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In this issue of The Institutional Risk Analyst, we speak with Amy Brandt , President and CEO of Docutech , which was acquired by First American (NYSE:FAF) earlier this year. Amy has decades of experience as an operator in the residential mortgage sector and spoke to us last week from Scottsdale AZ. The IRA: Amy, congratulations on the sale of Docutech to First American, which among other things is one of the largest title insurers in the US. Earlier in 2020, First American was named to the Fortune 100 Best Companies to Work For® list for the fifth consecutive year. Your timing is impeccable. We noticed that our friend Dan Perl closed the sale of Citadel Servicing to HPS Partners in February as well . Brandt: Yes, we closed the transaction and shifted to working from home a few days later. It has been an interesting ride, but we are very happy with the deal and the timing. The IRA: How do you see the industry uproar over the Federal Housing Finance Agency? The bank analyst Dick Bove of Odeon writes that FHFA Director Mark Calabria believes that “the government should not be in the housing industry.” Is this position credible or even realistic given the huge forbearance and delinquency numbers we may see due to COVID-19? Brandt: The world doesn’t work that way anymore. We don’t have the luxury of not having the government involved in housing finance—it is far too critical to public policy and the economy. The IRA: You have a unique perspective on the industry, looking at the processing of documents for a variety of purposes. How do you see the industry dealing with the challenge of COVID-19 from an operational perspective, including processing and documenting forbearance requests and the revolution? Brandt: What an incredible effort we are seeing from all parts of the mortgage community. The CARES Act dumped a huge administrative challenge on the mortgage industry, especially on the servicing side. Servicing is about keeping your costs as low as possible. After the passage of Dodd-Frank in 2010, servicing costs exploded. In recent years, however, thanks to a lot of work and new technologies, costs were coming down. There was a significant investment by industry in loss mitigation technology to make these types of events manageable, but the industry began this challenge with relatively thin reserves of people. Source: MBA The IRA: We are hearing a lot of reports from the channel that servicers are ramping up people and systems, even with everyone working from home. Is that the case with your clients? Brandt: We work with most of the lenders and servicers in the industry. Default events usually come from exogenous factors and result in a swelling of headcount and systems resources until the volume has been met. Default events usually come as a tsunami rather than a trickle, so the industry will be adding people and resources through 2020 and beyond to handle both forbearance and default servicing. It would be impossible for the industry to keep excess capacity waiting for these types of events under the current economic model in the mortgage lending business. The industry is simply not compensated to make these types of investments in excess capacity. The IRA: When we heard the FHFA start to talk about nonbank failures and transfers of large blocks of distressed servicing, we knew something was wrong. We have spoken with the major servicers and none of them are looking to onboard large blocks of conventional assets -- especially with the FHFA backing away from the market. There is nobody out there with hot capacity to take 50 or 100k loans. The legal, market and compliance risks are insurmountable. And we cannot even value MSRs at the moment – at least until the FHFA and Federal Housing Administration clarify how we are going to report and remediate delinquency. How do you see things as we enter May? Brandt: The mechanics of forbearance are challenging. If we start talking about second liens on existing mortgages or eventually modifying the notes, that creates enormous processing and documentation challenges that will raise the cost of servicing for the entire industry. The IRA: At present, the guidance from the FHFA and FHA seems to be to leave the mortgage notes undisturbed and not buyout the loans from pools, which will create a prepayment event for investors. But, if we start talking about buying the loans out of government and conventional securities, isn’t that going to be a big lift for the industry financially? It can take months to process and modify a loan when things are working normally. Brandt: It will be a very big lift. Financing four months of forbearance is one thing, but buying notes out of pools in order to modify the loan is going to be a very big lift – both for the private servicers and for the GSEs and the FHA, which guarantee the notes. Again, the mortgage industry is not architected financially or operationally to deal with this type of crisis event. This is why government support for the mortgage industry is essential. There is no pure technology solution out there that can deal with this event. The IRA: How many states are there today that can allow lenders to process purchases, refinance or modification transactions electronically? Brandt: That is a good question with a very complicated answer. The analysis is not just done at the state level, but goes down to the county. There are endless permutations of settlement processes in different parts of many states. The good news is that in terms of the total population of people and homes in the US, the coverage for e-closings and other types of electronic document systems is good – roughly 80 to 85 percent of the population. That does not mean that they don’t need physical documents, but we can close loans. The IRA: One of the great things about loan officers working on commission is that they will find a way. What do you see as the key challenges for the industry going forward? We were going to have a pretty good year in terms of production until the end of February. How does COVID-19 change the calculus for lenders and servicers? Brandt: We have seen a number of clients making changes in their offerings and resource allocations. The wholesale channels are really diminished, as lenders focus their people and available bandwidth on call center and direct channels. This is a shame because the broker community had made a strong comeback and was contributing to those strong volumes you referenced. The IRA: We are a little surprised to see the wholesale channel disappear, but maybe it is understandable. After all, the lenders are basically getting a warm lead. Is that right? Brandt: I think there are two reasons. First is human resources. You want underwriters and other personnel focused on the most value rich part of the operation, which is the direct lending channel. Wholesale always runs on a much thinner margin so the decision to direct resources elsewhere is understandable. The second point is that lenders, both banks and nonbanks, have capital constraints. They are going to write loans that have the highest quality and lowest probability of default. The risk/reward pricing around capital is another aspect of the decision process that is very important today. The IRA: We’ve seen that very clearly with the banks and nonbanks. JPMorgan (NYSE:JPM) , Wells Fargo (NYSE:WFC) and Mr. Cooper (NASDAQ:COOP) have all pulled back on wholesale lines. Many of the nonbanks we work with have pivoted away from non-QM and conventional loans in favor of government lending for most or all of their volumes. Clearly, the execution in government lending and the eventual value of the MSR appear to be superior. But, what you are saying about resource and capital constraints makes a lot of sense. What other factors are influencing how mortgage lenders are managing their people to address COVID-19? Brandt: Another factor to consider, in terms of changing offerings and prioritizing loan products, is that a lot of high value people are being moved from the lending to the servicing side of the business. Pulling resources away from lending to handle a massive surge in default servicing will impact industry volumes, revenue and expenses for the next several years. A lot of the default servicing tasks require a great deal of time and people. This is one reason why the FHFA and FHA need to give the industry as much clarity as possible on forbearance and default resolution, so that we know how to allocate financial and human resources. For example, if all of the loans in forbearance must eventually be modified or processed as a normal loan default, we need to know that now. The IRA: Once we get through the COVID-19 challenge, how do you view the prospects for the residential mortgage industry. As we mentioned, we were seeing strong demand across both agency and non-QM loans. Given that interest rates are likely to remain low for a long while, how do you see the prospects for the industry? Brandt: Traditionally when the economy slowed, homes prices fell, then interest rates went down and eventually housing pulled us out of the recession. Since the 2008 financial crisis, however, home prices have been driven by scarcity of supply and low rates. I don’t expect to see a significant decline in home values nationally, so affordability may be an obstacle. With the rate of unemployment, we now see, though, who knows what will happen to home prices in the near term. Rates will stay low, so if the economy rebounds, unemployment falls and the pool of eligible borrowers starts to expand, then we could see a relatively fast rebound in lending volumes. The IRA: Thanks Amy. Be well.

