foley is not the only corporate executive that has seemed like an idiot since 2020. Perhaps our favorite MEME stock of all is TSLA, a company that received over $1.5 billion in public subsidies in 2021 and 2020. Driven by the general mania regarding global warming, this manufacturer of electric cars with lithium ion batteries benefitted more from QE than most other MEME stocks. Indeed, in the most recent 10-K the company brags about the performance of TSLA as a stock as much as the company’s financial performance as a car maker. Sadly founder Elon Musk sold a large block of stock near the top to pay his 2021 federal income taxes. The components of TSLA revenue for the past three years is shown below from the latest 10-K. Note "Automotive regulatory credits." The key takeaway regarding TSLA and the other automakers that have gone down the lithium battery bunny hole is that EV technology based upon lithium batteries is neither green not sustainable. The power of the progressive-ESG crowd forced an entire industry to abandon efforts to develop new, sustainable technologies based on fuel cells in favor of using lithium batteries, an antiquated technology with no future. As we noted in “ Ford Men: From Inspiration to Enterprise, ” when Henry Ford wanted to build an electric car 120 years ago using nickel-ion batteries, Thomas Edison told him instead to use gasoline . Why? Because it is a more compact form of energy. Edison later denounced gasoline vehicles and worked with his lifelong friend on an electric car, but it was already too late to focus on alternatives to gasoline power. Ford, Edison, Guglielmo Marconi and Nikola Tesla all saw electric vehicles as the future, but all were stymied by inferior energy storage options of that time. In 120 years since, the periodic table has not changed. Notice that tiny hydrogen is in the top left corner. There are a few elements in the table that are appropriate for batteries, but none are optimal for passenger vehicles. In fact, nothing has really changed in the 120 years since Edison and Ford collaborated in Detroit except for the greater efficiency of electric devices. The only reason that companies like TSLA prosper is because of social engineering paid for by the US taxpayer and the zero interest rate policies of the Fed. Everybody who bought a traditional car last year in the US, for example, gave Elon Musk's car company about $100 in subsidies ($1.5b Reg Credits/17m vehicles). In a world without subsidies for “green” energy, TSLA would not exist. But the biggest subsidies of all go not to TSLA directly, but instead incentivize consumers to buy EVs. “When Denmark got rid of its tax credits for electric vehicles, Tesla's sales dropped by 94 percent,” writes Bill Wirtz of FEE . “In Hong Kong, the company saw a decline of 95 percent as the city got rid of comparable tax advantages for those buying electric cars.” What happens to TSLA and other EV makers as and when the public subsidies end? The combination of the subsidy for capital costs provided by QE, added to the direct public subsidies for EV’s, literally launched TSLA to the moon. That is why TSLA, of all the MEME stocks, jumped more than just about every other name we track. We believe that electric vehicles are the future, but we’re still waiting for a car with an internal power source and DC motors on all four wheels. Readers of The IRA who have not read "Ford Men" need to appreciate that when the gasoline-powered car was created by Henry Ford 120 years ago, the invention caused an immediate public sensation and without public subsidies. Dozens of car makers sprang up to meet the tidal wave of demand for affordable and reliable transportation. No social engineering by progressives was required. But EVs with batteries are neither reliable nor affordable, especially when you consider the investment necessary to enable a battery-powered fleet and remediate the toxic waste left behind by millions of used lithium batteries. Like the batteries in your smartphone, a lithium battery in a car wears out in a couple of years. And when new developments in fuel cells eventually displace lithium batteries, the billions spent to enable EVs will be shown to have been wasted. In the fog caused by the FOMC and global warming activists, such technical considerations have been barely noticed. Investors remain focused on the likes of Tesla and Revian Automotive (RIVN) . We like the long-term prospects of more conservative players such as Toyota Motor Corp (TM) , which continues to advance a broad agenda that includes battery powered vehicles , hybrids and fuel cells. TM is so conservative that they have missed whole cycles of EV hype from the global warming crowd. In addition to being the largest car maker in North America, Toyota is one of the best managed manufacturers in the world. And they understand that vehicles with DC motors and internal hydrogen power, and not retrograde lithium battery technology, are the future of transportation. Of note, Thyssenkrupp AG (TKR) is pondering an IPO for its hydrogen unit later this year. The first deployment of a viable hydrogen fueled consumer vehicle will change this conversation about batteries forever. Then we'll all look like idiots. Years from now, when tomorrow's children are driving past abandoned EV charging stations on America's interstate highways, they will recall the age of COVID, QE and the related hype around using lithium batteries to propel cars, and laugh. But human nature is always to chase the shinny object first and foremost. Henry Ford went to market in the early 1900s with a gasoline engine design of necessity, even though he loved electric cars. Ford Motor Co was Ford's third business venture after two failures. He needed a win. Elon Musk made EVs with batteries because it was the only viable commercial option. Given the demand created by the general mania behind electric vehicles, Musk astutely created the supply walking a path paved with public subsidies -- whether he likes them or not. Both men made the right choice at the particular point in time and profited as a result. So here's the question: If Henry Ford lived today, would he build electric cars? With lithium batteries? Don't forget the shipload of Porsches in the Atlantic this AM, burning due to a lithium battery fire. Happy Presidents' Day.

