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October 18, 2021 | San Diego | In this edition of The Institutional Risk Analyst, we speak with Stanley Middleman , Founder and CEO of Freedom Mortgage, about the US economy and the outlook for residential mortgages as we head into 2022. We’ve been fortunate to speak with Stan over the years about a range of issues that span his three decades as a mortgage banker and successful entrepreneur. Today Freedom is one of the top government lenders and issuers of Ginnie Mae MBS. Freedom operates in multiple channels, from wholesale to retail to correspondent and a national call center. They are also a leading mortgage servicer and among the savviest investors in whole loans and mortgage servicing rights (MSRs) in the industry. The IRA: Thanks for taking the time, Stan. We recently wrote in National Mortgage News about what seems to be an inevitable slowdown in the industry after an extraordinary 18 months. You remain pretty bullish, especially in terms of your call to us years ago about this strong housing cycle extending through 2025 or longer. Set the stage for us as we head into 2022. Middleman: You never know what’s going to happen because everything is unique in and of itself. Short-term predictions are a bad idea. What we do know, however, is that property values have been going up at an astronomical rate. One could contend that this cannot continue. But there is a long-tested rule in the mortgage industry that the peak of the last housing cycle is probably the trough for the next cycle. I think we have passed the previous peak, but there is a good bit more room for home price appreciation. The IRA: You said to us last year that 2019 would be the floor for the next correction. Is that still the right way to think of this cycle in terms of home prices? Middleman: We seem to be headed for several more years of home price appreciation. This is not an unreasonable assumption, since we have a shortage of inventory in terms of new home construction, especially affordable housing for new families. At some point, new supply will enter the market to satiate some of the extraordinary demand we have seen. Property values will continue to rise in the meantime and eventually supply and demand will meet, then supply will exceed demand, and then we’ll have a significant correction in home prices. The IRA: We’ve had a dearth of growth in terms of home construction and also credit growth in 1-4s since 2008. We did not really see any growth in mortgage credit until a decade later 2018. Is this just part of a normal cycle? Middleman: Yes, it always happens this way after a major housing correction. When was the last time we saw this kind of slump in creating new housing supply? The S&L crisis and the cleanup by the Resolution Trust Corp , which dampened activity for a decade. From the end of the 1980s right through until the early 2000s, we were in a major housing slump in terms of both credit and new home construction. Housing slumps can last for a long time, but then they tend to rise sharply for equally long periods once pent-up demand accumulates. We see that fact operating today with millennials coming into the home purchase market. As prices rise, buyers and investors jump into the fray. Then somebody gets the bright idea of building more homes. It is not a matter of if we’ll see new home supply, but when we will satisfy demand and from what sources. The IRA: Where does the supply come from in this market? There are so many obstacles to building new affordable homes in major metro areas. Middleman: One way to satiate the demand for residential housing is conversions of urban office space. Demand for office space in major metro areas is going to drop gradually over the next few years as leases are not renewed. I expect to see conversions of urban office space to an unprecedented degree. The falling demand for commercial office space of all descriptions will intersect with the demand for affordable housing in major cities. Then the economics will eventually work itself out in terms of valuations for these heretofore commercial assets. The IRA: Residential use generates a fraction of the income that a commercial office building supports. The depreciation of commercial office property is going to cause serious fiscal problems for major cities. Urban centers such as New York or Chicago cannot survive on residential use and tourism alone. Without a commercial heart, these legacy cities will require ongoing subsidies that dwarf the level of federal support during COVID. Middleman: Looking at trends in our industry, restructuring in urban office space is inevitable. As the price of unused commercial office properties falls, eventually new investors will come forward and convert these properties to other uses. This change is several years out and will take years longer, but we cannot go back to the days of pre-COVID business practices. We employ 10,000 people at Freedom. Many of them will never go back to a central office. Layer that change across the entire mortgage industry and then across other sectors of the economy. This change in business practices is going to result in reductions in the value of office buildings, which in turn will fuel conversions. The IRA: Your view goes directly contrary to the happy narrative about the rebound of the cities, but we completely agree. Cities like New York, San Francisco and Chicago cannot survive without a strong business base, but that is not a fashionable notion in today’s world. Middleman: Change is already visible in New York, Chicago, San Francisco and LA. It’s everywhere. If the shift to flexible work patterns is permanent, and I think it is, then the hybrid work model implies a lot of changes in how we work and where we work. And by the way, the hybrid model is more productive – by a huge margin. You are adding a couple of hours back to peoples’ days and improving their quality of life, family life, everything. How does this play out in residential housing markets? It is one more reason why I think that the scarcity of both urban and suburban housing will continue until at least 2025 or 2026. The IRA: What I hear you saying is that the losses in commercial office real estate valuations have already occurred but will take years to recognize. Is that fair? Middleman: Commercial office and residential markets are very different. Commercial restructurings move at a glacial pace, but there will be growing pressure on lenders and building owners to defend or improve the income from these assets. Meanwhile, the increase in prices in residential properties will result in a widening of the credit box to compensate. We already see many changes in Washington to that end. Moves to improve access to credit will drive prices even higher. You’ll see people flipping properties and making money. The home flipper TV shows will drive this trend, pushing prices even higher. We’ll start to see a wider and wider credit funnel because people want the party to continue. This will go on for several more years, but then we’ll see a significant correction. The IRA: There are a number of issuers that are already offering loans above the conforming limit in anticipation of a significant increase in the maximum loans size by Fannie Mae and Freddie Mac. But we are not supposed to call this a bubble. Charles Kindleberger , the noted MIT economic historian, describes a financial bubble as an “upward price movement over an extended range that then implodes.” In other words, a bubble can be identified only after it has burst. How do you see the wider market environment for housing and the broader economy? Middleman: Feeding into the credit equation are factors like the dollar, which is quite strong and attracts capital to our markets. You’ll see an infrastructure bill of some sort come out of Congress, though I have no idea what the number will be. There will be more taxation and more spending on non-accretive activity, which does not really support GDP growth. Unemployment will eventually move higher as growth slows and employers cut costs. Put that all together and we’re going to see lower interest rates down the road. The Fed will be forced to stimulate the economy again. And when unemployment rises and rates fall, we’ll see higher lending volumes—higher than is now reflected in most industry estimates. Maybe not in 2022, but in 2023 and beyond. The IRA: Investors had no trouble financing a $2 trillion build in the Treasury’s general account last year, but now the public cash pile is down below $100 billion. Our view has been that even with a cessation in the purchases of MBS for the Fed’s balance sheet, it will be tough to get interest rates to rise much further. Middleman: Wages are not keeping up with increased prices or even GDP growth, so it’s pretty safe to bet on continued easy policy from the Fed. Higher unemployment will force the Congress to provide more fiscal stimulus and will contribute to lower interest rates. In the medium term, I am still bullish on mortgage industry volumes. The IRA: Are we headed into a period of consolidation in the mortgage sector? Is cost control and headcount reduction the next thing? The message from NAMB was that change is coming. Middleman: I think you’ll see some tightening as interest rates rise in the short term. The industry will cannibalize one another for a while by cutting margins. We already see that happening in the wholesale channel. At Freedom, we don’t manage our business based upon volume, but rather on profitability. If we don’t like the price, then we don’t have to buy. We have a substantial book of business internally, so we can pick our opportunities or not. The IRA: Going back to our earlier conversations, is this a replay of the late 1990s and early 2000s, when servicing assets were trading at 7x multiples of annual cash flow? This is your favorite part of the cycle, is it not? Middleman: We saw great multiples in the 1990s, but today is not quite as high – at least not yet. Ask me that question in a year. We buy low and sell high. I was buying loans at cash positive numbers a couple of years ago. Now we increasingly see less attractive prices and multiples for MSRs, but still not quite to late 1990s levels. The IRA: Given your view of interest rates and the economy, its sounds like asset prices are going to remain high and interest rates will remain low. Middleman: If I am right about where interest rates eventually go, then that scenario will likely be correct. In every one of these cycles, like the early 1990s and the early 2000s, rates rose a bit before the economy slowed and rising unemployment forced interest rates back down. In 2003 and 2004, for example, we had an interest rate decline and the volumes in the industry surged to record levels. Some people thought that the party was over at that point. Ultimately these prognostications were wrong. The emergence of no-doc loans and other types of fringe products in the non-agency loan market kept the party going for several more years until 2007. Then we had a significant correction in home prices. I think we may be playing out a similar scenario today, but there are still years to go in the cycle. The IRA: And just by coincidence, as 2021 ends, we are looking for decade-high volumes for private label loans. Thank you, Stan. See you in San Diego. https://is.gd/WhalenFordBook

" Mark Cuban says ethereum has the ‘most upside’ as a crypto investment" CNBC Watching the fun of earnings this week, we have a certain feeling of déjà vu , a sensation that brings a chill to the back of the neck. The GSEs have just made the largest upward adjustment in the maximum price of a conforming loan in many years, reflecting the fact that home prices are galloping along at double-digit rates of increase. Investors are pushing prices on assets to truly silly levels. But there are still a few people in Washington who think that inflation is not a problem. Meanwhile there are signs that the one-way trade in US interest rates is also coming to an end. The 30-year mortgage rate has backed up nearly half a point since the lows of February, when we priced a 30-year jumbo mortgage at 3%. Today that loan would be a 3.5% coupon. And yet the inflation already baked into the system will keep the party in 1-4 family housing going for years to come. The only question is when, not if, the latest financial bubble will burst. Next week, The Institutional Risk Analyst will be in San Diego for the annual meeting of the Mortgage Bankers Association. We’ll be featuring several important interviews with industry leaders. Please reach out if you will be attending. For banks, the end of the bull trade in interest rates comes as the Federal Open Market Committee prepares to end its reckless purchases of securities. QE, as massive securities purchases are known in the Orwellian newspeak of the central bank, is one of the key drivers of asset inflation and also a big generator of future risk for banks and investors. By shifting the credit risk curve a couple clicks in favor of debtors, the FOMC has embedded massive future credit risk in the system. Whether we speak of home prices, stocks or crypto, all asset classes are inflated by the manic behavior of the FOMC. Because the Fed and Washington have decided to spare the financial markets the usual cleansing correction after a period of monetary excess, the degree of myopia visible in the financial markets today is more absurd than ever before. Investment managers, of course, will not warn their clients of the impending correction. After all, as one veteran trader reminded us on a recent plane ride, “the two is often more important than the twenty.” So true. Edward Chancellor writes in The New York Review of Books : “[P]rofessional investors, who fear that clients will leave them if they underperform, may be forced to buy overpriced stocks to preserve their jobs—that is, they rationally choose to make seemingly irrational decisions. This problem becomes acute when investment performance is measured over the short term; as Keynes observed in his General Theory, most money managers are concerned ‘not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.’ Such behavior makes markets inherently unstable.” JPMorgan (JPM) illustrates the risks ahead. While the bank managed to deliver a respectable performance in Q3 2021, the pain of rising interest rates was clearly visible. Not only did the bank’s cost of funds rise 3% sequentially, but the bank took losses across its securities book and also on its hedge for mortgage servicing rights (MSRs). JPM's cost of funds is still half of what it was a year ago, but that will change soon enough. Sadly asset returns are unlikely to keep pace as interest rates rise. The good news for JPM is that its servicing book grew above $500 billion after several quarters of declines. More important, the gain-on-sale margin for JPM’s considerable non-agency loan business also widened as benchmark rates rose over the past three months. Spreads not interest rates are what matter for bank profits. But how much credit risk is embedded in those loans being purchased by JPM and other banks from third-party originators? “Mortgage fee and related income totaled $596 million in the third quarter compared to $548 million the prior period. But the year ago was more impressive at $1.08 billion,” notes Paul Muolo at Inside Mortgage Finance . As we noted in our recent column in National Mortgage News , winter has come in the world of housing finance. Yesterday we commented to Stephanie Link and our friends on Twitter that big banks don’t make loans so much as they buy loans . When Wells Fargo & Co (WFC) reported a decline in loan originations, this means that the bank was not buying loans in the secondary market. And WFC’s third-party servicing book continues to decline rapidly, part of a broader run-off strategy by the bank to shrink its balance sheet. Note to investors in WFC: As loans on the bank's balance sheet prepay, they are not being replaced 1:1. Not even close. Again Muolo: “Wells’ third-party MSRs declined by $29.9 billion in the July-September period and now total $739.5 3 billion. The decline comes as servicing rights are continuing to increase in value.” Likewise, Bank of America (BAC) reported a modest increase in 1-4 family loan production, but again keep in mind that organically making a loan and buying/funding a third-party loan are two different things. Loans made through traditional retail systems are very expensive, while correspondent and wholesale channels offer aggregators better value. Of note, banks do not split-out each loan channel separately in their public disclosure. All that said, most of the issuers we work with are increasingly sellers of loans and servicing, while credulous Buy Side investors are clamoring to buy loan assets and MSRs at ever increasing prices. Duh. Normally, in a rising rate environment, lower coupon securities tend to fall faster in price than similar securities with higher coupons. In the inflationary asset bubble environment created by the FOMC, however, lower coupon MBS are well bid due to the optionality embedded in the residential mortgage loan. Prices for new issue conventional loans are trading at 4.5-5x annual cash flow, or roughly 125bps (25bps x 5). Prices for seasoned assets are appreciably higher. At this price, the asset is unlikely to be profitable through the cycle and may even be cash negative later in the life of the asset. Duration starved investors are indifferent to such concerns, however, as witnessed by the fact that government assets guaranteed by the FHA are trading well-above fair value. Again, the two is more important than the twenty for most investment managers. The logic of buying a government MSR asset at say 4x annual servicing income or ~ 125 bps (32bps x4) is fairly straight forward for an issuer. The FHA loan of say 2017 vintage has seen the price of the collateral rise in value so that the mortgage may now be refinanced into a conventional loan to be purchased by Fannie Mae or Freddie Mac. But what will happen to that conventional loan several years hence? The credit of the borrower probably has not changed, but the loan-to-value (LTV) ratio of the house has fallen 10-15 points thanks to Chairman Jay Powell and his pals on the FOMC. Today, the new conventional loan looks great. But in a couple of years, when home prices correct down to the floor of this credit cycle – say ~ 2019 prices – then the true credit characteristics of the asset will surge back into view. The conventional MBS issued by Fannie Mae or Freddie Mac will start to evidence default and loss rate characteristics normally found in a Ginnie Mae MBS. This is called "credit migration." The moral of the story is that as the Fed solves today’s problems, it also creates a new, bigger problem for the future. Since the socialist mandate in the 1978 Humphrey-Hawkins law is “full employment,” the bias to the US dollar system is always inflationary. The pursuit of political stability in the US because of the full employment prime directive and because the US targets fed funds as its main policy tool, carries with it the seeds of our eventual destruction. Now it is considered gospel in the crypto community that bitcoin, Ethereum, and other new age tokens are somehow immune to the eventual collapse or correction of the US dollar system. Arthur Hayes writes in BitMEX : “The cryptocurrency complex – led by Bitcoin – is the best hedge against hyperinflation because it resides outside of the mainstream financial system. Even the best performing traditional asset will never eclipse the returns of the crypto complex during a period of inflation, simply because all assets in the mainstream financial system are manipulated by central banks so that they do not output the correct inflationary warnings signals.” Well, no. The crypto system depends fundamentally on confidence. Back in March 2020, when bitcoin essentially traded down to zero, the positive correlation between the fiat world and the ethereal world was laid bare. Perhaps Elon Musk and Mark Cuban have a big enough pile of chips to pretend that the global poker game known as crypto is somehow disconnected from the rest of the financial world manipulated by central banks. Yes, the “tape” says bitcoin touched $5k at the low in March 2020. In fact, it was no-bid. We are all staring at computers or handsets, all of which are connected to the internet. The hard-wired herd mentality of human beings does not recognize the distinction between bank stocks or embedded options or crypto assets. When one market goes south, the rush for the door means that any and all financial assets will be suspect and therefore become illiquid. That’s why the better crypto traders all have contingency plans to liquidate their holdings and run back to the safety of fiat at the first signs of contagion. Bottom line: We all live in the same bubble regardless of the financial asset of choice. Again, Chancellor: “[M]ore accurate historical accounts of speculative manias and advances in the psychology of decision-making have failed to produce any noticeable improvement in financial behavior. On the contrary, over the past quarter-century, we have witnessed a succession of speculative bubbles, from dot-com stocks to the current craze for new technologies such as electric vehicles and cryptocurrencies." Ditto.

October 12, 2021 | In this Premium Service edition of The Institutional Risk Analyst , we set the table for third quarter earnings reports for the top US banks. For banks and other financials, credit costs remain muted or event negative, lending volumes are likely to remain flat and credit spreads remain under intense downward pressure despite rising market interest rates. Bank lending volumes are essentially going sideways as nonbanks lenders continue to take share across most major asset classes. Source: FDIC First and foremost, we must start the discussion by reminding our readers that Western Alliance Bancorp (WAL) , which we wrote about favorably earlier in the year, has out-performed every large bank in the US YTD. The WAL purchase of AmeriHome from Athene (ATH) is a great example of how well-run regional institutions can great big value for investors. Source: Google WAL may not have the low funding costs of the top six money center banks, but it is able to compete because of superior management and focus on balance sheet efficiency. The table below shows the funding costs for the top six US commercial banks and Peer Group 1. Source: FFIEC Notice that PNC Financial (PNC) at just 12bp has the lowest cost of funds in the group, even compared with U.S. Bancorp (USB) and Bank of America (BAC) . Like most banks, PNC has negative growth estimates going forward into 2022, but the Buy Side manager community continues to own this name and other large cap banks on the expectation of a future, positive earnings story. The Street consensus has PNC delivering 7% revenue growth with 20% earnings decline in 2022. Next we look at the gross spread on average loans and leases, an important measure for bank profitability. The only large bank that is even close to the average spread for Peer Group One is JPMorgan Chase (JPM) . Smaller banks tend to have better loan pricing power than larger banks. As a result, the unweighted average spread for the 131 banks in Peer Group 1 was over 4% but BAC was just 3.2%, one reason why the Bank of Brian performs so badly on the net income line. Source: FFIEC We exclude Citigroup (C) in this comparison because the bank’s subprime consumer book makes it more comparable to tiny CapitalOne (COF) than to its asset peers. Even though C is regularly grouped along with the other money center banks in terms of assets, it has a very different business model and funding base. Notice, however, that C has seen 200bp of compression in its gross loan spread since the end of 2019 . The Street has C doing almost $5 in earnings for the full year, then doubling in 2022 to just shy of $10 on less than 2% revenue growth. The stock is trading at 0.8x book value on a 1.8 beta. So, you get the Citi stock a discount but almost 2x average volatility vs the S&P 500. What a deal. Next let’s look at net loss vs average assets, a key measure of future credit losses. As the chart suggests, the reported losses of major US banks continue to fall, this due to soaring asset prices. Charles Kindleberger , the MIT economic historian, described a bubble as an “upward price movement over an extended range that then implodes.” In other words, a bubble can be identified only after it has burst. Source: FFIEC For banks and credit, the issue for the future is to understand how much has the FOMC’s aggressive monetary policy impacted credit spreads and asset prices. Since many of the better financials that we track have become sellers of assets rather than buyers in the past several months, we think it is important for investors and risk professionals to take note . Today’s benign credit environment is likely to have some surprises for investors in loans and related servicing assets tomorrow. Two sectors that bear watching at multifamily mortgage loans and urban office buildings, two traditionally solid asset classes that are being adversely impacted by the federal and state forbearance programs. Unlike residential loans that are largely curing themselves thanks to low interest rates and soaring home prices, urban multifamily assets and office properties are showing signs of stress. We expect these impaired asset classes such as urban office properties and multifamily housing to be a source of credit losses to banks in 2022. As the change in work patterns that resulted from COVID are confirmed be the attrition among tenants of urban office buildings, we expect asset prices to fall and conversions to begin occurring, a process that may take years to unfold. In a future interview in The IRA , the CEO of one of the nation’s largest lenders talks about how they are releasing office space around the country because the facilities have no prospect of being utilized. There is a huge corporate migration away from urban office space that has yet to be recognized by investors and policy makers. Below is the chart for net income and a percent of average assets, the summation of the first three charts that show funding costs, loan spreads and net credit loss rates. Note that USB, JPM and PNC are consistently leading the pack, then Peer Group 1, then BAC and Wells Fargo (WFC) following with below peer asset returns. Source: FFIEC Citi is competitive with other large banks due to its higher gross spread, but still manages to deliver a mediocre net income performance because of high funding costs and SG&A. The table below shows efficiency ratios for the group and Peer Group 1. Note again that BAC and WFC have elevated efficiency ratios vs the group, where JPM leads the pack with a ratio in the mid-50s. But look at the strong progress that Citi has made under new CEO Jane Fraser , dropping its efficiency ratio almost ten points over the last year. Source: FFIEC Another key metric to watch after the basic financial performance metrics is stock buybacks, even before dividends the single largest means of capital return to investors. Some banks such as JPM have resumed stock purchase at near pre-COVID levels, but others have not such as WFC and BAC. Given the weak outlook for earnings going forward, we do not expect banks to return to 2019 levels of stock buybacks anytime soon. Source: FFIEC Notice that JPM is still running below peak levels of share buybacks from 2020 and 2019. The Street has JPM delivering over $13 in earnings in 2021, but dropping to $11.85 in 2023. We agree that tight spreads and a dearth of attractive assets will continue to weigh on large banks. The disruption of the Asian market in terms of investment banking opportunities is another theme that we believe should be monitored carefully. Bottom line for US banks in Q3 2021 is that earnings and revenue growth are muted due to the environment created by the FOMC. Bank lending is lagging the huge levels of deposit growth seen over the past 18 months due to quantitative easing. The rise in interest rates seen at the end of the quarter has not provided relief to banks in terms of spreads, the most important component of bank net interest income. Until that changes, we do not expect to see expansion of bank earnings except from cost cutting and improved operating leverage. Our bank surveillance list is shown below. Source: Bloomberg The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. 