New York | The term “Greenspan Put” was coined after the stock market crash of 1987 and the subsequent bailout of Long Term Capital Management in 1998. The Fed under Chairman Alan Greenspan lowered interest rates following the fabled event of default and life continued. The idea of the Greenspan Put was that lower interest rates would cure the market’s woes. Unfortunately, the FOMC has since fallen into a pattern whereby longer periods of low or even zero interest rates are used to address yesterday’s errors, but this action also leads us into tomorrow’s financial excess. As one observer on Twitter noted in an exchange with Minneapolis Fed President Neel Kashkari: “Central Bankers are much like the US Forest Service of old. Always trying to manage 'nature' and put out the little brush fires of the capitalist system, while they seem incapable of recognizing they are the root cause of major conflagrations as a result.” When the Federal Open Market Committee briefly allowed interest rates to rise above 6% in 2000, the US financial system nearly seized up. Long-time readers of The Institutional Risk Analyst recall that Citigroup (C) reported an anomalous spike in loan defaults that sent regulators scrambling for cover. The FOMC dropped interest rates at the start of 2001 – nine months before the 911 terrorist attacks – and kept the proverbial pedal to the metal until June of 2004. Interest rates rose to 5.25% by 2006, but missed the previous highs of 2006 by a full point, a long-term trend reflected in lower earnings for banks and other credit market investors. Chart 1 below shows the return on earning assets for all US banks. The good news is that returns for US banks are rising after hitting a 40-year low at 0.75%. The bad news is that the peak return on assets will probably peak at 0.9%, a full 5bp below the levels of 2008 10bp below the 2000 peak of 1%. Source: FDIC Now 5bp may not seem like a big number, but when you are talking about $15.6 trillion in earning assets held by US banks, that number represents almost $8 billion missing from the industry's quarterly net income of $45 billion. The unfortunate dynamic of the “Greenspan Put” has been to slowly erode the earning power of banks, pensions and other savers in our economy by driving interest rates ever downward. But following the 2008 financial crisis, Chairman Ben Bernanke and later Janet Yellen doubled down. Call if the “Yellen Put.” Not content with merely driving short-term rates down to near zero, the committee embarked on a fantastic speculative adventure of market manipulation. The FOMC supposed that open market purchases of trillions of dollars in securities would somehow help the economy and get the heavily qualified measures of inflation like the Consumer Price Index to rise to a 2% target. Since then, statistical measures of inflation have barely moved, but asset prices for stocks, housing and commodities have galloped along at double digits. The true goal of the FOMC was not to restore full employment much less price stability, as required by law. Instead the US central bank was and is still today fixated on preventing a general debt deflation. Thus pumping up asset prices seemed the logical idea, even if it did not fit into the Fed's policy narrative. The fact that overall debt levels have surged thanks to the Fed’s use of low interest rates obviously begs the question: what was really accomplished? It also proves the wisdom that the monthly payment is all that matters, both to consumers and to heavily indebted governments. The global reality for the Fed, Bank of Japan and European Central Bank is the relentless increase in public debt. The Yellen Put has increased the debt load in the US and globally, but left the financial markets even more fragile than in 2007. A key measure of this danger was illustrated recently in Grant’s Interest Rate Observer , quoting Asset Allocation Insights , which notes that since 2008 the duration of the Bloomberg Barclays US Aggregate Bond Index has increased 62% to 6.2 years. Simple translation: Via manipulation of the credit markets, the FOMC has temporarily suppressed growing bond market volatility measured by duration. The Yellen Put means that bond prices will likely move at a brisk pace as and when volatility returns, a pace that will stun complacent investors. But meanwhile, the weight of the Fed’s $4 trillion bond portfolio first is going to result in an inverted yield curve. As the spread on 2s vs 10s in the US Treasury market relentlessly closes in on zero, the FOMC is grudgingly being forced to admit that open market purchases of securities may not actually impact the CPI or job creation. And remember, as Grant’s notes with understandable pleasure, that the bond market is now dominated by long-dated Treasury paper and corporate debt with minuscule coupons. And there is also a hidden duration extension risk event buried inside the $10 trillion market for mortgage backed securities, which will fall much faster in price than corporate debt. Again, the relevant terms here are volatility and option-adjusted duration. Not only has Chair Yellen and her colleagues created a time bomb of volatility in the US bond sector when it comes to market risk, but the extended period of low interest rates has also created a hidden wave of future loan and bond defaults. By suppressing credit spreads and thus the cost of credit, the FOMC afforded interior corporate and individual borrowers access to credit at premium, investment grade prices. Now the defaults are starting to accelerate. "For the first time since January 2017, the default rate for autos, bank cards and mortgages all rose together," said David Blitzer, managing director and chairman of the index committee at S&P Dow Jones Indices. The net charge-off rate for bank owned credit card receivables was 3.4% vs the near-term low of 2.8% in 2015, when banking industry credit loss rates troughed. Meanwhile, loss given default for bank owned 1-4 family mortgages reached a half century low at 24% in Q3 ’17, a measure of just how far the FOMC has gunned home prices in this credit cycle. Big question: when and how much will US home prices correct downward – if at all? Is the home price inflation caused by the Yellen Put permanent? As we noted in a post on Zero Hedge this past Black Friday, “Bitcoin & Fiat Paper Dollars,” the currency system created by Congress in 1862 was a product of the “exigencies of war,” to paraphrase the late Senator Robert Byrd. He was speaking about the Civil War era legal tender laws that force you to accept paper money in payment. By equating money backed with gold with paper money, Congress created a coercive system that allows the US Treasury to expand the currency without practical limit – so long as public confidence in the system is maintained. A profligate Congress is eroding confidence in Abraham Lincoln’s precursor to bitcoin – the greenback. The magnitude and length of the Fed’s latest rescue for the US economy dwarfs the modest credit support provided to markets after the failure of LTCM. With the advent of bitcoin and other crypto currencies, the more independent minded members of society are voting with their feet and fleeing the post-WWII currency system created by Washington at Bretton Woods. Given that the price tag of the Yellen Put stretches into the trillions of dollars, how big will the next Fed intervention need to be? For example, will the FOMC stand by and watch the US equity markets correct as China slows in 2018, destroying trillions of dollars in paper wealth? After all, the chief priority of the FOMC arguably is not full employment or price stability, but rather preserving the Treasury’s access to the bond markets. So here’s the question: Does the Yellen Put imply an open-ended commitment to support the equity and bond markets, and purchase more Treasury debt in the systemic event? Answer is most definitely “Yes.” And this fact allows our national Congress to ponder tax cuts in the face of the largest spending deficits in the nation’s history, in peace time or war. ________________ On Friday December 1, 2017, Chris Whalen will participate in a Real Estate Industry Forum event hosted by the Center for Real Estate Analytics at the Federal Reserve Bank of Atlanta. #Yellen #Greenspan #Citigroup #TheYellenPut #OAD #optionadjustedduration

In this issue of The Institutional Risk Analyst, we speak to Sanjiv Das, CEO of Lonestar’s Caliber Home Loans, a home mortgage originator and servicer established in 2013 by the merger of Caliber Funding and Vericrest Financial. Prior to joining Caliber, Das served as Executive Vice President, Global Financial Solutions at First Data Corporation (NYSE:FDC), where he led the international business and played an instrumental role in taking the company public. He has also held executive management positions at several other companies, including the CitiMortgage unit of Citigroup (NYSE:C) Das spoke with The IRA’s Chris Whalen last week. RCW: Sanjiv, thank you for talking to us. We first met you back in your days at CitiMortgage and since then you’ve done a lot of great things. Bring us up to speed on Lone Star/Caliber Mortgage and this new platform you’ve created for loan originations and servicing. SD: Thank you. Caliber is now among the top four non-bank lenders in the US mortgage market. We have a distributed model of sales professionals focused primarily on purchase loans. About three quarters of our volume is in purchase loans. Caliber's entire platform is engineered to partner with realtors, builders and brokers to enable financing home purchases across the nation. RCW: It is notoriously difficult to build a true retail channel through realtors, for example, as opposed to the advertising driven, direct to consumer approach of say Quicken. SD: Caliber's phenomenal growth is based on its dedicated loan officer distributed model, and is a testament to the fact that our Distributed Sales model and Quicken's Direct model, can both co-exist in a low-touch/high-touch world. Generally speaking, Direct lenders specialize in low touch refi's whereas Caliber specializes in Purchase. Caliber leverages its technology and digital capabilities to help our loan officers provide Realtors, Builders and Brokers transparency and confidence for their customers who are a buying a home. Our Distributed Sales and Operations model eases the complexity of getting approved for a mortgage and gives homeowners and realtors/builders the highest confidence of closing on time. Our entire team works like a trusted home purchase advisor. RCW: Well that is certainly a fortunate choice given that refinancing volumes have fallen by a third since the start of the year vs 2016. The MBA is looking for maybe 10% in purchase volumes, on the other hand, which is good news for Caliber. SD: Caliber’s model has worked very well. By focusing on strong realtor and builder relationships, with a primary focus on purchase transactions, our growth remains very solid despite the cyclical nature of the mortgage industry. We grew from $12 billion in loan originations in 2014 to $26 billion in 2015 and $41 billion in 2016. This is a great testament to a well implemented and robust Distributed Sales model. We are confident we will continue to grow in 2017. RCW: What drove your success? What took you down the road of focusing in home purchases? SD: Quite simply, there were not that many firms specializing in helping people buy homes. People define themselves as either Mortgage companies, tech companies or fintech companies, whereas at Caliber we define ourselves as a home purchase company. In Caliber’s business model, technology and digital capabilities enable the loan officer and realtor to provide a best-in-class homebuying experience, instead of front running the loan officer. We realize that even today, buying a home can be a complex, intimidating process. We believe our distributed sales model with best in class technology and digital support creates a high-confidence environment for buying a home. RCW: And I imagine that the realtors welcome your model as well. You are both focused on relationships. SD: That’s absolutely correct. The realtors know that Caliber is singly focused on closing purchase loans and can handle complex transactions that require extra diligence in some situations. The realtor-loan officer relationship is extremely important in ensuring the homebuyer has all the confidence they need to close on a home, no matter how complex. By the way, despite what's said about millennial home buying behavior, it is interesting to note that approximately 35% of our customers are millennials. This means that while people shop for rates online, a vast majority still turn around and come to their broker, realtor or builder to get a mortgage during the process of buying a house. The IRA: Given the enviable position you have created for Caliber in the purchase channel, how