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May 17, 2021 | President Joe Biden is seeking higher taxes on real estate transactions with gains of more than $500,000, a target aimed directly at the heart of small real estate investors, family farmers and owner-occupied businesses. In combination with his plans to eliminate step-up basis on the resolution of estates, the Biden tax proposal will greatly increase the cost of farmland and thus food prices, property prices and rental costs in some markets. The strategy on the political chopping block is the so-called like-kind or 1031 exchanges, which allow investors to defer paying taxes on real estate by rolling profits into their next property. Section 1031 of the Internal Revenue Code was put in place by Congress a century ago. The amount of money available for the Treasury is modest in the Biden tax proposal, but the economic damage will be vast. The congressional Joint Committee on Taxation estimated that 1031 exchanges may save investors only $41.4 billion in taxes from 2020 to 2024, CNBC reports , but the economic benefit of 1031 exchanges to small investors and rural communities is far greater. Roughly a third of all commercial real estate transactions involved 1031 exchanges and thereby preserve important wealth that supports communities. Why is Joe Biden declaring war on American family farmers, investors in multifamily real estate and Main Street USA? He’s not. This ill-considered proposal is the leftover agenda of former President Barack Obama , the result of a radical socialist program that stretches back nearly a century to America of the 1920s. In his classic book “ Revolt Against the Masses ,” Fred Siegel describes how in the 1920s, the writers and thinkers who called themselves “liberals” -- Herbert Croly , Randolph Bourne , H.G. Wells, Sinclair Lewis and H.L Mencken -- were really authoritarians who despised successful businesses and the idea of individuals building wealth by owning property. These ideologs cared nothing for economic prosperity, only political power. The political motivation behind President Biden's attack on real estate ownership is the same today. The modern day version of the left of the 1920s is visible in Germany today. The Biden plan for housing is a copy of the radical Green Party (former East German Communists) plans should they take power in September. Real estate transaction taxes are already double and triple in 'blue' states compared with the the level of 'red' states. And now the Greens want to attack new single-family construction by impeding zoning permits. And all of the real estate trade groups kowtow to the green political mob, which has full media support. “The Biden Admin is making a big political mistake with this effort at social engineering using the tax code,” notes veteran mortgage executive Alan Boyce . “Biden is declaring war on homeowners, family farms and independent businesses, many of whom invest in multifamily real estate. The combination of losing the 1031 exchange and the proposed higher Federal long-term capital gain (LTCG) tax with the higher State LTCG taxes causes a significant impact.” Using the tax code to attack wealth that has grown in the world of real estate over the past century makes perfect sense to the far-left ideologs in the Biden Administration. Yet ironically, the Biden tax proposal will accelerate the human exodus from blue, Democratic controlled states. Both CA and NY lost congressional seats in the latest census. Here’s some specific examples of how the Biden Administration tax proposals will hurt property owners in different states which is included in a separate spreadsheet . We look at 1031 exchanges in Coastal CA, Bakersfield, North Carolina, and Texas under current law and with the new Biden tax, for both sales and development of parcels into single-family homes. The analysis is based upon the principle of ceterus paribus or “everything else being equal.” We infer the price that a willing seller would accept for a property after taking into account the dramatically higher state and federal taxes. Should Biden impose a mandatory tax on the gain with double LTCG taxes, here’s what happens to happens to home prices: In expensive coastal CA, many real estate developments involve at least one 1031 (Examples 1 & 2). The state tax rate is 13.3% for all income over $500k. If you lose one exchange, land costs as a percentage of the cost of the house than doubles. Home prices need to rise by 16% for the builder in coastal CA to make the same amount of money. In Bakersfield, CA (Example 3), the land is cheaper than in coastal communities, but the high CA state tax rate makes for big pain in terms of taxes. Also, the CA tax regime pushes up the cost of a home ~ +37%. In the case of two 1031 exchanges in coastal California, the tax bite gets really bad. Now we have two sellers who need to raise the pre-tax price of their development ground sale to cover for the dramatic tax bite. Land as a percentage of home prices quadruples and home prices need to rise 55%. In NC, farmsteads are often sold to developers, with grandkids taking the cash and paying the LTCG taxes (Example 4 & 5). The State tax rate is 5.5%, thus the impact of Biden’s proposed doubling of LTCG doesn’t matter if the gain is spread out over lots of grandkids. If each grandkid stays under the $500k limit for the doubled LTCG tax, then there may be no tax impact at all. Net result is home prices in the Carolinas don’t go up so much, only 4 to 10%, even with the higher LTCG. In Texas, where there is no state tax, everything else is cheaper to do, house prices don’t go up so much. Thus, the impact is much lower than in CA. Again, the huge difference between CA and TX in terms of taxes will drive people out of coastal markets. Don’t even ask about New York. The logic in terms of raising tax revenue behind the Biden tax proposal is also deeply suspect. “According to a study by Profs. David C. Ling and Milena Petrova , nearly 88% of exchanged properties are sold after one round, often resulting in higher paid tax amounts over time than would have otherwise been due,” notes John Harrison the Alternative & Direct Investment Securities Association in a letter to the Wall Street Journal . “This reinvestment accelerates the velocity of money and prevents extended holding periods that lead to stagnation,” Harrison continues. “Furthermore, the study states that the repeal of section 1031 would harm tenants, property owners and the economy overall with a decrease in real-estate prices and long-term rent increases, to name a few.” Fortunately, there are some ways about the Biden Administration’s social engineering via the tax code. For example, the landowner can contribute the land into the LLC that builds the houses as a single-family rental (SFR) avoiding recognition of capital gain. But the really cruel joke of Joe Biden’s tax grab is on millennials, who must must give up the American Dream of owning a home. New American families face a lifetime of being renters like their counterparts in major cities in the US and Europe. Remember, the Blue Team hates homeowners, family farmers and small businesses. They want everyone to live in apartments in expensive large cities. Joe Biden and the far-left activists who control his administration really want Americans to stop building single family homes and instead force us to live in multifamily housing that gets more units per acre. The idea of American families owning their own home flies in the face of the political agenda of the Democrats, which is all about destroying the economic base of conservatives. If President Biden’s tax proposal is adopted, first time homebuyers will have to move to communities where the pattern of land transactions is less dependent upon 1031 exchange math and/or to lower tax states where the impact is lessened. But again, you have to wonder why Joe Biden is embracing a tax on real estate transactions that will ultimately accelerate the migration of Americans away from Democrat-controlled, high tax blue states.

May 14, 2021 | In this issue of The Institutional Risk Analyst Premium Service, we take a look at the Q1 2021 results for United Wholesale Mortgage (NYSE:UWMC) and Rocket Companies (NYSE:RKT) . Market valuations for both firms have suffered in recent days due to the selloff related to heightened inflation fears, but in truth the declining volumes and profit levels in the mortgage sector justified an adjustment. Source: Google Finance Notice the huge surge in RKT in March, a phenomenon likely facilitated by the following that RKT has gained among day-traders on social media such as Reddit. Since March, however, both stocks have given ground as earnings reports confirm the cooling of demand in the mortgage sector. Both stocks are off roughly 25% in the past six months. The results from UWMC confirm the trend in terms of both mortgage origination volumes and gain-on-sale (GOS) margins. The “total gain margin” reported by UWMC is an ersatz measure that is not directly comparable to either the metrics published by other issuers or the average GOS margins published by the MBA and other sources. The table below shows the financial results from the latest UWMC earnings report. UNITED WHOLESALE MORTGAGE CORP Q1 2021 UWMC defines “total gain margin” as total loan production income divided by total production. But what income? UWMC does not say. Our definition of GOS comes from Appendix C of the OCC’s handbook on mortgage banking, as shown below. When you look at the fact that total gain margin for UWMC was just 95bp in Q1 2020, and you factor in QE by the Fed and the huge amount of capacity the industry has thrown at the mortgage opportunity since March of last year, the idea that sale margins could be lower -- a lot lower -- in Q2 2021 is not so outlandish. That, indeed, is our view. The MBS survey shows that profit margins (excluding MSR adjustments and servicing income) averaged just 47bp since 2016. As our friend Joe Garrett notes, some mortgage lenders lost money in Q1 as the industry seemingly reverts to the mean, but making 47bp on a loan is not the worst thing in the world. The table below shows average loan profits from the MBA. Looking at the table above, 2020 was obviously an extraordinary year. Such cheery views aside, many independent mortgage banks (IMBs) slipped into loss in Q1 2021 and more will follow this quarter as falling revenues and profits, and inflated operating expenses, come into conflict. The table below shows the loan production results for UWMC as of Q1 2021. UNITED WHOLESALE MORTGAGE CORP Q1 2021 Notice that two thirds of UWMC’s production comes from refinance volumes, a sector of the market that is likely to contract rather significantly in the next several quarters, looking at the projections from the MBA. UWMC is predominantly a wholesale buyer of loans from brokers and has little retail or correspondent business. Thus the wild statements from UWMC CEO Mat Ishbia regarding catching up with market leader RKT in terms of lending volumes must be viewed as hyperbole at best and misleading to investors at worst. Since the UWMC earnings release is merely seven pages long and carries little in the way of detail or explanation, it is hard to know how to assess the information presented. What we can say, however, is that the gain figures show a 30% sequential decline in profit margins. Note in the table above that most of UWMC’s volumes are in conventional loans sold to Fannie Mae and Freddie Mac. Conventional loans have far lower profit margins than do government loans in the FHA and VA markets. The results for RKT are even more austere in terms of the amount of information provided to investors, with only year-over-year data provided in the table below from the RKT Q1 2021 earnings release . ROCKET COMPANIES Q1 2021 Looking back at the Q4 2020 earnings release for RKT, we see that the GOS margin at year-end 2020 was 4.41% and the average for the year was 4.46%. Based upon what we see in the secondary market today, we estimate that the GOS margin reported by RKT in Q2 2021 will be lower than Q1 of 2020 . Ever optimistic, RKT states in its earnings release that: “Our flywheel only continues to accelerate as we look forward to the second quarter and the rest of 2021.” Of course, “flywheel” is not a GAAP term, but obviously RKT is trying to put its best foot forward in a declining market, both in terms of volumes and profitability. Both UWMC and RKT are dependent upon refinance business for the vast majority of their volumes, although RKT does at least have a modest retail channel. RKT states: “Q1 '21 represented our strongest first quarter purchase closed loan volume in company history. In addition, we achieved our highest monthly purchase application volume ever in March 2021.” Unfortunately, RKT does not break down the components of loan volume in terms of refinance and purchase mortgage loans. Refinance loans are more profitable than purchase loans due to lower cost of lead acquisition and underwriting, but refinance volumes tend to disappear in a rising rate environment. We view RKT's refusal to provide this material information to investors as a significant omission in its public disclosure. Also, RKT's presentation regarding recapture rates is also misleading in our view. The conventional industry convention for presenting recapture is to divide the loans retained by the total unpaid principal balance (UPB) of the servicing book, which usually results in a recapture rate in the 20-30% range for industry leaders. But RKT states in its 2020 10-K: "Our recapture rate was 82%, 79%, and 73% for refinance transactions for the year ended December 31, 2020, 2019, and 2018, respectively. Our overall recapture rate was 73%, 64%, and 54% for the year ended December 31, 2020, 2019, and 2018 respectively." RKT states: "We define mortgage recapture rate as the total UPB of our clients that originate a new mortgage with us in a given period divided by total UPB of the clients that paid off their existing mortgage and originated a new mortgage in the same period. This calculation excludes clients to whom we did not actively market due to contractual prohibitions or other business reasons." We think that RKT's presentation of recapture of refinance loans is misleading to investors. As one senior industry executive told The IRA : "The cleanest and absolute way to calculate recapture is: recapture fundings over all payoffs. Nothing is excluded." That is: Recapture Rate = Recapture Fundings / All Payoffs The Bottom Line RKT is the market leader in 1-4 family mortgages in terms of both volumes and operating efficiency, one reason that its GOS margins are significantly higher than the industry average. Also, RKT has a substantial portfolio of mortgage servicing rights (MSRs) that should contribute positively to earnings as 2021 progresses. That said, we expect both lending volumes and GOS to be lower than expected in Q2 2021 and for the remainder of the year due to the large refinance component in RKT's volumes. The fact that RKT will not break out its refinance volumes as a percentage of total lending volumes does not make us have great confidence in the company's public disclosure. UWMC, on the other hand, is a one-armed bandit that operates predominantly in the wholesale channel, but is trying to mutate into a full-service IMB with correspondent and retail channels. As in the case of historical antecedents such as Countrywide, we do not expect this story to end well. A little more than a year ago, UWMC was on the brink of collapse when the FOMC "went big" in terms of adding liquidity to the markets. Today, the company is trying to defend its stock price by making a lot of inflated statements about future financial performance. CEO Mat Ishiba has a well-earned reputation for making wild and often times false statements about his firm's operations. So far the result is a stock price at all-time lows and a class action lawsuit against UWMC from a growing list of mortgage brokers. 