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“In an August 2005 interview, Robert Shiller predicted U.S. house prices could fall by 40 percent (Leonhardt, 2005). The S&P/CaseShiller U.S. National Home Price Index began to fall in the third quarter of 2006. The house price index for purchase transactions produced by the Office of Federal Housing Enterprise Oversight (OFHEO) declined for the first time (since 1993) in the third quarter of 2007.” David C. Wheelock FRB St Louis Review May/June 2008 January 4, 2022 | Over the holiday break, we focused on a couple of writing projects in between watching football and holiday reunions. In particularly, we wrote a new column for National Mortgage News on the return of the Zombie loan. We also put some finishing touches on a new paper on enhancing the liquidity of Ginnie Mae mortgage servicing assets that we'll be posting on SSRN . And we had a great conversation with Wilfred Frost of CNBC on the outlook for banks in the US in 2022. The good news of sorts is that the outlook for residentially house assets generally remains quite positive, with the exception of the prospective re-default of tens of thousands of loans that were modified at the behest of progressives in Congress as a result of COVID. As these zombie COVID loans default, again, servicers will simply modify the loans and sell the loans into a new pool – and pocket a new gain on sale. Perfect. Indeed, until such time as voters show the progressives the door, these re-defaulted or "zombie" loans will simply be rolled, again and again. And the taxpayer, through the GSEs and the FHA, will foot the bill. The bad news, however, is that the urban subset of commercial loans, including mortgages on multifamily real estate, are in for a tough year. National statistics for commercial real estate are improving, yet for some reason the indicator of loss given default or LGD for the $500 billion in bank-owned multifamily loans was 75% of the loan balance in Q3 2021. This is above the ten year average LGD for multifamily loans. Source: FDIC/WGA LLC Loss rates for multifamily loans owned by banks have been elevated for two years, even before COVID. While the absolute number of defaults is low, it is far higher than the other series for residential housing, all of which show net-charge off rates at or below zero. Notice that LGD on multifamily loans and 1-4s basically tracked up through 2017, then diverged. Meanwhile, the LGD for 1-4s was negative 130% in Q3 2021, meaning that banks are generating more than twice the loan proceeds in those rare instances when they sell a home in foreclosure. This metric, which is based upon the Basel I methodology, suggests that home prices are very inflated. Send those cards and letters to Chairman Jerome Powell c/o The Federal Reserve Board in Washington. Two obvious questions should occur to investment and risk managers: First, how big will the losses be to lenders as a result of the credit problems facing urban commercial and multifamily properties? Second, how much longer will the positive, really surreal credit conditions persist in 1-4 family assets? As we’ve already noted, there are signs of lender fatigue and credit stress in some of the more aggressive fringe products in the housing complex. Our best guess on commercial credit exposures is that banks and bond holders could face tens of billions in losses over the next several years. The change in asset utilization for many urban properties in New York City is profound. New York City and its environs face a difficult period of right-sizing government to fit a metropolis with an expanding sense of entitlement and a shrinking commercial base. The commercial real estate community and the lender banks are putting brave face on a daunting situation. A group of nine banks provided the $3 billion to SL Green, the National Pension Service of Korea and Hines’ One Vanderbilt in June 2021, The Real Deal reports . Wells Fargo reportedly originated half of the total debt, or $1.5 billion, while Goldman Sachs contributed $600 million. Bank of America , Bank of China , Bank of Montreal , Deutsche Bank and JPMorgan Chase each provided $150 million. One Vanderbilt is one of the newest and most attractive properties in Manhattan, located next door to Grand Central Station. But on the other side of GCT, 245 Park Avenue just slipped into special servicing before the New Year. Go further East to Lexington Avenue and then Third Avenue, and what you see is one mostly empty commercial building after another, from 42nd Street all the way into the 60s on Manhattan's East Side. Go west across the island of Manhattan to Hudson Yards on 10th Avenue in the 30s. Work on Phase 1 continues toward completion, again due to the forbearance of the bank lenders. When will Phase 2 begin, to monetize the remaining air rights over the westbound train tracks below? Nobody knows, but the payments for those air rights were financed with debt, of note. Keep in mind that, where possible, banks will roll commercial loans to avoid a more general markdown of impaired collateral in the portfolio, but there is only so long forbearance can go on until the rules break. Bank investors should watch Q4 2021 disclosure carefully for signs of regulatory forbearance for commercial and particularly multifamily residential assets in 2022. After all, it’s an election year. That is, don't just read the press release. Meanwhile , the Wall Street Journal reports that the US mortgage industry wrote $1.6 trillion in purchase mortgages in 2021 , a record that was broken in large part due to the Fed-induced housing price inflation. When the MBA stats for the full year are released, we suspect that the industry wrote fewer, bigger mortgages to achieve this feat. The conforming loan limit was $417,000 in 2008, but today is just shy of $1 million thanks to the FOMC. That's a more than 100% increase in 12 years of rising inflation and debt. As with the zombie COVID mortgages and underwater multifamily properties, there is likely to be a larger, more general delinquency problem with residential mortgages down the road, probably in time for the next Presidential election in 2024 or shortly thereafter. During this period, keep in mind, the FOMC intends to reinvest the proceeds of redemptions of both Treasury debt and mortgage-backed securities in the system open market account (SOMA), the engine of US inflation. That is, the FOMC will continue to stoke the fires of inflation by purchasing government debt and mortgage bonds rather than allow the SOMA to shrink. Quite to the contrary to the ignorant narrative about tapering quantitative easing or “QE,” the Fed will continue to suppress home mortgage interest rates and there will push further home price inflation, hurting affordability. We will simply run out of buyers, with or without an increase in housing supply, as has historically occurred. When pondering the outlook for US housing over the next five years, we think it is prudent to consult the historians. David C. Wheelock , a much revered economist with the St. Louis Fed, wrote the analysis for the May/June 2008 issue of Review (“ The Federal Response to Home Mortgage Distress: Lessons from the Great Depression ”). In discussing the Great Depression and the 2008 financial crisis, Wheelock notes that home prices actually peaked in the mid-1920s and, more recently, in 2005, but it took several more years before the proverbial wheels came off the skateboard. It is 2005 all over again kiddies. Wheelock writes: “Although the nominal value of mortgage debt peaked in 1930 and then declined, deflation caused the real value of outstanding mortgage debt to continue to rise until 1932. Thus, consistent with [Irving] Fisher’s (1933) classic “debt-deflation” theory, the burden of outstanding mortgage debt increased sharply during the contraction phase of the Great Depression and economic recovery did not begin until the real value of outstanding debt had begun to decline.” In modern day terms, the fact of a federal guarantee on principal and interest for agency and government insured MBS suggests that this time it will be different from 2008, when more than half the mortgage market was private label. Yet the differences between the market of 1925, 2005 and 2025 include both positive and negative factors. Yes there is a credit guarantee on the MBS, but the 1) liquidity risk and 2) cost of servicing due to Dodd Frank and general progressive craziness means that a big residential home price correction could become an existential event for many lenders. SO as we move into Q4 2021 earnings for financials in the next two weeks, keep your eyes peeled for news of restructuring of bank loans on urban commercial and multifamily properties. Defaults on commercial loans can be delayed for months, and have been since 2020. In 2022, though, with state and federal foreclosure moratoria ending, the economic cost of COVID will emerge as a factor for many lenders. But the day of reckoning in residential housing is still several years away. In a future issue of The Institutional Risk Analyst, we'll be looking at the Top Five US commercial banks -- JPMorgan Chase (JPM) , Citigroup (C) , Bank of America (BAC) , Wells Fargo & Co (WFC) and U.S. Bancorp (USB) . Then we'll take a deep dive, profiling Cross River Bank , a key financial and operational partner to a number of emerging fintech companies.

December 13, 2021 | In this Premium Service issue of The IRA Bank Book Q4 2021 , we ask whether bank fundamentals are starting to catch up to the very full equity market valuations, up some 40% since the end of 2020. And as a special Christmas thank you, this issue of The Institutional Risk Analyst is free for all of our readers through year-end 2021. As the year ends, income is up and credit defaults are down, at least for now and at least in single family housing assets. Yet there are storm clouds on the horizon for US banks in terms of commercial and consumer loan exposures as COVID loan forbearance ends on January 1, 2022. The IRA Bank Book Q4 2021 The social engineers on the FOMC have created a monster bubble in non-agency residential assets. Piggyback loans have reappeared and the level of fraud in loan manufacturing volumes is rising, classic late-stage indicators. The world of fix and flip loans is looking positively rancid, with levels of missed first payments soaring, raising questions about hidden risk on bank warehouse lines. Roughly one in three FHA residential mortgages that were modified during the past 18 months of COVID forbearance are headed for re-default. Bank owned multifamily credits continue to show unusually high loss severities. It could just be 2007 all over again, but the difference is that the problems arise from multifamily and commercial assets instead of 1-4s as in 2008. Enjoy the higher interest rates while they last. Once the true cost of credit starts to emerge in 2022, the plunge protection team may need to put pedal to the metal again. Bank equity market valuations, not surprisingly, have been going sideways since mid-year. Source: Google Review & Outlook The third quarter of 2021 saw some expansion in terms of nominal yield and also spreads for all US banks, pushing up the return on earning assets (ROEA) for the first time in almost a year. A big driver was $5 billion in negative provision expense in the quarter or a $19 billion total decline in credit provisions vs 2020. The return on average assets actually slipped a few basis points compared with Q2 2021, causing net income to decline, the FDIC reports. The chart below shows the long-term return on earning assets for US banks. Source: FDIC/WGA LLC Another big factor in the surge in Q3 2021 earnings was the falling cost of funds, just $8 billion in Q3 for the entire banking industry. The chart below shows the components of net interest margin through Q3 2021. Notice that interest income fell $45 billion from 2019 through 2020 due to the wasting effects of QE. Source: FDIC/WGA LLC Nearly three-quarters of US banks reported higher net interest income compared with a year ago, a promising sign. Banks saw higher non-interest income as servicing fees, investment banking and interchange fees all increased in Q3 2021 vs the same period in 2020. The allowance for loan and lease losses (ALLL) as a percentage of total loans and leases declined 55 basis points to 1.69% from the year-ago quarter due to negative provisions, the FDIC reports, but ALLL remains higher than the level of 1.18 percent reported in fourth quarter 2019. The chart below shows pretax income vs provisions, one of the most important income statement relationships in banking, back to 2007. Provisions may remain at or near zero for some time given the current sufficiency of the ALLL, a positive for earnings so long as credit expenses remain muted due to QE. Source: FDIC/WGA LLC With provisions expense likely to remain low for some time, the outlook for earnings should be positive – but we have a long way to go to reach some level of normality vs the pre-2018 bank earnings. Dividends are back up and above pre-2019 liquidity crunch levels, but bank income – if you subtract the impact of negative provisions – is still struggling. The FOMC would need to let interest rates rise by at least 100bp in order for banks to reach normal levels of income measured by asset and equity returns. As things stand today, we expect earnings for US banks to stabilize at 2018 levels and extraordinary GAAP adjustments to income end as 2022 progresses . Source: FDIC/WGA LLC The big area of expansion in bank balance sheet continues to be securities, while loan balances are just barely growing. The runoff of Paycheck Protection Program (PPP) loans is another source of portfolio deflation in Q3 2021 that is likely to become more pronounced in Q4. Commercial (C&I) loans were down $301.8 billion, or 11.9 percent in Q3 2021. The decline in C&I balances was driven by PPP loan forgiveness and repayments, and loan sales. Relative to the growth in deposits, the increase in loans in Q3 2021 was trivial, continuing a trend that goes back several years. Indeed, deposit growth surged even as lending essentially stalled. The FDIC reports: “Deposits grew 2.3 percent ($436 billion) in third quarter, up from 1.5 percent growth ($271.8 billion) reported in second quarter 2021 but below the first quarter 2021 gain that was boosted by federal support programs. Deposits above $250,000 continued to drive the quarterly increase (up $445.2 billion, or 4.5 percent). Interest-bearing deposit growth (up $284.6 billion, or 2.4 percent) outpaced that of noninterest-bearing deposits (up $185.4 billion, or 3.6 percent). More than two-thirds (68.7 percent) of banks reported higher deposit balances compared with the previous quarter.” With the end of QE, bank deposits should begin to run off, depending on whether the FOMC actually allows the portfolio to decline. The chart below shows the total deposits and loans for all FDIC insured banks. Source: FDIC The bank migration out of the world of residential asset sales and servicing continues, with nonbank servicers now accounting for more than half of all 1-4 family assets. Assets serviced for others (ASFO) by banks was $2.9 trillion at