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August 27, 2021 | In this issue of The Institutional Risk Analyst , we put two of our favorite banks, U.S. Bancorp (NYSE:USB) and PNC Financial (NYSE:PNC) in a head-to-head contest. Just for end-of-summertime fun, we toss in Truist Financial (NYSE:TFC) , another player in the half-trillion category. These three super regional banks, which have escaped the regulatory coma imposed upon the top four zombie dance queens – JPM , WFC , C , and BAC -- hold great value creation potential. But which is likely to realize this potential? Subscribers to The IRA Premium Service read on to find out. The fifth largest US money center, USB is based in Minneapolis and is a long-time favorite of The Institutional Risk Analyst with strong funding and revenue diversity. PNC is now of comparable size to USB and has a distinctly different business model that is migrating away from institutional business and toward greater retail exposure. TFC, which is the combination of BB&T and SunTrust , is also a contender. BB&T was always an industry leader in terms of financial performance and stability, SunTrust less so – much less. The combination has yet to regain the historical performance levels of BB&T. Quantitative Factors In 2009, other US banks were charging off vast percentages of loan portfolios, BB&T took its sweet time, quarters more time in fact, and thereby improved the bank’s default resolutions. The fact that the bank had the capital and, more important, the income to deal with credit expenses years after 2009 enabled BB&T to emerge from the crisis stronger. This operational strength, however, is not visible in the combined bank’s efficiency ratio, as shown in the first chart below. Source: FFIEC, EDGAR The chart shows the standardized measures for efficiency from the FFIEC through Q1 2021 and then the GAAP disclosure for Q2 2021. The regulatory definition of efficiency is: Overhead expenses / Net Interest Income + non-interest income. Under GAAP, however, issuers may adjust such measures, as in the case of TFC, which shows GAAP and “adjusted” efficiency in its earnings supplement. Looking at the history for our three banks and Peer Group 1, which represents the simple average of the 133 US banks above $10 billion in total assets, the clear leader is USB followed by PNC and then TFC. TFC’s GAAP efficiency was 71% in Q2 2021, but was 56% on an adjusted basis after deducting a $200 million charitable donation and, of course, newly discovered merger expenses related to severance. Surprise! To us, the GAAP number is the correct measure of bank management at TFC. TFC often tracks wide of Peer Group 1 in terms of operating efficiency, which is a troubling metric for a large bank. Most of the top 25 US banks have efficiency ratios in the mid-50s on a GAAP basis. TFC has a long way to go. Turning to credit, again USB leads the group, but in terms of the higher net credit losses reported by the bank vs PNC or TFC. Like its larger peers, USB has higher credit expense vs average assets than do its smaller peers and the average for Peer Group 1, which is dominated by smaller banks. Source: FFIEC Most US banks have seen credit losses moderate even during the period of stress caused by COVID in 2020. In Q2 2021, for example, USB reported a net loss rate of just 25bp vs 30bp in Q1 2021. PNC reported net charge-offs of 48bp in Q2 2021, up from 25bp in Q1 2021 and a three-year high. Of note, commercial losses rose sharply at PNC while consumer charge-offs fell. Net losses at TFC are generally running above both PNC and USB, suggesting that the mediocrity of SunTrust is still a drag on the combined bank’s performance. And note please that net losses for Peer Group 1 are running at half the rate for the top-ten large banks. Next, we turn to loan pricing, one of the most important contributors to bank earnings and also an important operational indicator. Under the quantitative easing from the FOMC, bank earnings have been under considerable pressure as margins have been squeezed and credit spreads have been under intense pressure. PNC, for example, reported a net-interest margin (NIM) of just 2.29% in Q2 2021, an interesting benchmark as you consider the historical gross loan spreads below. Source: FFIEC If you figure that PNC’s gross yield on its loan book will be about 3% or a bit higher in Q2 2021, the 2.4% NIM PNC reports on its loan book in its GAAP disclosure is in the right ballpark. Low funding and credit costs make all of this work, but PNC and other US banks have little in the way of net revenue should credit expenses and/or funding costs start to rise. Indeed, the average for Peer Group 1 outperforms the three large banks in this report by a significant margin, suggesting once again that smaller banks have more loan pricing power. The table below shows the pricing of the assets and liabilities on PNC's balance sheet and the components of NIM. This table, which most investors never see, shows just how difficult it is today for banks to generate asset returns. And the best returns by a wide margin come from consumer loans. Source: EDGAR After credit losses and loan pricing, we look at the cost of funds as the other leg of the stool in terms of the operations of a bank. As FDIC noted in its Q1 Quarterly Banking Profile : “The average yield on earning assets declined 1.1 percentage points from the year-ago quarter to 2.76 percent, while the average cost of funding earning assets declined 54 basis points to 0.20 percent, both of which are record lows.” Note that the total cost of funds for PNC in Q2 2021 was just 16bp. Source: FFIEC At the end of Q1 2021, PNC had the lowest cost of funds in our sample group, showing that large banks do have superior access to liquidity. The average for Peer Group 1 was just under 30bp at the end of March while our three subjects were below 20bp in terms of interest expense vs average assets. Notice that USB and Peer Group 1 move around the least, while PNC and TFC have seen more relative volatility in terms of funding costs. Since Q4 last year, both PNC and TFC have pushed down funding costs dramatically so that they are just behind JPMorgan (NYSE:JPM) and the other top money center banks, which basically lend money to themselves sub-15bps. Finally, we come to the last and most important quantitative factor, namely profitability. Notice we never talk about capital in this analysis, because ultimately it is the return on assets that matters for most banks. Non-interest revenue is also important, but providing priced services to customers is a very different business than lending and investing bank depositor funds, especially when the FOMC is aggressively manipulating the interest rate market. Source: FFIEC The sharp drop in bank income in 2020 was caused by the fear of a credit crisis due to COVID. In fact, there was no appreciable credit crisis for banks in 2020, but the United States did careen off the rails in terms of fiscal spending. The rebound in bank earnings was due to the recapture of loss provisions back into income in Q4 2020, and Q1 and Q2 2021, a process which is largely complete. Going forward in 2021 and beyond, bank results are likely to be dominated by the FOMC and the shape of the yield curve. Qualitative Factors When you look at our three bank subjects, each has a different business model and area of market focus and, as a result, a different funding profile and asset mix. Let’s summarize the three bank’s profiles: U.S. Bancorp USB has one of the most balanced business models of any large bank with more than 40% of revenue coming from non-interest revenue business lines. Only 53% of the bank’s assets are loaned out, meaning that the bank has excess deposit liquidity to the tune of $125 billion or roughly equal to the bank’s non-interest-bearing deposits. USB made almost $1 billion in Q2 2021 from its payments business and has become an island of liquidity serving national customers. This internal liquidity is one of the more important attributes of a money center bank. The table below from the USB Q2 2021 earnings presentation shows the components of non-interest income. In July, USB announced the acquisition of PFM Asset Management LLC , which will operate under its subsidiary, U.S. Bancorp Asset Management. The total AUM of USB’s asset management business is less than half a trillion dollars. In January 2021, USB acquired the debt servicing and securities custody services portfolio of MUFG Union Bank , an addition that continues to build its institutional business. USB’s acquisition of State Farm Bank’s deposits and credit card loans in March 2020 marked the first M&A deal for USB involving a bank or a deposit portfolio in about six years. All of these acquisitions, however, are additive and are unlikely to change the basic business model or asset size of USB, which has remained around $500 billion in total assets for many years. PNC Financial PNC also has a business model that is different from the typical commercial lender with three reportable business segments: Retail Banking, Corporate & Institutional Banking, and Asset Management. The bank’s loan book is less than 50% of total assets, but the nature of the business is changing with the sale of PNC’s stake in Black Rock Inc. (NYSE:BLK) . The recent acquisition by PNC of the US assets of Banco Bilbao Vizcaya Argentaria, S.A. (NYSE:BBVA) adds more than 600 retail branches in Texas, Alabama, Arizona, California, Florida, Colorado and New Mexico. It remains to be seen whether this collection of disparate, under-performing assets will deliver higher returns for PNC than they did for BBVA. Truist Financial Corp Of the three banks covered in this analysis, TFC is the most conventional in terms of its business model. TFC remains primiarly a commercial lender, but consumer balances now are nearly half of total loans. Of note, TFC's loan book shrank $6 billion or 2.1% sequentially in Q2 2021, but deposits continued to grow due to "continued government stimulus," TFC reports. The bank's loans-to-deposits ratio was 73% based on average balances or 20 percentage points higher than USB or PNC. The bank’s recent acquisitions, including Colonial Bank from the FDIC (2009), Susquehanna (2015) and SunTrust (2019), confirm this conventional retail bank model, but these transactions have also distorted the bank’s financial reporting under GAAP. TFC management has spent a lot of time placating various political constituencies in order to gain approval of the SunTrust transaction, which cost shareholder almost $600 million in pretax expenses just in 2021. The bank’s financial performance has suffered accordingly. Time spent on “investments in our communities” and ESG are hurting shareholder returns. Until TFC management refocuses its attention on asset and equity returns, as was traditionally the priority with BB&T, we look for the bank to continue to underperform its asset peers and Peer Group 1. The Bottom Line We continue to be fascinated by the evolution of PNC into a broader, retail-focused business, but for now USB get’s our vote in terms of business model and overall financial performance. While PNC’s earnings were up in the first half of 2021 more than the other banks in our group and even more than all of Peer Group 1, the release of credit loss provisions played a big role in this performance. As the year progresses, we’ll be interested to see how the run-rate results for PNC and other banks look once the effects of COVID have run out of the system. “PNC’s promise seems unlimited at the moment,” writes our friend Dick Bove . “Its recent acquisition of BBVA USA is creating multiple opportunities for the company in both products and geographies. The bank must now assimilate this bank and deliver on its earnings promise. The stock’s valuation suggests that investors expect this.” We agree and more, we wonder if the move by PNC away from an institutional focus and toward more of a retail bank is a good choice. As the chart below suggests, PNC has outperformed USB and TFC during 2021, but has underperformed the bellwether Invesco KBW Bank ETF . Investor expectations for PNC are, in our view, inflated beyond the possible benefits of an expanded retail strategy. Thus for our money, USB with its stubborn focus on a strong institutional business remains the best performer in the half trillion total asset category. Disclosures: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. 