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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May 12, 2021 | This week in The Institutional Risk Analyst , we examine the growing divergence between the various narratives working through the markets and the actual financial and legal risks that are in our collective face. More than anything else, fear-of-missing-out or “FOMO” seems to be the operative term in the financial markets in 2021. Like small mouth bass, we chase the shiny object. Whether you are chasing alpha in stocks or buying crypto tokens or making non-agency mortgage loans, the maddening crowd is FOMO. The herd chases the shiny object regardless of data or advice to the contrary. Let’s look at some reader comments for inspiration. One new reader asks if we have free trials for The IRA Premium Service . No, we have monthly subscriptions. Occasionally we publish profiles outside the paywall to provide an example of our work. Please refer to the FAQs or consult your spiritual adviser. Another manager of a small family office asks if we can offer subscriptions on a delayed basis, perhaps making content available after six months of aging. We’re flattered to hear that our prognostications have such a long shelf life. We’ll suggest it to WIX and let our readers know if and when such functionality arrives. Several readers of The IRA Premium Service commented on our analysis of the New York Community Bank (NYSE:NYCB) acquisition of Flagstar Bancorp (NYSE:FBC) , asking whether the former is not vulnerable to a downturn in valuations for urban multifamily real estate in New York City. Now that is the right question. Note that the veteran commercial lending team at FBC got full representation in the management of the combined bank. NYCB’s business model is skewed by decades of low or no credit costs c/o the FOMC, but will this benevolent state continue in the future? You still think that’s air your breathing Neo? Our subscribers know the answer. Another well-placed reader in Washington, D.C., asks about our view of the legal battle between Ripple Labs Inc . and the Securities and Exchange Commission over whether the token XRP is a security. XRP is the world’s fourth-largest crypto token today, with a roughly $70 billion market value, but is ultimately controlled by a single issuer, namely Ripple. Says another reader: “Thank you for what you said about crypto currencies on RealVision . Proponents do not comprehend that crypto exists because the powers that be allow it. Until they don’t. The world’s most dominant and powerful empire in history will not go down without a fight. That is not a judgement, it’s a fact. When the crypto’s are perceived as a threat, they will be gone.” The SEC says XRP meets the definition of a security because it’s an investment contract, the test articulated in 1946 by the Supreme Court in a case called SEC v. Howey . “Section 5 of the Securities Act is all embracing,” the agency wrote in the complaint. Ripple says that the SEC took their time blowing the whistle, suggesting there may be a political motive to the agency's actions. We agree with the SEC on the nature of single-issuer tokens. XRP and other tokens sold by single issuers are clearly securities under Section 5 of the Securities Act of 1933. The fraud provisions also come to mind, but the SEC is deliberately keeping the focus of the complaint narrow . US lawmakers have introduced legislation to clarify when a crypto token is a security or a commodity. Sorry folks, tokens that convert into nothing are just an electronic form of fraud. The fact that Ripple registered as a money service after its 2015 settlement with the Department of Justice and FinCEN is interesting but hardly relevant. To recall the work of Billy Preston and Bruce Fisher, "Nothin' from nothin' leaves nothin'." Meanwhile over at the classic FOMO scam known as Robinhood , the tech enabled broker-dealer startup is learning that the “gamification” of investing still carries some big operational hurdles. The idea that you can build a new platform that somehow avoids all of the operational and compliance requirements of the brokerage business is a bad joke, but somehow Robinhood was able to sell that false narrative to the financial media and credulous investors. Robinhood has filed a confidential S-1 with the SEC. Like Warren Buffett and Charley Gasparino at Fox Business , we’d love the have a look at that document. The IPO bankers are threatening to take this dubious concept public in the next several months, but our question is why? There is so much money sloshing around in private equity land, why take on the duties and risks of public ownership? Because in the time of FOMO, linger time equals risk. Over in mortgage land, FOMO is also very visible. That gurgling sound you hear is issuers of non-agency mortgages gently choking on a pipeline of lower coupon loans as yields rise and bond spreads widen. Everyone from Rocket Companies (NYSE:RKT) on down the line is jumping into non-agency mortgages, suggesting that a train wreck may be in progress. One reader opines: “Tons of low coupon (sub 3.125%) mortgages need to clear the PLS market in the coming weeks/months. It takes months to get the loans aggregated and through due diligence / RA process to securitize, so these inventories have seen a lot of widening. Could shake out some of the marginal ‘first time issuers’ and dealers with FOMO.” Yeah, FOMO. Of course, spreads in the primary lending market continue to tighten, with average secondary market profits falling towards an average of ~25bp vs 150bp in 2020. Meanwhile, the pricing of negative duration assets like mortgage servicing rights is soaring towards 5x multiples of annual cash flow. Of note, on conventional assets, that 5x multiple is 125bp of implied value vs public company comps ~ 90bp in Q1 2021. Most of the mortgage operators we know and trust, BTW, get nauseous when MSR valuations rise much above 50bp. The FOMO on a record year in 2020 caused a lot of inferior players in the mortgage market to load up on expensive sales talent and operational capacity, a trend that is about to reverse due to falling volumes. Even the FOMO-crazed crowd at Reddit may eventually need to admit that RKT and other lenders are a business that is largely correlated to interest rates. Not to be outdone, the folks at United Wholesale Mortgage (NYSE:UWM) continue to brag publicly that they will surpass the Rocket in terms of sales -- this after a particularly disappointing first quarter. In the film "John Wick 3," when Mark Dascascos said "I'll catch up with you John," what did Keanu Reeves say in reply? "No you won't." And speaking of artful FOMO, the folks inside the Biden Administration have apparently decided to tee up their own candidate to replace Federal Reserve Board Chairman Jerome Powell when his four year term ends. Due to FOMO, the Biden people think picking their own Fed chief is their duty and that swerving the central bank leftward will somehow gain them political advantage in 2022. You really cannot make this stuff up. Along with raising taxes on everyone and increasing regulation on everything and anything, apparently President Joe Biden thinks that making MD socialist and former bank regulator Lael Brainard Federal Reserve Board Chairman will help the Democrats hold onto the White House when VP Kamala Harris makes her run in 2024. Really, we kid you not. And the financial markets need to start believing it too. We suspect the financial meltdown that occurs when President Biden announces Brainard’s nomination as Fed Chairman will ultimately kill the nomination, but the damage to America's credibility will have been done. Imagine Brainard at the Fed and Janet Yellen at Treasury. The US would be positioned for market crisis followed by a severe economic contraction. You see, FOMO works both as a buyer and a seller, whether we speak of pretend assets like crypto tokens or tech stocks or non-agency mortgages or even slightly used politicians. It's all about confidence. When the rush for the door truly begins, there will be nobody to stop the flood of selling of stocks or crypto tokens. “The malady of commercial crisis is not, in essence, a matter of the purse," said John Stuart Mill , "but of the mind.”

May 6, 2021 | In this issue of The Institutional Risk Analyst, Brian Barnier ( www.feddashboard.com and City University of New York) discusses why the "data dependent" analytical process used by the Federal Open Market Committee for measuring inflation may be measuring the wrong thing. Price indices don’t really say what policymakers think they say. Central bankers often act as though price index statistics are the same as the “generalized price level” of theory -- and the level is caused primarily by monetary factors. Yet, hard data and daily life – especially during COVID – show that this assumption is false. That means a 2% target of any flavor isn’t what the FOMC thinks it is. The Fed's 2% inflation target needs to be replaced in a specific way. And investors need to embrace the data in order for the measure to be credible. “Monetarism” is widely debated. Oddly, the monetarist assumption of “inflation” is widely accepted. “Inflation” is assumed to be 1) change in generalized price level that is primarily caused by money supply (or at least monetary factors) and 2) that the “generalized price level” is statistically represented by a weighted aggregate average of product prices. The Federal Open Market Committee looks to the Bureau of Economic Analysis’ (BEA) Personal Consumption Expenditures (PCE) Implicit Price Deflator. (Statistically more appropriate for monetary policy than the Consumer Price Index (CPI) used for Treasury Inflation-Protected Securities.) This index is calculated from hundreds of product prices obtained or imputed by the BEA, Bureau of Labor Statistics (BLS) and Census Bureau. The Five Realities In a “Stats 101” sense, price indices are invalid for statistical inference because the average lacks a single mode and stable standard deviation. This is because prices by category have been diverging. Services prices up, nondurable goods (think food and energy) flat for a decade and durable goods down since 1995 (starting with electronics in the 1970s). Price categories changing in different directions – not a uniform monetary cause, as illustrated in the chart below. Falling durable goods prices are mostly the result of the global tech and trade transformation (with a recent uptick from the Trump-Biden tariffs and COVID). Plus, shoppers buy more when prices fall – busting the myths that falling prices mean weak demand and rising prices are needed fear to “induce” purchases. Rising services prices have mostly come from housing (it is estimated as a service of imputed rent), health care and financial services. Services are driven by public policy. Regarding health care, then Federal Reserve Chair Janet Yellen addressed health care policy in her 2017 speech to the National Association for Business Economics. Housing is local. Financial Services & Insurance (4th largest category in the PCE deflator) has long been a squishy number, not updated for the past decades of changes in financial markets and fintech. Absolute levels and change rates vary widely geographically as seen in the BLS CPI local data. (Kudos to the St. Louis Federal Reserve Bank’s FRED team for making this easy to see.) The rationale for “Core PCE” that subtracts product price causes beyond monetary causes could also remove most items in the PCE deflator. The rationale of agricultural technology after WWII or geopolitics for energy extends to most durables and services. There is little product-level evidence for monetary policy impact on prices. There are cases – such as the Effective Federal Funds Rate on house prices or foreign exchange rates that cascade to import prices. Yet, a broad mechanism is elusive. Central bankers can ask themselves some basic questions: 1. Is the cause of change in a product price due to monetary policy? 2. If not, is it a central bank’s role to counter nonmonetary causes? For example, upcoming stimulus and infrastructure laws, Trump-Biden tariffs, USMCA trade agreement, health care laws, people relocating due to COVID or to cut their taxes, preferences for luxury or convenience, falling costs of manufacturing, global supply chain reorganization (due to COVID or geopolitics) or the COVID spending skew. 3. What are the complications of using monetary policy tools in response to a nonmonetary cause of inflation? Will central banks set a threshold of acceptable distortions and inequities? Importantly, these questions aren’t about transitory verses longer product price increases, or asset prices increases. They are about cause. The problem of distinguishing between monetary and nonmonetary causes of inflation isn’t new. Official statistics, for example, show this situation is long-growing – starting in the 1970s as consumer electronics prices began to fall. Falling consumer electronics and oil prices did much to help Federal Reserve Chair Paul Volcker “break the back of inflation” in 1981. In official statistics and industry data, it’s been difficult to find theoretical “inflation” in open, industrial economies for decades. Even in the U.S. in the 1970s, the oil embargo, rise of the credit card, end of the Bretton Woods system and more makes identifying monetary causes difficult. Why are central banks so slow to adjust? Is it a structural problem? Back to the Future Irving Fisher , in his Purchasing Power of Money (1911) , showcased the mechanics of how things work. He famously diagramed a merchant’s scale to illustrate the role of money and listed causes of product price change. His list stands the test of time (he missed health care). John Maynard Keynes in his General Theory (1936) focuses us on data and offers us encouragement to change. First, in data. Keynes wrote of Alfred Marshall: “It seems that we have been living all these years on a generalization which held good, by exception, in the years 1880−86, which was the formative period in Marshall’s thought in this matter, but has never once held good in the fifty years since he crystallised it!” Today, it is nearly fifty years since the post-WWII period that enshrined current views of “inflation.” Second, Keynes concluded his preface with the following warning to future generations of economists: “— a struggle of escape from habitual modes of thought and expression. The ideas which are here expressed so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.” The FOMC makes a great fuss about embracing hard data and mechanics. Perhaps central banks would better serve consumers, businesses and investors by embracing a more reliable measure of inflation. A leading candidate is the stability of the trend in consumer durables, after a border adjustment (for trade barriers and FX). But as Keynes said nearly a century ago, the first task is letting go of obsolete and outmoded measures of price changes.