February 16, 2022 | When Facebook (FB) CEO Mark Zuckerberg sold his infant coin business Diem to Silvergate Capital Corp (SI) , he accepted a lesson that Walmart (WMT) , Alphabet (GOOG) and Apple (AAPL) have all learned over the years: banks have a federal monopoly on creating deposits and making payments. If you want to take deposits or have a hard IP address on the national payments system, namely a master account at a Federal Reserve Bank, then you got to be a bank. That is, a federally insured depository institution . Just ask Sarah Bloom Raskin. But who is Silvergate and why is this small bank from La Jolla, CA, buying FB’s stable coin business Diem? The simple answer to that question is that SI’s management team are smart and are taking advantage of the narrative in Washington, which is that stable coins will be a bank only product . We see SI as an audacious gamble on the interface between all crypto and fiat cash money, not simply stable coin tokens. At the same time, however, SI is not a very impressive model of a bank and has risks that most community banks do not face. Source: FFIEC This $16 billion asset bank, which had just $2 billion in assets at the start of 2019, trades at “only” 2.4x book today. It was trading just shy of 12x book in March of 2021, at the peak of the COVID market pump by the Federal Reserve. And why not? In the world of financials, Silvergate may be among the biggest meme stocks yet in the era of quantitative easing or QE. SI is not your typical bank over $10 billion in total assets. In fact, SI and its state-chartered bank unit, Silvergate Bank , grew so fast over the past year that the bank is not yet officially a member of Peer Group 1. SI is going to be dropping form Y-9C with the Fed shortly and providing other detailed reporting not available today. The growth in the bank’s assets has been matched by an equally torrid growth on the public market value of SI, as shown in the chart below. Very briefly, this crypto-focused bank was among the most highly valued banks in the US. But over the past year, SI has lost two thirds of its market value. Source: Yahoo Finance Founded in August 1988 as Silvergate Thrift & Loan Company, today the bank has $16 billion in total assets funded with $14 billion in certificates of deposit, most of which mature in one year or less. At December 31, 2021, Silvergate Bank had $1.7 billion in loans, $7 billion in Treasury securities, MBS and munis, and another $5 billion in deposits with other banks. The muni market has backed up about 60bp in yield since the start of 2022, of note. Because of the atypical asset structure of the bank, profitability is poor. Silvergate Bank ranked in the bottom decile of Peer Group 2 at the end of 2021, with net-income to average assets of just 72bp vs an average of 1.29% for Peer Group 2, which includes 115 banks from $10 billion to $100 billion in assets. The relatively weak fundamentals of SI and its subsidiary bank, however, have not prevented the stock from going “to the moon,” to borrow the language of Reddit, as shown in the chart below. Source: Google Notice that meme stocks such as SI and Tesla (TSLA) exploded when the FOMC began to make massive purchases of securities via QE in Q1 of 2020. In relative terms, the 90% up move in the S&P 500 over the past year barely moves the needle compared to SI (800%) and TSLA (+1,600%). And both of these MEME stocks have been correlated to moves in bitcoin and the VIX over the same period. SI has positioned itself as an enabler for crypto transactions, on the one hand, and a lender against crypto assets, providing greater “capital efficiency” (aka "leverage") for institutional investors. In January 2020, SI began offering a new lending product called SEN Leverage, which allows Silvergate customers to obtain U.S. dollar loans collateralized by bitcoin held at select digital currency exchanges and other custodians. For the three and nine months ended September 30, 2021, there were $162.0 billion and $568.1 billion, respectively, of U.S. dollar transfers that occurred on the SEN, compared to $36.7 billion and $76.5 billion, respectively, during the three and nine months ended September 30, 2020. The outstanding balance of SEN Leverage loans was $254.5 million and $77.2 million at September 30, 2021 and December 31, 2020, respectively. Think of it as warehouse lines collateralized with nothing and funded by FDIC-insured deposits. Most of the jumbo CD deposits we referenced earlier bear zero interest, providing what SI describes “mid-single digit spreads” in an investor presentation. The Silvergate exchange network or “SEN” allows 24/7 real time transfers of dollars and now euros, into and out of crypto assets. These flows totaled $35 million of transaction revenue, but also create risk for the bank, including facing a number of nonbank counterparties that are lightly capitalized and even less subject to prudential regulation. Robust AML and KYC compliance are perhaps the biggest challenges for this bank because of the essentially offshore nature of crypto trading. Source: SI Investor Presentation (February 2022) A growing area of business