do you see the rest of the market adapting – or not – to fall-off in refinancing volumes? SD: We anticipated that the refi boom would eventually subside. There is a lot of evidence that Q1 was difficult for many refi players. We expect that many smaller, less-capitalized players will exit the market. Caliber has the advantage of scale and capital. As part of this, we fully expect to see a number of acquisition opportunities with the right retail sales partners, this year. The IRA: We have that situation now. We could see 10-20 percent of the seller/servicers in the GNMA market exit the space in the next 12 months. They’ve been hanging on by their fingernails as the cost of servicing trebled. SD: That’s true. Non-bank players that will be successful in this coming cycle will be those that have capital, scale, efficiency and a robust business model. It sounds contrarian, but Caliber has been waiting for a year like 2017 to separate those of us that are extremely well capitalized from the rest. The IRA: Well, you worked at Citi with some of the best minds in the risk business. But the idiosyncratic risk of smaller businesses sometimes makes the financial analysis irrelevant. SD: Yes, as leaders in this sector, we understand capital and liquidity risk extremely well and have spent a considerable amount of time with the Agencies around how best to de-risk the industry in the event of a liquidity risk faced by smaller, less capitalized players. I'm delighted to report that the agencies and regulators understand the issues and are aligned with us in finding more robust solutions for the mortgage industry. The IRA: It is interesting that you are focused on the consolidation opportunity in the mortgage industry. Certainly helps to have the folks at Lonestar behind you. Much like Apollo with Athene and their subsidiary Amerihome Mortgage and then Fortress with NationStar and New Residential. Do you retain your entire MSR? Do you think about alternative financing for the MSR, kind of “capital light” if you will? SD: Yes we are very fortunate to have Lonestar behind us. They are extremely disciplined and assess us on our financial strength as a standalone company. We look at consolidation opportunities on the basis of the strength of our own balance sheet. We retain our MSR. With regards to alternative financing structure, we are constantly evaluating the most efficient capital structure for the company. We are very fortunate to have some great anchor financing partners in helping us explore new, cheaper ways to financing. The IRA: Do you sell any of your excess servicing strip (ESS)? Or do you carry the whole asset? SD: We carry the whole MSR asset. The IRA: How do you see the economy and the mortgage market going forward? The numbers from the MBA are pretty gloomy, both the loan origination numbers and their forward estimates for GDP. SD: We are taking a wait-and-see attitude on the economy. I would have thought that home buying would have picked up more significantly by now. It's clear the supply-demand imbalance is causing stress on home affordability. It will be interesting to see how future interest rate increases will impact home buying behavior. I feel comfortable about how Caliber is positioned in the purchase market, but I do think that 2017 will be an important inflection year in purchase. The IRA: The credit box is clearly opening. SD: There are a large number of customers who were impacted in the 2008 crisis with a good credit history that want to get back into mainstream borrowing. Many bank lenders are not ready for that. Good quality, non-agency eligible borrowers who demonstrate the ability to repay are a newly emerging market. We see that as an opportunity to work with these customers in a responsible way. The IRA: Are these scratch and dent sort of borrowers? SD: These are people who’ve had an event that disqualified them for an agency loan. Of the production that we have done, the delinquency rate experience has been extremely low. The IRA: How do you view the regulatory world? With the election of Donald Trump, the industry is hoping for some relief. SD: I take a slightly different view of regulatory matters. I’ve always believed that as long as lenders continue the highest standards of underwriting and risk management, regulation can be a good ally. The IRA: The simple answer is that by and large most large banks and non-banks are horribly inefficient. Platforms like Caliber and Amerihome are new, integrated operating and data platforms. The difference in efficiency, including avoiding errors, is staggering. SD: That is absolutely correct. Large banks had multiple platforms in the mortgage business, as a result of acquisitions that never got integrated. Now at Caliber we have one platform. By definition, we get it right. The IRA: Thanks for your time Sanjiv. #Caliber #SanjivDas #Lonestar #Citimortgage #CFPB

As the final days of summer 2021 come into view this week, mortgage executives are left to ponder the world post-Labor Day. A combination of political and regulatory threats is arising just as volumes and profitability in the industry weaken. And the biggest threat, as usual, is political. First and foremost, progressive politicians are desperately looking for a problem to solve in the world of 1-4 family residential mortgages, this as the backlog of Cares Act forbearance due to COVID quickly disappears thanks to the Fed. We wrote in an earlier post : "The once daunting pile of loans, millions in fact, that opted for CARES Act forbearance in 2020 are curing at a rapid pace, dashing the hopes of progressive activists for a train wreck in terms of low-income households. Likewise the liquidity trap we saw forming last April for Ginnie Mae issuers was literally averted by the Fed’s cheap money." For example, is there racial bias baked into GSE underwriting? A recent syndicated article on racial bias from The Markup , published by ABC News, AP, Market Watch and more , drew a great deal of attention from trade groups, policy makers and housing advocates. The only problem with the article by Emmanuel Martinez and Lauren Kirchner is that it’s completely wrong. First, the authors did not even include FHA/VA/USDA loans in their “research” into systematic discrimination. “The Markup has found that lenders in 2019 were more likely to deny home loans to people of color than to white people with similar financial characteristics,” the publication proclaims. But, wait, aren't GSE loans for rich people with plus +720 FICO scores? FHA is where low-income households access mortgage credit. Double duh. Naturally, former Federal Housing Administration (FHA) Commissioner, past Mortgage Bankers Association head and all-around good guy, Dave Stephens, took issue with the report. “HMDA data shows outcomes across a variety of variables, including race, but does not show FICO information,” he wrote in a comment. “Obviously to anyone in the business that’s a big deal given that FICO is a threshold data point that determines eligibility for a mortgage.” Bingo. While the GSE market tends to look at loans based upon risk factors such as LTV and FICO scores, the government loan market does not. This is why the whole premise of the article in The Markup claiming bias in GSE lending is so completely off base. But remember, progressives in and outside of the media are on a mission, to find a problem to solve – even if none actually exists. "From the beginning, we explained to The Markup that its analysis of HMDA data, and its pre-determined conclusions regarding mortgage lending, fail to take into consideration several key components that form the backbone of lending decisions, including a borrower's credit score and credit history,” the MBA said in a rare rebuke of a publication . "We also informed the authors upfront that by limiting their analysis to only ‘conventional’ loans, they would be painting an incomplete picture of the lending environment by purposely excluding mortgages guaranteed by government agencies like the FHA that are designed to help borrowers with lower credit scores and small down payments.” The reason that people of color are frequently denied conventional home loans has to do with the income levels and FICO scores of the applicants, not some deliberate conspiracy by lenders. When conventional loans to lower income, lower FICO score borrowers come up for sale into the secondary market, the execution suffers because of these attributes. For example, a borrower with a 620 FICO score and an 80 LTV loan would be hit with a 3% discount from Fannie Mae when the loan is purchased. But since progressives have no idea about mortgage lending, credit or markets, don’t even try to explain this little nuance to them. Source: Fannie Mae The embedded discrimination in lending by Fannie Mae and Freddie Mac comes in large measure from the loan level price adjustments (LLPAs) imposed by the Treasury under President Barack Obama after 2008. These additional fees were initially imposed by the Treasury to prevent GSE loans from prepaying, a hideous move that was meant to preserve the earnings of the GSEs by denying all conventional borrowers the right to refinance. Again, this policy came under Barack Obama. Successive directors of the Federal Housing Finance Agency have refused to remove these unnecessary fees, which can add points to the cost of a loan for a low-income household depending upon the loan-to-value (LTV) ratio of the loan and the FICO score of the borrower. But, again, don’t try to talk to a progressive about the secondary market execution for conventional loans to low-income borrowers. They have no idea and, frankly, the progressives don’t care about the details either. They are in search of the next cause. Today, LLPAs are perhaps the single biggest obstacle to a person of color seeking a loan from the GSEs, but you’ll never hear anybody in Washington and especially within the Biden Administration talk about them. Remember, the borrower is already paying the GSEs for mortgage insurance on the loan, so the additional fees imposed by LLPAs represent a terrible regressive tax that is weighted against low-income households and people of color. Got it? LLPAs add to the overall cost of the loan, making it more difficult to sell the asset given the inferior credit profile of the low-income borrower. Remember too that the consumer credit agencies and bond rating agencies all contribute to this problem because, again, of the lower income and FICO scores of the borrower. Adam Rust of the Community Reinvestment Association of North Carolina wrote: “Loan Level Pricing Adjustments” (“LLPA”) change both the cost and the accessibility of mortgage loans for consumers. Although relatively unknown, it is contributing to the ongoing weakness in housing prices. It makes it harder for American families to buy and sell homes. Since it moves many loans to FHA, it does little to relieve the risks associated with mortgage lending that is placed upon American taxpayers. The LLPA creates another hurdle for underserved borrowers." Since historically people of color tend to have lower incomes and also higher default rates, the bond market discriminates against these borrowers without even knowing their racial profile. The bond rating agencies use published methodologies that enshrine 1) FICO scores and 2) LTV ratios in the assessment of the pricing of a pool of loans. While the guarantee provided by the GSEs makes all of these assets seem homogeneous from the perspective of the investor, the pricing of these assets at the point of sale is still affected by the borrower’s credit attributes. Of note, all of the links to relevant pages of the Fannie Mae Selling Guide to the change in LLPAs from 2011 have disappeared from the web. In the government market, on the other hand, all loans are priced without a risk adjustment because of the direct federal guarantee. Historically, the FHA has priced all loans in the same way and has essentially allowed the stronger borrowers to subsidize the weak. But, of course, the folks at The Markup have no idea about any of these little details. The BIG story on alleged discrimination in GSE lending is whether Sandra Thompson, acting FHFA director, will walk-the-walk on improving access to credit for low-income borrowers and roll-back the LLPAs for the GSEs to pre-2008 levels. Thompson talks a good game when it comes to access and inclusion, but will she act now to remove these hideous LLPAs, which are a levy on the poorest Americans? Here’s a little hint for progressives: The continued use of the Obama-era LLPAs is a direct assault on people of color who want to purchase a home. But removing the LLPAs will likely push both GSEs into the red given the footprint reductions already put in place by former Director Mark Calabria . As with everything else in life, there is no free lunch when it comes to lending to high-risk, low-income borrowers.

