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July 5, 2017 | News last week that European Central Bank chief Mario Draghi was considering an end to the ECB’s extraordinary purchases of securities quickly let some air out of the Great Rotation into EU stocks. Sure the euro surged against a weakening dollar, but Europe’s mountain of bad debt remains unresolved -- even after the election of Emmanuel Macron to the French presidency. Yet hope springs eternal in some quarters after Draghi’s claim of a successful “reflation.” “All the signs now point to a strengthening and broadening recovery in the euro area,” Draghi told the ECB’s annual conference. “Deflationary forces have been replaced by reflationary ones,” the former head of the Bank of Italy declared. Draghi’s bull call on inflation provides optimism for relief on excessive levels of bad debt, albeit in a context where the EU’s rules on resolving dead banks remain entirely subjective. The July 4 approval of the latest state-supported rescue for Banca Monte dei Paschi di Siena (Montepaschi) illustrates the deflationary challenges still facing Europe. As part of the overhaul, Reuters reports, Montepaschi “will transfer 26.1 billion euros to a privately funded special vehicle on market terms, with the operation partially funded by Italian bank rescue fund Atlante II.” The bank will receive 5 billion euros in new public equity funds for its third bailout in a decade. Two weeks before the EU decision on rescuing Montepaschi, the Italian government supported the sale of two profoundly insolvent Italian banks. The assets of Popolare di Vicenza and Veneto Banca were sold to Intesa SanPaolo Group at an estimated cost to the government of 10 billion euros, marking Italy’s latest breech of the EU’s rules on state support for failing financial institutions. Like Montepaschi, where retail investors were heavily subsidized, the Intesa SanPaolo transaction avoids imposing losses on senior debt and depositors, but wipes out the equity and junior debt. This outcome reflects political as well as financial constraints in Italy, but shows how far there is to go in the process of resolving bad banks in Europe. Of note, Italy is being given control over the remaining “bad bank” to wind down as the assets and deposits are conveyed to Intesa SanPaolo. This permits a bailout of senior unsecured creditors. So Italy gets what it wants – continued circumvention of EU bailout rules. If a bank disappears, notes a well-placed EU observer, “state aid rules do not apply." Compare the sale of these two insolvent Italian banks with the resolution in early June of Banco Popular Espanol, which became the first EU bank to be resolved by the EU’s Single Resolution Board (SRB). Banco Popular had a third of total assets in bad loans and real estate owned, double the 15% average for all banks in Spain. (In the US, by comparison, non-performing loans plus real estate owned equaled less than 1% of total assets for all banks at the end of Q1 2017.) “The resolution of Banco Popular, under which it was acquired by Banco Santander S.A., is consistent with the EU’s Bank Resolution and Recovery Directive (BRRD),” Moody’s notes, “which restricts the use of public funds to rescue failing banks. The route followed by the EU authorities in the case of Banco Popular contrasts with the approach taken elsewhere to other ailing banks, notably in the case of the troubled Italian lender Banca Monte dei Paschi di Siena S.p.A.” The state bailout of Montepaschi, like the sale of the two smaller banks to Intesa SanPaolo, reflects political realities in Italy. “Montepaschi’s liability structure includes large volumes of bonds purchased by retail investors before the [Bank Resolution and Recovery Directive] introduction,” Moody’s continues. “Retail investors also accounted for around 40% of Banco Popular’s share capital and also held an undisclosed share of the bank’s Tier 2 instruments.” Well-advised institutional investors fled Italian banks years ago, partly because they could not trust official disclosure. So the Rome government countenanced the sale of “deposits” to retail investors by Montepaschi and other Italian zombie banks. The process of selling the deposits and good assets of the two Italian zombie banks to Intesa SanPaolo, while retaining the toxic waste in a “bad bank”, represents the true cost of this latest example of moral hazard in Europe. Draghi deserves considerable credit for the worsening situation at Montepaschi, starting with his tenure at the Bank of Italy. When the bank merged with Antonveneta, a troubled bank it bought from Spain’s Santander, Montepaschi’s troubles accelerated. Italy's third-biggest lender, received a 4 billion euro state bailout in 2012. The negative political consequences for the current government in Rome of the latest Montepaschi bailout are still unfolding, but Draghi and his fellow technocrats are the true authors of this mess. More, EU banks still face levels of bad debts that not only indicate insolvency, but under the EU’s often ignored fiscal rules, suggest a haircut for senior debt and depositors without state aid. As with the EU today, American officials in the late 1970s and 1980s bent the rules regarding bank disclosure to enable most of the larger, internationally active US banks to avoid a painful debt restructuring. The Latin debt crisis, trouble in the oil patch, and the S&L debacle pushed some of America’s largest banks to the edge of bankruptcy, starting a process of deregulation that is still little understood by investors and analysts. The Federal Reserve Board under Chairman Paul Volcker and other regulators allowed large banks to engage in off-balance sheet financial transactions that concealed tens of billions in loan exposures. This loosening of prudential standards regarding the treatment of off-balance sheet securities deals eventually led to the 2008 financial collapse. Three decades later, when concealed structured investment vehicles came back to issuers like Citigroup (NYSE:C), the results were disastrous. Today, officials in Europe led by ECB chief Mario Draghi are playing a similar game, pretending that bad public and private debt on the books of EU banks and investment houses, and held by individuals, is somehow money good. As with the US in the 1980s, the stark reality inside the EU banking system is being concealed under a heavy dose of technocratic obfuscation. Mountains of public debt in Europe also indicate proponents of the bullish EU equity trade may be a tad exuberant. Europe just dodged a bullet in Greece, where a last-minute deal with the International Monetary Fund allowed the member nations to kick the can down the road until next year. With debt at 200% of GDP, Greece is crippled economically and requires debt reduction in order to attract new investment. Over the past few months, investors have driven yields on Greek debt to the lowest level in years. To that point, investor optimism on the EU is predicated on an eventual debt bailout for Greece. Yet investors won't see any details on a long awaited Greek debt restructuring plan before the German elections later this year. The EU trade, as it were, depends an awful lot on what happens to Angela Merkel’s coalition this September. Economic reality is slowly leading the EU down the road to the assumption of bad debt of weaker states by the stronger members of the federation led by Germany. EU economic commissioner Pierre Moscovici has called for “debt reduction” in Greece, a proposal that is met with a lukewarm response by Germans. But will Merkel ultimately go along? "In the long run, in a completely integrated euro zone, we would talk about a ‘communitization’ of new debt, but we're not going to start with that," Moscovici told reporters last week. The necessary condition for the bull case on the EU is that the Germans must eventually embrace a federated structure for Europe, this as part of a gradual approach being advanced by leaders such as Macron in France and Moscovici in Brussels. Joint and several responsibility for all EU debts is the cost of unity. Such a scenario faces significant political and practical obstacles, most notably in Germany but also in France, where Macron must somehow convince his citizens to embrace German style economic behavior. A gradualist plan for a European federation seems unworkable so long as member states are able to borrow against Europe’s collective credit without toeing the line on fiscal reforms – as in the case of Italy and its troubled banks. “The euro crisis resulted from the fallacy that a monetary union would evolve into a political union,” writes Yanis Varoufakis, a former finance minister of Greece. “Today, a new gradualist fallacy threatens Europe: the belief that a federation-lite will evolve into a viable democratic federation.”