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August 23, 2021 | In this issue of The Institutional Risk Analyst, we feature a discussion with Lee M. Smith, Executive Vice President and President of Mortgage at Flagstar Bank, the main operating unit of Flagstar Bancorp (NYSE:FBC) . As one of the leading originators, servicers and warehouse lenders in the industry, Lee and his team at FBC have an important perspective on the industry and what lies ahead in residential mortgages. The IRA: Lee, thank you for taking the time. We’ve been through quite a year in the mortgage factory. Where are we now and what lies ahead for the residential mortgage business? Smith: We always appreciate your perspective and insights on the industry, Chris. It was indeed a very interesting quarter and year in mortgage given COVID, the lockdowns and low interest rate environment creating a $4+ trillion mortgage market in 2020. And it’s likely going to get more interesting. The IRA: Do tell. We’ve watched Rocket Companies (NYSE:RKT) guide to an up year on production if not profits. That suggests that they intend to take a lot of market share. It also suggests that the sharply lower projections for refinance volumes in the latest estimate from the Mortgage Bankers Association is a tad bearish. Source: Mortgage Bankers Association Smith: First of all, I think it’s important to differentiate between mortgage locks and closings when talking about share. Closings may be up in 2021 vs. 2020 but some of that is 2020 locks closing in 2021. It might not seem like a big deal, but some originators, like Flagstar, calculate gain on sale revenues off of locks while some calculate revenues off of closings. Just something to be aware of when comparing results. The IRA: Good point. What does that suggest for the future? Smith: A lot of mortgage companies that have gone public in the last year have talked about increasing market share and leveraging technology to do so. If you look at the MBA and agency projections, the mortgage market is forecast to get smaller in 2022 and beyond as the number of refinance mortgages in particular starts to decrease. So the question remains, is this technology real because not everyone is going to be able to grow market share in a declining market. As a result, I expect to see a lot more M&A activity over the next 12 – 18 months, as that’s the only way for some players to grow share. The IRA: So, the promise of new technology somehow transforming the mortgage manufacturing and servicing business has not yet arrived? Smith: I don’t think we’ve seen anybody really come to the fore in terms of growing market share based upon technology. That’s why mortgage remains such a fragmented industry. I think the top 25 originators account for approximately 37% of the market. Some platforms are more efficient than others, but we’ve not seen anything transformational as yet, like an “Uber” moment. It’s another reason, I think, that you’re going to see a lot of M&A activity in the mortgage space over the next 18 months. The IRA: Good to sell at the top, right? Most of the stocks in this sector are down double digits for the year to date. There will be downward pressure on valuations, especially if Mike Fratantoni’s forward production numbers for the industry are correct. Smith: Well, we are coming off the top now. That’s why a lot of mortgage companies executed on their IPOs six to nine months ago. The IRA: And we may not see certain IPOs get done later in this year. The SoftBank-backed digital lender Better.com plans to go public in the fourth quarter of 2021 via a SPAC at some silly valuation. They talk a lot about technology. We cannot see how that offering gets done with the industry under selling pressure. A lot of retail investors on Reddit have been burned on mortgages. These new retail investors would rather trade crypto currency! Smith: One of the primary objectives of any public, for-profit organization is to create shareholder value. It doesn’t have to occur immediately but it has to occur otherwise boards and shareholders will rightly start to ask questions of management and its strategy. Investors are looking at some of the mortgage companies that went public recently as benchmarks for further IPOs in the space. That’s why we like our diversified business model and the fact we’re a bank that is well capitalized. We have business lines that are complementary meaning we believe that we can generate strong and predictable earnings in any interest rate environment. The IRA: To focus on the market, even with the benchmark 10-year Treasury moving lower, how do you see the rest of the year unfolding? You’ve been watching these markets for years, but the traditional linkages between mortgage rates and benchmarks have changed. Smith: There are some interesting things going on in the market. The 10-year has recently moved lower after threatening to move higher, and a significant number of mortgages are still in the money from a refinance point of view. But 2020 was a huge year in terms of refinance activity making up two-thirds of total volume. At some point however, we’re going to see refi burnout, which explains the declining forecast numbers from the MBA and the agencies. But there are still a lot of mortgages in the money. With rates where they are today, purchase volumes should remain strong as low rates are helping affordability. And it seems the lack of housing inventory is starting to improve albeit slowly. The IRA: So where do you see volumes in 2021? Smith: Looking at the numbers from the GSEs, MBA and our own internal models, we should see a $3.9 trillion mortgage market this year after a $4 trillion market in 2020. We’re still forecasting over $2 trillion in mortgage volume in 2022 and 2023, which is very strong. Anytime you’re above $2 trillion, that’s a healthy mortgage market. The IRA: We will eventually run out of customers. Does the sharp increase in home prices make you worry about the change in loan-to-value ratios? Smith: No. There are a lot of buffers built into the QM rules, which is a good thing. The opportunity going forward may be that home equity lines will become more prevalent. If rates rise, then we could see consumers use HELOCs to tap into their home equity as a result of increases in house prices and valuations. The IRA: The Fed is talking about tapering MBS purchases. Does a change in quantitative easing or QE by the Fed impact spreads or volumes? Do we see a sharp increase in pricing if the Fed steps back from the MBS markets? Smith: I’m not sure that the Fed will start tapering just yet. The Fed defines “full employment” as unemployment being less than 4%. We’re not there yet. When the Fed does start tapering, it will likely move the long end of the curve higher. It remains to be seen what that does to margins. The primary secondary spread moved down quickly early in the year. It got to around 125 bps and has remained around that level for several weeks/months now. The IRA: Yes, as we wrote recently, the great price war between Matt Ishiba at United Wholesale and Rocket Mortgage has ended. Smith: I think we will remain in this general ZIP code in terms of secondary spreads for a period of time and perhaps remain here even regardless of what the Fed does in terms of tapering. We’ve found a level that seems to be working for a number of mortgage lenders. The IRA: Talk a little about the merger with New York Community Bank (NYSE:NYCB) . You are gaining a big multifamily book as part of the mortgage business and a lot of retails deposits. What can you say about the process and the days ahead? Smith: Both companies now have shareholder approval for the deal. With the merger, we would be creating a $90 billion bank and there’s very little business overlap between the two organizations which makes this transaction even more complementary. From a mortgage and servicing point of view, we expect to use the bigger balance sheet to grow across all sales channels and further enhance our RMBS program. We believe that with a larger balance sheet we will be able to support more issuance inventory and continue to step into market segments where the GSEs have stepped back, such as non-owner-occupied mortgages. The IRA: One area where we disagree with analysts is the likelihood of changes to the cash window. While the preferred stock purchase agreement (PSPA) with Treasury may be reopened at some point, we do not look for changes in the cash window or investor/NOO homes. We believe that the operational issues that led to the changes in the cash window make any reversal of the Calabria era policies unlikely. The Federal Housing Finance Agency under Mark Calabria clearly wanted to take most cash window pricing discretion away from the GSEs, period. Smith: Regardless of what happens with the GSEs, we see a lot of opportunity ahead. With a bigger balance sheet from the merger, we can hold a bigger inventory of loans to support our own RMBS program or portfolio more products and generate interest income. We can also support holding more MSRs if we choose to do so. New York Community Bank has 238 bank branches that haven’t had the benefit of a mortgage platform like ours supporting them and their customers. And we’ll be able to grow our warehouse business to support our existing and new correspondents. There is very little overlap between the two banks, so this is a growth story with plenty of asset and liability synergies created by merging the two organizations. The IRA: You have built a nice model at FBC where you have rather adroitly sold some of your servicing assets and embracing a sub-servicer model. This is the optimal economic model, selling the MSR but retaining the servicing and the escrows, as we’ve long argued. Look at AmeriHome, where they closed with Western Alliance (NYSE:WAB) and then sold the MSR and took back the financing for the bank! Sweet, low risk trade for WAB. We’ve been trying to gently tell our friends at Ginnie Mae that everyone is leaving the government servicing market. Are we wrong? Is the servicing asset in the government loan market going to be owned by independent mortgage banks and REITs? Smith: We like our mortgage business model a lot. We’re a bank. We originate in all six sales channels, including bulk, delegated correspondent, non-delegated correspondent, broker, retail and direct-to-consumer. We have a balance sheet and an RMBS program that gives us execution optionality, and we have a servicing and sub-servicing business that generates good fee income. We’re also a lender and provide financing to IMBs via warehouse, MSR, servicing advance and EBO facilities. We were the third largest RMBS issuer behind JPMorgan Chase (NYSE:JPM) and Goldman Sachs (NYSE:GS) in Q2 2021 and are the second biggest warehouse lender in the country. Coupled with being the sixth largest bank originator of mortgages and sixth largest sub-servicer in the country, it’s a powerful combination. We’ve also been a mainstay of the mortgage business for almost 35 years and are experienced navigating through all cycles. The IRA: It’s a great story. Thanks Lee.