the end of Q3 2021. Bank portfolio loans are more or less stable at $2.4 trillion, but HELOCS are rapidly disappearing at just $270 billion in unpaid principal balance. Nonbanks now service $6.6 trillion in 1-4s and, baring some act of insensitivity in Washington, will rise above $7 billion in short order. Source: FDIC, FFIEC, MBA At just $344 billion in Q3 2021, bank sales of 1-4 family mortgages are less than half of the level seen in Q3 2015. Of interest, after several quarters of no sales of C&I loans, banks sold $6.3 billion in commercial loans in Q3 2021. Sales of “other loans, leases, and other assets,” of note, also reached an all-time high of $99.5 billion, suggesting that banks are seeking to shed less attractive, “miscellaneous” exposures going into 2022. Source: FFIEC The value of MSRs owned by banks, which accounts for less than a third of the total servicing market today, rose over the past several quarters due to rising interest rates, secondary market demand and other factors. Notice that servicing fees are back in positive territory after spending 18 months at or below zero due to COVID and the progressive loan forbearance scheme in the CARES Act. Source: FDIC It is some indication of the absurdity of the CARES Act that almost all of the households that asked for or involuntarily ended up in forbearance have exited successfully. That said, look for the Consumer Financial Protection Bureau and other agencies to find faults of the most minor sort in handling CARES Act forbearance. As with the SEC under Joe Kennedy in the 1934-35, the CFPB’s agenda is entirely political. Other agencies such as the Office of the Comptroller of the Currency have likewise been taken over by progressive zealots, as we discussed in our comment on Cenlar FSB . Sector Charts Total Loans & Leases Source: FDIC Levels of default and delinquency continue to fall through Q3 2021, a trend we expect to see extend into 2022. Loan losses are at unusually low levels, however, suggesting that loss rates and provisions will normalize in the next year. As the chart below suggests, loss given default (LGD) has skewed lower during the period of QE since 2018. The average LGD on total loans since 2007 is 80%. As the Fed withdraws extraordinary open market intervention, these credit relationships will normalize. Source: FDIC/WGA LLC Total Real Estate Loans The $5.1 trillion portfolio of real estate loans represents a quarter of bank assets. Delinquency and net charge offs remain muted compared with the long-term averages, largely due to loan forbearance and low interest rates for carrying and refinancing assets. The modest uptick in delinquency that occurred in 2020 and 2021 has now largely abated and the related reserves for loss, have also been released. Source: FDIC The chart below shows LGD for all bank owned real estate loans, yet another example of Fed social engineering. The series is once again in negative territory due to QE and the general market mania observed in private loan assets that has developed in the past 12 months. Source: FDIC/WGA LLC 1-4 Family Loans In the $2.4 trillion residential loan sector, the non-current rate is hoovering above 2% and the net default rate is also negative. The LGD for the sector is negative 132% vs the LT average of 60%, an illustration of the huge distortions caused by QE and other governmental actions. Once COVID loan forbearance ends and the Fed ends purchases of MBS, we expect mortgage rates to rise and home price appreciation to moderate. Source: FDIC Source: FDIC/WGA LLC The table below shows residential mortgage delinquency rates by sector. Source: MBA, FDIC The big difference between December 2020 and this year, of course, is that we have not had significant foreclosures in the past 18 months, but 2022 will see a resumption of residential and commercial default resolutions and related regulatory action. In the final weeks of 2021, the mortgage industry received an unwelcome holiday gift from Consumer Financial Protection Board (CFPB) Director Rohit Chopra . The CFPB is preparing to announce multiple enforcement actions against several mortgage lenders for “deceptive practices” in dealing with COVID forbearance loans. Home Equity Lines of Credit As with 1-4 family mortgages, home equity lines of credit also show declining levels of delinquency and negative net charge offs. LGD for HELOCs was - 216% in Q3 2021, meaning that lenders are making 2x the loan balance upon default after paying off the loan. Source: FDIC Source: FDIC/WGA LLC GNMA EBOs Much like the other data series focused on residential mortgages, loans repurchased from Ginnie Mae pools are also showing moderating delinquency. The early buyout (EBO) trade has lost some of its luster, however, compared with a year ago when issuers were capturing record gain-on-sale margins on EBOs. Source: FDIC Inside Mortgage Finance reports that $11.14 billion of FHA/VA loans were repurchased from Ginnie MBS in Q3, the highest total of the year. The crowd of newbie investors investing in government servicing assets is astounding. Many investors, however, are learning that these trades are no longer profitable and, indeed, may actually generate a net loss when the loan is resolved. The resumption of foreclosures and the related increase in regulatory scrutiny of distressed loans will add to the cost of EBOs. Multifamily Loans Unlike the experience of most of the sectors of residential housing, the $492 billion in multifamily loans owned by banks are displaying high levels of loss upon default, a very bad sign for the future of many rental properties. The level of charge-offs is still quite low, but the level of delinquency is rising. More, the level of loss upon default is 75% in Q3 2021, above the long-term average LGD for multifamily credits of 60%. Source: FDIC Source: FDIC/WGA LLC Commercial & Industrial Loans The data series for most residential loans, excluding multifamily credits, generally show the impact of QE and monetary policy more generally in terms of subdued levels of default and delinquency. The $2.3 trillion in commercial and industrial loans owned by banks, however, display a more normal pattern of delinquency, albeit one that is still influenced by the skew in credit risk pricing that has occurred due to the radical policies of the FOMC. In particular, the decline in both delinquency and defaults in C&I credits since 2019 is largely attributable to the Fed and also fiscal spending that is now past. As these funds dissipate, we expect levels of delinquency and default in commercial credits to return to normal levels. Indeed, despite the positive impact on default rates of monetary and fiscal policy, LGD for C&I loans was 60.2% in Q3 2021 and is still above the LT average of 56%. Source: FDIC Source: FDIC/WGA LLC Credit Card Loans One of the most profitable areas of bank lending is credit card loans, but as with other asset classes, this loan category has been shrinking rapidly. At the end of 2019, credit cards receivables owned by banks totaled $916 billion. At the end of Q3 2021, credit cards totaled just $800 billion, up from $776 billion in Q2 2021. In the age of QE, the Fed’s stated policy goal of causing an expansion of credit has failed. Instead, as rates have declined and trillions of dollars in fiscal giveaways have flowed from Washington into the economy, bank lending has barely shown any growth even as deposits have surged. Source: FDIC Likewise, LGD for credit card loans has fallen dramatically to just 63% at the end of Q3 2021 vs the LT average of 81%. Remember that these are unsecured consumer loans. Once the latest fiscal infusion has run its course, however, we look for delinquency and net-loss rates to return to the mean. Source: FDIC/WGA LLC Auto Loans Like many other loan sectors, bank owned auto loans have benefited enormously from low interest rates and various federal and state forbearance programs related to COVID. The global shortage of semiconductors has also pushed up the secondary market price of used cars. Notice in the chart below that loan delinquency rates are still normal, but post-default loss rates actually touched just 30% in Q2 2021 vs the LT average loss rate over 50%. Source: FDIC With the start of 2022, however, most loan payment moratoria will end and the true cost of credit will surge back into view. COVID has also influenced loss given default for bank auto loans, as illustrated by the fact that LGDs for auto loans was actually negative in Q3 2021. The impact of disruptions in the supply chain due to COVID and the global shortage of semiconductors has made used cars more scarce, increasing prices for autos and necessarily pushing LGDs down as loan recovery rates have soared. Source: FDIC/WGA LLC The Bottom Line We look for bank earnings to improve as interest rates rise, but the more crucial question of spreads on assets is likely to remain largely neutral. Unless and until we see a true increase in demand for credit, it is unlikely that banks will have any effective pricing power on assets. While the FOMC is going to end asset purchases by as early as March 2022, we do not expect to see any change by the FOMC in target interest rates for some time. Any return of equity market volatility a la 2019 or 2020, however, is likely to cause the Fed to retreat from its current worries about inflation. The IRA Bank Book (ISBN 978-0-692-09756-4) is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Book. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Book are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Book represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Book is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Book is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Book. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

December 21, 2021 | Back in June of this year, we asked whether Upstart Holdings (UPST) would prove or discredit the use of “artificial intelligence” or AI in the credit underwriting process. UPST then went on a Fed-fueled tear, combining the hype factor of AI with quantitative easing (QE) c/o the FOMC to rise nearly 300% at one point this year, far outpacing other stocks and even crypto assets of all descriptions. In this Premium Service edition of The Institutional Risk Analyst , we take another look at UPST and also update our readers on the company formerly known as Square, now Block Inc (SQ) as in perhaps blockchain? Founder and CEO Jack Dorsey has stepped down from his other company, Twitter (TWTR) , presumably to focus on SQ. Of note, the two very different firms have remarkably similar stock performance over the past six months. Call it karma? Or are both TWTR and SQ just two badly inflated stocks losing altitude as the FOMC ends QE? Upstart Holdings We still don’t know whether the new age loan acquisition and underwriting tech behind UPST will stand the test of time in terms of delinquency, but we can say that UPST and SQ both illustrate the asset price inflation that has occurred during the COVID pandemic. The chart above compares UPST, SQ and TWTR. Notice that both fintech stocks exploded during the post-COVID flood of liquidity from the Fed and Congress both. UPST only went public at the end of 2020, but it quickly replicated the pattern followed by SQ once the FOMC opened the monetary spigots in March of that year. Since peaking back in September, both firms have given up significant ground and SQ is actually down for the full year. The full year total return on UPST, however, is over 250% as of yesterday’s close but down 30% in the past month. The huge upside in these stocks is driven by market hype and, to be fair, a focus on growth rather than earnings. At $165, SQ is trading at 25x book value compared to only 16x for UPST and 9x for PayPal (PYPL) . The only traditional bank anywhere near these valuation levels is the hyper-efficient American Express (AXP) at 5x book. The larger question is whether stocks revert to pre-COVID levels once the crisis has past and more normal credit conditions return. The good news is that UPST is profitable, but to that question about growth, the jury is still out. UPST had guided analysts to $600 million by Q3 2021 in total revenue but came in light at $544 million. Now the company has guided to $750 million for the full year or plus $200 million, which suggests a down quarter sequentially from the $228 million for the quarter ended September. UPST is, after all, a point-of-sale (POS) funnel for various types of loans, which are funded and closed by third-party banks like Cross River Bank (CRB). On note, the $12.8 billion asset CRB is a hyper-aggressive depository that serves as the lender for many nonbank firms, but has limited disclosure as a unitary, state-chartered non-member bank based in Bergen County, New Jersey. As of September 30, 2021, CRB’s loss rate was 2x the average for Peer Group 1. The bank has a high dependence on non-core funding, but has 20% total capital to assets – a measure of the risk involved in some of the bank’s business operations. Below is the organizational summary for CRB from the FFIEC. With the Fed tightening policy and ending QE, has the boom in nonbank lending also ended? UPST and many other nonbank lenders must answer that question in coming months. One indication of the uncertainty facing UPST is volatility. The UPST equity trades on a beta of 1.7x the average six-month market volatility and SQ is right behind at 1.5x beta. We give UPST a lot of credit for marketing and promotion, but less so for making any real changes in the world of loan underwriting. The Fed has been explicitly pumping asset prices since 2008 when QE 1 was announced . Now the US economy faces the prospect of sorting out the good assets from the bad after a decade of forced credit creation that arguably is mispriced by several notches of default probability. More, UPST has created a capital light model that avoids the risk and also much of the revenue from the loan, including the servicing strip. After all, it is the party that funds and closes the loan that owns the asset and owns the risk, even after the note is sold into the secondary market. Now you understand why CRB is sitting on 20% equity capital. “Cross River Bank and one other bank partner account for a substantial portion of the total number of loans facilitated by our platform and our revenue,” notes UPST in its most recent 10-Q . The relevant section of the 10-Q is below: "Cross River Bank, or CRB, a New Jersey-chartered community bank, originates a substantial majority of the loans on our platform. In the nine months ended September 30, 2020 and 2021, CRB originated approximately 72% and 58%, respectively, of the Transaction Volume, Number of Loans. CRB also accounts for a large portion of our revenues. In the nine months ended September 30, 2020 and 2021, fees received from CRB accounted for 65% and 59%, respectively, of our total revenue. CRB funds a certain portion of these originated loans by retaining them on its own balance sheet, and sells the remainder of the loans to us, which we in turn sell to institutional investors and to our warehouse trust special purpose entities. Our most recent commercial arrangement with CRB began on January 1, 2019 and has