February 20, 2026 | The latest edition of “The Wrap” features our view of the key events in Washington and on Wall Street over the past week. Don’t forget to watch “The Wrap” on The Julia LaRoche Show  every Saturday on YouTube to catch our discussion of what’s hot and what’s not in the world of finance and investing.  Midterm Elections The IRA  was in Washington for a series of meetings this week. While the media is filled with predictions of impending disaster for the GOP in the upcoming midterm elections, the reality is closer to neutral according to some of our more trusted sources. As one insider told us: There are only a handful of seats in the House that will actually be contested. The wildcard: If the US Supreme Court guts the progressive interpretation of the voting rights act , the Republicans will benefit in November. The Supreme Court may soon decide whether to hear an appeal of an Eighth Circuit decision that held that Section 2 of the Voting Rights Act can only be enforced by the Department of Justice — not by individuals or private organizations. The same source, who was inside inside the tent for ‘45, tells The IRA  that Rahm Israel Emanuel  is the odds on favorite to get the Democratic presidential nomination in 2028. Emanuel is an American politician, diplomat, and former investment banker who most recently served as United States ambassador to our most important ally, Japan, from 2022 to 2025.  A senior member of the Democratic Party, Emanuel represented Illinois in the U.S. House of Representatives for three terms from 2003 to 2009. He properly kicked the ass of Republicans as chair of the Democratic Campaign Committee. Emanuel is an effective and relatively conservative politician who will be a viable contender against likely Republican candidate Secretary of State Marco Rubio . Private Credit: Blue Owl Craters Blue Owl Capital (OWL)  shares tumbled this week after a decision to restrict withdrawals from one of its private credit funds raised fresh concern over the risks bubbling under the surface of the $1.8 trillion credit market. The OWL disaster took down the shares of other alternative asset managers. We think this is just the beginning of a major reset in private credit. Blue Owl shares closed 5.9% lower yesterday, while peers Ares Management (ARES) , Apollo Global Management (APO) , Blackstone (BX) , KKR & Co (KKR) and TPG (TPG) . also plunged. “Blue Owl’s decision highlights a key risk for retail investors drawn to private credit: such funds offer less liquidity than public markets, and firms can block their investors from cashing in,” reports Bloomberg .  Shares of the alternative asset manager fell about 10% on Thursday to the lowest level in two and a half years.  We previously warned our readers about problems in the credit sector. All of these private credit managers have told investors that private markets are superior to public markets, but clearly that is not the case. APO CEO Marc Rowan has argued that private markets are superior to public markets due to consistent excess returns (1.5% higher annually), better diversification, and lower risk than traditionally assumed. The debacle around OWL and other examples suggests that Rowan is mistaken. We wrote previously about the busted commercial mortgage REIT sponsored by APO (" Zombie Equity | AI, Debt & Private Market Risk "). Rowan has asserted in numerous public comments that the traditional 60/40 model for prudent investing is broken, driven by concentrated, volatile public markets, and advocates for private credit and equity to serve as the new core portfolio for retirement and insurance. But the fact is that investors in private strategies would have done far better over the past five years by investing in public markets. Silver: the Revenge of the Miners Silver prices dropped dramatically the end of January, but have since moved sideways following gold. A lot of uninformed observers have predicted a collapse in silver and gold prices, but such views ignore the tightness of the commercial market for precious metals and also many other industrial metals. Miners are now price makers instead of price takers, a remarkable reversal of fortunes in less than a year. Source: Google Finance This past week, AuAg Funds published its 2026 outlook , and the analysts said they expect gold prices to push decisively above $6,000 an ounce this year, and see silver prices reaching $133 an ounce - which would put the gold/silver ratio back to last month’s multi-year low of 45. But echoing our earlier comments, the Swedish fund manager warned that investors should be prepared for double digit price swings along the way.  AuAg Funds is a Swedish investment firm founded in 2019 by Eric Strand, specializing inUCITS-compliant funds focused on mining companies, precious metals (gold/silver), and electrification/green tech metals. They offer four active funds—Silver Bullet, Precious Green, Gold Rush, and Essential Metals—with over 100,000 investors across Europe. But the big warning sign we want to highlight for our readers is that China, the largest buyer of physical silver in the world, has imposed draconian limits on futures traders in Shanghai. “Starting February 27, all hedging positions in both the delivery month and the month prior will be forcibly reduced to zero—unless an entity has a pre-approved special hedging quota,” notes The Silver Academy . “Only bona fide industrial users — refiners, electronics producers, and solar manufacturers — will be allowed to maintain positions through physical delivery.”  Meanwhile, the ability of the COMEX in Chicago to deliver physical silver is eroding. If the exchange is forced to impose cash settlement on hedgers, says one observer, the the COMEX is finished in precious metals. Bottom line: We are maintaining our positions in silver and gold. Readers are strongly cautioned against naked shorting either metal since the fundamental demand for both gold and silver remains quite strong. One long-time observer tells The IRA that Chinese buyers are actually approaching artisanal producers of silver because of the extreme shortage in the global spot market.   Mortgage Rates Down US mortgage rates have been slowly, painfully moving lower, but but battle is more a function of lenders than anything happening in Washington. The big driver is prepayments of older mortgages as refinance transactions grow in volume. “Conventional rates pushed down towards 6.00% Jan 9th-16th, and were similar to where we currently stand today,” writes Scott Buchta  at Brean. “We expect to see pay-offs from this rally continue to flow through over the next 1-2 weeks, before backing off slightly until the latest round of refis begin to flow through in March.” The key indicator to watch is the 10-year Treasury note, currently yielding around 4.1%. If yields move up, then mortgage rates will follow. If the 10-year Treasury moves down in yield, then lenders will be incentivized to drop rates on new loans. Thirty year fixed rate mortgages have been grinding lower each month, but have retreated with each new Treasury refunding. Meanwhile, credit quality in the mortgage sector continues to slide as the rollback of COVID era forbearance programs exposes the true state of consumer defaults. We expect to see defaults in the FHA Ginnie Mae market to continue to rise in 2026. “The delinquency rate on loans handled by large mortgage servicers increased significantly during the fourth quarter of 2025. According to Inside Mortgage Finance’s  Large Servicer Delinquency Index, the overall delinquency rate increased by 46.6 basis points from the end of September, hitting 3.29% at the end of 2025.” 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 27, 2017 | Q: Are the annual stress tests good for bank stocks? See discussion on Yahoo Finance by clicking here (Interview starts at 12:30). Early in 2009, when the Federal Reserve Board began the annual exercise of “stress tests” for banks, confidence in the US financial institutions was nonexistent. The year before, Treasury Secretary Hank Paulson almost single handedly cratered the US economy by embracing the creation of a “Super SIV” to buy bad assets from the largest banks. Paulson’s ill-considered comment told investors that US banks like Citigroup (NYSE:C) were insolvent. At the time, JPMorgan (NYSE:JPM) was trading below $30 per share and other large banks were similarly discounted. As part of a broader effort to restore confidence in banks, the Supervisory Capital Assessment Program or SCAP was designed to measure whether the 19 largest banks with more than $100 billion in assets had sufficient capital. The key objective of the SCAP was not to actually measure capital per se, but instead to restore investor confidence in holding bank debt. In that sense, at least, the SCAP was successful. Kudos to Messrs Bernanke & Geithner. Yet the necessary decision to report the results of the SCAP publicly had significant future implications for banks and also for investors. In 2009, investors were concerned about a growing federal role in the banking system. And that is precisely what has occurred. The SCAP evolved into the Comprehensive Capital Analysis and Review (CCAR), which is the key part of the stress test duet that determines if banks can increase cash returns to investors. The Fed noted in May 2009: “The unprecedented nature of the SCAP, together with the extraordinary economic and financial conditions that precipitated it, has led supervisors to take the unusual step of publicly reporting the findings of this supervisory exercise. The decision to depart from the standard practice of keeping examination information confidential stemmed from the belief that greater clarity around the SCAP process and findings will make the exercise more effective at reducing uncertainty and restoring confidence in our financial institutions.” When the Dodd-Frank law was passed a year later in 2010, Congress included an expanded legal mandate to conduct annual stress tests and for hundreds of banks. In October 2012, the various federal regulatory agencies issued final rules implementing stress testing requirements for hundreds of public and private companies with over $10 billion in total assets. Most of these smaller institutions outside of the original 19 banks had no part in the 2008 financial crisis and were in fact victims. The bank stress tests continue the fine American tradition of punishing the victims. Since 2012, the stress tests have devolved, from a modestly useful annual process focused on the top institutions to a monumental waste of time and money. This effort is focused on most of the US banking industry as measured by assets. The chief architect of this regulatory effort was former Fed Governor Daniel Tarullo, who was responsible for bank supervision and resigned earlier this year. Governor Tarullo turned the stress test process into a nearly continuous form of supervisory torment involving bank management, directors and legions of consultants and lawyers. JPM CEO Jamie Dimon remarked frequently about the cost of stress tests, living wills and the various other requirements of Dodd-Frank. On top of required levels of capital, the Fed under Tarullo’s leadership proposed capital buffers and capital surcharges partly based upon the subjective stress test performance of each bank. The stated point of this exercise is supposedly ensuring the safety and soundness of US banks, but the reality is far different because the process has shifted from a short-term focus on restoring confidence in bank debt to an annual media event that impacts bank equity. So intense is Wall Street's interest in how stress tests could affect bank earnings that even Fed Chair Janet Yellen has become involved in the media frenzy. And the stress tests contain no information that would be material to investors. Violating the traditional confidence of the supervisory process to release stress test results serves no useful purpose, especially given that the tests are different for each bank. There is no comparability one bank to the next. How are analysts much less investors supposed to use this chopped salad? First and foremost, the bank stress tests do not measure the ability of a bank to weather the types of market stress seen in 2008. As regulators have known for decades, income is the key determinant of a bank’s ability to offset credit losses. Income, net of provisions for future losses, is also a key factor when it comes to predicting a bank’s probability of failure and thus maintaining investor confidence. When a bank starts to show (or event hint at) red ink due to climbing credit costs, investors start to flee and liquidity evaporates. The amount of capital the bank may or may not possess is immaterial, as illustrated by the events of 2007 and 2008. The added uncertainty caused by off-balance sheet finance (using the very same SIVs made famous by Secretary Paulson) led to the failure of many large firms from 2008 onward. Yet the only time that a bank actually consumes capital is when the institution fails and its net assets are being sold. As shown by the situation facing Citi in 2008, the GSEs, and in Italy last week, by the time that we actually start talking about a bank’s capital, that institution is already dead. Second, because of the public nature of the stress tests, the Fed and other regulators have become the very public arbiters of bank dividends and stock repurchases. The annual process of conducting the Dodd Frank Act Stress Test (DFAST) and CCAR has become a dual yardstick for whether a given banking organization can increase dividends and/or share repurchases to meet Wall Street’s expectations. The fact of the Fed conducting the stress test initial process publicly in 2009 made this evolution to the public stress test process inevitable. But any benefit in terms of bank safety and soundness has been lost as the stress test exercise mutated into a media circus that each year precedes second quarter earnings by a week or so. From an equity market perspective, the Fed’s timing could not possibly be worse. Ryan Tracy at The Wall Street Journal notes: “The tests will continue to matter to investors. The Fed will still use them to audit banks’ plans to boost dividends and buybacks for shareholders, and the