"It is not down in any map; true places never are." Moby Dick Herman Melville San Diego | News reports that prosecutors have dropped their case against Bruno Iksil, the former JPMorgan (NYSE:JPM) trader many know as the “London Whale,” comes as no surprise to readers of The IRA . Iksil, who resurfaced earlier this year , has been living in relative seclusion in France for the past few years. In previous comments posted on Zero Hedge , we dispensed with the notion that the investment activities of Iksil and the office of the JPM Chief Investment Officer were either illegal or concealed from the bank’s senior management. The fact is that Iksil and his colleagues at JPM were doing their jobs, namely generating investment gains for the bank. The outsized bets made by the “whale” in credit derivatives contracts resulted in a loss in 2012, but the operation generated significant profits for JPM in earlier years. As veteran risk manager Nom de Plumber told us in Zero Hedge in 2012: “This JPM loss, whether $2BLN or even $5BLN, is modest in both absolute and relative terms, versus its overall profitability and capital base, and especially against the far greater losses at other institutions. In practical current terms, the hit resembles a rounding error, not a stomach punch. As either taxpayers or long-term JPM investors, we should be more grateful than sorry about the JPM CIO Ina Drew. If only other institutions could also do so ‘poorly’………” When JPM and other large banks began to implement the Volcker Rule after the passage of the 2010 Dodd-Frank law, the activities of Iksil and his colleagues in New York began to come to light. Principal trading, which is now outlawed by the Volcker Rule, creates enormous opportunities – and conflicts -- for banks that act both as traders and lenders. We wrote in ZH in 2012 : “[D]ear friends in the Big Media, it is time to get a collective clue. The real problem with CDS trading by large banks such as JPM is not the speculative positions taken by traders like Bruno Iksil, but instead the vast conflict of interest between the lending side of the house and the trading side, whether the trader is on the arb desk or, in the case of Iksil, working for the CIO trading for the bank’s treasury.” When caught in the act, the bank naturally cast Iksil’s activities as being somehow illicit and against company policy. But in fact his trading activities had been understood, blessed and even directed by the JPM’s senior management going back years. Far from being a hedge for other exposures of the bank, in fact the strategy of the CIO’s office was to generate returns as the bank’s internal hedge fund. When as early as 2010 discussions reportedly occurred about “hedging” Iksil’s illiquid credit derivative positions, presumably those involved understood that this was a risk position taken as part of a deliberate investment strategy. That Iksil apparently believed that he could not be bullied by other counterparties because of the fact of trading for JPM speaks to how he viewed his activities, which were entirely visible to other market participants. The JPM CIO’s office under Ina Drew ran an active trading strategy, making markets around positions on a continuous basis to provide live valuations and generate short-term returns. The fact that big banks no longer trade their investment books illustrates the diminution of liquidity that has occurred since the adoption of the Volcker Rule. But for the banks, the legacy of the London Whale and the larger implementation of Dodd-Frank has left a deep mark on risk managers and those concerned with maintaining internal systems and controls at large banks. But now Iksil has accused JPM's Chief Executive James Dimon of laying the ground for what was eventually a $6.2 billion loss, Reuters reports . In an account on his website , Iksil also blames senior executives at the bank for the investment strategies that led to those losses. Iksil’s account now sounds an awful lot like what we heard from his former colleagues in New York some six years ago. At the time, JPM’s counsel had already mandated the elimination of the managers and traders in the CIO’s area as part of implementing the Volcker Rule, leading to a number of redundancies in New York. We know about the Whale because of the implementation of the Volcker Rule. But the key event that broke the scandal open was the public statement by Dimon, this in response to persistent press queries from The Wall Street Journal and Bloomberg News , that the rumors of losses in the CIO’s office were “a tempest in a teapot.” But for the public statement by Dimon, which required additional clarification and disclosure, the activities of the CIO that might otherwise have been dealt with in the fine print of JPM’s earnings release. Instead, JPM was forced to not only enhance disclosure of the CIO’s trading results, but then went through a firestorm of congressional hearings, regulatory questions and litigation that continues to this day. We recall sitting in the analyst presentation at JPM’s HQ dealing with the London Whale as Ken Langone glared at the assembled audience of Sell Side analysts. In his congressional testimony, Dimon attributes the bank’s loss to a modeling error, but in fact the exposure was simply ignored. Notice that at no point has the financial media or regulators questioned the company line about what actually happened and when. Iksil’s statements seem to take us back down that road and, specifically, to suggest that senior management at JPM was actively aware of the strategies taken by the CIOs office years before the big losses occurred. Our old pal Nom de Plumber commented over the weekend: “In the end, the London Whale disaster reflected the mis-marking of generic Index CDS trades, which then-CFO Doug Braunstein ignored. The problem was not complex risk modeling or market risk measurement. The quants tried to re-jigger VaR measurement of the trades, to avoid breaching risk limits-----for CIO trades which Jamie specifically demanded of Ina Drew......regardless of preceding protests from risk managers like John Hogan and Robert Rupp.” Nom de Plumber tells The IRA that Ina Drew was essentially running a hedge fund directed by Dimon and other senior managers, a fund that was largely kept outside of the bank’s risk management and reporting procedures. Consider the bizarre situation in 2011-2012 when counterparties of Iksil facing the JPM commercial bank were unable to make margin calls, but the JPM investment bank was making margin calls on these same counterparties for positions in the very same indexed credit derivatives. Bruno Iksil has waited for the proverbial concrete to harden over the past few years before coming forward with his latest accusations. This makes it difficult or impossible for Dimon and his lieutenants to change their story now. It will be very interesting indeed to see if anyone from the financial media or even the regulatory community picks up the new trail illuminated by Iksil’s statements. The episode involving the London Whale illustrates how difficult it is to learn the truth about the inner working of large banks. Big banks profit by exploiting information and conflicts found between the world of credit and the world of securities. Indeed, the CIO's office generated big returns for JPM over the decade or so that Iksil was with the bank. But the London Whale episode also shows in graphic terms why the Volcker Rule prohibitions against banks trading for their own account need to be preserved and strengthened. There is a fundamental conflict between a bank acting as a lender and trading credit derivatives. More, if the CEO of a bank – any bank – can short circuit the internal controls of his institution in order to enhance returns with a bet at the credit derivative roulette table, then by definition that bank cannot be safe and sound. Further Reading Long and the Short of JPMorgan http://www.zerohedge.com/contributed/2012-19-11/long-and-short-jpmorgan JPMorgan: What's the Fuss? http://www.zerohedge.com/contributed/2012-20-15/jpmorgan-whats-fuss Bruno Iksil, JPMorgan and the Real Conflict with Credit Default Swaps http://www.zerohedge.com/contributed/2012-15-11/bruno-iksil-jpmorgan-and-real-conflict-credit-default-swaps #LondonWhalen #BrunoIksil #JPMorgan #JamieDimon #ZeroHedge

New York | The failure of Bear Stearns & Co a decade ago illustrates the key lesson of financial markets, namely that non-banks are dependent upon 1) banks and 2) clients for liquidity. And no amount of capital will save a non-bank that has a deficit in terms of confidence. In times of market stress, credibility and character are far more important than capital. Like the Crisis of 1907, when JPMorgan (NYSE:JPM) had to rescue the trust banks at the behest of President Teddy Roosevelt, the investment banks in 2008 were abandoned by the markets. Lacking stable funding in the form of core deposits, the non-banks failed in droves, starting in 2007 with New Century Financial, once among the largest issuers of subprime mortgages. And it can happen again. Mark Adelson wrote in the Journal of Structured Finance : “By the summer of 2007, the prices of subprime mortgage-backed bonds already had begun to plunge. New Century, once a major lender, had declared bankruptcy; two hedge funds run by Bear Stearns were collapsing; and as emails obtained via lawsuits and investigations would later show, the rating agencies were well aware of the problems. In April 2007, one S&P analyst told another, ‘We rate every deal. It could be structured by cows and we would rate it.’” We recall sitting in a conference room with a group of investors early in March 2008, listening to people congratulate themselves for not "facing" Bear. Little did they suspect that the whole non-bank sector was toast and that Lehman Brothers would be next. While JPM took down Bear without a default, Lehman eventually failed and filed bankruptcy because nobody could get comfortable with the firm’s financials. The markets today are just as vulnerable to a "run on liquidity," with Goldman Sachs (NYSE:GS) now the smallest of the universal banks followed by Morgan Stanley (NYSE:MS). Since 2008, non-banks have grown in residential mortgages and other areas that are totally dependent upon bank financing. The changes made by the Securities and Exchange Commission in 1998 to Rule 2a-7, which prevents non-banks from issuing their own paper for purchase by money market funds, gave the big banks a monopoly on short-term warehouse credit, thus making the 2008 crisis inevitable. Bear was the smallest and least beloved of the bulge bracket Wall Street securities firms, having figuratively pissed on the floor by not agreeing to help rescue Long Term Capital Management in 1998. Nobody on the Street forgot that slight. Governance at Bear was at a minimum. The firm was run like a bridge tournament in a high school auditorium, with each table representing a different business unit and no overall enterprise management. Regulators and members of the academic community like to say that non-banks caused the financial crisis in 2007, but the reality is that banks as well as non-banks failed when liquidity disappeared. Regulators correctly point to issuers such as New Century, Lehman Brothers and Bear, Stearns as examples of wayward non-banks, but key players in the banking sector such as Wachovia, Washington Mutual and Countrywide also were culpable and vulnerable to runs. Jonathan Rose (2014) notes that during the subprime panic in 2007-2009, many large depositories such as Wachovia were subject to runs by institutional investors, both in terms of institutional deposits and even debt. WaMu, for example, lost significant deposits during 2008 leading up to its resolution by the FDIC and subsequent sale to JPMorgan. By March of 2008, in another example, Wachovia was seeing a significant outflow of deposits and demands from bond investors for early redemption which led to the bank being acquired by Wells Fargo later that year. Only the fact of “too big to fail” protected larger names such as Wells Fargo (NYSE:WFC), JPMorgan, Bank America (NYSE:BAC) and Citigroup (NYSE:C) from the contagion. The funding support provided to the non-banks and second tier banks by the large depositories, as well as the market demand provided by the mortgage securities issuance of the GSEs and large banks, are important factors that drove the overall demand for subprime mortgages. The eventual collapse of demand led to the failure of both banks and non-banks alike. Countrywide’s warehouse was largely financed by Bank of America, which was forced eventually to acquire the crippled institution. Washington Mutual and Bear Stearns were likewise funded by the large banks and money market funding, and were eventually acquired by JPMorgan with support from the Federal Reserve Bank of New York. Moreover, substantial parts of the balance sheet funding of “banks” such as WaMu and Countrywide were sourced from non-core deposits in institutional money markets. Many observers fret about the risk presented by nonbanks, yet the dependence of these institutions on bank financing means that the credit and market risk remains “in the bank.” In the event that a large nonbank financial firm in future experiences liquidity or solvency problems, the lender banks would almost certainly be compelled to acquire the nonbank. Non-banks, at the end of the day, are the customers of the big banks. That is the key lesson of the failure of Bear Stearns. #BearStearns #nonbanks #liquidity #lehmanbrothers #jpmorgan #citigroup #bankofamerica