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October 6, 2021 | Updated | Two weeks ago, most observers believed that Federal Reserve Board Chairman Jerome Powell was likely to be reappointed. Today his stock is trading at a steep discount and the entire Federal Reserve Board is now discredited, and subject to attack and ridicule by more radical members of Congress. But we think that Jay Powell will survive the firestorm of reputational risk. There is no "culture of corruption" at the Fed, as Senator Elizabeth Warren (D-MA) madly rants, but the Fed is now vulnerable due to profound errors in judgment by Powell and the Fed's legal division. Chairman Powell needs to quickly and forcefully put in place a new conflicts standard for all Fed employees that exceeds that required for private financial institutions. Indeed, he can simply copy the policies of the US Treasury. Boston College Professor Ed Kane , a long time member of the Shadow Open Market Committee, told The IRA : "I think the question is why did this negative information surface at precisely this point in time and not years ago? Whose purposes does it serve to undermine the reputation of top Fed officials when their success as pandemic fighters had taken it to new heights? Someone wanted to put them in their place and gave this information to the Senator, knowing what she would do with it." The spectacle of Chairman Powell experiencing the bitter taste of reputation risk is reason for quiet satisfaction among many big bank managers. For more than a decade now, since the 2008 mortgage meltdown and the passage of the Dodd-Frank monstrosity by Congress in 2010, the Fed has lectured the managers of the big banks to avoid headline risk. Since 2008, US commercial banks have fled consumer facing credit exposures, including virtually all government mortgage lending and also subprime auto loans and credit cards. The impact of the cautionary regulatory guidance from Fed bank examiners, combined with Basle III, Dodd Frank and the National Mortgage Settlement with the states, has been to turn banks into neutered islands of liquidity that no longer support economic growth or market function. When Senator Warren calls Chairman Powell “dangerous,” she is far too modest. Elizabeth Warren has done more damage to US banks and the employment prospects of Americans than anyone else in politics today. Her profound lack of understanding of banking and finance, combined with malignant narcissism and an endless desire for public attention, makes Senator Elizabeth Warren the most dangerous person in America today. And she will say or do anything to get attention. On the question of insider trading, however, Senator Warren is 100% correct. The rules of the Securities and Exchange Commission and FINRA are clear. Once you are tainted by non-public information that would be considered significant to investors , you are obliged to wait 48 hours after the public disclosure of that information before taking any action. The test of materiality, of note, refers to whether the information is significant to investors , not lawyers or bankers. Most banks and broker dealers regulated by the Fed, SEC, FINRA and other agencies have in place strict conflict rules that require disclosure of personal trading activity and, in some cases, a total ban on active investing. Research analysts, investment bankers and credit rating professionals, for example, must observe heightened levels of disclosure and often times total restrictions on personally-guided investments. Memo to Powell: When Fed governors and employees go to work every morning, they are tainted and thus should not make personal investment decisions, period . When we worked in the world of credit ratings at KBRA, for example, we were required to put all investments into passive, managed accounts. Whether you are a Fed governor, bank president or are working in research, you should be assumed to have non-public information. Duh! For some reason, the legal division at the Fed’s Board of Governors thinks that Fed officials are above such laws and regulations. But the hideous appearance created by the Fed’s casual approach to managing financial conflicts is the true culprit. Put it down to arrogance or hubris, but the Fed’s legal division in Washington needs to be cleaned out and repopulated with lawyers that actually understand financial compliance. We understand that there is some sort of unpublished conflicts regime in place at the Fed, but the rule has been proven entirely inadequate in terms of the practical test of public disclosure and partisan politics. The disclosures of trading by sitting Fed presidents and governors essentially gutted the Fed Board and opened the key policy making body at the central bank to political attack. And we understand that more revelations are forthcoming. “Think about Chairmen such as Martin, Burns, Volcker, Greenspan, and Yellen,” notes David Kotok , Chief Investment Officer of Cumberland Advisors. “Never have we seen this string of disclosures. Add three departures -- Clarida, Kaplan, Rosengren -- to vacancy, Randall Quarles, and now a Powell in political trouble. Governor Lael Brainard carries a public contribution to Hillary Clinton as political baggage.” “We have a central bank in turmoil,” Kotok continues. “Biden now faces four appointments to the Board of Governors, plus several regional Fed banks now are under microscopic surveillance. Hell of a mess to make profound monetary policy decisions. The most important central bank in the world now has to run a marathon of several years to some stabilization of policy and it has to do it with a broken leg.” Some of the names being floated to replace Chairman Powell include James Bullard at the St Louis Fed, Loretta Mester in Cleveland and Raphael Bostic in Atlanta. Either Mester or Bostic would be good choices for President Biden, who now also has a new and unanticipated problem to deal with along with the debt ceiling and federal budget. But we suspect that Jay Powell will survive the crisis. We understand that Larry Summers and Roger Fergusson have also been discussed at the White House in recent days, but just imagine what Senator Warren and other members of the crazy, noisy progressive wing in Congress will say. Bottom line is that more than any commercial bank, including the notable examples of Citigroup (C) and Wells Fargo (WFC) , the Federal Reserve Board has set a new standard for self-immolation via reputational risk. Amidst this scene of confusion and disarray at the Fed, there are rays of hope. Kotok notes: "Biden has precious little political capital to use. This means that a Powell reappointment still is the most likely outcome. Chairman Powell can handle the shrill screams from Warren & Co. And there is no evidence of Powell doing anything wrong himself." From your lips to God's ears David.

October 4, 2021 | What next for US relations with China and the EU? In this issue of The Institutional Risk Analyst, we speak with Dan Caprio , Co-Founder and Chairman of The Provident Group. Dan is an internationally recognized expert on privacy and cybersecurity and a close observer of commercial relations with the EU. This focus on the US-EU trade and political relationship necessarily requires a focus on China as well. The IRA: The New York Times just published the review of “ Red Roulette: An Insider’s Story of Wealth, Power, Corruption and Vengeance in Today’s China ” by Desmond Shum . The book describes a nation of 1.5 billion souls who are being held hostage by a criminal gang called the Chinese Communist Party. And the CCP will do anything to maintain power. Caprio: The CCP is potentially our secret weapon. Serious people are beginning to take a look at the implications for the reassertion of communist ideology in China, but the CCP is about to kill the goose that lays the golden eggs in economic terms. The IRA: Many in the west see Xi Jinping as a transformational leader, but all they’ve done since the opening under Deng Xiaoping four decades ago is import a lot of foreign capital, spend even more cash on economic disasters such as “Belt & Road,” and incur a huge pile of debt. We’ve been watching a financial implosion in China for years led by HNA , Anbang Insurance and now Evergrande , so the reassertion of CCP control was almost inevitable. Caprio: In some respects, we should not be surprised by what Xi is doing. Look at the way he has imposed draconian control over big tech, which a year ago was leading the charge for China around the world. All of this regulation and “data protection” is being done under the rubric of the “common prosperity,” but state control over data and technology is a very big part of the new policies. The IRA: Perhaps the moves by Xi to reassert party orthodoxy is not surprising, but it is also very sad. The economic prospects of China are driven by the private sector. The state sector only consumes value. Over the past 40 years we have gotten a taste for what China could do economically were it a free society. The protests in Hong Kong, the issue of data security vis-à-vis the US, and then COVID seemed to provide the pretext for Xi to clamp down on private political and economic freedom. You spend a lot of your time in the world of global data and security. What is next for the US and EU when it comes to China? Caprio: It seems that Xi finally decided that the private sector had become too powerful. From a party perspective, he perceived it as a threat to his power so he stepped in. Finding common ground with the EU on China will be a challenge since the Europeans don’t want to be forced to take sides and they are sensitive to not ganging up against China in public. The IRA: During his entire career, Xi has been very adept at destroying his political rivals. When the Honk Kong pro-democracy protestors came close to tipping over the local government, that seemed to force his hand. The big tech bosses could have posed an even greater threat. But as the old Maoist saying goes, “Political power comes from the barrel of the gun, and the Party shall never be subject to the gun.” Caprio: The CCP perceived the business sector had become too powerful so they cracked down. The Chinese are very good at coming up with reasons for these changes. It will be interesting to see how this plays out. The IRA: Interesting is one way to put it. If Xi believes that an independent Taiwan is also a threat, then we may see a move against the island. Military action in the Taiwan Strait could threaten the world’s access to semiconductors, both processors and memory. That becomes a global and common threat to the economies of both the US and EU, since neither has any significant manufacturing capacity in commodity silicon chips. Caprio: Much of my work over the past several decades has been trans-Atlantic privacy, trade and cyber security. Now we must pivot to deal with a host of issues coming out of China and Asia more broadly. The stability that was assumed in relations with China has now largely evaporated. The US and EU need to work together on China and not just because of shared values like democracy and freedom. Our eyes are wide open when it comes to the risks from China, especially a China that is an increasingly repressive and authoritarian at home. The IRA: So then, what do you tell your corporate and financial sector clients? Will there be closer cooperation between the US and EU over China issues? Caprio: The EU was obviously relieved by the outcome of the US elections last November. The EU was ready to go with a plan for a new Trans-Atlantic agenda, at least in part to have a common approach to China. Part of that included the creation of the Trade and Technology Council (TTC) , which is intended as a vehicle for renewed Transatlantic cooperation. But the reality is that it is very difficult to stand up a new organization and make it effective, especially after the US-UK-Australia submarine deal. The TTC meeting in Pittsburgh last Wednesday almost did not occur because of the reaction by France to the submarine deal. So, while the TTC goes forward, US-EU cooperation on China will have to wait for a while. Common tech and trade standards are an aspirational goal, but the subtext is China. Both sides are discovering that these sorts of bilateral organizations are much easier to propose than to make real and substantive. But the TTC is a step in the right direction and I’m optimistic some good will come from it. Hudson Institute had a good discussion on the TTC on September 29, 2021 . The IRA: The Chinese have been astute in their dealings with the EU, staying largely out of the crosshairs of the regulators. The major targets for EU regulators are American companies such as Alphabet (GOOG) and Apple (AAPL) , for example. Caprio: To that point, the really interesting aspect of the transatlantic relationship is the whole discussion about privacy and how it’s overshadowed by national security and surveillance concerns. The Europeans view privacy as a fundamental human right and it’s embedded in their Constitution. Both sides recognize we need to negotiate a new Privacy Shield deal as soon as possible. There seems to be a commitment to get that done before the end of the year. We need a comprehensive federal privacy law in the US since the lack of such a law is hurting the US around the world. The EU had a data directive law in the late nineties and now GDPR, yet the law entrenches large incumbents and the European are having a very hard time enforcing it. The IRA: The US and EU are polar opposites in many ways, first and foremost how they conceive of freedom. The EU view of economic freedom, for example, is a lot closer to the deterministic and authoritarian world of China than the US. How do we bridge this gap? Has the EU gone a little overboard with data security? Caprio: The European Court of Justice (ECJ) invalidated the EU-US Privacy Shield in July 2020 on national security and surveillance grounds. The ruling from the ECJ focuses exclusively on the US while giving the Chinese a pass. The EU and China do not share common values. The EU adopted a risk based approach to privacy yet they continue to struggle with the question of harm to what. The ECJ rulings have very little to do with privacy and are a backlash partly due to the revelations by Edward Snowden . All of the concern has been on the US and almost zero on China. This discussion is not about privacy but rather about national security, but the Schrems II decision by the ECJ has thrown this whole discussion into chaos and focused EU attention on the US. The IRA: Sounds like a heavy lift. Where does the solution begin for commercial users of data? Don’t the national security arguments win out? Caprio: A solution is going to take a lot of political will on both side of the Atlantic. Transatlantic data exchange is at risk under the new EU data protection regime. Large companies can deal with the new rules, but small businesses dealing with data transfers on an ad hoc basis is untenable. GDPR is an effective barrier for smaller US firms that want to do business in Europe. Smaller firms cannot afford the cost of compliance with EU law. Under the old regime known as “privacy shield,” there were perhaps 5,000 US firms participating and 90% of these were small enterprises. The IRA: The damage from Snowden continues to grow. This is not very well understood by US investors and corporate managers. Caprio: The EU believes that privacy is a fundamental right. The Snowden revelations are very fresh in people’s minds in Europe. Those revelations have animated a lot of actions in the EU against US companies in the past few years. The IRA: The Chinese government is obviously going to play the EU and US off against one another to take advantage of the fallout from Snowden. How do you see this playing out for the next three years of the Biden Administration? Caprio: The Biden Administration could use Executive Orders to satisfy most of the EU concerns, but that does not result in the US having a data protection law at the federal level. The EU would like to see the US change federal law to align with their data protection regime, but that is a big ask. The EU wants redress rights for EU citizens in the US. They want a legal right of appeal. My guess is that the Biden Administration will go with an Executive Order. The IRA: Well perhaps the EU should seek rights of redress in China as well. Chinese citizens lack such rights, but perhaps foreigners will be given unequal rights of action in Chinese courts? Caprio: Well, yes. The Chinese are in the midst of creating a data protection law. I have heard serious people saying that the US should follow suit. The Chinese law is first and foremost about internal control. Is the Chinese law going to do anything about state power and surveillance? No. But the US is frequently compared to China nonetheless. We have a lot of work to do in coming months. But we need to fix the US-EU divide on data security if there is any hope of a common approach to China. The IRA: Thanks Dan. Keep fighting.

