July 10, 2018 | Last week we posted a snippet from Rob Chrisman’s housing finance blog about former Fed Chair Janet’s Yellen being "puzzled" due to the lack of home ownership by Millennials. The ensuing reaction was an order of magnitude above our normal level of discourse, leading us to think that there is a raw nerve among Americans when it comes to home prices. Here is the Chrisman excerpt: I found this note sent to me a few years ago by John Hudson by Roy DeLoach of the DC Strategies Group titled, "Hang-in there, Millennials - The New Sub-Prime Mortgage Wave Is Coming." Roy is a former CEO of the National Association of Mortgage Brokers. "Hang in there, Millennials and all you other wanna-be first-time buyers still residing in Mom's basement. The Federal Reserve, Fannie Mae and Freddie Mac could soon be riding to your rescue. Well, not just your rescue, but perhaps more importantly, to save the economy, too. Which is the real reason they want you to take your 'rightful' place in the chain of life known far and wide as the 'Housing Ladder.' "Actually, Fed Chairwoman Janet Yellen is perplexed 'why so many Millennials choose to rent' rather than purchase a home. There was a collective chuckle in the room when I heard her make that statement at a recent House Financial Services Committee hearing. I only pray there are some in Washington who are not only not as confused as the Fed Chair, but also are seeing the very same statistics I am looking at and coming up with the same answer. The way I read the tea leaves, housing is in deep trouble and will likely fall apart sometime in late spring 2016 -- just in time to become an election year issue." In terms of housing market operating dynamics, De Loach was accurately describing the internals in the world of lending and servicing residential loans. But like many of us in the industry, he could not know just how high the Fed’s bond market manipulation via QE would take home prices. In the new edition of The IRA Bank Book, we describe the continued distortion of credit loss metrics in both residential and multifamily asset classes. Eventually, these metrics will revert to the mean and beyond. The importance of the fact that US bank credit metrics are showing essentially zero cost in residential lending from portfolio loans is that it begs the question as to home price valuations and thus loan-to-value (LTV) ratios. A number of analysts have predicted an imminent reset in terms of home prices, but this has not happened for several reasons. The chart below shows the Case-Shiller average for US home price appreciation. First, real estate is a local market, so generalizations such as Case-Shiller are dangerous. New York City has been slumping for the past two years, but other markets around the country such as Denver remain hot. The work of Weiss Residential Research clearly shows a turn in some major urban markets that have been moving higher since 2012 and before. But these moves seem more a function of buyer exhaustion than a permanent move to a buyers market. They key factor is cheap money chasing a limited supply of homes. Second, the US home market is in a classic supply squeeze. Referring to the work of Laurie Goodman at Urban Institute, the US is adding less than 1 million new units per year net of attrition of obsolete homes. Basically, new household formation is 50% higher than the growth in new housing units. More, the Fed’s manipulation of interest rates and credit spreads encouraged Wall Street to allocate capital to buying residential homes as rental properties, further limiting supply of homes available for sale. Net, net, Millennials have been priced out of the housing market because the omniscient souls on the Federal Open Market Committee think that boosting asset prices will lead to more spending and job creation. Instead, low interest rates and help from the GSEs (Fannie, Freddie and Ginnie) have driven up home prices beyond the reach of many home owners in major metro areas. Ed Pinto and Paul Kupiec wrote in The Wall Street Journal in March 2018: “Since mid-2012, real home prices have increased 28%, according to data from the American Enterprise Institute. Entry-level home prices are up about double that rate. In contrast, over the same period household income has barely kept pace with inflation. The current pace of home-price inflation is increasing the risk of another housing bubble.” Lenders will be happy to hear that home owners are not even tapping the increased equity in their homes as in the 2000s, one reason why home equity loans (HELOCs) continue to shrink by double digits as a bank asset class. CNBC’s Diana Olick had a good segment “More homeowners leaving home equity untapped” on Monday. Given the Yellen Inflation in home prices, the question for lenders, of course, is how much to discount home prices over a 15 or 30 year time horizon? This week we got to sit with one of the leaders of the mortgage finance world. The conversation eventually turned to credit. The consensus was that a recession in 2020 was not necessarily going to bring significantly elevated credit loss rates, but that by the mid-20s credit costs would be rising appreciably. We continue to point to 2015 as the trough for credit costs at US banks generally and note that more normal portfolios like commercial and industrial loans (C&I) are showing rising defaults and loss rates, what you would expect at the end of a Fed-induced boom. But meanwhile in the world of mortgage finance, things are anything but normal. Just look at the intense competition among JPMorgan (JPM) and the other megabanks for non-bank fiduciary balances in the commercial deposit market. The FOMC has indicated that short-term interest rates are rising, but long-term benchmark rates such as the 10-year Treasury bond are falling. Because of this move in long-term yields, modeled valuations for mortgage servicing rights (MSRs) will likely fall this quarter, requiring “fair value” adjustments to capital and income. Meanwhile, MSRs are trading in the secondary market at record cash flow spreads, in excess of 5.5x annual cash flow for conventional servicing. And the cost to originate and service loans has never been higher. If this environment of extraordinary high prices and low operating spreads is intended to be helpful to the housing finance sector, then we respectfully suggest that our friends on the FOMC ought to think again. Sadly, even as home prices have surged, none of the FOMC’s promised benefits have materialized when it comes to jobs, income or overall GDP growth. Indeed, the increase in home prices has locked-in many empty nesters in states like CA and NY. The big question: Is the Yellen Inflation in home prices permanent? Further Reading Bank Earnings & QT: Mysterious Shrinking NIM https://www.zerohedge.com/news/2018-07-04/bank-earnings-qt-mysterious-shrinking-nim The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. 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.

July 1, 2018 | Last week The Institutional Risk Analyst attended an evening presentation by Professor Edward Altman of NYU Stern School of Business at The Lotos Club of New York. Entitled “The Altman Z-Score After 50 Years: What is it Saying About Current Conditions & Outlook for Global Credit Markets,” Professor Altman’s comments were as usual understated and entirely on point. “Fifty years ago, we published the Altman Z-Score,” Dr. Altman told the audience of friends, colleagues and former students. “Frankly I am as surprised as anyone that it is still around.” The five factor Z-Score model published by Dr. Altman in 1968 is shown below: Dr. Altman attributes the longevity and, indeed, growing popularity of the Z-Score to the fact that the model is simple and easily replicated, and the fact that is works. “Empirical finance models generally have a half life of a couple of years…. But if the model is simple, easy to replicate – and replication is really important in scholarly finance – and is accurate, then other researchers start to compare their models to the simple model.” “The other reason that the model is still around is that it is free,” Dr. Altman notes. According to its founder, the Altman-Z Score has predicted roughly 80-90% of all non-financial bankruptcies since it was first published. The Z-Score is entirely public source and is used without commercial restriction in business, corporate finance and investing. Needless to say, the Z-Score and its derivatives generate a lot of traffic online at portals such as Bloomberg, Credit Risk Monitor and S&P. “All I wanted was one penny [per hit],” Dr. Altman says of his elegant creation, which is “simple, accurate and free.” Invoking author Malcom Gladwell’s book “Outliers,” Altman says that his work would have been created by another researcher as computers became more wisely available in the 1960s. “It is really important to be in the right place at the right time,” he observed. This confirms our judgment in “Ford Men: From Inspiration to Enterprise that luck is the most important thing in life. Dr. Altman witnessed the birth of the high yield or “junk” bond market in the early 1980s, a market that encompassed the world of sub-investment grade credits. “The market in 1982 was about $10 billion and comprised of fallen angels, companies that were beautiful at birth and investment grade, but like all of us as we get older we get ugly,” says Altman. “We lose our hair, we get wrinkles and we get downgraded.” Since that time, the Z-Score has been incorporated in corporate and bank risk models for corporate default or “mortality” as Dr. Altman likes to say. In particular, the three zones of “safe,” “grey” and “distress” in terms of credit originally defined by Dr. Altman are now widely disseminated and accepted as benchmarks. He explains the evolution of the model and its use: “The guidelines we established back in 1968 were the so-called zones. Above 2.99 the firm was in the safe zone. Below 1.8, in the distressed zone with a highly likely probability of bankruptcy. By the way, above 3.0 and below 1.8 the Z-Score had a 100% accuracy back in 1968. The model was built for manufacturing companies and in those days big companies did not go bankrupt. Things have changed. The zones are enshrined on the Internet, on Google and Wikipedia, but the problem is that they are no longer appropriate. But that doesn’t keep people from using it because its on the Internet and the Internet is always right.” Dr. Altman explains that there has been an incredible migration of risk in the US economy over the past fifty years reflected in the increased debt leverage in the system. He notes that when the high yield debt market was born, the market was measured in single digit billions, but today the total junk debt outstanding is $3 trillion globally and more than half in the US. Likewise leveraged loans did not exist, but today this is a $1 trillion market that fuels much of the total non-investment grade debt issuance. Altman also believes that the fact of global competition and capital markets has led to more, larger bankruptcies. “In a good year there are roughly 50 bankruptcies of companies with assets more than $1 billion, what we call billion dollar babies,” notes Altman. “As a scientist in this area, I love bankruptcies. Already this year, in this benign credit cycle, we’ve had 14 billion dollar bankruptcies.” Altman states that as the amount of debt leverage has increased in the global economy there has been a compression of credit ratings: “How many 'AAA' rated companies in the US? Two. Johnson & Johnson and Microsoft. Two left. Why is it that there are not more 'AAA' rated companies? Leverage.” The migration of companies down to “BBB” ratings simply reflects the fact of more debt and the desire to stay this side of the line of investment grade. “What rating would you like to be as the chief financial officer of a company,” ask Altman. “We did a survey many years ago and the answer was ‘A.’ What is it today? ‘BBB’ The ‘BBB’ category is exploding. That is the preferred rating. Why? Because if you are ‘A’ it means that you are not exploiting low cost debt. If you are ‘BBB,’ it means that you have higher effective returns for your shareholders. This is why over the past fifty years credit risk has migrated from very low to very high. It has exploded into a global debt bubble and this is not just companies. It's governments and households.” Turning back to mortality, Altman spoke about how “life expectancy changes over the life of a person or a company – what we call contingent probability. In financial markets much like real life, promises are made to be broken. How do you break a promise? You default. You don’t pay back as promised. When assessing default probability, we’ve got gorgeous ‘AAA’s, handsome ‘AA’s, decent looking ‘BBB’s, not so good looking ‘BB’s, and downright disgusting ‘CCC’s. And people have been buying those disgusting ‘CCC’ bonds with great frequency over the past five years.” Dr Altman notes that “we are in a benign credit cycle” and that non-financial corporate debt levels vs. GDP are back to 2008 levels, yet default rates remain low – below 2%. Indeed, the Z-Scores for corporate issuers have risen from 4.8 in 2007 to 5.1 in 2017 even as debt levels have grown. He also notes that high recovery rates for bond and loan investors, plus low interest rates and credit spreads, and ample liquidity, are all signs of benign credit cycle “that has gone on, incredibly, for eight years.” And yet Professor Altman is hardly sanguine about the immediate outlook. “We have been in a ‘risk on’ cycle, meaning easy money and brisk buying,” Altman observes. “Risk on means that people forget risk and take a lot more exposure to get higher yields in this low-rate environment. Using a baseball metaphor, we are in extra innings with respect to the benign credit cycle. Investment grade debt has been exploding since 2007 and high yield debt is also up. A lot of this money is being used for corporate stock buybacks.” “Shrinking equity and exploding debt is a disaster waiting to happen – and it will happen if we have another recession,” Altman concludes. “And we will. Its just a matter of when. I’m not a forecaster of economic activity, but surely given the accumulation of debt, if we have a recession then we will have another credit crisis. It may not be as big as 2008, which was more focused on households. This time the risk is more in the corporate area. But unless things change in terms of market discipline, we are going to have some very nasty repercussions in the debt markets.” The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. 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.

June 26, 2018 | During our fishing trip to Leen's Lodge last week, there was a lot of discussion about the markets and whether the Fed is going to successfully manage the return to normalcy. Our bet on that question is “no” as we noted in a missive yesterday by Jeff Cox of CNBC: “The Fed's effort to control the rise of its key interest rate is running into some problems.” Dr. George Selgin of Cato Institute has a timely new paper appropriately entitled "Floored" that discusses this issue of the FOMC using interest on excess reserves as a “floor” for the Federal funds rate. In the paper, Selgin talks about “how the Fed’s floor-system experiment came about, what its intended and actual consequences have been, and why either the Fed itself or Congress should bring the experiment to an end as rapidly as can be done without causing further economic damage.” Instead of reviving the private market for Fed Funds, the FOMC has used Basel III and paying interest on excess reserves or “IOER” to turn the trading of short term funds into a lab experiment. Instead of creating a traditionl “corridor” system for managing short-term rates, with IOER near the bottom of the policy range and the discount window rate at the top, the FOMC opted for a more radical experiment. Selgin notes: “Had [the FOMC] actually employed interest on reserves to establish a proper corridor system, as it planned to do in 2006, and even had it allowed interest to be paid on excess reserves with that aim alone in mind, paying interest on reserves wouldn’t have constituted a radical change. But as we shall see, when the Fed actually put its new tool to work, a corridor system was no longer what it had in mind.” Selgin cites some revealing passages from former Fed Chairman Ben Bernanke, who justifies the need for paying interest on excess reserves to prevent interest rates from falling too low. “[By] setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much [emergency] lending we did,” stated Bernanke in 2015. Was Bernanke’s comment an admission that negative rates are as a general matter undesirable? Perhaps. Selgin notes: “Although they were keen on providing emergency support to particular firms and markets, Fed officials recognized no general liquidity shortage calling for further monetary accommodation. The challenge, as they saw it, was that of extending credit to particular recipients without letting that credit result in any general increase in lending and spending…. for the most part the Fed was counting on IOER to encourage banks to accumulate excess reserves instead of lending them.” So even though the FOMC saw "no general liquidity shortage," they continued with extraordinary measures. Selgin’s paper makes clear that the FOMC had no firm idea how the use of IOER as a floor for interest rates would impact the markets and the US economy. In particular, the idea of using IOER as a way to dissuade banks from lending illustrates the speculative and, indeed, irrational nature of FOMC deliberations. As the renowned physicist Richard Feynman states: “It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong. In that simple statement is the key to science.” But of course economics is not a science, a fact illustrated by the Fed’s decision to pay IOER in combination with massive open market purchases of Treasury paper and mortgage backed securities. There is some support for the idea that the decision by the Fed to use IOER as a floor for interest rates negatively impacted bank lending and economic growth, as shown in the chart below. Source: FDIC There are many factors affecting the growth rate for loan portfolios, but what the data from the FDIC clearly suggests is that the surge in bank deposits seen from 2012 onward was not matched by a commensurate increase in bank lending. Also, as we’ve discussed previously, sales of loans by US banks have declined 10 fold since the mid-2000s. Again, Selgin: “The Fed’s decision to switch to a floor system at a time when equilibrium market interest rates were collapsing, and to do so with the aim of propping-up its policy rate to keep it above the zero lower bound, contributed to the severity of the recession, while limiting the Fed’s options for promoting recovery. Thanks to it, the U.S. economy has been in the grip of an above-zero liquidity trap since the trough of the Great Recession.” Although the impact of the Fed’s policies with respect to paying interest on excess reserves has generated a great deal of debate in the economics community, the other aspect which has received far too little attention is how quantitative easing impacts long-term interest rates. The Federal Open Market Committee was sold a bill of goods by the staff of the Board of Governors and FRBNY chief Bill Dudley. Specifically, we hear that Simon Potter, Head of the Markets Group at the Federal Reserve Bank of New York, (and Dudley) told the FOMC that they could hold any quantity of reserves indefinitely as long as they could do reverse repo operations to set a rate floor to accompany the ceiling rate system (interest on excess reserves or IOER). The Potter-Dudley assertion that short-term REPOS can suffice to manage any amount of excess reserves seems to be refuted by experience, however, especially given the combination of IOER with aggressive open market operations (aka “QE”). “The correct strategy all along would have been for the Committee to pause at 1.5% for Fed funds (2 hikes ago),” notes former Fed researcher officer Walker Todd. “The Fed could then begin to sell off the mortgage backed securities until the resulting long end rate increases began to put upward pressure on the Fed funds rate. Then the Fed would be in the more comfortable situation of following the market upward instead of trying to lead against market résistance, which is what is happening now.” As Chairman Powell and the FOMC raise the interest rate floor, the size of the Fed’s portfolio seemingly prevent long-term interest rates from rising. The securities holdings of the Fed and other global central banks are entirely passive, with no trading or hedging operations to influence long rates to rise, thus the spread between short term rates and longer maturities is shrinking rapidly. Unless the FOMC relents and starts to actively manage longer-term rates by selling securities and/or swaps and futures, the Treasury yield curve is likely to invert by year-end. In the event, the financial markets will react negatively and force the FOMC to delay any further rate hikes until long-term interest rates actually start to rise of their own volition. Until then, the short-term liquidity trap created by the Fed’s misuse of IOER will be a continued obstacle to policy normalization, on the one hand, while the Fed’s massive QE portfolio will act as a cap on long-term bond yields. And the FOMC has yet to admit publicly that they indeed have a problem of their own special creation. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. 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.

June 9, 2018 | Back in April we published a comment, "Bank Earnings & Financial Repression," that introduced the concept of the Financial Repression Index. In a related working paper available on SSRN, "The Financial Repression Index: U.S Banking System Since 1984," we define the index, which essentially shows the distribution of bank interest income between debt investors and bank shareholders. At the end of Q1 2018, almost 84% of all income earned by banks on leverage went to bank shareholders as a result of the Fed's policy of "Quantitative Easing," while the remainder went to depositors and bond investors. Thirty years ago, that situation was reversed. The secular decline in US interest rates has very clearly been paid for by depositors and debt investors, while the share of interest earnings apportioned to bank equity investors has grown. In the 1980s, almost three quarters of bank earnings on loans and investments flowed to depositors and bond investors. As recently as 2008, the distribution of profits was roughly 50/50. The chart belows shows the Financial Repression Index updated through Q1 '18. Notice that the index has now turned downward after peaking at 90% of bank interest income allocated to equity holders. With bank interest expense growing more than 50% year over year, net interest margin for banks will flatten and eventually turn negative in 18-24 months -- perfect timing for the next recession in the US. The chart below shows the components of net interest income for all US banks through Q1 '18. Source: FDIC Craig Torres of Bloomberg reported last week that former Fed Chairman Ben Bernanke, the father of QE, predicted that the US economy is headed for a recession by 2020. Thanks Mr. Chairman. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. 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.