August 19, 2021 | Today in The Institutional Risk Analyst , we ponder the good and bad aspects of extreme Fed monetary policy, including the massive purchase of securities or “quantitative easing” in the Orwellian newspeak used by the central bank. As we’ve told our readers for many years, ignore what the Fed says and instead watch their actions in the money markets. One of the clear benefits of Fed monetary policy is seen in the housing channel, where those smart enough to own or buy a house have received a vast windfall, literally trillions of dollars in paper gains thanks to the surge of home prices in the past several years. Empty nesters are selling. Even American families who own a home and are experiencing financial stress are being floated on a sea of cheap credit c/o the Federal Open Market Committee (FOMC) under Chairman Jay Powell . The once daunting pile of loans, millions in fact, that opted for CARES Act forbearance in 2020 are curing at a rapid pace, dashing the hopes of progressive activists for a train wreck in terms of low-income households. Likewise the liquidity trap we saw forming last April for Ginnie Mae issuers was literally averted by the Fed’s cheap money. Meanwhile, in the rental channel, there is chaos as forbearance unwinds. One leading loan servicer and warehouse lender told The IRA this week that while the rental forbearance process is a complete fiasco, the resolution of loan forbearance for home owners is moving quickly. Improved waterfalls used by loan servicers to guide the assistance process help a lot, but the big positive provided by the FOMC is home price appreciations (HPA), aka asset price “inflation.” The fact of strong HPA has enabled loan servicers to address the issue of COVID forbearance and also unemployment when it comes to defaults on 1-4 family mortgages. The increase in the value of the assets gives servicers home equity that can be used to assist distressed home owners going through medical or employment related disruptions. A troubled borrower that cannot get back on track in terms of repaying the mortgage can simply sell the house and walk away with the net proceeds. We maintain that one of the reasons that loss-given-default for prime bank-owned 1-4s has been negative for the past several years is strong HPA and the related decline in loan-to-value ratios. Think of the chart below showing negative net defaults for the $2.2 trillion portfolio of bank-owned mortgages as the inverse of HPA. Source: FDIC/WGA LLC We recall the prediction of Stan Middleman , founder and CEO of Freedom Mortgage , that 2019 would be the floor of the next home price correction. Stan told us last summer that the correction might not come until 2025 or years later. Yesterday in New York City we caught up with Laurie Goodman of Urban Institute , who confirmed her long held view that home prices are likely to stay at current levels due to a lack of supply. But if the impact of QE has been salubrious for troubled consumer debtors, it has been a disaster for holders of many debt and even equity securities. Investors in mortgage-backed securities (MBS) have been suffering with negative returns on their cash for years due to the tidal wave of FOMC-engineered loan prepayments. Every new MBS that comes to market is immediately in the money for refinance thanks to QE. Mortgage lenders are happy to oblige. But in the US equity markets, the Fed’s open market purchases have reduced the amount of duration available to investors, forcing buyers to climb up the risk curve in search of positive returns or any assets at all. We have seen waves of offerings from decidedly inferior issuers that, in different times, might have been viewed as outright acts of fraud. The silence from the SEC is deafening. The advent of crytpo as retail asset class illustrates the damage done by the Fed in terms of the shifting the quality of the risk-reward equation against investors. Think of securities fraud as another cost of the Financial Repression by the FOMC. "Crypto Is ‘95% Fraud, Hype, Noise, and Confusion," says the Federal Reserve Bank of Minneapolis President Neel Kashkari . In the mortgage sector, for example, even some of the stronger issuers have failed to create any value for shareholders. As we wrote in our latest note for subscribers to our Premium Service (“ Update: Rocket Companies and United Wholesale Mortgage ”), falling volumes in Q2 2021 hurt industry profits and, most important, gain-on-sale (GoS) spreads. The big question: will mortgage sector profits rebound in Q3? Will GoS spreads recover to 2020 levels? How does the impending tapering of QE by the Fed impact the primary-secondary market spread, which has been hovering around 125bp for much of 2021. For the growing number of investors burned by mortgage stocks in the past six months, the answers to those questions no longer matter. Source: Edgar In the broader equity markets, the investor carnage caused by the FOMC is even more mind-boggling. Tens of billions of dollars in investors’ funds have been deployed in various frauds and schemes ranging from crypto currencies to supposed “emerging growth” companies. One of our favorites is RobinHood (NASDAQ:HOOD) , which brings new meaning to stealing from retail to enhance insider returns. HOOD combines the daunting operational risks of running a FINRA-regulated, retail-focused broker dealer with trading in crypto currency, a rancid enchilada of unknowable risks that we cannot imagine being suitable for most investors. Indeed, crypto trading seems to be the most interesting part of the HOOD model. “ Robinhood gained popularity as a brokerage app offering commission-free stock trading,” writes Sam Ro in Axios . “But the company's recent performance suggests the current crop of retail traders are more interested in cryptocurrencies than stocks. ” Ditto Sam. This is all about a lot of retail investors chasing the shiny object. Skip past the sell yada yada in the HOOD quarterly earinings and you'll find remarkable things. HOOD reported a “surge” in revenue in Q2 2021, but operating expenses kept pace with the increased volumes, resulting in a $501 million loss in Q2 and a $1.9 billion accumulated loss YTD. Notice that like United Wholesale Mortgage (NASDAQ:UWMC) , HOOD engages in a great deal of accounting legerdemain in terms of changes to the fair value of assets and liabilities. HOOD states in the IPO prospectus: “We intend to use a portion of the net proceeds we receive in this offering to repay approximately $325.0 million that we expect to borrow, shortly prior to the completion of this offering, under our revolving credit facilities to fund our anticipated tax withholding and remittance obligations of approximately $325.0 million related to the IPO-Vesting Time-Based RSU Settlement and IPO-Vesting Market-Based RSU Settlement (assuming the effectiveness of this offering on March 31, 2021 for purposes of any applicable time-based vesting conditions; the initial public offering price of our Class A common stock of $38.00 per share; and an assumed 45% tax withholding rate).” After sticking HOOD shareholders with a $325 million tax bill from the vesting of founder shares in the IPO, roughly half of the proceeds from the offering BTW, HOOD then goes on to report another operating loss. But it gets better. In Q2 2021, HOOD launched another surprise on shareholders by increasing the “fair value” of convertible notes and warrant liability to the tune of $528 million or a total of $2.1 billion YTD. Remember, this is double entry GAAP accounting here. See table below from HOOD’s Form 10-Q. HOOD’s capital structure is supported by $5.1 billion in convertible debt, $2.1 billion in redeemable preferred equity and an accumulated deficit of $2.1 billion. Roughly half of the $3.9 billion increase in “cash” reported by HOOD in Q2 2021 is attributable to the change in fair value of convertible notes and warrant liability . Don’t you just love GAAP accounting? The moral of the story is that for every problem fixed by the FOMC by embracing radical monetary policy, more problems are created. For every consumer debtor in the mortgage market floated by QE and radical monetary policy, an investor is fleeced by the latest fraud to come down the rails of the great Wall Street sausage factory. There is, after all, no free lunch for investors when the Fed is serving the thin guel of Financial Repression.

August 17, 2021 | Updated | Last week, Rocket Companies (NYSE:RKT) reported Q2 2021 earnings. Like the rest of the industry, RKT showed significant slowing of volumes and profitability in the second quarter, with results negatively impacted by rising interest rates and a consumer exhaustion after a torrid year of record loan production. Total loan origination volume for RKT fell 20% to $83 billion in the quarter while EBITDA was cut in half to $1.2 billion vs $2.4 billion in Q1 2021. Gain-on-sale (GOS) margins for RKT fell to 2.78% vs 3.74% in Q1 2021 and a record 5.2% in Q2 2020, reflecting the squeeze on credit spreads that is negatively impacting the entire interest rate complex. RKT's GOS margins are shown below. The big question: Will the industry snap back due to now falling interest rates? Of course, defining what we mean by “snap back” requires some discussion. First and foremost, we have the issue of volumes, which lower rates for MBS and new mortgage notes will presumably take care of in due time. Word from the channel is that it took at least a quarter point drop to get the proverbial patient to move in terms of consumer volumes – but move it did in July. Then comes the question of secondary market spreads, which may continue to tighten as the year progresses. RKT CEO Jay Farner boldly predicted higher lending volumes in 2021, suggesting that the nation’s most efficient producer intends to take market share with both hands: “We are entering the third quarter with tremendous momentum across our entire platform and we are poised to have a record year across our platform from Rocket Mortgage to Amrock, Rocket Homes and Rocket Auto. I'd like to think about this. Over the past several years Rocket Mortgage has grown volume and taken market share consistently. In 2018 we originated $83 billion in mortgage volume. In 2019 that grew to $145 billion and we ended 2020 with $320 billion in mortgage volume.” Like Mr. Cooper (NASDAQ:COOP) , RKT managed to build its portfolio of mortgage servicing rights (MSRs) even though constant prepayment rates (CPRs) remain in the 20s or higher in the case of RKT. The Detroit-based firm services 2.2 million loans and carries its MSR at a multiple of 3.46x annual cash flows or around 85bp of mostly conventional servicing asset. COOP, by comparison, carries its servicing at 1.1x book or 110bp, which is about right given how fast RKT pools tend to prepay. Moving to United Wholesale Mortgage (NYSE:UWMC) , the firm managed to grow volumes sequentially Q1-Q2, but almost lost money in the process. Second quarter 2021 net income of $138.7 million included a $219.1 million decline in fair value of MSRs as compared to $539.5 million for 2Q 20 including $70.0 million of expenses related to amortization, impairment, and pay-offs of MSRs. Readers of The Institutional Risk Analyst will recall that UWMC CEO Matt Ishiba is a man unafraid to promote his company regardless of the reality. Ishiba calls Q2 2021 “Our best quarter of all-time.” He previously offered to match the price of any loan in the broker channel through the end of June 2021. The result was a $450 million drop in adjusted net income and a two-thirds cut in EBITDA, this as expenses rose almost 10% sequentially. Look for cost cutting in Q2 2021. The table below comes from the UWMC press release. It is important for readers to remember that UWMC, which is a company incomparable to any other mortgage company, uses non-standard metrics to describe its business. Thus “total gain margin” is