September 29, 2021 | In this Premium Service issue of The Institutional Risk Analyst , we return to the world of interest rates and inflation expectations, what we laughingly refer to as monetary policy in the U.S. As was the case this past June, Treasury yields are rising and spreads are beginning to emerge from the Fed-induced coma. The vast amount of cash injected into the system by the Fed and Treasury has retarded market function and driven the portion of bank balance sheets funded with deposits to a 50-year high. But the biggest factor weighing on the debt and equity markets is the ebbing credibility of the FOMC under Jerome Powell and the Treasury under Janet Yellen . We truly live in the age of the dilettante. Two Federal Reserve Bank Presidents have resigned in the past week following revelations regarding personal trading activities that are, at best, inexplicable. Just how did the Fed arrive to 2021 without a policy on managing conflicts and personal investing? But the bigger credibility gap for the Fed arises from the lack of consistency in Fed monetary policy. A timely research paper by Jeremy B. Rudd published by the Fed Board of Governors throws a rather critical light on Fed policy making: “Economists and economic policymakers believe that households' and firms' expectations of future inflation are a key determinant of actual inflation. A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.” This remarkable paper serves as a rebuke to the shepherds of conventional thinking inside the Fed and the surrounding media. If you say you are aiming for 2% inflation and you get it, then it is time to change policy toward tightening. Even the Bank of England has announced its intention to raise interest rates in light of the rapidly mounting inflation in the UK. But, of course, that assumes that the markets or members of the FOMC and other governing bodies of other central banks are inclined to listen. Rudd then states the obvious: “Related to this last point, an important policy implication would be that it is far more useful to ensure that inflation remains off of people’s radar screens than it would be to attempt to “re-anchor” expected inflation at some level that policymakers viewed as being more consistent with their stated inflation goal. In particular, a policy of engineering a rate of price inflation that is high relative to recent experience in order to effect an increase in trend inflation would seem to run the risk of being both dangerous and counterproductive inasmuch as it might increase the probability that people would start to pay more attention to inflation and—if successful—would lead to a period where trend inflation once again began to respond to changes in economic conditions.” As we write this report, home prices are galloping along at double-digit monthly growth rates, the highest levels of increase seen in a century. John Kenneth Galbraith wrote about this period in his classic, “The Great Crash 1929,” when tiny fractional interests in unimproved land in FL changed hands at ridiculous prices. The FL land rush of the 1920s was the precursor of crypto tokens. After the crash, it took half a century for FL land prices to recover to previous levels. Today we see millions of people duped into “investing” in crypto currencies. A professional investor even paid $300 million for the Bob Dylan song catalog. This is a transaction supported by literally a handful of songs few people below the age of 40 even recognize. And real estate giant Zillow Group (Z) has floated hundreds of millions in ABS supported by future home sales. All of these indicia of the madness of crowds are the result of Fed monetary policy. To quote Friedrich Nietzsche: “Madness is rare in the individual—but with groups, parties, peoples, and ages it is the rule.” Our twitter buddy Komal Sri-Kumar noted this week: “I have said repeatedly since I changed my view Jan 5 on UST 10yr that yield will move up and, when it does, will rise sharply rather than gradually.” Of course, the 10-year has been falling in price along with the Japanese yen, even as surging dollar balances are supporting bloated stocks. The economists at both the Fed and European Central Bank are in full retreat as “transitory” inflation becomes very real, particularly in the energy sector. You can blame soaring natural gas prices in Europe on COVID, but the more likely culprit is Russian dictator Vladimir Putin , who is squeezing EU consumers in a parting gesture of contempt for outgoing Chancellor Angela Merkel . And in recent weeks, of note, gas futures have outperformed crypto. There are “no signs that this increase in inflation is becoming broad-based across the economy,” Christine Lagarde said at an ECB conference. “The key challenge is to ensure that we do not overreact to transitory supply shocks that have no bearing on the medium term.” Like the Fed, Lagarde is trying to defend the ECB’s policy stance of continued bond purchases, but events are rapidly outmaneuvering all of the major central banks. When EU consumers sit freezing in their homes this winter because of the price of natural gas, Ms. Lagarde’s protestations will not matter. Secretary Yellen has indicated to Congress and the Biden Administration that the middle of October is the deadline for raising the debt ceiling. We discussed this previously in our missive (“ Debt Ceilings & Interest Rate Floors ”) that the Fed is legally constrained against coming to the rescue of the Treasury. Indeed, once the U.S. government shuts down on October 1st, the tenor of the debate in Washington will grow ever more bitter. Looking beyond the immediate issues of debt ceilings and federal spending, the past year under the Biden Administration has seen unprecedented outlays for relief to consumers and business alike. Insolvent pension funds around the country were turned aright. Consumers received benefits that were unneeded and saved the cash. The good news is that the economic crisis of COVID is over, but the larger crisis of American leadership remains. Market Trends In the world of mortgages, we have described how the Biden Administration is planning to loosen the floodgates of residential mortgage lending, removing at least 1.5% from the cost of an FHA loan (“ Joe Biden Doubles Down on Housing ”). We expect to see these changes in November, soon to be followed by similar reductions in fees for the GSEs. Overall, the reduced friction for low-FICO loans could be worth an immediate 10-15% volume increase in FHA lending, but within a narrative of secular decline in Ginnie Mae issuance. But as we pull tomorrow’s sales into today, there is always the question of tomorrow being a tad light down the road. Source: MBA The Biden Administration has extended forbearance for millions of borrowers who have already enjoyed a holiday from mortgage payments of a year or more, additional evidence of the breakdown of fiscal discipline in the US. Soaring real estate prices, however, are a more powerful force and will encourage many distressed homeowners to sell the property and pocket the net proceeds after the loan is paid in full. “We estimate that $4.5 billion (roughly 4% of delinquent G2 loans) of loans will be impacted by the FB extension period,” Citigroup (C) analyst Ankur Mehta writes. Share is “disproportionally high in 2021 vintage, and it is the highest in 2.5s of 2021 at 17%.” The current extension only applies to FHA loans, but other agencies may follow, Mehta notes. Meanwhile in commercial lending, there is good news and bad news. We noted in The IRA Bank Book that there is a segment of multifamily rental assets that are getting hammered, with loss severities nearing 100% at default. But in other corners of the world of commercial real estate, big bets are being made on the rebound of major cities. Trepp reports: “Given the strengthening of the economy as more areas lift COVID-19-related restrictions, the number of CMBS loans that are delinquent or in special servicing has steadily declined. The percentage of loans with the special servicer, for instance, fell to 7.79% in August, representing the eleventh consecutive month that the rate has declined. Meanwhile, the percentage of loans that are more than 30-days delinquent declined last month to 5.64% from a 9.02% high seen in August of last year.” Source: MBA CREF Part of the reason that the visible default rates in commercial real estate (CRE) are falling is the great wall of cash chasing too few assets. The fact that loan resolution volumes are also falling, of interest, means that the delinquent note was somehow cured, is a telltale indicator of an asset price bubble. When duration-starved investors are willing to buy busted commercial loans above par, that is not a good indicator for credit or inflation. Just as bank default rates have been driven negative by the truly insane bid for 1-4 family assets, in CRE there are literally hundreds of funds, REITs and other players scouring the landscape in search of investible assets – and most have access to leverage to juice the returns to the level required. Look for delinquency rates on CMBS to fall toward 4% by year end. One close observer of the luxury residential scene in Whitefish, MT, reports that the out-of-town bid for even modest properties continues to push prices into the 7- or 8-digit price range. There is no rhyme or reason for the continued rise in real estate prices in Whitefish save the fact of a dearth of assets and a steady supply of greater fools. Indeed, the scarcity of assets remains the dominant theme in Q3 2021 and will likely continue until the FOMC actually begins to taper. The fact is that the US Treasury has been the dominant issuer or debt in 2021, followed by the residential mortgage sector. Corporates have enjoyed a good year, but nothing like Treasury and mortgage issuance. Federal agency securities and ABS have been trending lower for the past year, as shown in the chart below from SIFMA. Starting in March of 202o, mortgage issuance went through the roof, at one point around November peaking at $600 billion in new MBS is a single month. Corporate bond issuance likewise spiked during the same period. But notice that in the time since last summer, total debt issuance excluding Treasury debt has declined. Bank lending is also flat. These two data points are suggestive of coming deflation. Depending on the outcome of the latest fiscal standoff in Washington, the interest rate picture could go from stable to decidedly bearish and in a short-period of time. Even if conservatives in Congress are able to beat back progressive demands for $4-5 trillion in new spending, an addition $2-3 trillion in US borrowing to fund all sorts of popular but ultimately ridiculous projects may finally tip the scales against the Treasury in the global markets. As we have noted previously, the assumption of stability is the key negative factor in the US economic equation. The FOMC has already signaled that mortgage bond purchases will be reduced in coming months, but Treasury purchases will continue – if only to maintain the size of the system open market account (SOMA). A reduction in securities holdings by the SOMA implies an equal reduction in bank reserves, something most bank CEOs would welcome. The Federal Reserve Bank of NY plans to conduct approximately $56.3 billion in agency MBS purchase operations over the period beginning September 29, 2021. As and when these purchases are actually tapered, look for 30-year mortgage rates to rise between 1-2 percentage points. The housing boom will then be well and truly ended. Home prices will start to weaken. Then comes the question: What next?