"A remarkable consensus has developed among modern central bankers ... that there's a new 'red line' for policy: a 2 percent rate of increase in some carefully designed consumer price index is acceptable, even desirable, and at the same time provides a limit. I puzzle at the rationale. A 2 percent target, or limit, was not in my textbook years ago. I know of no theoretical justification." Paul Volcker April 27, 2021 | There is a growing awareness on Main Street that inflation is a problem. Everybody knows about the run-away markets for financial assets and single-family homes. It seems that the stocks with the least substance are likely to benefit the most in the current interest rate environment. But vendors and suppliers are starting to raise prices in the face of scarcity in supply chains, the precursor to a significant increase in inflation. The growing gap in valuations between different stocks is starting to drive a feeding frenzy, from SPACs to plain old M&A. Sometimes liquidity crazed buyers are taking out higher valued stocks. Witness the spectacle of New York Community Bank (NYSE:NYCB) , trading 10% below book value, taking out Flagstar Bancorp (NYSE:FBC) at a substantial premium over book. And as our friend and fishing buddy Ed Pinto at AEI has long warned, the combination of low interest rates and easy credit from lenders is killing affordability and creating future credit losses for the Treasury. Just in time, President Joe Biden is offering a $15,000 tax credit for first-time home buyers. This nonsensical policy will only make matters worse when these borrowers default in a couple of years. For the same reason, BTW, we just can't see NYCB keeping that gnarly FBC Ginnie Mae servicing book. Of course, the common thread in this story is inflation, plain old excess demand for limited assets. Given that the elasticity of supply seems to have yet to reach a boundary, however, it appears that the culprit here is the excessive liquidity created by global central banks. The financial markets, confirming Say’s Law, proves that creating assets of whatever dubious quality or substance generates demand. But the creation of liquidity by the Fed plays an important role besides merely dealing with short-term market volatility. The creation of assets, some better than others, is part of the oldest part of the playbook for the Federal Open Market Committee, namely the recipe for avoiding global debt deflation. Irving Fisher’s famous work on “debt contraction deflation” is the masterpiece on the Great Depression and the foundation of later studies by which former Fed Chairman Ben Bernanke rescued the world in 2007. “We must,” our friend Fred Feldkamp likes to remind us, “NEVER forget the Fisher/Bernanke combined lesson. It starts with the national income accounting identity that ‘savings’ must and always will equate with ‘investment’. That is an “identity” because that is how we have constructed the world’s national income accounts. It says that the total of all debt and equity must (and always will) equate with the total of all capital investment.” Debt is always an amount set by contract but it is necessarily a “value” that fluctuates with the market by its present value, determined by “base rate plus spread,” to establish the ultimate daily market value of debt. That’s why Treasury rates and bond spreads are vital data points. They set the day-to-day value change of total debt. Equity markets are bid up and down by investors, based on expectations regarding earnings and other factors, including the perceived actual future cash flow burden of daily market values for debt. When either equity or debt value “crashes” as in Q1 of 2020, the value of “savings” necessarily shrinks and that necessarily undermines the value of the world’s total “investment.” What Fisher showed (and Chairman Bernanke understood) is that capital assets necessarily crash in value unless debt grows to replace any sudden market value drop. Equity values recover when confidence is restored. We have seen that recovery over the past year. But while Chairman Bernanke advocated aggressive action to combat debt deflation, he also understood that there were limits to the FOMC’s actions. In particular, the actions taken under Fed Chairman Janet Yellen have gone further than merely restoring balance between debt and equity. The FOMC, by doing too much for too long, now attacks the very pricing mechanisms upon which the capital markets and the US economy vitally depend. First Yellen and then Fed Chairman Jerome Powell have increased the Fed’s purchases of debt even after any danger of generalized debt deflation has disappeared. More radical members of the FOMC such as Governor L ael Brainard focus on employment for the bottom quartile of the US workforce, yet the fact is that the Fed’s job is to ensure full employment generally not in particular. The whole point of the political compromise that led to the Humphrey-Hawkins legislation of half a century ago was not to guarantee a job for every US citizen. Perhaps Yellen and Powell should go back and read the statute as passed by Congress. Sadly, Treasury Secretary Yellen and Chairman Powell have become so cowed and politicized that they are no longer able to carry out their duties under the law. Secretary Yellen prattles on in public about the risk of global warming, but ignores the growing sea of fraud in global financial markets. Archegos, Wirecard and Greensill, to name but three prominent financial schemes. All of these financial failures are all the result of the FOMC’s excessive actions and the impact on risk perception by investors. These frauds have caused billions in losses to financial institutions, but Yellen and Powell remain clueless and indifferent to their legal duties as regulators. There is no question that the FOMC needed to “go big” in December 2018 and in April of 2020. Yet none of the current members of the FOMC seem to have the personal or political courage to say no to political fashion when enough has been done. The triple mandate in the Humphrey Hawkins statute says full employment and price stability, and also stable interest rates. By failing to moderate monetary policy when these goals have been met, the FOMC is creating an inflation problem in the future. “[W]ith the Fed undertaking one of the most radical monetary policy experiments in history, you’d think there would at least be more debate,” notes The Wall Street Journal . “All the focus on race and gender obscures that what really matters at the Fed is the value (not the color) of money.” But the bigger threat is to the credibility of the central bank. Two decades ago, former Federal Reserve Board Chairman Alan Greenspan and his colleagues on the FOMC presided over the lowest interest rates since WWII. The terrorist attack on September of 2001 had spurred the central bank to reverse course and ease tighter policy put in place to cool the financial bubble in technology stocks. The reason for this change in interest rate policy was to arrest any negative economic response from the dastardly attack on 9/11. But the long-term negative impact of that decision by the Greenspan Fed continues to color our economic life two decades later. No matter your good intentions as a central banker, attempting to fine tune the economy is a dangerous act of folly, especially after a major disruption such as 911 or COVID. The bond market is delivering this message to Chairman Powell, but in the ridiculous political climate in 2021, we seem doomed to repeat past mistakes over and over again. Each excessive injection of liquidity provided by the FOMC in response to a major externality such as COVID creates the conditions for the next financial crisis, in this case a maxi housing price reset in 2024 or 2025. At the end of the day, financial stability is a function of both Fed action to address the clear and present danger of debt deflation and also moderation to maintain some semblance of price stability in the face of political demands by extremists on either end of the spectrum. When the economy begins to recover, that is when the FOMC should start to taper its market intervention -- not when inflation is already a problem as it is today.

April 22, 2021 | In this issue of premium service of The Institutional Risk Analyst , we take a look at Citigroup (NYSE) in the wake of Q1 2021 earnings and the most recent announcement by new CEO Jane Fraser . In short, Citi announced exits from consumer franchises in 13 Asia and EMEA markets. Citi plans to focus on building wealth management in four centers in Asia, a less than credible strategy in 2021. Citi reported $7.9 billion in income in Q1 2021, including $3.2 billion in loan loss reserve releases. Excluding the reserve release, which represents revenue earned in 2020, income would have been $4.7 billion. This figure is closer to the true run rate going forward. Remembering that Q1 is generally the best quarter for most banks and financials, so it’s all downhill from here. There is nothing new in the Citi announcement. Other than the fact of a new CEO, the announcement by Fraser could have been made by any of her predecessors going back decades to John Reed (1967-2000). Citi sold its Smith Barney wealth management business to Morgan Stanley (NYSE:MS) more than a decade ago, thus the announcement by Fraser merely confirms that this was a very bad decision. The table below summarizes the Citi announcement. While many of Citi’s peers such as MS and UBS Group (NYSE:UBS) have migrated away from capital markets and investment banking, and toward wealth management, Citi has drifted through years of government ownership and weak leadership by the board of directors. It is not that either Jane Fraser or former CEO Michael Corbat are bad managers, far from it. Yet neither are up to the real task, namely selling or breaking up a $2.3 trillion asset bank that no longer has a reason to exist. Ponder the fact that the businesses targeted for exit had a combined efficiency ratio of nearly 80%, meaning that they are barely profitable. Corbat cleaned up the previous mess at Citi, but lacked the gravitas to tell the board of directors what they need to hear: sell the bank, either as a whole or in pieces. US regulators would probably welcome such a solution to the problem with Citi, a problem that stretches back half a century to the Latin Debt crisis and its messy aftermath. The LDC debt crisis ended up with Citi merging with Travelers under Sandy Weill , a situation not like the merger of Chase Manhattan with JPMorgan after the Penn Square collapse. The classic Mexico dirty money scandal known as “White Tiger,” which involved Raul Salinas de Gortari and Citibank Private Banking, enabled Weill to eject Reed early on. One day we’ll write the rest of that story. But the key point is that a large money center bank once called First National City mutated into a subprime lender at home and a platform of convenience for the U.S. intelligence community offshore. None of the pieces ever made sense in business terms. In many ways, Citi in the 1970s and 80s took on the international roles played by lenders such as Manufacturers Hanover and Chemical Bank, both in retail and institutional banking. But the bank never had a compelling or dominant position either domestically or internationally, leading to a franchise that is light on core deposits and very dependent upon market funding like a nonbank. None of the markets marked for exit ever made operating sense for the bank. Citi did business in a lot of venues around the world, competing with the European and Japanese champion banks for showcase multinational corporate and sovereign business. Yet at home, the nonbank finance company culture of Weill grafted onto the commercial bank, creating a frightening combination of transactional risk and junk grade consumer credit exposure with a gross loan spread far above its peers. Source: FFIEC The blended gross spread on Citi’s loans and leases is 7% today, but the spread on the bank’s $200 billion in consumer loans is far higher, a “B” equivalent in terms of the gross spread vs rating agency