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

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

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

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

April 28, 2022 | Premium Service | Looking at the financial results for Flagstar Bancorp (FBC) , you can see the pain being felt by the entire industry devoted to manufacturing and selling residential mortgages. “A Trifecta of Bad Mortgage News for Flagstar: Lower Volumes, GOS and Layoffs,” declared Inside Mortgage Finance quite accurately. BTW, GOS means “gain on sale,” the most important three words in lending. Then we turn to Annaly Capital Management (NLY) , a REIT that buys agency mortgage backed securities (MBS), and the situation is remarkably different. How do we parse this tale of two very different mortgage players? Source: GOOG Flagstar Bancorp First we start with FBC, a company we profiled this time last year (“ Profile: NYCB + Flagstar Bancorp ”). In 2021, FBC was one of the best performing banks in the US, as we noted in our profile of NexBank (“ Profile: NexBank Capital, Inc. ”). FBC is also among the larger subservicers of residential mortgage loans and also the second largest warehouse lender to other banks and nonbank mortgage companies. A year later, FBC is seeing revenue and earnings slow after a torrid 18 months of mortgage banking activity. Of note, the progressive mafia led by Senator Elizabeth Warren (D-MA) is still holding up the regulatory approval of the FBC merger with New York Community Bank (NYCB) . The chart below from the FBC earnings report shows how FBC’s performance has changed with the sharp increase in interest rates during Q1 2022 and the continued decline in earning assets. Notice that the GOS income and thus pretax income for FBC were down sharply in Q1 2022, a reflection of the adverse change in pricing that has occurred in the secondary loan market since the end of 2021. More, while net interest margin increased 15bp to 3.11%, utilization rates measured by the volume of loans held for sale and also warehouse loans to mortgage lenders declined. That is going to be the story for most of 2022, falling volumes and slowly rising NIM. Also note that FBC’s average deposits decreased 9%, driven by a decline in custodial deposits. The bank’s cost of funds edged up to 0.26% vs 0.31% in Q1 2021. Total revenue for FBC fell to $325 million in Q1 2022 vs $513 million in Q1 2021, again due to the sharp decline in mortgage related activity. Net GOS revenue was just $45 million in Q1 2021 vs $227 million a year ago. The GOS margin of 0.58% contrasts with the 1.84% in Q1 2021, when the residential mortgage industry was experiencing record volumes and profits. The chart below from the FBC report shows trends in NIM, which rose above 3% for only the second quarter since 2019, even as earning assets have fallen for three consecutive quarters. Annaly Capital Management We purchased a position in NLY at roughly half of book value in April of 2020, when there was blood in the streets and a number of REITs were near the tipping point due to margin calls. By “going big” with securities market intervention, the Fed of New York moved forward TBA rates down in yield by couple of hundred basis point in 30-days, forcing issuers with short positions to essentially give dealers all of their cash for a month. Wind the clock forward two years and NLY is trading at 0.8x book value and has managed to survive the past two years of QE madness and actually thrive. The traditional investor in agency MBS has diversified into mortgage servicing rights (MSRs), a move we applaud and now accounts for 10% of capital. MSRs are negative duration assets with cash flow, similar to a Treasury interest only (IO) strip but with more volatility due to the idiosyncratic nature of prepayments on residential mortgages. No amount of computer power can really, really enable you to predict when Fred and Wilma are going to sell or refinance their home. Family decision cycles, for example, vary with geography and income. But with skill and a lot of data, issuers can certainly encourage and facilitate such blessed events, which in good times generate substantial income. Today, as we noted in our last Premium Service comment in The Institutional Risk Analyst , many conventional issuers are losing money on every conventional loan they close. NLY benefits when there are few prepayments on mortgages, which impacts both the MBS and also the MSR. In a rapidly rising rate environment, prepayments on MBS you bought at a premium are painful. But NLY now hedges that basic dynamic by owning MSRs and benefitting from the extension of maturities on mortgage portfolios. We also applaud the sale of the middle market loan portfolio in Q2 2021, focusing NLY on the residential asset. NLY’s NIM rose slightly in Q1 2022, but so did the cost of funds due to the dramatic shift in the Fed’s interest rate narrative. Even though the FRBNY has continued to purchase securities through the month of April, interest rates have backed up dramatically. In fact, Q1 2022 was one of the worst periods ever for the bond market and fixed income investors, yet NLY managed its position quite well. The table below is from the NLY Q1 2022 earnings presentation. NLY is positioned nicely to manage its portfolio in a rising rate environment. The new issue market for residential loans is going to slow dramatically in 2022, with volumes moving to the relatively safety of the FHA and Ginnie Mae assets, on the one hand, and non-QM loans on the other. Comparisons with the 2006 period are entirely appropriate, albeit for different reasons. Net mortgage spreads are near or above 5-year highs, thus we believe that the environment for REITs like NLY is promising, especially with the added benefit of the MSR portfolio in the mix, which increases in value as rate rise. The major risk factor, as in 2020, is whether the end of FOMC purchases of MBS is going to impact market liquidity and thus the cost of funds. The chart below from the NLY Q1 2022 earnings presentation shows the MBS current coupon vs the average yield for 5-10 year Treasury paper. With most industry MSR valuation models using high-single digit assumptions for prepayment rates going forward, there is a great deal more visibility on future cash flows than NLY and other REITs have enjoyed in many years. Liquidity remains a potential risk, but as reserve assets decline and bank purchases of government MBS return to normal levels, we think that the agency REITs like NLY will have the wind at their backs for a change. Sadly, lenders and issuers such as Flagstar will not have the same degree of visibility on future volumes and earnings. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

