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July 12, 2021 | This week in The Institutional Risk Analyst , we prepare for the media fest known as large cap bank earnings. We held forth on the subject earlier (“ Update: Top Five US Banks | JPM C BAC WFC USB ”). July 13, 2021 CNBC WEX To summarize for new arrivals, Q2 bank earnings will be inflated by GAAP adjustments to income as reserves put aside last year migrate back into income this year. But Q2 2021 will likely be the peak for US bank earnings in 2021. In terms of run rate revenue going forward, investors and analysts ought to look at 2019 rather than 2020 as a baseline for forward estimates. Source: FFIEC We suspect that investment banking performance will be strong based upon the results last month from Jefferies Financial Group (NYSE:JEF) . H/T to Dick Bove . JEF is a lone broker dealer model operating among the ersatz banks such as Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) . Indeed, Charles Schwab (NYSE:SCHW) now has significantly more core deposits than either GS or MS. While earnings will be up big vs 2020, it is 2019 that is the relevant comparison. After the surfeit of unneeded loan loss reserves is exhausted, we suspect that the US banking sector will resume its brutal march towards zero net-interest margin. Only an end to quantitative easing by the Federal Open Market Committee can change this trajectory. Source: FDIC “The average net interest margin contracted 57 basis points from a year ago to 2.56 percent, the lowest level on record in the Quarterly Banking Profile (QBP),” noted the FDIC in Q1 2021. “Net interest income declined $7.6 billion (5.6 percent) from first quarter 2020 as the year-over-year reduction in interest income (down $29.8 billion, or 17.6 percent) outpaced the decline in interest expense (down $22.2 billion, or 68.7 percent). Despite the aggregate decline in net interest income, more than three-fifths of all banks (64.4 percent) reported higher net interest income compared with a year ago.” Below are some thoughts on the commercial banks that report tomorrow starting with JPMorgan (NYSE:JPM) : JPM : The Street has JPM doing ~ $9 per share in 2021, increasingly magically to $13 in 2022. Revenue is expected to be down this year and flat in 2022. JPM was trading around 1.9x book value at Friday’s close, up almost 60% YTD. Note, however, that JPM has lagged the other large cap names. And all of these stocks have essentially traded sideways since institutional managers rushed into these names early in 2021. Source: Google GS : Goldman Sachs is expected to do $8.50 per share in earnings in Q2 2021 and $45 for the full year, but the Street then has GS earnings falling in 2022 to below $30 per share. Go figure. Like many financials, the GS equity market valuation has basically doubled in the past year on flat revenue. If you want earnings volatility, you’ve come to the right place. FRC : First Republic Bank (NYSE:FRC) closed Friday a bit over 3x book value, a premium valuation for this high-touch asset manager. The Street has FRC reporting $7.50 per share in 2021 and $8 in 2022 with 20% revenue growth, of note. The growth rate magically falls to just 13% in 2022. The good news is that much of FRC revenue comes from non-interest fee income. The key takeaway from Q2 2021 bank earnings is that Q2 is likely to be the best quarter for US banks for the rest of 2021 and thereafter. Unless there is a fairly radical change in FOMC policy, we expect bank NIM to remain under downward pressure, especially with longer-dated benchmark rates falling and little evidence of loan growth. Source: FDIC/WGA LLC Funding costs for the US banking sector are likely to fall again to all-time lows in Q2 2021, but cheap liquidity c/o the FOMC does little for bank earnings when asset returns are also falling. As the FDIC noted last quarter: “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.”

July 6, 2021 | Our earlier comment in The Institutional Risk Analyst about the Federal Reserve Board’s interest rate “tweak” and rescue for money market funds (“ Fed Hikes Rates, Rescues Money Market Funds ”) generated quite a few comments. The consensus seems to be that the US is caught in a liquidity trap caused by near-zero interest rates, trillions in unnecessary fiscal stimulus and an aging population that is disinclined to spend much less borrow. In classical terms, we are taught that spending must match taxation or the system is choked by hoarded cash. But what happens when the spending is pointless, asset prices are soaring and we are loitering at the zero bound of interest rates? That’s why the fact that the Fed feels the need to again employ reverse repurchase agreements (RRPs) on a massive scale is notable. Our profiles of Upstart Holdings (NYSE:UPST) and Blend Labs generated a fair amount of reader mail and scores of subscriptions to our Premium Service by anxious investment bankers and public relations professionals. We can only be flattered. For the record, we are interested in talking to any financial institution that has good things to say on-the-record about either UPST or Blend. To us, the emergence of numerous examples of fintech “skin jobs” in the world of public finance is merely a symptom of the disease known as Quantitative Easing or QE. When you shift the risk curve and give crap issuers access to funds on investment grade terms, money moves -- quickly. A skin job, for those not paying attention, is a derisive term for a replicant in the 1982 Ridley Scott film “Blade Runner .” Relatively substantial fintech firms such as Square (NYSE:SQ) represented a software and business process “skin” applied to the world of legacy banking and consumer finance. These firms are disruptors in a sense that they force the legacy monopolies to adjust and improve. The important point, of course, is that the dinosaurios do change and they will incorporate the features of upstarts into legacy offerings. And all this is made possible thanks to QE. The once disruptor SQ, of course, eventually had to become a commercial bank in order to compete with the larger banks. Only insured depository institutions can have a master account at a Federal Reserve Bank and only banks have federal deposit insurance. If you as a “disruptor” don’t have a master account or FDIC-subsidized funding, then you are the customer of a bank. Get used to it. And naturally enough, MMFs are customers of commercial banks. The high tide of zero-cost investment capital that has floated literally dozens of IPOs and special purpose acquisition corps or “SPACs” has also tended to lower the quality of the offerings. As the cost of capital declines, it seems, the real value of the opportunities available also decays. But when early-stage companies can raise equity capital from the likes of Softbank or dozens of other private equity firms, there is little or no credit discipline involved. Equity finance is about the future. In a world of low or zero interest rates, expected returns are entirely based upon capital appreciation from a future sale. Duration and potential volatility are infinite. The return of and on capital depends fundamentally on a greater fool arriving to buy thy precious asset. The issuer has no cash flow obligations in the form of dividends or interest payments. In the era of Meme Investing, profitability is discouraged. All focus and attention by investors depend upon the expectation of a future sale at a higher price point . A century ago, Bernard Baruch would bristle at being called a “speculator,” a contemptuous term focused on financiers of a certain ethnic background. Baruch noted that “a speculator is a man who observes the future, and acts before it occurs.” But in today’s markets, speculation is more a matter of faith than empirical observation, giving investors and economists a common point of departure. We have no visibility on markets or credit thanks to QE. Watch members of the dismal science struggling to understand the interplay between fiscal spending and the open market sales of securities by the Federal Reserve Board via RRPs. The idea that the Fed must insert a hard floor underneath interest rates comes as a surprise to many, but since the central bank has largely nationalized the heretofore private market for federal funds, it does not really matter. Fed funds is a purely government market controlled by economists. Notice that the yield on T-bills is now tracking the rate on RRPs, the new de facto lower limit for US interest rates. Paul in Paris notes that the Fed’s reverse repurchase agreements have matched almost precisely the flow of funds out of the Treasury General Account (TGA) and into US banks. Bingo. The fellow wearing the lion costume working the buttons and leavers behind the big curtain is not Bert Lahr , but Fed Chairman Jay Powell . He is trying to fine tune global dollar liquidity. Some observers see RRPs as a means of preventing rates from rising, but we disagree. The increase in interest paid on bank reserves (IOR) and the RRPs are about defending the lower bound and, indirectly, protect banks and MMFs from the disaster of negative interest rates. Yes, the Federal Reserve Board did direct an increase in rates several weeks ago, but only as an expedient to prevent rates trading further into negative territory. Back in June, when there was talk of the reflation trade ending, our friend Ralph Delguidice reminded us that there was indeed basis expansion. This was only a short-lived promise, however, just a teaser really. The Treasury and agency market promptly tightened in the past several weeks along with secondary market spreads for agency securities. But please don’t confuse that movement with the continued downward pressure on short-term interest rates. “Mr. Pozsar thinks the Fed's monetary easing has skewed investors' incentives,” reports Julia-Ambra Verlaine of Dow Jones . “Ultralow rates and central bank bond buying have kept the yield on the 10-year Treasury note, a key reference rate for borrowing costs throughout the economy, hovering around 1.5%, below the rate of inflation. The three-month Treasury pays less than the reverse repo facility.” "If a money dealer could borrow at zero and do something with the money, he or she would do it," said Mr. Pozsar. "The opportunity set is so poor." We demur to that last point. Of note, US banks have a cost of funds around 15bp, yet lending is flat to down. We wonder if Pozsar’s observation about skewed investor incentives is not the key observation for both lenders and well as managers to consider. Meanwhile, with well over $1 trillion in funds parked in RRPs at the FRBNY, we need to ponder the shift in reserve balances from banks to MMFs. The deposits being gathered by the FRBNY via RRPs, as noted earlier, are essentially an offset for the cash being spent by the US Treasury via outlays from the TGA. Poszar and others note correctly that this vast recycling of liquidity is “sterilized” in monetary terms, but that does not mean that the operations have no significance to banks or markets. Specifically, we anticipate a shift in deposits out of banks and into the Fed that could further complicate liquidity in Q3 2021. Again Poszar: “We’re looking at $1.3 trillion of flows from bills into RRPs by the end of August!” Although banks will certainly be selling securities to the FRBNY as part of QE and will thereby will create new short-term deposits, the vast scale of RRPs dwarfs the monthly levels of new QE purchases and thereby implies a shift of hundreds of billions in liquidity out of banks and into the sterile sanctum of the central bank. In essence, the Fed's operations to remove cash from the system via RRPs is an offset to the fiscal operations by the Treasury. MMFs, don’t forget, keep their cash in a large commercial bank. But when Vanguard does a RRP with the FRBNY, the MMF gets a risk-free asset and the cash leaves the markets entirely. Managing this liquidity juggling act is the next challenge facing Jay Powell and his colleagues on the Federal Reserve Board. As former Chairman Ben Bernanke told his colleagues years earlier, once you start QE you cannot stop. As in December 2018, September 2019 and April 2020, the Federal Reserve Board is playing the Wizard of Oz, trying to navigate the ebb and flow of dollar market liquidity as Congress spends trillions more that we don’t raise via taxes. The likelihood that the Fed gets it wrong and plunges the markets into another liquidity crisis a la December 2018 is fair to middling. Buckle your shoulder harness and have a great week.