numerical part of the exams will still be crucial to determining those payouts.” So are stress tests good for bank stocks? No. The stress test process is part of the expanded regulation of the US economy by the Fed since the 2008 financial crisis. Dodd Frank has reduced the opportunities for banks to earn profits, while limiting their ability to provide new credit to support economic activity. Payouts to investors are now held hostage to the opaque annual stress test process conducted by the Fed and other regulators. American banks have been neutered as sources of alpha for investors. Through the prohibition of principal trading activities and any type of risk lending, banks have become low risk, no alpha platforms. The stress test process has transformed the capital finance dimension of banks into a regime similar to the rate setting process applicable to heavily regulated electric utilities. This is not a problem of bank management, but of our public officials in Washington. While the evidence continues to mount that over-regulation of banks is constraining economic growth and job creation, there are still voices in Washington that seek additional regulatory constraints on banking. Elizabeth Warren (D-MA) told The Wall Street Journal last week that President Donald Trump does not have a mandate to lessen regulation of banks. She said: “You do polls across this country, and I’m talking about polls of everybody—Democrats, Republicans, Independents, Libertarians, vegetarians, everybody. Somewhere in the neighborhood of 80% and upward believe that the largest financial institutions in this country need more regulation, not less regulation.” Senator Warren’s comment is right but only mimics what Teddy Roosevelt proved a century ago, that most people hate big banks. But is her prescription for more regulation a good idea in terms of public policy? Absolutely not. Warren’s comment suggests that politics, not substance, is her true motivation when it comes to yowling about bank regulation. But at least she is asking questions. Looking at the patchwork of regulations, punitive capital rules and meaningless stress tests that have been embraced by Congress since 2008, there is little that either protects the taxpayer or promotes a healthy banking system. The only thing that the current regime for U.S. banks ensures is that financials will have little upside in terms of equity valuations unless and until the regulatory situation changes. That was the whole point of the rally in banks stocks following the November 2016 election. At about 1x book value, today most bank stocks are fairly valued given the current regulatory regime and their business opportunities. Some of the better performers among larger cap names such as US Bancorp (NYSE:USB), Bank of the Ozarks (NASDAQ:OZRK) and Wells Fargo (NYSE:WFC) command higher valuations due to strong financial performance, but most banks simply do not deserve higher book value or earnings multiples in the current regulatory regime. The financial crisis is over. The DFAST/CCAR process needs to be ended as a public exercise. Future capital adequacy analysis by regulators should be performed privately as it was prior to 2009. The regulatory burden on banks needs to be reviewed with an eye to removing regulations that fail either to make banks safer or support economic growth. And remember that bad banks never die from lack of capital, they just run out of cash. 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 24, 2017 | The IRA is writing today from Camp Kotok, which is held each year at Leen’s Lodge in Grand Lake Stream, Maine. We are in Washington County, which is on the border of New Brunswick, Canada, and about 200 miles north of Bangor up Rt 9. This is Down East Maine, the land of Thoreau with rolling hills and lots of beautiful rivers and lakes. The conversation this year is much the same as the narrative on Wall Street, focused on the new records for asset values and questions about what happens next with the Fed and the markets. Each day, analysts ask whether the markets can continue to climb the wall of worry to every higher (and more incredible) valuations. But at Leen’s we are concerned about more weighty matters. This week brought the latest results of the Fed’s annual stress test circus, a strange coming together of financial media and regulators in a celebration of disinformation. The stress tests don’t test the ability of banks to withstand losses, but rather the skill of bank managers at responding to the inane procedures set forth by the central bank. The real risk in banks is not what you can read in published financials or Fed stress tests, but the unknown. They key indicator of a bank’s ability to absorb loss is not capital, but income. During the 2008 financial crisis, the US banking industry diverted tens of billion of dollars from income to provisions for future losses. After a couple of years, the crisis was contained and banks regained profitability. In those cases where capital (or more specifically, confidence) was in doubt, such as Citigroup (NYSE:C) and Wachovia, the institutions failed. The Street cares about stress tests because it is believed that good results will allow banks such as Citi to return more capital to investors. The fact that the Fed’s manipulation of credit markets and spreads via QE makes higher future credit losses likely for banks is not even mentioned. Indeed, the fact that stress tests don’t explicitly include the negative impact of monetary policy on bank loan portfolios makes a mockery of “macro-prudential” policy. We should always remember that the bank stress tests were not meant to measure capital or loss absorption capacity, but rather to restore confidence. Investor confidence is a function not of capital, but of the degree to which investors believe that they understand risk. In 2008, markets disintegrated because trust was broken by acts of financial fraud contained in the “off balance sheet” liabilities of major financial institutions. Today, markets are far too trusting of the clairvoyance of the leadership at the Fed and other government agencies. We are especially amused by reports coming out of China about official concerns regarding the credit quality of heavily indebted state companies. China is a festival of bad debt and inadequate disclosure that makes the shenanigans of 2008 pale in comparison. As in 2008, what the markets don’t know is the real risk, not the amount of capital in published reports. You can be sure, however, that in the days and weeks ahead new surprises will keep emerging from China’s corrupt kleptocracy . We continue to be cautious about the outlook for financials in Q2 2017 and beyond, in part because the catalysts behind the bull trade in financials early in 2017 have largely failed. Interest rates are falling, bank earnings are flat and new lending volumes are decelerating. Credit costs for consumer and business loan portfolios are rising. Yet it is still possible to find analysts who think that financials are the next big thing. The one truth that remains unaltered is that financials are a reflection of the markets which they serve. We worry that by gunning the economy with years of unnecessary QE, the Fed has embedded significant future credit losses on the books of many banks and funds, raising questions as to whether the income and capital of today is adequate to meet the requirements of tomorrow. Loan losses and future risks are currently understated, thus investors need to exercise caution in making asset allocation decisions. But fortunately, our main concern today is catching fish and wishing the readers of The IRA tight lines and a good weekend.

“Markets go up on an escalator, they come down on an elevator. This is the most hideously overvalued market in history.” David Stockman June 19, 2017 | Last week’s action by the Fed was an effort to restore normalcy, but in the context of extraordinary action by the central bank. When you tell markets that the risk free rate is zero, it has profound implications for the cost of debt and equity, and resulting in different asset allocation decisions. Ending this regime also has profound implications for investors and markets. In the wake of the financial crisis, some investors found comfort in the fact that when risk free interest rates are at or near zero, the discounted future value of equity securities was theoretically infinite. Markets seem to have validated this view. But to us the real question is this: If a company or country has excessive and growing amounts of debt outstanding against existing assets, what is the value of the equity? The short answer is non-zero and declining. But hold that thought. Reading through Grant’s Interest Rate Observer over the weekend, we were struck by the item on China Evergrande Group (OTC:ERGNF), a real estate development company and industrial conglomerate that has reported negative free cash flow since 2006, but has made it up in volume so to speak. The stock is up over 200% this year, Grant’s reports. The real estate conglomerate has its hands into all manner of businesses and seems to typify the China construction craze. Grant’s recalled an earlier observation by a US Texas real estate manager in the 1980s, something to the effect that real estate is not a cash flow business, but rather an asset appreciation business – until you can no longer service the debt. We can recall hearing similar cautionary comments about the dangers of leverage from Kevork S. Hovnanian years ago, when he spoke about holding on to some of his land investments in South Jersey for decades and with no debt. Today the idea of investment without leverage draws ridicule, partly because unlevered returns in most industry sectors are down in single digits. The observation from the unknown Texas real estate man three decades ago pretty much sums up the state of the US economy. This week as The IRA heads for Leen’s Lodge in Grand Lake Stream for some Spring fishing, we see bubbles in the water just about everywhere, but little in the way of revenue growth. Empty retail locations are multiplying across Manhattan. Earnings in sectors like financials are up on cost cutting and share repurchases, but supported by little else. Asset prices for all manner of investments have risen by double digit rates or more, but income – that is cash flow – seems wanting. As in the early 2000s, the Fed has squeezed credit spreads and thereby gunned asset prices, but to little effect in terms of employment or especially income. QE did not work, notes FT Advisors. While some of our fishing partners believe that tight spreads are always a benefit to the economy, when spreads fail to differentiate relative credit risk, then eventually equity must be restored via a little old fashioned deflation – right? Consider the case of Amazon (NASDAQ:AMZN). Here’s a company with relatively little debt and fewer profits, but high revenue and equity market growth rates. The company has less than $2 billion in net working capital supporting $140 billion or so in revenue, but trades at 3x sales and 21x book value. Moody’s has AMZN at “BBB+” based upon improving debt service cover for its $20 billion in long term and lease obligations. One of the fabulous FAANG stocks – this after Facebook (NYSE:FB), Apple (NASDAQ:AAPL), Amazon, Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOG) -- AMZN last week announced the acquisition of Whole Foods Market (NASDAQ:WFM) for $13.7 billion. The consideration to be paid, in cash of note, is a rounding error compared with the $472 billion market cap of AMZN. And like AMZN, WFM is a low or no margin business as well, thus the pairing seems entirely appropriate -- but is also enormously disruptive. AMZN + WFM adds to the financial black hole created in retailing by AMZN. The combination of AMZN and WFM is seen as bringing the deflationary apocalypse for the retail food sector, one of the more vulnerable parts of the US economy. Jim Cramer of CNBC says "AMZN is a deflationary force. Fed needs to think about it." True, but the more interesting question is how the massive expansion of debt orchestrated by the Fed since 2008 and particularly with QE after 2012 has impacted equity market valuations for stocks such as AMZN, as shown in the chart below. By pulling trillions of dollars worth of duration out of the US financial markets via quantitative easing (QE), the Federal Open Market Committee has shifted risk preferences for both debt and equity. The net result is a series of debt-fueled bubbles in various asset classes, but none larger and more problematic than in large cap US equities. In order to “normalize” the credit markets, the Fed must be willing to let the equity and debt markets adjust in the short-run – by no means a given. With the toppy state of equity market valuations, the components of FAANG may be in for some significant downside. Part of the reason that the FOMC remains so clearly hesitant about reducing the size of its balance sheet is the well-informed suspicion that the Street will be unable to absorb the increase in volatility that will accompany true market normalization. Since much of the market in US Treasury debt and agency mortgage paper such as GNMAs is controlled by foreign central banks, the free float is small. Dealer inventories are minimal, thanks to the Volcker Rule. The end of portfolio reinvestment and even modest sales will increase both longer yields and market volatility. For those of us who have been critical of Fed policy since the end of QE1 in 2012, the return of more normal levels of volatility would be a positive sign that the central bank finally is willing to allow markets to once again price risk. But the downside is that the fiscal situation in the US and overseas could see yields on government debt rise dramatically once investors fully appreciate that the days of QE are ended. Having redefined “normal” based upon the extraordinary environment maintained by the FOMC since 2012, the Yellen Fed is now faced with its greatest test, namely allowing the financial markets to engage in price discovery without overt government support. We’ve been talking for years about the financial implications of the Fed’s portfolio and how trillions in duration negatively influences yields and spreads, but credit also impacts equities. At the same time, mounting levels of public and private debt call into question whether investors can really invest in equities for the longer term without an assumption of more or less continuous QE. Where would stocks like AMZN and WFM be trading in the absence of QE? Just as a zero percent risk free rate suggests an infinite valuation for equities, the end to official market manipulation by the Fed suggests an equal adjustment in market valuations as we walk back from extraordinary to normal. 