a term of four years with an automatic renewal provision for an additional two years following the initial four year term. Either party may choose to not renew by providing the other party 120 days’ notice prior to the end of the initial term or any renewal term. In addition, even during the term of our arrangement, CRB could choose to reduce the volume of Upstart-powered loans that it chooses to fund and retain on its balance sheet or to originate at all. We or CRB may terminate our arrangement immediately upon a material breach and failure to cure such breach within a cure period, if any representations or warranties are found to be false and such error is not cured within a cure period, bankruptcy or insolvency of either party, receipt of an order or judgement by a governmental entity, a material adverse effect, or a change of control whereby such party involved in such change of control provides 90 days’ notice to the other and payment of a termination fee of $450,000. If we are unable to continue to increase the number of other bank partners on our platform or if CRB or one of our other bank partners were to suspend, limit or cease their operations or otherwise terminate their relationship with us, our business, financial condition and results of operations would be adversely affected.” “In the nine months ended September 30, 2020 and 2021, one of our other bank partners originated approximately 19% and 34% of the Transaction Volume, Number of Loans, respectively. In the nine months ended September 30, 2020 and 2021, the fees received from this bank partner accounted for approximately 15% and 25% of our total revenue, respectively.” Of note, UPST discloses that “the current maximum annual percentage rate of the loans facilitated through our platform is 35.99%,” a fact that has led to UPST and its partner banks getting involved in usury litigations in several jurisdictions. The basic problem is that UPST, as a thin POS, is not licensed as a lender. Even though the partner banks are able to avoid much state regulation due to the fact of FDIC insurance, UPST and its capital light model cannot. As UPST states: “There is an ongoing risk that government agencies and private plaintiffs will seek to challenge these types of relationships.” The relationship between UPST and the lender banks, of course, is the major point of vulnerability in the business model. Unlike Varo Bank , which chose to seek and win a full OCC bank charter with the support of Warburg Pincus , UPST chose to take the relatively easy but higher risk bank of being a loan POS and sales conduit for several banks. Our only question is why does Cross River Bank need UPST? The company states in its latest 10-Q: “We note that the OCC issued on October 27, 2020, a final rule to address the ‘true lender’ issue for lending transactions involving a national bank. For certain purposes related to federal banking law, including the ability of a national bank to ‘export’ interest-related requirements from the state from which they lend, the rule would treat a national bank as the ‘true lender’ if it is named as the lender in the loan agreement or funds the loan. However, the rule was subsequently challenged by the Attorneys General from seven states and ultimately repealed by Congress pursuant to the Congressional Review Act on June 30, 2021. No similar rule applicable to state-chartered banks was issued by the FDIC, and thus there is no longer a clear federal standard.” Regulatory risk aside, the big question we have is credit. The only way to test the underwriting of UPST is by following their loans through a down credit cycle. As we said, call us in 2025 when housing is likely to be in the midst of a major correction a la 1980 and 2007. Both of these major down cycles in credit lasted a decade and includes a significant recession. Just imagine how many of the hundreds of thousands of delinquent residential loans that were kicked down the road via COVID modification schemes in 2021 will begin to re-default in 2022. The same outcome is likely for the small commercial loans made by UPST and dozens of other fringe lenders that erupted from the earth due to the FOMC. It’s 2005 all over again. Block Inc. Turning now to SQ, the firm founded by Jack Dorsey in 2009 is starting to show signs of maturity, namely slower growth. In our earlier comment, we noted that SQ is less of a fintech company and more of a payments play comparable to giants such as Visa Inc (V) and Mastercard (MA) . Dorsey, however, seems to favor the world of crypto tokens for his corporate identity, thus the name change. Mr. Dorsey may come to regret this decision. To us, the true value of SQ is in facilitating payments for a growing ecosystem of businesses around the world, not speculating in crypto tokens which we view as a fad that will eventually burn out. Like PYPL, however, SQ’s leadership seems to believe that embracing electronic gambling – the true nature of crypto – is somehow accretive to shareholders. In the nine months ended in September 2021, SQ generated $13.6 billion in revenue vs $6.3 billion in 2020, a 115% increase. Gross profit was $3.2 billion vs $1.9 billion a year earlier, up just 68%, indicating that the cost of revenue grew faster than revenue. Total operating expenses of $3 billion grew 52% YOY, including a $70 million impairment charge for bitcoin losses. SQ managed to report $239 million in income for the first nine months of 2021 vs a loss of $81 million in the previous year. The 7% EBIT margin is comparable to other financial services firms. Thus, the question comes: Is SQ really, REALLY worth 25x book value? Our respectful answer to that question is no. We believe that SQ, which we owned through December 2018, is a good comp for MA and V and should continue to grow with the world of global payments. But we think that the performance of both UPST and SQ over the past 18 months has more to do with QE and the monetary policy of the FOMC than any intrinsic value created by Mr. Dorsey. Once these and other financials start to trade on fundamentals rather than asset price inflation expectations, then we believe that the valuations are likely to return to earth. Disclosures: L: 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. 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First the Fed and Bank of England colluded to destroy LIBOR for no real reason save regulatory pique. Then the Fed and Group of Thirty suggested centralized clearing of Treasury debt, a very bad idea. Now, the Fed and SEC want to lobotomize mutual Money Market Funds (MMFs), this just as banks are pushing corporate cash out of the house. In this issue of The Institutional Risk Analyst , we update our readers on a question we first addressed this past May, namely the impending death of MMFs as cash equivalents. Is there anywhere safe for large investors to stash short-term dollar liquidity as the Fed nationalizes the private money markets? In our widely read comment, “ Fed Prepares to Go Direct with Liquidity ,” we talked about the plans of the Federal Reserve Board and the Securities and Exchange Commission to suspend redemptions by MMFs during times of market stress. Now the Wall Street Journal confirms our earlier report, which comes just as corporate investors have been migrating out of bank deposits into MMFs. With the FOMC now intent upon shrinking bank balance sheets by ending quantitative easing or "QE," cash investors are trapped. As we take a look at the state of the US money markets as year-end 2021 comes into view, we cannot help but be amazed by the market’s inaction as the Fed and SEC prepare to make a substantial change in US market structure. If the banks have closed the window for large deposits and MMFs are no longer safe as repositories of cash, where is a corporate CFO or Treasurer going to park next week’s payroll? This fundamental question is unlikely to be answered in the near-term, meaning that cash is going to seek out alternatives. The process of shifting around trillions of dollars in liquidity with the sudden end of QE is unlikely to be helpful in the days and weeks ahead. The market narrative is fixated on COVID as the reason for the equity market selloff, but the real reason is the changes underway at the Fed with the end of quantitative easing. We noted last month in “ As the Fed Ends QE, Stocks and Crypto Will Retreat ” that QE was the fuel for stock and home price appreciation. The proverbial F-16 has reached its operational ceiling, meaning that everything from meme stocks to crypto tokens are in for a correction. The chart below shows total issuance for key debt markets from SIFMA through November. Notice that mortgage issuance is falling rapidly along with corporate debt sales. In our most recent banking industry survey, we focused on the fact that the return on earning assets for banks rebounded in Q3 2021, this in large part due to a shift in asset returns for largest banks. But the change also reflects the forcible expatriation of large deposits from banks to short-term funds. Dick Bove notes that mounting liquidity at banks ultimately forced a change from banks to MMFs: "These deposits created a problem for the banks because loan volume was plummeting and, therefore, the deposits were not being loaned to the private sector. Instead, the banks were forced to put the money into deposits at the Federal Reserve and Treasuries… The banks have taken a number of steps to stop the deposit inflow such as asking large corporations to put their money into institutional money market mutual funds (I-MMMFs) and not the banks.” Markets now expect that the FOMC is going to end purchases of MBS by the end of March, a good development because of the rapid decline in volumes that is expected in the new issue market and the brisk bid for loans and servicing. The mortgage market does not need further assistance from the FOMC with conventional servicing assets going for multiples of annual cash flow of 5-6x, near the peak levels of several years ago and the 1990s. Source: FDIC With the volumes in the MBS markets headed south and Washington’s Build Back Better legislation lost in the political fog for now, there may be a shortage of paper relative to the past several years. Indeed, if we go back to a core thesis that two factors, namely the availability of 1) cash and 2) risk free collateral together comprise the liquidity of US markets, then tightening is already baked into the economic pie beyond simply ending QE. Look for the bank deposit series in the chart above to come down sharply in coming months. Any mismanagement of the tightening process by the FOMC could see the market repeat past liquidity tantrums in 2020 and December 2018, with potentially severe political consequences for Fed Chairman Jerome Powell and the Fed as an organization. But the added fly in the proverbial ointment is the prospective changes in the workings of MMFs, a badly considered structural alteration to the US money markets that could have dire consequences for the dollar and the domestic liquidity situation for Treasury debt. The WSJ reports: “The Securities and Exchange Commission plans to offer changes to make the most-vulnerable subset of money-market funds less susceptible to runs by their investors. The changes would include a measure called swing pricing that firms including BlackRock Inc. and Federated Hermes Inc. have warned could destroy swaths of the industry.” In terms of global asset allocation, large holders of dollar cash now have a problem. On the one hand, the largest banks have basically told them to go away in terms of holding large amounts of cash on deposit. Corporate depositors, as a result, have migrated away from the money center banks to MMFs. This is effectively out of the frying pan and into the fire. The MMFs now are now under a cloud because the SEC has finally decided to do the unthinkable, namely repudiate the admittedly fanciful idea of liquidity on demand at par. For example, a large portion of the counterparties using reverse repurchase agreements (RRPs) to earn income on cash are MMFs. Thus comes the question, what happens in terms of asset allocation if the SEC plan regarding MMFs is adopted? The chart below shows securities held by the Fed, total and MBS, and the level of RRPs. Investors and financial media moguls generally need to accept that the folks at the Fed and other central banks view private markets as an inconvenience, especially when the public debt issuance of the G-30 nations has become more than a bit of a joke. Heavily indebted OECD members are still essentially given a pass when it comes to sovereign credit ratings and, in particular, the risk weights for Basel bank capital requirements. Q: Imagine what happens to this group of heavily indebted sovereign debtors in a rising dollar rate environment? Same question for private debtors that have been effectively subsidized to the tune of hundreds of bps of default probability during QE. Now you know why European Central Bank chief Christine Lagarde is so adamant about not changing policy. The Fed’s primary directive, namely keeping the market for Treasury debt functioning, trumps all other concerns and public policy mandates, even if that means doing permanent violence to private markets and financial institutions. If the Fed needs to go around the big banks with reverse repurchase agreements to give the MMFs and small dealers liquidity, then they will. If the Fed needs to sequester cash inside MMFs when the markets throw a tantrum, that will happen as well. And if the Fed decides to kill the LIBOR market and replace it with SOFR, a benchmark in search of an actual market, then they will do that as well. Nobody in Congress or the markets seem to have the wit to challenge the Fed's market edicts. Even industry leaders like Jamie Dimon , CEO at JPMorgan (JPM) , are strangely silent. As the Fed pushes the private markets aside in the quest for some sort of managed stability in the US money markets, it draws nearer to the day when the market standing of the Treasury itself will be in doubt. Killing the private markets, Chairman Powell, is also an attack on the market for Treasury debt. Or put another way, when the US government is the largest issuer of debt, private investor protection becomes less of a priority. The folks at the Fed and Treasury may believe that they are acting in the national interest, but the markets ultimately will be the judge. And remember, the "problem" with market volatility is caused by the FOMC's own actions, first and foremost QE. Looking at the deposit chart above, QE seems to have been a failure when it comes to stimulating credit creation and therefore jobs. The chart below shows total system assets vs the VIX. Much like the levies built by the Corps of Engineers along the Mississippi River to manage floods, trying to manage the ebb and flow of dollar market liquidity by using ever greater constraints on investors only makes the bad market events worse. The money markets, large bank deposits and TBAs, and dollar swaps are all part of a larger ecosystem the the folks at the Fed seem determined to destroy. Will anyone in Congress or the financial community challenge the Fed and SEC's self-destructive actions?