for the bank is lines of credit and letters of credit for crypto trading, which SI books as off-balance sheet liabilities. While the amounts are small relative to the bank's capital, the amounts are growing steadily. Total off-balance sheet items were $119 million at the end of 2021 vs $57 million at December 31, 2020. These items were assigned 100% risk weights by regulators and equaled roughly 10% of Tier 1 capital at year-end 2021. Shareholders’ equity increased $777.8 million to $1.1 billion at September 30, 2021, compared to $294.3 million at December 31, 2020. The increase in shareholders’ equity was primarily due to two common equity offerings. The bank will need to continue to grow capital to support a larger asset and deposit base, but so far core profitability is not providing sufficient support for capital growth. Our bottom line on SI and Silvergate Bank is that the bank part of the business is mediocre and unlikely to deserve a valuation multiple much above its asset peers, which means a book value multiple of equity closer to 1 than to 12. The operating efficiency of the bank at 43% is good, but expenses are rising faster than non-interest income, which seems to be the point of the business model. Income from assets is modest and does not leave the bank’s management much room for error in terms of either interest rates or credit. If you believe that crypto is a long-term investment asset, then SI seems to have stolen the march on some if its larger competition. The volumes moving through the SEN network are impressive, but it is less than clear how the bank benefits from these flows besides making loans against crypto assets as "collateral." The funding structure of the bank is unusual and, in extremis, volatile since a large portion of the deposits reprice within one year. We also wonder if higher levels of market volatility are not going to hurt the already modest returns that the bank earns on assets. As interest rates rise, the attractiveness of the bank's zero interest rate deposits may decline. 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.

And now, Master, I myself invite you To drain this vessel In which smokes and bubbles No longer Death, no longer poison, but life! MÉPHISTOPHÉLÈS ( Faust Libretto ) February 14, 2022 | A big Happy Valentine’s Day to all of the readers of The Institutional Risk Analyst . We all just spent the past week watching the slow destruction of the remaining credibility of the Federal Open Market Committee, a big problem for global equity markets that trust in the judgment of central bankers. The messy situation at the Fed begs the question: Is it time for Congress to repeal the Humphrey-Hawkins law? Part of the challenge to understanding Fed policy is that the central bank has very publicly lost its way. In an attempt to parse the “FedSpeak,” as he so aptly calls it, Steve Liesmann at CNBC has begun to rely on the language of the schoolyard to explain Fed behavior – or lack of it. But alas, there are no “take backs” or “do overs” in global finance. In fact, as Liesmann and others have noted, the Fed has still not changed policy since the start of the year. What's the fuss? The FRBNY is still buying billions of new MBS each week, even as the mortgage industry is reeling from a decidedly weak fourth quarter. A quick look at the Bloomberg terminal reveals that bond issuance in many markets is slowing as 2022 begins. Source: SIFMA Long-term interest rates are already headed higher, a fact that is having a big impact on less efficient home lenders. New age mortgage firm Better.com , for example, just revealed a $111 million loss in the first nine months of 2021, driven by – wait for it -- $1 billion in “corporate expenses,” Inside Mortgage Finance reveals. Does this include that trip to Pebble Beach for dozens of industry operators and biz dev moguls? Better.com is just one of dozens of new age enterprises that are happily destroying shareholder value c/o the FOMC. And the FOMC continues to ease policy even as February draws to a close. Notice that the aggregate mortgage related issuance in November and December was the lowest monthly rates in years. More important, notice the sharp decline in Treasury and also corporate issuance in Q4 2021 after the Treasury rebuilt its cash reserves. In January, the Treasury actually ran a surplus. During this period, the Fed did not adjust its purchases for the system open market account (SOMA), helping to force real interest rates ever more negative. If you consider QE “stimulus” inflationary, then Fed policy actually accelerated inflation in the November-January period. The big deficit at the FOMC, of course is nerve. Having allowed themselves to climb down into the mosh pit of partisan politics during COVID, the central bank is now faced with a clear rebuke from markets and consumers in terms of inflation. Rising prices are a political problem for the White House and Congress, but the Fed has already traded that coin. Getting “ahead of the curve,” as Fed staffers now claim to want, is unlikely with the Fed’s toolbox so badly depleted. Note, though, that the FOMC continues to drag its