September 24, 2021 | As home prices approach truly silly levels and stress is starting to build in the housing finance system, the Biden Administration is preparing to double down on housing. The fact that Biden's approval numbers are in free fall in national polls does not affect the progressive desire to make housing the latest American entitlement. President Bill Clinton caused the 2008 financial crisis by excessively encouraging home ownership in the early 2000s. Specifically, Clinton allowed the GSEs to buy low-quality, private label mortgages, assets that eventually caused the GSEs to fail. The GSEs were the suckers in that housing cycle. Now Joe Biden (or someone acting in his name) is again going to throw gasoline on the proverbial fire of asset price inflation. Gretchen Morgenson and Joshua Rosner wrote in Reckless Endangerment : "Just as [former Fannie Mae CEO] Jim Johnson had recognized that earnings growth was essential to Fannie Mae's continued success, political influence, and his lush pay packages, [ Angelo] Mozilo knew that he had to keep feeding the beast to keep his company's stock price high. In 2005, Johnson brokered a deal that would boost Countrywide's loan production overnight." Since taking office, the Biden Administration has made over a dozen changes in the rules applicable to the Federal Housing Administration including broadening the eligibility for condo loans and making it easier for borrowers with student loan debt. But these incremental changes were as nothing compared to what is coming. Our sources indicate that the FHA is preparing to drop the 175bp upfront fee and some or all of the life-of-loan insurance on government-insured loans. This will make the FHA market hyper-competitive vs the GSEs, Fannie Mae and Freddie Mac. Now that President Biden has removed Republican Federal Housing Finance Agency Director Mark Calabria , the GSEs will respond. Acting FHFA director Sandra Thompson has already taken steps to align the GSEs with the Biden Administration’s policies to encourage housing even as the markets are showing signs of fatigue. After years of FOMC-induced asset price inflation, does the housing market really need more help? Clearly the Biden Administration thinks the answer is yes. Earlier this month, Thompson suspended the changes made to the preferred stock purchase agreement (PSPA) between the GSEs and the Treasury, including changes to the amount of loans or MBS that issuers can sell via the cash window. Inside Mortgage Finance reports: “The PSPAs, as most GSE watchers know, define the nature of the government backstop for Fannie Mae and Freddie Mac. In January, during the final days of the Trump administration, then FHFA Director Mark Calabria and Treasury Secretary Steven Mnuchin agreed to end the net worth sweep — however, only after taking steps to reduce what Treasury perceived as risky practices at Fannie Mae and Freddie Mac.” These risky practices included the use of the cash window, as well as multifamily lending volumes and caps on the volume of mortgages the GSEs can purchase for second homes and investment properties. FHFA also published a notice of proposed rulemaking that would dramatically revise the enterprise regulatory capital framework that governs the operations of Fannie Mae and Freddie Mac, lowering their capital requirements significantly. Thompson has made no public statement about the risky practices cited in the latest amendment to the PSPA or whether her suspension of the PSPA changes means that these practices are now acceptable. Since these changes were made for specific operational reasons, and not ideology, one wonders if Acting Director Thompson has decided to forgive and forget. We hear that there is a report by the FHFA Inspector General on the risky practices specific to the cash window that has not been released to Congress or the public. Specifically, during the Calabria term several issuers were using the cash window at Fannie Mae and Freddie Mac as a substitute form of warehouse facility. Instead of getting a bank credit line, the issuers figured out how to arbitrage the GSE cash window and, in effect, circumvent the capital rules for issuers while adding risk to the GSEs. The GSE personnel who were responsible for these unsafe and unsound practices at the cash window have since left the building, but no public announcement was ever made by the FHFA OIG or Director Calabria. So far under AD Thompson, there has been no written guidance provided to issuers on whether the bad old days of using the GSEs to finance warehouse pipelines will be allowed going forward. Given that the banks are charging sub-1.5% for secured warehouse lines today, one wonders why the FHFA feels the need to disintermediate the commercial banks. It’s not like lending volumes have crashed, although the latest projections from the Mortgage Bankers Association show a significant drop in refi volumes in 2H 2021. Source: Mortgage Bankers Association Meanwhile, as we noted in the most recent edition of The IRA Bank Book , signs of stress are mounting in the mortgage complex, with loss given default (LGD) for bank owned 1-4 family mortgages at -115% in Q2 2021. The 40-year average new loss at default for bank owned 1-4s is 69%. An LGD of -115% on 1-4 family first liens means that, on average, banks are generating proceeds from foreclosures that are more than twice the loan balance. Of even greater interest, however, is the fact that LGD for $500 billion in bank owned multifamily loans is now nearing 100% loss. Could it be that the progressive insanity of suspending rental payments for 24 months has created a credit problem in multifamily assets? Yes. Remember, these multifamily bank owned loans are 50 LTV affairs that have been the gold standard of bank credit for decades, but now we see multifamily assets moving in the opposite direction of other housing loans. Will we see buildings being abandoned by landlords in major cities around the US? The answer sadly is yes. Source: FDIC/WGA LLC As we did almost two decades ago in The Institutional Risk Analyst , when IRA co-founder Dennis Santiago observed in 2005 that Countrywide and Washington Mutual were starting to shrink, let’s put down a marker for future reference. We think that the changes being contemplated by the Biden Administration at the FHA and FHFA to make housing credit even cheaper and more easily available will cause the next housing crisis. Remember, the FOMC is already subsidizing residential housing to a huge degree via the massive purchases of government and conventional MBS. As and when the Fed begins to taper MBS purchases next year, mortgage rates will rise and so will the LGD for 1-4s and other housing loan categories. Beneath the apparently calm and largely artificial credit surface in US housing lurks significant financial and economic hazards. Once the cost of credit in 1-4s is again positive, banks will again face financial and operational risk from residential exposures. And as with so many things in business and in life, risk is about mean reversion.

September 20, 2021 | Federal Reserve Board Chairman Jerome Powell says under oath that asset purchases by the FOMC are not impacting home prices. But he is mistaken. The public data from the Federal Deposit Insurance Corp on bank loan loss rates says otherwise, Mr. Chairman. You see, when that rare foreclosure on a 1-4 family residential loan occurs, banks on average generate 2x the loan balance in sale proceeds from the home. Loss given default on 1-4s at the end of Q2 2021 was minus 115% percent . The LT average LGD for bank owned 1-4 family loans is 63%. Does that sound like no impact to readers of The Institutional Risk Analyst ? Source: FDIC/WGA LLC Review & Outlook In the Q3 2021 edition of The IRA Bank Book , we document the slow destruction of US bank asset and equity returns by the FOMC. In the age of Financial Repression and quantitative easing (QE), banks, money market (MM) funds, pensions, insurers, and really all savers are endangered species. For now, the negative impact on bank returns is masked by positive GAAP adjustments to income due to COVID. By year-end, however, the run rate incomes for the industry will be significantly below Q1 2021. Do most investors understand this impending change? Source: FDIC/WGA LLC The chart above shows returns on earning assets (ROEA) for US banks through Q2 2021. We’ve backed out the $10.8 billion in negative loan loss provisions from Q2 2021 net interest. On this basis, run rate net income was just $59.6 billion in Q2 2021, down from the adjusted $61 billion in Q1 2021, when the industry took $16 billion in loan loss provisions back into income. Look for run rate income for the industry –- excluding further reserve releases -- to be somewhere in ~ $60 billion range for Q3 2021 or $10 billion below Q2 2021. Next we focus next on dividends, where the sharp drop in run rate income suggests that the elevated dividend rates seen in the first half of the year may be at risk. Dividends were $36 billion in Q2 2021 vs run rate income of $59 billion, thus depending on the view of regulators there may be an effective cap on dividends going forward. Again, if you eliminate the sharp downswing in income in 2020 due to fears of a COVID-driven credit crisis and also the spike in income in 1H 2021, the quarterly run rate for the industry is about $60 billion – perhaps lower. Source: FDIC The table below shows share repurchases by the top BHCs through Q2 2021. Notice that share repurchases by JPMorgan (JPM) are running at about 25% of 2020 levels. We look for these numbers to rise in Q3, in part because Buy Side managers expect buybacks to rise, but again forward income may not support higher rates of capital return. Source: FFIEC, EDGAR In the 2017-2019 period, banks saw a sharp drop in profits due to market volatility and the horribly tight credit spreads in 2018 and 2019. This difficult time was followed by a manic uptick in profits and secondary market spreads in 2020, led by 1-4 family mortgages. Run rate income for all lending is likely to remain muted for the balance of 2021, thus it seems appropriate to note that the last time bank net income was exceeded by dividends was 2009. The reason why we raise the possibility of lower bank income going forward is that loan growth is essentially nil in the banking industry at the moment, while deposits have exploded, one reason why ROEA has been falling in the past several years going back to 2019. Some bank loan categories such as HELOCs, credit cards and 1-4 family first liens have actually been falling. Source: FDIC Source: FDIC Given that the US has seen record debt issuance during the past several years, the poor performance of banks in terms of 1) making, 2) buying and/or 3) selling loans into the ABS market is striking. As the table below illustrates, progressives in Congress led by Senator Elizabeth Warren (D-MA) have essentially neutered the largest banks in terms of selling ABS or even 1-4 family mortgages. Warren, who recently suggested breaking up Wells Fargo (WFC) for its continued failure to clean up operational problems, has cost the US economy millions of jobs by essentially taking banks out of risk lending and related securities issuance. Source: FDIC Dick Bove at Odeon states the case succinctly: “The key area of weakness is in commercial and industrial (C&I) lending. The hope for the future is in consumer lending. However, bottom line, the banks are being picked apart by competitors which means that the Bull case on banking must be adjusted to consider that loan growth will not be as robust as thought going forward.” Although the US banking industry has managed to achieve a great deal of operating efficiency, the ability to create revenue has not kept pace as more nimble nonbank originators have stolen market share to Bove’s point. Notice the elevated efficiency ratios of WFC, suggesting that the bank is in serious crisis in terms of negative operating leverage. WFC needs to get into the 50s and stay there, implying future expenses reductions are in store. Source: FFIEC Banks are even starting to acquire nonbank lenders in an effort to address a significant competitive advantage for nonbanks in terms of lead acquisition, close rates and servicing. Fifth Third Bancorp (FITB) , for example, in June announced a definitive agreement to acquire Provide , a digital platform for healthcare practices. Behind every nonbank lender, there is generally a bank to underwrite and fund the loan, almost always prior to sale into the ABS market. In our profile, " Upstart Holdings: Victory for AI? Or Not... ," we noted the connection with Cross River Bank in NJ. The nonbanks are earning the lion's share of the fees in these partnerships with legacy banks. Of note, in March WFC agreed to sell its corporate trust services business to Computershare for $750 million. The deal is set to close in the second half of the year. Meanwhile, Bloomberg News reports that banking also ran Deutsche Bank (DB) sought unsuccessfully to acquire the WFC trust services business, but was rebuffed by the Federal Reserve Board because of the bank’s continuing problems with internal systems and controls. DB is a key