“The past is a foreign country: they do things differently there.” L.P. Hartley, The Go-Between (1953) November 29, 2021 | The peace of the Thanksgiving holiday was shattered when governments around the world imposed new restrictions on travel from South Africa, where a novel mutation of the COVID virus emerged. Once optimistic views of a return to normalcy were discarded in mere moments. Securities related to the travel and hospitality industry took the requisite hit. Source: GOOG We all were perhaps a bit overly sanguine about the end of COVID as a global threat to personal and societal health, but the delusion was nice while it lasted. Israel has completely closed its border to travel and the US has banned travel from South Africa. Many nations in the EU were already dealing with local flareups of COVID and will now likely head toward mandatory lockdowns this winter. Germany is set to decide on tougher Covid-19 restrictions and could even opt for a full lockdown amid record daily infections and mounting pressure on hospitals. Perhaps most notable is what is not changing, namely the nearly complete lockdown in China. Authorities in Beijing have made clear that they will not reopen in a similar manner to the U.S. and Europe, regardless of the economic consequences. A study released before the holiday states that China would face a “colossal outbreak” on a scale beyond anything any other country has yet seen, if it were to reopen in a similar manner to the U.S. “Our findings have raised a clear warning that, for the time being, we are not ready to embrace ‘open-up’ strategies,” the researchers wrote in the study , which naturally was part funded by the Bill & Melinda Gates Foundation . They added that the approach of “certain western countries” rested “solely on the hypothesis of herd immunity induced by vaccination,” Bloomberg News reports. Of course, the idea that vaccination imparts “herd immunity ” is probably not a practical goal . Herd immunity comes via evolution, adaptation over many thousands of years. The flu virus that killed countless millions during the Dark Ages no longer is a threat. Vulnerable populations have been rendered extinct, but the survivors have herd immunity. Yet the great marketing imperative of Western commerce has given such ideas as “herd immunity” via vaccination substance. In communist China, on the other hand, the imperative is security and political control, thus the idea of a Western-style reopening is unthinkable. A significant increase in COVID cases could threaten communist party rule. The fact that few Chinese are actually vaccinated and most with the less desirable Sinovac jab has forced China to employ a flexible lockdown strategy to enforce the “zero COVID” rule. Given the political imperative of control, it could be many years before China reopens. Ponder the significance for the global economy of an extended China lockdown. The Chinese response to COVID is instructive for a number of reasons. First and foremost, if you cannot afford to lose control of the number of illnesses, then a lockdown is essential to control COVID. If your priority is a rapid restoration of commerce and related social interaction, on the other hand, then you reopen once you’ve reached ~ 50% vaccination and hope for the best. The comparison between the chaos of Germany and the cold determinism of China is notable. The decision by western nations to re-open earlier this year evidenced herd behavior. In the US and other western nations, the view of the herd is the operative rule. Official health pronouncements are often ignored or even attacked as somehow infringing on personal rights, this in a society where celebrity is credibility. Celebrity is ephemeral and a function of the crowd, however, while considered, sometimes terrible judgments that lead to glory and renown tend to be more enduring. Shanghai The Chinese response to COVID is notable because the communist party is deliberately imposing its will in place of the popular herd tendency, which naturally is for opening. In China, the government is prepared to lock down whole cities and regions indefinitely at the first sign of contagion and enforce this cordon. Even if the policy of rolling lockdowns cuts points off GDP, the rule of zero COVID is maintained. Time will tell which policy is more effective for society as a whole. Meanwhile, in the world of crypto, the herd mentality seen throughout the global financial markets is in full force and then some. If you think it is dangerous to express divergent opinions on dealing with COVID inside Xi Jinping’s nation prison, then consider the situation in crypto land. Brent Donnelly of Spectra Markets writes: “The BTC and crypto hype machine is 10X more powerful than the 1999/2000 internet hype machine. Nobody is ever going to tell you when to sell. It is borderline verboten for anyone in crypto to even utter a bearish word. Keep that in the back of your mind. Every story you ever hear is going to be bullish.” Donnelly notes that whereas a lot of market movers such as Paul Tudor Jones were pounding the table regarding crypto and equities in 2020, the favorable conditions for such speculations are now reversing. “And all those new TradFi types that have just bet their careers on crypto will not be able to ignore the turn in the Fed cycle as easily as non-macro crypto maxis,” Donnelly concludes. The chart below shows BTC vs the S&P 500. Source: IBKR Just as herd behavior has taken stocks and crypto tokens to new heights since the Q1 2020 correction, the thundering herd is prepared to ride these same markets back down in a Fed tightening phase. Sure, global demand for dollars will increase as the next COVID wave runs through Western market economies, making it difficult or impossible for the FOMC to actually raise the cost of credit. But the narrative of a slowing economy and another COVID pandemic shock will be a tough reality for the perma-bull crowd to ignore, both in stocks and crypto. It may not be possible to discuss the fundamentals of bitcoin and other crypto assets with any precision, but it is possible to observe the deteriorating fundamentals of US banks and other financials. The culprit is a flattening yield curve. The Fed will taper MBS purchases as planned, hopefully faster. The prepays will be reinvested in Treasury coupons, not T-bills, further flattening the Treasury curve. The chart below shows the Treasury yield curve vs dollar swaps as of Friday's close. Source: Bloomberg Most of the pain felt by credit market participants in October was due to curve flattening. In September, by comparison, the shift in the curve was most significant. Curve flattening will be the challenge going forward, but 10s-30s could actually fall in yield depending on market conditions and the direction of the herd due to the latest COVID scare. It is notable, as this edition of The IRA goes to press, that oil and other commodities are already rebounding from last week’s selloff. Look for the Fed to keep the overall size of the system open market account (SOMA) portfolio ~ $7 trillion, meaning that they will buy only to offset net prepayments. Until the purchases of MBS end, now targeted for June, Fed MBS purchases may grow relative to supply as new issuance slows dramatically. Total GNMA outstanding in particular is basically flat for the year and will start to decline with lower refinance volumes. The Fed will not talk about raising target interest rates for some months, in part because they hope that ending MBS purchases will cool the housing market. The Board staff also continues to believe that inflation in other sectors is transitory. The hope prior to Thanksgiving was that a combination of ending QE and improvement in supply chains will eventually push inflation stats lower. The renewed focus on COVID will alter that calculus as winter deepens. The problem, of course, is that once you change psychology with respect to inflation and/or pandemics, it is hard to change it back and especially when COVID fears are contributing to scarcity. Vendors will resist giving back price increases after years of absorbing hidden inflation, especially when COVID provides a convenient excuse. A renewed lockdown in the US could present the Fed and markets with a lethal combination of rising inflation and an economic recession. And meanwhile, China remains in lockdown.