default scales. But the larger point to make is that less than $700 billion of Citi’s $2.3 trillion in assets is actually in loans, while the rest is invested in securities. The bank has $550 billion in core deposits, but over $650 billion in foreign deposits. The rest is funded off the Street. Our friend Dick Bove wrote this week that breaking up Citi has been one of his long-held views. We agree. He writes: “For about 25 years now Citigroup has been breaking itself up. Its new CEO is continuing this policy. The haphazard nature of this approach has not generated great profits for shareholders. Therefore, the company should seriously consider stopping this erratic and poorly thought-out process of dissolution and lay out a well-researched program of dissolving the company that will benefit shareholders, employees, and customers.” The 2008 collapse of Citi illustrates the volatility of the universal bank model. More, Citi has been unable to articulate a strategy for growing shareholder value since leaving government control. Instead, the bank has doubled-down on an unstable mix of global institutional and retail businesses, none of which has even competitive mass in terms of market share. Like its ideal wealth management client, Citi is a seagull with a global reach but no single market upon which to anchor the business. The subprime consumer business produces nice returns, as does the payments platform, but the investment bank is both a blessing and a curse. Sometimes the investment and commercial banks produce great returns, other quarters they bleed risk. For instance, in February 2021, Citi announced that a restatement of $390 million due to an increase in operating expenses ($323 million after-tax) recorded within Institutional Clients Group, resulting from operational losses related to “certain legal matters.” The financial impact of this adjustment and restatement lowered Citi’s fourth quarter 2020 net income from $4.6 billion to $4.3 billion. Like Goldman Sachs (NYSE:GS) , Deutsche Bank (NYSE:DB) and, of course most recently, Credit Suisse (NYSE:CS) , Citi has a certain idiosyncratic aspect to its risk profile that is impossible to quantify or to ignore. We’ve had a negative risk rating on GS, DB and C for over a year not because of our view of the stock, but rather due to the unknowable aspect of the risk profiles of these universal banks. Add CS to the list. In a market where the FOMC is literally and without apology sucking duration out of public markets like an insatiable alien hedge fund, stocks obviously must go up, even these financial dogs. But, of course, some stocks go up more than others. The table below shows some of the members of our bank surveillance group. Suffice to say that the book value multiples and credit default swap spreads of these banks have grown or been cut in half, respectively, over the past twelve months. The table below shows the names currently in our bank surveillance group. IRA Bank Surveillance Group Source: Bloomberg Notice first and foremost that Citi remains below book value despite the impact of QE on global equity valuations. Indeed, Citi is at the bottom of the group in terms of multiple of book value. When you consider that names like GS and Capital One (NYSE:COF) were trading at a significant discount to book six months ago, the lack of performance of Citi is striking and, we believe, begs the question. Even with the strong quarter in terms of reported revenue, Citi’s efficiency ratio remained at 57%, the poorest operating efficiency among the top five banks. And this ultimately is why the bank still trades below book value even though its asset peers remain at 52-week highs. The poor financial performance is reflected in the pricing for both the bank’s debt and equity. Shrinking the business is unlikely to generate improved shareholder value in the near term due to the expense of exiting these retail markets. The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Profile is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Profile. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

April 19, 2021 | In this issue of The Institutional Risk Analyst, we feature a discussion with Nom de Plumber , the pseudonym for a prominent Wall Street risk manager who is currently ensconced at a major bank. While it is generally our policy to avoid anonymity, the fact of employment in a large company or bank means that you have no First Amendment rights. As we learned the hard way many years ago, the only free press is the one that you own. The IRA: Good to connect again after the year of COVID. You’ve made some interesting comments on how the Consumer Financial Protection Bureau and the Federal Housing Finance Agency , to name a couple, have been treating the independent mortgage banks (IMBs). When servicing was controlled by banks, you could impose stupidity like foreclosure moratoria and it did not really matter. Now that IMBs control two-thirds of the mortgage market, it kind of matters. Care to elaborate? Source: FFIEC NDP: Sooner or later the delinquencies will really have to manifest as actual losses and defaults. Millions of people who’ve lost their jobs or their business are not paying their mortgages, so we have what is effectively a default in drag. Foreclosure moratoria and payment holidays do not fix the problem of unemployment and affordability. Sooner or later the python has to poop the pig. Someone has to eat those forgone cash flow losses. The IRA: In a funny way, we’re right back to April 2020 in terms of the issues facing the IMBs. The Federal Open Market Committee bought us a year, correct? Now the mortgage market is reverting to the mean, as we discussed with John Dizard in The Financial Times over the weekend ( "Easy money might be over in US mortgage banking boom" ). NDP: A default is a default. You can modify the loan or put the arrears at the back of the loan, but from a present value (PV) perspective that is a huge hit. In the conventional market, the GSEs will eventually absorb the loss, but in the meantime the IMBs must finance this and also the expense of dealing with the delinquency. In the government market, the seller/servicers eat part of the loss. When we had banks as servicers, this was not a problem. You could use bank deposits to fund servicing advances. But IMBs don’t have much capital or excess liquidity. Had the GSEs finally not come forward last year to take responsibility for liquidity we might have seen some IMBs shutting down last summer. The IRA: It took FHFA Director Mark Calabria some time to figure this out. We’re told that he basically makes decisions without consulting the career staff at FHFA or the GSEs. The decision last year to impose the 50bp tax on refinance transactions, for example, came with no warning to conventional issuers or the GSEs. He is at once the laughing stock of the housing finance community, but is also a huge problem. Look for loan repurchase demands from the GSEs as Mark's next big idea. To your point, the monoline servicers seem to be in the biggest trouble in terms of both liquidity and prepayments. Servicers face the cost of default mitigation, on the one hand, and prepays on the other. Is this a perfect storm for IMBs? NDP: Servicers depend upon the stable world of notional amortization. Default based amortization where there is no fee recapture of any sort, meaning no payment for fixing COVID forbearance loans, is going to be brutal for the IMBs. The fundamental problem is that the politicians and consumers think that the servicers all have money set aside to pay for the CARES Act and other types of debt payment holidays. The regulators too at FHFA and FHA assume that there are piles of cash just sitting there ready to be tapped in time of emergency. But there is no cash. The disconnect in Washington comes from not understanding the difference between a bank and a finance company. IMBs don’t have internal deposit driven liquidity. Capital is an afterthought. They live on cash and available financing. The IRA: The IMBs generally pledge net assets to back warehouse lines, gestation and TBA trading, all provided by the big banks, so the idea of a secret cash pile is pretty amusing. With the nice profits made in 2020, the industry grew book equity and AUM on net, but had to contend with severe prepayments, 30% or more in some cases. The whole US banking industry lost 20% of total loan balances and servicing in 1-4s net over the past four quarters. But you used the “f” word the other day, namely forbearance. How much forbearance is there in the US banking industry particularly for commercial real estate? NDP: Some of the credit concerns are being addressed by an economic recovery, but many analysts including you have said it remains an open question as to the total credit cost of COVID. Commercial servicers, for example, were pretty lenient in 2020 but many have finally stopped providing forbearance to borrowers, which are mostly commercial buildings in this case. Even for deep pocketed landlords, will they have the capability to finance operating deficits for years to come? The IRA: And the desire. There were many properties abandoned in NYC in the 1970s. We think this cycle could be worse because of the poisonous politics in the city. New York State and City need to start thinking about being competitive with other states instead of raising taxes. NDP: The New York Times is writing very sobering reports about office space and the dynamics of making these properties profitable again. If we have major tenants shrinking their office footprint and also renegotiating terms on the space that they are willing to keep, that fundamentally changes the net operating income (NOI) assumptions behind the valuations for these assets. The buildings that are delinquent and want to recover cannot because falling NOI pulls out the ground beneath their feet. The property cannot be financed without significant new equity, cash the landlord does not have because his tenants are not paying him. The IRA: We keep pointing this out to people in Washington. The crisis with COVID is about the bottom quartile of the economy, workers and small business that have been crushed by lockdowns. In aggregate, the credit numbers for consumers are fine. But the situation for commercial and multifamily real estate assets where the NOI has changed permanently is a very disruptive and destructive change, for REITs, bond investors and also municipal debt. Can we get people to focus on the coming bloodbath in moribund urban commercial real estate? NDP: Reality will come back into sharp focus because there is no political support for helping commercial landlords or tenants. Like 2008, reality will hit first in commercial properties. Here’s the thing: After 2008, you really did not see office space utilization change that much, so pricing settled down pretty quickly. Now, we are talking about significant and permanent changes to utilization and the rate for space, both at once. Reality will be cushioned for consumers, but the delinquent borrowers will still be resolved. The impact on commercial real estate will be earlier and harder. What is interesting to think about is whether commercial servicers, which also advance and collect, will be impacted. Commercial servicing is chunkier, but in basic terms is the same as residential when it comes to paying the note holders. The IRA: Isn’t is remarkable how low consumer loss rates remain, forbearance or not? NDP: Consumers have become very adept at managing their credit. They keep up on credit cards and auto loans, for example, even subprime auto. But with each financial crisis, you see a tendency for people to game the system in terms of consumer relief programs. This time the cost has fallen upon the nonbank servicers and nobody in Congress knows or cares. But we may not be too far from the day when a large nonbank servicer turns to the FHFA and FHA, demands immediate assistance with the cost of consumer forbearance, and threatens to shut off the lights and walk away if the cry for help goes unanswered. The IRA: Yeah, like we’ve said before. Be well.