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 15, 2017 | Below are some thoughts for the discussion at Cato Institute in Washington, D.C., today, “Financial Crisis and Reform: Have We Done Enough to Fix the Government-Sponsored Enterprises?” The title for today’s discussion is a question “Have We Done Enough to Fix the Government-Sponsored Enterprises?” The short answer is “Yes.” A decade and a half before the US government took over the GSEs in 2008, Harold Ramis came out with a film called “Groundhog Day” starring Bill Murray, Andie MacDowell, and Chris Elliott. Murray’s character, an arrogant TV newsman from Pittsburgh named Phil Connors, is caught in a time loop, repeating the same day over and over again. Talking about GSE reform has taken on a similar quality. There is a crisis in the world of mortgage finance, but it has nothing to do with the debate of government-sponsored enterprises such as Fannie Mae and Freddie Mac. The situation with the GSEs is a Washington story that deals mostly with issues of equity and public policy, but gets virtually all of the attention from the financial media. To the bond market, though, the only validation needed to support the “AAA” rating of the GSEs is the credit support of the United States, period. The “sale” of the GSEs 50 years ago was a financial fraud perpetrated by members of Congress and a number of Presidents going back to Lyndon Johnson. The US government never “loosed dominion” over the GSEs, to paraphrase Supreme Court Justice Louis Brandeis, who ruled in 1925 that an incomplete sale “imputes fraud conclusively.” The erstwhile shareholders of the GSEs, seen through that prism, are really creditors rather than owners. Meanwhile, the business of making and servicing loans is being slowly decimated by over-regulation, soaring operating costs and uneven interest rate markets. Over-regulation of the mortgage industry hurts banks and non-bank financial institutions, and their customers and shareholders. More the any other change to the Dodd-Frank law, the standard for regulation of lenders needs to be revisited. A bizarre line of thinking prevalent in the academic world says that increased regulation of commercial banks since 2008 has somehow made non-banks more competitive that depositories, which are after all GSEs just like Fannie Mae and Freddie Mac. Banks have access to the Discount Window, federal deposit insurance and other subsidies, and are protected from hostile takeovers by the Fed. But of course, we all know that Feinberg’s First Law states that no private entity can compete with a GSE. In fact, the increased regulation of home mortgage finance has made it virtually impossible for many smaller non-bank firms and community banks to operate profitably in the residential mortgage market. There is a steady exodus of both banks and non-banks out of residential lending and servicing, particularly from the government guaranteed market overseen by the Federal Housing Administration (FHA). The growing dominance of the remaining non-banks in the FHA market raises both liquidity and credit concerns. Non-banks have the least ability to fund FHA lending, servicing and loss mitigation tasks, yet they are now well more than half of the total market. And the FHA is taking share away overall from the GSEs through insuring below-prime loans, paper the commercial banks won’t touch. In 2014, JPMorgan (NYSE:JPM) Chairman Jamie Dimon very publicly moved his bank out of the FHA market, a trend that has been followed by many other commercial banks. Dimon is especially critical of the FHA’s use of the False Claims Act, Civil War era legislation that was intended to protect the government from fraud by suppliers. Many industry participants say that the False Claims Act has been used abusively by the Department of Justice to extort fines and settlements from banks and non-banks alike. Many of the supposed “violations” of law alleged by the DOJ did not happen at all, but the mere threat of criminal prosecution of a bank’s officers and directors has been enough to compel most private lenders to settle and pay. Not only have these unwarranted fines been costly for shareholders, but the withdrawal of banks from the FHA market has, according to Dimon, reduced mortgage lending by banks to the tune of about $300 billion annually. Likewise, the undefined “abusive practices” standard contained in the Dodd-Frank law has been used to extract billions in fines from banks as well as non-banks. Only in rare instances such as Quicken’s litigation with the DOJ and PHH Corp’s (NYSE:PHH) now famous Constitutional challenge of the Consumer Finance Protection Bureau (CFPB) have private lenders been willing to fight back against this abuse of power by the CFPB and DOJ. Most of us are familiar with the travails of Ocwen Financial (NYSE:OCN), but literally dozens of other non-bank mortgage firms have been unjustly penalized by the CFPB and state agencies. Most recently, the CFPB issued a sensational statement, saying it was fining Fay Servicing, a high-touch distressed mortgage servicer in Chicago, more than $1 million for “illegal foreclosure practices.” According to the CFPB, an “investigation” found that Fay Servicing was “keeping borrowers in the dark” about their foreclosure prevention options. Like many mortgages firms that have settled with the agency, Fay founder and CEO Ed Fay took issue with the characterizations in the CFPB’s remarkable press release. He notes that his firm was not asked to pay a fine, otherwise known as a civil penalty payment. Rather, Fay was asked to pay $1.15 million in redress to borrowers; to offer borrowers opportunities to pursue foreclosure relief; and comply with mortgage servicing rules. This action against Fay, PHH, Ocwen and many, many other firms follows the familiar pattern of the National Mortgage Settlement and the CFPB’s rule making authority, both of which essentially allow aspiring politicians to tax private mortgage firms for “abusive practices” or “violations of law” without any due process or transparency. And at the top of the political food chain, the US Attorney and the CFPB act as judge and jury in a modern day Star Chamber in issuing enforcement actions and fines. The cost of regulation is seen in the expense required to make or service a home loan. According to the Mortgage Bankers Association, the average cost of servicing a performing loan rose to $181 in 2015, three times higher than in 2008 when the cost per loan was $59. The average cost of servicing a non-performing loan grew to $2,386 in 2015, almost five times higher than in 2008 when the cost per loan was $482. This increase in cost was driven by one public policy priority enshrined in Dodd-Frank, namely protecting American consumers from abuse of process when they failed to repay their home mortgages. Defaulting on your mortgage has become a new American entitlement. With the election of Donald Trump, both banks and non-banks believed that salvation was at hand. Stock prices soared on the promise of deregulation of the financial services industry, both via reform legislation and more simply by putting agencies such as the DOJ and CFPB back into business friendly hands after eight years of bleeding under the Obama Administration. The Trump Administration has proposed that the CFPB be substantially stripped of its powers, but events in the bond market have created even bigger headaches. Yet despite a lot of positive talk coming from Washington, the situation facing the mortgage industry is dire as Q2 2017 comes to an end. First and foremost, the talk early on regarding infrastructure spending and lowering taxes took Treasury bond yields up half a percentage point in the three months after the election. The sharp rise in rates right after November 2016 put the kibosh on mortgage refinancing, driving industry volumes down sharply. As shown in the chart below, the Mortgage Bankers Association (MBA) has future refi volumes flat lined at $100 billion per quarter into 2019 vs $250 billion per quarter in Q2-Q4 2016. Because of the upward move in interest rates in the three months following the election of Donald Trump, today the mortgage industry is running light on home lending volumes to the tune of $300-400 billion this year. When you hear us suggest that the Federal Open Market Committee could easily sell $50-100 billion per month in mortgage bonds from its hoard, this decline in agency issuance is partly the reason. The chart below shows the 10-year Treasury bond and 30-year mortgage rate. If you understand the concept of option adjusted duration, then you’ll perceive that by maintaining a position of over $2.2 trillion in mortgage securities, the Federal Open Market Committee has created a downward bias on long-term interest rates. The resulting compression in bond yields (and credit spreads) now visible in the mortgage and forward rate/TBA markets is in direct opposition to the policy objectives of the FOMC, of note. This is why we believe that Chair Yellen and the FOMC err in putting increases in benchmark rates ahead of portfolio sales. The operating results for the industry reflect the political and financial confusion that the two above charts illustrate. MBA Vice President of Industry Analysis Marina Walsh and her colleagues have dutifully assembled statistics for the US mortgage industry in Q1 2017 and the results are truly dreadful. "The drop in overall production volume in the first quarter of 2017 resulted in the highest per-loan production expenses reported since inception of our study in the third quarter of 2008," said Walsh. "While higher production revenues mitigated a portion of the cost increase, production profitability nonetheless declined by more than half the previous quarter. For those mortgage bankers holding mortgage servicing rights, an increase in mortgage interest rates resulted in MSR valuation gains and helped overall profitability." Other key MBA findings: Average production volume fell to $455 million per company in the first quarter, down from $690 million per company in the fourth quarter. Volume by count per company averaged 1,944 loans in the first quarter, down from 2,811 loans in the fourth quarter. Average pre-tax production profit fell to 10 basis points in the first quarter, down from an average net production profit of 24 bps in the fourth quarter. Since inception of the Performance Report in third quarter 2008, net production income has averaged 51 bps. Purchase share of total originations, by dollar volume, rose to 68 percent in the first quarter, compared to 58 percent in the fourth quarter. For the mortgage industry as a whole, MBA estimated purchase share at 59 percent in the first quarter. When our friends in the regulatory community ask us why the mortgage industry does not make more investments in expensive new technology to improve the servicing process, we gently remind them that half of the industry is not profitable. Most of the rest have equity returns in mid-single digits at best, paltry results that consign these businesses to mostly debt financing, with full collateral of course. A cynic might say that no sane investor would allocate capital to this business -- unless there is serious scale involved, say at least $100 billion in unpaid principal balance (UPB) of loans serviced. Go big a la Nationstar (NYSE:NSM), Quicken, Flagstar (NYSE:FBC) or Lonestar’s Caliber, or go home. Since for most non-bank mortgage firms the intangible MSR is the only real capital asset, innovative financing for loan servicing assets is currently the holy grail. For regulators and researchers to compare non-banks with heavily subsidized and regulated banks is fanciful, but it also reflects an indifference on the part of the policy community regarding the real world impact of regulation on people and markets. The changes in regulatory incentives in the banking world since 2008 have made residential loans among the least attractive loan types for any financial institution. Regulators have actively discouraged banks from engaging in either lending or servicing below-prime loans. With some notable exceptions, most banks have decided to avoid residential lending. Why? Because the risk-adjusted returns are relatively low once high operating expenses and regulatory/reputation risk is factored into the equation. The goal of any regulatory change in the mortgage world should be to preserve the protections for consumers that were codified in the National Mortgage Settlement and also contained in Dodd-Frank, but make the regulatory process less adversarial and, frankly, more fair. The current regulatory environment for consumer lending in the US is entirely counter-productive for both consumers and investors. Former Solicitor General Ted Olson said of the Dodd-Frank consumer agency in arguments for PHH: “The CFPB’s structure is the product of aggregating some of the most democratically unaccountable and power-centralizing features of the federal government’s administrative state.” Nothing better proves Olson's point than the treatment of the mortgage industry by the CFPB over the past five years. The employees, customers and investors of mortgage companies enjoy the same Constitutional protections as all Americans. They should be treated with respect and fairness, rather than disdain and indifference. No other industry in America faces the level of punitive hostility that the mortgage community endures at the hands of the CFPB and other agencies. If regulators work with the industry to balance fairness with regulation, mortgage industry profitability will improve and with it the possibility of operational improvements that best serve consumers and investors as well. 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.