June 19, 2018 | Even as the Federal Open Market Committee raised short-term interest rates last week, the Trump Administration doubled down on trade war to gain leverage in the midterm elections loom. The markets have not reacted well to the bellicose language coming from the White House, with financials in particularly under-performing the markets. But you don’t need to look very far to understand the travails affecting the US banking sector. One reason why banks are selling off is the prospect of significant layoffs and operating losses in the mortgage sector. Rising costs and tight production spreads have driven the mortgage industry into the red this quarter, with many shops not even meeting minimum production levels to achieve break even. Rob Chrisman warned in his weekly comment that he expects to see at least one large bank shedding “thousands” of people this summer because of the combination of tight spreads and the over $8,000 per loan cost of new residential originations. Another, more important reason for fading on the US large cap financials, particularly given the extraordinary run last year, is that the easy growth for the industry is at an end, both in terms of loans and deposits. We had a fascinating conversation last week with Lee Adler, proprietor of The Wall Street Examiner, about the “extinguishment” of reserves as the Fed’s Quantitative Easing treasure trove runs off. Adler contends that the runoff of QE means an end to the easy deposit growth seen by US banks over the past half decade. “Under QE Fed lent money to Treasury in the form of note and bond purchases,” Adler explains. “By redeeming the notes and bonds as they mature, the Fed is effectively calling in those loans at the pace of $30 billion per month now, going to $40 billion in July, and 50 in October. Treasury pays the Fed off with cash it raises in additional note and bond sales. Investors bought the bonds with their bank deposits." "Those deposits are extinguished when they are withdrawn from the investors' accounts, go into Treasury account, then from Treasury account to Fed to pay off the maturing paper," Adler continues. "The asset disappears from the Fed's balance sheet, and so does the bank reserve deposit because the bank's customer used it to buy the new bonds. The new bonds now exist, but the money used to purchase them was extinguished when the Treasury used it to pay off the Fed.” “Deposit growth is slowly grinding to a halt, adds Adler. “It should go negative in the next couple months, especially if ECB makes more cuts in QE. Some of the ECB QE money was flowing instantly to US. Since ECB went from 60 to 30B QE their deposit growth has also slowed and less money flowed to US to buy bonds and stocks.” And sure enough, Alder’s prognosis is confirmed by the data from the FDIC, which shows that bank deposit growth has basically dropped to near zero over the past year. The chart below shows quarterly deposit growth rates going back to the mid-1980s. Notice that even during the years of aggressive Fed asset purchases, bank deposit growth rates were modest after the initial fear surge in non-interest bearing deposits after the 2008 debacle. Source: FDIC Of course, weak loan demand is another reason why deposit growth has been relatively restrained in this cycle. What demand has existed was focused on the hotter metro markets, which are starting to evidence late stage buyers fatigue. And as we’ve noted previously, bank regulators have been tapping the breaks on residential and multifamily credit for several years now. We also are reminded once again that there is no national market for residential real estate in the US. The folks at Weiss Analytics, in fact, confirm that with their latest data. Weiss Analytics reports that red hot metros such as Las Vegas, Seattle-Tacoma and Denver-Aurora are starting to see a decline in the number of transactions with rising home prices. In 2015-2016, these markets were at one stage showing virtually all home sales with rising prices, a measure of the enormous asset price distortions caused by the FOMC in the real estate sector. Just by coincidence, credit costs of the decidedly prime residential loans owned by US banks bottomed in 2015. Performance of first-lien mortgages remained unchanged during the first quarter of 2018 compared with a year earlier, according to the Office of the Comptroller of the Currency’s (OCC) quarterly report on mortgages. But what the data from Weiss Analytics suggest is that the heady sellers market of 2016 is rapidly changing two years later. The table below shows the percentage of sales in different markets where prices were rising. If our colleagues at the Fed and OCC want a list of markets where banks are likely to face credit challenges in the next few years, they could do well to ponder the list above, which features some of the highest price volatility numbers of any residential asset markets in the US. And notice that the exurbs north of Washington DC are in a state of collapse, a sure sign that these recession proof venues are about to flop into a tenants market. We’ll bet dinner at 21 Club that the loss given default (LGD) for these hyperbolic residential markets is close to zero or lower, as is the case currently with bank-owned multifamily exposures. With LGDs nationally for US bank owned residential exposures still in the 20% range vs the long-term average of 65%, it is pretty clear that credit costs in residential will rise in the future as the Fed continues to tighten credit and the US economy slows. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. 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.

June 11, 2018 | Dale Hemmerdinger is the consummate New Yorker. He is a real estate executive and active public citizen. He oversees the properties and service subsidiaries of his family real estate company, ATCO, as well as its parent company, The Hemmerdinger Corporation and The Hemmerdinger Foundation. In 2007 Governor Eliot Spitzer nominated Dale to serve as Chairman of New York’s Metropolitan Transportation Authority. He formerly served as Commissioner of the New York City Conciliation and Appeals Board during the Administration of Mayor Ed Koch. Dale is active in many public and private organizations in New York and is known for his honest and incisive perspective on the political economy. The IRA: Dale, thank you for taking the time. Let’s start with your perspective on the New York real estate scene. How do you put the boom of the past decade into perspective? Hemmerdinger: There have been a number of cycles over the years. New York tends to follow the direction of the national economy but it also has its own real estate cycle. Like many other businesses, when times are good the lenders tend to lend and the builders tend to build – often too many buildings all at once for the demand. Demand for any type of real estate at a given moment is difficult to determine. What tends to happen, when there is a real need for office space or residential space, we all tend to build together and therefore we build too much. The IRA: Certainly looks that way. Are landlords actually getting squeezed at the moment and contrary to the popular press? Hemmerdinger: In the 2008 down cycle, we had a squeeze on rents for almost everything in New York. In the financial business, the situation was even worse. The overhang of office space in New York that was no longer needed by banks, insurance companies and financial firms was huge. All of these constituencies were cutting headcount and reducing space. As the economy improved and we started to come out of the slump, there was a presumption that rents were going to rise at a very steep angle, which has been the history of New York real estate. In previous cycles, rents went up fast and higher than before. This time that really didn’t happen. The slope was very gradual if positive at all. The IRA: That certainly does not track with the rising rent narrative in other markets around the U.S. What happened to make New York different? Hemmerdinger: A decade ago the City and New York State changed the law regarding what you could build with how much state subsidy, etc. The threat of further change to things like the 421a exemption for affordable housing caused many developers with buildable plots to decide that this was the moment to build. The combination of this need for space together with a change in the law, these two things coming together, gave us the building boom you see today. All you need do is walk around the city to see the construction activity. And it is not only in Manhattan, but in Long Island City and the other boroughs. There is a huge amount of building for New York at a given time. The IRA: Long Island City is certainly amazing. Multifamily buildings, hotels and even retail along some of the side streets. Does this construction make sense economically in terms of the market for this new space? Hemmerdinger: It costs a lot to build in New York. The problem is whether there are enough people who can afford to move into this new space. There is no question that there is demand for the space, but at what price? That gap between cost to build and the rental market is going to be a big problem in terms of new residential construction. On the commercial side, we started this cycle with double digit vacancy rates already. Anything over 10% vacancy is what I call a renters market. Keep in mind that vacancy rates are determined by estimates from real estate brokers… The IRA: You mean like the way bankers in the City of London used to determine LIBOR? Hemmerdinger: It is an approximate number determined by the major brokerage firms. Thus anything over 10% in terms of published vacancy rates for commercial space is a tenants market. So we started this cycle with 11% vacancy and no surprise there is a lot of pressure on high-end commercial rents. The IRA: Are you referring to the Third Avenue corridor, for example, where there is ample vacancy for office space? Hemmerdinger: Glad you asked. That is one of the myths of real estate. The old buildings are actually terrific. It’s the middle layer of buildings in terms of age that have problems. Older buildings built before the age of air conditioning have high ceilings and windows that open. Very attractive for tenants. There’s a middle layer of buildings from the 1960s and 1970s where the ceilings were very low and are difficult to retrofit. That’s why you see some of the lovely older building around town being renovated. They are really wonderful properties and affordable for the tenants and amenable to modernization. You give me Rockefeller Center, which has high ceilings and beautiful windows, and we can make it as modern and attractive as any new building. The