This week in the premium service of The Institutional Risk Analyst , we take a look at the merger of Western Alliance Bancorporation (NYSE:WAL) with AmeriHomeMortgage (AH) . This public report is an example of the content available to subscribers to The IRA premium service. WAL is the $33 billion asset parent of Western Alliance Bank , a state-chartered depository based in Phoenix, AZ. AH is controlled by insurance companies owned by Athene Holding Ltd. (NYSE: ATH) , and funds managed by Apollo Global Management, Inc (NYSE:APO) . WAL closed at $88 on Friday, an equity market valuation of 2.6x book value and a 17x trailing price to earnings. WAL closed below 50bp in credit default swaps on Friday, roughly in line with the large money centers such as Citigroup (NYSE:C) and Bank of America (NYSE:BAC) , with a beta of just 1.6x the average market volatility. No surprise then that both Moody’s and Kroll Bond Rating Agency reaffirmed the long- and short-term ratings for WAL immediately after the transaction was announced. Indeed, KBRA put AH on watch for a rating upgrade to reflect the superior credit of the bank holding company. KBRA noted last week: “AmeriHome’s Issuer rating was most recently affirmed on October 26, 2020 in an action that was supported by the company’s consistent multiyear operating performance, and reasonable pro forma leverage, following a partially debt financed special dividend to its owners – insurance companies owned by Athene Holding Ltd… and funds managed by Apollo Global Management – as well as the company’s bolstered liquidity. AmeriHome’s credit profile has benefitted from a highly qualified management team, the majority of which gained some of their most valuable experience during and following the Global Financial Crisis (GFC).” The “capital light” nature of the AH business model and the focus on acquiring loans from a network of trusted partners results in superior equity returns, lower risk and an investment grade credit profile from the major agencies. We believe that combining the hyper-efficient AH loan acquisition and servicing platform with a solid regional lender such as WAL promises to make 1+1 > 2. Last week WAL described the transaction in a press release: “AmeriHome brings a B2B approach to the mortgage ecosystem through its relationships with over 700 independent correspondent mortgage originator clients, including independent mortgage bankers, community and regional banks, and credit unions of all sizes. Based in Thousand Oaks, CA, AmeriHome is the nation’s third largest correspondent mortgage acquirer, purchasing approximately $65 billion in conventional conforming and government insured originations during 2020 from its network of independent mortgage originators and managing a $99 billion mortgage servicing portfolio, as of December 31, 2020.” The proposed transaction, which is currently expected to close during 2Q 2021, is priced around 1x book and envisions AH retaining a corporate structure as a subsidiary of Western Alliance Bank. This structure as an operating sub of the bank will provide AH with shelter from much of state-law regulation and licensing requirements due to the fact of FDIC insurance and federal regulation as per the SAFE Act. AH is one of the top correspondent lenders in the US and a major player in the conventional loan market. AH has a low-cost operating model compared to its peers among independent mortgage banks due to its relatively new internal systems and controls, as well as an outsourced model for loan servicing. The table below shows loan origination and unpaid principal balance (UPB) through Q3 2020 from the AH S-1 filed with the SEC . At the end of Q3 2020, AH had assets of $6.9 billion, corporate debt (excluding $2.4 billion in secure warehouse lines) of $360 million, and mortgage servicing rights (MSRs) totaling $830 million. Notice that the MSR equals ~ 0.86% of the total unpaid principal balance (UPB) of the loans serviced. In the nine-months ended September 30, 2020, AH reported net revenue of $709 million, up over 100% year-over-year. With interest rates rising and mortgage volumes starting to slow, it is reasonable to expect industry volumes to slow. WAL is an outstanding performer and one of the stronger regional banks in Peer Group 1, which includes the top US banks over $10 billion in assets. The bank’s net income as a percentage of average assets was 1.38% at the end of Q3 2020, placing WAL in the top 10% of large US banks. Net losses on loans and leases were 0.06% vs 0.28% of total loans for Peer Group 1. The gross spread on WAL’s total loans and leases was 4.82% in Q3 2020 vs 4.35% for Peer Group 1, putting WAL in the top third of large banks in terms of loan pricing. By putting AH within the bank’s operational and regulatory envelope, WAL can achieve big synergies and cost savings, even while operating the mortgage acquisition and servicing business as a separate division within the depository. AH CEO Jim Furash and his veteran team came through the crisis and have proven their business model over the past decade, making a compelling case for the transaction with regulators. AH built their platform with the support of ATH and APO, which gives them a big leg up vs the competition in terms of both financial and risk management, and operating efficiency. WAL too is very well-managed, with an efficiency ratio calculated by the FFIEC of 40% in Q3 2020 vs 62% for Peer Group 1. That puts WAL in the top decile of all large banks in the US, where this indicator has been for the past five years. In Q3 2020, the bank’s earning assets as a percentage of average assets was 95.7% vs 92% for Peer Group 1, again putting WAL in the top decile of its peers in terms of keeping maximum sail aloft. We have long advocated the idea of an independent mortgage bank (IMB) combining with a strong regional lender because of the economics of retaining escrow balances within the bank and thereby growing a business that supports both mortgage lending and servicing, while greatly enhancing the liquidity and income of the depository. WAL’s bank subsidiary has almost $30 billion in core deposits and only $1.5 billion in non-core funding, creating the potential for big growth ahead as the bank expands lending and other services to the AH ecosystem funded with the escrow deposits of the servicing book. We view the combination of AH and WAL as a showcase transaction for the mortgage bank concept we outlined previously in The Institutional Risk Analyst and on SSRN . We hope that other IMB’s take the hint. The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Profile is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Profile. Interested parties are advised to contact Whalen Global Advisors LLC for more information. Winter Sale Ends March 1st!

November 8, 2021 | In this Premium Service edition of The Institutional Risk Analyst , we look at the Q3 2021 earnings results for PennyMac Financial Services (PFSI) , Rocket Companies (RKT) and Home Point Capital Inc. (HMPT) . Suffice to say that 2021 is not a bad year by any measure, but most operators tell us that the year is getting stranger by the day. Increasingly hectic secondary market activity in loans and servicing, shrinking spreads and soaring prices are some of the highlights. The key trends we’ve seen so far from Q3 2021 earnings remain 1) falling volumes and 2) tighter margins across most product types vs last year. HMPT reported this week, making a “turnaround” of sorts from a disastrous Q2 by selling a GNMA mortgage servicing portfolio for proceeds a bit over $120 million and thereby paying a dividend. The MSR sale by HMPT accounted for half of Q3 2021 revenue of $275 million, down from $510 million in Q3 2020. The GOS margin for HMPT dropped from 286bp in Q3 2020 to just 84bp in Q3 2021, again illustrating the intense competitive environment in the secondary mortgage market. Source: HMPT Q3 2021 Market leader RKT saw an improvement in results compared with Q2 2021, but a significant year-over-year decline in revenue, loan volumes and operating cash flows. The gain-on-sale revenue (GOS) of $2.6 billion in Q3 2021 was 40% below the record $4.3 billion in Q3 2020. More significant, RKT saw a $341 million decline in the fair value of its mortgage servicing rights as prepayments on mortgage-backed securities (MBS) remain high. Source: RKT Q3 ‘21 Not only did RKT sell MSRs, Inside Mortgage Finance reports, but it also acquired $3.6 billion in UPB of servicing assets to feed future refinance lending, an expensive investment to capture 20-30% of payoffs in a given pool. As we noted in our last report (“ Update: New Residential Investment, Fortress & Softbank ”), many issuers – including RKT – don't calculate recapture correctly and thereby manipulate their metrics for customer retention. The irony, of course, is that RKT pools tend to prepay faster than the industry average. Said CEO Jay Farner during the RKT earnings call: “In addition to generating our clients organically, we acquired MSRs with an aggregate unpaid principal balance of $3.6 billion during the third quarter. This is in accordance with our growth strategy as we have found that our industry-leading retention rate positions us to generate attractive returns through select MSR portfolio acquisitions.” RKT has guided analysts up 10% for the full year 2021 in terms of funded volumes, but with GOS margins in the range of 265 to 295 basis points or half of last year’s peak levels. Significantly, RKT has $3 billion in liquidity used to self-fund loan volumes, meaning that it does not have to use a warehouse line from a bank. But Farner may end up using that cash to buy more loans and servicing as lending volumes fall. Farner noted that the increase in home prices actually adds profits to the industry per unit volumes: “We're excited about 2022 because if we kind of look at where industry experts are projecting, they're talking about the continued growth. I'm seeing forecasts [8-plus] percent. We're seeing median home prices estimated to be north of $435,000. And as home prices grow, of course, mortgage amounts grow, and you understand how our business works that is great for the unit economics of our business, more revenue generated on the same units that we're putting through the system. So just in general, the industry looks very strong.” RKT has assembled an impressive “ecosystem” of companies to take a fee out of every stage of the mortgage lending process from realtors to a home listing platform to Amrock Title to Rocket Mortgage for the loan and servicing. That said, most of the comparisons made for RKT are to 2019 financial results, a natural choice since net results in 2021 is likely to come in below 2020. Even as volumes fall, RKT is trying to make up the difference in a falling volume market by shifting from refinance transactions to more expensive purchase mortgages. With the wholesale channel now running at break even or worse, retail loans are an expensive way to build revenue, but RKT has lower costs than many competitors. Interestingly, PFSI is taking a different route and is focused on call center and servicing income as sources for future profitability. RKT is predicting that it will reach 10% market share by the end of 2021, a notable goal that will likely also see profits cut in half compared with 2020 levels. The table below shows revenue, income and earnings before interest, taxes, depreciation and amortization of intangibles such as MSRs. Note that adjusted EBITDA for RKT is running at 50% of last year’s levels. Source: RKT Q3 2021 Although the FOMC has announced a tapering of its massive open market operations (aka “QE”), the Fed will be taking a bigger slice of dwindling MBS as well as Treasury debt issuance until well into 2022. Thus, for MBS issuers such as RKT, PFSI and HMPT, the market may see secondary market rates fall in Q4 2021 and 2022, this even as lending volumes decline. There are a number of factors that impact coupon rates in the world of MBS, however, as illustrated in one comment last week. “A 1.45% 10-year yield makes Fannie Mae’s 2% the main production coupon,” according to Bloomberg’s Alyce Andres . “When rates were rising a few short weeks ago, mortgage originations switched from 2% to 2.5% coupons. More production in higher coupon mortgage-backed debt means less duration hitting the market because proportionately more payment is received before final maturity. Now, the opposite is true, and that added duration could weigh a bit on bonds.” PFSI saw the same erosion of GOS margins and net income as RKT and HMPT, this even as total lending volumes for 2021 may actually exceed 2020, using the estimates from the Mortgage Bankers Association . Mortgage rates some 200 bps below peak levels of the end of 2018, when mortgage rates were near 5%. PFSI notes that direct lending and servicing are driving profitability, a statement that could also be made about RKT. When issuers like RKT and PFSI, who usually eat their own cooking in terms of acquiring assets, are paying up for servicing and early-buyouts to generate new loan volumes, you know that the going in the secondary loan market is getting tougher by the day. Source: PFSI Q3 2021 In the quarter ended September 30, 2021, PFSI reported total net revenue of $786 million, down almost 30% from Q3 2020. Total net revenue YTD for 2021, $2.5 billion vs $2.7 billion, is still close to 2020 results, however, due to the strong showing by PFSI in the first half of 2021. Total expenses for the nine months of 2021 are above 2020 levels by 15%, suggesting that significant cost cutting is a given in the months ahead. Servicing revenue rose 7% so far this year, but the amortization on PFSI’s MSR and $80 million in hedge losses almost offset total servicing results. The shift in the Treasury yield curve in September was responsible for most of the pain in the world of hedging as a flattening trend caught many investors and issuers unawares. What many operators in the mortgage finance sector know, however, is that a need for operating expense reduction and rising cost of asset creation are two factors that are largely beyond their control. Meanwhile, a flattening Treasury yield curve signals increasing concern that Federal Reserve efforts to keep inflation in check will derail the economic recovery. We suspect that the FOMC’s compromise is to end purchases of MBS and slow acquisitions of Treasury debt, a policy mix that may hold new surprises for mortgage issuers. Specifically, a softer bid for MBS relative to Treasury yields may allow for wider spreads in 2H 2022. In the meantime, look for lending volumes and spreads to remain under pressure. 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.