feet on changing policy. It’s almost as though Powell & Co expect to awake from a bad dream and find that inflation is no longer a problem. Reserve Bank Presidents such as James Bullard and Ester George are publicly calling for a radical change in monetary policy. Sadly, the hawks on the FOMC have no choice but to speak publicly when the FOMC has gone so badly off the rails. The lack of clarity on the Fed’s legal mandate contributes to an atmosphere of confusion in the markets. Governors and Reserve Bank presidents conduct media interviews as and when they so choose. In the days of Chairmen like Paul Volcker and even Alan Greenspan , the chairman spoke publicly and presented the consensus position of the Committee. Other FOMC members were silent unless and until they were asked to carry the consensus message. Legendary staff chief Ted Truman would have it no other way. Today, by comparison, we have policy chaos at the Fed, with FOMC members scored via dot plots and competing with one another for media attention. Whatever consensus exists among FOMC members as to the dual mandate of Humphrey Hawkins is unclear. Meanwhile, the FOMC is clearly not fully in command of the little operational details like how to end QE. Since 2008 and the term of Chairman Benjamin Bernanke , the Fed has lost its way, both in terms of policy implementation and as an organization. As the Fed’s public credibility ebbs, the markets sense the lack of direction and certainty of purpose, resulting in even greater uncertainty and market volatility. Notice that market volatility measured by the VIX has increased during the period of extraordinary asset purchases via QE. Likewise the volatility of the Treasury market has also increased as the SOMA portfolio has grown. Keep in mind that the assumption by the FOMC in approving "going big" via QE was that a surfeit of liquidity would eliminate the need to "fine tune" the market. Yet the opposite seems to be the case. Part of the problem, of course, is that most investors and media are focused on the equity markets. The Fed’s manipulation of the bond market via QE, on the other hand, is an abstraction. We’ve started counting the number of times that media and investment professionals opine that the Fed is going to start selling securities . In fact, nothing like that is in the cards. The fact that smart investors and media don’t understand this nuance is telling. When the Fed does finally, belatedly react to the change in inflation indicators over the past six months, it will need to “go big” in terms of target rates simply to regain some degree of credibility. Just as the Fed went “big” with QE in 2020 in the face of the uncertainty of COVID, now the central bank must claw back some modicum of authority by going the other way. But, again, the most daring policy likely to come from the FOMC is merely ending new purchases and allowing the Fed’s $8 trillion portfolio to slowly run off. Fed Chairman Arthur Burns noted in August of 1971 that he had failed to stop the closing of the gold window, reckoned as one of the more significant events in the history of the dollar in the post-WWII era. Yet the decision to end gold convertibility of dollar was relatively passive. “The gold window may have to be closed tomorrow because we now have a government that seems incapable, not only of constructive leadership, but of any action at all,” Burns wrote in August 21, 1971. “What a tragedy for mankind!” Half a century ago, the inflationary pressures that caused the US to stop redeeming dollars for gold at $35 per ounce were growing, with seven dollars outside the country for every dollar’s worth of gold at Fort Knox. Today the 147.3 million troy ounces of gold in Fort Knox is worth about $270 billion, but offshore dollar assets are measured in double digit trillions of dollars. In 1971, people inside and outside the US government still believed that it was possible to create real economic outcomes via government fiat, all the while maintaining low inflation. Burns talked of an “incomes policy,” trading higher wages for productivity gains even as President Richard Nixon embraced wage and price controls to offset the inflationary impact of the Vietnam War. In 1978, when Congress passed the Humphrey Hawkins law, the mandate for full employment and price stability was enshrined within the Federal Reserve Act. This political compromise juxtaposed jobs vs inflation, a conflicted relationship that cannot be managed either practically or politically. When the Fed could no longer deliver the goods after 2008 by just lowering interest rates, buying government debt became the policy tool of choice. As we noted in American Conservative (“ When The Fed Became A Socialist Job Creator’ ), the Fed is a progressive, New Deal institution. And Humphrey-Hawkins was an explicitly socialist law imposed by a Democratic majority in Congress that must inevitably lead to inflation. When Fed Chairman Bernanke tried to differentiate between credit easing and QE in a 2009 speech in London , the world witnessed the last gasps of the dual mandate. Since 2009, QE has delivered monumental inflation, this