April 12, 2021 | In this issue of The Institutional Risk Analyst , we look at three key issues that you are unlikely to hear discussed in the financial media as banks and nonbanks begin to report Q1 2021 earnings this week: Poor visibility on “expected” credit losses, Ever shrinking net-interest margin, and Massive loan prepayments in Q1 2021 Simply stated, US banks are twice as expensive as they were a year ago looking at earnings and assets, but have less transparency and greater volatility in terms of credit costs and income going forward. Leading off earnings for the big boys on Tuesday, we’ve got one of our favorite specialty bank holding companies, Charles Schwab Corp (NYSE:SCHW) . On Thursday we have another favorite we wrote about earlier (“ Western Alliance + AmeriHome = Big Possibilities ”), Western Alliance Bancorp (NYSE:WAL) . Of note, that transaction closed in a matter of weeks, no surprise given the capital and operating strength of the bank. After WAL, we’ll hear from JPMorgan (NYSE:JPM) , Wells Fargo & Co (NYSE:WFC) , First Republic Bank (NYSE:FRC) and Goldman Sachs (NYSE:GS) . JPM is at a five-year high, this after losing half of its value in the volatility downdraft of April 2020. JPM is up 170% since 2017, illustrating the fact that inflation is not low, even when it comes to relatively pedestrian bank stocks. GS is up a mere 120% and WFC is down 13% over the same period. FRC is right behind JPM when it comes to equity market performance. The table below shows quarterly dividends declared by the top-five US BHCs. Source: FFIEC Of note, the Street consensus has JPM revenue down 4% in 2021, GS down almost 5% this year and WFC revenue down about the same amount as JPM. WAL, by comparison, is expected to turn in 44% revenue growth in 2021 and 2022 due to the acquisition of conventional mortgage aggregator AmeriHome from Athene (NYSE:ATH) , a unit of Apollo Global Management (NYSE:APM) . The first key issue facing investors in US banks is visibility on credit. Former Fed Chairman Paul Volcker forced US banks to forbear on Latin debtors for a decade in the 1980s. At the same time, US regulators allowed zombie thrifts to continue to write business, a colossal mistake that cost taxpayers hundreds of billions in capital losses. But the great game of asset price inflation continued. The forbearance that some lenders are providing today, often at the behest of federal regulators, is a cause for concern. How do we define “expected loss” when we pretend that dead assets are viable? We keep hearing suggestions of widespread forbearance in the commercial real estate channel, where asset values of many commercial buildings now are difficult to estimate. Net operating income is unknowable. We noted in “ The IRA Bank Book Q1 2021: Loss Reserve Releases to Boost Earnings, ” that default rates across the board are too good to be true given the degree of dislocation in many sectors of the economy. As we watch banks releasing loan loss reserves this quarter, will they reveal the degree of credit forbearance being provided to large commercial borrowers? When good loans are hard to come by, banks make bad loans. Just as in the 1980s with the S&Ls, the rules have been relaxed de facto in the name of avoiding a generalized debt deflation. Banks figure that it is better to support troubled developers now instead of foreclosing, a messy public process that tends to undermine that key ingredient in any leverage system, confidence. But what shall we do in three or six months? More loans after bad? We'll talk more about modern bank forbearance in a future conversation with our old friend Nom de Plumber . When Fed Chairman Jerome Powell tells members of Congress that US banks are strong and well capitalized, does he mention widespread forbearance for delinquent commercial borrowers? No, Powell does not. Long-time Volcker friend and associate Richard Ravitch described the dire situation facing New York City last week in the Wall Street Journal : “The city has over twice the national unemployment rate. Given the number of commercial and residential tenants who aren’t paying rent, the city will likely see a significant reduction of property-tax revenue, which accounts for more than one-third of municipal revenue. Hotels and restaurants are empty, the entertainment industry closed down. An enormous number of offices are empty because people have moved out of the city or are working from home.” We figure that bank loss rates on commercial exposures in Q4 2020 understate by as much as half likely future losses. This is due to the impact of the CARES Act and state lending moratoria for consumers and unofficial forbearance for commercial obligors. But while we feel pretty good about the outlook for residential assets, not so with commercial exposures in major metros. Q: Will the Fed and other regulators allow banks to milk loss reserves to boost income in Q1 2021 – even knowing that future losses on commercial exposures in major cities could be significant? A: Yes. The operating assumption seemingly being followed by US prudential and housing regulators is that the economic recovery will heal all wounds when it comes to credit. We believe, however, that the benefit of Fed largesse is going to be uneven, just as the distributive effects of US monetary policy have been uneven going back half a century. We spoke about this with our friend Ed Kane (“ Interview: Ed Kane on Inflation & Disruption ”). The second key issue you are unlikely to hear about from Buy Side pontificators this earnings cycle is the continued shrinkage of net-interest margin or NIM. Even as the FOMC has driven down the cost of funds for banks to record lows, the return on earning assets (ROEA) is falling just as fast, compressing bank margins and cash income. Notice in the chart below that net interest income only rose in Q4 2020 because the cost of bank funding collapsed. Bank warehouse lines for agency loans are now quoted in fixed spreads ~ 1.50-1.75% without any mention of either LIBOR or SOFR. Gross interested income was actually flat sequentially in Q4 2020, but interest expense fell to just $12 billion for the entire $21 trillion in assets held by the US banking industry. A decade ago in Q4 2010, the total assets of US banks were less than $14 trillion. But remember, inflation is still too low according to the FOMC. Source: FDIC/WGA LLC The fact is that cash to investors from banks in terms of dividends and share repurchases are running at about half of 2019 levels, part of the large environment of income annihilation that has guided the actions of the FOMC for more than a decade. The diminution of income to investors under quantitative easing has been massive and largely benefits the US Treasury. The final factor in Q1 2021 bank earnings will be prepayments, both of residential and commercial loans. The accelerating runoff of assets under management (AUM) is a major factor contributing to the decline in bank interest earnings. As we noted in The IRA premium service over the past month, US banks have suffered huge capital losses in 2020 due to loan prepayments for portfolio and also assets serviced for others. Assets totaling 20% of bank 1-4 family mortgages prepaid in 2020 and were mostly captured by nonbank lenders and the bond market, leaving banks and nonbanks alike scrambling to replace lost income. Giant end investors in mortgage servicing such as Lakeview and New Residential (NYSE:NRZ) have been decimated by annual prepayment rates in mid-double digits. Do you suppose that the folks on the FOMC have ever thought about the cost to investors of accelerated prepayments due to low interest rates? With the rise in interest rates, conventional theory holds that bank lending margins should expand, but in fact the opposite is the case. Indeed, margins on both consumer and commercial loans are tightening as rates rise and volumes soften. Meanwhile, bids for whole loans and servicing assets are well-above fair value as growing numbers of investors enter the market in search of returns. Sound familiar? The parallel between inflated prices for homes, loans and mortgage servicing assets is not a coincidence. Yet in residential 1-4s, secondary market spreads are once again so tight that more and more lenders are down cash after the close and even sale of the mortgage. This means they are dependent upon servicing fees to recoup net cash outlays to originate the loan. The year 2020 was one of those rare periods when lenders were actually up cash on lending for much of the year, a lot. Both banks and nonbanks alike face a very painful year where prepayments on older, higher coupon loans will continue to generate losses, but the ability of banks and particularly REITs to replace these assets with new loan production is constrained. In essence, we have created the perfect storm for lenders of all descriptions, with political payment moratoria threatening to bankrupt some monoline owners of loan servicing later this year. If you pay 2x annual cash flow for an asset, which then prepays two months later, you lose money. Bottom line is that financials are more expensive than ever measured by the ability of banks and nonbanks to pay dividends to investors. Visibility on future credit losses is poor and the rate of prepayments on consumer and commercial loans is making it even more difficult for financial firms to maintain equity returns in terms of dividends and share repurchases. Other than that, everything is great. Have a good week.

April 8, 2021 | The growing push-back against the Biden infrastructure plan and trillions more in deficit spending comes as the US economy is recovering by leaps and bounds. The mere fact of vaccination, effective or no, is probably worth several points of GDP simply by improving the national mood. The positive impact on consumers and some parts of the economy is massive and ongoing, even as other sectors struggle with deflation. In many respects, it is April 2020 all-over-again. The FOMC bought us a year in the housing market with QE and low rates. Now we are back to square one with weak or even negative lending and bond issuance volumes. In terms of the economy, residential housing is not the problem. The low default rates in most 1-4s other than the government-insured sector suggest there is no credit issue in housing. The Fed is focused on employment and other sectors of the economy, but the bias remains deflationary outside of the overheated equity markets. Some months ago, we predicted that the Democratic majority in the Senate was an illusion. The splinter in the ointment is a West Virginia Senator who is a Great Society Liberal, but has little in common with the socialist tendency presently calling the shots in Washington. "Senator Manchin's (D-WV) Apr. 8 Washington Post opinion essay where he states his opposition to the use of budget reconciliation leaves us pessimistic regarding prospects for passage by Congress in 2021-22 of a $2+ trillion broadly defined infrastructure plan that was outlined in the Administration’s American Jobs Act," writes Byron Callan of Capital Alpha Partners . The fact that President Joe Biden is already signaling weakness by putting the corporate tax rate out for negotiation illustrates the flimsiness of the progressive agenda. As Republicans regain confidence, we fully expect to see one of the half dozen marginal Senate Democrats cross the aisle -- but probably not Manchin. If the Republicans can delay another month or so, the rising economy may well shred any remaining argument in favor of fiscal stimulus and give them back the majority in the Senate. Meanwhile in Foggy Bottom, the FOMC says there will be no change in ST interest rates nor in QE, but the markets are calling bull-feathers. Earlier this year, the FOMC lost control of the bond market when the 10-year T note spiked. Note, however, that yields on the benchmark 10-year Treasury note started working higher last Summer and Fall. In fact, the rate spike in February 2021 marked the acceleration of an existing trend higher in rising interest rates. Notice, for example, that mortgage bonds were comfortably in the green this week until the Federal Reserve's latest buying operation ended, then prices slipped and yields rose. Many analysts seem to ignore the fact that the Fed may not be able to end QE because it has become an important part of the bond market. The FOMC faces a possible net addition of another $1 trillion in spending and borrowing in 2021. Also, there are a number of federal trust funds that are now running negative in terms of net cash flows, increasing the funding burden on the Treasury. For every dollar of trust fund release, the Treasury must raise $2 in cash. A scenario such as 2018, when the FOMC thought it could end QE and raise target rates is impossible today w/o a major change in federal spending by Congress. Meanwhile in the world of real estate finance, the results are, well, lumpy as you might expect. We described some recent observations in our last missive (“ Update: Commercial, Residential Loans & MSRs ”), mainly that urban commercial real estate is moribund and is unlikely to bounce back to previous valuations. Even a successful economic recovery measured by national statistics could see valuations for New York office buildings cut in half because of new, lower levels of utilization and NOI. The loud gnashing of teeth you hear in the background is the sound of progressive cadres bemoaning the fact of the building economic recovery. In the residential housing market, for example, the number of households using loan forbearance is falling fast, rendering the appeal of pro-consumer policy moves in doubt. If there is no crisis, then who needs a bailout? The announcement by the Consumer Financial Protection Bureau , for example, that it is considering a nationwide foreclosure moratorium for ALL residential loans angered members of the mortgage community. But troubled loans may not be a big deal if consumers continue to leave forbearance successfully at the current rate. The CFPB announcement is just more of the same progressive politics of regulatory extortion and abuse. The CFPB does not actually have the legal authority to impose a national moratorium on loan foreclosures, but the mortgage industry is unwilling to fight – so far. For that matter, the Centers for Disease Control does not have the legal authority to impose a national moratorium on evictions of renters. But as the financial situation facing landlords becomes ever more dire, even progressives may need to pay attention to the details. The basic problem with spending on “infrastructure” is the same as the problem with affordable housing. Everybody wants it, but infrastructure and housing are expensive loss leaders – especially in blue states like New York where feeding layers of corruption are required for any public task. Building in New York City costs in excess of $600/psf not including the cost of the land, which is also ridiculously expensive. Think $5k psf all-in cost including land for New York City construction. How does one make this affordable? The truth of the matter is that inflation in living costs and asset valuations has rendered major metros too expensive for even affluent households. Since the FOMC refuses to allow any deflation in asset prices, consumers get no relief. But the fact of the COVID pandemic has added a powerful downward bias to some, but not all, sectors of the commercial real estate sector. For now, the buoyant stock market provides a welcome distraction, but the commercial real estate sector is an open wound that will remain for years to come. Earlier this week, Jim Cramer on CNBC's Mad Money provided a fascinating commentary on why stocks go up. He remarked on the fact that merely mentioning a stock, regardless of the news content, causes the price to rise. The fact of a brokerage firm issuing a hold on a stock causes the price to go up. And most tellingly, Cramer noted that the spasmodic upward thrusts in stock prices do not cause sellers to enter the market. In the world of quantitative easing, all boats rise on a sea of fiat paper dollars. The trees grow to the sky, for now. Our big worry is that activity in the corporate bond market remains muted, this along with flat to down commercial lending that will be confirmed by bank earnings next week. As those bright lights on the FOMC debate whether the central bank should start to manipulate the entire Treasury yield curve, the market is reacting in ways that are not altogether encouraging. We do note, however that mortgage related issuance is rebounding, confirming our anecdotal observation that issuers are still seeing strong volumes in 1-4s despite a 50bp increase in 30-year mortgage rates. The BIG question is what happens to the bond markets if the Biden Administration continues to grow federal deficits. A bond selloff could cascade into the equity markets and cause a major mishap a la the recent mess with Archegos , a family office that accumulated insane leverage through bilateral swaps with banks. Ultimately the Fed’s low interest rate policies created the circumstances for Archegos and other spread trade frauds such as Wirecard and Greensill , to name but two high profile cases. At the present time, the consumer side of the US economy is booming along with stocks and residential mortgages. The rest of the economic landscape is littered with assets and industries that are in varying stages of distress and showing accelerating levels of deflation. Eventually these deflationary black holes may start to matter in the thinking of investors. An equity market selloff could have substantial negative repercussions for the global markets and cause some financial institutions to take major losses on hidden derivatives positions. Yet the bigger risk is that a market break could shred the little credibility possessed by the Biden Administration and Treasury Secretary Janet Yellen , leaving the US entirely exposed to the vagaries of the markets. If the Biden infrastructure plan fails, Americans face a Lame Duck government less that a year into Biden’s first term. Stay tuned.