IRA: Agreed. Look at the renovation of the old New York Times building as another example. The location of older properties also tends to be better in terms of proximity to transportation. We started talking the other day about the new developments over on the West Side of Manhattan, which are absolutely beautiful buildings but a hike even from Penn Station. How do you see those properties positioning in an already glutted commercial market? Hemmerdinger: First thing, the public transportation to Hudson Yards is not adequate to make it work. It’s great for the chiefs who have cars or drivers, but it will be very tough for the regular people who go there every day for work. When I was on the MTA Board, I argued with Governor Spitzer that we should demolish the Jacob Javits Convention Center, which is now too small for events, and then redevelop the entire area with more transportation. We should have residential where Javits Center sits today and then a new convention center and business space going east towards Penn Station. But again the construction cost and also the politics intervened. The assumption that the area on Eleventh Avenue will gentrify and attract businesses is going to be very tough to achieve. They are doing a lot of deals to fill the space, but will these deals work over the medium to long-term? The West Side is very different from what Larry Silverstein is building downtown at the Freedom Tower. Everything is there; shops, amenities, transportation. The presentation is fabulous. The IRA: Given the amount of empty storefronts visible in midtown Manhattan, we agree that growing a healthy street level economy on Eleventh Avenue will be a challenge. But what about other areas of the City that are seeing a construction boom? Hemmerdinger: Ultimately it is the peripheral stuff that always has trouble. Its already starting in Long Island City where we have 16,000 new apartments. That is a lot. We are already dealing with an overcrowded subway system coming in from Queens, so there will be a transportation squeeze in Long Island City over time. The IRA: Long Island City is a barren urban landscape. Not much natural pedestrian traffic and the dominating shadow of the Queensboro Bridge. Very much like the West Side and particularly the High Line Park in some respects. There is only so much you can do to beautify Eleventh Avenue or Queens Plaza without a total redevelopment, correct? Hemmerdinger: Most of the most precious public spaces in New York like Central Park have evolved their own support networks over time. There are a lot of rich people who live around Central Park and pay directly though taxes and by donating to the Central Park Conservancy to maintain it. The Conservancy has done a fabulous job. Public fixtures like the High Line have a much smaller base of supporters, but funding from the community and also from real businesses, above and beyond public funds, is needed to make any neighborhood work long-term. The IRA: But why did we see the enormous scale of development in New York over the past 10 years? Even with the legal changes, it seems like the scale of development has soared compared with past cycles. How did the low level of interest rates contribute? Hemmerdinger: The first thing was the legal changes we mentioned before. Owners did not want to take the chance that future laws would be less permissive. Then interest rates were really low when all of these projects started. Also, there was an awareness that you could purchase air rights and create buildings that were really remarkable. The view of Central Park from the 80th floor is fabulous. You’re in the clouds sometime. So they were producing a product that was limited and very desirable. The problem is that you don’t make money selling the penthouse to a Saudi prince. The IRA: No? Hemmerdinger: No. You have to sell the middle of the building as well. Selling the properties that are not so glamorous at premium prices is the key. There is a real question as to whether there are enough people who can afford these new developments, which will likely put downward pressure on rents. My sense is that there has been enormous overbuilding at the price. You can already see the pressure on rents as unsold condo properties go onto the rental market. The IRA: So what is the outlook for New York City high end residential over the next 18-24 months? Our friend Jonathan Miller at Miller Samuel refers to it as “aspirational pricing” in the current market when it comes to offered prices. And he says capitulation could take years. Hemmerdinger: It is not a question of whether there is demand for the space. The question is can you afford to live there given the cost of rent, which is a function of the cost of construction? Building in New York is very expensive. I think things will get worse as more of these new condo projects come on line, are unsold and they end up in the rental market. If you remember three and four years ago, almost half of condominium sales were to out of town buyers. That flow of cash has slowed. Our experience is that the purchase market for high end properties is down about 10% from peaks of two years ago. When these condos don’t sell, the banks will force the developer to put them into the market as rentals. You will see increasing concession to buyers and falling rents for tenants as landlords try to at least fill buildings so they don’t feel like mausoleums. And then we will have a normal recession. The IRA: Nice. So what is coming in the event of rising interest rates and perhaps a slower economy? Do we have a crisis in commercial real estate in New York? Hemmerdinger: For projects that are not yet completed, they will be facing an increasingly hostile financing market. You can’t get out of a construction loan until you have a certificate of occupancy. Hopefully the developer has a take out for the construction loan, but the debt market is going to be very tough if rentals are soft and the purchase market is even softer. When it comes to prices, think of it as a cake. The top part of the market can squish the most while the bottom of the market will barely move. The higher the initial price of the property, the bigger the potential percentage drop in a down market. In the suburbs, for example, there’s a vigorous market up to a million dollars or so, then the volumes drop dramatically. Greenwich has a ten year supply of homes available for sale. But as you know I like to be optimistic, both about the property market and New York in general. The IRA: Thanks Dale The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. 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.

August 19, 2026 | Since 2024, the US markets have danced to the tune chosen by President Donald Trump, a song of irrational highs and frightening lows that has kept the entire world on edge. Nobody knows what Donald Trump will say or do from one moment to the next, including the commander-in-chief. In this issue of The Institutional Risk Analyst, we ponder the macro view as Trump II nears the halfway point. Oil prices are up more than 25% since the Iran war began on February 28, 2026. International benchmark Brent crude trades above $91 per barrel, driven by persistent supply constraints and shipping disruptions in the Strait of Hormuz, but prices for diesel fuel and other key oil byproducts are up even more. Heating oil is set to be a major pain point for consumers , driven by tight global diesel supplies, war in the Middle East, and reduced refinery capacity. The dollar, by comparison, is trading near multi-month lows against major foreign peers, driven down more by softening U.S. economic data and shifting Federal Reserve interest rate expectations than the geopolitical conflict itself. Gold prices have begun to climb again as it becomes increasingly clear that the Fed cannot and will not do anything to slow the upward creep of producer prices, this despite the verbal intonations from the central bank about fighting inflation. No surprise, global central banks continue to move out of Treasury securities and into gold. “The most violent oil shock in history came and went inside the first half of 2026,” notes Thomas Roderick, Portfolio Manager at Trium Epynt Macro Strategy. “While the matter is not yet settled, what it revealed matters more for gold than it does for crude… Something has changed in the plumbing of the world economy, and the asset with the most to gain from the change is not oil. It is gold.” Trump as Lame Duck Karoline Leavitt, the White House press secretary and one of the most public-facing officials in the Trump administration, announced her resignation last week. The steady flow of officials exiting the Trump Administration suggests that the beginning of the lame duck presidency is about to begin. With the prospect of the end of Trump II in sight, however, investors are slowly waking up to the fact that much of the economic damage done by President Trump in terms of higher interest rates and inflation cannot easily be undone. What is clear, though, is that the political reaction against four years of Trumpian destruction and general insanity will be broad and powerful, and will continue long after he departs the scene. If you want to see a likely image of the political future post-Trump, look at conservative Republican governor Brian Kemp and Democratic Senator Jon Ossoff in Georgia. Affordability has become the key issue on Main Street for members of both political parties. Fact is, Donald Trump has presided over the highest level of inflation since President Gerald Ford ran on a platform of repairing affordability in 1976 and lost the Presidency to another Georgia politician, Jimmy Carter. Take an example from Zohran Mandami’s socialist paradise in New York City. Median Manhattan rent reached $5,000 in July, up 6.4% year over year, according to Miller Samuel and The Real Deal. Available listings plunged more than 39%, the steepest annual decline in a decade. Brooklyn also tightened, with rents reaching $4,500 while inventory fell 27%. “A growing share of apartments are being marketed through private broker networks, paywalled platforms, or entirely off-market channels, reducing the inventory renters can actually see,” the Real Deal reports. “Some brokers are reportedly charging as much as $4,000 for access to hidden listings.” And rent increases are accelerating in many metros around the country. And yet even with the cost of living top-of-mind for many Americans, there are signs that the US is sliding into a housing market correction of epic proportions. We’ve been talking about a housing market correction around 2028 since we published our biography of Freedom Mortgage founder Stan Middleman, “Seeing Around Corners," in 2024. Remember Stan's prediction about US home prices: "Misery on the 8s." Mike Hawthorne writes in Substack: “In early July 2026, Florida had more than 215,000 active residential listings—roughly one of every seven homes for sale in the United States. Yet Florida contains only about 7.3 percent of the nation’s total housing stock. According to the Parcl Labs data behind those figures, nearly 45 percent of Florida listings had already received a price cut, and more than 10 percent were being offered below the price their owners had previously paid.” It may just be a coincidence, but it was 100 years ago that the bottom fell out of the Florida real estate market. The speculative bubble in Florida real estate described by John Kenneth Galbraith in “The Great Crash 1929” peaked in 1925 but finally collapsed in September 1926. FL real estate prices did not recover for 50 years. But today, the great speculative bubble is not found in Florida scrub land, but in Wall Street AI stocks and private credit. The Fed Passes on Inflation – For Now