“Stock prices have reached what looks like a permanently high plateau." Irving Fisher October 1929 This Thursday The IRA’s Christopher Whalen will be in Washington to participate in an event at Cato Institute, “Financial Crisis and Reform," We'll talk with Cato's Ike Brannon about whether enough has been done to “fix” the problem, real or imagined, with Fannie Mae and Freddie Mac. The question posed by the title of the Cato Institute panel suggests that Washington has the slightest idea about the “problem” in the mortgage business much less a solution. You can be sure that nobody actually working in the US mortgage market is losing any sleep over the fate of these troublesome government sponsored enterprises. Whether you’re lending, servicing loans or managing interest rate risk, you’ve got bigger issues than the fate of the GSEs. Excessive regulation and fickle benchmark interest rates top the list. More on Mortgage Finance in the Age of Trump in our next comment. And that same evening also at Cato, we’ll be speaking to The Prosperity Caucus about the new book “Ford Men: From Inspiration to Enterprise” and talk about the brave new world of “mobility.” And we’ll have some good stories to tell about John Carbaugh, Robert Novak and other former members of the Prosperity Caucus. The past eight months since the election of Donald Trump has been anything but stable, either for investors, lenders or consumers. Coming off of the Brexit vote in the United Kingdom last summer, the events that followed the Eighth of November have seen markets soar on waves of optimism, only to be thrown down in bitter disappointment. And the economic indicators are no more clear than they were before the US election. Wall Street desperately wants to believe that interest rates are headed higher, part of a larger need to confirm that the current market and economic situation is returning to normal. Yet fact is, after eight years of monetary experimentation by Bernanke, Yellen & Co, interest rates are falling, debt markets are at record levels of issuance and the new-issue equity markets are largely barren of value. It is notable that despite the downward movement in Treasury yields, there are still analysts willing to make public arguments about the benefit to banks of rising interest rates. While net interest margins for all US banks did rise about 10bp in 2017, this was largely due to the upward move in rates after the surprise electoral win by President Trump, as shown in the chart below. Since the end of the year, however, the twin pillars of the bull trade in financials – rising interest rates and deregulation – have been eroded to the point of disappearing entirely. We spoke about the prospects for legislation helping the banks with our friends on CNBC’s “Squawk Box” on Friday . The fact that there are still analysts willing to tout the positive aspects of rising interest rates when the 10-year T-bond is sinking towards 2% yield illustrates the indomitable optimism of Wall Street – and the degree to which forward risk indicators are diverging. We called for a 2% yield on the ten year T-bond at the end of last year, a viewpoint that is confirmed by the mounting evidence of credit problems in asset classes from credit-cards to commercial real estate to auto paper. By embracing the modern equivalent of “trickle down” economics via asset price manipulation, the Federal Open Market Committee has succeeded only in adding a new layer of speculative debt atop the financial carcass as it stood around 2010. As this latest vintage of debt issuance ripens, we may be surprised at the rate of change in terms of credit losses at banks and inside ABS. "Although card standards were extremely tight in the years following the financial crisis, if underwriting then loosened materially, as the rise in charge-offs suggests, asset quality could continue to deteriorate rapidly going forward, especially in the event of a recession," notes our colleague Warren Kornfeld at Moody's . As we opined in earlier missives, the key relationship to watch when it comes to bank earnings is not interest rates or even net interest margin, but provisions for credit losses vs operating income. This is an especially important topic because the folks at the FASB are currently negotiating with the banking industry about changes in estimated future loss rates on loans that could add 10% or so to the cost of bank provisions for credit losses. Our friends in the bank credit channel say that the impact of the rule change by FASB will be for banks to over-report likely loan losses, which will then lead to larger recoveries after the defaulted loan is fully resolved. The standard is expected to take effect in 2020, although FASB has indicated that it may revise the rule to address industry concerns. It is more than a little amusing to see the FASB advocating a change in presentation to bank loan loss provisions that will effectively result in over-reserving for credit losses. This was traditionally the position taken by prudential regulators, while the SEC always tended to want to see loan loss provisions kept to a minimum so as not to artificially understate earnings. Shareholders will, eventually, see the cash returned to the bottom line via recoveries, but seeing this reversal of roles is a rather delicious irony. Changes in accounting rules, however, will not change the underlying economic reality of excessive debt. We worry about the fact that the latest period of exuberance engineered by the FOMC has embedded significant future losses in the financial system. While the US may be a good bit healthier than the EU or China when it comes to absolute debt levels and credit quality, the fact remains that the predominant tendency in the US credit markets remains deflation. The 20th Century US economist Irving Fisher worried about the decline of income in the event of a debt deflation , yet today we face a different problem. A combination of technology, innovation and the aging demographics of the key industrial economies is limiting income growth even as asset prices are goosed ever higher by monetary policy and structural constraints. One reason we expect that the widely anticipated rate hike by the Fed this week will be the last is that members of the FOMC seem to at least understand that the US economy is slowing. Rising credit losses in a variety of asset classes will force the central bank to pause on the road to normalization and prepare to battle another bout of old fashioned debt deflation. Irving Fisher noted in 1933 “that great depressions are curable and preventable through reflation and stabilization,” but it remains questionable whether the FOMC has in fact achieved either of these blissful ends over the past eight years. Fisher worried that “when over-indebtedness is so great as to depress prices faster than liquidation, the mass effort to get out of debt sinks us more deeply into debt,” but in 2017 the problem is different. In the 1930s, the debt markets were allowed to clear without government manipulation or support, resulting in catastrophic debt deflation. Today the Fed artificially supports elevated asset prices in the vain hope that a “wealth effect” of some sort will “trickle down” and boost incomes. Memo to Chair Yellen: There is no wealth effect, there is no wealth effect. What is clear is that the Fed has added to the collective credit bubble, begging the question as to when asset prices will readjust downward again to match flat income levels. Not only has US public debt almost doubled since 2008, but private debt has likewise risen by mid-double digit rates. The slowly rising cost of credit visible in banks and the bond market may herald the start of a new type of debt deflation cycle. Thus we expect June to be the last rate hike by the Fed in 2017 and perhaps for years to come. As with January/February 2016, our friend Nouriel Rubini writes , concerns about faltering US growth could put further rate hikes on hold. Just imagine how Wall Street will greet that happy news. The real question for investors is when will the Fed be forced to publicly reverse course on rate increases, then cut rates and maybe even resume asset purchases to keep debt deflation at bay for a while longer. #Bernanke #yellen #Cato #Banks #CNBC #GSEs

June 8, 2017 | In this issue of The Institutional Risk Analyst, we speak to John A. Kanas, Chairman of BankUnited (NYSE:BKU). Kanas rose to prominence in the banking world first by building North Fork Bank into a leading northeast community lender, then selling it in 2006 to CapitalOne Financial (NYSE:COF) for $14 billion in cash and stock . In 2009, he led an investor group, which included Blackstone, Carlyle Group, Centerbridge Partners and WL Ross & Co, that acquired a failed Florida thrift called BankUnited. Kanas and his veteran team rebuilt the bank and doubled the institution’s assets over the past seven years. He stepped down as CEO of BankUnited in January, handing the reins over to COO Rajinder P. Singh . We spoke to him last week from Florida. RCW: John, thanks for taking time to speak with us. When you look back over building North Fork and BankUnited, two very different banks, how do you think about these two institutions? JK: Building North Fork really was about the banking market of the 1990s and 2000s. BankUnited was a failed bank that we acquired from the FDIC in 2009. Both banks were similar in that they served a local community of businesses and consumers, classic relationship banking. You had to understand the local landscape and give your customers white glove service. As today, the competition for deposits and loans in those days was intense. RCW: Is there more competition today in the industry among smaller banks than the larger institutions? JK: Competition among smaller institutions has always been intense. The larger banks have very different funding models. The smaller banks are going head-to-head for the best customers in the markets they serve. The larger banks really don’t focus on those types of customers, small to mid-size businesses, for example. RCW: And the larger banks tend to be half market funded as opposed to core deposits. It sounds like the smaller banks need the deposits. Is that good? JK: Yes, there is clearly an ongoing need for deposit growth at banks. Mid-cap and smaller banks tend to be fully loaned out with ratios of loans to deposits in the 90 percent range vs. the 70s years ago. RCW: The data from the FDIC suggests that, over the past 30 to 40 years, banks have seen the average return on earning assets fall from over 1% to just 75bp today. Has this shrinkage in asset returns forced banks to increase their leverage by making more loans? JK: In part that is definitely true. Remember that we have been operating in a period of declining interest rates for decades, so banks have been forced to adjust their business models to support returns. RCW: Your peers among the better run community banks tend to have loan to deposit rations in the 90 percent range, yet the old models used by bank regulators and rating agencies penalized banks for being fully loaned out. Does the credit sector need to rethink how they assess loan to deposit ratios and bank business models? JK: That is correct. In today’s market, a well-run institution has to be fully loaned out to make the asset and equity returns work. RCW: Does the question of success or failure for a bank ultimately come down to credit management? Look at Bank of the Ozarks (NASDAQ:OZRK). We get calls constantly from investors looking to short that stock because of the focus on C&I lending and commercial real estate. Our response is “be careful what you wish for.” Bank of the Ozarks has a very strong credit culture and went through the financial crisis pretty much unscathed. In fact, our friends at Kroll Bond Ratings just put OZRK on watch for a ratings upgrade ! JK: A lot of people have lost a great deal of money trying to short OZRK over the past several years. The bank has performed extremely well despite their focus on real estate lending. RCW: At BankUnited, you tended to stay away from areas such as residential mortgages and auto loans, preferring to focus on commercial lending. Has this included lending on construction and development in your footprints in New York and Florida? The banking industry’s portfolio numbers on C&D lending are literally half of where they were before 2008, largely because the loans were charged off and restructured. A number of banks failed because of C&D. How do you view the C&D sector given your focus on FL and NY? JK: The regulators have been very direct with their guidance to the industry regarding C&D lending because of the experience that you mentioned. It has been very tough to expand that asset