December 18, 2021 | Several years back, at a conference in Cancun, Mexico, sponsored by the Association for Private Enterprise Education , we were gently chided by none other than John Taylor , for suggesting that then Fed Governor Janet Yellen was not sufficiently worried about inflation. "Are you suggesting that Dr. Yellen is not concerned about inflation?" he growled. Years later, our worries about now Treasury Secretary Janet Yellen’s weak focus on price stability appear to have been prescient. Of note, Yellen finally acknowledged that inflation was a problem last week when she said it was time to stop characterizing inflation as temporary. Sadly, Janet Yellen remains an inflationist for whom full employment is the only mandate in Humphrey Hawkins. The former Fed Chair really did not address inflation head on in her public statements last week. Instead, Secretary Yellen punted and suggested that the Omicron variant of the coronavirus could prolong the problem of rising prices. But she failed to call out the primary causes, namely idiotic fiscal policy from the Congress and a compliant attitude from the central bank. There are many reasons for surging demand-pull inflation in the US, first and foremost the grotesque expansion of the Fed’s balance sheet since 2018. But more than the size of the central bank’s subsidy for the Treasury’s fiscal largesse, the implementation of the Fed’s radical policy agenda has done significant damage to private markets and counterparties. The chart below shows the Fed’s tactical position as we enter 2022, with a long book of Treasury securities ($6 trillion) and agency MBS (over $2 trillion) on the left scale and a short-position via reverse repurchase agreements (RRPs) of $1.5 trillion shown on the right scale. As we noted since our missive this summer (“ G-30 Liquidity Panic: Standing REPOs and Centralized Clearing ”), the FOMC has been attempting make some modest alterations to US market structure before moderating monetary policy. Now policy is changing despite the Fed's earlier plans. In particular, the creation of “standing” RRP and forward repurchase facilities were seen by the Fed staff as a tools to moderate and manage a process of tapering securities purchases without causing a liquidity crunch. The forward repurchase facility, in particular, is a means to provide cash directly to end users by circumventing JPMorgan (JPM) and the other large banks. The sudden surge of visible price inflation globally has forced Chairman Jay Powell’s hand early in Fed terms, this even though the FOMC is months behind the markets and consumer expectations in terms of fighting inflation. The abortive transition away from LIBOR is coming at a particularly bad time for the short-term money market, but the social engineers on the Board’s staff in Washington are not concerned with mere legalities. They are busy saving the world. Another big idea from the Fed that has yet to be implemented is centralized clearing of US Treasury securities. We noted in a previous missive that the Group of Thirty made the suggestion at the behest of the Fed and Treasury, who both have the same problem, namely too much Treasury debt. The fact that Congress, rained trillions of dollars more in unnecessary liquidity onto the US economy in 1H 2021 distorted balance sheets and income statements for years to come. It is important for investors and risk managers to understand that many of the market structure problems that the Fed now seeks to fix, starting with the unnecessary elimination of LIBOR, are a function of earlier policies implemented by the Board of Governors and related acts of folly by the Congress. President Joe Biden may own the inflation problem politically, but the swelling debt of the US Treasury starts with the poorly considered tax cuts enacted by Congress under President Donald Trump . The good news, of sorts, for Chairman Powell and his remaining colleagues on the Fed Board is that further spending legislation from Congress has a decreasing probability of success in 2021 and may simply die in 2022. A moderation in the Treasury’s debt issuance, combined with a sharp drop in new agency mortgage bond issuance, will tend to keep the bond market tight even as the FOMC tapers purchases for the system open market account (SOMA). Powell et al may be late to the inflation party, but they can still salvage the tactical situation if Congress remains in gridlock. The Fed’s liquidity calculous changes, however, if the economy slows and Congress decides to come together for another multi-trillion-dollar fiscal giveaway. This is one reason, we suspect, why the DTCC published a white paper in October pushing back on then Fed-Treasury proposal for centralize clearing of all US government debt. Like the SOFR replacement for LIBOR, the Fed’s social engineers are trying to use the model for cleared OTC swaps as a new paradigm for the Treasury market. That model may not work. But no matter, economists can just assume it will work. The DTCC noted: “A number of market participants who do not engage in the swaps market are critical liquidity providers to the US Treasury market.” Translated into English, if the Fed uses the same insensitive and uninformed perspective that was employed with the let's kill LIBOR fiasco, then the liquidity in the market for Treasury debt may suffer. Only 13% of all Treasury trades are centrally cleared and the remaining 87% of the market have no interest in joining the clearing house. Hopefully the Fed will understand that the central clearing proposal is DOA, but remember these are economists. Again, take the handcuffs off the banks in terms of trading their own account and the problem is solved. But nobody at the Fed, including the cowardly Powell, dare to tell Elizabeth Warren (D-MA) and other members of Congress the truth about liquidity. Dodd-Frank and the Volcker Rule have reduced liquidity in the market for US Treasury debt. Duh. Liquidity ratios and other rules have essentially taken the banks out of the business of providing cash to the markets. "Fed leaders are obsessed with avoiding blame for predictable responses to their actions," Professor Edward Kane tells The IRA . He continues: " When have Fed leaders ever acknowledged that their policies and strategies lie at the root of most of the market evolutions they find themselves worrying about? Volcker cleverly professed to have shifted to targeting monetary aggregates, not because he suddenly became a monetarist. He did so because adopting that targeting scene allowed him to disclaim responsibility for sending interest rates to the moon. The only exception I can think of fell during the postwar era of pegged yield curves, because Fed leaders' goal was to win back their so-called "independence" by blaming Treasury stubbornness for the postwar inflation." Since the 2010 Dodd-Frank law and the related Volcker Rule essentially got the largest banks out of the business of underwriting Treasury auctions, the market is now dependent upon non-bank funds for liquidity. Right on time, the folks at the Fed and other central banks have decided to attack the nonbank funds that provide liquidity to the Treasury market. You really cannot make this stuff up. But then again, former Treasury Secretary Tim Geithner was involved with crafting the Group of Thirty proposals. The Bank for International Settlements has declared that investment activity that takes place outside the banking system requires a new, broad-based set of global regulations to tackle inherent instability. There is no mention of the fact that perhaps the US has been issuing too much debt, leading to the very market instability that so troubles the economists at the BIS. This new policy on nonbanks is being pushed by Claudio Borio , chief economist at the Basel, Switzerland-based BIS. Mr. Borio holds no elective office. He is merely an economist. But he feels the need and, more important, the authority to make huge changes in market structure and private financial institutions, changes that are usually the province of elected officials. The net effect of the actions of the BIS will be to reduce market liquidity even further. After “a period in which there is aggressive risk taking, you have a build-up in leverage. You think that markets are liquid, whereas in fact under stress they are not going to be liquid,” Borio said in an interview with Bloomberg News . “You can smooth this out by building buffers in good times -- whether that’s in the form of capital, for solvency, or in the form of liquidity, to avoid fire sales -- so that when bad times arrive you will have a bit more room for maneuver.” Sadly, the “room to maneuver” sought by the gnomes at the Fed and BIS comes at the expense of private markets and investors. Instead of focusing on the mounting debt of the industrial nations, the BIS and Fed want to attack the investors who buy the debt. The chart below is familiar to readers of The IRA and shows the Treasury yield curve out to 30 years and dollar swaps, which trade through Treasury yields. Source: Bloomberg Placing constraints on market activity generally leads to liquidity crises, as we saw in 2019 and 2020. Yet despite this empirical evidence, look for the folks at the BIS to push the Group of Thirty nations for restrictions on leverage for non-bank financial firms in 2022. This will not end well. It is alarming that the Fed, Treasury and BIS somehow can fail to acknowledge the primary and growing role played by funds in the market for government debt. Having neutered the big banks after 2008, what did policy makers at the Fed, BIS and Group of Thirty expect to happen? To solve the "problem" of non-banks, take off the shackles from the large commercial banks in terms of market liquidity. Of course, the economists who work at the Fed and other agencies will never admit error, much less go back and correct a mistake after the fact. As the Fed and other agencies seek to preclude liquidity crises, in fact periods of contagion will grow more frequent as the sources of liquidity become ever more constrained and the public debt of the US grows larger.

December 1, 2021 | In this Premium Service edition of The Institutional Risk Analyst , we return to several names that we featured earlier this year, Wise Plc (WISE) , Better.com and United Wholesale Mortgage Corp (UWMC) . Starting from the ridiculous and working forward to the sublime, we’ll begin with the Katzenjammer Kids antics of UWMC CEO Matt Isihiba and his team, touch wheels in the magical world of new age mortgage lending, and land finally at WISE. Suffice to say that both UWMC and WISE show signs of growing pains and a lack of good business advice and internal controls. Next week, our subscribers will feast upon the Q4 2021 edition of The IRA Bank Book , our quarterly survey and outlook for the US banking industry. UWM Holdings If you work in the mortgage industry, you find time each day to read Rob Chrisman’s commentary, a daily compendium of market announcements and industry analysis that often contains precious little gems. This past week, Rob took notice of the latest twist from UWMC, namely an abortive attempt to sell $1 billion worth of insider shares even as the stock has been languishing well-below last year’s IPO price. In January of 2021, UWMC was a $13 stock. Somehow the folks at UWMC did not take notice of the fact that secondary stock offerings for all issuers, including IMBs, have basically disappeared in the past several months. Deals are getting done, but the public holders are not looking to see the managers who have been awarding themselves big stock based compensation heading for the door. “The industry took note of United Wholesale’s stock plans,” Chrisman writes with his usual understatement. One East Coast broker wrote to me, asking, ‘What’s up at UWM? Initially trying to buy back the outstanding 8%, but doing a public stock offering eight months after the IPO and after the stock tanks, makes it look deceptive.’” Chrisman revealed that according to a new amended S-1A filing with the Securities and Exchange Commission, "SFS Holding Corp. has registered 150 million shares of United Wholesale Mortgage common that it intends to sell ‘from time to time’ as market conditions allow. The maximum offering price is $7.00 a unit. The gross proceeds could total roughly $1.05 billion if all goes well.” Chrisman detailed that SFS, which is controlled by UWMC CEO Mat Ishbia, planned to sell 50 million shares of common stock. After the deal was pulled, UWMC said this to investors: "The offering was intended to increase UWMC’s public float by approximately 50%, thereby making it a more liquid, tradable stock for larger indexes and institutional investors, while at the same time utilizing the company’s buyback authorization to reduce the number of fully diluted shares outstanding. However, the market’s reaction to the offering resulted in a share price level at which SFS is not willing to sell. With the termination of the offering, no shares of common stock will be sold by SFS at this time. Instead, the company intends to accelerate its previously announced buyback program and defer its plans to increase public float to a later date." Buying back shares in an IMB that is facing declining volumes in its primary business channel is not likely to be a path to success for UWMC or any other IMB, to be fair. With yesterday’s news that the FOMC intends to taper mortgage bond purchases, the outlook is for higher mortgage rates (already 0.5% above the February lows) and perhaps even wider spreads. But for firms that are primarily dependent upon wholesale channel volumes, the future appears bleak. We suspect that UWMC CEO Ishiba will destroy as much shareholder value as possible, then announce his intention to take the IMB private sometime in 2022. As one observer told The IRA : “Yep, these are very smart people making big time smart choices.” Better.com Moving right along, we come to Better.com , a new IMB that has managed to buy its way into the top-20 issuers during a period of low or even negative default rates in residential 1-4s. Now the Softbank sponsored Better.com has been forced to take down an addition $750 million in funding, TechCrunch reveals, raising questions about the previous statements regarding a public offering. TechCrunch reports: “The new arrangement will replace the prior agreement wherein $950 million of the $1.78 billion in committed financing from Aurora and SoftBank would have been used to purchase existing shares from Better’s stockholders rather than the company receiving it directly to its balance sheet.” The fact that Better.com insiders are no longer able to, in effect, sell shares to Softbank in the current risk environment speaks volumes about the deterioration of conditions in the US equity market more generally. As we noted about with respect to UWMC, this is not the right moment for secondary offerings. After yesterday's Senate hearing, Fed Chairman Jay Powell has taken a hawkish turn and is now promising to accelerate the taper of MBS and Treasury bond purchases by April of 2022. Given that mortgage lending volumes are also falling, it is hard to say what the net effect will be on mortgage rates and volumes, but MBS spreads to the Treasury curve have widened in the past several weeks. Look for Treasury Secretary Janet Yellen to become increasingly critical of Powell and the FOMC as the Fed Chair seeks to rescue his agency's credibility on inflation. This will not be a positive environment for bringing weak stock offerings to market. Of note, Aurora Acquisition Corp (AURC) and Softbank continue to maintain that Better.com is worth almost $7 billion. More than a mortgage play, Better.com has mutated into areas such as insurance, making comparisons with traditional lenders difficult. More, like Blend Labs (BLND) , Better.com has acquired a title company during a bull market in mortgage lending. But as anyone familiar with mortgages knows, title is an awful business in a declining mortgage market. Both in the case of BLND and Better.com, acquiring a title company at the peak of a lending cycle does not give us great confidence in the judgment of management. AURC recently disclosed that its auditor had informed them that the company needed to restate its financials for the past year and that previous financial disclosure and public statements could no longer be relied upon by investors. Aurora stated in a November 2021 8-K: “The Audit Committee concluded that the Company’s previously issued financial statements issued in connection with the Company’s initial public offering, dated March 8, 2021, and contained in the Company’s Quarterly Reports on Form 10-Q for the periods ended March 31, 2021 and June 30, 2021, originally filed on May 26, 2021 and August 11, 2021, respectively (collectively “Non-Reliance Periods”), should no longer be relied upon. Similarly, related press releases, earnings releases, and investor communications describing the Company’s financial statements for the Non-Reliance Periods should no longer be relied upon.” Of note, in the November 12, 2021 amended S-1, AURC reports that Better.com had $172 million in income in 2020 on $875 million in net revenue. In the first six months of 2021, mortgage platform revenue almost tripled vs 1H 2020, but operating expenses and stock-based compensation rose faster, driving Better.com to a small net loss. We can only wonder what the full year 2021 will look like as refinance volumes continue to fall and loan delinquency slowly rises, pushing up operating and net-interest expenses. But more to the point, the idea that AURC is going to be able to float a post-merger Better.com at multiples of book value seems fanciful looking at the public comps. We think that the cash infusion by Softbank may be the first of several such investments. We place a low probability on the Better.com IPO getting done unless and until US interest rates start to move lower. The natural value of a well-managed mortgage company is somewhere around book value. Wise PLC Finally, we arrive at WISE, a supposed disruptor in the world of global payments. We wrote favorably about the company earlier this year and even bought the LSE-traded stock. It appears from press reports that WISE convinced some of the investor community that they were more focused on pushing down cash transfer costs than making money for shareholders. The market value of WISE plummeted. Fortunately, the most recent financials tell a different story, with WISE steadily growing revenue, operating expenses rising less so and pretax income increasing accordingly. Unlike many fintech plays in the US, WISE looks remarkably normal, almost boring. But in the present environment, boring is good. WISE increased forward guidance and the stock responded favorably. Of note, the WISE board asked CEO Kristo Kaarmann to appoint tax advisers following disclosure of a fine for defaulting on his personal taxes, The Telegraph of London reported this week. The Estonian co-founder of the payment services provider was fined 365,651 pounds sterling ($486,864) for deliberately defaulting during the fiscal 2018 tax year on 720,495 pounds of taxes. Kaarmann welcomed the suggestion of professional. WISE's stock jumped almost 8% on Tuesday's close, but then retreated the following day. It is still very early days for WISE. The company faces some difficult challenges in displacing the staid and very corrupt monopoly of large banks that control money transfers around the world. The revolutionary, change-the-world attitude of WISE will not endear them to large global banks. Clearly the senior management team of visionary disrupters that founded the company will need to transition to a more institutionalized management team and compliance culture in order for WISE to win these coming battles. Disclosures: L: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC S: UWMC, RKT 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.