April 5, 2021 | This week in the premium service of The Institutional Risk Analyst , we take stock of the uneven situation facing banks, REITs and bond investors holding commercial and residential real estate assets three months since the inauguration of President Joe Biden . We also update readers of The Institutional Risk Analyst on developments in the market for residential mortgage servicing rights (MSRs), perhaps one of the hottest institutional strategies for 2021. Commercial Real Estate The commercial loan sector continues to show signs of moderating stress looking aggregate data from bank balance sheets and commercial mortgage-backed securities (CMBS). The credit performance of commercial and multifamily loans in March was the best in nearly a year, yet there also was a slight month-to-month uptick in payments missed, the Mortgage Bankers Association reports. Some 95% of commercial and multifamily loans were current on payments in March, up from 94.8% in February, according to the MBA's CREF Loan Performance Survey . But average delinquency ticked up slightly, suggesting that investors and landlords face a long road ahead. Given the lack of true visibility into this entirely lumpy asset class, use aggregate survey data on commercial real estate (CRE) loans with great caution. In the public equity markets, the valuation for commercial REITs followed the larger complex of financials higher since our last report in January with the rally in interest rates. From a low of 0.4x book value a year ago, the mortgage REITS tracked by KBW reached 1.1x book in February, but traded off since then on worries of rising interest rates and uncertainty as to credit trends. Visibility into the actual condition of many equity REIT portfolios is poor. Like REITs and even leading residential nonbank mortgage lenders such as Rocket Companies (NYSE:RKT) , the public market valuations for US financials peaked in early February, when mortgage interest rates touched the low for this cycle. Note, however, that yields on the benchmark 10-year Treasury note started working higher last Summer and Fall. The rate spike in February marked the acceleration of an existing trend higher in interest rates. When assessing commercial read estate credit, we always remember the sage wisdom of our friend Alex Pollock , Principal Deputy at the Office of Financial Research in Washington. He reminded us years ago that most of the commercial exposures in a typical commercial bank are tied to real estate one way or another. The chart below shows the delinquency for $2.5 trillion in commercial loans held by US banks, roughly half of which is explicitly tied to commercial property. We discussed this series in detail in the latest IRA Bank Book for Q1 2021 . Source: FDIC Much of the pain now being felt by owners of commercial real estate is obscured behind the world of equity REITs, a $3.5 trillion gross asset market that is largely funded with public and private equity and, indirectly, mortgage debt held by banks and bond investors. Cooperative apartments and condominiums are frequently financed via first lien mortgages held by local banks. “The balance of commercial and multifamily mortgages that are not current decreased in February to its lowest level since April 2020,” reports the MBA. Some 94.8% of outstanding loan balances were current, up from, 94.3% in January. An average of 3.5% were 90+ days delinquent or in REO, down from 3.6% a month earlier. The chart below shows the largest components of the universe of commercial real estate assets held in REITs, banks and CMBS. Single- and multi-family rentals are not shown. Source: NAREIT, FFIEC, TCW After REITs, the property component of the $3 trillion in commercial and multifamily bank loans follows in terms of sheer size. Default rates on multifamily loans held by banks remain suppressed by the CARES Act and state law debt payment moratoria, but loss given default (LGD) on these loans is finally rising after years in negative territory, as shown below. Source: FDIC/WGA LLC Last in size in the world of commercial real estate is the world of CMBS, which totals about $600 billion in total outstanding issuance, including some $400 billion of that amount in CRE conduit loans of varying descriptions, a chopped salad of commercial property exposures. The CMBS market peaked at $750 billion in 2008, then sold off down to $500 billion by the end of 2017, then began a slow climb back to present levels. New issuance flattened out at the end of 2019 and has gone sideways ever since. In the world of CMBS, the average delinquency picture continues to improve with the US economy, but with a heavy emphasis on location. Assets located in the major cities remain under severe downward price pressure due to tenant defaults and payment moratoria, but assets in suburban and rural areas are fairing better. “Delinquencies improved across all CMBS sectors but SFR-M in February,” notes asset manager TCW. “Conduit delinquencies decreased 16 basis points to 7.92%; SASB-S delinquencies decreased by 13 basis points to 1.85%; SASB-M delinquencies decreased by 343 basis points to 4.66%; Freddie loans delinquencies decreased by 5 basis points to 0.19%; SFR-S delinquencies were flat at 0.0%; SFR-M saw an increase in delinquency of 8 basis points to 2.83%.” The main worry for the future in terms of CRE and CMBS both are elevated vacancy rates, which in turn reduces income and valuations. Average vacancy rates for office buildings across the US are hovering around 20% nationally. Published statistics from landlords are taken at face value in the media, but do not factor in the amount of inventory that has been deliberately taken off the market. Landlords are trying to manage office inventories for scarcity in order to recover pricing power in many urban markets. Likewise, published retail vacancy rates nationally are around 10% and apartments are in the mid-single digits, according to the MBA. Again, location, location is what matters. While the fact of federal credit guarantees allows us to treat residential assets as homogeneous, with CRE the story is totally different. Different property types have been impacted by COVID in different ways, thus the national averages for prices and rental revenues, for example, are completely useless for an investor focused on a specific asset in a specific market. Last week, we took the photo below of the F train station on 57th & Sixth Avenue in Manhattan. What is missing? Midtown Manhattan, Thursday April 1, 2021 We expect that the changes in behavior, asset utilization rates and thus revenue due to COVID have impacted office buildings in major urban metros for years to come. If we see further contagion in US cities due to permutations of COVID now visible in Latin America and Asia, then these moribund urban assets may be permanently impaired. Long commercial lease terms hide some of the downside price effects of this change in behavior, but reports of major tenants such as JPMorganChase (NYSE:JPM) seeking to sublease large blocks of office space in New York are not a bullish indicators. Last year saw significant declines in sales volumes for most CRE assets, but industrial and multifamily assets rebounded in Q4 2020, the MBA reports. Cap rates have fallen slightly on a national basis looking at the averages gathered by the MBA and TREP, but again, it is the particular location and use of assets that tells the tale in terms of asset valuations and cap rates. In Manhattan, for example, discounts of 40-50% and other cash concessions are reported in The New York Times as signs of optimism for the residential apartment market. Observes C.J. Hughes: “From soaring condos in affluent enclaves like TriBeCa to boutique buildings on gentrifying blocks in the East Village, Manhattan is awash in price cuts.” But sadly, Manhattan is not awash in people, the key ingredient that makes the city possible in economic terms. The credit implications of large price concessions and discounts are obviously horrific and suggest many properties are, in fact, under water. Cap rates are in a free fall at the moment, though “value buyers” are reported to be coming into the market. Our view is that we still have not found the bottom in terms of valuations because the net operating income (NOI) part of the equation remains entirely speculative. Whereas Manhattan buildings traded at double digit multiples to NOI prior to COVID, today these assets are, in theory at least, in mid-single digits. Commercial assets located in legacy cities such as New York and Chicago, for example, are likely to be suffering in terms of remittances for many years to come. Thus, the NOI and thus the long-term value of the asset is questionable. While the national delinquency rate for CMBS is in mid-single digits nationally, different sectors are showing wide dispersions in asset performance and loan to value (LTV) ratios. Single asset single borrower CMBS are averaging just above 100% LTV while hotels are over 200%. Offices are far better across all CMBS vintages, but the lack of price discovery makes these numbers suspect. Kroll Bond Rating Agency , for example, noted in its March surveillance report on the nearly $300 billion in CMBS deals (roughly 50% of the market) rated by that agency’s veteran team: “The March delinquency rate held steady, at 5.9%, compared to February. “The lodging delinquency rate increased to 17.2% versus 16.7% in the previous month. However, the delinquent and specially serviced rate among lodging loans actually decreased to 21.6% from 21.9%. About 40% of the new delinquencies were listed as current but with the special servicer in the prior month. “Multifamily and office also recorded increases in their delinquency rate, to 3.3% from 2.2% and 1.5% from 1.3%, respectively. The increases were driven by a couple of larger newly delinquent New York City loans, including Yorkshire and Lexington Towers, a $400 million loan secured by a multifamily property in New York City and 3 Park Avenue, a $182 million loan secured by an office property. Both were not with the special servicer in February.” In illustration of the choppy nature of the assets that comprise the CMBS world, especially in the larger urban centers, KBRA continues: “The overall conduit delinquency rate fell 80 bps to 7.1% from 7.9% during this period. However, not all MSAs trended lower, with New York and Chicago recording the highest increase in their delinquency rates (150 bps to 9.6% and 120 bps to 12.1%, respectively). Atlanta and Miami fared better, recording the biggest improvement in their delinquency rates (240 bps to 5.5% and 180 bps to 8.7%). Further, a breakdown by property type showed two notable lodging delinquency rate changes—New York City (rising to 44% from 23.8%) and Atlanta (declining to 13.7% from 25.5%) over the six-month period .” We believe that the published statistics on REITs, bank CRE and multifamily, and CMBS understate the degree of credit impairment and ultimate loss severity in the commercial asset class. Landlords around the country and particularly in urban areas continue to put a brave face on a very serious situation where underutilized assets and falling remittances threaten to undermine NOI, valuations and private and municipal credit over the medium to long term. The sharp decline in sales of large commercial and multifamily properties in Q4 2020 speaks volumes as to the uncertainty regarding valuations. Published net absorption rates for commercial office space, to take another example, are negative but still understated because landlords are taking assets off the market entirely. In New York City, for example, we estimate that commercial absorption rates published by firms such as Cushman & Wakefield are significantly below the actual rate. The current national vacancy rate of 18% published by REIS , a 26-year high, may still be considerably understated in cities such as New York. Unless and until we start to get a better handle on NOI and thus cap rates, we think buying legacy assets in major US metros is a crap shoot at best. Residential Mortgages In stark contrast to the dire situation facing investors and landlords with CRE exposures, the credit situation facing investors in 1-4 family mortgages remains benign, almost surreal, with net loss rates for bank owned loans near zero and LGD for bank and even conventional loan exposures likewise deeply suppressed by 1) massive purchases of T-bills and RMBS by the FOMC and 2) the relative scarcity of 1-4 family homes. The chart below shows LGD for bank owned 1-4 family mortgages through December 2020. Note that like the multifamily series, we are starting to observe upward spikes now that suggest a change in direction after five years of falling loss severities for residential assets. Source: WGA LLC While the credit picture in prime 1-4s and even conventional loans owned by the GSEs are in good shape, the credit picture in government-insured assets is decidedly negative. HUD Secretary Marcia Fudge said a week ago: "Given the current FHA delinquency crisis and our duty to manage risks and the overall health of the fund, we have no near-term plans to change FHA’s mortgage insurance premium pricing. We will continue to rigorously evaluate our strategy and work transparently with Congress.” Fudge’s statement accompanied HUD’s quarterly report to Congress on the financial status of the Mutual Mortgage Insurance Fund , which noted that the rate of seriously delinquent mortgages has increased from 4% to 12% in the past year, while early payment defaults have risen from 1% to 6%. Source: MBA/FFIEC Notice that delinquency rates for bank-owned and conventional loans generally are below 2009 levels, when the US banking industry charged off over $100 billion in impaired private label mortgages. Delinquency rates for FHA loans are higher, however, suggesting that the impact of COVID on US homeowners is falling disproportionately on lower income borrowers. We suspect that a large portion of government loans will cure and get back on track, but there could still be millions of households that require some form of assistance, a loan modification or will end up in foreclosure. The immediate challenge facing the residential mortgage industry, however, comes not from credit loss but rather then sharp deceleration in mortgage lending and particularly refinance transactions since the inauguration of President Joe Biden. The negative reaction of the bond market to the fiscal program of the Biden Administration has seen with the sharp