not comparable to GOS reported by RKT or other mortgage firms. What we can say is that this measure is down 75% year-over-year (YOY). Needless to say, Mr. Isihiba is no longer challenging other issuers with a promise to match secondary market prices for wholesale loans. UWMC stepped up the value of its MSRs from cost to fair value in 2021, creating several billion in paper capital in the process. The weighted average coupon on the MSR is below 3% and the unpaid principal balance has grown 150% in the past year with an average age of loans of 7 months. UWMC’s MSR portfolio is 80% conventional loans, high teens government loans and a tiny jumbo mortgage business. The table below shows balance sheet highlights for UWMC. The firm held $12 billion in loans available for sale at the end of Q2 2021, a 125% increase from the previous quarter. Comparisons with the growth rates for the Countrywide Financial of old are entirely appropriate, but we hear that this crew does not have the capital markets skills of their storied predecessor. That could be good or bad depending on your perspective. While UWMC reports total equity of $2.6 billion, in fact its tangible equity is half that amount if you subtract the step-up of the MSR valuation, bringing non-funding debt to more than 100% of tangible equity. If you consider that the $1.3 billion in tangible capital is just about enough to fund the credit haircut on the staggering $12 billion in warehouse lines, there is very little left in the cash drawer. But the fact of high leverage does not daunt Mr. Ishiba: “UWM is built to succeed not only when there is a refi boom and margins are at record highs, but also when margins are compressed and purchase business drives the volume. Consumers are increasingly coming to realize that working with a broker is the cheapest, fastest and easiest way to get a mortgage, and as long as the wholesale channel flourishes, so will UWM as the undisputed leader and champion of the channel." Looking at RKT and UWMC, we have two very different perspectives on the mortgage business. Both companies are being buffeted by market volatility and sharp swings in secondary market spreads, but RKT has the broader business model and greater operational efficiency. In terms of MSRs, both firms feel the negative impact of the shift in the Treasury yield curve, which continues to be the biggest factor impacting MSR valuations. When Ishiba states that UWMC will prosper “as long as the wholesale channel flourishes,” he states the case succinctly. UWMC is the classic bottom-feeder, what we lovingly call the monkfish . His fate will follow conditions in the wholesale channel, which is the first channel to disappear in a rising interest rate environment. Will interest rates rise anytime soon? Probably not, but the market does not care. As a result, look for UWMC to push the envelope in terms of loan purchase volume as Ishiba tries to balance declining profitability with higher volumes. We all know how that story ends. When Countrywide ran into a brick wall in 2006, Bank of America (NYSE:BAC) as warehouse lender was there to acquire what remained two years later. As and when UWMC runs into trouble due to either interest rate risk or credit expenses, there will be no large bank warehouse lender to catch the fall. Indeed, just to remind everyone how fast things can change in the mortgage finance channel, below is the income statement from Countrywide’s last 10-Q for March 31, 2008, prior to the close with BAC, showing negative revenue . The growing number of investors who have been burned in mortgage stocks have learned a hard lesson, namely housing is highly correlated to interest rates and particuarly credit spreads. Add quantitative easing to the mix and you get some truly bizare outcomes. If you don't know what a coupon spread is or how spreads relate to the valuation for MSRs, then you don't belong in this investment, period. That is why most of the stocks in this sector have been flat to down all year. Source: Google Finance

August 9, 2021 | In this Premium Service issue of The Institutional Risk Analyst , we review a couple of earnings announcements, including Mr. Cooper (NASDAQ:COOP) and New Residential (NYSE:NRZ) . The big surge in income and net worth caused by the Federal Open Market Committee last year is rapidly ending. Winter has returned to mortgage land. More, virtually every nonbank mortgage finance company that went public in 2020 now trades below its offering price, Inside Mortgage Finance reports. The big question this week is whether the planned IPO for Better.com will be pulled, an eventuality sadly that we predicted several months ago when things looked much brighter in the world of 1-4 family mortgages. Source: Google Finance The chart above gives you an idea of the performance of a representative slice of the world of independent mortgage banks (IMBs). Only Guild Mortgage (NASDAQ:GHLD) , a strong purchase mortgage lender that was actually public in a former life, is up over the past year as of Friday’s close. Meanwhile, mortgage application app Blend Labs (NYSE:BLND) , which we profiled earlier (“ Profile: Blend Labs, Inc ”), is down more than 10% since its July IPO. Readers will recall that BLND acquired Title365 from COOP for almost $500 million just prior to the IPO, an astounding valuation for a title insurance underwriter that greatly enhanced the revenue of the seller and makes the buyer look, well, ridiculous. Mr. Cooper’s veteran operating team produce the best disclosure in the mortgage sector, providing investors with a good description of the firm’s operations and market conditions overall. The Q2 2021 financials show both the deceleration of the mortgage sector and the vast profits that were generated between April of 2020 and today. Total book value per share at COOP rose from $21 a year ago to over $37 in Q2 2021, a big achievement that pushed the firm’s considerable tax loss carry forwards down to just 35% of total equity from 70% a year ago. This improvement addresses a major criticism from some quarters of the ratings community about the quality of COOP’s capital structure. Pretax operating income for COOP was just $227 million vs $354 million a year ago, reflecting a big drop in originations. Similar results were visible across the industry, with Loandepot (NYSE:LDI) , which is down 57% this year at Friday’s close, delivered a double digit decline in volumes and a 94% sequential decline in earnings. Most striking, LDI CEO Anthony Hsieh declared when his earnings were released: “We’ve entered a transitional period and expect to see industry consolidation as some lenders may not be in a position to withstand the headwinds, whereas we are confident and excited for the future.” Of note, Inside Mortgage Finance reports, Hsieh talked about layoffs and cost cutting, a trend we expect to see pick up a great deal of steam during the rest of 2021. The results described in COOP’s Q2 2021 presentation illustrates the situation going forward. Most of the pretax net income for the firm in Q2 2021 came from the sale of Title365. Without this one-time event, pretax for COOP would have been below $100 million. Total EBITDA, however, excluding Title365, was over $215 million, but this was half the cash flow generated a year before, as the table below from COOP’s quarterly presentation illustrates. COOP reported a negative mark-to-market of $180 million on its mortgage servicing rights (MSR) as mortgage rates and swap rates decreased during the quarter, but coupon spreads actually rose modestly at the end of the period. The month-over-month value change attribution for MSRs across the industry was overwhelmingly due to the shift in the Treasury yield curve, SitusAMC reports. COOP ended Q2 2021 with a 115bp valuation for its MSR, down from 122bp in Q1 2021. Most significant, COOP saw its pretax originations margin fall from just over 3% a year ago to 1.36% in Q2 2021, a stark example of how quickly things can change in the world of mortgage finance. COOP indicates that pricing pressure in the increasingly competitive correspondent channel was responsible for the decline in volumes and spreads. It is interesting to note that COOP’s servicing book grew to $654 billion year-over-year, this even with prepayment rates remained in the 20-30% average range over the past year. New Residential Since the start of 2021, NRZ has made some big strides, including the acquisition of Caliber Home Loans . Combined with NewRez (formerly Shellpoint), the addition of Caliber gets NRZ to $170 billion estimated 2021 originations and $490 billion in servicing UPB. Caliber is a solid business and, along with Freedom Mortgage and GHLD, has a strong presence in all three channels, wholesale, correspondent and retail/direct-to-consumer. The addition of Caliber was a necessary piece of the puzzle, but NRZ has acquired that piece at the top of the originations market and the related public equity valuations for IMBs. NRZ CEO Michael Nierenberg likes to buy at the top. If you skip over the many pages of sales fluff in the NRZ financials and focus on the Appendix of the company’s Q2 2021 presentation, the picture also reflects growing operating stress, but with some significant differences vs COOP. The fair value of the NRZ MSRs and excess servicing fell $200 million to $3.8 billion, unlike the organic growth shown by COOP. Gain on sale revenue fell sequentially from $403 million to only $286 million in Q2 2021, consistent with the contraction in volumes seen across the industry. But most significantly, NRZ continues to grow leverage and credit exposure, while COOP and other issuers have been pushing down leverage. NRZ barely made $121 million in net income Q2 2021, including $34 million in the reversal of loan loss provisions back into income. In 2021, NRZ has reversed $54 million of credit loss provisions back into income. Origination pretax income for NRZ was $800 million in 2020, $191 million in Q1 2021 and $75 million in Q2 2021, a very stark illustration of trends across the mortgage lending sector. Net servicing revenue was negative $111 million, including almost $300 million in realized losses from MSR amortization and resulting decreases in cash flow. Total revenue fell 62% from $1.2 billion in Q1 2021 to $454 billion in Q2 2021. Outlook The challenge facing both NRZ and COOP is that any uptick in volumes due to lower benchmark interest rates is likely to be offset with higher prepayments, putting pressure on servicing income and also origination expense. Also, the decline in interest rates since June has not yet resulted in an increase in refinance activity, the single most profitable transaction for any mortgage lender. Origination expenses at NRZ, for example, have grown even as revenue peaked last summer and since declined sequentially. When origination revenue peaked at $459 million in Q3 2020, origination expense was just $147 million vs $219 in Q2 2021 with less than half the origination revenue. Again, expense management will be a favorite topic across the industry going forward into 2H 2021. Since the middle of June, the benchmark 10-year Treasury note has rallied, driving yields lower and pulling the 30-year mortgage rate down as well. In the near-term, this will pull millions more existing loans into the money for refinance. This fact will also tend to increase prepayment rates, which will generate servicing losses as MSR amortization increase. Higher loan origination volumes will help, but higher origination expenses and tighter spreads will drive less revenue down to the net income line. Like commercial banks, IMBs are suffering from tightening spreads in the secondary loan market. If the 10-year Treasury note continues to rally and spreads continue to tighten, then the balance of 2021 could see operating conditions continue to deteriorate and IMB public market valuations under downward pressure.