“Anyone taken as an individual is tolerably sensible and reasonable – as a member of a crowd he at once becomes a blockhead.” Friedrich von Schiller, as quoted by Bernard Baruch “A Short History of Financial Euphoria” John Kenneth Galbraith (1993) November 15, 2021 | Back in May of this year, we published a comment that described the three key components that the Federal Reserve Board was seeking to put in place prior to a change in monetary policy and specifically an end to quantitative easing or “QE” (“ Fed Prepares to Go Direct with Liquidity ”). To review, those components are: Liquidity : First, the FOMC is going to make permanent the RRPs, essentially accepting the proposal by the Federal Reserve Bank of St Louis to create a standing repo facility for banks and nonbanks alike. This means that funds, REITs and especially smaller dealers are going to be able to go direct to the Fed of New York and finance collateral, breaking the monopoly control of the big primary dealer banks. Money Market Funds : Second, and this change is already in process, “swing pricing” for money market funds and corporate bond funds will allow the Fed and the Financial Stability Oversight Council (FSOC) to manage market liquidity. For investors, this means that the Fed and FSOC will be able to suspend immediate cash redemptions on money market and corporate bond funds in time of liquidity stress. The message here is simple: “We’ll get back to you.” Centralized Clearing : Third and most significantly for the large banks, the Fed and FSOC are going to push for central clearing of all Treasury securities, killing the predominantly bilateral market for US debt and also eviscerating the monopoly of the primary dealers on financing collateral. As our friend Ralph Delguidice reminded us at the time, centralized clearing of Treasury collateral closes the door to those big, 100:1 leverage offshore trades in risk-free collateral that the big banks love. The trouble, of course, is that only a few of these three necessary conditions for monetary tightening are actually in place. The Fed has stood up a facility for reverse repurchase agreements (RRPs) that is open to a variety of financial institutions. Indeed, the rate hike on reserves this past July by the Fed’s Board of Governors was a direct sop for banks and money market funds that were close to collapsing under the weight of zero rates and QE. The chart below shows the total assets of the Federal Reserve System as well as holdings of mortgage-backed securities (MBS) as part of the total on the left axis. On the right access, we see the $1.5 trillion in RRPs. Fed officials have stated publicly that the use of RRPs to sop up cash injected by QE is a “transitory” phenomenon, but we suspect that the need to subsidize MM funds and banks is going to only grow as the Treasury yield curve flattens. When the FOMC is forced to end purchases of MBS and instead routes prepayments into longer-term Treasury collateral, the mother of all curve flatteners is just around the corner. As the shift in Fed purchases via QE starts to accelerate, the total amount of liquidity in the system will decline – thus the need for a standing forward repurchase facility for securities. We have argued on Twitter that the FOMC should be targeting duration rather than interest rates. Think of duration as the average time it takes to get half of your money back from an investment. The impact of forcing interest rates down is to lengthen the duration of fixed-income assets. If the coupon on a bond is low or even negative, then the duration of the security -- i.e, when you receive a return on investment -- extends. But what happens when the fact of low interest rates incentivizes issuers to repay securities earlier, even with a prepayment penalty, and refinance these liabilities with new debt or even equity? Then duration suddenly shortens and investors are forced to deploy funds into other assets. This has been the impact of QE on MBS and all callable securities. As the FOMC throttles back on QE, the central bank is essentially leaving more duration in the markets for investors. Think of duration as the opportunity to earn a return. As QE recedes into memory, investors will have more opportunity to earn returns away from stocks, necessarily affecting the supply-demand balance in the markets. And duration, of course, is another way of measuring financial repression by global central banks. There are many factors, plus and minus, that impact this balance, but history suggests that a cessation of QE is bad for stocks. The table below from FRED shows the S&P 500 on the right axis and the total assets of the Federal Reserve System on the left axis. Again, there are many factors that will impact the balance between stocks and bonds, but the simple fact is that when the FOMC stops creating hundreds of billions of dollars in liquidity each month, and buying securities for the System Open Market Account (SOMA), then the proverbial risk curve will shift back toward its positions pre-QE. Early stage companies will find it harder to raise new capital and investors may even start to demand higher returns for risk taken. Just imagine that. And in the meantime, we view the end of QE as a net negative for global stocks as well as crypto. Everything is correlated in a crowd. But as new mortgage lending dives below 5 million loans in 2022 vs 10 million in 2020, mortgage spreads may not widen for months or even years. On the other hand, inferior companies locked out of the equity markets may be forced to raise debt, which could be good for spread widening. Yet the long-term impact of QE may be to distort the markets for years to come, both up and down, as the geniuses on the FOMC try to fine tune the widening disaster of market manipulation that we politely refer to as monetary policy.

November 10, 2021 | This past weekend, The Institutional Risk Analyst enjoyed a tour of Lyndhurst Mansion in Tarrytown, NY, the gateway to the Hudson Valley. Lyndhurst is best known as the home of the notorious financier and railroad magnet Jay Gould , but in fact he was the third owner of the Gothic castle. Constructed between 1838 and 1842, the original house was built upon farmland as a haven from the filth and contagion of New York City. Jay Gould In the 1800s, the enemy of urban residents was cholera, yellow fever and small pox, vile sources of pestilence that pushed the death rate to almost 5% in some years or roughly twice the death rate of the Spanish flu in 1918-1922. When the NYC Board of Health was established in 1866, disease was still killing 3% of the population annually. The death rate in New York at the end of the Civil War was twice that of London or even Philadelphia. Source: Columbia University The death rates seen in New York City the mid-1800s are far higher than the worst of COVID, which the New York Times estimates to be below 35,000 people out of 8.4 million NYC residents in 2019. An estimated 500,000 people have left the city since the start of 2020, a vast increase in the net outflow that existed pre-COVID and continues today. COVID only made the problems facing New York City accelerate. The difference between the 1800s and today, of course, is that the leaders of New York City in the years prior to the Civil War never even considered a lockdown or the other measures taken in 2020 to fight epidemics. Indeed, such was the commercial focus of New York that the fact of limited space and frequent epidemics did not cause any reaction from the political class other than charity. It was not until the early 1900s that the deplorable health conditions in American cities, combined with high levels of price inflation, began to become a progressive political issue. In fact, it wasn't until the 26 th President of the United States, Republican Theodore Roosevelt , that social insurance, including health insurance, was even considered . Today New York City has contended not only with COVID but with an outbreak of political antagonism toward the business and financial elites that has accelerated the migration of business and investment out of cities like New York, Chicago and San Francisco. In the 1800s, these legacy cities could depend upon a growing and vibrant business community to buffer the economic shocks caused by epidemics, recessions and wars. In 2022, however, the same technology that allowed businesses to operate remotely during COVID has now enabled them to leave the legacy cities forever. Last November, before the Democrats took control of the Senate, we asked whether NYC faced financial default (“ Will Senate Republicans Force New York into Default? ”). Billions of dollars in subsidies later, NYC is still functioning, but without a commercial heart. Yes, some brave souls have ventured back to Manhattan in search of deals on the most expensive residential real estate in America, yet the commercial heart of the Big Apple has been cut out by progressive lunacy in the streets and in City Hall. Business, whether large employers or landlords, are now the stated enemy of most New York politicians. Back in 2019, we spoke to Dale Hemmerdinger , the former Chairman of the Metropolitan Transportation Authority and the head of a large commercial real estate manager and developer (“ The Interview: Hemmerdinger on the End of Hope for NY Multifamily Housing ”). Since that interview, the fortunes of residential housing in the New York suburbs have improved, but the dire situation facing multifamily housing in NYC has deteriorated further. Hemmerdinger told The IRA two years ago: “Our new projects are in markets like Charlotte, NC, and Austin, TX. We have more coming down the pike. In these markets, we are welcomed for bringing capital and financial know-how to growing communities. We are considered friends and often partner with local developers. In New York, by comparison, we are the enemy. The Democrats in Albany couldn’t go after the big private equity funds, so instead they attacked the local developers and small business owners, the very people who invest in New York and make it livable. These are very self-destructive policies.” Under socialist Mayor Bill DeBlasio , hostility toward the business community in New York only intensified as the cost of living in NYC has reached absurd levels. Even with the decrease in residential and commercial rental costs due to COVID, New Yorkers spend far more for food, housing and other necessities than residents in the more affluent suburbs. New York is a very expensive city, with layers of taxes, regulation, graft and corruption that add to living cost. This cost differential begs the question as to whether you can ever make NYC affordable for people of average income without massive subsidies. Even before COVID, NYC was coping with the increasingly irrational behavior of New York politicians, who are admittedly mostly liberal Democrats of varying flavors. Voter registrations in NYC run 7:1 blue vs. red, so expecting rational behavior when it comes to public spending is a dream that has been dead since the departure of former Mayor Michael Bloomberg . A Wall Street mogul, Bloomberg was gracious enough to pretend to be a Republican during his successful tenure as mayor. Under the disastrous Democrat Bill DeBlasio, NYC has spent every dollar of revenue coming in the door and then some. The city spends about $100 billion annually, leaving an accumulated deficit of almost $200 billion funded with debt, and net liabilities for other post-employment benefits of $117 billion. As of the end of the fiscal year at June 30, 2021, NYC had revenues of $99 billion, including $32 billion in real estate taxes, $28 billion in state and federal aid, $15 billion in personal income taxes, $8 billion in other income taxes and $7.6 billion in sales and use taxes. Most of these line items depend upon the business community, first and foremost, to make ends meet. The bigger deficit created by DeBlasio was the loss of public confidence in the police and other governmental institutions when his office embraced rioters in the streets during COVID. Much of mid-town Manhattan was closed and boarded up when DeBlasio refused to support the police and instead sided with looters and criminals who took full advantage of the chaos in New York City just a year ago. Similar scenes were seen in Chicago, Portland and other cities. The public confidence in New York’s security situation, which was built up over decades by David Dinkins, Ed Koch, Rudi Giuliani and Michael Bloomberg , was flushed down the toilet in a matter of hours by Bill DeBlasio. The financial and social damage done to New York City by Mayor DeBlasio and his fellow Democrats is incalculable at this point in time and ongoing. The good news in FY 2021, however, was that the fact of the city being largely closed pushed down spending significantly. Governmental expenses fell by $5 billion as spending for public safety and schools declined. The arrival of billions more in federal subsidies c/o the Biden Administration also helped to float the city on a sea of liquidity through the end of FY 2021. But health expenses and payments to city hospitals rose by $2 billion due to COVID. As NYC reopens, however, there are dramatic credit events ongoing that are going to result in lower revenues for the city going forward. We have already alluded to the dire situation facing owners of multifamily real estate even before COVID. After a year of rent moratoria imposed by the Biden Administration and, incredibly, the Centers for Disease Control, many landlords are facing bankruptcy. Unlike single-family residential real estate, the resolution of insolvency for commercial properties including rental apartments is a largely institutional affair that occurs behind closed doors. As in the 1970s, we expect to see a rising number of multifamily properties sliding into bankruptcy and abandonment when owners realize that they cannot recover their operating costs. Keep in mind that these rental properties are no longer financeable with banks because of 1) the 2019 rent control law passed by Albany and 2) national COVID rent moratoria that have greatly reduced the value of these properties. Take an example. A bank that started 2020 with a 50% mortgage loan on an apartment building in NYC today is looking at a troubled-loan that is probably closer to 75 or 100% of the property value. This commercial loan will likely be placed into a troubled-debt restructuring (TDR) by state and federal bank regulators, meaning that the property cannot be refinanced. The bank will ask the property owner to add cash to bring the loan back to a 50% loan-to-value or LTV, but the property “owner” is unlikely to throw good money after bad. The owner will hand the city the keys and walk away, meaning that the property will deteriorate. The chart below from the most recent IRA Bank Book for Q3 2021 shows the loss severity on $500 billion in bank owned multifamily loans and $2.4 trillion in residential mortgages. Note that the loss severities on 1-4 family mortgage loans, HELOCs, residential construction loans are currently negative, thus the trend in multifamily loans is notable and disturbing. Strangely, nobody in the financial media seems to care about this emerging story. Source: FDIC/WGA LLC More problematic for New York City, however, is the situation with respect to commercial office properties. If you take a ride up to one of the top floors of a midtown Manhattan tower at dusk and look around, what you see are empty buildings. Commercial leases, like mortgage loans on multifamily properties, are long term assets that are generally of seven or even ten years’ duration. But as leases run off, the tenants are frequently letting the space go. At best, the tenants will downsize into smaller office space that is more conveniently located. At worst, the tenant will leave NYC entirely. The landlord will drop the rent on the property and look for new tenants. Over time, as commercial landlords face attrition in their tenant base, especially from larger tenants, the value of these commercial properties will also decline. The mortgages on the under-utilized commercial buildings in Manhattan will see LTVs rise above 50%, meaning that bank lenders and bond investors, and regulators, will request a cash infusion from the building owner to bring the loan back above water. Even if the owner is willing to advance more cash and continue paying the mortgage, the next step will be to seek tax abatement from New York City because of the drop in the value of the property. And remember, property taxes are the single largest revenue line item in the New York City annual budget. During COVID, we were amused by the confident statements from the likes of JPMorgan (JPM) and Goldman Sachs (GS) about reopening their offices in Manhattan, this even as they quietly moved senior executives out of the city to new suburban locations. Recall too that New York City’s new Mayor, Eric Adams , is a younger, perhaps smarter version of Bill DeBlasio. Adams is a political opportunist with no particular competence as a manager and even less of a political base. Just as Democrats in Congress have begun to attack investors who want to renovate blighted urban multifamily properties, Adams will be forced to demonize the business community to survive politically in New York City. BTW, Adam’s thinks that crypto trading should be taught in NYC schools. He has zero credibility with the city’s already distressed businesses and, even as a former cop, with the New York City Police and Fire Departments. Over the next several years, as the economic cost of the COVID lockdown becomes full visible in the business community and commercial real estate market, New York City may face its second financial crisis in half a century. Stay tuned.