August 17, 2026 | Updated | Some observers think that United Wholesale Mortgage Corp (UWMC) collapsed into the arms of Oaktree Capital Management, a unit of Brookfield (BN), last month because they erroneously hedged potential exposure from a REIT called Two Harbors (TWO), a company UWMC ultimately did not buy. But this is wrong. TWO was fully hedged already. United Wholesale Mortgage investors are accusing the company and its leaders of securities fraud over their public statements, or lack of, regarding the lender's ill-fated hedge. But the alleged "hedge" regarding the effort to purchase Two Harbors is not what led to the financial collapse of the largest residential mortgage lender in the US. During an August 6th earnings call, CEO Mat Ishbia addressed the hedge loss repeatedly, stating that UWM doesn't traditionally hedge its mortgage servicing rights but did so to "protect" against the risk in acquiring Two Harbors and its large MSR book. "We were over-hedged, if you think of it that way, protecting against the Two Harbors transaction," Ishbia said on the call. But this statement is false. In fact, UWMC collapsed because Mat Ishbia extracted hundreds of millions of dollars in cash from a company that was never really profitable. UWMC was run for volume, not profits. Indeed, his aggressive strategy for winning new residential loan business compressed profits across the entire mortgage industry. Debt and asset sales facilitated this canard. How did Mat Ishbia fool everyone for so long? Proceeds from Sale of Mortgage Servicing Rights ($000) Source: EDGAR If we look at the public filings of UWMC, and compare them with other mortgage lenders such as Rocket Companies (RKT) and PennyMac (PFSI), it is pretty clear that UWMC paid dividends with the proceeds of unsecured debt, overvalued assets, and sales of mortgage servicing rights (MSRs), often below cost. This scheme was encouraged with fanciful presentations of company financials to attract capital from credulous retail investors and support from equally imprudent analysts. In Q2 2026, for example, UWMC claimed to have a gain on sale of 133 basis points, which is 100% wholesale production. The comparable figure for PennyMac was 100bp and RKT was just 68bp. But wait, if UWMC was making so much more gain on sale than these other players, why didn’t RKT and PFSI pick up incremental market share? Because UWMC was overpaying for the loans. After all, UWMC has 40% market share. In fact, UWMC misrepresented their gain margin, as they call it, as revenue when it really represented a cash expense. UWMC had a stated gain margin in the 10-Q twice that of the other lenders. How did they do this? Were they really that profitable? The answer in the UWMC financials seems to be no. If we drill down into their 10-Q (all of this information is from public filings), another explanation emerges. UWMC basically said their loan production income was $527.2 million, and their "gain margin" was 133 basis points. So that implied they did $39.6 billion of loans sold in Q2 2026. The UWMC 10-Q says that they retained servicing on 95% of what loans they originated. This means that they retained servicing on $37.7 billion of originations. Their mortgage servicing rights or MSR table says they capitalized $1.04 billion, a little bit more, on that $37.7 billion in UPB. That implies 276.7 basis points of servicing retained. If we do a little bit more digging into what the average servicing strip was at the end of the quarter versus the beginning of the quarter, and what their sales were, what their amortization was, it appears that they retained a 47 basis point servicing strip on that $37.7 billion. This would imply that they retained the MSR on a 5.9x multiple of annual servicing income (~ 30bp) on loans with about a 50-50 mix of conventionals and Ginnie Mae. But is that multiple right? Today a 50-50 mix of conventionals and Ginnie Mae loans, in a secondary market loan sale, would be priced at a 4.5x multiple of annual cash flow. If you're lucky. This suggests that UWMC overpriced their MSR by 1.4x on that 47 bp strip, which by the way is about 70 basis points on unpaid principal balance (UPB) of the loan servicing retained. Take 133bp minus 70bp and this gets UWMC down into line with the gain-on-sale for RKT and PFSI. But here's the best part. In order to raise cash to staunch the red ink from operating losses, UWMC would sell MSRs into the secondary market below cost. UWMC would pay excessive prices for loans, sell the mortgage note into a securitization at a small cash loss but then sell the servicing asset at a 10-20% discount to secondary market cost, according to several national lenders. The result was a business that rarely made a profit. Net Cash (Used In) Provided by Operating Activities ($000) Source: EDGAR Now the gain on sale by RKT or PFSI in the wholesale channel is cash, but the “gain margin” reported by UWMC in Q2 2026 appears to be an accounting gain. RKT reportedly sells the servicing from loans originated in the wholesale channel because any effort at retention is futile. PennyMac retains its wholesale MSR, as they disclose, but they do not solicit that portfolio for refinance for 18 months. So if UWMC overvalued their new origination servicing, then obviously they're probably overvaluing their entire MSR portfolio. This is where UWMC apparently decided to take an interest rate bet -- not a hedge. If they won Two Harbors and rode the servicing up to the levels where UWMC’s MSRs were marked for leverage purposes with lenders, Ishbia would get more borrowing capacity. Viola. UWMC grew the fair value of MSRs 30% in the past six months, net of a $800 million cash sale. So let’s further assume based upon the public disclosure the UWMC book value multiple on the total MSRs held is 5.36x annual cash flow. Let's assume that that's maybe three quarters of a multiple overvalued or ~ 30bp. This suggests that the UWMC assets are overvalued by about $750 million. If UWMC took that actual mark to the fair value of the MSR, it would knock their tangible book value down to just $230 million. UWMC operates on a razor thin cash reserve compared to other large lenders and has $3 billion in unsecured corporate debt. Events of Noncompliance So what happens next? UWMC raised $1.65 billion at the end of Q2. A billion and a half from Oak Tree, $150 million from the Ishbia family. And the billion and a half is actually senior to the $150 million. There's an A1 preferred and an A2 preferred, for Oaktree and Ishbia, respectively. UWMC is supposed to do a “rights offering” in Q4 which is going to raise another $400 million. They will first offer it to existing shareholders as common stock at the greater of $2 or 85% of the weighted average price of the 10 days before November 12th of 2026. Unless the UWMC stock's trading above $2 by November, no common stockholder in their right mind is going to buy it. Then the deal says, any amount of the $400 million that we don't raise, UWMC can raise through Oaktree. Oaktree has the choice of either accepting the terms of the rights offering that is offered to the public. Or they can take a class A3 preferred equity, which has basically the same terms as the A1 and A2, but it's subordinate to both. Oaktree is not going to put another $400 million up subordinate to their existing position. As it is Oaktree may never recover their original investment. So then the agreement goes on and says if neither of those parities raise the $400 million, the Ishbias are obligated to fund the $400 million at the same terms as Oaktree. So they can either take common at the greater of $2 or 85% or the A3 preferred. Now this is where it gets really interesting. In the agreement with Oaktree, there is a provision referring to events of “noncompliance.” One of the events of noncompliance is if the tangible book value of the stock drops below zero when you exclude the preferred shares. Another occurs if the Ishbias fail to inject new capital when required. So let's say that Oaktree demands that the books of UWMC be cleaned-up and the MSR write-off is $750 million. Then net worth drops basically down to zero and Ishbia is a whisker away from an event of noncompliance. In that event, Oaktree gets to name the majority of the board and takes over the company. Allowing himself to be forced out of the company by not contributing another $400 million to the equity may be a convenient exit for Mat Ishbia. He could say he tried to support UWMC, but was forced out by Oaktree – this after putting in another $150 million in July. And Oaktree is left to try to salvage value from a mortgage lender that has not really been profitable going back years. Remember that UWMC sold $800 million in MSRs in 1H 2026, yet still the company required a $1.6 billion rescue. If Oaktree is now first in line in terms of dividends on its preferred shares, there will be nothing left for Ishbia or his long suffering common shareholders. Ishbia’s personal holding company, SFS, received hundreds of millions in dividends each year that were effectively funded with asset sales and corporate debt. But the big question now for the industry and Oaktree is how much does the business model of UWMC need to change in order for the company to be really profitable? Industry gain-on-sale margins have been compressed for years by UWMC’s excessive bids for loans in the wholesale channel. Will profitability return to the residential mortgage industry now that Ishbia is no longer calling the shots? And what will it take for Oaktree to recover their $1.5 billion investment in United Wholesale Mortgage Corp? The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. 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.