July 3, 2021 | Updated | In this Premium Service edition of The Institutional Risk Analyst , we look at impending IPO of Blend Labs, Inc. (BLND) , a new entrant into the mortgage space that promises “to bring simplicity and transparency to financial services.” The S-1 filed with the SEC includes a great deal of hopeful fluff about “data-driven journeys from application to close.” The document has all of the right words. But what does BLND actually do to earn money? And is it really worth 10x book value in an IPO? Simply, BLND provides a service of processing loans, but not taking interest rate and/or market risk. Simply stated, BLND facilitates borrowers completing a loan application. If this reminds you of our recent note on Upstart Holdings (NYSE:UPST) (“ Upstart Holdings: Victory for AI? Or Not... ”), you are correct. A capital light overlay that is part lead generator and part marketplace, BLND’s software sits atop different banks and service providers in a cloud-based suite of apps. Lot's of frosting, but not much cake. The company has some heavy hitters from the world of mortgage finance in senior leadership, but the rest of the team has a tech pedigree rather than experience in loan processing operations. We seem to recall some talk about blockchain coming from company’s founder, but no more. Founder and CEO Nima Ghamsari held forth on the benefits of blockchain for BLND as late as 2018 during an IMN conference , but it is interesting to note that three years later, the term does not appear in the S-1. Last month, Forbes reported that Ghamsari was given a potential $10.9 billion compensation package, giving you some idea of the ambitious valuation that Goldman Sachs (NYSE:GS) and Allen & Co plan for the IPO. To say that BLND has made the loan application process a commodity would be a reasonable assessment and they should be able to make money, albeit with a very low margin. Sound familiar? Perhaps we can think of BLND as a sub-servicer a la Cenlar FSB , except in this case a sub-servicer for loan applications instead of payments. According to Crunchbase , BLND has raised about $700 million in private equity Blend’s IPO filing comes three months after the startup raised $300 million in a Series G round led by Coatue and Tiger Global in January, Barron’s reports. The fintech was valued at $3.3 billion with the last round, a statement said. Blend announced the acquisition of Title365 from Mr. Cooper (NASDAQ:COOP) on Mar 15, 2021 for $422 million. It is important to note that the acquisition of Title365 has not closed yet, creating a bit of a mess in terms of the company’s financials. And did we mention that COOP is retaining a minority stake in Title365? For 2019 and 2020, Title365 revenue was $105.3 million and $212.1 million, respectively. The acquisition is subject to regulatory approvals and is expected to close in the second or third quarter of 2021. But Ghamsari seemingly is in a big hurry to go to market and plans to list the company before the Title365 deal is actually done. “Title365 will be integrated with our software platform, which enables financial services firms to automate title commitments and streamline communication with consumers and settlement teams,” BLND proclaims. “Together we will enable our customers to accelerate the title, settlement, and closing process at scale for mortgages, home equity lines of credit, and home equity loans.” The table of contents for the financials for BLND and Title365, which are carved out of the disclosure from COOP, are shown below. We doubt most financial professionals, much less retail investors, will be able to comprehend this presentation of BLND's financials. BLND has been losing money steadily and it is not clear that this model will grow its way to profitability given the low margins for such services. Also, buying a title company at this stage of the game, funded with debt and right before an IPO really begs the question about the whole business model. If the software and ecosystem created by BLND is so valuable and has such leverage, then why are we buying a title insurance underwriter? The financials from BLND’s S-1 are shown below. The $422 million in consideration to be paid for Title365 includes about $390 million in goodwill, half of which represents the insurers customer relationships. Needless to say, we tend to treat such intangible assets as an expense in drag. Investors should ask a similar question about this "asset." Another question to consider: Why is COOP selling Title365 if it is such a great business? The folks who run COOP are pretty sharp, thus again we wonder just what makes buying Title365 compelling for investors in BLND as a mortgage/fintech story? Obviously having BLND pay a multiple of book for Title365 was a great deal for COOP. If buying a loan processor with a captive title company does not get you very excited, then your instincts serve you well. While this can certainly be a steady business given strong industry volumes, it is hardly worth a $3 plus billion valuation much less multiples of that amount. The IPO will feature a two-tier ownership structure, with Ghamsari retaining explicit control over the company with 40:1 super voting shares. “Mr. Ghamsari will be able to determine or significantly influence matters submitted to our stockholders for approval even if he owns significantly less than 50% of the shares of our outstanding capital stock on an as-converted to Class A common stock basis,” the S-1 states. “Mr. Ghamsari’s concentrated control could discourage others from initiating a potential merger, takeover, or other change of control transaction that other stockholders may view as beneficial.” Bottom line is that operations professionals in the industry tend to like BLND CEO Ghamsari on a personal basis, but have little good to say about the product offering. As with other new era lending and mortgage servicing platforms we have examined over the past several years, BLND seems to be heavy on promises and techno babble, but relatively light when it comes to delivering operational and financial benefit in an industry where expense management is always Job 1. One former user of BLND told The IRA : "I was on a Blend integration team and was not impressed. They told us it was going to 3x our production. It did not. Most LOs stopped using Blend as a point of sale because it was easier to manage your pipeline without it. TIAA used Blend and they’re now exiting all mortgage related operations. Most importantly, Blend, Mortgage Hippo, Rocket Mortgage and all the other point of sales had one major flaw: they didn’t improve the customer experience (customer complaints didn’t change post-Blend because nobody complains about having to complete a 1003 [Fannie Mae loan application], that’s an expected consumer behavior). All Blend is is a digital 1003. Getting a borrower to complete a 1003 is not a problem. So, in the end, Blend didn’t solve any major pain points for the customer experience." One key complaint we’ve heard from multiple issuers is that the members of the BLND team are impressive technologists, but they do not know mortgage operations. BLND reportedly is comfortable with super easy, plain vanilla processing tasks, but throw a twist into the mix and the technology reportedly stumbles. Anyone familiar with bank and nonbank lending knows that every loan is different, thus AI systems cannot be too brittle or they break. More significantly, there is the question of the ROI once you interrupt your operations to add the BLND offering to your platform. Like MOST of the new era tech solutions being thrown at lenders today, the market is getting to a point where by the time you pay the fees, endure the down time and eat unexpected integration costs, you are not saving all that much money any more. As one industry operations veteran told The IRA : “The ROI is not really worth the time and investment to adopt. It is only a matter of time before Ellie Mae or Black Knight Empower just copies what Blend does and builds everything into their LOS.” We agree with the cautious assessments we’ve heard from a number of market participants. Like Square (NYSE:SQ) and other providers of new solutions into legacy markets where lender are displaced, the market for loan processing and servicing systems is highly concentrated and inhabited by some aggressive and implacable competitors. Having observed the behavior of industry incumbents such as Ellie Mae and Black Knight (NYSE:BKI) , we fully expect BLND to be targeted by the hyper-aggressive sales teams of these two incumbents. BKI, of note, trades at 4.5x book or several times the multiple of most of its customers with the exception of Rocket Companies (NYSE:RKT) at just shy of 5x today and CoreLogic (NYSE:CLGX) at 7.5x. Of note, CLGX just acquired ClosingCorp, Inc. which "streamlines the quoting and ordering of critical settlement services needed to originate and service a home loan, eliminating friction, cost and risk." Sound familiar? Our mortgage surveillance group sorted by price/book is below. Source: Bloomberg To believe the happy talk from BLND and their advisors regarding the prospective IPO, you need to believe that this software provider is worth 10x book. Is BLND worth more than RKT, or entrenched data monopolies and solution providers such as BKI or even CLGX? No, we’ll hit the bid on that trade right now. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. 