November 12, 2021 | In this Premium Service installment of The Institutional Risk Analyst , we update readers on several new entrants into the world of public mortgage companies and related vendors. Suffice to say that the shrinkage in lending volumes is not being kind to any of the inhabitants of the mortgage ecosystem, including lenders such as United Wholesale Mortgage (UWMC) and Guild Holdings (GHLD) , or the mortgage tech lead gen player Blend Labs (BLND) . As we’ve said several times in our column for National Mortgage News , winter has arrived in mortgage land. Or to paraphrase our friend and fellow mortgage maven Rob Chrisman , ponder a 2022 lending market that’s 75% purchase mortgages and just 4.79 million units vs ~ 10 million new loans in 2020. Hmm? Blend Labs Inc. Earlier this year, we wrote critically about BLND (“Profile: Blend Labs, Inc ("BLND") , a startup that promised to change the way that loans are sourced and originated. “The S-1 filed with the SEC includes a great deal of hopeful fluff about “data-driven journeys from application to close.” The document has all of the right words. But what does BLND actually do to earn money? And is it really worth 10x book value in an IPO?” we asked back in June. No, is the answer, not even close. The chart below shows BLND at the close yesterday. Source: Google This week, BLND reported results and the bottom line was exploding operating expenses and a $76 million net loss. More to the point, just imagine how the results for BLND would look w/o the addition of Title365, which was acquired just prior to the IPO? As readers of The IRA will recall, the purchase of Title365 for 4x book value, a ridiculous and unreasonable valuation, was apparently meant to window dress the weak revenue of BLND’s lead generation business. Source: BLND Q3 2021 Now 90 days later, we can see that the addition of the title insurer has not really changed the overall complexion of BLND, which remains a company in search of a business model. Generating leads and completing loan applications forms is the easy part of the lending process. Income verification as a business? Please. We are still waiting for folks at BLND to articulate a real value proposition for this expensive learning process. Meanwhile, the folks at industry leader Black Knight (BKI) are probably rolling on the floor. Don't hold your breath waiting for BKI or Intercontinental Exchange (ICE) , owner of Encompass, to take the shareholders of BLND out of their misery. And remember that as volumes fall, title insurers are forced to pair back expenses to survive – one reason why the folks at Mr. Cooper (COOP) were smart to sell Title365 at the top of the cycle. But if you are largely ignorant about the mortgage industry, then you would not know that title insurance is not really insurance at all – just an expensive service that does not scale with volume. Of note, BLND raised full year 2021 revenue guidance midpoint by $13 million, but that still leaves the company bleeding cash as expenses grow faster than revenue. United Wholesale Mortgage Moving on, UWMB reported decent earnings in Q3 2021, although the lack of clarity on the earnings release date was a bit unnerving. UWMC managed to push volumes up to $63 billion, but on declining gain-on-sale (GOS) margins. Close your eyes and imagine how this chart will look in Q3 2022. Source: UWMC Q3 2021 Of interest, UWMC has anticipated the key question going into Q4 2021 and 2022, namely the cost per loan. Loans in the wholesale channel are the least costly way of acquiring assets after the call center. Retail loans are the most expensive. UWMC is the largest wholesale lender in the US, which basically means that they buy “warm” leads from mortgage brokers. But as we end the year and go into 2022, the cost per loan is likely to rise if CEO Matt Ishiba’s comments about moving to purchase mortgages is to be taken at face value. Source: UWMC Q3 2021 The net results for UWMC tell the tale in terms of the future. Adjusted EBITDA was $290 million in Q3 2021 vs $210 million in Q2 2021 and $1.4 billion in Q3 2021, an 80% drop in operating cash flow compared to last year . Source: UWMC Q3 2021 As the wholesale channel disappears in what is likely going to be a rising interest rate environment, we worry that UWMC may be forced to retrench significantly. It’s one thing to talk about growing expensive retail lending capacity in an up market, but doing so in a declining volume market is just not possible short of divine intervention. UWMC is locked in a death battle with #2 wholesale player Rocket Companies (RKT) , which we profiled earlier this week. RKT is more efficient, more aggressive and has far deeper pockets than does UWMC. Guild Mortgage Moving from the ridiculous to the sublime, we lastly focus on GHLD, one of the leading purchase mortgage lenders in the US alongside Caliber, now the NewRez unit of New Residential Investments (NRZ) and Freedom Mortgage . GHLD net revenue totaled $413 million compared to $564 million in 3Q20, illustrating the stability of the purchase model. Adjusted EBITDA totaled $108 million compared to $267 million in 3Q20, a 60% decline and, again, reflecting changing market conditions in the secondary market for residential loans. EBITDA was $108 million in Q3 2021 vs $267 million in Q3 2020. Notice in the chart below, however, that GHLD is steadily building share in purchase loans. Source: GHLD Q3 2021 The big difference between GHLD and UWMC is that the former is accustomed to managing the ebb and flow of purchase mortgage activity given the movement of interest rates. Yes, profits will become more challenging for all lenders as 2022 proceeds, especially if the FOMC is forced to accelerate a change in policy to combat inflation. But moving into purchase mortgages from a strong base in wholesale and call center channels, both for RKT and UWMC, will be a difficult process. Retail lending is about loan officers who have relationships with realtors, a fact in the market that has yet to be changed due to the advent of smart phones and the internet. The recent announcement by RKT of a partnership with Salesforce.com (CRM) to drive purchase mortgage volume is notable but as yet entirely untested. Notice the market leading GOS margin reported by GHLD. Source: GHLD Q3 2021 As GHLD notes in its Q3 2021 presentation: “More stable origination volume, more consistent margins, and increased stability through interest rate and refinance cycles.” That just about says it all. As we move into year-end, look for the stronger players in purchase lending to become islands of stability, while lenders that have prospered during the extraordinary period of low interest rates and refinance volumes will retreat. As we’ve noted many times in The IRA , when the FOMC pulls home sales from tomorrow into today using low interest rates, eventually tomorrow ends up being a little light. The total number of originated 1-4 family loans increased by 5.3 million or 67% between 2019 and 2020. Refinance loans grew 150% from 3.4 million to just over 5 million loans in 2020, according to the FFIEC. Home purchase lending increased just 6.7% from 4.5 million to about $4.8 million. To put the case very directly, the US lending community did almost 10 million purchase and refinance loans in 2020. So, if we are going to do less than 5 million loans in 2020, what does that imply for issuers that have not been strong historically in the purchase market? What does it imply for vendors such as BKI and BLND? As we've been taught over and over again, residential mortgage lending is a cyclical business that is entirely correlated to interest rates. When rates rise, the wholesale channel disappears and only the best managed purchase mortgage lenders with the strongest relationships and servicing books will survive. Disclosures: L: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, S: UWMC, RKT 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.