player in the world of custody for residential and commercial mortgage securities, but has recently been hobbled by serious operational problems in its custody business. Acquiring the WFC custody business would have been a boost for DB, but instead the trouble-plagued bank is more likely to sell its US banking business eventually. If DB cannot grow in the US, then selling Deutsche Bank Trust Company makes sense – as we have written in past comments . As a general matter, the retreat of banks from the ABS markets continues unabated as does the parallel retreat from loan servicing. The chart below shows all bank MSRs and net servicing fees from the FDIC. Banks do not report individual business line results for servicing, but servicing government loans is generally a loss leader among commercial banks. Source: FDIC Only one significant depository, WFC, continues to purchase government servicing assets and then only to slow the decline of its total assets under management (AUM). Many other banks and IMBs have exited the government loan market or have become sub-servicers of MBS, as in the case of Flagstar Bancorp (FBC) . The table below summarizes the major subsets for bank and nonbank servicing activity in 1-4s. Source: FDIC, FRB St Louis Our outlook for 2H 2021 is for income to essentially flatline around $60 billion per quarter, with credit costs remaining low and asset returns under continued pressure. The wild card in the mix is the fiscal deadlock in Washington, which could eventually lead to a US debt default – an event that could see a jump in volatility in interest rates and spreads. Bottom line: Look for bank credit loss severities to remain below average for 2021 and into 2022, but revenue and earnings also are likely to remain under downward pressure until the FOMC ends QE. Credit Charts Total Loans Looking at the top level view, total loans & leases continues to show a relatively normal pattern, albeit with defaults, noncurrent loans and LGDs falling sharply due to the Fed’s massive purchase of debt under QE and also the positive impact of federal spending in 1H 2021. Notice that loss given default for the $10.8 trillion in total bank loans is falling steadily in 2021. Source: FFIEC Source: FDIC In different times this would be reckoned as a positive for bank earnings, but loan spreads remain muted at best in the same way as bond spreads. And yes, LGD for all $10 trillion in bank loans has fallen 20 points in the past year. The subsidy to debtors created by the actions of the FOMC and also the fiscal actions of Congress is captured in the FDIC bank credit metrics. Source: FDIC/WGALLC Total Real Estate Loans Unlike with total loans and leases, the $5.1 trillion in bank owned real estate loans shows a relatively abnormal pattern in terms of defaults and LGD. The net loss rate had actually climbed to 60% at the end of 2020, but the surge in FOMC bond purchases in 2021 and subsidies and debt moratoria in response to COVID again pushed LGD down toward zero. We suspect that the actual economic loss rate is closer to 60% than to zero, thus when the FOMC begins to taper QE we look for LGD to revert to the 30-year mean of 66.7% Source: FDIC Source: FDIC/WGALLC Construction & Development Loans As with total real estate loans, construction & development loans display an abnormal pattern with considerable volatility, with LGDs near or below zero. The mad rush to acquire properties outside of urban areas has pushed asset prices to truly silly levels, but we are told by the folks on the FOMC that this asset price inflation is a transient phenomenon. With the bid for non-agency loans still significantly better than the execution in the agency market, this suggests to us that the bubble in real estate continues unabated. Source: FDIC Source: FDIC/WGALLC Residential Construction Loans Source: FDIC Source: FDIC/WGALLC 1-4 Family Mortgage Loans The skew visible in C&D loans is even more apparent in 1-4 family first lien mortgage notes, where charge-offs are essentially zero or negative, and LGD is likewise deeply negative, below 100% of the loan balance. In the rare event that a bank-owned 1-4 actually defaults, the result of the foreclosure generates proceeds 2x the loan balance. In view of this data, it is incredible for Chairman Powell to say that Fed policy is not impacting home prices. In most cases, however, the struggling debtor will sell the house and pocket the net proceeds from the sale, one reason why the level of defaults is so low. Through Q2 2021, LGD on residential mortgages was negative 115% vs the long-term average of 63%, clear evidence that the FOMC’s policies are dramatically impacting the price of residential homes. Source: FDIC Source: FDIC/WGALLC As the FDIC notes this quarter: “Loans that were 90 days or more past due or in nonaccrual status (noncurrent loans) continued to decline (down $13.2 billion, or 10.8 percent) from first quarter 2021, supporting a 12-basis point reduction in the noncurrent rate to 1.01 percent. Noncurrent 1–4 family residential loans declined most among loan categories from the previous quarter (down $5.9 billion, or 10.9 percent), followed by noncurrent commercial and industrial (C&I) loans (down $3.1 billion, or 13.9 percent). Three-fifths of all banks reported a reduction in noncurrent loans compared with first quarter 2021.” Home Equity Lines of Credit The HELOC portfolio of US banks is now down to just $277 billion or a 14.4% decrease in unpaid principal balance over the past year alone. While some observers believe that HELOCs may eventually rebound as an asset class, as and when interest rates rise, we note that this has yet to occur. HELOC portfolios of US banks have been falling for a decade and could disappear entirely in the next two to three years. Source: FDIC HELOCs are a product designed for rising interest rate environments, but the growth in home equity suggests that the sheer weight of cash available may help to rescue this rapidly disappearing asset class. When do UPBs start to rise again? Ask Chairman Powell. Note that LGD for bank HELOCs was minus 150% in Q2 2021, the biggest downward skew of all 1-4 housing assets. Source: FDIC/WGA LCC GNMA Early Buyouts (EBOs) As the rate of defaults and past due in bank real estate loans has fallen, the rate of bank purchase of delinquent loans is also receding. The bank exodus from the world of government lending is also contributing to this trend, but the high cure rates for loans under forbearance under the Cares Act or state moratoria is rapidly depleting the supply of EBOs held by banks. Source: FDIC Multifamily Loans Unlike residential loans, multifamily assets have seen rising levels of delinquency, due in part to the fact that many of these properties are rentals. Federal and state rent payment moratoria have badly damaged many landlords and the data reflects a rising tide of credit loss severity. Source: FDIC Notice that LGD on the $490 billion in bank multifamily loans is rising quickly to 100% loss, well in excess of the 69% LT average. This move in loss rates for bank owned multifamily assets is a story that is largely under the radar of most investors and credit analysts. Source: FDIC/WGALLC Commercial & Industrial Loans After residential mortgage loans, C&I loans have experienced the largest decline in non-current loans. The FDIC notes: "Loans that were 90 days or more past due or in nonaccrual status (noncurrent loans) continued to decline (down $13.2 billion, or 10.8 percent) from first quarter 2021, supporting a 12 basis point reduction in the noncurrent rate to 1.01 percent. Noncurrent 1–4 family residential loans declined most among loan categories from the previous quarter (down $5.9 billion, or 10.9 percent), followed by noncurrent commercial and industrial (C&I) loans (down $3.1 billion, or 13.9 percent). Three-fifths of all banks reported a reduction in noncurrent loans compared with first quarter 2021." Source: FDIC Likewise, LGD for the $2.1 trillion in bank C&I loans shows the distortion due to the actions of the FOMC and also the COVID related fiscal action by Congress. This positive effect on bank credit loss severity is likely to be "transitory," however. Source: FDIC/WGALLC Bank Credit Card Loans As we noted earlier in this report, bank credit card portfolios have been falling in terms of loan balances since 2019, suggesting that consumers are saving rather than spending. This is a problem for the FOMC since credit creation is a key goal of policy. In fact, with bank loans as a percentage of total assets at the lowest levels in decades, the entire framework for Fed monetary policy seems in question. Since WWII, the FOMC has used lower interest rates to pull tomorrow's sales into today. This no longer seems to be working. Source: FDIC Notice that, like other bank loan categories, noncurrent and net-defaults for credit cards have been falling for the past year. Also, LGD for bank credit cards was just 70% in Q2 2020, the lowest level in half a century and well-below the 83% average for that period. Source: FDIC/WGALLC Bank Auto Loans Like most of the loan series discussed in this report, auto loans also evidence the distorting effects of QE, extraordinary spending by Congress and also the supply chain disruptions caused due to the shortage of semiconductors for new cars and trucks. Source: FDIC In the chart below, LGD for bank auto loans again shows the impact of QE, fiscal action by Congress and the strong demand for used cars due to supply constraints. Realized losses on bank auto loans are at the lowest levels observed since the FDIC began reporting data on this loan category. Again, this positive credit metric would normally be bullish for bank earnings, but we believe that the impact on bank credit losses is likely to be transitory. Source: FDIC/WGALLC The IRA Bank Book (ISBN 978-0-692-09756-4) is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Book. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Book are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Book represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Book is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Book is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Book. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

September 13, 2021 | In this issue of The Institutional Risk Analyst , we ponder the state of the US financial markets in the final weeks of the third quarter of 2021. The economy is slowing, a U.S. debt default again looms, but life continues, albeit stranger each day. Next in The IRA Premium Service , we’ll feature our IRA Bank Book industry survey for Q3 2021. We predicted almost a year ago that bank net-interest margin was headed towards zero. The FDIC now notes in its Quarterly Banking Profile : “The average net interest margin contracted 31 basis points from a year ago to 2.50 percent—the lowest level on record. The contraction is due to the year-over-year reduction in earning asset yields (down 53 basis points to 2.68 percent) outpacing the decline in average funding costs (down 22 basis points to 0.18 percent). Both ratios declined from first quarter 2021 to record lows.” Source: FDIC Now you might think that the state of the US banking system ought to be a key concern of members of the Federal Reserve Board, but you’d be wrong. Instead, members of the Board, joined by former Fed Chair and now Treasury Secretary Janet Yellen , are planning ways to work-around the American political process and thereby avoid an event of default by the United States. Writing Friday night in the Financial Times , John Dizard notes: “We had a hint of the risks and what actions the Fed can take from a transcript of a teleconference of the central bank’s policy-setting Federal Open Market Committee on October 16 2013 . It was released in January 2019 and is the most recent published account of the emergency “actions” the central bank plans to keep markets open in the event of a shutdown, according to a person familiar with the matter. Yellen and current Fed chair Jay Powell were on the call as board members.” Call us cynical, but isn’t the timing of news reports about the personal trading activity of members of the FOMC a little convenient? The absurd spectacle of members of the FOMC actually trading their own personal investment accounts flies in the face of regulations for bankers, credit and stock analysts and most other financial professionals in the US. And this all just happened to surface at the end of last week – at the same time that “extraordinary” measures by the Fed to avoid a Treasury default were gaining attention? Hmmm. As it turns out, the FOMC actually discussed in 2013 ways to skirt federal law and roll maturing US Treasury debt by one day at a time. This was intended to give the Treasury under President Barrack Obama time to obtain an extension of the debt ceiling from Congress. Both political parties seem determined to push the credit standing of the United States to the breaking point in pursuit of partisan advantage, thus the Fed is looking for a solution. Congress allowed the limited authority for the Fed to purchase debt directly from the Treasury lapse in 1981. For history buffs, please see the excellent 2014 