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June 29, 2021 | First we give kudos to Dr. Lawrence Summers in this edition of The Institutional Risk Analyst . He correctly called out Federal Reserve Chairman Jerome Powell for the growing contradictions in US monetary policy. But even Summers, who famously commented on the difference between insiders and outsiders in the world of public policy, is still behind the curve when it comes to monetary policy. Simply, even smart guys like Larry Summers reflect the outsider narrative, a description that holds that the Federal Open Market Committee is just thinking about changing policy in the future. In fact, the FOMC has been shifting policy for months, but this reality is not yet palatable to the public narrative on monetary policy that one finds in the media mainstream. Powell himself called the change a "tweak" when, in fact, it constituted an explicit bailout for money market funds. "Investors stashed a record amount of cash in an overnight facility at the Federal Reserve on Thursday," reported Colby Smith in the FT last week, "after the central bank started paying interest on the money to prevent negative rates taking hold in parts of the US financial markets." Dr. George Selgin of Cato Institute put it succinctly last week : “Despite having switched to a ‘floor’ operating regime in October 2008 (and permanently in January 2019), and thereby all but ending interbank lending on the fed funds market, the Fed continued to maintain the pretense of ‘targeting’ the fed funds rate. But in reality, it no longer used open-market operations to keep a freely-fluctuating interbank funds rate close to its targeted value.” “Instead, [the FOMC] adjusted its policy stance by altering the interest rate it paid on bank reserves (IOR rate),” continues Dr. Selgin. “Lending on the fed funds market didn't cease altogether only because some GSEs w/ Fed balances aren't eligible for IOR. So, they lent their balances to banks for a share of the banks' IOR earnings. The fed funds market became nothing more than a locus for such arbitrage.” Our version of George’s outstanding graphic from FRED is below. As the chart illustrates, the Federal Reserve Board hiked interest rates on IOR and RRPs last week. Years ago, we coined the term “managed stability” to describe the Fed’s control over the largest money center banks operating in Latin America, a less than distinguished group led by the predecessor of Citigroup (NYSE:C) . For many years, the Fed and other regulators kept these banks on de facto life support, all the while pretending all was well. In the intervening years, the FOMC has rejected the guidance of Congress in the 1978 Humphrey Hawkins law, guidance that explicitly commands the central bank to focus on private sector solutions to the problems of growth and full employment. Instead, the central bank has followed the political fashion, skewing ever more interventionist and socialist in its policies. Today, for example, a target of 2% inflation is equated with price stability. In the search for a perfectly managed market, the chairs and members of the FOMC have borrowed the bad example of Europe and approved a creeping nationalization of the short-term money markets. The level of federal funds has become a polite irrelevancy in 2021, yet the keepers of the conventional narrative pretend that there is still a private market for overnight unsecured lending between banks. In fact, like the money center banks of old, today money market funds are now wards of the state. Killing LIBOR, seen in this light, was a necessary condition for achieving “managed stability” in the US capital markets. Why bother investigating the role of money market funds in the market volatility of March 2020? The Fed has already made its decision to bail them out without consulting President Biden or the Financial Stability Oversight Council. More than merely taking over the private market, the Federal Reserve Board has also supplanted the FOMC in terms of making US monetary policy. While the FOMC sets the level of asset purchases for the system open market account (SOMA), the Fed’s seven seat Board of Governors sets the level of IOR and RRPs. Again, Dr. Selgin explicates: “[The set-up allows the Fed to maintain the fiction that the FOMC, which sets the target range limits, is regulating the stance of monetary policy, as the Federal Reserve Act requires it to do, when in fact... [I]t is the Federal Reserve Board, which sets the IOR and ON-RRP rates, that's really calling the shots, albeit with the FOMC supplying its rubber stamp and (supposedly) making the actual decisions.” Having now changed the emphasis of monetary policy from excessive ease to a more muddled form of schizophrenia, investors are left to ponder the next thing. The Fed is still buying Treasury debt, mortgage-backed securities and forward positions in agency securities known as “TBAs,” on the one hand, but taking hundreds of billions in cash out of the markets via RRPs. Source: FRBNY What is the net, net market position of the Fed? Nobody inside or outside the pretty building on Constitution Avenue has the faintest idea. As funds flow out of the Treasury General Account into banks, the Fed is desperately trying to reduce the amount of cash in the US banking system with RRPs. Meanwhile, money market funds are now lending hundreds of billions daily to the Fed, which the central bank uses to fund ever more QE. With each purchase of T-bills and MBS via QE, the Fed is adding to the surfeit of liquidity but not actually encouraging banks to lend. This is one of the most interesting and least noticed aspects of US monetary policy. The Fed is paying lip service to fostering growth and full employment, but its actual policy seems to be retarding credit creation within the US banking system even as it acts to prop-up money market funds. Meanwhile, outside of the largest US banks, the markets have run riot, with the Fed’s liquidity fueling an asset bubble of historic proportions. The year 2021 is already looking to set another record in initial public offerings. Add the fact of higher rates and perhaps even wider spreads, and financials take on a far more positive outlook. The basis trade has moved a lot in recent weeks on precisely this promise, suggesting banks, REITs and funds may get further relief from QE. The only issue is the fragility of the narrative around Fed policy, a significant issue that relates directly to confidence. The Fed somehow pretends they can manage an increasingly unsteady policy construct of asset purchases and short-term sales via RRPs. The hope is that taper of MBS can be accomplished without further bad PR about the Fed boosting home prices and killing affordability. But the bigger issue is that shifting QE to Treasury notes and bonds means that the current Fed balance sheet is now the new normal, more or less $7-8 trillion. That suggests that the level of inflation seen in housing and other assets over the past several years is unlikely to be transient and may represent the new floor for the eventual maxi correction several years out. So when you hear people talking about the Fed tapering QE next year, you know they are behind the proverbial yield curve.

June 21, 2021 | In this issue of The Institutional Risk Analyst , we comment on the refusal of the largest US banks to support the emancipation of slaves during the Civil War. The holiday now recognized nationally as Juneteenth, when federal forces made freedom a reality for millions of slaves in America, is significant for Wall Street. Why? Because the big banks in Boston, New York and London did not support “Lincoln’s War.” The large state-chartered banks that existed in 1860 mostly were against the war of emancipation because it would interfere with the cotton trade, which was one of the largest export industries in the US in the early 1800s. American traders imported between 30,000 and as many as 100,000 enslaved Africans each year during the late 1700s and early 1800s to support the cotton trade and other agricultural endeavors. The big banks in Boston, New York and London financed this hideous trade in human beings. William Edward Burghardt Du Bois (1868-1963) The slave model of agriculture was “reckless,” to recall W.E.B. Du Bois in his classic Harvard University dissertation, “The Suppression of the African Slave Trade in the United States (1638-1870).” His meticulous description of the economics of slavery and the battle to suppress it exposed the fact that financing the slave trade was profitable for many banks and companies in the north. When President Abraham Lincoln entered Washington as the new President in March of 1861, the Treasury was empty and the federal army had been paid and sent home. To finance the war to end slavery, Lincoln tasked a character named Jay Cooke to act as agent to sell Treasury bonds. Cooke became the foremost money lender of his day, but decades later went bust trying to buy the Northern Pacific Railroad. Lincoln’s Treasury also issued unconvertible “greenbacks” (there was no central bank), that had no connection to gold. Of note to crypto enthusiasts, the laws declaring the unconvertible paper dollar “legal tender” were passed in 1862 and 1863. In 1860, total US government debt was $65 million, but by the end of the conflict the total federal debt was $2.6 billion. Hundreds of millions in unbacked paper money was issued to float the cost of the conflict. The cost of the war to the Confederacy was equally large, about $2.25 billion. Of this, about $250 million was financed via taxes, about $500 million via borrowing and $1.5 billion via printing press money. By the end of the war, both federal greenbacks and the equivalent unbacked paper money of the Confederacy had depreciated to about 5% of face value measured in gold. And the banks in the north lent money to both sides. Lincoln embraced the issuance of paper money during the darkest years of the Civil War, when the Confederacy seemed to be on the brink of military victory. And even as Union armies fought against the Confederacy, the big banks in the north were still supporting the cotton trade in the south. Du Bois describes the economic power of the southern cotton producers: “By 1822 the large plantation slave system had gained a footing; in 1838-1839 it was able to show its power in the ‘cotton corner;’ by the end of the next decade it had not only gained a solid economic foundation, but it had built a closed oligarchy with a political policy. The changes in price during the next few years drove out the competition many survivors of the small-farming free labor system, and put the slave regime in position to dictate the policy of the nation.” Lincoln and his Secretary of the Treasury, Salmon Chase , convinced Congress to pass the National Bank Act of 1863. The law established federally chartered banks to compete with the state banks led by JP Morgan . National banks were allowed to “double leverage” federal debt held in the vault, providing a very tangible incentive for investors to charter federal banks and buy government debt. And greenbacks, of note, paid interest during the Civil War, a feature that may return given the wild profligacy of the US Congress in 2021. The textbooks say that national banks were established to create a more stable currency, but in fact these new banks were made to counter the monopoly power of state-chartered banks and, indirectly, to help finance the cost of the Civil War. Hixon (1993) notes that national banks created nearly $300 million in new “money” by issuing greenbacks and lending same to the federal government at a great profit. Wall Street once ran from a graveyard to a river. Today it has become, in the measured words of Dr. Charles A. Beard , a new Appian Way of the world. But never forget that the antecedents of many of today’s biggest banks opposed the effort to end slavery. Wall Street would have happily left the cotton trade undisturbed. When the slave traded finally ended in the United States on June 19th, 1865, those working in lower Manhattan to finance and facilitate the slave trade turned to a new profession, namely the business of selling stocks and bonds. In the years following 1865, the growing nation demanded more and more currency to satiate its need for finance and a means of exchange. Millions became billions and the builders of yesterday became the buyers and speculators of today. The railroad barons became bankers and the bankers bought the railroads in a swarm of amalgamation that pushed stock prices ever higher. Formerly a railroad right of way and stock yard where the trade in slaves was financed, the big Wall Street banks become the chief beneficiaries of that new evil, namely inflation.