Trump Pavilion from the Van Wyck Expressway New York | Q: Besides stocks, what asset class has benefitted the most from the radical monetary policies of the Federal Open Market Committee? A: Multifamily real estate. And what asset class most worries federal bank regulators today? Same answer. By means of introduction, multifamily real estate in major urban areas has been one of the most popular and solid asset classes for US banks historically going back to WWII. Family fortunes, including that behind Donald Trump and many other New Yorkers, started in the 1950s with multifamily housing in Manhattan, Queens and the other boroughs of New York City. Net loss rates on these assets, measured over years and decades have been among the lowest of any bank loan category, but short-term changes in valuation in the 1990s and 2008 were severe. Since the passage of the 2010 Dodd-Frank legislation, regulators have made some draconian changes to limits on bank loan types and loan-to-value (LTV) ratios that, some say, are stifling responsible lending and make little sense from a credit perspective. Most recently, federal regulators have proposed regulations that replace the high volatility commercial real estate (HVCRE) regulations with a new and much simpler High Volatility Acquisition, Development and Construction (HVADC) exposure, a measure that incorporates more risk from construction and development loans. Is all of this concern warranted? Yes. Thanks to the folks who sit on the FOMC, prices for multifamily real estate have risen so rapidly since Dodd-Frank that today net default rates are actually negative. As we’ve noted in previous missives, loss-given default (LGD) for the $400 billion in multifamily loans held by US banks is negative in four of the past six quarters. In plain terms, banks are profiting from defaults on multifamily loans because collateral prices have risen so rapidly, as shown in Chart 1 below. Source: FDIC In the world of analytics, a negative net default rate is a “red flag” because it indicates that markets have reached an outlier position that cannot be sustained. The negative loss rates post-default seen today contrast with the 100% LGDs that applied during the 2008 financial crisis. Even going back to the economic slowdown of the late 1990s, LGDs on bank multifamily exposures were relatively high. Yet as an asset class, multifamily bank loans have been among the most stable credits on the books of US depositories, especially community banks in major urban metro areas. More, while bank portfolios for multifamily loans have been stable, the overall flow of funds into multifamily assets via the asset-backed security market has surged during the period of low rates and “quantitative easing,” as shown in Chart 2 from FRED. Source: FRED Often times the most powerful limits placed on banks are not contained in statutory provisions, but in the guidance institutions receive from regulators. For the past couple of years, the Office of the Comptroller of the Currency has been giving cautionary guidance to banks and thrifts about lending on multifamily real estate in major urban areas, especially multifamily rental properties. We are talking here about Washington DC, New York, Los Angeles and Dallas, among the major urban metros. The guidance for smaller banks was that such exposures should generally not exceed 300% of tier one equity capital. Ironically, the concern of prudential regulators in multifamily housing is driven by the actions of another set of regulators acting on the FOMC. Multifamily real estate as an asset class has been among the most effected by the FOMC's manipulation of credit spreads and asset prices of the past decade. Prices for high end real estate in major metros such as Denver, Seattle and Austin have soared in recent years, fueled by low interest rates and ready supplies of private equity capital sitting on the sidelines. Ed Pinto at AEI sent us Chart 3 below, which compares the growth rate of total debt with multifamily rental units. While loan-to-value ratios for urban multifamily properties have actually fallen since the crisis, dollar exposures to banks have risen with valuations. In response, regulators and particularly the OCC have been restraining community banks from exceeding the 300% guidance in terms of total exposures. Indeed, it has been made very clear to national banks who lend on small, rental and owner-occupied commercial properties that they cannot exceed the guidance. The 300% guideline on in-town multifamily assets is in fact a cap. As the OCC noted in 2015: “Although the underwriting for loans that finance these smaller properties is similar in many respects to the underwriting for loans that finance larger properties, there are important differences that are useful to consider. The biggest difference is often the borrower. These borrowers often have less experience and fewer resources than investors in larger properties.” Since that time, however, the OCC’s views have apparently hardened, bankers tell The IRA , especially in the past year. The vehicle for delivering the message to banks is the examiner in charge of inspecting that institution. This “informal” guidance has significant weight, however, and illustrates some of the subtle issues that Republicans are hoping to address in Washington as they take control of agencies such as the OCC as well as through regulatory reform. Because of the OCC’s conservative stance, state chartered banks that focus on commercial lending have a big advantage over national banks. When state regulators and the Federal Deposit Insurance Corporation work with state-chartered institutions, they typically allow a bank to exceed regulatory guidelines if that bank shows the ability to manage credit risk. A good example of such an institution is state-chartered Bank of the Ozarks (NASDAQ:OZRK), a national lender that leads its peer group in terms of credit performance. The bank is shedding its bank holding company, meaning FDIC is the sole federal regulator for this commercial lender. This gives the state-chartered OZRK a decided advantage over national banks its size or larger. It needs to be stated that the OCC’s caution regarding commercial real estate is well-considered given the froth in all types of real estate. Increased asset prices for commercial real estate have caused a commensurate increase in the dollar amount of loan exposures even as LTV ratios have fallen since the 2008 crisis. Whenever prices for real estate are rising at a rate far higher than the underlying economic growth rate, caution is advisable. That said, multifamily and related commercial loan exposures at all US banks are performing extremely well. The $400 billion in bank loans secured by multifamily real estate held by US banks showed a tiny 0.15% non-current rate at the end of Q2 ’17 and charge-offs were essentially zero. Looking back to the 1990s, multifamily loans have gone through periods when non-current rates have risen sharply as shown in Chart 4 below. Source: FDIC But net losses after default have been extremely low, both in the 1990s and more recently. This was largely because these properties are so widely sought after by local investors. With LTV ratios for multifamily assets in the 50 percent range and falling, it also needs to be said that the intensity of the OCC’s focus on risk from multifamily loans in large markets such as New York seems overdone. Not only did multifamily loans perform better than most other real estate asset types during the 2008 financial crisis, but the equity behind these loans has basically not gone down in half a century. This point is especially powerful when you consider that the agency is at times recommending that national banks substitute unsecured commercial loans for fully secured loans on multifamily real estate. We hear that it has even been suggested to some banks by OCC personnel that commercial real estate lending on beachfront property is preferable to loans on multi-family rental properties located in cities such as Seattle and Miami. Really? In order to accept as true the OCC’s apparent position that multifamily loans pose a threat to the safety and soundness of US banks, you’d need to expect that valuations for these liquid and popular real estate assets are about to be cut in half. In fact, the default and recovery statistics for multifamily real estate loans held by banks and in ABS suggest just the opposite, that there is a strong market for assets that do default and that prudently run credit exposures in these assets have considerable protection against loss given those rare default events. While there is certainly reason to be concerned about the sharp upward move in prices for all manner of real estate given the FOMC’s extraordinary policy actions, residential real estate in major urban centers is decidedly not a source of risk for banks and thrifts. Leveraged loans? Unsecured commercial credits? Sure. The real issue illustrated by frothy real estate markets is not the safety and soundness of banks, but rather asset price inflation caused by the low interest rate policies of the FOMC. #multifamily #FOMC #OCC #LossGivenDefault #OZRK

New York | Since we are in the midst of earnings season, we thought to check in with James Koutoulas , CEO of Typhon Capital Management , a tactical futures-focused hedge fund manager located in Chicago. We met James when he led the customers of the defunct broker dealer MF Global to a full recovery of $6.7 billion in their epic fight with the firm’s former CEO and New Jersey Governor Jon Corzine . Since then he and his growing stable of portfolios managers have managed to surf the waves of global volatility, a task that affords James an always interesting perspective. The IRA: James, thanks for your time. Talk to us about your view of the markets given your broad offering of strategies, everything from metals to crypto. Koutoulas: We have 15 managers in our stable at present. Through March our best performing strategy was our Leonidas Macro Fund which is up 32%year-to-date. What I emphasize to our team is stick to your knitting. If you are a grain trader, your job is to trade grain spreads. You must be cognizant of global events and demand, especially now with COVID-19 and the way it changes the behavior of major exporters. In times of crisis, all correlations tend to trend towards 1, so focusing on the fundamental return drivers of your strategy is still the key. The IRA: We imagine that energy has been an active area for you this quarter. Tell us about the action in energy and oil. Koutoulas: I spend a lot of my time with the global macro team and we’ve had an incredibly active quarter like the rest of the street. The massive increase in volatility around oil, the plunge in prices down to $20 per barrel, and the very modest rally have been a challenge. There is a great deal of uncertainty due to demand destruction and big stocks of crude floating around the world. The Saudi attempt to destroy other producers by flooding the market, and the Russian response, has made this among the most active trading markets. Our energy strategy is part of the Leonidas Macro Fund, both led by George Michalopoulos who used to be Citadel’s senior most energy derivatives traders. He’s up 14.5% YTD in the energy book, but only averaging about 1% margin usage to support that outstanding energy PNL. The IRA: So, really, how do you trade a market that is so volatile and so idiosyncratic? Koutoulas: We really try to avoid taking directional bets. For Leonidas’s huge quarter, we had almost no directional bet, and instead we bought up cheap, fixed risk option structures to give us a long volatility profile. We started doing that in January once we saw the writing on the wall with COVID19. Back in October we wrote about the markets exhibiting “pre-crisis behavior” When you saw overnight borrowing rates spiking to extraordinary levels, that told you that something was disturbing these normally risk-free markets. Going from near zero to ten percent in a day told you that something systemic was going to happen. We didn’t know about COVID-19 yet, but something was already wrong in the markets’ plumbing in the fall. The IRA: A tremor in the force. Do you think the weakness in new issue volumes in corporates and ABS visible in that period was telling us the same thing? Koutoulas: It’s remarkable to me how the Federal Reserve has managed to suppress discussion of the true causes of the repo volatility. You can blame volatility on a trading desk blowing up or some other reason, but to me ten years of QE and artificial liquidity infusions, followed by periods of liquidity shortage, are the causes of our collective pain. The artificial liquidity in the market re-inflated all the asset bubbles that popped in 2008 and then took them to even greater size, so the calculus really came down to when the correction would occur. To our view and what we wrote at the time was that the market was starting to break down in October in some very basic ways and that systemic risk in the system was already high. Then COVID19 came around and was the catalyst for the selloff. The IRA: And certainly, commodities and particularly oil seems to have been impacted the most from the anticipated demand shock. Would you agree? Koutoulas: Our macro and oil manager identified COVID-19 as a major catalyst behind much of the moves in commodities very early on. But there were other signs -- if you looked. For example, consider the number of corporate CEOs that resigned in Q4 2019 and Q1 of 2020. The party was clearly over. A year and more ago, people started using the term “late cycle” and the whole orientation of the market was turning. All of the narrative was preparing people for a market turn. And we were already showing economic weakness before we got into 2020. Copper prices, the Baltic Dry Index , the repo market and the credit market. They were all flashing warning signs and a number of the more experienced managers said so – but the crowd ignored the warnings. So COVID19 materializes and it was a perfect, simple catalyst to deflate the artificial bubble. Once we knew the virus had a long incubation period and traveled through the air, there was not way to stop it – and the markets reacted. The IRA: The virus seems to mostly affect the elderly and infirm, but the economic impact is also very much hitting the most vulnerable parts of society, people who don’t own businesses and cannot seek assistance. Given that testing an isolation are clearly the best approaches to dealing with COVID19, how long is the impact likely to be felt? Both in the economy and also politically? Koutoulas: The shame is that an earlier response might have saved a lot of lives. Had we gone to a quarantine in February, for example, and stepped on the gas in terms of testing, we’d be ahead of the game now. There was no political capital, however, to push the nation to a quick response. Donald Trump was fighting the failed Democratic impeachment effort, so only when he started to recover in the polls was President Trump able to marshal the focus and resources needed to respond to COVID19. In retrospect, the trumped-up impeachment charges brought by Nancy Pelosi (D-CA) were very costly indeed. The IRA: A total waste of time. And it set the stage for the great market evacuation that has destroyed trillions in paper wealth. How do you see the outlook for the markets and the economy, especially the commodity complex? Our view on US banks, for example, is that roughly half of the households seeking a holiday on mortgage payments will eventually turn into outright defaults. Koutoulas: The impact on small business and younger workers generally is severe. Many millennials start off in trades and service businesses, which are being decimated. For people in finance, we tend to get into this isolated bubble. The contractors and waiters and other workers are having trouble getting help and are literally running out of cash. Your average middle-class person who was just barely getting by in the gig economy is getting crushed. All of the infrastructure designed to help a few people cope with economic stress is now being overwhelmed. There will be a lot of collateral damage even if the lockdown ends soon. There will be massive economic destruction from COVID19. The IRA: So what do you tell your investors? Koutoulas: Maybe it's our roots in commodities trading, but we have been yelling about market technicals since 2018. We explicitly told clients in our writings and even started a conference business conference to tell investors that we’ve had a ten-year bull rally floated on Fed credit. Be proactive! Take some money off the table. That was the message. We continue to emphasize trading strategies that are first and foremost liquid. We like relative value relationships where we are unlevered. Our bet was driven mostly by a macro view of the economy, in oil for example. We made money not because we bet one way on falling oil prices, but because we worked the spread relationships combined with some very cheap VIX options. And we made 14.5%. These are the types of strategies that let you trade volatile markets but protect you at the same time. The IRA: Thanks James. Be well.