rise in benchmark bond yields. The chart below shows the latest actual quarterly survey data and projections from the MBA for residential mortgage originations. Source: MBA The sharp decline in refinance volumes projected by the MBA is a function of interest rates, while the purchase volume decline is impacted by rising rates and also affordability and home availability after several years of double-digit gains in home prices. We continue to believe that purchase and refinance volumes will out-perform the MBA’s projections, but wholesale channel buyers such as RKT, loanDepot (NYSE:LDI) and United Wholesale Mortgage (NYSE:UWM) are likely to be hurt by falling volumes. Lenders with stronger purchase businesses and established retail channels such as Caliber, Freedom, Guild Holdings (NYSE:GHLD) , and Amerihome, which is being acquired by Western Alliance Bancshares (NYSE:WAL) , are likely to benefit. In addition to our concerns over interest rates and volumes going forward in the residential loan market, the twin risks of credit and prepayments are also very much in mind, as illustrated by the Ginnie Mae issuer data shown in the table below. These are the top 25 seller/servicers operating in the government loan market. Top 25 GNMA Issuers (February 2021) Source: Ginnie Mae Note that while issuers such as Wells Fargo (NYSE:WFC) and RKT have relatively pedestrian levels of delinquency, the nonbank issuers such as Mr. Cooper (NYSE:COOP) , Lakeview and Freedom are down in the mid-80 percent range in terms of performing loans. Also, both Lakeview and PennyMac (NYSE:PMT) have loaded upon on early-buyouts (EBOs), along with COOP, WFC and U.S. Bancorp (NYSE:USB) . These EBO trades looked like home runs six months ago, but may be more like singles or strikeouts today depending on how those delinquent loans are resolved. Both with respect to COVID loans and delinquency more generally, mortgage servicers face an increasingly hostile environment in terms of the regulatory world. With radical progressives now calling the shots at the Consumer Financial Protection Bureau (CFPB) , we expect to see renewed flows of enforcement actions. The latest COVID relief legislation essentially forces lenders to play counselor and wet nurse to distressed consumers and without any compensation for their efforts. As we’ve noted in previous reports, the cash cost of resolving delinquent loans in the FHA/VA/USDA market can easily reach into tens of thousands of dollars, particularly when the CFPB is forcing loan servicers to serve as credit counselors. With the added threat of regulatory sanctions and fines, GNMA issuers face substantial risk in the weeks and months ahead as the industry works through the remaining COVID loans subject to forbearance. Funding and fixing delinquent COVID forbearance loans is a loss leader for government lenders and a significant source of financial and reputational risk for publicly owned issuers. The public attack on Ocwen Financial (NYSE:OCN) by the CFPB under Richard Cordray and state regulators in 2018 over bogus escrow account allegations is a case in point that should not be forgotten. After three years of litigation, OCN largely defeated the CFPB in court but OCN shareholders paid a terrible price in the meantime. Mortgage Servicing Rights With interest rates rising and production volumes falling, it makes sense that mortgage servicing assets are also rising in value. Large investors have already figured this out. Still, high prepayment rates are somewhat blunting the enthusiasm for this naturally occurring negative duration asset. That said, the steady rise of interest rates since last summer managed to push up the value of bank-owned MSRs for the first time since the middle of 2019. Source: FDIC Banks actually managed to return to profitability on servicing after a year of negative net servicing results. Fat gain on sale margins made up for this, however, with the industry taking down $27 billion in gain on sale for RMBS issuance in Q4 2020, according to the FDIC. If the banks could even approach the levels of efficiency of independent mortgage banks (IMBs) in the residential market, the gain on sale number could have been over $50 billion in Q4 2020. With the fair value of bank-owned MSRs now below $30 billion, this means that IMBs now control something like $60-70 billion in servicing assets. As the 10-year Treasury climbs towards 2% but short-term rates remain nailed to the floor thanks to QE, there is growing speculation that the FOMC may be forced to raise rates sooner rather than later. In the event, the improving valuation environment for MSRs is likely brighten even further. The Treasury curve is essentially flat out to 24 months and then goes up at a fairly steep rate. The change in coupon spreads suggests an expansion of MSR valuations, but then there is the question of gain-on-sale margins. The primary “asset” inside the MSR is the opportunity to refinance the loan for the consumer and thereby gain a 4-5% gain-on-sale into an RMBS. Normally it takes five years of collecting servicing fees to equal the profit from one refinance event. Remember that 2020 was one of those rare periods when lenders actually were up on cash after the close and sale of a residential mortgage loan. The RMBS spread to Treasury’s peaked last March at almost 2% and has since slowly compressed to about 75bp today. Meanwhile, prepay speeds remained high in February despite expectations of slowing. The percentage change in prepays speeds was higher in newer vintages, according to SitusAMC, but overall prepayments remain high. Thus, while investors want to put more cash to work in servicing assets, the task of picking the right entry point remains painful. As lending volumes and secondary market profit spreads revert to low and eventually no profitability, lenders will look to the MSR cash flows and refinance opportunities to make up for the cash loss on new lending. Valuations will rise and, in particular, the capitalization rate of new government MSRs will expand from the ~ 80bp/ 2.5x multiple average we saw in last quarter’s earnings. New production capitalization levels for government 3% coupons are above 3.25x and headed to 3.5x annual cash flow by the time March data is released. It will be interesting to see where public banks and IMBs mark their legacy servicing in Q1 2021 earnings compared with new issue coupons with slower prepayment speeds. Meanwhile, we continue to believe that issuers, REITs and funds with excess liquidity should be accumulating conventional servicing with both hands. GNMA servicing is a different matter entirely, but holds great value if the investor works with the right servicer. Remember, the beginning of February 2021 was probably the inflection point for interest rates for years to come. If our suspicion that the FOMC has lost control of the Treasury curve proves correct, then MSRs could be a fabulous trade for institutional investors that have the right relationships with issuers and servicers. As shrinking margins squeeze profits for lenders in 2021, the ability to recapture refinance events and retain those loans in portfolio will grow in importance.

What a difference a year makes. Twelve months ago, some of the industry’s largest independent mortgage banks (IMBs) were in danger of tipping over due to the liquidity wave unleashed by the Federal Open Market Committee in response to COVID. We hear that a federal rescue nearly occurred for several IMBs a year ago. These same firms are flush after a year of feasting on record lending volumes, but today face a labyrinth of risk in resolving delinquent loans now under the protection of the CARES Act and state lending moratoria. While the number of loans in forbearance is dropping fast, by the summer there will still be many hundreds of thousands of loans that have not exited successfully and will likely go to modification or foreclosure. How these loans are resolved is crucially important to both consumers and the investors that hold the paper on these mortgages. Given that IMBs now service two-thirds of all 1-4 family residential mortgage loans, the risk to the nonbanks from COVID is significant and growing. Note in the chart below that the flight of commercial banks from owning and servicing 1-4 family loans continues unabated, a trend due entirely to Dodd Frank, Basle III and regulation of mortgage lending. Note particularly the huge decline in servicing assets under management (AUM) for banks in Q3 2020 due to loan prepayments. The IMBs captured these loan refinance events. Source: MBA/FFIEC Few policymakers in Washington understand that the mortgage servicer acts on behalf of the note holder and is legally bound by the investor’s rules and contractual provisions. The CARES Act represents an illegal intrusion into that private contractual relationship, part of a larger attack on private contracts and business that is a core strategy of the progressive political agenda. The losses incurred by bank and nonbank servicers as a result of the CARES Act and state forbearance laws arguably represent an unconstitutional taking from these private companies and their owners. Members of Congress and state officials need to appreciate that without investors and the loan servicers who represent their interests, there is no housing finance market. The cavalier imposition of loan forbearance laws via the CARES Act, no matter how well justified in terms of compassion and immediate human need, has an enormous cost that has largely been ignored by elected officials. Last year the Federal Housing Finance Agency under Director Mark Calabria decided to subsidize part of this cost of dealing with COVID for the GSEs by imposing an “adverse market” fee on new mortgage refinance loans. This policy implemented by FHFA is an overt and decidedly progressive transfer of value from stronger borrowers to the weak. As refinance volumes fall, however, this relatively painless fix is disappearing along with the revenue and liquidity float that enabled the industry to deal with COVID in 2020. Source: MBA Private mortgage servicers, however, have been left hanging by consumer-fixated progressive politicians in Washington and around the nation. Progressives effectively expect IMBs and banks to spend part or all of their income from record lending volumes in 2020 to help consumers. Politicians are largely oblivious to the longer-term consequences to the markets and the US economy of their false generosity. In legal terms, bank and nonbank mortgage servicers must follow the credit waterfall defined by the investor in the Fannie Mae, Freddie Mac or Ginnie Mae security. In finance, under a waterfall payment scheme in a typical private mortgage security, senior lenders receive principal and interest payments from a borrower first, and subordinate lenders receive principal and interest payments after the seniors are paid in full. In agency and government mortgage-backed securities (MBS), all of the investors are treated equally in terms of allocations of principal, interest and, most important, expenses. In representing the investor in MBS, mortgage servicers face a conflicting maze of private contractual requirements, agency rules and CARES Act and state laws. For example, even if a delinquent borrower qualifies for a program higher up on the credit waterfall in terms of losses to investors, servicers often do not have an option to offer a program – even if it may be in the consumer’s best interest long term (i.e, a partial claim vs loan modification). Servicers are required to review a borrower’s eligibility for programs set forth by the investor and insurer of the loan (Fannie Mae, Freddie Mac or the FHA). In instances where the borrower does not qualify for federally mandated investor/insurer programs, servicers may still be required to offer them a permanent solution required under state law. Every servicer must prepare their servicing executives and systems for all of these potential scenarios. Many states have enacted legislation that requires a mortgage servicer to offer a forbearance program to the delinquent borrower if they do not otherwise qualify for relief. Servicers are forced to comply with state law and offer the program, even if the program conflicts with the contractual duty to the note holder and/or the rules set forth by the federal agency that insures the loan. States such as Massachusetts, for example, have created a template that now competes with the FHA, the GSEs, VA and USDA. All have different programs and normative templates for offering relief. The timing of the end of forbearance and foreclosure relief is crucial for servicers, both in terms of helping consumers and protecting themselves from a myriad of risks. By no coincidence, many lenders now refuse to do business in states such as Massachusetts and New York. For example, what is the current timeline (under existing relief measures and agency guidance) for borrowers to begin rolling off of CARES Act forbearance and/or foreclosure moratoria? Do servicers have obligations to the borrower, for example, ahead of the expiration of forbearance relief in terms of notices or communication? Questions: If the servicer gets these steps for dealing with COVID forbearance loans wrong, could they face loan repurchase demands from the GSEs or a refusal to honor insurance claims from the FHA? A: Yes. If the servicer gets these steps wrong, will they face state sanctions? A: Yes. The GSEs specifically require servicers to contact a borrower in forbearance 30 days before the program ends, but the loan insurers require such a contact “prior to the end of forbearance or at the end of forbearance.” Which timeline should the servicer follow? All of the above. As the largest cohort of delinquent customers begin rolling off forbearance in Q2 2021, twelve months after the majority of the customer base of banks and IMBs requested debt relief, servicers will face the challenge of managing multiple channels for dealing with distressed consumers. Extensions will help spread the timing of the of end of consumer forbearance, but this also means that an even larger portion of the population will now exit between Q2 and Q3 of 2021. Indeed, the many possible borrower scenarios must be scripted by the servicer, which in turn must roll out training, compliance and IT support for all of these permutations of borrower distress. Keep in mind that servicers are debt collectors working for the investors (and, indirectly, the US government as guarantor of the MBS), not credit