justified in the name of short-term expedience that make a mockery of the “price stability” portion of Humphrey Hawkins. The FOMC during the terms of Chairman Bernanke, Chair Janet Yellen and now Jerome Powell document the consensus view at the Fed over the past decade or more that “inflation is too low.” The first impact of QE was asset price inflation, a sea of institutional liquidity that enabled ridiculous behavior in the world of asset creation and allocation. Ponder the shift in investor perception that made investments such as better.com seem like a good idea. And there are literally hundreds of other companies that share this quality – or lack thereof. We’ll be writing about some of these names in coming weeks. But in the meantime, enjoy the ride in the financial markets over the rest of 2022 as the Fed seeks to reclaim virtue when it comes to fighting inflation. The markets will shoulder the burden, this even though few bankers or equity managers yet perceive the adjustment that lies ahead. One wealthy business owner told The IRA last week: “If the Fed does the right thing now, I will loose 25% of my net worth due to the obvious and necessary reset in stocks, but that’s OK. I’m still up a lot. But if Powell doesn’t take strong action now to control inflation, then we are all in big trouble.”

February 10, 2022 | In this issue of The Institutional Risk Analyst , we look at NexBank Capital, Inc. and its subsidiary bank, NexBank . With total assets of just below $10 billion, NexBank is the fourth largest commercial bank in Dallas and consistently ranks among the top banks in Peer Group 2 for equity returns and capital growth, operating efficiency, and asset quality. NexBank has two banking offices in Dallas, TX, and is institutionally focused, leveraging a very efficient operating model. It has three divisions—Institutional Banking, Commercial Banking, and Mortgage Banking. The following data and analysis are as of September 30, 2021, using data from the FFIEC and S&P Global, unless otherwise noted. Source: FFIEC NexBank’s earliest predecessor institution, Terrell Building and Loan Association , was chartered in 1922. Today NexBank is a state chartered, FDIC-insured subsidiary of NexBank Capital, Inc., a single bank holding company that was organized by a group of private investors in 2004 and today includes a single depository and a broker-dealer. The company’s growth has primarily been organic. In terms of recent M&A transactions, NexBank acquired College Savings Bank , a state savings bank based in NJ, in December of 2015. We wrote about NexBank back in 2017 (“ Which Are the Best Performing US Banks? ”) when we looked at some of the top-performing banks, large and small, in the US. Since that time, the total assets of the US banking system have risen dramatically due to the inflationary policies of the Federal Reserve Board. This fact puts growing pressure on NexBank and the larger members of the 144 depository institutions in Peer Group 2, which includes banks between $1 billion and $10 billion, to take the decision to go above $10 billion in total assets. NBC is focused on providing financial and banking services to institutional clients, financial institutions and corporations. Its primary subsidiary, NexBank, a commercial bank, core offerings consist of the following: Institutional Banking offers a suite of specialized lending and depository services to institutional clients and financial institutions. Commercial Banking offers a range of traditional banking products with a focus on real estate lending and commercial and industrial financing, as well as deposit and cash management services. Mortgage Banking provides conforming, government, non-conforming jumbo, and non-QM through wholesale and correspondent channels as well as traditional warehouse lines of credit. The group also offers MSR and EBO Financing. NexBank’s diversified $5.6 billion gross loan portfolio has concentrations in residential mortgage loans and commercial real estate loans. The 1-4 family residential loans are originated through both the wholesale and correspondent channels as well as through warehouse facilities for large mortgage bankers. Commercial lending largely consists of commercial real estate lending with focus on multifamily, followed by commercial and industrial loans. NBC is not structured and managed like a typical large community bank, thus peer comparisons must be made carefully. The business includes a strong focus on mortgage specialization in terms of acquiring and managing a portfolio of housing assets and related revenue lines. Among the ten largest mortgage specialization banks, NexBank had among the best equity returns in Q3 2021. Note in the table below that the lead bank of Charles Schwab Corp (SCHW) is the largest mortgage specialization bank in the US. Source: FFIEC Assets in $000s. For the full year 2021, NexBank had a return on average equity of 17.68%, according to S&P Global . Most of the economic capital risk in NexBank, as a result, comes from the securities portfolio rather than lending. Note in the chart below that the gross spread on NexBank’s portfolio of