June 17, 2021 | In this latest edition of the Premium Service of The Institutional Risk Analyst , we ponder the nouvelle cuisine known as artificial intelligence (AI) applied to the world of unsecured consumer lending. Upstart Holdings (NASDAQ:UPST ), a portfolio company of Third Point LLC , is one of the more prominent and successful examples of machine learning applied to creating and managing unsecured credit risk. Will it work "through the cycle?" Ask us in 2025. As we told the FDIC and other regulators in our comment letter on AI as employed by insured depository institutions: “While the progress in machine learning is impressive, horsepower in terms of computational capacity does not translate into intelligence. In fact, machines, are never going to be ‘intelligent’ in the way that we apply this term to human beings. As a result, prudential bank regulatory agencies as a group must parse the difference between the promise of AI, as marketing and media concepts, and the technical and practical realities as applied to owning and managing insured depositories.” Former Warburg Pincus Vice Chairman William Janeway noted in an October 2018 interview in The IRA (“The Interview: William Janeway on Capitalism and the Innovation Economy” ): “AI systems seem to be good at pattern recognition when they have been properly trained as to the pattern in question. They are good at playing games where the rules of the game are given exogenously such as in chess or go. They are good at that. But the games that really matter, like the Three Player Game, are those where we must co-invent the rules as we go along. For example, in any conversation, even with people you know well, you are constantly trying to understand the context of the words used by the other speaker and vice versa.” What Janeway illustrates is that no matter how much you train an AI system to identify patterns, to apply quantitative methods to understand human behavior, the ability of consumers and creditors to change the rules of the game as they go through time renders such systems vulnerable to failure or deliberate gaming. But beyond the question of the fragility and brittleness of AI systems, however, there is the broader issue of how AI is being used today to replace or augment people involved in managing credit and operational risk. Upstart as Challenger Companies like UPST represent a challenge to traditional credit risk management. The world of FICO scores and collateral are the twin pillars of secured consumer finance, but unsecured lending is entirely another matter. From the relatively pedestrian unsecured consumer loan portfolios of large banks such as JPMorgan (NYSE:JPM) and Bank of America (NYSE:BAC) , to more risky consumer lenders like Citigroup (NYSE:C) and Capital One (NYSE:COF) with default rates measured in points, to subprime lenders with gross loss rates that stretch into double digits, unsecured consumer credit is a profitable but also a hazardous business. Over the past five years, credit data providers led by Experian (LON:EXPN) have sponsored a challenger to Fair Isaac (NYSE:FICO) and the FICO score, Vantage Score, which uses non-traditional measures such as utility bills and social media profiles to make a determination about the borrower's ability to support credit. UPST represents an operating business built upon such ersatz metrics, combined with intensive data mining of borrower behavior. UPST describes itself in its 2020 10-K: “We are a leading, cloud-based AI lending platform. AI lending enables a superior loan product with improved economics that can be shared between consumers and lenders. Our platform aggregates consumer demand for high-quality loans and connects it to our network of Upstart AI-enabled bank partners. Consumers on our platform benefit from higher approval rates, lower interest rates, and a highly automated, efficient, all-digital experience. Our bank partners benefit from access to new customers, lower fraud and loss rates, and increased automation throughout the lending process.” Translated into plain language, UPST is essentially a lead generation platform that finds borrowers, presents these borrowers to banks for funding and sometimes retention in portfolio, and sells some of the production that the banks don’t want to investors. UPST is kind of a mix between a wholesale channel for generating leads for unsecured consumer loans and the marketplace concept of Lending Club (NYSE:LC) , including a securitization channel. The market value of the common equity of UPST is up over 300% in the LTM. Some of the obvious comps are shown below: UPST describes its business: “Loans issued through our platform can be retained by our originating bank partners, distributed to our broad base of institutional investors and buyers that invest in Upstart-powered loans or funded by Upstart’s balance sheet. In the year ended December 31, 2020, 21% of the loans funded through our platform were retained by the originating bank and 77% of loans were purchased by institutional investors through our loan funding programs. Our institutional investors and buyers that participate in our loan funding programs invest in Upstart-powered loans through whole loan purchases, purchases of pass-through certificates and investments in asset-backed securitizations.” Of note, UPST discloses that it does not own a broker-dealer despite its sales of loans and ABS to investors. This is key business model difference with SOFI, for example, which uses a FINRA regulated broker dealer as its platform. Lending Club has become an FDIC-insured bank. In this regard, UPST provides a key piece of information: “A large fraction of the whole loans sold to institutional investors under our loan funding programs are originated by Cross River Bank , or CRB. In the year ended December 31, 2020, CRB originated 67% of the loans facilitated on our platform and fees received from CRB accounted for 63% of our total revenue. Our current agreement with CRB began on January 1, 2019 and has an initial four-year term, with a renewal term for an additional two years following the initial four year term. We enter into nonexclusive agreements with our whole loan purchasers and each of the grantor trust entities in our asset-backed securitizations, pursuant to which we provide loan servicing.” How does UPST manage to originate loans that other firms cannot or will not? Via artificial intelligence and using non-standard credit metrics other than FICO scores. While these data points are new and innovative, they are not tested in a down credit environment. UPST attempts to address these concerns: “Credit is a cornerstone of the U.S. economy, and access to affordable credit is central to unlocking upward mobility and opportunity. The FICO score was invented in 1989 and remains the standard for determining who is approved for credit and at what interest rate. While FICO is rarely the only input in a lending decision, most banks use simple rules-based systems that consider only a limited number of variables. Unfortunately, because legacy credit systems fail to properly identify and quantify risk, millions of creditworthy individuals are left out of the system, and millions more pay too much to borrow money.” Translated into plain language, UPST lends to borrowers who cannot access credit via a FICO score based credit process. These borrowers may not even have sufficient utilization of credit to generate a FICO score. UPST continues: “We leverage the power of AI to more accurately quantify the true risk of a loan. Our AI models have been continuously upgraded, trained and refined for more than eight years. We have discrete AI models that target fee optimization, income fraud, acquisition targeting, loan stacking, prepayment prediction, identity fraud and time-delimited default prediction. Our models incorporate more than 1,000 variables and benefit from a rapidly growing training dataset that currently contains more than 10.5 million repayment events. The network effects generated by our constantly improving AI models provide a significant competitive advantage—more training data leads to higher approval rates and lower interest rates at the same loss rate.” So, the basic thrust of the UPST model is to use AI to originate and sell consumer loans, whether to banks or to investors a la LC, SOFI, et al, but without the cost of being a bank or broker-dealer. This originate-to-sell model also includes less kind comparisons including Citibank (2008) and Greensill Capital (2020), the latter which originated commercial paper for sale to investors, but collapsed amid allegations of fraud. Third Point, however, claims that AI has helped UPST deliver truly exceptional credit results: “Upstart’s AI platform has yielded a 75% reduction in loss rates. Upstart’s ongoing model improvements deepen its competitive moat and continually strengthen its business case. This is reflected in increased credit rate requests and increased loan conversion leading to ~87% CAGR in the total number of loans transacted. Upstart’s model benefits from flywheel dynamics that should drive compounding growth through a cycle of continuous model feedback and improvement. As the platform grows, more data points (payments, defaults, etc.) are fed into the model, thus improving its accuracy and supporting additional share gain. An understanding of the opportunities presented by AI and machine learning has been an important theme we have expressed in numerous investments at the firm.” Of course, terms such as “moat” and “flywheel” are not defined in GAAP, but you get the idea. It’s different this time, we're "going to the moon" a la Reddit. As we noted in our comments to the FDIC on AI, one of the difficulties in assessing UPST and other AI enabled lenders and loan servicers of the latest vintages is that the credit markets are currently skewed by the actions of the FOMC. The chart below shows loss given default on bank-owned credit card loans. Source: FDIC/WGA LLC Credit spreads are compressed and net-default rates on secured assets such as mortgages and auto loans, for example, are falling and in some cases negative . Credit, at the present time, seems to have no cost, as we saw in 2004-2005. Thus measuring the stressed performance of the nouvelle cuisine production of UPST and other fintech lenders is difficult or impossible. As and when the great credit correction comes, however, we suspect that UPST and other lenders and servicers that have been created since 2008 will be put to the test and, in some cases, fail rather spectacularly. While UPST states that investors in its loans and asset backed securities (ABS) have no recourse to the lender, this same contractual reality did not prevent investors from demanding early redemption from originate to sell lenders such as Wachovia and Citigroup. The firm does have repurchase exposure on $6.2 billion in loans sold to investors, of note. Goldman Sachs (NYSE:GS) took UPST out at $20 per share at the end of 2020, but since then the stock has traded as high as $170 but closed on June 16,2021 at $119 or just shy of a $10 billion equity market cap. Is 30x book value a ridiculous valuation for this provider of warm consumer loan leads to banks? Yes, we’d say so, which is probably why the stock has lost 40% of its value in the past several months. Without QE as the lubricant, this model would not exist. We are told: “Upstart-powered loans originated by bank partners are either retained by the bank partners, purchased by the Company and immediately sold to institutional investors under loan sale agreements, or purchased and held by the Company for a period of time before being sold to third-party investors, or held by the Company.” As we’ve note above, we’ve heard this story before. Once upon a time, there was a company called Ocwen Financial (NYSE:OCN) that had a visionary CEO who thought algorithms and the precursors of AI were sufficient to handle the servicing of distressed mortgage loans. OCN and many other banks and non-banks were proven wrong in this view. We’ll withhold judgement on whether AI enhanced credit products will result in superior credit results “through the cycle” for UPST, but suffice to say that we are skeptical. The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. 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June 14, 2021 | The global bank regulatory community delivered a resounding rejection of the world of bitcoin and other “untethered” crypto tokens last week. Tokens are “tethered” when they are tied to the value of a real currency. By applying the highest possible capital weighting to bitcoin, the Bank for International Settlements (BIS) essentially put crypto assets that are not fixed in value against a traditional currency into the financial bait bucket under Basle III/IV. “When the only tool you know how to use is a hammer, everything looks like a nail,” remarked our friend Ed Kane , Professor of Finance at Boston College, upon hearing the news. In the world of global bank capital requirements, 8% capital vs assets is the standard that is set equal to 100% risk weight. Capital risk weightings go from “zero” for most government debt exposures, to 20% risk weight for parastatal entities such as Fannie Mae and Freddie Mac, to 50% for secured loans on real estate, to 100% for typical unsecured corporate exposures. By assigning a 1,250% risk weight to crypto assets, the BIS is essentially saying “no thanks" to bitcoin. The impact of this impending decision will be felt widely. First and foremost, new banks such as Square (NYSE:SQ) and SoFi Technology (NYSE:SOFI) , both of which have acquired banking charters, must now decide whether to remain in the world of non-banks. To actually adopt a banking charter, as SQ has done, means leaving the world of crypto assets behind. The rules applicable to the world of regulated banks do impact the world of non-banks, however. The tendency of corporate chieftains such as Elon Musk at Tesla (NYSE:TSLA) to “invest” liquid funds into bitcoin will likewise be tempered by the fact that banks effectively cannot take positions in tokens. Indeed, the concerted lobbying effort to see bitcoin considered an “asset” under GAAP may have been dealt a fatal blow. The BIS decision exposes one of the central contradictions of bitcoin and other crypto assets, namely the tension between being a means of exchange for goods and services and a speculative commodity. The volatility of bitcoin and other speculative tokens renders these virtual collectibles too abstract for insured depository institutions. Edward Price , writing last week in The Financial Times , illustrates the point: “Self-assured speculators, and early-adopters, like crypto because its value can increase. Those with the opposite temperament, those seeking a hedge, like crypto because it may keep its value if fiat explodes. Those who study crypto can only scratch their heads. Is it an asset or a currency? For commerce or for wealth? The question, however, misses the point. Money is always used as liquidity, savings and record-keeping. Crypto is no different. It’s just particularly rubbish at the first two and obsessive on the third.” The BIS decision hopefully serves as a wake-up call for all of the happy bitcoin enthusiasts who actually believe that this penny arcade version of “money” could ever survive in a significant way in the government-centric world of money and banking. Since WWII, the obligations of governments in the OECD have occupied the pinnacle of risk assets, even when these government are traveling the road to perdition in terms of issuing public debt. While some observers want to believe that the BIS designation carries with it come type of recognition for crypto, with friends like these bitcoin needs no enemies. Authoritarian regimes from China to India have made clear that bitcoin and other crypto tokens will not be tolerated besides "official" money. But in the rest of the world, the BIS rules make investing in bitcoin prohibitively expensive. First, readers need to understand that when the BIS says 100% risk weight, that means putting up 8% capital vs a given asset. With bitcoin and other untethered cryptos, a 1,250% risk weight means putting up 100% real cash capital for the face value of the token. If you as a bank own $100 worth of bitcoin, that means putting up $100 in capital. And the capital allocation changes with the value of the bitcoin, meaning more real capital if the value of bitcoin rises – the opposite of how, for example, margin requirements work for stocks. When the value of a stock rises, the customers buying power increases. With bitcoin owned by banks, however, the situation is the opposite. As the value rises, the bank must increase the capital allocation to the asset. What the BIS exposure draft means is that banks will never take principal positions in or lend against bitcoin. The BIS treatment of equity exposures to banks is instructive as shown below. Zero percent risk weight : An equity exposure to a sovereign, Bank for International Settlements, the European Central Bank, the European Commission, the International Monetary Fund, a multilateral development bank (MDB), and any other entity whose credit exposures receive a zero percent risk weight under regulatory capital rules. 20 percent risk weight (1.5% capital) : An equity exposure to a public sector entity, Federal Home Loan Bank, Fannie Mae, Freddie Mac and the Federal Agricultural Mortgage Corporation (Farmer Mac). 100 percent risk weight (8% capital) : Equity exposures to: Certain qualified community development investments, The effective portion of hedge pairs, and Non-significant equity exposures, to the extent that the aggregate carrying value of the exposures does not exceed 10 percent of total capital. • 250 percent risk weight (20% capital) : Significant investments in the capital of unconsolidated financial institutions in the form of common stock that are not deducted from capital. • 300 percent risk weight (24% capital) : Publicly traded equity exposures. • 400 percent risk weight (32% capital) : Equity exposures that are not publicly traded. • 600 percent risk weight (48% capital) : An equity exposure to an investment firm, provided that the investment firm would (1) meet the definition of traditional securitization in the regulatory capital rules were it not for the application of the definition and (2) has greater than immaterial leverage. In response to news that tiny El Salvador has made bitcoin legal tender, an official at the BIS and former member of the executive board of the European Central Bank (ECB), Benoit Coeure , insists that bitcoin has not passed the test of being "a means of payment." Coeure notes: "We have been clear at the BIS that we don’t see bitcoin as having passed the test of being a means of payments. Bitcoin is a speculative asset and should be regulated as such." In order to qualify for 1,250% risk weighting (100% capital), bitcoin and other untethered crypto tokens occupy the riskiest corner of the financial world. Indeed, as one banker told the FT , by assigning such a punitive risk weight to these tokens, the BIS is essentially saying to the banking industry that bitcoin is not a permitted asset for banks. Of course, as the Federal Reserve, ECB and other G-20 central banks develop their own electronic currencies, you can be very sure that these officially blessed tokens will have zero risk weights. Soon the world of crypto tokens will again be an exclusive playground for criminals, terrorists and money launderers as legitimate users of electronic payments migrate to stable value tokens. Adios bitcoin !