counselors or social workers trained to advise troubled debtors. When Congress asks servicers to play babysitter to delinquent borrowers, they unilaterally impose the operational and compliance cost of this task upon the mortgage industry and do so without compensation or apology. As Director Calabria said to Congress last September, if you don’t like the adverse market fee, then pay for the CARES Act. Members of Congress did not respond to Calabria’s challenge. As the federal and state forbearance periods end, the industry will get hit from all sides by operational and political hazards caused by the political act of debt moratoria. If foreclosure moratoriums last longer than loan payment forbearance, for example, servicers will struggle to meet investor timelines & state law regulations. Who are the issuers affected by these uncertainties? See below. We currently own Annaly (NYSE:NLY), of note. The IRA Premium Service Mortgage Group: ACGL, AGNC, AI, BKI, BXMT, CIM, CLGX, COOP, ESNT, FAF, FBC, FMCC, FNF, FNMA, IMH, LADR, MFA, NLY, NRZ, NYMT, OCN, PFSI, PMT, RKT, RWT, STWD, TWO, UWM, WAL Servicers will blow through contractual obligations to investors and guarantors because of the conflicting requirements of the CARES Act and state law moratoria. Further, because of the vast disruption to the legal community caused by loan forbearance in 2020, servicers, attorneys, custodians and courts will not be able to handle the surge in foreclosure caseload. Delays and errors will result in operational issues and consumer confusion and anger – all because nobody in Washington bothered to ask what debt relief under the CARES Act and state law moratoria would really cost. After a year of minimal foreclosure volumes, law firms will be unable to execute according to investor and insurer timelines. Between one third and half of law firm staff related to foreclosures were furloughed during the past year, according to some estimates. It will be difficult for foreclosure firms to ramp up in advance of the moratorium end date, especially since nobody in Congress or the states seems to know when that will be precisely. Court backlogs and delays will extend the foreclosure timelines, creating increased costs to investors, insurers and servicers. The debt collection part of a mortgage servicer’s business will suddenly be taken from zero to 100% capacity and more. A lack of orderly wind down from foreclosure moratoria could flood the market with housing stock, result in abandoned properties and neighborhood blight, something that has not been seen since the great financial crisis of 2008. What can be done to improve this situation and speed the resolution of COVID forbearance loans that do not get back on track? First, the FHFA and FHA should eliminate trial modifications for all payment forbearance and foreclosure programs for conventional and government loans. Most of these trial modifications do not succeed with profoundly troubled borrowers and add complexity to the process. Second, enable and empower the mortgage servicers to provide the customer up front with all options available to them and allow the consumer to choose what's best for their circumstance . By putting aside the idea of trial modifications and instead immediately acting in the best interest of the consumer, the interests of the note holder and guarantor will often be best served as well. That is, 1) protect the home and 2) act to maximize the net present value of the note. The proposal to embrace a national policy for streamline refinance may seem obvious, but there remains a lot of resistance to embracing a broad national refinance strategy instead of loan modifications because large MBS investors dislike prepayments. As we’ve noted previously in The Institutional Risk Analyst , the effective yield on MBS is currently negative due to high rates of prepayments (" Negative Returns are Now In US Mortgages "). If you pay 104 for the MBS thanks to QE from Fed Chairman Jay Powell and the FOMC and get prepays at par, then you are losing money. All investors and insurers should mirror the FHA in opening up COVID streamline options regardless of delinquency status. By refinancing all agency and government loans down to current market rates, mortgage industry can enhance the credit of the entire national portfolio and save some, but not all, borrowers from foreclosure. Ultimately it is the bond holders that are picking up the cost of COVID c/o the FOMC, but we think the folks at PIMCO, Black Rock ( NYSE:BLK ) and the Bank of China can fend for themselves. By kicking the can down the road, we at least buy time for the borrower and also allow the servicers to generate more revenue by re-pooling the new loan into a new MBS. More than anything else, simplifying how we deal with COVID forbearance loans will save IMBs and the entire mortgage industry, including MBS investors, time and heartache in terms of risk and litigation. Of course, progressives will never agree to such a streamline refinance strategy, no matter how good it may be for consumers, because members of the trial bar are one of the main sources of political contributions to the Democratic Party. Yet unless we simplify and focus the role of the servicer when it comes to COVID loans on serving the best interests of investors and consumers both, IMBs and global investors may soon follow the example of commercial banks in fleeing the world of mortgage finance. Again, without IMBs and large bond investors, there is no US housing market.

March 25, 2021 | In this edition of the premium service of The Institutional Risk Analyst , we set up bank earnings for Q1 2021. Despite all of the heavy breathing coming from the endless parade of constructive Buy Side managers on financial media, bank equity market valuations are still lower today than the levels seen this time last year, as shown in the chart below. Source: Yahoo Part of the reason for this irrational exuberance from Buy Side managers is that there are not a lot of alternatives to large cap financials. Just as American consumers are faced with an increasing scarcity of housing assets, investment managers are left to pick among the leftovers in the world of value-based equity finance. Large banks may be big in terms of market capitalization, but are equally constrained in terms of forward earnings potential. As we noted in the most recent edition of The IRA Bank Book , Q1 2021 will be a good quarter for bank earnings because of the prospect of significant loan loss reserve releases back into income. Take JPMorgan (NYSE:JPM) , for example, which had $28 billion in loan loss reserves at the end of 2020 vs $13 billion at the end of 2019. Half of this amount could arguably be released into income during 2021. The timing and magnitude of the loss reserve releases, of course, will depend crucially upon the preferences of regulators and auditors. With charge-offs unchanged from the previous four quarters, we estimate that the Federal Reserve Board and other prudential regulations will slowly allow JPM to recapture billions per quarter during 2021 – at least as long as credit loss rates remain muted. The chart below shows net charge-off rates for the top five US commercial banks as a percentage of average assets. Source: FFIEC As you can see, net loss rates have risen for U.S. Bancorp (NYSE:USB) while the rest of the group and Peer Group 1 have declined since Q2 2020. We have learned over the years that USB marches to its own drummer when it comes to the timing of loss recognition, suggesting to us that the bank may have been cleaning house ahead of further COVID credit losses this year. When you have strong capital and income, you have the luxury of being proactive on credit. But as you can see in the chart below, USB is suffering compression on gross loan spreads just like the rest of the industry. Notice too that Citigroup (NYSE:C) actually saw loss rates decline in Q4 2020, this from the most subprime consumer portfolio in the top ten. Citi routinely has over 100 basis points of net default from its subprime credit card and unsecured consumer portfolios, which have a gross spread in the mid-teens. Most of Citi’s asset peers, by comparison, have credit card portfolios with a gross spread of 500bp or one third of the gross spread of Citi. Totally different businesses. Indeed, Citi looks more like a finance company than a commercial bank, a legacy of acquisitions long ago. Source: FFIEC Despite the strong downward pressure on asset returns, the top five banks are still managing to report modest earnings, though again far below the levels of a year ago. A big part of helping banks maintain some degree of profitability was falling funding costs, which are now down to an average of just 41bp for all of Peer Group 1. Note in the chart below that Bank of America (NYSE:BAC) has the lowest cost of funds of the group but also has some of the worst asset returns, resulting in an overall mediocre performance. Source: FFIEC The net, net of falling funding costs, weak loan growth and soft pricing for large commercial and industrial (C&I) loans is weak income. US banks are running at income levels that are less than half of a year ago. The reserves being released back into earnings were earned a year or more back, thus the prospective visibility on future earnings is not very good. The chart below shows the earnings for the top five commercial banks through year-end 2020 as a percentage of average assets. Source: FFIEC Looking at the group, both BAC and Wells Fargo & Co (NYSE:WFC) are trailing the average for Peer Group 1, which is dominated by smaller, better performing banks. Smaller banks tend to have better loan pricing and asset returns than their larger peers. JPM and USB, the traditional exemplars among the top five banks, are running above the Peer Group 1 average. The weak and idiosyncratic performance of WFC has to do with the continuing management turmoil in the wake of the banks breakdown in internal systems and controls with the fake account scandal. The banking business at WFC remains sound, but the situation in the CSUITE continues to hurt the bank’s bottom line. The past several quarters earnings for WFC have been so bad that you could justify dropping the bank from the top-five for analytical purposes. The situation at BAC, however, is more serious because it illustrates the culture of mediocrity that has prevailed at the bank for more than a decade under CEO Brian Moynihan . Even after years of restructuring, avoiding risk and killing profitable business lines, Moynihan managed to report a capital loss of $2.4 billion in 2020 related to an accounting restatement. The destruction of shareholder value at BAC is monumental and ongoing. During the Q4 2020 conference call, BAC noted that consumer loan defaults in credit cards are likely to rise in Q1 2021 and fall thereafter, the result of COVID deferred loans working their way through the system. Other banks are reporting similar observations, suggesting that whatever “wave” of consumer credit defaults related to COVID is now working through the system could be largely complete by Q2 2021. Earnings Outlook Looking at bank earnings for Q1 2021, there are two primary considerations for investors. First, quarterly bank dividends are somewhat constrained, as shown in the table below showing year-end 2020 data, yet most banks have maintained payouts to investors. Source: FFIEC Citi and BAC have seen significant improvements in dividends declared by the parent bank holding company, while WFC has suffered as a result of managerial and operational issues. But none of the peers of JPM can compete with the magnitude and consistency of the House of Morgan when it comes to returning cash to investors. Notice that BAC’s balance sheet is 80% of the size of JPM and produces barely more than half the dividend income. The mediocrity of the House of Moynihan is manifest, yet not a soul on the Sell Side says a word about a management change at BAC. This bank is dead money for investors, IOHO, until we see changes in the CSUITE and board of directors of BAC. The table below shows share repurchases by the top five banks as reported to the FFIEC. Again, JPM is the clear leader in returning cash to investors. Notice that WFC used to be even with JPM in terms of share repurchases, but today is running around half of the House of Morgan. Overall, share repurchase have been more constrained than dividends. Source: FFIEC None of our friends and colleagues in the world of equity managers can accept that most of the top-five banks have negative revenue growth rates for 2021, an inconvenient fact in a world that must already justify diminished cash-to-me returns from banks. The Street consensus has revenue for USB down single digits, for example, but earnings up of course. BAC is shown with a 1% revenue decline in 2021, this after an estimated 7% decline in Q1 2021 according to the Street consensus. Earnings are seen at $1.90 per share in 2021 and, almost magically, rise to $2.50 in 2022. Somehow, some way, Sell Side analysts always manage to contrive estimates for higher revenue in the out years to justify today's stock recommendation. The Street has the House of Morgan shrinking revenue this year, perhaps as CEO Jamie Dimon also follows through with his threat to shrink assets by driving large deposits out the bank with rising fees. Negative interest rates are a reality in the US as money centers like JPM and WFC start to impose punitive fees on large depositors. Not only has the Federal Reserve Board ended the special dispensation for banks with respect to capital measured via the simple leverage ratio (SLR), but we expect that the Federal Deposit Insurance Corporation will also end dispensation for banks with respect to deposit insurance premia. Net, net, we expect to see US banks getting smaller in 2021 as they attempt to shed or avoid the FOMC’s creation of bank reserves. Remember, as money flows out of the Treasury General Account at the Fed with new stimulus spending authorized by Congress, the money becomes a bank deposit, swelling the size of US banks further. For this reason, we remain very bearish about asset returns for US banks as the FOMC continues its massive asset purchases under quantitative easing (QE). We expect returns on earning assets for US banks to fall another 5-10bp over the next four quarters to the lowest levels in half a century. Source: WGA LLC The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. 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