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

April 22, 2022 | Premium Service | With this edition of The Institutional Risk Analyst , we return to a couple of interesting banks with roots in the mortgage industry, but that’s where the similarities end. Silvergate Capital (SI) and Western Alliance Bancorp (WAL) were two of the best performing bank stocks of 2021, but both are now following the bank group lower and for different reasons. The former is being hurt by flagging interest in crypto assets, the latter by the nuclear winter in housing caused by the lurch in Fed interest rate policy. Where is value for these two names and the broader banking sector? Source: Google Western Alliance Bancshares (WAL) We profiled WAL early last year , just as the bank had closed its acquisition of AmeriHome from Apollo Global (APO) portfolio company Athene (ATH) . In those happy days, AmeriHome was raking in the profits from QE, with gain-on-sale margins for conventional loans in the 3-4 point range. There are virtually no conventional lenders in the US today that are profitable when they sell a loan into the secondary market. Why? Because forward prices (yields) in the too-be-announced (TBA) market are galloping higher and faster than the advertised annual percentage rates for residential mortgages. This is significant for WAL and AmeriHome because they are among the largest aggregators of conventional loans along with PennyMac (PFSI) . Specifically, instead of trading at 3-4 point premiums to par, TBAs for current production are at a 1-2 point discount. This means that every loan being sold into a conventional MBS today is a dead loss for lenders . Notice in the screenshot below from Bloomberg that the only TBA shown above par are FNMA 4.5s, meaning that many lenders are losing money on every loan sold into the secondary market. This past week we saw several conventional loan pools with 700+ FICO scores on average and weighted average coupons (WACs) above 6%, in some cases near 7% coupons. These pools were sold into 6% FNMA securities for delivery in May, a TBA contract that is not yet even shown on the Bloomberg screen. We also saw two pools of non-QM jumbos that priced above 101.87 with WACs above 7.5%. What is suggests is that mortgage rates are already above 6% effectively, but the insane competition in the shrinking market for conventional loans is holding down prices and annihilating a market with 50% over-capacity. WAL saw net down slightly in Q1 2022 vs Q4 2021 at $240 million, with net interest margin of 3.3%. The bank continues to be one of the best performer in Peer Group 1 measured by metrics such as efficiency and credit. WAL reported zero charge offs in Q1 2022 and showed delinquent loans at just 0.15% of total loans. Shareholder equity rose by $1.3 billion YOY, a reflection of the bull market in housing assets that is now sadly a fast fading memory. We don’t have any stability concerns for the $55 billion asset WAL as we enter a period of uncertainty over interest rate policy and great market volatility. The bank’s held-for-investment loan portfolio has grown enormously (43%) YOY, but deposits have also increased by 36% due to the massive mortgage escrow balances controlled by AmeriHome. The impact of the AmeriHome acquisition is clearly visible and largely in a positive way, but we look for loan volumes at WAL to fall sharply in 2022 along with the rest of the mortgage industry. At 1.6x book value at the close today, the stock is not cheap but it is down from 2.6x a year ago when it outperformed most large banks. Silvergate Corp (SI) We profiled Si back in February of this year , but much has changed in the past several months with interest rates up and crypto valuations falling. SI was trading at 12x book value at the end of Q1 2021, but today the stock is trading around 2.5x, a significant drop YOY, but SI is up sharply from a month ago. Note that SI has a beta of 2.5x the average market volatility, a function of the crypto component in the stock’s audience. WAL by comparison, has a beta of 1.5x and the KBW Bank ETF has a beta of 1.3x. There are clearly some investors who are still bullish about the SI crypto business. For us, the big change in the mix is the declining attractiveness of the crypto trade as the FOMC raises interest rates dramatically, providing a tangible alternative to crypto assets as a shelter from financial repression. If you think of SI, Tesla (TSLA) and all of the MEME stocks as a reflection of real interest rates, the timing of the down move in SI begins to make some sense. Or to put it another way, a year ago SI’s market valuation was inflated by expectations regarding the profit potential of crypto, but today such expectations are greatly reduced. While the bank continues to grow income and its customer base, the flow of crypto transaction across its proprietary SEN network fell dramatically in Q1 2022, as shown in the table below from the SI Q1 2022 earnings presentation. Given the small size of the depository, SI is obviously not of interest to investors because of its community banking or legacy mortgage business. With $16 billion in total assets (vs less than $2 billion in 2019) and an unusual liability structure, SI’s bank unit is idiosyncratic to put it mildly. As and when the blown falls off the crypto rose entirely, we suspect that the bank could shrink back down to ~ $2 billion in assets. The continued attraction of SI for investors is clearly crypto, but we still don’t see the profits to support the risk of crypto involvement. The swooning volumes in the world of crypto currencies is an important factor for investors and risk counterparties to consider. The table below is from the latest SI earnings presentation. We have previously expressed concerns about SI’s business model, both in terms of the composition of the bank’s balance sheet and the risk to the bank posed by extensions of credit with crypto assets as collateral. The torrid growth rate for the bank’s assets, which are mostly invested in agency securities, is another obvious red flag. The non-interest income side of the ledger is clearly the point of attention for investors, yet this metric declined in Q1 2022. The chart below is from the SI earnings presentation. With the explosion of the war in Ukraine and related sanctions against Russian nations and institutions by the US and other nations, counterparty risk must also be considered when assessing the risk profile of SI. Suffice to say that anyone involved in crypto trading and other services in the US, onshore or offshore, must have a know your customer (KYC) and anti-money laundering (AML) regime in place to avoid violating US sanctions or face serious legal repercussions. This tiny community bank in Southern California may be along the casualties of the latest convulsive lurch in FOMC interest rate policy. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information. Disclosure: L: EFC, NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC

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

April 18, 2022 | Premium Service | Last week Goldman Sachs (GS) and Morgan Stanley (MS) reported Q1 2022 earnings. Both firms managed the return to “normal” reasonably well in terms of overall results, but the former continues to evidence a high degree of volatility in line items that ought to be stable. Dick Bove put the situation well last week, saying that Goldman Sachs needs to demonstrate “to what degree can it control its destiny?” That is the right question for readers of The Institutional Risk Analyst to ask as the FOMC is prepares to end QE, significantly raise interest rates and normalize credit costs along with it. Both MS and GS essentially have three business lines: Institutional Securities , including capital markets and investment banking Wealth Management , including advisory and brokerage services for individuals, and Investment Management , including institutional investment services and funds GS further breaks down its institutional securities business into global markets and investment banking, a revealing choice that illustrates the firm’s dependence upon trading the markets and other transactional business. The stable periodic income generated by the MS wealth and investment management lines stand in sharp contrast to Goldman's volatility. Neither firm breaks out commercial lending as a separate business line, but in the case of GS, credit may be a future vulnerability. In terms of AUM, MS had $1.6 trillion in assets under management in proprietary mutual funds and annuities at the end of 2021 vs just $595 billion for GS, according to the FFIEC. MS generated $1.6 billion in fees from this AUM vs $1.3 billion for GS, suggesting that Goldman Sachs clients are paying significantly higher fees for the privilege. The first observation to make in comparing MS with GS is that the latter has far greater volatility in its financial results. What GS labels “Asset Management,” which is the firm’s institutional investment business, swung from $4.6 billion in Q1 2021 to just $546 million in Q1 2022, an 88% decline YOY and a 81% decrease sequentially. The chart below shows the net revenue by segment for Goldman Sachs from the firm’s Q1 2022 results. MS reported a modest increase in net revenue YOY and a 24% decline sequentially, but Wealth and Investment Management lines were relatively stable. Consumer and Wealth Management at GS, by comparison, grew 21% YOY and rose 7% sequentially. These two GS revenue line items are relatively small compared with Global Markets and Investment Banking, which tend to account for the lion’s share of revenue. At MS, by comparison, Wealth and Investment Management regularly account for roughly half of firm revenue, as shown in the table below from the MS quarterly results. MS has made the progression from independent investment bank before 2008 to universal bank and asset manager in the years that have followed. GS, on the other hand, pays lip service to growing its banking business, but continues to focus its financial and human resources chasing high-risk investment banking revenue. The result at GS is a more volatile business model than MS, with a smaller core deposit base and, significantly, higher credit losses than the 130 members of Peer Group 1. At the end of 2021, MS had $329 billion in core deposits vs less than $200 billion for GS. Both firms have been focused on growing banking deposits, but MS has been willing to grow liquidity via acquisitions while GS has preferred to grow organically. The result is that, at the end of 2021, MS had a cost of funds of just 12bp vs average assets or well-below the 23bp average for Peer Group 1. GS was at 41bp in Q4 2021 or 2x the peer average. Amazingly, GS generated the lowest net interest margin of Peer Group 1 at just 48bp at the end of 2021. Source: FFIEC One of the big concerns we have about GS is credit. Despite the fact that GS is a tiny commercial bank in terms of total assets, the firm regularly reports credit losses that are higher than the average for Peer Group 1, which