class. The message from regulators is that C&D lending must be done very carefully. RCW: The number of home builders have been cut by a third since 2008. It is not hard to understand the concerns of regulators given the number of bank failures. How does the US grow the amount of credit available to support new construction of single family homes? The asset prices for residential properties in your footprint have been soaring and the credit metrics for defaulted construction loans are extremely good. JK: C&D loans today tend to be 30-40 percent loan to cost as most, meaning that there is a lot of equity in these deals. The regulators have a very cautious posture toward construction lending and this is reflected in LTV ratios. Yet if I were running my own bank today, without being accountable to other shareholders or regulators, I would do nothing but construction lending because there is such a great need. RCW: And better returns than residential mortgages or prime auto loans. Let’s go back to BankUnited transaction for a moment. When you acquired that bank from the FDIC, what was different about that experience vs building North Fork? JK: When we bought BankUnited in May of 2009, we were one of less than five bids for the bank. I was working with Wilbur Ross at the time to identify opportunities in the banking sector. The situation in the markets was very uncertain. Nobody in the financial world had a clear vision about what to do next. The prices for failed bank assets reflected this uncertainty. North Fork was a much more conventional story having been forged out of 18 acquisitions over 30 years. RCW: When then-FDIC Chairman Sheila Bair and her colleagues at the FDIC sold Indymac in January 2009, the literally room was empty. The FDIC put loss-sharing on the table and got the party started, but it sounds like not much changed in several months between that transaction and the acquisition of BankUnited. JK: The pricing did not change immediately. Our original plan going into the BankUnited transaction was to buy a number of failed banks in Florida but once we closed the acquisition, the pricing in the market improved dramatically for the FDIC. That ultimately drove our decision not to continue with a more aggressive acquisition plan. RCW: So how about today? The whole industry was taken up by 20-30% following the election of Donald Trump. What do you tell your shareholders about the movement in banks stocks over the past six months? JK: There was a lot of enthusiasm after the election given the prospect for tax cuts and deregulation, but this promise has faded. It is not clear what will actually be changed in terms of the regulatory environment this year. RCW: It looks like the regulatory relief for small banks will be the easiest thing to get through the Congress. Do you agree with that? JK: Yes, there is clearly support for regulatory changes to help small banks. The support for rest of the agenda is far less clear, including tax cuts and other changes outside of the regulatory sphere. The community bank sector is very competitive right now when it comes to deposits particularly. There is a case to be made that smaller banks need relief so that they can continue to provide credit to local customers. RCW: So talk about the community banking sector going forward. There is a flood of opinion coming from the investment bankers and consultants that says that community banks are doomed and the industry will consolidate down to 1,000 banks. Is that your view? JK: I can remember first hearing those arguments about the demise of community banking back in the 1970s. Community banks are more relevant today than ever. So long as you have small communities with local businesses that need to be financed, community banks will be the only option to support this part of the American economy. RCW: Former Fed Chairman Paul Volcker reportedly once said that the only innovation in banking has been the ATM machine. Is that true? Is the industry changing of its own volition or is change being imposed? JK: Technology is clearly changing the industry in a number of ways, but there are also cases where the local demand for services actually goes the other way. We had looked at closing some branches in FL, for example, but when some of our competition shuttered branches, we found that our business grew at our facilities. The fact is that when people enter into a significant transaction like a business loan or home purchase, they want to talk to someone face-to-face. RCW: There is a lot of talk about how technology is pushing the industry towards branchless banking, yet the statistics seem to suggest that while consumer like to shop online, they also like to sit across the table from a banker when they enter into a major transaction like buying a home. And bankers often like to have a look at a prospective customer before committing on a loan. JK: Correct. When consumers or small business people enter into a significant commitment, they frequently want to do it in person. Going back to my earlier comment about “white glove” service, community banking is about individual service above all else. In the competitive environment in the industry today, you must be as aware of your customers’ needs as you are about new technology. RCW: We are part of a debate in the financial economics community about whether the fact of the Fed paying interest on excess reserves negatively impacts lending. Given the competitive environment you described, do you think that the fact of the Fed offering 1% risk free on excess reserves impacts your calculus as a lender, either in terms of price or the actual decision to lend? Net of FDIC deposit premiums, you’re making 85 to 90bps. JK: Any time risk-free investments are available to banks they present competition to building loan assets. Interest on reserves at the 1% level is no exception. RCW: We hear periodic rumors about you possibly going to Washington. The Wall Street Journal had a comment earlier this year. Is there any truth to these reports? JK: I have had some discussions with the Administration about a number of possibilities. There are some very capable people being considered for positions in the bank regulatory world but the process is ongoing. There are something like 150 individuals being considered for the positions that require confirmation alone. I don’t have any specific plans at the moment. I have a two year commitment as Chairman of BankUnited and look forward to being helpful to the industry as opportunities arise. RCW: Thanks for your time John. 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. In terested parties are advised to contact Whalen Global Advisors LLC for more information.

February 17, 2026  | Last week Federal Reserve Board Vice Chairman for Supervision Michelle " Miki" Bowman gave a very significant statement  about banks and the Basel III risk weights for residential loans and mortgage servicing rights to the American Banker Association. This statement was important because it is the first time in 15 years that an American regulator implicitly rejected the European view of mortgage loans, MSRs and other intangible assets related to consumer finance. The changes proposed by Governor Bowman, if made effective, will have a significant and very positive impact on banks and non-banks operating in the residential mortgage market. The United States began negotiating the Basel III framework with European counterparts and other international members of the Basel Committee on Banking Supervision (BCBS) shortly after the 2008 financial crisis, specifically starting in 2009–2010 under Presidents George W. Bush and Barack Obama . Following the collapse of Bear Stearns in March 2008 and then Lehman Brothers in September 2008, the takeover of the GSEs and the forced sale of Countrywide to Bank of America, the BCBS began a comprehensive revision of capital standards, with a focus on strengthening the framework in 2009 and announcing the overall design of the Basel III package in July 2010.   What Basel III represented in practice was a rejection of GAAP accounting and the well-established acceptance of intangible assets in American finance, especially payment intangibles like MSRs with identifiable cash flows. Instead the US negotiators, who had no discernable brief from the Obama White House or the banking industry, accepted the European hostility towards intangible assets under the IFRS accounting rules and particularly real estate finance. Both fully secured mortgage loans and MSRs were unfairly demonized by US and European officials who frankly did not understand or appreciate the economic significant of secured finance in the US economy. MSRs were assigned a 250% risk weight even though servicing assets carry no credit risk. Today, MSRs are one of the most sought after and valuable assets in finance. More, even after the 250% risk weight assigned to servicing assets under Basel III, banks were forced to subtract the MSR from capital, mimicking the treatment of this valuable intangible asset under international accounting rules. Adding to the damage, the mortgage agencies such as Fannie Mae, Freddie Mac and Ginnie Mae mimicked the idiotic Basel III treatment of MSRs and imposed similar requirements on independent mortgage banks (IMBs). Under Basel III, Mortgage Servicing Assets (MSAs/MSRs) are subject to strict limits, requiring banks to deduct amounts exceeding 10% of Common Equity Tier 1 (CET1) capital. Additionally, the aggregate of MSRs, deferred tax assets, and investments in unconsolidated financial institutions exceeding 15% of CET1 must be deducted. Amounts below these thresholds are risk-weighted at 250%. It is difficult for Americans to understand the hostility of EU regulators towards intangible assets and mortgage finance in particular. Regarding MSRs, everything that doesn’t affect European banks, who don’t engage in disintermediated finance in mortgages, is regulated out of existence. Secured finance in Europe is largely controlled by government agencies, one of the reasons why economic growth in Europe is so constrained. The crucial mistakes made during the negotiations for Basel III led to a bank withdrawal from residential lending and holding MSRs over the decade following the implementation of Basel III. For this reason, the import of the changes suggested by Governor Bowman are enormous. She suggests two key modifications to Basel III: Two regulatory proposals will soon be introduced that, among other broader changes to the regulatory capital framework, would increase bank incentives to engage in mortgage origination and servicing. First, the proposals would remove the requirement to deduct mortgage servicing assets from regulatory capital while maintaining the 250 percent risk weight assigned to these assets. We will seek comment on the appropriate risk weight for these assets.  This change in the treatment of mortgage servicing assets would encourage bank participation in the mortgage servicing business while recognizing uncertainty regarding the value of these assets over the economic cycle.   Second, the proposals would also consider increasing the risk sensitivity of capital requirements for mortgage loans on bank books. One approach would be to use loan-to-value ratios to determine the applicable risk weight for residential real estate exposures, rather than applying a uniform risk weight regardless of LTV. This change could better align capital requirements with actual risk, support on-balance-sheet lending by banks, and potentially reverse the trend of migration of mortgage activity to nonbanks over the past 15 years.     It is way too early to discuss the significance of Bowman's proposal, but there are some obvious points for both banks and IMBs. First, if banks no longer must subtract MSRs from Tier 1 capital, the economics of holding MSRs will change a lot. Banks will retain or purchase more MSRs for portfolio, adding a strong incentive for banks to increase their share of residential lending. IMBs will remain more efficient than banks, however, and will likely remain the largest servicers of mortgage loans. The same point applies to Bowman's proposal regarding whole loans, which have been declining as a portion of bank assets for 40 years (see chart). Scoring the risk of residential mortgages by loan-to-value (LTV) ratio makes enormous sense. More, by ending the need for banks to subtract MSRs from capital, the Fed's proposal will almost certainly force the FHFA and HUD/Ginnie Mae to revisit capital requirements for IMBs that were based on the misguided Basel III framework. Source: FDIC We'll be writing more about this issue in coming editions of The Institutional Risk Analyst . 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.