August 3, 2021 | Updated | This week The Institutional Risk Analyst is at Leen’s Lodge in Grand Lake Stream, ME , for the annual Camp Kotok event. We use this opportunity to describe what’s next in terms of structural changes for US interest rates and the money markets. As a primer, read that very popular post (“ Fed Prepares to Go Direct with Liquidity ”) and then buckle your shoulder harnesses. Many of the changes to the US Treasury and REPO markets that were predicted in our comment this past May are coming to fruition. These changes to the structure of US markets arise because of growing concerns over the stability and liquidity of the market in US Treasury securities, fears that already led the Federal Reserve Board to hike the interest rates paid on bank reserves a month ago. Notice, all you economistas , that the Fed has discontinued the series on interest paid on excess reserves but there is as yet no replacement series visible on FRED. The new report published by the Group of Thirty last week contains a great deal of information about changes that are being put into place to address the growing liquidity problems in the market for US Treasury debt, changes we described earlier this year. The report authored by former Treasury Secretary Timothy Geithner and a host of Wall Street luminaries states: “[A] series of episodes, including the “flash rally” of 2014, the Treasury repo market stress of September 2019, and the COVID-19 shock of March 2020, have created doubts about its continued capacity to absorb shocks and focused attention on factors that may be limiting the resilience of Treasury market liquidity under stress.” The report then goes on to describe why this is happening, namely a dearth of capital supporting market-making activity in Treasury debt. And why has this deficit in terms of capital supporting the market occurred? Because of the Dodd-Frank legislation, particularly the Volcker Rule, Basle III and a variety of other factors. West Grand Lake, June 2021 The REPO market liquidity crises seen in December 2018, September 2019 and April 2020 are all self-inflicted wounds, the result of an incompetent national Congress and equally flaccid regulators, who mistake reducing and constraining market function with reducing risk. Again, the report: “The root cause of the increasing frequency of episodes of Treasury market dysfunction under stress is that the aggregate amount of capital allocated to market-making by bank-affiliated dealers has not kept pace with the very rapid growth of marketable Treasury debt outstanding, in part because leverage requirements that were introduced as part of the post-global financial crisis bank regulatory regime have discouraged bank-affiliated dealers from allocating capital to relatively low-risk activities like market-making.” The fact that we predicted this very eventuality several years ago in The Institutional Risk Analyst and Zero Hedge gives us little joy (“ The Volcker Rule & the London Whale ”). The implementation of The Volcker Rule, added to the other restrictions contained in Dodd-Frank, had to result in reduced market liquidity. We last argued this very point over lunch with the great man in Manhattan back in 2017. "That's the usual self exculpatory crap from the perpetrators of the crime Fed and Treasury policymakers," notes our friend Lee Adler of Liquidity Trader . "The problem is $200 billion a month in new supply. So the Fed has to absorb 90% of it one way or another. It doesn't matter what the conduit is, or how many they are. The Fed must absorb and fund 90% or the market will collapse." In a practical sense, December 2018, September 2019 and April 2020 were caused by poorly implemented regulations that have actually made it impossible for large dealer banks to support the Treasury market in times of stress. Can't make this up. The solution is to amend Dodd-Frank and the Volcker Rule, but Congress is far too dysfunctional for a solution so subtle. The first step to be taken in response to this threat to the Treasury market is for the Federal Reserve Board to create “a Standing Repo Facility (SRF) that would guarantee to a broad range of market participants the availability of repo financing for Treasury securities,” the report states. H/T to George Selgin at Cato Institute and the folks at the FRB St Louis in this regard. “In addition, an SRF would limit demands for market liquidity under stress by allowing holders of Treasuries that want cash to obtain the cash by tapping the SRF rather than selling the securities. This would extend the logic behind the repo facility that the Federal Reserve provided to foreign and official monetary institutions at the end of March 2020.” Those standing Fed facilities for EU central banks are now essentially permananent, keep in mind. All this translated into English, the Fed is now going around the largest banks to provide liquidity to the markets directly. Since the banks have been neutered by Dodd-Frank and the Volcker Rule, the central bank is now going to push JPMorgan (NYSE:JPM) et al out of the way and disintermediate the large dealer banks entirely. As we’ve said before, the Anglo-American model of finance is being discarded by the Fed in favor of a government-centric, European model a la Frankfurt. The second major recommendation from the Group of 30 that is also being implemented is central clearing of Treasury trades. This marks a deliberate move away from dependence upon principal trading firms or PTFs for liquidity in the market for government securities. Again, since Congress and the regulators have forced banks to remove liquidity from the Treasury markets via the Volcker Rule and Dodd-Frank, the Federal Reserve and the Treasury will fix “the problem” by ending bilateral trading in Treasury securities. The report states: “All trades of Treasury securities and Treasury repos executed on electronic interdealer trading platforms that offer anonymous trading by interposing an interdealer broker between buyers and sellers should be centrally cleared." What this mean in plain terms is that a great deal of the institutional trading in risk-free collateral is being pulled into the daylight, a change that could have significant implications for dealer banks and their prime brokerage customers. The report recommends that all Treasury repos should be centrally cleared. The report also goes on to say that “market participants and regulators should continue to study how dealer-to-client cash trades of Treasuries might best be centrally cleared, including via the sponsored clearing model, and assess the private and public policy cases for central clearing using whatever is the optimal model.” As Ralph Delguidice alluded in our earlier comment, this change will greatly reduce the ability of bank-affiliated dealers to allow big leverage in client trades. The 100:1 leverage that is possible in offshore, bilateral transactions is not possible in the context of a centrally cleared transaction. Lest we forget, excessive leverage led to a $5.5 billion loss for Credit Suisse (NYSE:CS) in the case of the Archegos transactions. Such leverage involving Treasury collateral will basically not be possible. This change has enormous implications for US based PTFs and the dealers that service their needs. Simply stated, the rich rewards that big US banks have earned via the offshore dollar trade have been changed forever, a fact that will show up in capital markets results of the largest dealers. We'll be addressing these institutions in future Premium Service comments from The Institutional Risk Analyst .

July 30, 2021 | For a while now, we have been watching the collapse of the “out of China” trade even as foreign investors have been pouring new money into what they think are Chinese stocks. Now China has taken a page from trade wars of old, imposing a strict regime of "national treatement" on Chinese companies. The joke, of course, is on foreign investors who think that investing in China is merely about asset allocation and not risk. Foreign investors in China stocks are not really buying stakes in Chinese companies, but rather put cash into indirect vehicles that can be dissolved at the wave of the hand of China’s dictator, Xi Jinping. In China under the Chinese Communist Party, there is no legal protection for private investors or anything else. China’s Anbang insurance group was sold for $5.2 billion earlier this month, part of the collapse of a cohort of conglomerates, including HNA Group and Dalian Wanda . These firms embodied China’s “going out” policy, which led to aggressive foreign investment and expansion in the mid-2010s. Now this highly leverage surge of investment has collapsed. This rush of highly leveraged investments from China saw HNA briefly become the largest investor in Deutsche Bank AG (NYSE:DB) . Since then, HNA has defaulted on billions in debt and other obligations, including money owed to thousands of employees and retail investors. The scandals pouring from the wreckage of HNA and other Chinese companies and banks seems to be unending, including officials of China’s top government lender, China Development Bank . Xu Weihua , a former president of the China Development Bank’s branch in the southern island province of Hainan, is now under investigation by the “Central Commission for Discipline Inspection.” Dozens of other officials have been jailed in a growing campaign against “corruption” in response to billions in losses to investors and the Chinese state. In the first half of 2021, China defaulted on a record $18 billion in corporate debt . In another sign of the unwind of the “out of China” trade, technology distributor Ingram Micro officially closed its $7.2 billion acquisition by private equity firm Platinum Equity . The long-awaited deal frees Ingram Micro from financially troubled HNA Group. In today’s poisonous political environment between Beijing and Washington, such an acquisition as Ingram Micro would be impossible by a Chinese firm. “The government of President Xi Jinping is placing a priority on reducing excessive debt in the corporate sector,” Nikkei reports. “By doing so, however, it risks pushing a legion of companies into difficulty with financing their businesses. That could then choke the nation's economic growth in the coming years.” But for now, China is awash in dumb money from offshore. While foreign investors think they have been investing in Chinese stocks, in fact Beijing had created a mechanism – call it “variable interest entities” or VIEs – that have the appearance of allowing foreign investors to invest, but always kept control firmly in the hands of the Chinese Communist Party. These indirect vehicles for gathering foreign investment may now be in jeopardy. “There has always been this political risk around China,” says Leland Miller , founder of China Beige Book . “For years, foreign investors bought indirect stakes in Chinese firms via what looks like a VIE, but did not actually invest directly. We winked at the lack of audits for Chinese firms listing on US exchanges and other departures from US law. Everything was fine until recently. And now China is having to rethink this arrangement rather considerably. The precipitating issue this time is big data and the national security implications.” Miller tells The IRA that the recent interventions by Beijing in a number of planned IPOs for Chinese firms in the US marks a larger change in how China will interact with foreign investors and governments. Specifically, Beijing will not allow Chinese firms to list their shares offshore unless they ensure that their business and the related data are protected from the enforcement of US law. Investors generally don’t care about things like protecting “big data,” but this is topic number one for the Chinese state. The topic is not sexy nor is it conducive to attracting investors, but control over big data is causing a shift in the relationship between Beijing and foreign capital. Bottom line: Beijing wants to ensure that Chinese law trumps US law when it comes to Chinese companies. Of course, China’s assertion of national treatment for its companies has always been this way, but foreign investors pretended otherwise. Now, says Miller, there is starting to be seriousness on the Chinese side when it comes to protecting mainland companies from the reach of US law – even if it means that smaller Chinese firms lose access to foreign capital. “China has played the game with foreign investors for a long time,” Miller tells The IRA . “VIEs were not technically illegal as a means of gathering foreign investment, but China played the game. Access to foreign capital is clearly important, but it is not the most important thing to Beijing.” Miller thinks that Beijing will boost Hong Kong as part of a shift way from dependence upon the US capital markets, even if that means that they must adjust to less access to capital in the near-term. But the biggest implication is for foreign investors in China, who have been unwilling to acknowledge any China risk in the past. Now that the US has begun to insist that Chinese firms follow US law, Beijing has pushed back, effectively saying that Chinese law is the governing authority. This posture represents a striking confrontation with Washington, which is accustomed to imposing US law around the world unilaterally and often without significant push back. The implications of this evolving confrontation between the US and China is that global firms seeking to do business in the west and in China must essential bifurcate themselves into separate silos, with data and IP segregated into buckets for the purposes of complying with national legal requirements. After years of listening to the happy nonsense coming from foreign investors, Beijing has now embraced a new policy of national treatment for all Chinese companies. Under a best-case scenario, the new assertiveness by Beijing implies a major change in how global companies operate and raise capital. There may not be ways for some companies, for example, to adhere to Chinese and US law at the same time. Some companies may not find it possible to do both, creating risk for these enterprises and their investors. As the US and China adjust to this new reality, the EU is also in the mix, asserting national treatment for companies that do business in the Eurozone. The image of data residing “in the cloud” must now be revised to accept the separation of businesses into clearly defined units that operating under local laws. Forget storing data in the cloud. Those servers used to store company data must be physically located in the nations that exert legal control. Foreign investors that treated investing in China as merely another asset class choice now face unfamiliar country risk in terms of the political evolution of Beijing’s posture vis-à-vis the US, EU and other states. Now offshore investors must assess whether a given company or industry will become this week’s punching bag in the political battle between Beijing and Washington. Despite the massive losses accumulating from HNA and other Chinese firms that participated in the out of China investment wave, Beijing has picked an opportune time to rebalance the relationship with the west. Money from credulous foreign investors has been pouring into China. As the situation becomes more clear, however, the surfeit of cash from abroad may gradually turn into an exodus. “It has always been considered impossible, unthinkable that the Chinese would invalidate a VIE,” says Miller. “Now such an outcome has gone from unlikely to a real concern. Investors need clarity on this issue or they are not going to be able to invest in China as they’ve done in the past.”