June 4, 2018 | Ever heard of the European Monetary Authority? Hold that thought. For more than a decade now, banks in Europe have been free-riding on sovereign credit support, a fact that has attracted more than a few foreign investors. With the political devolution now underway in Rome, however, Eurobanks have begun to trade again on their intrinsic credit. In an important new paper from The Institute for New Economic Thinking, Professor Ed Kane of Boston College states the problem succinctly using ratings from our friends at Kamakura: “[T]he recovery of European megabanks from the 2008-09 crisis has been incomplete. Creditors of Europe’s giant banks still seem to be relying on implicit guarantees. In particular, credit spreads on the bonds of these banks appear to be relatively insensitive to the level of the issuer’s longer-term probabilities of default. Coupled with the high pairwise correlation that KRIS default probabilities show between major US and European banks, this finding suggests that creditors do not expect the EU’s bail-in requirements to play much of a role in resolving megabank insolvencies during the next crisis.” Even before the 2008 financial crisis, global regulators were moving on a set of proposals that eventually became known as Basel III. When the discussions began in earnest, the ask from the US side was that Europe do something about non-performing loans in the banking system. The Europeans, for their part, insisted that housing assets – particularly evil mortgage servicing rights or MSRs -- be consigned to the bad bucket along with other supposed intangibles such as net loss carry forwards. Below is our discussion last week with Brian Sullivan of CNBC. The final Basel III document focused mostly on liquidity and capital, but neatly skirts the issue of credit quality. The US banking system is particularly strong when it comes to recognizing and liquidating defaulted loans, in large part because US banks generate strong profits and are able to resolve bad debts in reasonable periods. In Europe, however, banks are less profitable and debtors tend to have the upper hand. There are no bankruptcy courts in Europe. As a result, EU banks have tended to extended forbearance to defaulted obligors, particularly those with access to political influence. There are three pillars of the Basel bank supervision approach: (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. Most of these pillars are observed in the omission in Europe. Capital requirements, notably illustrated by the cases of Deutsche Bank AG (DB) and Montepaschi Group, are largely a fiction. Supervision is fragmented among the 28 EU member states. And market discipline in the EU is largely prohibited via explicit legal limits on short-selling and official “guidance” to banks, rating agencies and large investment firms. Since 2010 when the Basel III rules were announced, there has been a steady but painfully slow recognition by the Europeans that something needs to be done about credit quality and therefore bank solvency. In March of 2018, the European Central Bank announced that bank loans that become non-performing after January 1, 2018 must be adequately reserved, but left aside the issue of non-performing loans recognized prior to this year. The seemingly absurd ECB announcement about reserving loans that go bad from January 1st of this year is part of a larger political dance. The ECB is trying to perform damage control among and between member states that still control bank supervision at the national level while at the same time paying lip service to capital and Basel III. There is no mechanism for supervising EU banks on a unified basis, nor any agreement on loss sharing or even a retail deposit insurance safety net. And the biggest obstacle to moving forward with these initiatives is the enormous public antipathy toward banks. In Italy the government has managed to move significant amounts of bad loans off the books via securitizations with government guarantees on the senior tranches. “Huge volumes of NPLs (€37bn in 2016 and over €47bn in 2017, according to consultancy Deloitte, have been sold by banks, often to specialist American hedge funds like Cerberus Capital Management or Fortress Investment,” the Economist reports. The European Commission has agreed that these securitizations of bad loans do not constitute state aid “as the guarantee will be priced at market levels.” The latest official figure on bank NPLs from the Bank of Italy is 11 percent of total loans, an enormous figure but better than the mid-teens number reported in 2016. Banca Monte dei Paschi, for example, reported 14 percent NPLs at the end of Q1 ’18. By comparison, a bit over 1 percent of loans held by US banks are currently marked as past due. The peak of US NPLs was 5.5. percent in Q4 2009, when the US banking industry charged off $60 billion in bad credits in a single quarter. Such an act of financial housecleaning is impossible in Europe. Investors may gain some comfort from the upbeat views of consultancies such as Deloitte, who noted in a 2016 report on the early efforts to securitize Italian NPLs: “While these reforms may not be the all-encompassing panacea that is needed, any moves to cleanse bank balance sheets of distressed debt has to be welcomed.” But as we’ve told any number of investors over the past few years, there is no practical way to estimate loss resolution timelines or recoveries on non-performing commercial assets in Europe. Of course, auditors like Deloitte and the other major firms must operate in the world of stated financials and prudential regulation as it exists in Europe today. Because of issues with both the definitions behind and presentation of financial disclosure in Europe, particularly when it comes to credit, we still view the official numbers on NPLs in Italy and the rest of southern Europe as being deliberately understated. In Italy, for example, prudent investors proceed on the assumption that total NPLs are probably twice the official levels. Italian banks, owing to political and financial realities, are not prepared to bring their level of asset quality and disclosure to the levels of their US counterparts. When the new ECB rules on NPLs go into effect in 2021, it will be interesting to see if Italy and other Southern European nations actually comply. If you are doing business with a bank anywhere in Europe, the reality is that a foreign investor or ratings analyst or banker or regulator will never know if a given bank is sound or not. There is no culture of disclosure in the EU when it comes to banks. There is no SEC Edgar system for public banks, no FDIC and FFIEC for all US depositories. The disclosure by Monte dei Paschi of its bad loans is contained in a single table. Click here to see the Bank Holding Company Performance Report for Deutsche Bank Trust Corp, the top-tier unit of DB in the US that was recently red flagged by the Fed for operational issues. There is no similar public source of information in Europe for DB or any other depository. Instead in the EU there is a private network of data dissemination based upon 28 national accounting rules and national regulatory regimes. Your only indicators of risk are prices for a bank’s debt and equity and the relevant sovereign benchmarks. Since as Professor Kane observes many EU banks have been trading like quasi sovereign credits, recent market volatility begs the question as to both bond spreads and equity market valuations. Of note, the guarantee pricing mechanism for the Italian NPL securitizations depends upon the pricing for credit default swaps (CDS) for a basket of Italian issuers as well as the credit support of the Italian government. With the rise of the explicitly anti-euro coalition in Rome, the practical value of that Italian state guarantee certainly comes into question. One aspect of this situation that deserves attention from investors is the precarious nature of funding in the EU banking system. In the Euro zone, German banks make the system go by carrying over €900 billion euros of float in the form of unsettled credits for the rest of the system. This means that German banks enable payments by banks in Italy, Spain, Portugal, and Greece, notes former Fed counsel and researcher Walker Todd. Todd explains that the US Federal Reserve System avoids the buildup of large inter-district debit and credit balances by settling accounts systemwide on a weekly basis. “In the old days, that is why $10,000 notes existed -- to facilitate the clearings,” Todd avers. For whatever reason, when the euro was established in 1997, no provision for periodic intercountry clearing and settlement was included. This has led inexorably over time to the strongest member country extending a great deal of unintended credit to the rest of the EU system, especially the weakest countries' banking systems. As the M5S/Lega coalition engages with the other EU member states, they would do well to remember that the Germans ultimately are financing short-term borrowings via the ECB. Of note for investors in Italian banks, German chancellor Angela Merkel rejects any debt forgiveness schemes for Italy – one of the early demands from the M5S/Legal government that was apparently dropped – at least for now. Merkel stated flatly that solidarity among euro area members should not lead to "a debt union” – a concept that would spell political suicide for Merkel and her coalition. Yet it is some measure of the dire situation in Europe that the German leader leaves open the possibility of a bailout for Italy. French President Emmanuel Macron advocates the creation of a specific budget for the euro area, with the appointment of a finance minister, and the transformation of the European Stability Mechanism (ESM). ) into a European Monetary Fund (EMF). Merkel apparently agrees. "If the entire eurozone is in danger, the EMF must be able to provide long-term credit to help countries, Merkel said last week. “Such credits could be spread over 30 years and granted on the condition that the beneficiaries undertake structural reforms." The reality in Europe is that structural reforms never occur in large member states, only in the subordinate states such as Ireland, Greece and Spain. Italy, as Europe’s largest debtor state, lacks the political will to get its banks and fiscal situation in order. Thus Merkel seems to be preparing the way for a bailout for Italy if for no other reason than to protect German banks. Think of it as a larger version of the Greek project. The M5S/Lega coalition has explicitly threatened sovereign debt default, an explicit act of extortion focused on Germany and Angela Merkel. Is an EU bailout bullish for Italian banks? Maybe in the near term. But ultimately we think that Italy’s fiscal disarray will destroy the EU and lead to an Italian exit and currency devaluation with the reintroduction of the lira. In the event, banks in Italy and throughout the euro area will be severely impacted. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. 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.