The US mortgage industry has just been through the best 18 months in terms of volumes and profitability in a decade. As we head into 2022, the old issues of managing expenses and scalability come back into focus. Many firms are already selling servicing assets to raise cash, a sure sign that profit margins are getting tight. Other firms are buying servicing at record prices to perhaps capture refinance opportunities. Successful firms must find a way to achieve cost savings in heretofore sacred parts of the mortgage factory such as loan underwriting, which is the most costly and also important part of the lending process. But every loan is different. A typical loan has literally tens of thousands of variables that an underwriter must navigate on the pathway to approval. Most firms have error rates for loan underwriting in low single digits. To be successful in 2022 and beyond, mortgage lenders must move that error number a couple digits to the right of the decimal point. In this issue of The Institutional Risk Analyst, we speak with a revolutionary in the world of lending, Tom Showalter, Founder and CEO of Candor Technology . The IRA: Tom, you started Candor back in 2017 to solve several problems with the loan manufacturing process. You identified rising costs and shrinking margins, a high error rate in underwriting with the potential for bias, and as a result, a poor experience for the consumer. Talk about how you came to this vision. Tom Showalter Showalter: Prior to joining the mortgage industry, I worked for NASA in the aerospace industry. The mortgage industry has huge amounts of complexity and spends aggressively on technology, but has yet to see that technology spend returned in the form of increased productivity and profits. I began to think about how we can transform the process of manufacturing a loan into something closer to the zero-error tolerance world of aircraft and space travel. The IRA: That sounds like a heavy lift for an industry that has spent a decade retooling after the 2008 financial crisis. Despite the overlay of robotics and automation, lending remains a very labor-intensive manufacturing model more akin to Henry Ford in 1910 than Boeing Company (BA) today. Showalter: At the heart of the problem lies something very fundamental. The integrity of the mortgage asset, the loan, has been suspect since the 2008 meltdown and is still suspect today. We will have 100% due diligence on private label mortgage deals. The only ways of increasing the loan integrity are manual, which means slow and expensive. In our analysis, it was the lack of integrity in the mortgage loan that we sought to correct. We thought, if we could find a way to use a machine to dramatically upgrade the integrity of the mortgage loan, we can achieve gains in speed, productivity and profit levels, but only if the loan produced by our methods met the highest standards of integrity. We viewed this problem at two levels. One was to improve the integrity of the data used to manufacture a loan. Secondly, using that high integrity data, we would ensure that the loan met all guidelines, ensuring a high level of decision integrity. The IRA: You’ve stated that until Candor, technology solutions in the mortgage industry did not have a meaningful impact on cycle time or net profit per loan. The aerospace industry has made improved asset efficiency and the avoidance of error the rule going back to WWII. How do we make similar progress in mortgage lending? Showalter: What we’ve learned is that once we taught a machine how to ensure the integrity of the data and the decision, the mortgage origination process became incredibly fast, shrinking loan origination cycles. Lee Smith from Flagstar Bancorp (FBC) told you back in August that “I don’t think we’ve seen anybody really come to the fore in terms of growing market share based upon technology.” That is another way of saying that mortgage firms basically have no upside in terms of operating leverage. The industry has spent billions on robotic systems that automate what is still a largely manual process. Loan underwriting is too complex, too variable for such an approach. That’s why we decided to apply the basic tools of behavioral science to underwriting mortgage loans. IRA: Talk about the specific tools employed in the Candor process to get the task to completion. Showalter: At the heart of the aerospace industry approach is its reliance on engineering and mathematics to craft the technology necessary to advance its fortunes. Just as you wrote in your “ Ford Men ” book, Ford Motor Co (F) embraced assembly lines to meet demand for cars. Aircraft manufacturers had to meet demand for civilian and military aircraft, but with zero tolerance for error. Two forms of technology leveraged constantly by the aerospace industry (and not leveraged by the mortgage industry) are “expert systems” and “system safety engineering.” The IRA: Never heard those terms used in the context of residential mortgage lending. Talk about what this means. What is the aerospace industry doing that the mortgage industry is not? Showalter: “Expert systems” is a technology where you teach a machine how to think like an expert. Expert systems are used by the intelligence community to replicate the thought process of the 95th percentile intelligence analyst. They are used by the medical industry to replicate the thought life of a diagnostician and by aircraft manufacturers to replicate the diagnostics needed to repair a jet engine. “Systems safety engineering” is a design methodology supported by a special form of mathematics that enables an aerospace engineer to design a very complex system, one with over a million interacting components and ensure that it operates flawlessly for hours, days, weeks on end. Used in this context, “expert systems” means the art of teaching a computer how to think like a particular kind of expert, such as a loan underwriter. With an expert system approach, for example, a less seasoned team can produce a fully underwritten file without an underwriter, then present the loan file for approval with a complete history of all of the data and decisions in that process. The IRA: Traditional systems and controls in the world of banking and consumer finance are focused on managing decisions by people. How is your approach different? Showalter: Using technology to define and limit the lending process results in greater efficiency, with more loans, fewer errors and, importantly, less opportunities for lender bias. We not only make the underwriting process more disciplined, but we are able to improve initial to final approval, pull through and deliver a significant increase in asset turns via a decrease in time to funding. In people-based systems, machines do a portion of the data aggregation and analysis, but people do the final analysis and make the decisions. This also creates a huge bottleneck. There are too few people with high levels of final analysis and decision-making skills. The IRA: Better asset turns are always good. We wrote favorably about Western Alliance Bancorp (WAL) earlier this year when they acquired AmeriHome from Apollo (APO) . These folks understand asset turns. WAL was the best performing large bank so far stock in 2021. Mortgage lenders would certainly welcome ways to make the underwriting process more efficient. Is it really possible for Candor to improve operating leverage in areas such as underwriting? Showalter: Our expert system simulates the decision-making ability and high-level cognitive tasks of human experts – but without human bias. Humans approach tasks by using a narrative, a model of past loans, that is used to assess a new borrower. And again, this is not robotics or “AI” but rather a way of engineering a very narrow and specific decision process. The IRA: That sounds impressive. How does this work in practice as part of a loan origination system (LOS)? Showalter: Think about how we underwrite a loan today. There is tremendous complexity in the process. Every loan has a unique combo of 1003 loan application information + supporting data. As a result, each loan begins at a different point of departure. The underwriter can’t follow the same process to solution. When new data & information refute previous conclusions, underwriters must pivot and begin the underwriting process all over again in real time. Candor automates ~ 90,000 real time micro decisions on every loan. By using the machine to perform these tasks, we speed the underwriting process and leverage your most valuable people, namely the experienced underwriters, in reviewing and providing a formal approval. The IRA: How does this application of decision technology address the issue of loan quality? At present we are in a period where credit risk appears to have no cost, as in 2005, but we all know that after a period of high lending volumes credit problems appear. The GSEs and FHA start making loan repurchase demands due to defects. How does you address this issue of loan quality? Showalter: In 2019 and 2020, when volumes were at the highest levels in history, technology could not handle the load. The technology of the day could not provide the critical thinking necessary to accomplish the underwriting challenges of record volumes. Technology deficiencies forced lenders into adding droves of critical thinking talent (e.g. underwriters, loan processors). Lenders saw a large portion of the profits go to paying exorbitant salaries as the industry drained the labor pool of underwriting talent. Loan manufacturing slowed considerably, costs grew and treatment of borrowers become less consistent. The IRA: In other words, we increased the potential for error as volumes grew? Sounds like the early 2000s. Showalter: By embracing decision technology, we enable lenders to perform a more complex transaction, faster, less expensively and with much greater consistency. We believe this new approach will produce loans that the secondary market would be happy to buy and, indeed, will prefer over time. Just as investors shy away from MBS with high default or prepayment rates, we believe that investors and guarantors like the GSEs or FHA will gradually come to favor loans created with technology like Candor. The IRA: That is a pretty bold statement. Why are you so confident that applying the technology used in the world of aerospace can truly change the mortgage industry? Showalter: In the past, one industry, the aerospace industry has been asked to do something of immense complexity, to do it safely and to accomplish things previously thought impossible like putting a man on the moon, providing extremely safe commercial jet travel, and supersonic flight and even space slight. The aerospace industry had to invent the technology necessary to manufacture and fly the planes and space craft necessary to accomplish these most difficult objectives and do it safely. The aerospace industry successfully developed the technology that would transform it from one of the riskiest on the planet to one of the most reliable. Aerospace technology can produce a plane that contains over 1 million interacting components, all of which operate flawlessly. To accomplish this miracle, aerospace technology has not only made aircraft and spacecraft extremely reliable, it made these machines smarter. We have to make the mortgage lending process smarter and less biased by human limitations just as the aerospace industry did with aircraft and space travel. The IRA: Enabling lenders to leverage parts of the process map such as underwriting would bring some truly revolutionary changes to the industry. Is this revolution really possible in the world of residential lending? Showalter: I believe so. Decision technology can be applied to any type of credit creation. It is possible to port aerospace technology into the mortgage space and do so without requiring the industry to completely rethink and reinvent itself. What the mortgage industry needs is a technology that will embed the critical thinking skills necessary to make and underwrite a mortgage with the same degree of perfection that we see in the manufacture of complex machines such as aircraft and space vehicles. We can do this. The IRA: Thank you for your time, Tom.