July 19, 2021 | Updated | On Friday, the Federal Housing Finance Agency (FHFA) announced that Fannie Mae and Freddie Mac (aka “the GSEs”) will eliminate the 50bp Adverse Market Refinance Fee for loan deliveries effective August 1, 2021. FHFA acting director Sandra Thompson has reversed one of the more controversial aspects of her predecessor’s tenure, a welcome sign of normality at this key agency in the world of residential housing finance. Read our July 29, 2021 Comment letter to GNMA! Meanwhile, just a week earlier, our friends at Ginnie Mae suddenly floated a request for public comment on a bizarre proposal for new issuer eligibility standards that would crush many government lenders. The announcement came late in the day Friday, meaning that Ginnie Mae buried the request on the website. Indeed, we hear that Ginnie Mae originally planned to release the rule without any request for public comment. The reaction of the industry to the proposal is first and foremost shock and incredulity, especially after four years of uncertainty under Mark Calabria at FHFA. During COVID, Ginnie Mae and the rest of HUD worked closely with the industry. But now the industry's trust in the willingness of Ginnie Mae to be a source of stability has been badly compromised by a proposal that seems to lack any cohesion or specific rationale. The Institutional Risk Analyst spoke to a dozen issuers and mortgage bankers in the past week. Most did not believe that Ginnie Mae could possibly be serious about the proposal. Specifically, the new requirements for issuers of Ginnie Mae MBS seem ill-considered and would cause much damage to the market for government-insured loans. “The proposal is so contrary to everything that Ginnie Mae and the FHA have said publicly about protecting the value of the government asset,” one prominent industry leader told The IRA . “For Ginnie Mae to act unilaterally on this issue, without new leadership appointed by President Joe Biden is extraordinary.” For us, the most striking thing about this proposal is that Ginnie Mae’s risk management team ignores the huge strides made by nonbank mortgage firms to de-lever their balance sheets, pay down bank lines and acquire term financing for working capital and financing MSRs. Under this rule, the mortgage firms that added to capital over the past year would not invest in MSRs and, indeed, would arguably be sellers of servicing. For this reason alone, the Ginnie Mae proposal makes little sense. “It does not sound like HUD or Secretary Marcia Fudge were consulted on the decision,” says another CEO in the government market. “This proposal will be problematic for smaller issuers, particularly issuers that serve low income, disadvantaged communities. All of the small lenders that serve highly specialized communities will be gutted and forced to sell servicing assets for nothing. This rule could cost literally tens of billions in losses to banks and nonbanks alike." The diagram below illustrates the Ginnie Mae proposal: First and foremost, the Ginnie Mae proposal penalizes independent mortgage banks (IMBs) for holding MSRs on government-insured loans. While the proposal is styled as a “risk based” rule, obviously in imitation of the Basle framework for banks, in fact the proposal increases financial risk on the industry while making government servicing assets impossible to hold. Under the above rule, issuers could own private label MBS or even penny stocks with 5:1 leverage and get better capital treatment than on government MSRs. The proposal by Ginnie Mae is a significant embarrassment for the agency, if for no other reason than the math behind the numbers makes no sense. The new rules proposed by the career staff of Ginnie Mae led by Gregory Keith essentially cuts the net worth of most large issuers to 1/3 of the levels calculated under present rules. We are told that Ginnie Mae acted now, before the FHFA acts on its own capital rule, so as to have the regime apply to 2022 issuer financials. Incredibly, the proposed rule from Ginnie Mae makes it difficult for issuers to employ term debt to finance their business, but then penalizes the ownership of the MSR. The entire proposal illustrates how US policy regarding mortgage issuers has been polluted by the thinking of European regulators, who have a pathological aversion to residential housing finance. In Europe, for example, payment intangibles such as MSRs do not even exist as assets under IFRS accounting rules. Properly understood, however, MSRs are vital sources of working capital and liquidity for mortgage banks. Ginnie Mae treats them as a source of risk as do US bank regulators and their counterparts in the EU. Ginnie Mae never actually says what specific risk is driving this process -- other than perhaps the competitive risk to commercial banks posed by more efficient IMBs. Not only was the MSR given a 250% risk weight under the Ginnie Mae scheme, one executive tells The IRA , but no other assets received this punitive risk weight. Several industry operators told The IRA that the proposal will definitely reduce liquidity in the MSR market. “To negatively impact excess MSRs makes zero sense,” notes one operator with decades of experience at banks and nonbanks. “Other than loans held for sale, MSRs are the largest and most valuable capital asset of a mortgage lender. The FHFA calculation of net worth to total assets makes a lot more sense for IMBs. This proposal will hurt issuer profitability and also impact liquidity, which will adversely effect mortgage rates for consumers.” “The basic problem with this proposal comes down to simple math,” notes another industry veteran. “Let’s say you are a mortgage lender and you want to hold MSR. Under this proposal, the most leverage you could put against an MSR would be 30% or half of current levels in the industry. It seems that Ginnie Mae has recognized that MSRs are a risky asset, but reading this supposedly “risk-based” proposal, you’d think that MSRs were the only risky asset. The clear message from Ginnie Mae is do not invest in government servicing assets.” “But then you have this bizarre notion of subtracting the excess MSR from the numerator in the capital calculation," continues the executive. "This is the most problematic part of the proposal. It’s hard not to be very critical of Ginnie Mae because this analytical approach simply makes no sense. Anyone who has spent even a little bit of time with the industry data from the MBA knows that under this proposal, many smaller issuers in the government market fail.” The rule as presented by Ginnie Mae for public comment simply will not work. The “risk based” formula actually reduces industry liquidity by increasing the reserves of IMBs, reserves that the industry cannot use it times of stress, and making government servicing assets worthless. The mortgage servicing asset, lest we forget, is not only a source of steady cash flow for issuers, but contains embedded optionality in terms of refinance opportunities that is arguably worth more than the fair value of the asset under GAAP. Prudential regulators don't even recognize this extremely valuable optionality, one reason bank lending performance in 1-4s is so poor. “This is an anti-liquidity proposal,” another prominent Ginnie Mae issuer told The IRA on Friday. “If you really look at where the stress was in the industry last year, it was the REITs. People like Two Harbors (NYSE:TWO) and other hybrid REITs thought that their MBS positions hedged the MSR, but when rates get low enough, the MBS misbehaves too. But instead of focusing on actual risk, Ginnie Mae has decided to reduce the liquidity of all government issuers, large and small.” The mortgage industry concerns with the proposed Ginnie Mae rule for issuers can be summarized in a couple of points: Risk-based standard : Imposing a bank-like risk-based capital standard for IMBs is a bad idea and does not recognize the difference in sources and uses of capital between depositories and finance companies. Ginnie Mae should encourage IMBs to issue term debt whenever possible and hold government-insured loans and MSRs as a key part of capital. Penalize MSRs : The calculation method excluding certain MSR assets and the 250% “risk weight” for MSRs will destroy the value of government servicing. Given Ginnie Mae’s professed desire to protect value of Ginnie MSRs, why would HUD propose a bank-like capital rule on MSRs? If anything, Ginnie Mae ought to monitor participations in MSRs, but not discourage issuers to retain the asset. Liquidity : The rule penalizes loans held for sale, but does not penalize other assets. Why hold an additional 20bp cash reserve against a government-insured asset that is eligible for pooling into MBS and will be cash in 30 days? Government loans should be zero risk weight and conventionals 20% in line with Basle III, right?? The proposal also penalizes low-risk assets such as prepaid expenses at 100%? Why? “We are 50 percent below the net worth requirement once the math gets laid out, which is unfathomable to me,” another large issuer told us last Friday. “Ginnie Mae assigns a punitive, 250% risk weight to their own MSR, but then they don’t count term debt in the calculation for capital? That is problematic for every government issuer. We can adjust our business, but the problem is that the math calculations in this rule will be devastating to smaller issuers.” The combination of changes proposed by Ginnie Mae will make it impossible for IMBs to grow their business. The prudential regulators, the DOJ and CFPB have already chased the commercial banks out of the government loan market. If now Ginnie Mae chases the independent mortgage banks out, who is going to make government-insured loans or hold government servicing? Unlike prudential regulators who spend years working with the banking industry on risk-based standards and credit loss benchmarks used for this purpose, Ginnie Mae presents no rational basis for its actions. They give IMBs credit for cash and take out the grossed-up footing for HECMs and MBS, for example, but there is nothing else "risk based" about this unfortunate proposal. The REITs that almost went out of business a year ago would look great under the Ginnie Mae proposal, but the government issuers that supported the government market through COVID during 2020 would look awful. One thing Ginnie Mae ought to consider is how many government issuers will be downgraded by Moody’s (NYSE:MCO) et al if this proposal actually goes into effect. Meanwhile, Ginnie Mae will become entirely dependent upon REITs and banks to own government MSRs as nonbank issuers become mere brokers and sub-servicers. If this proposal were authored by JPMorgan (NYSEJPM) CEO Jamie Dimon and his residential mortgage team, it could not be more perfectly suited to annihilate the non-banks that currently control more than two-thirds of the government loan market. Not only will this proposal crush the liquidity of government servicing assets, but it will make nonbanks liquidate their portfolios of MSRs into a collapsing market. But more than any specific point, the real tragedy of this poorly thought-out proposal is that Ginnie Mae has badly damaged its credibility with the mortgage industry. When you issue a rule that would crush the holders of half of all government MSRs, it tells the people who manage government lenders that you really don’t care about the industry. The basic political problem facing Ginnie Mae and HUD Secretary Fudge is that they must either withdraw this proposal immediately or continue with a rule that would destroy much of the government loan market.