“Far from the madding Crowd’s ignoble Strife, Their sober Wishes never learn’d to stray; Along the cool sequester’d Vale of Life They kept the noiseless Tenor of their Way” Thomas Gray (1716-71) June 8, 2021 | In this issue of The Institutional Risk Analyst , we survey the scene of “meme” investing, a fascinating phenomenon that reminds us that humans are anything but rational, especially when confronted with change. A meme, for those unfamiliar, is: 1 : an idea, behavior, style or usage that spreads from person to person within a culture. 2 : an amusing or interesting item or genre of items that is spread widely online especially through social media. One of the downsides of the FOMC’s social engineering is that deflation in financial assets or prices more generally is never allowed to occur. This means that the portion of the market that is, to be polite, irrationally exuberant, is never purged from the system. There is no reset, no time out from the silliness, thus the speculative froth simply grows until it spills out of the glass. Fed Chairman Jay Powell effectively is short an equity put option to the world. The narrative is the carrier of the meme, the river of absurdity and credulity that transmits the speculative virus to the broader population. As more and more people became aware of the get-rich potential of bitcoin or other crypto currencies, for example, the meme narrative expanded, spawning an army of true believers that will tolerate no disagreement with their faith. The speculative madness is not limited to ethereal concepts like crypto currencies and the growing number of derivatives. Consider the meme icon and theater operator AMC Entertainment (NYSE:AMC) , a recent high-flyer that has used the artificial environment provided by the FOMC to raise billions of dollars to support a business that seems headed for the dust heap of history. As Michael Whalen discussed with The IRA back in 2017 (“ The Economics of Content: Michael Whalen ”), the world of film and video content is in the midst of a massive shift in terms of who holds the leverage on pricing. The pendulum is swinging back in the direction of artists and owners of content that are able to go direct to customers via social media. Michael Whalen, who spends his days acquiring and curating legacy content for Cutting Edge Group, predicted a while back that the owners of legacy TV content would eventually pool their assets in desperation. And four years later, viola ! The business of making and selling content for electronic artists is changing in ways that render conventional channels such as theaters as moribund as bookstores. Many analysts and media have pointed out that AMC is a business with significant challenges once the appeal of going out again and free popcorn loses its luster. The leverage that was taken on during the COVID lockdown has now been refunded somewhat with a huge equity raise. But to what end? Of course, AMC is an edifice of financial solidity compared with GameStop (NYSE:GME) , the now infamous software retailer and meme icon that introduced many older Americans to the world of www.reddit.com . Once a haven for non-financial discussions, the Reddit community suddenly exploded into the world of investing. Simply, a group of day traders chatting on Reddit annihilated several hedge funds, pushing GME up to truly silly levels. You could tell the Reddit kinder that GME is a dud, but it does not matter. We participate in some of the discussions regarding Rocket Companies (NYSE:RKT) , which is after all just a mortgage company, albeit a really good one. But the vernacular used by the RKT fans cruising on Reddit ignores things like facts and industry analysis, in favor of a purely emotional narrative. “Going to the moon” is a representative sample of the Reddit discourse on RKT. Even in the pedestrian world of financials, the narrative has raced ahead of reality and, in some cases, entirely in the opposite direction. Witness our old friends at Barron’s gently pumping already toppy bank stocks in this week’s issue with the prospect of loan growth? Hello? The names selected are solid performers, but generally speaking, loan growth has been trending down for years. The only way banks grow their portfolios is to buy loans originated by non-banks. Fortunately Barron’s managed to mention Baird analyst David George , who argues rightly that any pickup in loan growth will be muted. “We continue to expect core loan growth will be soft near term as corporations utilize large cash buffers to fund working capital and capex needs before borrowing from banks.” Ditto David. And consumer loan growth is muted as well. As we note in the most recent issue of The IRA Bank Book , loan portfolios are continuing to shrink even as the data from the Federal Reserve shows new lending growing. How can this be? Well, if you look at the stock of loans instead of merely the inflow, then you must also take note of loan redemptions or outflow as well as loan sales. Banks ended significant sales of credit card receivables years ago. That's a hint. Net, net, banks are seeing redemptions of loans, thus the portfolio is shrinking in many categories. Notice two things. First banks are more buyers of loans than lenders. Second, sales of loans by banks have also plummeted, another sign that banks are seeing net runoff of loans. And this is not just about corporates. C&I loans did rise $200 billion in Q1 2021, but only after quarters of net runoff. Consumer credit utilization, of note, is falling in residential mortgage lending after a torrid 2020. Source: FDIC Notice that bank credit card balances started trending down in mid-2019. This is not about COVID, but changes in consumer behavior pre-COVID. Yet just about every investment manager and generalist reporter on the planet somehow manages to relate the prospect for bank loan growth with recovery from the COVID lockdowns. Now it is interesting to note that the folks at Baird, who do know a few things about banks, recently changed their view of Capital One Financial (NYSE:COF) , citing the high market valuation. The price of COF has tripled since March 2020. But to be fair, the $420 billion asset COF is an inconsistent performer that shows volatility in asset and equity returns vs Peer Group One. Given the heightened risk, COF is no bargain at 1.2x book. Source: Yahoo Finance George downgraded the bank to neutral from outperform and has a $145 price target, $20 below the current market. The consensus price objective is higher at $166.87, an unusual example of a Sell Side analyst rejecting the narrative of rising bank stock valuations. As we’ve note previously, when you see high-risk names like COF, Citigroup (NYSE:C) and Goldman Sachs (NYSE:GS) trading above book value, then it’s time to take your money off the table and play with the house’s chips. Pointing out that a subprime monoline credit card lender with a proclivity for screwing up efforts to diversify into new areas should not be trading at a premium might seem overly negative in the world of meme investing. Don’t be a hater, say the kiddies on Reddit or the crypto surfers on Twitter. Be happy. Take a final example. Nouvelle mortgage lender Better.com , after unsuccessfully seeking an IPO, finally agreed to be acquired by a SPAC at the end of this year. The projected $7.8 billion valuation is, well, silly. Why? Because Better.com is simply a mortgage company with a slick web site. Also, Better.com raised money from the notorious Softbank of Japan. Softbank and several funds have committed to invest in Better.com post close to goose the (valuation) growth even further. Once upon a time, such behavior was called securities fraud. We note that Swiss banks are currently shunning Softbank because of the mounting cost of the Greensill fraud, the Financial Times reports. Softbank was a key investor in that fiasco as well as the Wirecard fraud in Germany, of note. In addition, the prospect of a close for Better.com in Q4 ’21 may be a challenge since many US residential lenders will be unprofitable by the end of the year. Secondary spreads could be inside 40bps, we are told. Even with the FOMC sucking tens of billions in MBS into the SOMA each week, we could see valuations in the mortgage complex give ground between now and December. Q: What do you suppose will happen if the FOMC stops buying MBS, leaving the market to only private investors who are not indifferent to prepayments? Hmm? As with RKT, Better.com is just a mortgage company that runs the same CFPB-compliant servicing systems as other firms, has the same awesome people, and is 100% correlated to interest rates and employment, period. We won’t know if the puffery about a better way to make and service mortgages works until the eventual market reset. In the meantime, just remember that manufacturing a residential mortgage purchase loan costs 2-3x that of a refinance loan. It’s all about confidence you understand, whether we talk of markets or politics. But an investing world that is a function of confidence rather than earnings can only end in tears. When the illusion of confidence ebbs, then investors will run back to cash flow, as is currently the case with fund flows out of stocks and into bonds. Meanwhile, the FOMC is madly trying to sop up excess liquidity via reverse repurchase agreements even as it adds more liquidity via QE bond purchases for the system open market account. “The heavy use of the [overnight] RRP facility tells us that foreign banks too are now chock-full of reserves,” warns former Fed staffer Zoltan Pozsar . Reserves will earn little return. As we have noted more than once in The Institutional Risk Analyst , once you as the central bank go down the dark road of QE, you cannot stop buying assets and you cannot go back to square one. Add the reality of sudden, massive changes in fiscal spending and the logic of FOMC fine tuning breaks down entirely. The Fed did half a trillion dollars in reverse RRPs at the end of May. What about this week? In the strange new world engineered by the FOMC via quantitative easing, facts do not matter. Valuations do not matter. All that matters is confidence in ever inflating asset valuations c/o the Federal Reserve Board. For now, just do like Softbank, Elon Musk et al and keep throwing money at a given asset class like Bitcoin until the price goes up. In the world of meme investing, the assumption is inflated prices forever – until the Great Asset Price correction finally arrives. And in the event, don't forget, we shall all be so surprised. To this point, Anna Della Subin writes in The New York Review of Books : “What do we learn of a world seen only through its illusions? Hoaxes, whether modern or ancient, tend to act as mirrors for the greater confidence games around us, from the claims to power of politicians and kings to the self-righteousness of those who assert they have a greater access to God.”