October 28, 2021 | On January 1, 2022, the state and federal moratoria on residential home foreclosures will end. The relative quiet that has prevailed in the market for 1-4 family loans will also likely conclude, ushering in a new period of regulatory danger for mortgage servicers. Illustrating the mounting risk, the Office of the Comptroller of the Currency issued a consent order with Cenlar FSB , the largest loan sub-servicer in the US. Below are some thoughts on why this event is important to both mortgage lenders and servicers, and the investors in this sector. This CO for Cenlar contains a laundry list of issues many banks and mortgage servicers have seen in the past. That said, this action is the most stringent order applicable to a bank we can recall from OCC in a decade. While there is no fine (and no finding of consumer harm, of note), the limit on transfers, board actions is draconian even for a large bank. It will take years, significant resources for Cenlar to remediate. In simple terms, the OCC seems to have decided to apply large bank rules to a small bank that happens to be the largest sub-servicer in the market. Cenlar is known as a large but squeaky-clean platform. But the bar has now been raised and Cenlar's reputation has been damaged by the OCC's action. Again, there was no finding of consumer harm or even an error, so the OCC's actions seem entirely preventative. Keep in mind that OCC's actions are, in part, driven by a desire to avoid reputation risk that arises from weak systems and controls. But that is precisely the effect of this CO by the OCC. Big question is whether the states, CFPB take this example and start to apply these standards for “unsafe and unsound” practices more broadly to IMBs. For the short and medium-term, the biggest chunk of sub-servicing capacity in the mortgage industry has been taken offline. Given the record flow of MSRs going to buy side investors and smaller banks, there is likely going to be a prolonged shortage of sub-servicing capacity in the industry. Could be years before Cenlar is able to take new assets. Indeed, Cenlar may need to raise capital and/or consider other steps in response. In January 2022, foreclosures will begin and the states and CFPB will be waiting to pounce on ANY sign of error with respect to remediation of consumer defaults. Handling non-QM loans will be especially problematic for servicers because they do not come under the CARES Act moratoria from a legal perspective, but regulators will pretend that they are and dare lenders and servicers to fight. A conflict between investors and regulators may result in litigation. What fun. The period of relative quiet from CFPB and other agencies may be ending. Mr. Cooper (COOP) reported Q3 earnings this week and saw earnings drop sequentially as volumes likewise fell. Unlike Q2, there was no $485 million gain from the sale of Title365 to Blend Labs (BLND) to boost reported earnings. BLND reports earnings on November 10th, just five days before the end of the reporting period. We’d be surprised if BLND is even close to profitable. The Street estimates that BLND will lose money this year and next. The expenses of Title365 may actually hurt BLND's results going forward. COOP marked up the valuation of its MSR book to 121bp, reflecting the increasingly frothy conditions in the secondary market for MSRs. This resulted in a $153 fair value adjustment to earnings compared with a $135 million markdown last quarter. COOP also benefitted from $131 million in revenue from early-buyouts of government loans (EBOs). Many of these loans were modified and sold into new pools. Of note, the redefault rate for modified FHA loans is in mid-double digits through Q2 2021. The EBO opportunity for banks and IMBs is trending lower as these distressed credits that do not get back on track inevitably fall into foreclosures. While under GAAP issuers are not allowed to include the optionality of the refinance transaction in the valuation of an MSR, but investors clearly are mindful of that opportunity. For the same reason that MSR valuations are rising, COOP actually saw its gain-on-sale margin expand in Q3, a welcome but likely temporary bump caused by rising Treasury benchmark rates. Of note, the major buyers of conventional MSRs are large banks and IMBs, as well as community banks hungry to replace earning assets. Unlike government loans which trade only at the pool level, conventional loans may be bought and sold individually, a feature that is particularly attractive to community banks. Indeed, banks and IMBs are outgunning funds and REITs in the secondary market for MSRs. As total returns are pushed down below the minimum 7% unlevered yield that is the minimum for Buy Side investors, banks are winning more and more pools. This may be cause for concern, however, since the rate of migration from FHA loans and Ginnie Mae pools over to conventionals is accelerating. How many buyers of conventional MSRs today understand that they are paying premium prices for pools comprised increasingly of FHA borrowers with no additional mortgage insurance? The movement from government to conventional assets, often via a cash out refinance, is good for consumer liquidity, but may carry future problems for banks as and when asset prices fall and default rates begin to normalize. Investors in conventional MSRs may be called upon to support servicer loss mitigation activities. These newly coined conventional borrowers are a direct result of the market manipulation of the Federal Open Market Committee. Because loan-to-value ratios have fallen so dramatically as home prices have risen, many FHA borrowers can take cash out and avoid private mortgage insurance in their new conventional loans. Down the road, however, the FOMC’s social engineering will carry significant risks for banks, investors and the GSEs themselves, which will once again make loan repurchase claims on lenders and their investor clients to compensate for the cost of loss mitigation.