May 21, 2018 | This week The IRA will be at the MBA Secondary Market Conference & Expo, as always held at the Marriott Marquis in Times Square. The 8th floor reception and bar is where folks generally hang out. Attendees should not miss the panel on mortgage servicing rights at 3:00 PM Monday. We’ll give our impressions of this important conference in the next edition of The Institutional Risk Analyst. Three takeaways from our meetings last week in Paris: First, we heard Banque de France Governor Villeroy de Galhau confirm that the European Central Bank intends to continue reinvesting its portfolio of securities indefinitely. This means continued low interest rates in Europe and, significantly, increasing monetary policy divergence between the EU and the US. Second and following from the first point, the banking system in Europe remains extremely fragile, this despite happy talk from various bankers we met during the trip. The fact of sustained quantitative easing by the ECB, however, is a tacit admission that the state must continue to tax savings in order to transfer value to debtors such as banks. Overall, the ECB clearly does not believe that economic growth has reached sufficiently robust levels such that extraordinary policy steps should end. Italian banks, for example, admit to bad loans equal to 14.5 percent of total loans. Double that number to capture the economic reality under so-called international accounting rules. Italian banks have packaged and securitized non-performing loans (NPLs) to sell them to investors, supported by Italian government guarantees on senior tranches. These NPL deals are said to be popular with foreign hedge funds, yet this explicit state bailout of the banks illustrates the core fiscal problem facing Italy. And third, the fact of agreement between the opposition parties in Italy means that the days of the Eurozone as we know it today may be numbered. The accord between the Five Star Movement (M5S) and the far-right League Party (Lega) of Silvio Berlusconi marks a deterioration in the commitment to fiscal discipline in Europe. Specifically, the M5S/Lega coalition wants EU assent to increased spending and cutting taxes – an explicit embrace of the Trumpian economic model operating in the US. The M5S/Lega coalition is essentially asking (or rather blackmailing) the EU into waiving the community’s fiscal rules as a concession to keep Italy in the Union. The M5S/Lega coalition manifesto, entitled appropriately “Government for Change,” suggests plans have been made for Italy to leave the single currency, calls for sanctions against Russia to be scrapped and reveals plans to ask the European Central Bank to forgive all of the Italian debt the ECB purchased as part of QE. John Dizard, writing in the Financial Times on Friday, notes the new spending in Italy will be funded via “mini-BoTs,” referring to Italian T-bills. The M5S/Lega coalition apparently wishes to issue small (euro) denomination, non-interest-bearing Treasury bills. The paper would be in the form of bearer securities that would be secured by Italian state tax revenues. Dizard notes that the logical conclusion of the Italian scheme, which allows the printing of a de facto fiat currency in the form of bearer bonds, will result in either Germany or Italy leaving the EU. The Italian evolution suggests that Ben Bernanke, Mario Draghi and their counterparts in Japan, by embracing mass purchases of securities via Quantitative Easing, have opened Pandora’s Box when it comes to sovereign debt forgiveness. We especially like the fact that mini-BOTs will be in physical form, printed like lottery tickets. The spread on Italy is now trading 1.65 percent over German Bunds vs 1.5 percent last week and is likely to widen further. Among the biggest challenges facing Italy’s new government and all EU heads of state is the growing economic policy divergence between the US and Europe. Again, to repeat point two above, the Europeans have no intention of raising interest rates anytime soon and, to this end, will continue to reinvest returns of principal from the ECB’s securities portfolio. Given the Fed’s focus on raising interest rates in 2018, it seems reasonable to assume that the euro is headed lower vs the dollar. The assumption on the Federal Open Market Committee, of course, is that US inflation is near 2 percent, giving us a real interest rate measured against LIBOR at 3 percent, for example, of one hundred basis points. But what if the FOMC is wrong about inflation and, particularly, if the favorite inflation measure used by American economists is overstated? Is the ​broadly defined ​personal consumption expenditure (PCE) index, which the FOMC relies upon for​ assessing economic conditions and fiscal policy, inflation, and employment​, really the best measure of price change? And is the FOMC currently making a rather gigantic mistake in raising interest rates further? Our friend Brian Barnier at Fed Dashboard has done some interesting work on this question over the past several years, including his May 10, 2018 missive (“Concentrated price changes mean less control for the Fed”). The chart below from Fed Dashboard shows the components of PCE. The chart illustrates how difficult it is to discern a central tendency in the bundle of data that goes into inflation indicators such as PCE. As Barnier writes: “’Inflation is back’ has been a big headline. Is that true? Yes, if ‘inflation’ means the weighted-average price change of products No, if ‘inflation’ means price increases caused by monetary factors or widespread price increases.” The San Francisco Fed has also done some great work on this issue of "PCE diffusion." If you are indeed a data dependent monetary agency, the idea of using the center point average of the diverse factors in PCE as a bellwether for monetary inflation is a bit odd. Notice, for example, that increases in the cost of financial services such as banks, auto insurance and financial advice are among the biggest positive factors in the PCE index. Increases in interest paid on excess reserves (IOER) by the Fed also positively impacts PCE, Barnier tells The IRA. Important for Europe, the Fed’s use of PCE is leading to rising interest rates, which in turn is driving up dollar borrowing costs in Europe, as shown in the FRED chart below of three month LIBOR vs three month Treasury bills. The FOMC’s view of inflation also is supporting a rally in the much battered dollar. But what if the Fed’s favorite indicator, namely PCE, is overstating the actual rate of price change? Economists on both sides of the Atlantic like to neatly separate “real-world” indicators like interest rates and debt from supposed monetary factors such as PCE. But the divergence of monetary policy in the US and Europe suggests this is difficult in practice. There seems to be a basic conflict in how inflation is perceived in Washington and Brussels. This conflict of visions promises to be increasingly problematic in the weeks and months ahead with a stronger dollar and higher US interest rates pressuring emerging nations. The big risk we see both for Europe is that the narrative being followed by the FOMC assumes that inflation is rising, at least as measured by PCE, when in fact deflation driven by excessive debt may still be the central tendency of aggregate price change. If PCE is overstating monetary price change, then the FOMC should not raise rates further. So the good news is that Europe is showing some signs of life in terms of economic growth. A weaker euro may help in the near term. The bad news is that the EU’s banks remain largely crippled by non-performing loans accumulated during previous economic slumps. And the level of debt held by nations such as Italy is growing steadily. With the UK already headed for the door, the latest political developments in Italy may presage the end of the EU as it stands today. How the Germans and other euro nations deal with the new government in Italy will tell the tale. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. 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.

May 28, 2018 – Happy Memorial Day. "Let us have peace." Grant's Tomb The Mortgage Bankers Association Secondary Expo is always one of the more important events of the year for the housing finance industry and 2018 was no exception. MBA Chief Economist Mike Fratantoni delivered the expected bad news that the industry slipped into net loss on new loan origination for the first time since 2014. Soaring regulatory costs and shrinking spreads are the culprits. But the industry remains upbeat. Rob Chrisman summed it up: “I know many owners and CEOs of residential lenders… and would never bet against their success. They represent a very savvy, entrepreneurial, and street-smart group of individuals but are faced with many risks, with LO comp, technology, housing inventory, and shrinking margins in the forefront.” We could not help but be impressed by the innovation on display at the MBA event. A number of mortgage lenders are getting into new areas of credit such as “business lending” (aka funding fix n flip strategies) and other short-term credits. Reverse mortgage lenders are getting into forward jumbo lending, while jumbo shops now want to do reverses. REITs are buying lenders and old mortgage bankers are spawning new REITs. And there is even talk of non-bank construction and development (C&D) lending. The fact that the likes of Goldman Sachs (GS), Zillow and Redfin are in the market for financing fix-and-flip projects and single-family rentals gives some investors confidence. And yes, the market has grown significantly. But we worry the Bernanke-Yellen monetary joy juice known as "QE," which has pushed up home prices by multiples of the supposed PCE inflation rate, is behind this surge in demand for home improvement loans. Cool off the home price appreciation and this new credit market chills out as well. To give you an idea of the level of frenzy in bank C&D lending, in Q1 '18 US banks reported a negative cost of credit for this $350 billion asset class. Somehow we can’t see the opportunistic diversification into business lending ending well. And the fact that GS has decided to add fix n flip to crypto currencies in its portfolio of BIG IDEAS is most definitely a concern. Lending on collateral like a residential home is a far better of a business than unsecured lending to small, often unincorporated businesses focused on home flipping. Some shops will lend 90% on the purchase of the spec home and then fund 100% of the improvements on the asset as well. As and when home prices stabilize in high value MSAs, the rationale behind this business will evaporate. There are certainly signs that the credit market for residential exposures had matured. With the collateral under the residential mortgage sector showing continued signs of being “too good to be true,” loss rates actually rose in Q1 ’18 to 27% after falling into the twenties a year ago. This rate of loss given default (LGD) is still among the lowest levels seen in almost half a century for bank owned residential loans, as shown in the chart below. The average LGD for bank RESI loans going back to the early 1980s is 66%, of note. Source: FDIC Gillian Tett of the FT last week became the latest financial writer to call US housing a bubble. Tett confirms that the Federal Open Market Committee has manipulated US real estate prices to the point where a messy correction is inevitable. The downward skew in loss rates over the past several years certainly supports that view, but nobody on the FOMC seems to want to talk about real estate prices and how racing valuations have outrun conventional measures of inflation much less potential home buyers. National Association of Realtors (NAR) released a summary of existing-home sales data showing that housing market activity this April fell 2.5 percent from last month and dropped 1.4 percent from last year. The MBA has total loan origination flows basically flat at $1.6 trillion annually through 2020. In markets such as New York, Austin and San Francisco, volumes in high end properties are softening. Luxury prices in New York actually peaked several years ago. Tett writes: “But estate agents say that sales volumes in the first quarter of 2018 were at their lowest level for six years. Meanwhile the median price per square foot was 18 per cent lower than a year earlier, according to some reports. That leaves Manhattan estate agents nervously gossiping about the local outlook. However, it should prompt investors and policymakers to ask a bigger question: could New York’s jitters herald declines in other non-US real estate markets too?” Ditto Gillian. In fact, the increase in loss rates on 1-4 family loan defaults is not yet mirrored in actual rates of default and delinquency. Past due bank owned loans at 2.5% is at the lowest