July 27, 2021 | Back in January, we published a comment (“ A Tale of Two Frauds: Bitcoin & GSE Shares ”) that compared two recent schemes, namely the bitcoin-tether game and the equally odious pretense of privatizing Fannie Mae and Freddie Mac . In both cases, a large crowd of retail investors are or were convinced of the solidity of the speculation. In the case of the latter, the game now seems to be up. And the former wager involving tether and bitcoin seems headed in that very same direction. Most recently, The US Justice Department is investigating possible bank fraud by executives of Tether Ltd ., according to Bloomberg News: “Federal prosecutors are scrutinizing whether Tether Ltd concealed from banks that transactions were linked to crypto, said three people with direct knowledge of the matter who asked not to be named because the probe is confidential.” The major complaint against tether is that this opaque market is a leveraged feeder into bitcoin, essentially a dark pool of liquidity of unknown provenance used to manipulate the price of the leading crypto market. Tether Ltd denies allegations that it is a fraud, including through its banker Gregory Pepin of Deltec Bank and Trust in the Bahamas. While strong denials of wrong-doing are welcome, Tether Ltd so far has not been able to provide an independent audit of its reserves, a key sticking point for many managers, even those who are strong advocates of crypto assets. One post on Twitter recently, replying to Carl Quintanilla at CNBC , summed up the view of some skeptics regarding Tether Ltd and Deltec Bank: One well-known crypto manager told The Institutional Risk Analyst that the simple solution to the questions is an audit. “Without an audit by an independent third party, my instinct says that this has to be a scam. A credible audit is the answer the market wants to hear on tether.” The relationship between Tether Ltd and Deltec Bank has also drawn criticism, particularly as the size of the footings of tether and bitcoin have grown. Tether Ltd maintains that the outstanding tether tokens are fully backed by liquid assets. Detractors in the markets and social media claim that the small Bahamian private bank is unable to account for the financial flows into and out of tether and bitcoin. The most recent list of licensed banks on the web site of the Central Bank of the Bahamas is dated June of 2018 , giving our readers some idea as to the level of supervision and regulation on the UK-governed island nation. There are no public financial reports for Bahamian banks, even resident institutions such as Deltec, available on the CBOB web site. Managers contacted by The Institutional Risk Analyst profess indifference about the controversy surrounding tether and bitcoin, but they are worried that any scandal touching Deltec Bank could have serious financial and economic consequences for the Bahamas. “We hope to see the Central Bank of the Bahamas ascertain the true situation regarding tether and determine a course of action,” one manager told The IRA . “If the CBOB doesn’t get ahead of this situation, the jurisdiction will suffer from the fallout and that is something Bahamas can ill afford at this time.” Indeed, even if it turns out that Deltec Bank and Tether Ltd have committed no wrongdoing, authorities seem to be focusing on losses to investors, the general liquidity of the tether platform and the relationship with a small Bahamian bank. Although the composition and location of reserves supporting the issuance of tether tokens is said to be a primary focus of regulators in the Bahamas, that is not the only issue of concern. The lack of transparency of the tether platform, the risk to retail investors, and the uncertain provenance of its participants and liquidity, creates continued interest on the part of regulators globally. Back in October of 2020, the Department of Justice published a lengthy “cryptocurrency enforcement framework detailing its approach to the nascent space and discussing potential crimes,” Coindesk reports . “The document also suggested the U.S. government would enforce its laws regardless of where exchanges – referred to as virtual asset service providers, or VASPs – are based. In other words, these exchanges should comply with U.S. laws – even for their non-U.S. customers.” “Because of the global and cross-border nature of transactions involving virtual assets, the lack of consistent AML/CFT regulation and supervision over VASPs across jurisdictions – and the complete absence of such regulation and supervision in certain parts of the world – is detrimental to the safety and stability of the international financial system,” the DOJ framework states. The size of the tether market and the lack of clarity as to the resources of Deltec Bank, which provides no financial information to the public on its web site, naturally attracts attention. Investigations by the State of New York and DOJ add credence to claims that the entire arrangement between tether, bitcoin and Deltec Bank is a Ponzi scheme, especially in view of the $60 billion in footings now attributed to Tether Ltd and its sister company, Bitfinex . Q: Could the tether market and a small, little-known private bank in the Bahamas be the precursor of the next systemic market event in the US? In February 2021, Tether Ltd agreed to pay an $18.5 million fine to end a New York probe over allegations that the company moved hundreds of millions of dollars to cover up $850 million in losses . But now the DOJ inquiry regarding possible bank fraud raises a new risk for all participants in tether and bitcoin. Just as the infamous American gangster Al Capone was taken down for violations of income tax laws, the world of crypto is under an oblique assault by regulators around the world. The particular routes of attack are consumer protection, anti-money laundering (AML) and know-your customer (KYC), to start. Add bank fraud, tax evasion and facilitating terrorism to the mix and you have a pretty good roadmap for the future of crypto assets that are not 100% onshore for the purpose of US law. Compliance with US law and regulation is the new litmus test for crypto assets. The fact that Treasury Secretary Janet Yellen has raised the issue with the Financial Stability Oversight Council (FSOC) should be sufficient warning to the wise. Yet apparently intelligent people like Tesla (NYSE:TSLA) founder Elon Musk and Twitter (NYSE:TWTR) and Square (NYSE:SQ) founder Jack Dorsey continue to encourage retail investors to traffic in crypto assets that may ultimately be problematic in terms of US law and regulation. The basic problem with crypto assets such as bitcoin and tether is not merely the possibility of financial fraud, a very real risk IOHO, but AML and KYC. The same US financial regulatory regime that has nearly destroyed offshore venues such as Bahamas is now focused on crypto. The concern is that the market for crypto includes criminals, terrorists and other parties that are not onshore in terms of US law and regulation. Any individuals facilitating transactions with such parties are tainted by these illegal activities. When you read reports about bank fraud investigations focused on Tether Ltd., remember that in many ways this is the least of their problems. The draconian and entirely deterministic world of AML and KYC enforcement is coming for all parties who traffic in offshore crypto assets such as bitcoin and tether. The search party is led by FinCEN, the Secret Service, the US intelligence community, and a host of state and federal agencies, including bank regulators, FINRA and the SEC. A couple of months ago, we commented on the draft rule published by the Bank for International Settlements regarding the 1,250% prospective Basle risk weighting for crypto assets owned by banks (“ BIS Says "No Thanks" to Bitcoin for Payments ”). Essentially, banks face a daily margin call on crypto assets and must maintain a 100% cash reserve (or 1,250% Basle risk weight) against the asset. But, again, this is the least of the bank’s problems when it comes to touching crypto assets. The more problematic aspect of crypto for the depository would be to conduct AML and KYC against bank customers and their counterparties, who would need to document the source of proceeds in the purchase and sale of crypto. Customers of a US bank, for example, might need to provide a complete provenance of the crypto asset back to inception to ensure that no violations of US law occurred. Fortunately, we have the blockchain documenting the crypto transactions, a handy record to assist the work of US regulators and prosecutors in the months and years ahead.

July 23, 2021 | Many of the readers of The Institutional Risk Analyst ask why we hate Bank of America (NYSE:BAC) CEO Brian Moynihan so. In fact, we love Brian as much as we adore all bank lawyers. Our criticism arises because the financial performance of the depository founded by A. P. Giannini as the Bank of Italy in 1904 is truly awful, as we discuss below. BAC is the worst performing bank in the top-five US commercial banks and often underperforms the average for Peer Group 1. We don’t make up BAC’s numbers. IOHO, Moynihan and the entire board of directors of BAC ought to be walked out of the building. The first measure to examine is operating efficiency, an area where BAC has consistently underperformed its peers. In the most recent Q2 2021 financials, BAC reported an efficiency ratio (Overhead Expenses / Net Interest Income + Non-Interest Income) of almost 70% or roughly ten points above JPMorgan (NYSE:JPM) . The average for Peer Group 1 in Q1 2021 was 59%, according to the FFIEC. Source: FFIEC, EDGAR, Q2 2021 Estimate for Peer Group 1 Notice in the chart above that even in a quarter where financials were generally improving across the industry, BAC managed to underperform its large bank peers including Wells Fargo & Co (NYSE:WFC) , which remains in regulatory purgatory and operates under an asset cap. Note too that Citigroup (NYSE:C) greatly improved its operating performance in Q2 2021. The next measure to consider is asset returns. As we have noted in the past, BAC generates less income per dollar of assets than its large bank peers. The historical performance data from the FFIEC is shown in the chart below. In Q2 2021, BAC managed to report a return on average assets of 1.18% -- including $3.4 billion in provisions expense from 2020 that was reversed back into income. Source: FFIEC Of note, the BAC’s loan portfolio has fallen almost 8% since Q2 2020, even as total assets have swollen due to QE by the Fed. Indeed, BAC’s securities holdings are bigger than the bank’s entire loan portfolio. The basic problem at BAC is asset returns. Since the management team under CEO Moynihan has made avoiding risk their chief priority, this also means that the $3 trillion asset depository also misses a lot of opportunity for profit and earnings. Notice, for example, that JPM at $3.6 trillion in assets generated almost a third more revenue at $32 billion in Q2 2021 vs BAC at $21 billion. JPM is 20% larger in terms of assets, but generates a third more earnings. When we consider the reasons for BAC underperformance, the gross spread on the bank’s loan book is one of the first factors to consider. The chart below shows the historical spread information compiled by the FFIEC. Note that BAC’s gross spread on total loans and leases is nearly a full point below JPM and is also significantly lower than the average for Peer Group 1, which includes the top 125 banks in the US above $10 billion in assets. Source: FFIEC Indeed, if you consider that BAC’s gross spread on loans and leases is below that of the constrained WFC, the picture takes on an even more dramatic coloration. The only thing that saves BAC, to an extent, is the fact that the bank’s cost of funds is extremely low. The chart below shows the historical interest expense for the top five banks and Peer Group 1. Source: FFIEC In the most recent quarter, BAC’s cost of funds fell to just $1.1 billion vs $1.6 billion in Q2 2020, yet the bank’s net interest income was down $400 million YOY. Part of this is caused by the relentless downward pressure on yields due to the Federal Open Market Committee’s policy of massive asset purchases or QE. But the other factor behind the bank’s poor financial performance comes from asset returns, as shown in the table below from BAC’s Q2 2021 earnings release. Source: EDGAR Another factor tending to hurt BAC’s overall performance is credit loss, where the bank is right behind JPM in terms of net charge offs. Indeed, BAC’s loss rate is 2x the average for Peer Group 1, yet the bank does not have the income to compete with the House of Morgan when it comes to the bottom line. How can Brian Moynihan prattle on about managing risk and sustainable growth when his loss rate is not sized with his asset returns? Source: FFIEC At the end of the day, BAC is a bank that has been drifting since the 2012 National Mortgage Settlement, a near-death experience that saw the parent company planning for a voluntary Chapter 11 bankruptcy filing to cleanse the massive liabilities acquired from the purchase of subprime lender Countywide Financial . Since that time, BAC has lagged the group in terms of asset and equity returns, the legacy of an entrenched management team that has made risk avoidance the priority but has not grown the business. Since the start of 2021, BAC and other names have experienced a considerable rally as investors anticipated the return of billions of dollars in loan loss provisions back into income. The earnings of Q1 2021 may well be the peak for the year, as illustrated by the decline in BAC’s income even despite the earnings release. By no coincidence, the equity market valuations for the top banks have been trending lower since the end of the first quarter of this year. Notice in the chart below that of the five top banks, WFC has been the best performing stock in 2021 followed by BAC, a cautionary point that suggests that quality of operations is not always the best determinant of market performance. Source: Google Finance 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.