is comprised mostly of smaller commercial banks. Keep in mind that the Fed has muted loss given default via QE, so the fact that GS is experiencing poor credit performance is remarkable. Net loans and leases were just 16% of total assets for GS at the end of 2021 vs 23% for MS, but the credit performance of the GS loan portfolio is poor compared to MS. The gross credit losses of GS loan book are an order of magnitude higher than MS or Charles Schwab (SCHW) , for example, which barely report credit losses at all. Notice in the chart below that both GS and Raymond James (RJ) reported large, idiosyncratic credit losses related to COVID at the end of 2020. Peer Group 1 also showed above-average losses at the end of 2020. Source: FFIEC Given that credit expenses are likely to rise in a secular fashion back to normal levels over the next several years, we believe that the credit performance of GS ought to be monitored carefully by investors and risk professionals. But perhaps even more of a concern than the bank's credit is the firm’s industry leading derivatives exposure. At the end of 2021, GS had the highest gross derivatives position of the top US banks, followed by MS, Citi and JPM. These positions are predominantly interest rate swap contracts, but notice that the oversize derivative position of Goldman Sachs has little impact of the firm’s above-peer funding costs. Source: FFIEC One area where GS excels when compared with the other large banking groups is operating efficiency, where the firm has the lowest efficiency ratio of the top-ten depositories. At nearly five points below JPM in 2021, GS’s efficiency ratio is where it needs to be given some of the disadvantages that face the smallest universal bank in the US market. In fact, GS is in the bottom quartile of Peer Group 1 in terms of efficiency ratio, an impressive showing given that there are some regional banks with efficiency ratios in the 40- and 30-percent range represented in the unweighted peer average generated by federal regulators. Source: FFIEC The bottom line for us when comparing MS with GS is that the former is 20% smaller than Goldman Sachs in terms of total consolidated balance sheet assets, but generates more net revenue with less risk. Simply stated, Morgan Stanley has a much more diverse and sustainable business model than Goldman Sachs At times GS has “killed it,” to paraphrase one hyperbolic headline from CNBC , with outsize investment banking or trading results. Yet the firm’s business model lacks a solid third leg for the proverbial stool in terms of a large banking business and/or wealth management business. The dependence upon investment banking and trading results creates inherent instability in the GS business. MS can always depend upon the more stable wealth and investment management lines to pay the bills in times of market volatility or global upheaval as we see due to the war in Ukraine. For this reason of business model stability, we have long advocated a merger with a large regional bank. Acquiring a large advisory business would also make sense, but SCHW and MS already have largely captured most of the attractive candidates. Sad to say, GS does not have a currency to acquire a large advisory business like SCWW or even RJ, which trade at higher multiples than GS. When you need to swing for the right field fence on every pitch in order to make next quarters’ earnings, this makes GS vulnerable to large swings in the markets and operational risk events such as the continuing 1MDB scandal in Malaysia. MS is a more stable, lower risk business that naturally has higher risk adjusted returns. As the Fed ends QE and begins to run off its balance sheet, we expect GS to resume its traditional place at a modest discount to book value. MS should trade at a small premium to book, reflecting its more stable business, but we would not buy either stock at current levels. Disclosure: L: EFC, NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

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

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