"[F]rom early spring throughout 2009 and until mid-year 2010, the Fed engaged in the first major quantitative easing program of purchases of government agency debt and agency-guaranteed mortgage-backed securities. The Fed’s purchases reached a cumulative total of $1.285 trillion, and excess reserves reached nearly $1 trillion. Essentially, the new reserves provided by the purchases program enabled the banking system to fund the repayment of about $1 trillion of various forms of advances to financial institutions under the [Fed’s] emergency lending program. The emergency lending program ended, but quantitative easing replaced it." Walker F. Todd "The Problem of Excess Reserves, Then and Now" American Institute for Economic Research May 2013 June 6, 2017 | Is the neo-Keynesian era over at the Federal Reserve Board? Press reports indicate that the Trump Administration finally has decided upon at least two new appointees for new Federal Reserve Board governors. President Trump is expected to nominate investment banker Randal Quarles and economist Marvin Goodfriend to two of three vacancies at the central bank. Despite the media attention to these new appointments, Wall Street does not yet seem to appreciate how the eventual selection of three new Republican governors could change the policies and personal chemistry at the central bank. At a minimum, the arrival of two and eventually three GOP appointees on the Fed board may have a significant impact on how Fed policies impact the credit markets. Since the appointment of Janet Yellen in February 2014 for a four-year term ending February 2018, the Federal Open Market Committee has followed a predictably neo-Keynesian path, at least in rhetorical terms. The Fed’s use of “quantitative easing” or QE was an attempt to synthetically create the economic impact of deficit spending by the federal government. Yet as the above quote from our friend Walker Todd suggests, the central bank has pretended to focus on stimulating growth and employment, when in fact it has been bailing out the big banks once again. This symbiosis between the Fed and the largest banks, who are the chief beneficiaries of QE, has seen the central bank create trillions of dollars worth of risk-free assets for the biggest banks in the form of $4 trillion plus in excess reserves. The massive overhang of liquidity created by the Yellen Fed has swelled the monetary base of the US economy, but has had little or no impact on employment, consumption or inflation – at least not yet. To quote from Todd’s important talk at Levy Institute last year: “The Fed should have learned from the experience of the earlier quantitative easing programs that its purchases of securities do little or nothing to increase the quantity of bank credit actually supplied to the general economy. Purchase programs might make sense in some circumstances if they helped make real interest rates positive, but generally real rates have been negative since 1Q 2009. The Fed’s methodology is not necessarily entirely irrational, but the evidence is that it simply has not worked.” Once there are three new Republican governors on the FOMC, however, Chair Yellen may find herself being challenged on some of the most basic assumption that underlie current Fed monetary policy. The incredible description of QE as a form of economic stimulus, for example, may be questioned given the paltry success of the policy so far. Both Quarles and Goodfriend are reliable conservatives who are unlikely to acquiesce in this view of current Fed policy. For example, Goodfriend’s current position as the “Friends of Allan Meltzer Professor of Economics” at Carnegie Mellon’s Tepper School of Business and his published research makes it seem improbable that he would support the FOMC’s direction under Yellen. His 2014 essay, “Why Monetary and Credit Policies Need Rules and Boundaries,” illustrates how he differs from the radical monetary policy regime under Yellen. But as one reader of The IRA does note, Goodfriend did advocate NIRP in his remarks at Jackson Hole. It is important to recognize that the Yellen Fed has diligently worked to weed out any dissenting voices among the regional Reserve Bank presidents, thus dissonant views among the governors will represent a new challenge for Chair Yellen, a change that could see her step down before the end of her term. Fed Chair's have traditionally resigned when they are on the losing end of policy votes by the FOMC. The unfortunate departure of Richmond Federal Reserve President Jeffrey Lacker, who announced his resignation in April after admitting that he indirectly discussed sensitive information with an analyst regarding the Fed's plans for economic stimulus, conveniently eliminated an important dissident on the FOMC who had consistently questioned the efficacy of QE. "I wouldn't have gone down this asset-purchase path. I'm in the camp that we should taper and stop right now," Lacker told CNBC’s Squawk Box in a 2013 interview. "I think a reasonable case can be made that path of unemployment wasn't affected much by quantitative easing we've seen over the past few years." The big change facing the Yellen Fed is that the chair actually may start to hear questions from the Republican governors asking what the FOMC is doing in terms of monetary policy and why. The fact that the Fed did not immediately start to shrink its balance sheet following QE 2-4 speaks volumes about the intellectual orientation of the FOMC, which has been entirely willing to accept the neo-Keynesian, Paul Krugman worldview that additional open market intervention was required even after the abortive 2009 fiscal stimulus. But the true irony is that the supposed stimulus of QE was in fact a sop for the banking industry, especially the largest banks. As Todd notes, the start of QE 1 was not meant to help the economy, but instead a move by the FOMC to liquefy the US banking system in the immediate aftermath of the 2008 financial crisis. Without QE1, the major US banks could never have raised sufficient liquidity to repay the emergency loans made by the Fed in 2009. In addition to the immediate subsidy for the largest banks, the Fed’s open market purchases of securities since 2009 have compressed credit spreads but done little to help boost employment or consumption. As we noted in previous issues of The IRA , the cost of credit in bank loans and bonds has been suppressed by the Fed's actions, suggesting that above-average credit losses await banks and bond investors down the road. The chart below shows relative corporate and government credit spreads going back a decade. Source: FRED With the significant exception of the China market hiccup at the start of 2016, high yield spreads have been consistently below the long-term average during Yellen’s tenure. The current FOMC frets about the potential dangers of unwinding the Fed’s bond portfolio, but the reality is that today the duration-starved capital markets could easily absorb the entire amount over a period of a couple of years. Keep in mind that new issuance of mortgage backed securities by the GSEs is running several hundred billion dollars below last year’s levels. With this significant decrease in bond issuance by the GSEs, it is unlikely that the Fed can raise interest rates until the central bank’s portfolio has been significantly reduced. The prospect of Quarles joining the Fed raises an interesting historical question. The last Mormon banker to sit as a Fed governor was Marriner Eccles, who became associated with the term “pushing on a string” after his testimony to Congress in 1935. Then as today, Eccles knew that monetary expansion such as QE did not work because consumers were unwilling to spend. But the Eccles was not doctrinaire in his economic views and actually became a strong advocate of fiscal stimulus to offset a deficit in investment spending, a situation very similar to that existing today. As Allan Meltzer noted in his classic book, “A History of the Federal Reserve: 1913-1951,” Eccles went further than any of his colleagues on the Fed and attributed the excess of savings to inequitable income distribution. “Eccles differed from his predecessors in his belief that government had to take responsibility for the economy,” wrote Meltzer. “He devoted much of his time to advocating fiscal measures, especially increased spending on investment financed by government borrowing to expand demand.” Like Donald Trump and the Republican majority in Congress, both FDR and Henry Morgenthau believed in the 1930s that a balanced budget and cuts in government spending were the surest path to economic recovery. Yet Marriner Eccles believed just the opposite and became a leading advocate for deficit spending to address the lack of investment and consumption during the Great Depression. As noted in our 2010 book “Inflated: How Money & Debt Built the American Dream,” John Kenneth Galbraith would later describe the Fed under Eccles as “the center of Keynesian evangelism in Washington.” It seems pretty clear that confirmation of Randall Quarels and Marvin Goodfriend will mark a significant and welcome change at the Fed, but observers of the central bank should remember the case of Marriner Eccles when it comes to predicting the behavior of Fed governors. That said, the transition from Democratic to Republican control on the FOMC may finally signal the return of a bear market in the world of fixed income after decades of manipulation by the US central bank.