June 3, 2021 | As the second quarter of 2021 winds to a close, the banking industry saw strong GAAP earnings, buoyed by the reversal of over $14 billion in loan loss reserves back into income in Q1 2021. This money was earned last year, however, and masks the relative weakness of core bank earnings outside of highly variable business lines such as investment banking. After putting aside $60 billion in reserves in Q2 2020, the industry is now releasing these funds back into income, an accounting rather than a cash event, as illustrated in the chart below. Source: FDIC The actual swing in loan loss provisions is larger than $14 billion, since in “normal” periods the industry puts aside $10-15 billion in new reserves each quarter. If we adjust the stated pre-tax income for Q1 2021 by say down a modest $20 billion, the earnings of the industry fell sequentially in the first quarter of the year. You won’t hear that negative comment from the major financial media, however, because investment managers are committed to owning the banks at near-record valuations. Notice in the chart below that the best performer over the past six months has been Western Alliance (NYSE:WAL) , which just happens to be among the best performing large banks in Peer Group 1. Even as public market valuations for US banks soar to levels well-above a year ago and bond spreads likewise have contracted to 2007 levels, the return on earning assets for the banking industry fell to a 50-year low in Q1 2021. We anticipate that bank asset returns will continue to drop so long as the FOMC persists with quantitative easing, as illustrated by the chart below. Source: FDIC/WGA LLC It is interesting to note that the Fed has already begun to taper its purchases of agency mortgage-backed securities (MBS) because of falling issuance in the housing finance sector. Meanwhile, lending spreads are continuing to tighten in most markets, following the example of corporate bond spreads. As the Federal Deposit Insurance Corp noted in the Quarterly Banking Profile : “The average net interest margin contracted 57 basis points from a year ago to 2.56 percent, the lowest level on record in the Quarterly Banking Profile (QBP). Net interest income declined $7.6 billion (5.6 percent) from first quarter 2020 as the year-over-year reduction in interest income (down $29.8 billion, or 17.6 percent) outpaced the decline in interest expense (down $22.2 billion, or 68.7 percent). Despite the aggregate decline in net interest income, more than three-fifths of all banks (64.4 percent) reported higher net interest income compared with a year ago. 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.” The good news in Q1 2021 was that the amortization of mortgage servicing assets slowed and the results for trading and investment banking were up double digits. Servicing fees also rebounded into positive territory after several quarters in the negative. We expect that the investment banking results will likely revert to the mean in Q2 2021, while servicing income and amortization of servicing assets should contribute positively to bank financial results as loan prepayments continue to slow. The components of bank revenue are shown below. Source: FDIC A big source of positive lift in Q1 2021 results came from the reduction in non-interest expense across the board, a trend we expect to see maintained in Q2 2021. As the FDIC notes: “Nearly two-thirds of all banks (65.3 percent) reported higher noninterest expense year over year. However, the average efficiency ratio (noninterest expense as a percentage of net interest income plus noninterest income, which indicates the cost of generating bank income) during this period declined 2.7 percentage points to 60.5 percent. Banks in all QBP asset size groups reported improvements in this ratio.” The good news in terms of non-interest income, however, was offset by some continued weakness in lending volumes and the overall leverage on the balance sheet, which fell to just 47% of total assets deployed in loans. While our colleague Joe Adler notes in a recent post that new lending volumes continue to be strong, prepayments also remain brisk across all asset types. Readers should remember that large banks tend to be more buyers of loans than originators of these assets, an important distinction that is often missed by Wall Street. To give our readers a sense of just how skewed by Fed actions are the financial results of US banks, the chart below shows the growth rate for net operating income going back five years. While the Fed managed to engineer a huge increase in bank income in Q1 2021, including an increase in net interest margin and the release of loss reserves, the industry is still $40 billion or some 22% below the Q3 2019 peak of $180.8 billion for gross interest income. That is, bank interest income is shrinking due to QE. Source: FDIC In other words, the reduction in the cost of funds for banks is largely responsible for the increase in net interest income, but income from earning assets is likewise falling towards zero. The decline in NIM illustrates this trend. But the change in net operating income also shows a basic truth about the past five years, namely that income growth rates have been muted and at times dreadful. This experience mirrors that of independent mortgage banks (IMBs) over the same period (2018-2019), when primary-secondary spreads were very tight and lending profits suffered. Source: FDIC If we back out the conservative $20 billion in loss provisions from the Q1 2021 results, the actual return on equity (ROE) for the industry in Q1 2021 was closer to 12% and the return on assets (ROA) would be more like 1%. Indeed, this is the run-rate baseline we believe that analysts and investors should use for the industry going forward, not the GAAP results shown in the chart below. Once the release in loan loss provisions is complete, the industry’s income on a going forward basis should fall to this level. Source: FDIC The Bottom Line As the charts above suggest, we expect NIM for the banking sector to continue to fall as the earnings on bank assets reflect the relentless downward pressure of current FOMC policy. The release of reserves earned in 2020 will mask this alarming trend for the next couple of quarters, yet the basic direction of bank fundamentals in terms of asset returns and net-interest income is flat to down. We expect the return on earning assets to touch 50bp before the FOMC relents and changes policy later this year. This suggests that NIM for the industry as a whole could fall below 2% by December, a diminished level of income that puts the entire US financial system and especially larger banks at risk. For example, the return on total earning assets for JPMorgan Chase (NYSE:JPM) was just above 2% at year-end 2020 vs 3.52% for Peer Group 1. Banks profit from the spread between funding and the return on assets, but while cheap funding helps earnings in the near term, eventually asset returns fall to the same level. This is the situation facing the US banking industry today. Unless and until the FOMC changes policy and ends its massive social experiment via QE, an experiment that is clearly deflationary, we expect bank earnings to come under growing downward pressure. Credit Charts From a big picture perspective, the credit profiles of most US banks improved in Q1 2021 as net charge-offs to loans fell below 40bp for the first time in many years (Q3 of 2006). Much of the improvement in the average data for all loan types is due to the impact of QE on housing sector exposures, which continue to exhibit extraordinary metrics in terms of net-loss and also loss given default (LGD). COVID and other factors are also flowing through different loan categories, as discussed below. Notice in the first two charts for the $10.8 trillion in total loans and leases that realized losses as well as LGD have fallen sharply since Q2 2020. It is reasonable to ask what happens to this picture as and when the FOMC moderates monetary policy and QE. Total Loans & Leases Source: FDIC Source: FDIC/WGA LLC Moving to the biggest sub-category on bank balance sheets, namely total real estate loans, there is also clearly a downward impact on LGD for the $5 trillion in real estate loans owned by banks. Net-charge off rates basically are zero and non-current loans have begun to flatten out with the end of the COVID lockdowns. Notice the huge downward skew in LGD after several quarters of large net-charge offs in 2020. Again, it is reasonable to ask what will happen to this portfolio as and when the FOMC changes policy. Our view is that LGD for all real estate loans will start to normalize toward the 67% LT average loss rate as more urban commercial real estate (CRE) is restructured to adjust for lower operating income. Total Real Estate Loans Source: FDIC Source: FDIC/WGA LLC Construction & Development Loans Like the real estate category, the small portfolio of bank construction and development (C&D) loans evidences a significant skew in terms of LGD, but far less than loans for 1-4s and HELOCs. Last quarter LGD for the $380 billion in C&D loans was 41% and non-current loans stood at 0.72%. Source: FDIC 0 Source: FDIC/WGA LLC 1-4 Family Residential Loans While the data for real estate loans appears normal at the top-level portfolio, the series for residential mortgages is extremely skewed and evidences the radical social engineering from the FOMC. Rising home prices have pushed down the cost of credit default in the $2.4 trillion in 1-4s owned by banks to -73% in Q1 2021. This means that when a rare event of default actually occurs, the bank forecloses on the property, pays off the loan and then takes a profit! The LT average LGD for 1-4 family mortgage loans is 67%. Notice that non-current rates for 1-4s, after rising immediately after the start of COVID lockdowns, has flattened out and is slowly declining. Source: FDIC Source: FDIC/WGA LLC Home Equity Loans The bank portfolio of home equity loans or “HELOCs” continues to shrink, with the total unpaid principal balance (UPB) now below $300 billion. The skew in loss rates for HELOCs is as extreme as it is with 1-4s with net charge-offs and LGD both in negative territory. Of note, non-current rates on HELOCs are rising and are still mostly in normal territory compared with first lien 1-4s. Source: FDIC Source: FDIC/WGA LLC Rebooked Ginnie Mae Loans (EBOs) Another important perspective on the world of 1-4 family loans comes from the data series published by the FDIC on rebooked Ginnie Mae loans, known in the industry as “early buyouts” or “EBOs.” These are delinquent loans that have been repurchased by the Ginnie Mae MBS issuer and have thus been “rebooked.” Source: FDIC In Q3 and Q4 of 2020, issuers