treatment by New York Fed economist Kenneth D. Garbade , “ Direct Purchases of U.S. Treasury Securities.” The abstract reads: “Until 1935, Federal Reserve Banks from time to time purchased short-term securities directly from the United States Treasury to facilitate Treasury cash management operations. The authority to undertake such purchases provided a robust safety net that ensured Treasury could meet its obligations even in the event of an unforeseen depletion of its cash balances. Congress prohibited direct purchases in 1935, but subsequently provided a limited wartime exemption in 1942. The exemption was renewed from time to time following the conclusion of the war but ultimately was allowed to expire in 1981.” Garbade’s timely history lesson published a year after the subject FOMC meeting was a not-so-gentle rebuke to the staff of the Fed Board in Washington. The Fed’s lawyers apparently advised members of the FOMC a year earlier that they could lawfully accommodate the Treasury’s cash needs. In fact, as Garbade documents, the advice which led to the FOMC discussion in October 2013 was completely wrong. Not only is it unlawful for the Fed to purchase debt directly from the Treasury, but more important, as Dizard alludes in the FT , the value of Treasury debt as collateral is nil once it gets within one day of maturity. Rolling the maturing Treasury debt for a day does not help the shortage of risk-free collateral, especially if you are cognizant of the collateral rules of the various exchanges and clearing houses. But it now seems that neither Chair Yellen nor then-governor Jerome Powell were properly informed. Several of the actions reported in the FOMC minutes seem to be illegal on their face. Action 8 discussed by the FOMC, for example, would remove Treasury securities with delayed or potentially delayed payments by buying them outright for the Fed’s account. Action 9 would exchange customer’s or dealer’s bonds that are on the verge of default with bonds in the Fed’s portfolio that have later interest or principal payments. Now most casual observers think that the Fed’s dual or actually triple mandate from Congress via the Humphrey Hawkins legislation includes guiding monetary policy so as to achieve full employment, price stability and, lest we forget, stable interest rates. In fact, the true mandate that motivates the Fed’s actions is illustrated by the 2013 FOMC meeting. That is, to keep the market for US Treasury debt open and functioning, and thereby avoid a U.S. default. The debt ceiling and tax raising circus now playing out on Capitol Hill adds certain difficulties to the Fed's fine tuning task. Since a large portion of the Fed’s holdings of Treasury securities are in the form of short-term bills, the approaching political confrontation in Congress over the debt ceiling presents technical problems for the money markets. First, since the FOMC is currently running over $1 trillion in reverse repurchase agreements (RRPs) with money market (MM) funds, a lack of collateral eligible for repo will throw the FOMC’s efforts to manage the vast flow of liquidity released by Congress earlier in the year into disarray. Notice, in this regard, that the Treasury General Account (TGA) has now fallen from $1.7 trillion to ~ $200 billion, yet the volume of RRPs remains elevated. Readers of The IRA may recall that the public narrative behind the RRP facility was to soak up the liquidity flowing from the TGA into bank accounts from the COVID recovery legislation. As the cash flowed out of the TGA, the collateral used to “sterilize” the TGA was released, but you would not know if looking at the short-term markets. Of interest, domestic bank deposits rose about $800 billion since Q4 2020, but much of this flow is due to the Fed's bond purchases under quantitative easing (QE). Second, a future lack of collateral is already suggested by the guidance from the Treasury regarding the size of the TGA. This trend that will impact the fixed income and equity markets both since demand for risk-free collateral is the key factor behind U.S. interest rates. The entire US economy depends upon a foundation of leverage on risk-free collateral held by banks and investors. If you have less Treasury, government and agency collateral, then you have less leverage for the system and less economic growth. If the Fed tries to “adjust” by selling collateral to satisfy private demand for Treasury paper and government-insured MBS, then tapering will have well and truly begun – involuntarily. This is one reason why the Fed securities desk should sell into market strength and be ready to buy when weakness appears. The mechanical and public management of QE is a major impediment to the Fed's ability to manage this dynamic mess of a situation. Few people inside or outside of the Federal Reserve fully understand the fragility of the current monetary construct. In past years, the Fed was the proverbial dog shaking the market tail. Today, however, the vast fiscal flows from Treasury unleashed by the Congress have greatly added to the complexity of the Fed’s liquidity management task. The FOMC talks of tapering, but actually making it happen without a market tantrum is another matter. The prospect of trillions more in new taxes and debt-funded federal spending from Congress, on top of the $1.7 trillion already spent this year, adds even further to the risk of market instability. Remember that back in July when Federal Reserve Board raised the interest rate paid on reserves and RRPs, Chairman Jay Powell called the move a “tweak.” The July interest rate hike was ignored by the Big Media, but was an inconvenient turn in the happy economic narrative. Powell's "tweak" was a pretty clear attempt to bolster the yield floor under US assets and thereby defend MM funds and banks. The growing fiscal chaos in Washington makes such efforts problematic, however. Since the Democrats lack a true majority in the Senate, there is no visibility on future fiscal policy out even a few months. Should the debt ceiling fight result in a disruption in new debt issuance, Treasury yields could fall significantly. This may seem a strange response to an approaching event of default, but the markets still don't believe a default can occur. If Congress decides to play chicken, the FOMC may find it is no longer able to defend the lower bound as investors rush to buy supposed "risk free" assets. In the event, look for MM funds, commercial banks and other users of leverage to complain loudly and seek additional subsidies and support from Washington. US banks and funds cannot function in a zero or negative interest rate world, either financially or in terms of internal systems and controls. As we noted at the top of this comment, the cost of funds for the entire $20 trillion asset US banking industry was less than $10 billion in Q2 2021, a rounding error. The only trouble is that the return on earning assets for US banks and MM funds is now falling faster than funding costs due to the mounting demand for risk-free collateral, even more than the artificially suppressed cost of funds. Indeed, the Fed needs to raise interest rates soon to avert a serious calamity. If you subtract the GAAP release of bank loan loss provisions in Q2 2021 back into income, then the net interest income for the banking industry was below $120 billion or $30 billion below 2018 peak levels. MM funds are basically in the same boat. As and when Treasury market yields are significantly negative, look for pressure to grow on the Federal Reserve Board to come to the rescue of MM funds and banks. That ringing can just you hear in the background is the zero rate alarm. Sound for collision.

Volatile markets have finally made policy makers start to fret about excessive leverage and sky-high asset prices, two results of years of equally excessive monetary policy. Former Federal Reserve Chair Janet Yellen, for example, worries from the speaking circuit about excessive leveraged lending and the level of corporate debt across Wall Street. "Corporate indebtedness is now quite high and I think it's a danger that if there's something else that causes a downturn, that high levels of corporate leverage could prolong the downturn and lead to lots of bankruptcies in the non-financial corporate sector," Yellen told New York Times columnist Paul Krugman. As with past appearances, Yellen never directly admits that some of her own policy decisions contributed to the problematic accumulation of barely investment grade corporate debt now teetering on the brink of downgrade. But she did make this remarkable concession: "Recent research has identified possible linkages between monetary policy & leverage among financial intermediaries. It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage & excessive risk-taking in the financial system." Bravo Janet. Meanwhile, the US markets continue to suffer from the mounting concerns about future economic growth and, therefore, rising credit costs. Recall that the definition of a systemic event is when markets are surprised. Most categories of new debt issuance are down double digits compared with a year ago, as shown in the table below. While Treasury debt issuance is up 15% year-over-year (YOY), corporate debt issuance is down 18% and municipal issuance is down almost as much. Source: SIFMA Notice that issuance of agency securities is also down, a result of falling lending volumes in the residential and commercial mortgage sectors. Some of the paper that might have been packaged and sold into the agency market in past years is now being retained in portfolios or sold into private deals. Note too that the issuance of asset backed securities is also down double digits for the year. When volumes in key debt markets are falling, it is a pretty good guess that asset prices will soon follow. And even as markets recoil from risks real and imagined, the benchmark 10-year Treasury bond continues to rally, forcing the yield curve to invert. There are endless swarms of experts pontificating on the meaning or not of a flat yield curve, but the obvious observation is that buying pressure on the 10-year bond remains brisk. Indeed, do observe that 2s and 10s have been rallying since early November. Last time the yield curve inverted was 2005, then as now a period with loan volumes falling and asset prices about to follow. Two years later, asset prices collapsed and banks were subject to liquidity runs regardless of the level of capital. When asset prices fall to cents on the dollar, "we were all broke for a while" as one colleague at Tudor observed a decade ago. But don't bother policy makers with facts. Witness Federal Reserve Governor Lael Brainard, who thinks that banks ought to raise more equity capital now that profits are booming and the economy is relatively stable. Sounds great, yes? But sadly Governor Brainard repeats the same nonsense about increased capital that is found too often in the world of academia. Many policy makers see punitive levels of capital as a panacea for addressing market risk. Also, many economists believe that banks should not be profitable at all and instead should simply be managed as public utilities, thus profitability is seen as a secondary concern. The only trouble with higher capital is that it makes banks less stable. Raising capital above the level needed to 1) absorb actual credit losses and 2) grow deposits reduces bank profits, thereby weakening the banks ability to fund credit losses. Provisions for credit losses come from income, not capital. Banks with weaker revenue and profits trade at lower equity multiples, increasing the cost of debt and equity capital. Eventually poor profitability leads to situations like Deutsche Bank (DB). Even as markets show signs of entering a new deflationary cycle, current and former Fed officials roam the financial landscape, talking about increased regulation and capital to solve problems of market risk that the Fed itself created with its extraordinary policies. But static piles of capital sitting safely invested in Treasury bills do not help a bank absorb losses. Big spreads and profits are what make banks like JPMorgan (JPM), U.S. Bancorp (USB) and BB&T (BBT) so stable and so highly valued by investors. Chair Yellen, for example, keeps talking during her numerous public appearances about "holes" in the financial regulatory system, but the biggest holes are intellectual, in the minds of federal regulators who don't seem to appreciate that capital is only important to dead banks and their creditors. In fact, banks like community lenders that manage credit well should be allowed to maintain less capital than their peers. Chair Yellen and Governor Brainard may eventually admit that extraordinary monetary policy increases market volatility, but the corollary to that obvious statement is more ominous. No amount of bank capital can protect financial institutions during periods of investor fear and market panic. If the US central bank is going to use the manipulation of asset prices to conduct monetary policy, then they should expect to see periods of extreme market volatility as a result. And no amount of book equity capital can save you when the bid goes to zero.