May 31, 2017 | Financials swooned this week as investors now seem to accept that much of the Trump program is in doubt – at least for 2017. No surprise then that yesterday large-cap financials actually closed down for the year. In our last edition of The Institutional Risk Analyst , " Macro-Prudential Delusions: Bank Credit Outlook 2H 2017 ," we referred to how in April the forward guidance from Capital One Financial (NYSE:COF) caused financials to begin their swoon six weeks ago. The bank’s comments to analysts during Q1 earnings concerned prospective loss rates’ on the bank’s consumer loan book through '17. COF is off its high of $96 per share in February and closed yesterday at $76, largely due to concerns about eroding credit quality and a failure to deliver in Washington. What gives? Short answer is that the period of artificially low loss rates c/o the FOMC is ending and investors are squirming. The first thing to notice when starting your analysis of COF is that the majority of the bank’s loan book is in consumer loans. While the larger peers of COF tend to view credit cards and consumer lending as an important adjunct to a broader business, this bank is just the opposite. There are two bank subsidiaries of COF, Capital One, National Association in MacLean, VA and Capital One Bank (USA), National Association, Glen Allen, VA. The risk profiles of the two banks are very different. The former earns a “A” bank stress rating from the Total Bank Solutions Bank Monitor, while the latter earns a “C” due to the high default rate on the credit card business. Capital One Bank is about one quarter of COF’s assets and reported 721bp (7.21%) of default in Q1 ’17. Loss given default last quarter was 80%, but COF’s credit card bank boasted 1,500bp of gross spread on its loans -- not including fees. The whole company reported 300bp of default in Q1 ‘17, illustrating that COF has a far riskier portfolio than most commercial banks, large or small. The average default rate for all US banks was only about 60bp in Q1. COF’s loan loss rate is several standard deviations above the industry average, but it is not nearly the most risky member of the credit card specialization group defined by the FDIC. Consumer lending was a traditionally hard-money, nonbank business. But COF has turned itself into one of the largest subprime consumer lending businesses after Citigroup (NYSE:C). There are smaller niche providers of subprime credit that have loss rates and gross loan yields far above those of COF and the larger banks. But among the top 50 banks, COF is clearly an outlier in terms of business model and internal default rate targets. By comparison, Citi’s credit card portfolio showed 125bp of default in Q1 ’17, the highest among the top four banks by assets. But then again, what COF’s team calls “commercial lending” at Capital One Bank was throwing off over 300bp of default last quarter. The industry average default rate for C&I loans is about 44bp. Back in 2009, COF peaked at 740bp of default for the whole bank vs one third that figure for all banks. COF’s default rate for the credit card book touched 1,100bp (11%) of total loans in 2009. Obviously funding costs, which in the case of COF include core deposits as well as brokered money, are a crucial part of the model. The chart below shows COF’s gross default rate vs the large bank peer group. The red circle shows Q1 '17. Source: FDIC To make this subprime model work, COF and consumer lenders must make more money per dollar of assets than typical commercial banks. Adjusted operating income as a percentage of earning assets is 7.5% vs less than half that rate for the large banks in Peer Group 1. The gross yield on COF’s loans and leases is over 9% vs 4.3% for other large banks. So, for example, COF generates a net interest margin over 6% vs below 3% for most large banks. The high yields on credit cards and consumer loans enable the bank to absorb oversize losses. COF’s provisions for loan losses are 10x the industry average, but earnings coverage of losses is far lower than for average banks, just 2x vs almost 20x for Peer Group 1. This may explain the sharp stock selloff last month following COF’s earnings warning and 50bp uptick in defaults. That said, C with a beta of 1.55 is technically a more volatile stock than COF as of yesterday’s close. Behind the profitability, COF has a significant backstop with 13% equity to total assets. The almost $400 billion asset bank is also significantly more efficient than its larger peers. And the low double leverage at the parent level allows for accessing the capital markets to fund growth opportunities. But the fact remains that COF is an outlier among large banks because of the high-risk nature of its loan portfolio. If you convert the 329bp (3.29%) of COF defaults into a bond rating, it comes out to a “B” rating. The implied “B” bond rating of COF’s portfolio illustrates the deliberate business model decision that COF has made by focusing on credit cards and consumer credit. The scale below shows the approximate credit ratings breakpoints for actual credit default levels that my friend Dennis Santiago included in the original IRA Bank Monitor in the early 2000s. Target Debt Rating/ Loan Default Rate (Basis points) AAA: 1 bp AA: 4 bp A: 12 bp BBB: 50 bp BB: 300 bp B: 1,100 bp CCC: 2,800 bp Default: 10,000 bp Think about it: On a good day, the average American consumer is maybe a “B” credit in terms of a default probability, one out of 8-10. The good news is that the bank’s emphasis on consumer exposures gives COF a very short duration loan book – less than three years average life – but also more exposure at default with 150% unused lines vs credit already utilized by customers. Even when COF has acquired other banks, the management team has tended to focus on growing the credit card book while running off other categories such as residential mortgages. The chart below shows the major components of COF’s loan book since 2011. Source: FDIC And even with all of the income from the below-prime loan book, COF barely manages to earn positive risk-adjusted returns in the TBS Bank Monitor, not due to the loan book but because of market exposure from the bank’s securities investments. The big factor for investors to ponder with COF is that this 1.2 beta stock may move lower, faster than other large cap banks when default rates start to rise. Think of it as a measure of equity beta linked to loan credit quality. If COF has 10x the default rate of other large banks now, after years of credit market manipulation by the Fed and other central banks, the downside for the stock could be considerable if our thesis about the Fed suppressing the cost of credit turns out to be correct. Only time and the FOMC can tell. 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.

February 16, 2026  | Last week saw significant declines in many stocks, both in the broad world of technology and other sectors. Some of the more significant declines were actually in biotech and health sciences, but AI-related stocks have borne much of the brunt of the selling. If publicly owned stocks are cratering, what does this say about valuations of tech companies funded by private equity? In a timely article just published, Forbes asks: " Why Private Equity Is Suddenly Awash With Zombie Firms?" Tech bellwether Nvidia (NVDA)  dropped dramatically last week, but less than the stock had fallen in January or in December of last year.  Cisco Systems (CSCO)  tumbled 11%–12.3% on a downbeat outlook, making it one of the largest single-day drops last week. Microsoft (MSFT)  is down 20% since January due to investor fatigue over the absurd AI narrative. Are these stocks a buy on the bounce?   Source: Google Finance It is difficult for investors to discern true value in technology stocks, public or private, even as it becomes apparent that the AI mania is largely a waste of economic resources. As political opposition to creating the electrical generation infrastructure to power terrestrial AI operations grows, the statements of Elon Musk about putting AI into space to access solar power look more and more prescient. But the real issue with valuations of AI schemes is more basic. The low-interest rate period of 2020-2024 created by the FOMC not only distorted the money markets, but also skewed the valuation of equity -- all equity. Following close on the heels of electric vehicles and private credit, AI was just the latest false marketing narrative to emerge from Wall Street. The inflation caused by QE distorted investor perceptions and left hundreds of billions of dollars in mispriced public and private equity investments littering the financial marketplace. These investments span sectors from AI to software to commercial real estate. “Private credit funds have not yet taken significant writedowns on their loan books — but cracks have begun to show,” the FT  wrote last week about the growing debacle in private equity investments in software . “Investors are on edge after a BlackRock fund took a knife to its valuation of education software company Edmentum, sending the value of the fund to its lowest level since March 2020.”  Witness the fact that the AI startup Anthropic just raised $30 billion on a massive $350 billion private valuation. But this begs the question: What would happen to the valuation of Anthropic if the firm were public today? Only in the fantasy world of private equity can a company pretend that such supposed valuations are reasonable. But the key thing to remember about private “equity” investments is that they often involve a lot of debt.   Take the example of Apollo Commercial Real Estate (ARI) . The commercial real estate REIT had traded at a substantial discount to book value in the 70s, so the sponsor Apollo Global Management (APO)   sold almost the REIT’s entire portfolio to another affiliate, insurance company Athene , at a price of 99.7. How is it possible for APO to engineer a transaction that apparently disadvantages a regulated insurer whose business is providing annuities to retirees? Good question. Notice that even after selling the commercial real estate to Athene, ARI is still trading at a 20% discount to book. Source: Yahoo Finance As of January 2022, Athene was no longer an independently traded public company and became a wholly owned subsidiary of Apollo. Athene previously traded under the ticker "ATH" but it merged with Apollo to create a combined company, with Athene acting as its retirement services business. The transaction allows Apollo to conceal distressed commercial real estate loans inside an insurer, which generally book assets at “cost” rather than fair value. “What has raised eyebrows among some industry observers is the price Athene agreed to pay for the loan portfolio: a roughly 20% premium to the real estate investment trust's recent trading levels,” wrote Warren Hersch  in Life Annuity Specialist . “For the past four years, ARI said, its shares had traded at a substantial discount — averaging about 77% of book value — a gap the company attributed to public-market skepticism toward commercial real estate credit.” The fact that private sponsors like APO and Blackstone (BX) are retreating from the pricing discipline of public markets strongly suggests that investment vehicles sponsored by these firms are facing financial problems. The equally interesting fact that many financial sponsors jumped onto the AI band wagon is cause for even greater concern given the falling public valuations of such ventures.  Blackstone Real Estate Income Trust (BREIT) is a publicly registered, non-listed REIT. While it is registered with the SEC and provides regular disclosures, it does not trade on a public stock exchange, meaning shares are not liquid and are valued monthly by Blackstone rather than by market demand. BREIT was hit with large demands for redemptions in 2024, but rebounded last year because of investments in – you guessed it – data centers tied to AI. “Blackstone Real Estate Income Trust, known as Breit, posted a total return of 8.1% for the year and ended with over $54 billion in assets, according to the firm,” writes Peter Grant  of the Wall Street Journal . “That is up from a 2% return in 2024 and a loss of 0.5% in 2023.”  But like the Apollo investments in commercial real estate sold to insurer Athene, BX puts the debt from its private equity investments inside a private vehicle, which it values. Our friend Victor Hong  reminds us that under the classical Modigliani-Miller Theorem ,  the value of a business depends upon the NPV of its assets, regardless if financed with debt or equity. Put another way, the capital structure of a company does not affect its overall value, but it does directly impact the fees for the sponsor. The private equity community likes to pretend that they are adding great value to companies by using debt leverage, but isn’t this just an old fashioned leveraged buyout? The debt investors in a private company are the true owners unless and until the debt is satisfied. The fact that investors in private "equity" transactions must rely upon the conflicted sponsors for valuations is a red flag. Modigliani-Miller Theorem “Why would private equity funds need to use ANY debt?” Hong asks. “Company owners can add true value without debt, having full financial flexibility. The Miller-Modigliani Theorem posits that debt itself creates no incremental value. Perhaps, private equity funds make money by just selling debt and extracting dividends and fees -- even if the privatized companies do not improve performance.”  As valuations for speculative private equity investments related to everything from AI to commercial real estate seek a new equilibrium, questions about the LT viability of these massive investments will grow. The obvious example is electric vehicles, which were once all the rage and now have caused losses to automakers in excess of $100 billion. Commercial real estate too during COVID was seen as a sure bet, but now is a source of massive and continuing losses for private investors. Will the eventual rationalization of AI investments cause damage on a similar scale?  In a future comment, we'll look at the selloff in large cap bank stocks to update our subscribers about the big changes in the WGA Bank Top 100. 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.