July 15, 2021 | In this Premium Service edition of The Institutional Risk Analyst , we look at Wise Ltd (LSE:WISE) , the money transfer business that is designed to disrupt the monopoly bank control over the multi-trillion annual flow in cash transfers. The company’s model is “fintech” because technology enables the model for payments, but the “f” word does not appear in the offering document. We believe that WISE is one of the most interesting emerging players in the world of global payments, a rare fintech play that actually makes money. WISE will certainly upset a lot of large financial institutions. Banks and non-bank cash transfer houses that feed them volumes earned over $260 billion in 2020 moving hundreds of trillions of dollars globally. Just as Square Inc. (NYSE:SQ) attacked the antiquated bank model for vendor credit card accounts, WISE is assaulting one of the most opaque and least competitive markets in the world. WISE promises huge upside benefits for small business and consumers. The graphic below from the WISE prospectus shows the different markets where WISE operates and the regulatory environment. “Moving money internationally is broken,” notes the WISE prospectus for its listing on the London Stock Exchange . “Traditional banks are reliant on an outdated network of correspondent parties and held back by complex infrastructure. This means that both people and businesses have been overpaying for slow transfers, inconvenient customer experiences and are hit with opaque and hidden fees when moving money internationally.” The graphic below from the WISE prospectus illustrates the company’s strategy: WISE has created an ecosystem of affiliates and partners that enables the company to go around the traditional network of bank correspondents, a radical agenda that is unlikely to be welcome by larger banks, incumbent cash transfer providers or global central banks. Private models such as WISE, for example, could render the Fed's promised " FedNow " cash transfer network obsolete before it is even operational. The WISE network is comprised of different types of nodes in various markets, with a variety of levels of access to the national payments system. This is a key point because, in the UK and Europe for example, non-banks have direct access to the payments network. In the US and many other nations, a bank cash and securities monopoly controls access to payments. Yet the pressure on the US and particularly the Federal Reserve Board to change is enormous, both from the perspective of liquidity (“ Fed Prepares to Go Direct with Liquidity ”) as well as consumer demands for faster, cheaper ways to send cash across borders. “We have spent ten years building a replacement infrastructure for correspondent banking and have already made great progress in fixing the important problem of moving money across borders cheaply, conveniently and with transparent fees,” WISE states in the prospectus. As a disruptor of a very old and staid part of the world of banking, WISE has an enormous market opportunity. That said, the company also is a target for every traditional bank, foreign exchange house and regulator around the world that views change as unwelcome. Non-bank financial firms are regularly demonized as being unsafe and unsound. These are biased and unfounded accusations, yet a reality that WISE and other non-banks must fight every single day. In addition, WISE has taken the market and counterparty risk of global cash transfers onto it own books. By creating what is essentially an internal market for the exchange of currencies, WISE must manage its overall and specific country risk just like a depository institution engaged as a correspondent. WISE describes how it manages this risk, but the proof will be provided over time. For example, WISE discloses that it has been dragged into a legal dispute with a Brazilian bank located aptly in the State of Parana. WISE states: “Wise is currently engaged in a dispute with a Brazilian financial institution, MS Bank. Wise has filed a lawsuit pending service of process in the High Court of Justice, Business and Property Courts of England and Wales, Commercial Court for the return of approximately £6.0 million (comprising approximately U.S.$7.5 million and R$4 million) that were held in a liquidity pool for Wise transactions and are being improperly retained by MS Bank in violation of an applicable contract.” No amount of technology and innovation, sadly, can counter the natural tendency of individuals and business located in badly governed countries to violate contracts and behave badly. Brazil is a “BB” rated country with a volatile economy and a weak social society, where the rule of law is fragile and frequently qualified by political factors. WISE has made a claim against MS Bank in a UK court, but it may have no effective recourse in Brazil. Enforcing a judgement from a UK court in Parana State, for example, is likely to be impossible. Despite all of these risks and challenges, WISE has managed to achieve profitability, but note that there is a credit reserve for the Brazil dispute. Market and credit risk are significant factors facing WISE and its investors. That said, so far credit costs have remained relatively low even as the business has scaled its revenue quite rapidly and with little net-leverage besides guarantees on lease finance obligations. The WISE income statement is below. The growth of the WISE model is impressive and, again, suggests that the business model is scalable and potentially profitable as a long-term proposition. Examine the discussion of free cash flow in the prospectus. Ultimately founders of WISE state that they intend the push the cost of transfers to zero. WISE has also issued 1.6 million multi-currency, Visa and Master Card debit card that allows users to “spend money around the world at the mid-market rate, with low conversion fees and zero transaction fees.” The graphic below from the WISE prospectus illustrates the firm’s impressive growth to date. Ultimately WISE is a play on the relentless advance of technology that lowers costs and eventually forces change in the legacy world of banking and payments. We do not minimize the risks and challenges to WISE in leading this revolt against the old order in cross border payments, especially for consumers and small business. As WISE notes, the smallest users of cash transfer services bear the greatest portion of the cost of moving money from one country to another. Based upon the offering prospectus, WISE seems to be generating increasing amounts of free cash flow as it grows its business, a rare example of a disruptor model that has achieved profitability without consuming vast amounts of capital up front. We’ve purchased common shares of WISE this week for our portfolio and intend to watch the progress of this fascinating early-stage business with great interest. 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.

June 23, 2021 | In this edition of The Institutional Risk Analyst , we update our readers on the top-five commercial bank holding companies (BHCs): JPMorgan (NYSE:JPM) , Citigroup (NYSE:C) , Bank of America (NYSE:BAC) , Wells Fargo & Co (NYSE:WFC) and U.S. Bancorp (NYSE:WFC). We share this example of the Premium Service of The Institutional Risk Analyst with all of our readers. BNN-Bloomberg: U.S. banks looking to get smaller post COVID-19 Of note, USB has now dropped to the number eight position, supplanted by Charles Schwab (NYSE:SCHW) at $580 billion in total assets and more than $350 billion in core deposits. The good news is that Q1 2021 earnings for the large bank group were much improved, but the bad news is that much of that income was earned a year ago. The table below shows the top 13 BHCs by total assets. Source: NIC The first key indicator we look at is income, where all of the top five commercial banks have seen significant improvements. One consistent factor present in all of the results was the release of loan loss provisions (LLPs) back into income, which essentially means that credit reserves put aside in 2020 are now migrating back into income in 2021. Once this release of LLPs is finished, however, the run rate revenue and income for the group is likely to decline. Source: FFIEC The Street has JPM earnings rising from $8.80 in 2020 to $11 at the low end of the estimates for 2021, but on declining revenue. The sequential comparisons in the charts above are obviously quite skewed, but an inspection of the 2019-Q1 2020 results illustrated above gives you a better sense of the run rate going forward, excluding the one-time release of LLPs. Of note, all of these names hit 12-month highs at the end of Q1, but JPM and Citi have since given ground. Source: Yahoo There was a relatively late rush by institutional managers into BAC and WFC early in 2021, largely due to the fact that these relative underperformers were cheap. Now they are not so cheap, but they are still underperformers as shown in the first chart showing net income vs average assets. Sadly, most professional equity managers cannot even discuss the business model difference between the top five US depositories. There is always a contrarian element in the world of institutional money managers that believes that WFC and BAC, two badly managed banks, will somehow spring back to life. We politely disagree with such uninformed views. USB and JPM are the best performers in the group financially and operationally, and in our view, are still the best value, albeit quite expensive due to the effects of the FOMC’s quantitative easing. Notice how little volatility in book value multiples occurred with JPM and USB vs the rest of the group. The chart below shows the gross spread on total loans and leases for the top-five BHCs. Source: FFIEC Notice also that the gross spread on loans and leases for the entire group is falling even as earnings surged in Q1 2021. Indeed, BAC and WFC are the worst performers in the top-five and are actually tracking well-below the average for Peer Group 1, which includes the top 125 banks in the US above $10 billion in total assets. The subprime portfolio of Citi generates the biggest spread, but C only manages to hit peer net income levels once credit expenses and operating costs are subtracted. With the evolving situation regarding interest rates and FOMC policy, there will not doubt be an expectation among veteran investment managers that bank earnings will be helped. This is not always the case, however, because banks make money on spreads not interest rates. Spreads on loans and securities remain under pressure as Q2 2021 draws to a close, thus caution is recommended before concluding that banks will see expansion of loan spreads and thus earnings in 2021. The chart below shows net loss rates for the group vs average assets, again illustrating that the relatively benign credit environment is the biggest driver of bank earnings at present. Notice that BAC’s loss rate is elevated compared with the other banks and especially Peer Group 1. Since BAC’s income is tracking below the peer average, the net results are not particularly impressive. Source: FFIEC Notice also the nose-bleed levels of loss being generated by the subprime loan book of Citi, a bit over 1% net charge-offs vs less than 40bp for the other four banks and less than 20bp for all of Peer Group 1. Even though Citi makes a lot of money on its assets, the credit costs and operating expenses still result in a mediocre outcome overall. Outside of Citi, the highest loss rate of the top five BHCs is JPM, but CEO Jamie Dimon makes more money per dollar of assets. Finally, we look at funding costs, the chief benefit to banks from the FOMC’s quantitative easing program. Funding costs are at historic low levels, as shown in the chart below. But low funding costs does not help offset shrinking spreads. Source: FFIEC Of interest, the lowest funding costs in the group were found at JPM, at 16bps vs average assets. Next behind JPM is BAC at 18bp through Q1 2021, but the poor asset returns and operational efficiency of BAC delivers poor results overall. The Bottom Line The earnings of the top-five banks in Q2 2021 are likely to hit the same levels seen in Q1 2021 due to the release of credit reserves from last year, but we believe that results in 2H 2021 are likely to fall to the actual run-rate for revenue and income at current levels of business volumes. Most of the larger U.S. banks are tracking toward lower levels of revenue in 2H 2021, creating some significant challenges for investors that have crowded into some very expensive stocks. Source: Google Finance Our exposure to the equity of financials is limited to a stake in Annaly (NYSE:NLY) that we began accumulating last summer at 0.5x book and some bank preferred stocks. The current level of valuations for large US banks are simply not attractive for us and reflect a disconnect between fundamentals and market prices that is largely a function of the actions of the FOMC. So long as the FOMC continues with QE, we expect that bank equity valuations will remain elevated, but the gap between earnings and revenue, and equity market valuations, may continue to grow. In the meantime, look for that same group of institutional money managers that were pounding the table for Wells Fargo and the Bank of America in Q1 to push bank stocks higher between now and the end of Q2 2021. The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Profile is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Profile. Interested parties are advised to contact Whalen Global Advisors LLC for more information.