September 9, 2021 | In this issue of The Institutional Risk Analyst Premium Service , we consider two questions: Which are the top performers among the banks we follow in terms of equity market valuation, both relative and absolute? And which US financial will best weather the coming storm of a major equity market correction? Few of the largest U.S. banks are in this group, a sad commentary on the fact that many Buy Side managers prefer the liquidity of mediocre large-cap stocks to the superior financial performance of smaller names. And thanks to the Federal Open Market Committee, several perennial underperformers have also risen to the top of the proverbial airation tank. Will they survive a market correction? Read on… In terms of relative value, that is, total equity market return over the past 12 months, the top-ten financials are shown below. Notice that the list includes several stocks that have not exactly been stellar performers, but rose to the top thanks to the FOMC and insatiable demand from Buy Side managers. A rising tide of monetary inflation lifts all asset prices. Source: Bloomberg Western Alliance Bancshares (WAL) , which we have previously profiled in The IRA , is one of the best performing banks in Peer Group 1. The acquisition of residential mortgage aggregator AmeriHome from Apollo (APO) portfolio company Athene Holdings (ATH) positioned the bank for explosive growth in 2021 in terms of total equity returns. Next on the list is CapitalOne Financial (COF) , a monoline credit card lender with a bank charter. COF has traditionally traded below book value due to the high-risk nature of its loan portfolio. COF ranks in the 97th percentile of all large US banks in terms of credit loss, 1.2% of total loans and leases vs 0.16% for Peer Group 1. Even with the considerable push from the FOMC, however, COF still trades at just 1.1x book value, an illustration of how far this stock has run. Another perennial dog is Ally Financial (ALLY) , which we profiled in October of last year (“ Bank Profile: Ally Financial Inc. ”). ALLY has delivered over 100% equity returns in the past year, but the $180 billion asset specialty consumer lender continues to underperform its peers financially. Today ALLY trades at 1.2x book value, but was half that a year ago -- and for good reason. The key structural problem with ALLY is that its high cost of funds makes the bank largely uncompetitive. ALLY’s cost of fund is over 1.2% of average assets vs < 20bp for the average of Peer Group 1. Even with a yield on loans and leases that is a point or more better than the large bank average, ALLY remains in the 97th percentile in terms of interest expense vs total assets. In any equity market selloff, we look for ALLY to underperform the market. Another dog that has surged during the LTM is Goldman Sachs (GS) , which delivered 103% total equity returns over the past year but has slipped in recent days. CEO David Solomon continues to build the firm’s assets management business via small acquisitions, but has resisted our advice to merge with a depository to stabilize the group’s funding base. GS is a great broker-dealer and a mediocre depository that now trades at 1.5x book value, twice what it was a year ago. Like COF and ALLY, we look for GS to underperform in any equity market correction. At Morgan Stanley (MS) , however, the situation is different from GS in a qualitative sense. MS has a far stronger banking business and also a more stable and profitable asset management arm. Likewise, Charles Schwab Corp (SCHW) continues to grow its AUM and $500 billion plus core bank deposit base, and has a book value multiple that reflects this strength. The table below shows the top-ten financials sorted by book value of equity (P/B). Notice that momentum plays such as GS, COF and ALLY have disappeared, but MS and SCHW remain due to their superior financial performance and operating leverage. Source: Bloomberg Fintech and payments play Square Inc. (SQ) dominates the rankings due to the overbought nature of the stock. We first got into SQ back when it was in single digits, this based upon our surmise that Buy Side managers desperate for fintech spice to add to portfolios would pile into the sector. Sure enough, several years later SQ is one of the most overvalued financials in our surveillance group, especially when you consider that this company is basically a competitor of Visa (V) at 13x book value, Mastercard (MA) at 52x book value, and American Express (AXP) at 5x book value. But of course, SQ has added the magic word to its business model: crypto. Another observation from this list is the inclusion of First Republic Bank (FRC) , a high-touch asset manager and so-so unitary bank that shed its holding company in 2008. The decision to become a unitary bank made sense in terms of cutting operating expenses, but greatly reduced the bank’s public disclosure for investors. Bank OZK (OZK) shares this unfortunate characteristic. Despite the $240 billion assets under management (AUM), FRC generates relatively little in the way of non-interest income. In fact, there is a 4:1 ratio between net interest income and total non-interest income at FRC – the polar opposite of SCHW, for example. The 1% ROA and 12% ROE are fine, but no different than the sort of asset and equity returns available from other banks. Trading north of 3x book value and at a premium to SCHW and MS, we have a hard time justifying the #4 ranking of FRC other than to say that Buy Side managers clearly like the stock. Put FRC in the same outlier bucket as SQ and PayPal (PYPL) when it comes to understanding the public market valuation. To us, FRC is too small to survive as an independent bank, so perhaps we can treat the outsized equity market valuation as an impending takeover premium. Another important name that makes both the relative and absolute value lists is Discover Financial (DFS) , a monoline credit card issuer that consistently ranks among the top financial performers in Peer Group 1 along with AXP. DFS ranks in the 99th percentile of Peer Group 1 in terms of interest income vs total assets, net operating income and overall net income. As and when a major equity market correction arrives, we’d hold onto DFS as a strong qualitative anchor in the storm for any long-term portfolio. WAL, MS, JPMorganChase (JPM) and U.S. Bancorp (USB) round out the top ten banks in terms of absolute value measured by book value multiples. The fact that these names are in relatively "normal" positions, despite the FOMC’s extraordinary market manipulation, says to us that these names will likely fare better than some of the more highly valued stocks on the list. As an analyst at MS wrote this week: “Stocks may fall 15% by year-end. The issue is that the markets are priced for perfection and vulnerable, especially since there hasn’t been a correction greater than 10% since the March 2020 low.” Indeed. Those financials with basic operating strength are likely to perform far better than the Meme stocks such as SQ or PYPL. When we heard SQ co-founder Jack Dorsey starting to prattle on about the opportunities in crypto, that did not give us greater confidence in the company's business model. Perhaps long V and MA, short SQ, will be the short strategy of 2022. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

September 7, 2021 | If we told you that a group of banks and REITs outperformed fintech stocks during the first nine months of 2021, what would you say? But hold that thought. Leen's Lodge September 4, 2021 In this issue of The Institutional Risk Analyst , we ponder the remains of 2021 after several days of fishing at Leen's Lodge in Down East, Maine. Some people believe that the Federal Open Market Committee is in a hurry to end bond purchases and raise interest rates, others seem inclined the opposite direction. But fact is, stocks and housing prices in the US are racing ahead at double digits, faster than in the 2000s, raising an ugly but entirely appropriate comparison regarding inflation and asset prices. Speaking of assets, we’ll be presenting some of the top-performing US banks in the next issue of The Institutional Risk Analyst for subscribers to our Premium Service . The performance of the bank group in 2021 is striking, especially since the fundamentals of most banks have weakened since Q1 of this year. As we approach the end of the third quarter of 2021, lower revenues, earnings and NIM seem to have finally caught the reluctant attention of Buy Side managers. As a result, stocks have been griding sideways since May, when talk within the FOMC of tapering asset purchases disturbed giddy market participants. If we told you that a group of banks and REITs actually outperformed the fintech sector this year, would you believe it? Notice that Western Alliance Bancorp (NYSE:WAL) , which we profiled earlier this year (“ Western Alliance + AmeriHome = Big Possibilities ”), has outperformed Square Inc. (NYSE:SQ) and other fintech plays in terms of total return. Indeed, the one-year total return calculated by Bloomberg for WAL was twice that of SQ, which ranks #9 on the list. You still think that’s air you are breathing? While home prices are indeed continuing to gallop along at double digit annual rates, the volumes in the mortgage lending space continue to slow. This presents the FOMC with yet another dilemma since any increase in interest rates is likely to slow lending volumes even more. Meanwhile, as we approach the end of Q3, banks are positioning for yet another weak quarter in terms of loan growth, a key indicator of the direction of current and prospective earnings. Looking at the FRED chart above showing the 10-year Treasury note and the 30-year mortgage series from Freddie Mac, the former has essentially been shuffling sideways for the past year. This stable rate environment, however, has been positive for REITs, which have seen total returns over the past year in high double digits or about half the rate of return of banks. We own Annaly (NYSE:NLY) common BTW. Names such as Redwood Trust (NYSE:RWT) , Chimera Investment (NYSE:CM) and MFA Financial (NYSE:MFA) have led the REIT group, which tends to cater to a retail, income oriented investor base. The average dividend yield for the REIT group is just 9%, according to KBW, roughly half of the level of two years ago. This is one reason why the scarcity of risk-free collateral engineered by the FOMC is the dominant market factor. Giant REIT New Residential (NYSE:NRZ) is the laggard in the group with “only” a 48% total return over the past year. Once again, the FOMC proves that pigs can indeed fly and even soar given enough inflation. Angel Oak Mortgage (NASDAQ:AOMR) , which floated its shares in June on the sea of liquidity provided by the FOMC, is another laggard in the REIT group that may eventually regret its public debut. While there remains considerable uncertainty as to the timing of any change in FOMC policy, we remain skeptical that the Fed can change any aspect of policy without provoking a market event. The excessive upside moves in valuations for stocks and housing assets, for example, suggest that a correction is not only likely but entirely necessary. To get from here to there in terms of returning markets to "normal" may require navigating some very rough water. Keep in mind that despite the big gains of the past year, most if not all of the resi REITs are trading at or below book value. Banks, on the other hand, are trading near multi-year highs even as fundamental languish. Dick Bove confirms our recent trashing of Bank of America (NYSE:BAC) : "Revenues are meaningfully below where they were in 2009. Moreover, they are basically showing no growth in the past few years. They are erratic and in a downward trend." Ditto. Yet, thanks to the FOMC's excessive stimulus, BAC was one of the best performing bank stocks in the past year. The timing and direction of any rate change is going to hinge on changes to the Fed’s purchases of Treasury bills for the system open market account or SOMA, perhaps the most significant acronym in finance today. Strategist Ethan Heisler at KBRA puts the situation succinctly in his excellent monthly slide deck: “Given that the bulk of the Treasurys the Fed holds in its SOMA portfolio is concentrated in the front end of the yield curve (see Slide 6), bank treasurers could theoretically anticipate upward pressure on short-term yields in 2022 when it begins to taper. On the other hand, this month’s refunding announcement by the Treasury hints at bill-issuance reductions during auctions in the fall that may offset the upward pressure on yields by reducing supply.” Since the FOMC is currently the largest purchaser of both Treasury paper and MBS, the timing of any change in purchases for SOMA will obviously impact valuations across the interest rate complex, particularly for banks and REITs. Any increase in yields on the 10-year Treasury, for example, likely will be negative for mortgage lenders, which may be the worst performing sub-sector for financials in 2021. It seems increasingly apparent that the FOMC cannot make any change in policy without provoking a catastrophic sell-off in equities and the dollar. One former Goldman Sachs bond trader opined last week: “ Judy Shelton's commentary, " Congress Needs to Rein In a Too-Powerful Federal Reserve ," has the correct motive but understates the seriousness of the mess the Fed has created. They have driven asset prices to absurd levels, and have made Americans owners of homes they will be walking away from down the road. The Federal Reserve cannot stop their purchases and money creation. The whole financial system would implode. Why do you think the Chinese are getting out of Treasury paper? They see it coming. The dollar will eventually leave its Fed induced heights.” So the good news is that banks and REITs have outperformed fintech leaders over the past nine months. The bad news is that the FOMC has so distorted financial markets in the quest for the socialist utopia of “full employment” that any change in policy is likely to provoke an investor tantrum. The most recent weak jobs data gives markets a bit more room for exhuberance, but any sign of policy change by the FOMC could provoke a massive selloff in global equities as asset prices and fundamentals become reacquianted. More than ever before, the FOMC is the prisoner of history to paraphrase Jim Grant . Or to recall the wisdom of Professor Ed Kane from our discussion about COVID and monetary policy this past February (“ Ed Kane on Inflation & Disruption ”): “Many seem to be hoping that things will go back to the way things were, back to ‘normal.’ But I am always reminded of the concept of ‘hysteresis’ which basically says we may travel up one path in response to outside forces, but when these outside pressures subside, we should not expect that we will return to the same ways of doing things. We have to recognize that hysteresis is a general phenomenon. Investors, in particular, must ask what kind of paths will unfold if and when we establish herd immunity, and accept that the good old days cannot completely return.”