such as Wells Fargo (NYSE:WFC) , Penny Mac Financial Services (NYSE:PFSI) and New Residential (NYSE:NRZ) were aggressively buying EBOs in the hope that these loans could be cured and sold into a new MBS pool, generating a substantial gain-on-sale event for the issuer. Instead, many of these delinquent loans may linger for months as the servicer tries to resolve the loan, generating substantial cash losses for the issuer. Multifamily Loans As with 1-4s and HELOCs, bank loans backed by multifamily properties have shown a significant downward skew in terms of credit costs, but less so than other residential assets. The $480 billion in bank-owned multifamily loans saw LGDs reach into negative territory in 2019 and 2020, however the series has now reversed back into positive loss values, suggesting that some assets have been adversely effected by COVID and are starting to generate losses to banks. The net charge-off rate remains near zero, but non-current loans are rising and LGD was 67% in Q1 2021, above the LT average for this key metric. Source: FDIC Source: FDIC/WGA LLC Commercial & Industrial Loans After total real estate loans, C&I credits at $2.5 trillion in UPB are among the most important assets on bank balance sheets. Roughly half of these "commercial" loans are related to commercial real estate loans. LGD for C&I loans has been falling since last year due to the effect of the FOMC’s radical policy prescription, but we suspect that the series will turn and start to rise as 2021 progresses and the restructuring of commercial assets accelerates. It is important to note that despite the positive impact of low interest rates on credit loss, LGD for commercial bank exposures is still above the LT average of 57%. Source: FDIC Source: FDIC/WGA LLC Credit Card Loans While the data for credit card loans is relatively normal compared to loans in the real estate complex, the results for Q1 2021 do show some impact from QE and ultra-low interest rates. Card balances continue to fall, however, after peaking near $1 trillion in UPB at the end of 2019. Of note, bank credit card loans totaled just $760 billion as of the end of Q1 2021, but loans to individuals continued to rise at $928 billion. Source: FDIC Unsecured consumer loans are some of the highest yielding assets that a bank can hold, thus watching credit cards and other unsecured credits provides important insights regarding future bank earnings. We suspect that card balances will stabilize in coming quarters, but the one imponderable is whether proceeds from home sales will be used to pay down consumer loan balances. Source: FDIC/WGA LLC Auto Loans Bank-owned auto loans stood at $500 billion at the end of Q1 2021, but the credit metrics for this largely prime asset class are anything but normal. Realized losses on auto loans peaked above 70% of the loan value in 2016 and has declined ever since. Source: FDIC When COVID exploded onto the scene in April of 2021, the impact on the auto sector was to reduce the supply of new vehicles and increase the value of used cars. The result in terms of bank credit was a sharp drop in realized losses on defaulted auto loans. LGD on delinquent auto loans fell to just 35% at the end of 2020. Look for this metric to revert to the LT mean as 2021 progresses. Source: FDIC/WGA LLC As COVID recedes and the auto industry eventually addresses the shortage of semiconductors that has limited the supply of new cars, we expect that the LGD will return to the LT average of ~ 55% of the face amount of the loan. Notice that non-current auto loans were trending higher since 2018, but fell in Q1 2021. The net-charge off rate has remained muted due to the strong market for used cars, a situation that may persist through 2022. The IRA Bank Book (ISBN 978-0-692-09756-4) is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Book. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Book are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Book represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Book is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Book is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. 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June 1, 2021 | In this issue of The Institutional Risk Analyst, we feature a comment by Lee Adler , publisher of Liquidity Trader . Lee is one of the better-informed observers of the market for US Treasury and agency securities, and among the best Fed watchers in the business. As is our custom, Lee follows what the Federal Open Market Committee actually does in the markets, not what they say in carefully manicured statements written by the Fed’s all powerful Washington staff. Banking Indicator Review As Fragile As Ever Liquidity Trader May 23, 2021 Back in September I wrote about why I was giving up on the banking system indicators. Essentially it boils down to this. Every time there’s a critical problem in the banking system due to banker malfeasance, the Fed steps in to paper it over and reward the criminals. That’s why we focus on the Fed more than anything else. Regular review of the banking indicators was useful once upon a time. The Fed has rendered them irrelevant. But I promised to keep an eye on them, and it has been 5 months since we last looked. That’s enough time that, if anything material has changed, we need to know about it. So herein is a review, our first since last December. In this report, I highlight the charts. The charts really speak for themselves. The bottom line is that the system remains extremely vulnerable to a decline in Treasury prices that is probably coming in the second half. Likewise, the return of optimism in commercial real estate is problematic. The banks are taking no precautions. There’s no sign of recognition of the looming losses. It means that the entire banking system could be destabilized in the second half of this year. The Fed will have to act, massively. History shows that the Fed won’t act in time to prevent a breach of the system. History also shows that the Fed has the power to ultimately make its actions give the appearance of stabilization, leading to the return of animal spirits. But I don’t know if it will work yet again, and we can at least expect a significant break first. So I would want to be out of harm’s way at the first sign of trouble in the markets, likely coming this summer. Now here’s a review of the banking indicator charts. Total Bank Loans Stall The pandemic related surge in lending has collapsed and total lending activity has gone dead in the water. A 7-year uptrend in loan growth has ended. My guess? The big boys don’t need to borrow money when the Fed is giving them free money every week. All banking indicators in the following charts are as of May 12. Bank Loans Ex Repo Still Growing The degree of the deleveraging in the economic lending sphere since May is more visible using a measure that strips out Repo lending. Loans, ex-repo, gyrated in response to pandemic programs, and they have fallen sharply in the last year. But looky, looky! The uptrend remains intact! Repo Borrowing Collapses Banks, and particularly Primary Dealers, use repo financing to acquire and carry their bond inventories. They normally borrow most of the purchase price of these securities using repurchase agreements (RPs). RPs are very short term loans backed by the collateral of the purchased securities, mostly Treasuries and Agency MBS. You can see the correlation between the growth of the banks’ holdings of Treasuries and repo financing on this chart. That broke beginning in January. Banks and dealers don’t need repo when the Fed is cashing them out every week. And they really don’t need repo lately, since the Treasury has been paying down $40-45 billion per week in T-bills. The Treasury redeems those securities and pays back the holders with cash into their accounts. Money money money money everywhere. Where Does Homeless Money Go? Into Reverse Repos At the Fed When the Treasury pays down T-bills, it takes that paper out of the market and sends cash back to the holders of the paper. They can’t roll it back into T-bills, because there are none to be had. So what do they do? Why, they lend it to the Fed overnight, of course! Gotta show that prudence on their balance sheet. If you can’t hold T-bills, a loan to Fed is even better. In other words. “Gonna do it. Would be prudent!” Since February 23, the Fed has paid down $533 billion in outstanding T-bills. Some dealers and institutional recipients of that cash stretched out on the curve a bit and bought longer term paper, which helped stabilize the bond market. But as of Friday, May 21, those erstwhile T-bill holders had sent $369 billion of the cash they got from the Treasury, into overnight (same as cash) RRP accounts at the Fed. Apparently they put $164 billion into other securities and the rest into RRP. On this chart, I’ve put RRP line item (blue) overlaid with an upside-down view of the Treasury’s cash account at the Fed (red). They don’t correspond dollar for dollar, because the Treasury is spending money on other things and receiving revenue at the same time. But the correlation is obvious. Loans to Shadow Banks The Fed tracks a category of bank loans called "Loans to Non Depository Financial Institutions." The Fed defines these loans as “loans to real estate investment trusts, insurance companies, holding companies of other depository institutions, finance companies, mortgage finance companies, factors, federally-sponsored lending agencies, investment banks, banks’ own trust departments, and other non-depository financial intermediaries.” In other words, shadow banks. As opposed to repo borrowing, which is backed by the collateral of US Treasury securities, these loans may or may not be collateralized. There’s no sign of a lending slowdown here. Leverage reigns supreme. Other Loans Not Classified AKA Margin, Still Growing! The Fed defines this line as “loans for purchasing or carrying securities, loans to finance agricultural production, loans to foreign governments and foreign banks, obligations of states and political subdivisions, loans to nonbank depository institutions, unplanned overdrafts, loans not elsewhere classified, and lease financing receivables.” The year to year change briefly went negative, thanks to what economists call “base effects.” The year ago period was the pandemic emergency. But let’s focus on the overall trend. Outside of the wild gyrations around the emergency, the trend is intact. The line is rising almost dead center in the channel. Ah, sweet leverage, as collateral values, mostly stocks, only go up forever (sarcasm). We can guess that at some point all this leverage will unwind, leading to a very bad outcome. But when? That’s the question.