October 25, 2021 | After a blissful week immersed in the world of housing finance at the Mortgage Bankers Association annual meeting in San Diego, we thought to return to ground zero of monetary policy. Below are three questions we’d ask Federal Reserve Board Chairman Jerome Powell if the opportunity arose. Suffice to say, we’d like some guidance on the size of the System Open Market Account or SOMA over the next three years. But hold that thought. On Wednesday in NYC, we dive back into the world of mortgage loans and related servicing assets at an event sponsored by IMN in New York City. We’ll be talking with some industry leaders about the political and regulatory threats to the market for residential mortgage servicing rights or “MSRs,” one of the most attractive and also most treacherous assets in the financial world. Just imagine an investment with negative duration, cash flow and a tendency to disappear at a 30% annual rate! A while back in The Institutional Risk Analyst , we noted that the 50-50 split in the US Senate allowed for binary outcomes in terms of policy. The fact of an equal division makes every vote a super vote, and makes the holder of that vote the arbiter of every issue that comes before the Sentae. That man, of course, is Senator Joe Manchin (D-WV) , who refuses to support the progressive agenda for trillions more in political giveaways. Mother Jones , of note, reports that Manchin is considering a move to “independent” status and would caucus with Republicans. This would deprive President Joe Biden of a Senate majority and thereby put the final torpedo into his decidedly bizarre fiscal agenda. Since there is little visibility on fiscal policy, here's our first question for Chairman Powell: Q: How do you plan future monetary policy given the uncertain future of the Biden spending plan? How does Treasury plan for future cash outlays? Fred Hickey , author of The High-Tech Strategist , describes the increasingly absurd fiscal scene in his latest letter: “When the COVID pandemic hit, that was the excuse for politicians (both Democrats and Republicans) to start with the massive hand-outs. Since then, we’ve had one trillion-dollar program after another – almost too many to remember… The National Debt is now $28.8 trillion and will approach $30 trillion once the so-called debt ‘ceiling” is lifted, as has always been done in the past…” All of this new federal debt has been accumulated during a period of radical open-market operations by the Federal Reserve, a departure from previous governance in Washington that has seen the central bank’s balance sheet double over the past two years. The Federal Open Market Committee has discussed tapering purchases of mortgage-backed securities (MBS), but purchases of Treasury debt likely will continue in order to maintain liquidity in the system. Thus our next question for Chairman Powell: Q: If the FOMC tapers purchases of MBS, will they allow the SOMA to shrink as the mortgage bonds run off? Agency and government MBS are prepaying at 25-30% annual rates or CPR. So figure net shrinkage of $600-700 billion annually? In the past, when the FOMC attempted to reduce the size of the SOMA, liquidity disappeared from the money markets and then an equity market tantrum occurred soon thereafter. The chart below shows the $8 trillion SOMA and reverse repurchase agreements (RRP), which drain cash out of the markets and peaked around $1.6 trillion on September 30th. Note that RRPs were also significant in the 2017-2018 period. The investors holding $1.6 trillion in RRPs with the FRBNY will presumably be willing to purchase similar securities as and when the COVID cash wave dissipates and the Treasury resumes debt issuance. The multi-trillion cash pile that the Treasury accumulated last year is now visible in RRPs, thus, if anything, there continues to be a surfeit of demand for risk-free assets. The question is how can the FOMC rebalance the supply-demand equation without spilling the proverbial punch bowl onto the floor, as happened at the end of 2018 and in September 2019? Where would US interest rates go if the Fed stops at ~ $8 trillion in SOMA assets and simply replaces Treasury securities as they mature on the central bank’s balance sheet? We suspect that benchmark interest rates would fall, but with much greater volatility. And since the Treasury is now the largest issuer in the US bond market, we may yet test the limit of investors’ appetite. If the Fed tapers MBS purchases and Biden's spending plans are greatly reduced, for example, there may yet be an imbalance between demand and supply. For the same reason that bitcoin is surging towards $100k, the “silent majority” of investors, to borrow a Nixonian phraseology, seems willing and indeed anxious to purchase the IOUs of Uncle Sam. The same can be said of agency and government MBS, as well as whole loans and even MSRs. Note too that corporate (aka "junk") debt issuance has gone vertical over the last three months, driven by strong Buy Side demand. Meanwhile, issuance of federal agency securities, municipals and ABS continue to be weak. During our trip to San Diego last week, we heard tales of JPMorganChase (JPM), PennyMac (PFSI), and other large depositories and IMBs, buying conventional MSRs at 5-6x annual cash flow or 125-150bps. The buyers are looking to replace assets that are running off their servicing books at a brisk 25% of total assets each year. One downside of financial repression via low or zero interest rates is that the duration of securities eventually goes to zero as well. This relatively high runoff rate for financial assets is seen not just in residential MBS, but is visible in all manner of commercial loans and housing assets. Even with the backup of the Treasury yield curve over the past month, rates remain very low by historical standards. Even government MSRs guaranteed by Ginnie Mae are going at levels well above fair value, suggesting to some that the irrational exuberance has gotten a bit silly. The strategy operating for a bank or nonbank to pay 150bp for a conventional MSR includes the value of the option to refinance the mortgage, an obvious consideration that strangely is not recognized by GAAP. The folks at the Securities & Exchange Commission and the Financial Accounting Standards Board don’t recognize the optionality of in-the-money loans within an MSR. Go figure. But more to the point, the MSR is a negative duration asset with cash flow. The option to create new duration in terms of a new mortgage loan seems a contradiction, but a good one. The old MSR disappears, two new assets are created and, let us recall, a gain on sale occurs for the new mortgage note. Send regrets to the MBS investor who receives a prepayment at par. What seems apparent, however, is that there is still a large crowd of banks and nonbanks willing to pay premium prices for MSRs or loans on the basis that there are going to be opportunities to refinance those loans at lower rates. This is not to say that everyone is a buyer of mortgage assets today. But there remains a large crowd of investors willing to play interest rate roulette with the FOMC. There are a number of notable exceptions, including Texas Capital Bancshares (TCBI) , which has recently sold much of its MSR book . A growing crowd of independent mortgage banks, large and small, are sellers as well as they seek to raise operating cash. Even with a rising tide of sellers, however, supply is unlikely to meet demand for mortgage assets anytime soon. The global crowd chasing returns in fixed income assets is big and unlikely to be satiated in the near term, thus we continue to see lower rather than higher rates ahead. Sure, the FOMC is going to pay lip service to inflation for a while. Yet when the economy slows and the ratio of job seekers begins to equal job openings – currently 1:1.5 today -- look for bond prices to rally, interest rate benchmarks to fall and stocks to swoon, including our favorite ersatz equity play, bitcoin. Then we'll want to hear an answer to our last question for Chairman Powell: Q: What is the target size for the SOMA over the next 36 months? Source: FDIC The dynamic created between the Treasury's fiscal operations and the size of the SOMA is imponderable and a likely source of future market volatility. If the FOMC allows the SOMA to shrink, then reserves will fall along with bank deposits. That's why we think the FOMC needs to provide guidance to the markets as to the expected size of the SOMA over the next several years and especially if the FOMC ceases purchases of MBS. Rates may even rise in the near term if market liquidity comes into question. But look for the FOMC to act early and go big in terms of forward repurchase agreements, to add cash to the markets through or by going around JPM and the other zombie banks, at the first sign of liquidity stress. After all, the last thing that the debt or equity markets need at the present time is another Fed-induced tantrum.

October 22, 2021 | In this issue of The Institutional Risk Analyst , we take a look at one of our favorite large banks, Western Alliance Bancorp (WAL) of Phoenix, AZ. We wrote about WAL in February (“ Western Alliance + AmeriHome = Big Possibilities ”) and the $50 billion bank holding company proceeded to lead the large bank group in terms of equity returns. In this edition of the Premium Service of The IRA , we compare WAL to some of the largest banks in the US. No surprise, the comparison is more flattering for the smaller institution. WAL illustrates why the largest banks are “dead money,” to paraphrase Kevin O’Leary speaking on CNBC , but super regionals continue to create significant value for customers and shareholders. WAL reported Q3 2021 earnings yesterday after the close. In Q3 2021, net income was $236.9 million and earnings per share of $2.28, up 74.4% and 67.6%, from $135.8 million and $1.36, respectively. Net revenue was $548.5 million, an increase of 79.7%, or $243.2 million, compared to an increase in non-interest expenses of 88.4%, or $109.7 million. As we’ve written previously, the acquisition of AmeriHome Mortgage from Apollo Global Management (APO) has created big value for WAL shareholders. The AmeriHome transaction closed in April of this year. For those not familiar, AmeriHome is one of the leading aggregators of conventional loans in the secondary market and is head-to-head with the likes of PennyMac Financial (PFSI) and the largest banks to buy 1-4 family mortgage loans. Let’s look at WAL vs. the largest US banks to get a sense of just how much better this $50 billion depository performs vs these institutions and Peer Group 1, which includes the 130 largest US banks. First let’s look at credit loss rates as measured by the FFIEC. As you can see, WAL’s net charge-off rate is a fraction of that normally seen for its larger peers. And this stellar credit loss performance has been the norm for WAL going back many years. Note WAL’s net loss rate of 0.01% of average assets in Q2 2021 vs the 0.13% average for Peer Group 1. Source: FFIEC Next, we turn to the gross spread on loans and leases, which reflects how the bank is able to price its loans in the market. Again, WAL outperforms Peer Group 1 and even bests JPMorganChase (JPM) by a wide margin. Not only does this reflect the superior operating performance of WAL, but also highlights how smaller banks tend to have better loan pricing power than larger banks. Look at the comparison between WAL and laggards such as Bank of America (BAC) and Wells Fargo (WFC) . WAL’s net interest margin of 3.43% at Q3 201, compared to 3.71% a year ago, illustrates the intense margin compression experienced by all US banks due to the Fed’s radical monetary policy. Yet that performance puts WAL in the top third of Peer Group 1. Source: FFIEC After the bank's gross loan spread, the next factor to ponder is funding costs. Again, WAL has a superior funding profile despite the fact that this bank is tiny in terms of total assets vs U.S. Bancorp (USB) and other large banks. Indeed, only JPM and PNC Financial (PNC) had lower funding costs over the past year – a remarkable metric. Since closing the AmeriHome transaction, WAL’s core deposits have grown to $40 billion or 80% of total assets, including $20 billion in non-interest-bearing deposits. Source: FFIEC Finally, we look at the bottom line, net income vs total assets. Not only does WAL exceed the returns of JPM and other large banks, but does so by a wide margin. Note too that WAL was delivering this above-peer performance before the acquisition of AmeriHome. One reason for this strong operating profile is that the bank’s level of loans vs total assets is ten points higher than the average of Peer Group 1 and has been going back at least five years. The team at WAL understands how to maximize operating leverage while maintaining stellar credit performance. Another reason for the strong performance is the low operating expenses, with an efficiency ratio of 44% vs the Peer Group 1 average of 58% calculated by the FFIEC. Source: FFIEC WAL has significant double leverage (116%) at the parent level vs an average of 103% for Peer Group 1 but no short term debt or trading exposures. We expect that the bank will pay down the term debt incurred for the AmeriHome transaction and return to the peer average level that existed prior to the acquisition earlier this year. WAL's payback on this double leverage (Equity investment in subs – equity cap / Net income) is 80% vs 25% on average for Peer Group 1, another indication of the bank's strong operating profile. WAL grew assets 53%, capital 30% and net loans and leases 38% through Q2 2021 as a result of the AmeriHome transaction, making WAL one of the fastest growing banks in the country. Bottom line is that WAL is one the best performing small banks in the US based upon equity market valuations and growth rates. Among asset peers, only the unitary Signature Bank (SBNY) performed better over the past year, as shown in the chart below. We’ll be profiling SBNY in a future report. In the meantime, keep your eyes on WAL as a bellwether for the US banking sector as well as the world of mortgage finance, where the bank is now one of the dominant players in aggregating conventional loans in the secondary market. 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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