level since Q4 ’07, an unfortunate yet accurate historical coincidence. A decade ago as today, credit seemed to have no cost and banks were reporting negative rates of loss. That situation pertains in the $400 billion portfolio of bank owned multifamily loans, where recoveries continue to exceed cash losses due to the huge price increases in this popular asset class. The rates of delinquency and charge offs are near zero for bank owned multifamily loans, as shown in the chart below. Source: FDIC Most of the operators we polled think that the low profit margin environment in residential lending will persist for years, even as sales volumes flatten out. Of interest, the MBA has purchase mortgages growing steadily in its loan production estimates, while mortgage refinancing volumes steadily fall. Obviously mortgage refinancing is less attractive in a rising rate environment, But will home purchase transactions continue to grow in the post-QE world? This is the key question that will validate – or not -- expectations for businesses operating in the world of mortgage finance. No surprise then that yields for both conventional and government-insured mortgage servicing assets are trading briskly in single digits. During our discussion of mortgage servicing rights (MSRs), one of the panelists wondered if it would not be possible to see mortgage prepayments drop even below current low levels. From left, Phil Laren of MCTrade, Charles Clark of Everbank, RC Whalen, Seth Sprague of Phoenix Capital & Mark Garland of Mountain View. The upward movement in prices for MSRs over the past year has been striking, with cash flow multiples for conventional MSRs north of five times annual cash flow and new issue GNMA MSRs in the mid-threes compared to half that level twelve months ago. This year marks five years running that yields on MSRs have fallen, a process now accelerating due to rising interest rates. Seth Sprague of Phoenix Capital told the audience that institutional cash focused on the MSR market has surged over the past year. “Liquidity has basically doubled along with the number of buyers compared to a year ago,” he noted and added that rising interest rates are making the escrow balances associated with MSRs increasingly valuable along with the expectation of low prepayment speeds. Mark Garland from Mountain View said that “We’ve all talked a lot about non-banks growing market share. We are starting to see the banks coming back to the MSR market. Banks are being very competitive. And we’ve seen new shops come to the marketplace. We traded a deal recently where the 30 year [cash flow] multiple went above 5.5 times. That would have been unimaginable six months ago.” As the mortgage industry struggles with the “benefits” of quantitative easing and ultra-low interest rates, current and former Fed officials travel around the country congratulating themselves on their cleverness and engaging in chest pounding demonstrations over the profits earned via QE -- profits that should have gone to private investors but instead were remitted back to the Treasury. Sadly for Bernanke, now the FOMC's System bond portfolio is badly under water to the tune of tens of billions of dollars. In fact, QE resulted in the transfer of trillions of dollars in income from private investors to the state and created grotesque distortions in asset prices like stocks and real estate. The acceleration in MRS valuations over the past year is as much about rising interest rates as it is due to Fed market manipulations. Instead of boosting job growth and home affordability, the good citizens at the Federal Reserve have through excessive regulation and QE engineered scarcity of homes and a declining market for mortgage finance – precisely the opposite of the goals they pretend to pursue. One thing that is pretty clear though is that over the past five years the cost of buying a home has soared faster than the official inflation rate, a fact that is likely to result in thousands of job losses in the mortgage sector over the next year and more. Consolidation is the name of the game in the world of mortgage banking, driven by sharply increased operating costs, falling loan origination profits and rising interest expenses. The concern of course is what happens when home prices inevitably weaken. Martin Feldstein, writing in the Wall Street Journal, warns similarly for stocks but would likely also add a bubble in housing to the list of FOMC accomplishments: “Year after year, the stock market has roared ahead, driven by the Federal Reserve’s excessively easy monetary policy. The result is a fragile financial situation—and potentially a steep drop somewhere up ahead.” Next week, the Institutional Risk Analyst will release the new edition of the Bank Book, including a discussion of current banking industry trends in credit and operating performance, and profiles of the top US banks. #BenBernanke #JanetYellen #inflationQE #MortgageBankersAssociation

May 13, 2018 | Why is economic growth so modest in the United States given the low levels of interest rates? Or as Jim Glassman of JPMorganChase (JPM) wrote last week: "According to popular theory, Treasury yields should be much higher than they are, given the current rate of GDP growth." Remember when regulators talked about a nonsense called "macroprudential" policy? The short answer to the riddle of growth vs interest rates posed by Jim Glassman is excessive regulation. Sadly when we hear from a number central bank officials and economists tomorrow at the Banque de France, there won’t be any discussion from the assembled expertsof a conflict between monetary policy and regulation. Perhaps the single most oppressive factor in the US economy today is the Federal Open Market Committee. Since the 2008 financial crisis, the FOMC has subsidized the US banking systems to the tune of about half a trillion dollars per year, yet the committee members insist that their policies are intended to promote job creation and economic expansion. Most of the benefit of lower interest rates have flowed to the largest banks and leveraged investors while the US economy has largely healed itself. Do the math: $100 billion per quarter in subsidies to banks in terms of low deposit rates and bond yields, plus billions more per month paid by the Fed risk free in interest on excess reserves (IOER). Bank net interest margins shrank dramatically in the past year as market rates have risen, yet the subsidies continue to flow because deposit rates have barely moved. And the sad part is that, even as the FOMC effectively competes with the US Treasury by paying IOER, it is also encouraging banks not to lend to support real economic activity. We illustrated the mathematics of financial repression in The IRA last month (“Bank Earnings & Financial Repression”). The dirty little secret kept by the FOMC is that were it to actually stop paying IOER tomorrow, the Fed funds rate would probably be cut in half. That would not fit into the macroprudential fantasy that justifies the actions of the Fed over the past decade. Within the strange, neo-Keynesian logic that operates within the US central bank, the FOMC believes that it must use IOER to manage interest rates upward to prepare for the next recession. But by pushing up short-term interest rates when there is so little real demand for credit, the FOMC may actually cause the next recession. So why does the central bank feel compelled to force short-term interest rates higher? Didn’t the FOMC buy $4 trillion in Treasury debt and mortgage backed securities in order to promote risk taking and investment to boost employment? Well, sort of yes and sort of no. The fact is that demand for short term credit is much weaker than the FOMC is willing to admit. And as we have discussed previously, the FOMC refuses to take losses on the System portfolio by actually selling bonds. Thus, to Glassman's point, there is an effective cap on long-term interest rates. Even as the Fed was manipulating credit spreads and credit markets via quantitative easing, prudential regulators were increasing capital requirements for banks and discouraging lenders from taking risk. Specifically, bank capital levels have basically doubled since 2008, which leaves less of the bank balance sheet available for lending. We discussed this asset allocation issue with Dennis Santiago of Total Bank Solutions a couple of weeks back (“The Interview: Dennis Santiago on Banks, Blockchain and the Goddess of NIM”). More important, the supervisory guidance to banks from prudential regulators, in particular the officials at the Federal Reserve Board and the Office of the Comptroller of the Currency, has been to avoid risk taking. Hard ceilings have been placed on all manner of bank loan exposures, from commercial and industrial loans to construction finance and multifamily and residential real estate. As with the increased capital levels, the guidance from US regulators makes it effectively impossible for banks to maintain levels of credit needed to fuel higher economic growth. In addition to limiting overall bank loan exposures for much of the US economy, federal regulators have specifically limited lending to consumers, particularly the bottom third or so of Americans in terms of credit scores. Roughly one third of all Americans who can actually qualify for a FICO score have score below 650. This puts them out of reach for most bank lenders, especially the largest banks. Even as the overall credit quality of US consumers has been rising over the past decade, banks have effectively been told to only lend to consumers with credit scores north of 680-700. According to the company formerly known as Fair, Isaac & Co, the average FICO score rose to over 700 last year. The chart below from FICO Blog shows the distribution of FICO scores through 2017 and is republished with permission. The reason that non-banks have come to control more than half of the US mortgage market is that the depositories were told to avoid any default and/or reputational risks involving US consumers, who are viewed by federal regulators as being toxic. This guidance is not written down anywhere the public may see it, but the effect on credit availability from banks is stifling economic expansion and arguably offsets much of the positive benefit from the FOMC’s manipulation of interest rates. If all of this seems a little bit crazy, it is. The folks on the FOMC bend the rules of monetary mechanics and more, but prudential regulators have put in place guidelines and unpublished rules that effectively freeze out millions of Americans from getting loans for their new business or to buy a home. If you think that the 2010 Dodd-Frank law was meant to protect consumers, then you’re right. It protects them from gaining access to credit on reasonable terms from federally insured banks. Of course you’re probably thinking that the non-bank lenders are picking up the slack with less affluent Americans, but not really. Banks may be levered 10-15 times on equity, but non-banks lever their capital just 1-3 times -- if they want to access the investment grade sector of the capital markets. So even if non-banks are willing to lend to borrowers with inferior credit, their ability to support lending volumes is constrained by limited balance sheets. One reason why lending volumes for the US residential mortgage market have fallen for the past three years is that there simply is not enough capacity to support these less attractive borrowers. More, the Fed’s manipulation of asset prices has pushed the cost of a home beyond the reach of many American families. Meanwhile, the competition among banks and non-banks for loans to more affluent borrowers has driven loan spreads for assets such as mortgages and auto loans down to all-time lows or even negative. So what is to be done? In simple terms, we need to moderate the oppressive bank regulatory environment to allow banks to lend on reasonable terms to creditworthy borrowers. At the same time, the FOMC needs to realize that pushing up short-term rates much above current levels in the near term is going to be counterproductive and could lead the US down the path to a recession. There is simply not enough leverage available in the US economy to support higher growth at today's interest rates – especially given the regulatory restrictions placed upon banks when it comes to capital and lending. If we proceed with the FOMC’s planned rate hikes, the proverbial aircraft runs the risk of stalling at the end of the runway rather than taking off. Until we can somehow harmonize regulation of private credit with public monetary policy, this conflict of visions between the FOMC and federal bank regulators poses a serious risk to the US economy. The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. 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.