May 25, 2021 | In this issue of The Institutional Risk Analyst Premium Service, we talk about the outlook for interest rates and the impact on banks and other financial intermediaries of the structural market changes that we described in our last issue . We start our comment today, however, with the increasingly manic behavior of the market for mortgage servicing rights, a negative duration asset that performs the opposite of a bond. The competition for assets in the financial markets has reached a fever pitch, not just for stock and bonds. Yesterday Ocwen Financial (NYSE:OCN) disclosed that it has agreed to acquire significant conventional MSRs from AmeriHome , which was just acquired by Western Alliance Bancorp (NYSE:WAL) . Significantly, WAL is selling the AH MSRs to OCN and is acquiring a financing asset, a good trade in a market that already sees late vintage servicing changing hands at 5x cash flow. With the on-the-run MBS spread to Treasuries headed to 0.5% vs almost 2% last summer, the market conditions facing mortgage issuers and investors alike are increasingly difficult. Less efficient lenders are already losing money on most loans at close, thus selling the MSR along with or separately from the sale of the mortgage note into an MBS is increasingly attractive – even mandatory. Of note, MSRs on FNMA 3% coupons are trading north of 5x annual cash flow. It is important to remember that in most “normal” markets, lenders are down cash at the close of a loan but make up the difference by retaining the servicing asset. For banks with diversified balance sheets, the decision to retain the MSR is relatively easy. But for independent mortgage banks (IMBs), the need for cash is intense and growing as primary-secondary market spreads fall. Issuers are anxiously awaiting the replacement of FHFA Director Mark Calabria by the Biden Administration, but the pain inflicted by the changes made to the conventional market may persist all summer. The latest version of the Preferred Stock Purchase Agreement between the Treasury and the GSEs included changes to the cash window purchases by Fannie Mae and Freddie Mac, changes that are forcing large issuers to look for alternative channels for selling loans. For example, United Wholesale Mortgage Corp (NYSE:UWMC) just priced a private MBS comprised 100% of QM loans. Several market participants remarked on the tight terms for the deal, but spreads are likely to continue to tighten. The 2.5% coupon for the senior tranches of the MBS are likely to tighten further. Note that the CLTV is only 65% for this prime jumbo deal, a reflection of the steady increase in home prices. Of note, the UWMC deal uses variable servicing fees depending upon the degree of delinquency in the deal. KBRA notes: “Under a variable servicing fee framework, mortgages incur servicing fees that, in aggregate, increase as loan performance worsens and/or loss mitigation activity increases. Not all prime transactions use this servicing framework, more often using fixed servicing fee rates, though the use of variable servicing fee frameworks has been a growing trend. For the subject securitization, we expect the all-in servicing fees over the transaction’s life will be less than the total fees for comparable transactions with fixed servicing fee rates for all loans.” Call us in 2025, when the market for 1-4 family homes is likely in the midst of a significant price correction, to talk about the servicing fees in this and other “variable” servicing fee deals. In good times, servicing a 1-4 family loan only costs a couple of basis points. But as soon as the loan becomes distressed, the cost of servicing can increase by 10x or more. Issuers such as UWMC and New Residential (NYSE:NRZ) that use variable cost servicing contracts are betting that home prices will not correct – ever. Meanwhile in the world of commercial banking, the movement of cash out of the Treasury’s General Account (TGA) into the banking system is causing a great deal of pain for depositories. Already awash in cash due to QE, the banks are now being inundated with additional unwanted liquidity that is likely to further depress asset returns. To this point, the $351 billion in reverse repurchase agreements (RRPs) priced last week represents a belated effort by the FOMC to manage this massive cascade of cash. Not only do we expect to see the Fed make permanent facilities for adding cash and/or collateral to the markets, but we further anticipate that between now and year end, the Fed and Treasury will make structural changes to the markets that allow the US central bank to taper QE and even raise target interest rates without another “taper tantrum.” This includes imposing circuit breakers on money market and other funds to suspend redemptions in times of market stress. Simply stated, the FOMC does not want to be in a position where it needs to provide liquidity support for money market and other funds should rates need to rise. Indeed, we believe that the central bank, having badly mismanaged the US interest rate equation since last April, will 0be forced to change its monetary policy stance much sooner than the consensus anticipates. While a change in interest rates will be a positive for the banking sector, the next shoe to drop after the creation of permanent RP and RRP facilities by the Fed will be a Treasury initiative to force all counterparties to clear trades via the clearinghouse. The quid pro quo of providing standing RP and RRP facilities that are open to all banks, dealers and REITs, for example, will be centralized clearing of Treasury debt and agency MBS. We agree with the views of our colleague Ralph Delguidice at Pavilion Global Markets that this change will essentially bring an end to bilateral trading in Treasury debt, with the attendant decrease in leverage available to dealer banks and their prime brokerage customers. Smaller dealers and investors will benefit, but the market monopoly of the primary dealers will end. If we think of the RRPs last week by the Fed as the beginning of tapering, then the imposition of centralized clearing will be the death knell for the Anglo-American model of finance, where 80% of trading today is conducted bilaterally. In its place, the US will adopt a European-style model with the central bank at the center and all leverage entirely visible to the clearing house, where the members are joint and severally liable for all trades. Just as we learned in Frankfurt years ago trading for Bear, Stearns & Co, the Bundesbank has a front row seat on the exchange floor. Source: FDIC In the 1980s, regulators such as Paul Volcker and William Taylor allowed the largest banks to increase leverage via off-balance sheet financing. As Volcker told us in 2017: "The banks were broke. What else could we do?" The change to centralized clearing of Treasury collateral, however, will reduce leverage and future earnings power for the largest banks. The 100:1 leverage available offshore using Treasury collateral as the catalyst for highly levered trades (as illustrated by the Archegos disaster) will not be tolerated in future. While some observers doubt such changes will actually occur, we remind one and all that the Fed’s chief concern is keeping the Treasury debt market open and functional. The corollary to this rule is that liquidity stress includes both cash and risk-free collateral, meaning that the Fed will be ready to provide either to the markets in order to keep visible volatility firmly under control. A Whether interest rates need to rise or fall in the future, the FOMC intends to cut the ends off the risk curve in order to ensure the Treasury’s uninterrupted access to the global capital markets. These changes may seem expedient from the perspective of the Fed in Washington, but have no doubt that the end of bilateral trading in Treasury collateral will negatively impact the US capital markets and particularly bank earnings for years to come.

May 21, 2021 | Back in 2019, we published a post in The Institutional Risk Analyst called “ Nationalizing the Federal Funds Market ,” that talked about the increasingly overt actions of the Federal Open Market Committee in the market for short-term funding. Then as now, we view the actions of the FOMC as slowly destroying the private money markets in the US and preparing to very visibly push the big banks out of the transmission chain of monetary policy. One reader of The IRA asked yesterday: “Brother maybe you can help me understand: reverse repo 351BN 5th largest ever. What is going on? Any thoughts? No rush but I haven't heard anyone talking about this. I don’t get with all the excess why banks need to be doing this. Haven’t seen it since march 2020.” Now that is the right question. As we told Keith McCullough at Hedgeye recently, the Fed’s primary concern is not employment or inflation, but rather keeping the market for Treasury securities functioning. In this we agree entirely with our friend Ralph Delguidice , who has believed for several years now that the Fed is preparing to take direct control over the market for Treasury securities. He wrote in a recent missive for Pavilion Global Markets : “Before the Fed can even think about thinking about raising rates or tapering the pace of QE, they have a suite of urgent repairs to make to the wholesale financial infrastructure supporting the US capital markets. In the year-end 2020 report to Congress, the Financial Services Oversight Council (FSOC) highlighted several specific areas of ongoing systemic concern. The first—and by far most pressing— is the problem in the Repo markets, AKA ‘The Usual Suspects,’ which failed disastrously in the fall of 2019.” Ralph and many other colleagues who trade the short-term money markets in the US have long identified a basic structural problem that has existed since the passage of Dodd-Frank in 2010 and also the many changes to the Basle bank capital framework. What problem? That the big banks sometimes step back from the money markets and deny liquidity to nonbank clients. For the Fed the worry is not the small nonbanks, but the resulting market volatility as they scramble for liquidity. In 2019 and 2020, for example, there were periods when the FOMC was adding liquidity to the markets, but the top wholesale banks led by JPMorganChase (NYSE:JPM) essentially folded their arms and went no bid. This refusal on the part of the large banks to participate cost many smaller participants months’ worth of profits due to a sudden, unanticipated lack of liquidity. Some firms almost failed, including several large mortgage lenders. Thus we come back to the reader question: Why did the Fed feel the need to absorb $351 billion in cash yesterday via reverse repurchase (RRP) transactions when the banks are seemingly awash in cash? Is there a shortage of collateral? Maybe Treasury Secretary Janet Yellen needs to issue some T-bills? A: The cash liquidity inside the banks is actually retarding lending activity, as evidenced by the fact that bank lending continues to fall along with bank assets. The largest banks are desperately trying to shed short-term liquidity as rapidly as possible even as loan portfolios shrink. If you’ve been following the conversation on Twitter, Delguidice has outlined three basic changes that are coming to the US money markets, changes that have implications for banks, cryptos and anything else that interacts with the world of dollar liquidity. First, the FOMC is going to make permanent the RRPs, essentially accepting the proposal by the Federal Reserve Bank of St Louis to create a standing repo facility for banks and nonbanks alike. This means that funds, REITs and especially smaller dealers are going to be able to go direct to the Fed of New York and finance collateral, breaking the monopoly control of the big primary dealer banks. H/T to George Selgin at Cato Institute. Second, and this change is already in process, “swing pricing” for money market funds and corporate bond funds will allow the Fed and the Financial Stability Oversight Council (FSOC) to manage liquidity. For investors, this means that the Fed and FSOC will be able to suspend immediate cash redemptions on money market and corporate bond funds in time of liquidity stress. The message here is simple: “We’ll get back to you.” By imposing a global “time out” for conventional funds, the FOMC no longer need provide liquidity support for funds. During 2019 and 2020, during times of liquidity contagion, the Fed essentially had to provide liquidity to MMFs and corporate funds in order to avoid a market break. Now the onus shifts onto investors. The winners here are the exchange traded funds (ETFs), which have shown superior performance during periods of market stress, and independent dealers. Third and most significantly for the large banks, the Fed and FSOC are going to push for central clearing of all Treasury securities, killing the predominantly bilateral market for US debt and also eviscerating the monopoly of the primary dealers on financing collateral. “This gives the Fed direct control over leverage,” Delguidice tells The IRA . “Today, 80% of the bond market trades bilateral. The Fed has decided rightly that the market for Treasury debt is too important to leave up to the whim and caprice of the large primary dealers. Many of these banks will get out of providing repo financing once the Fed steps into the market.” In the world of asset financing, having the Fed always ready to provide liquidity to counterparties with Treasury or agency collateral will smooth volatility and make a repeat of year-end 2018 or April 2020 less likely. Many smaller dealers, nonbank lenders and REITs would welcome such a change. Yet these developments also mark a major, historical change in how the US money markets operate and particularly the central role of the money center banks, a quaint but increasingly dangerous point of failure in the vast market for US government debt. Think of the post-COVID period in US history as marking the end of the old Anglo model of finance. Having JPM decide it does not care to add liquidity to the markets in times of stress is a policy challenge to the FOMC that cannot be tolerated if the Us central bank ever hopes to taper QE, much less raise the target rate for federal funds. But the changes outlined by Delguidice and also echoed by many market traders, changes that we agree are inevitable if not immediate, will present a huge challenge to the major US banks as time goes on. We’ll be outlining the impact of those issues on banks and nonbanks in greater detail in a future comment for the Premium Service of The Institutional Risk Analyst.