largely purchased loans and leases exhibits far less volatility than some of its higher-risk asset peers. As discussed below, the bank’s superior operating efficiency means that NBC is able to manage a lower risk franchise. Source: FFIEC Using nominal measures looking at average assets NexBank underperforms some of its more complex asset peers such as Cross River Bank and Beal Bank , yet in Q3 2021 the bank delivered a 6% Risk Adjusted Return on Economic Capital (RAROC), according to Total Bank Solutions . Look at average assets vs operating income, for example, and NBC is in the bottom third of Peer Group 1. But look at equity returns and capital growth rates, on the other hand, and NBC is in the top 5% of the 150 institutions in Peer Group 2. In Q3 2021, for example, NBC earned a 21.4% equity return on its investments in NexBank and the broker-dealer unit. Among mortgage specialization institutions below $100 billion, NexBank is one of the best performers. In Q3 2021, NexBank delivered a 18.25% ROE and a 1.3% return on assets (ROA), according to data from the FDIC. One reason for the strong equity returns of NBC is the bank’s stellar credit performance, in some quarters with zero net loan losses. With the exception of 2020, when NexBank saw losses rise above the Peer Group 2 average due to one charge-off on a large syndicated credit with COVID exposure, the bank has tracked well-below its peers in terms of credit performance. Likewise, Loss Given Default was negative or near zero historically, but rose to near 100% in 2020 due to credit expenses arising from the response to COVID. Source: FFIEC The strong historical performance of NexBank enables it to operate with lower allowance for loan & lease losses (ALLL) and lower levels of capital compared with the Peer Group 2 average. For example, in terms of exposure at default (EAD), NexBank carries unused credit commitments equal to just 10% of loans and leases compared with 100% or more for larger banks. More, with risk weighted assets (RWA) of just $6.2 billion (or 64% of total assets) at September 30, 2021, NexBank had Tier 1 capital to RWA of almost 14%. Operating efficiency is another notable area where NBC and its bank unit excel, both compared to its asset peers and larger banks. NBC has tracked below the average level of efficiency in Peer Groups 1 and 2 for many years. Source: FFIEC Due to the strong efficiency and high levels of equity returns, NBC has been able to build the capital of NexBank to a far greater degree and in less time than its asset peers. The level of debt at NBC is above peer due to the high levels of double leverage used to downstream equity capital to NexBank. An important sub-component of bank operating efficiency is non-interest or overhead expense, another area where NBC excels compared with its peers and industry leaders such as FBC. NBC’s ratio of overhead expenses vs average assets is the lowest in Peer Group 1 or 2 at 0.8% vs the Peer Group 2 average of 2.32%. In operating as well as credit terms, the bank’s superior operating efficiency means that NBC is able to manage to a lower risk business profile than its peers. Source: FFIEC At the end of Q3 2021, NBC had 131% double leverage vs 105% on average for Peer Group 1, but NBC retained over $400 million in earnings during that period. Total capital inclusive of $240 million in Tier 2 capital was $950 million for NBC. Going back to the creation of NexBank in 2004, the goal was always building shareholder equity on a conservative business foundation. As a result of declaring modest dividends at the parent level, NexBank has seen 150% growth in retained earnings over the past five years. Total holding company equity capital was $580 million at the end of Q3 2021. NexBank reported over $700 million in Tier 1 capital at the end of Q3 2021. NexBank maintains a highly liquid balance sheet and employs a sophisticated strategy to manage interest rate risk. Net loans and leases as a percentage of total deposits are below the average for Peer Group 2, reflecting the bank’s focus on investing in mortgage loans and related securities and assets, such as mortgage servicing rights. In stark comparison to more aggressive asset peers such as Cross River and Beal Bank, NexBank has steadily decreased its reliance upon noncore funding as its capital base has expanded. Roughly half of Beal Bank’s $8.1 billion balance sheet, for example, is funded with volatile sources of funds. Cross River Bank, likewise, has half of its $11.5 billion in assets funded with volatile funding sources. NexBank’s core deposits equaled 99.4% of total deposits and volatile funding sources equaled less than 5% of total funding at Q3 2021. The IRA Bank Profile 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 IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile 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 Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile 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 Profile 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 Profile. Interested parties are advised to contact Whalen Global Advisors LLC for more information.